Business Law and Strategy

2nd Edition
by Sean Melvin

Complete Chapter Solutions Manual

are included (Ch 1 to 50)

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 Chapter 1
Legal Foundations and Thinking Strategically

CHAPTER OVERVIEW
This chapter discusses important touchstones for understanding the legal process and identifying
legal issues that arise in the business environment.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Articulate a working definition of law and explain its origins. Knowledge
Categorize various laws and articulate the functions of law and legal systems. Application
Explain the importance and benefits of legal awareness for business owners Application
and managers in creating strategy and adding value to a company and the role
of counsel in decision making.
Differentiate between and provide examples of primary and secondary Analytical
sources of American law. Thinking
Apply the legal doctrine of stare decisis in a business context. Application

Teaching Tip: Manageable Material

Students are often overwhelmed with their first introduction to law. It is important to cover the
material in manageable amounts and use lots of examples, both real and hypothetical.

I. INTRODUCTION TO LAW [p. 3]

Points to emphasize:
• Law is a body of rules of action or conduct prescribed by controlling authority and
having legal binding force. (Black’s Law Dictionary)
• Law may be set down in written code or take the form of judicial decisions and actions of
government agencies.
• The common characteristic of state law is that it creates duties, obligations, and rights
that reflect accepted views of a given society.
• Important to business, the law provides a mechanism to resolve disputes arising from
duties and rights and allows parties to enforce promises in a court of law.

II. CATEGORIES OF LAW [p. 3]

Points to emphasize:
• It is helpful to breakdown law into broad categories based on classifications to a
particular function or a right afforded by law.

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 • Table 1.1 sets out the various categories of law and provides examples.

• These categories are not mutually exclusive. For example, a person who punches another
person in the face has committed both a criminal act (the crime of assault and battery)
and a civil wrong (the tort of assault and battery).

A. Language of the Law [p. 4]

Points to emphasize:
• It is vital that business students have a basic understanding of legal terminology that
might be used in a business context in their future careers.
• Black’s Law Dictionary is the authoritative source for legal terms.

B. Functions of Law [p. 4]

Points to emphasize:
• Law provides for a system of order that defines rules of conduct and levies punishment
for violation of those rules.
• One purpose of law is to ensure consistency and fairness and to promote equality and
justice in society.
• Another purpose of law is to create a system for resolving disputes by providing a basis
for deciding the legal interest and rights of the parties.
• In business, law serves as an important catalyst for commerce by promoting good faith
dealing amount merchants and consumers and giving some degree of reliability for
business planning and commercial transactions.

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III. LAW IN CONTEXT: BUSINESS AND STRATEGY [p. 5]
Points to emphasize:
• The first step to learning how legal decisions should be made in a business context is to
develop legal insight by understanding the fundamentals of legal theory and how they
may impact business.
• The second step is learning to apply legal theories in practice and recognizing that having
legal awareness may present opportunities for proactive business planning. This
awareness may empower business owners and managers to limit liability, gain a
competitive edge, and add value to the business.
• Managers who work cooperatively with attorneys make better business decisions.

A. Business Swimming in a Sea of Law: Defining Strategy [p. 5]

Points to emphasize:
According to Harvard Business professor Constance Bagley, “business is swimming is a sea of
law.” Consider the following current regulatory trends:
• Navigating increased U.S. and foreign regulation (e.g., regulation of financial markets,
European Union (EU) regulation of antitrust and consumer privacy).
• Varying international regimes in trade and intellectual property (e.g., World Intellectual
Property Organization versus developing nations).
• Stiffer penalties for noncompliance (e.g. Amazon was recently fined US$887 million by
an EU privacy regulator for violations related to its advertising policies).
• Increased officer and director liability (e.g., liability for data breaches and ransomware
attacks).
• Substantial increase in attorney-directors for U.S.-based corporate boards.
• Changing legal landscape (e.g., uncertainty surrounding use of Covid-19 related waivers
and workplace rules).

B. Using Strategy in Legal Decisions [p. 6]

Points to emphasize:
• A strategy refers to a set of guide posts created to achieve an overall objective.
• The legal environment is full of uncertainty regarding the level of compliance and the
level of enforcement.
• Business leaders often pursue legal strategies such as (1) noncompliance, (2) avoidance,
(3) prevention, and (4) value creation or legal competitive advantage.
• Business owners and executives deploy tactics to achieve the objectives as part of the
strategy.

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 C. Role of Counsel [p. 6-7]
Points to emphasize:
• Business owners and managers should work with counsel to increase business
opportunities, reduce costs, and limit risk and liability.
• In-house counsel refers to counsel that is part of the executive or midlevel management
team in a business.
• General counsel, who are in-house counsel, may also serve a secretary (corporate officer)
who is responsible for record keeping and complying with notice and voting requirements
of the board of directors.
• Business lawyers or corporate lawyers devote their time to advising businesses on issues
such as formation, governance, labor and employment laws, regulatory agency
compliance, legal transactions, intellectual property, and other legal issues important to
business operations.

IV. PRIMARY SOURCES AND LEVELS OF AMERICAN LAW [p. 7]

Points to emphasize:
• Much of American law is derived from English legal doctrines.
• Modern law is generally a combination of constitutional law, statutory law, common law,
and administrative law at the federal, state, and local levels. These sources of law are
known as primary sources of law.
• Managers who work cooperatively with attorneys make better business decisions.

A. Constitutional Law [p. 7-8]

Points to emphasize:
• Constitution law is the foundation for all other law in the United States and is the
supreme law of the land.
• It functions with other laws to (1) establish a structure for the federal and state
governments and set rules for amending the constitution; (2) grant specific powers for the
different branches of government; and (3) provide procedural protections for U.S.
citizens from wrongful government actions.
• Constitutional law includes permanence (basic principles of society and rarely amended)
and preemption (constitutional law is supreme over other sources of law).

Case 1.1 Kelo et al. v. City of New London, Connecticut, et al.

Facts: New London had experienced decades of economic decline. State and local officials
targeted New London for economic revitalization. The New London Development Corporation
(NLDC), a private nonprofit entity, was established to assist the city with economic
development. The NLDC’s development plan aimed to leverage Pfizer’s relocation to New
London and create new hotels, restaurants, and shopping. The city council authorized NLDC to
acquire property by exercising eminent domain in the city’s name. Kelo and a few other holdouts

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refused to negotiate with NLDC and brought action in the New Long Superior Court claiming
the taking of their property would violate the Fifth Amendment of the U.S. Constitution, which
states: “[N]or shall private property be taken for public use, without just compensation.” The
case ultimately made it to the U.S. Supreme Court.

Opinion: The U.S. Supreme Court allowed the NLDC to take Kelo’s property in exchange for
just compensation. The Court stated that public use encompasses public purposes to
accommodate changing social needs such as economic revitalization.

Case Questions

1. Is it ethical to place a city redevelopment project on hold by behaving strategically as a real

estate holdout? Note that Kelp’s house was initially appraised at $78,000 and after five years of
litigation the City paid her $442,000 as just compensation for taking her property.
• Support for Kelo’s position was strong. Does this imply that NLDC’s economic
revitalization plan is not what the majority of society wanted? If so, doesn’t current
public opinion determine what is ethical or not ethical?

2. What competing interests is the court trying to balance in this case? Did the Court strike the
right balance? Explain.
• The Supreme Court was trying to balance the property rights of the individuals with the
city’s right to combat the spread of economic blight. Some argue that the Court did strike
the right balance by allowing the city to use eminent domain to stop the spread of the
blight while giving just compensation to the individual. However, this view is not
universally shared. As a response to this case, over 30 states passed or considered passing
legislation to offer further protection of an individual’s property rights.

3. Focus on Critical Thinking: Could an alternative solution have been reached in this case?
• The Court could have ruled in favor of the individuals instead of the city. If the Court
held that the plan to revitalize the city was not clear. This outcome would allow public
condemnation of property if there was a clear plan on how to use the land. Also, the
Court could have ruled that the “public use” argument in this case was just a pretext. The
“use” really benefits Pzifer and not the public.

B. Statutory Law [p. 9]

Points to emphasize:
• Statutory law is created by a legislative body; the U.S. Congress is the exclusive
legislative body for the passage of federal law.
• A bill is a draft or a proposed federal statute that Congress has not yet passed or the
executive has not yet approved.
• At the federal level, the president may sign a bill into law or veto it. Congress can
override the veto with two-thirds majority vote.
• At the state level, the governor has the authority to sign a state bill into law.

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 • Statutes at local levels are called ordinances and generally regulate issues such as zoning
or impose health and safety regulations.

Case 1.2 United States v. Ulbricht, 31 F. Supp. 3d 540 (S.D.N.Y. 2014)

Facts: A grand jury indicted Robert Ulbricht (Ulbricht) for conspiracy to launder money
obtained from illegal activities. Prosecutors alleged, among other things, that Ulbricht was
engaged in money laundering conspiracies by designing, launching, and administering a website
called Silk Road as an online marketplace for illicit goods and services. It operated much like
eBay. Ulbricht would receive a portion of the seller’s revenue as commission. He allowed
payment only via bitcoin, an anonymous and untraceable form of digital currency.
Ulbricht filed a motion to dismiss arguing partly that he could not be guilty of money
laundering because the use of bitcoins did not fit into the statute’s requirement that money
laundered be a result of a “financial transaction.” Because the IRS treats bitcoins at property,
transactions involving bitcoins cannot form the basis for a money laundering conspiracy.

Opinion: The U.S. District Court ruled against Ulbricht. The court noted that bitcoins carry
value and act as a medium of exchange; thus, they fall into the meaning of financial transaction
in the money laundering statute.
Case Questions

1. Why did Ulbricht point out that the IRS treats bitcoins at property?
• Ulbricht was trying to argue that bitcoins are property and not currency. As such, he
argued that he could not be guilty of money laundering if he did not use currency in his
transactions.

2. Does that fact that Ulbricht created Silk Road have any bearing on the court’s decision?

• Yes, the money laundering was conducted through Silk Road and Ulbricht was getting a
commission from the transactions on Silk Road. Ownership and control can be used to
connect Ulbricht to the money laundering scheme.

3. Focus on Critical Thinking: Is the court interpreting the statute or filling in a gap that exists in
a statute? If Congress had wanted to include digital currency in its definition of financial
transactions, why didn’t it do so by naming it specifically in the statute or in an amendment
to the law? Did the court overreach in this case by trying to decipher the intent of Congress?
• The court interpreted the intent of Congress in passing the statute. Bitcoin was not around
when the statute was passed and Congress has not yet passed a bill to clarify this issue.
Given that Congress has not responded, the court did not overreach in this case. Congress
may feel there is no need to clarify given the courts’ correct interpretation of the intent of
the statute.

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 C. Administrative Law [p. 11]
Points to emphasize:
• Administrative law is the source of law that authorizes the exercise of authority by the
executive branch agencies and independent government agencies.
• Federal administrative law is largely authorized by statutes and the Constitution, and
rules for applying the law are articulated and carried out by administrative agencies.
• Administrative agencies are empowered to administer the details of federal statutes and
have broad powers to impose regulations, make policy, and enforce the law in their
designated area of jurisdiction.

D. Common Law [p. 11]

Points to emphasize:
• Common law is essentially law made by the courts. It is composed of principles of law
based on a just resolution of disputes between parties, which also set a specific standard
for other courts to follow when the same dispute arises again.
• Precedent is when courts apply the law of a previous case to current cases with similar
facts.

E. Law versus Equity [p. 12]

Points to emphasize:
• The terms law and equity are used to describe the appropriate measure of judicial action
intended to compensate an injured party in a civil lawsuit; these measures are known as
remedies.
• Remedies at law generally take the form of money damages.

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 • Equitable relief is in a form other than money, such an injunction and specific
performance.
• Case 1.3 addresses whether an equitable remedy is appropriate in a breach of contract
case.
Case 1.3 Wilcox Investment, L.P. v. Brad Wooley Auctioneers, Inc. et al., 454 S.W.3d 792
(Ark. Ct. App. 2015)

Facts: Wilcox Investment Limited Partnership (Wilcox) entered into a contract with Brad
Wooley Auctioneers, Inc. (Auctioneers) to market and sell by auction 333 acres of real property
owned by Wilcox in Arkansas. Shollmier was declared the highest bidder with a bid of $235,000.
Wilcox refused to complete the sale because the property was appraised in excess of $950,000.
Shollmier sued for specific performance.

Opinion: The Court of Appeals of Arkansas affirmed the jury’s verdict in favor of Shollmier.
The court held that there was no evidence of collusion between Shollmier and Auctioneers and
rejected the Wilcox’s argument that the auction contract was void. Specific performance was
awarded to Shollmier.

Case Questions

1. Why wasn’t money an adequate remedy in this case?

• Property is considered unique. Money is not an adequate remedy because it cannot be
used to buy an exact piece of property. It will not make the injured party whole. Further,
Shollmier had not actually paid any money yet.

2. What does Wilcox mean when he alleges that Shollmier engaged in collusion?
• Wilcox alleges that Shollmier engaged in collusion with the auctioneers to get the
property at a discounted rate. The jury found no evidence of collusion.

3. Focus on Critical Thinking: How would Wilcox have prevented the property from being sold
below the appraised price at auction?
• Wilcox should have required the auction to have a reserve price; in other words, the sale
would not be completed if the bid was below a given amount.

F. Secondary Sources of Law [p. 13]

Point to emphasis:
• Secondary sources of law have no independent authority or legally binding effect but are
used frequently to assist courts when interpreting statutory or applying judicially created
law.
• In the business context, the most important secondary sources of law are (1) Restatements
of Law, a collection of uniform legal principles focused in a particular area of state law,
and (2) various sets of model state statutes.

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 • The purpose of law is to increase the level of uniformity and fairness across courts in all
50 states.
• State legislatures and courts are free to adopt all, adopt part of, or reject secondary
sources of law.

V. STARE DECISIS AND PRECEDENT [p. 14]

Points to emphasis:
• The doctrine of stare decisis, is the principle that similar cases with similar facts and
issues should have the same judicial outcome. It requires all lower courts to follow the
case precedent.
• Once an appellate court has decided a particular case, the decision becomes a case
precedent.
• On a case-by-case basis, courts may depart from precedent on the basis that technological
or societal changes render a particular precedent unworkable.

Teaching Tip: Stare Decisis

Explain to students the pros and cons of stare decisis. It allows individuals and businesses to
have some degree of confidence on how a court will rule if a case has similar facts, but it does
not allow for evolving societal standards of behavior or expectations.

Case 1.4 Flagiello v. Pennsylvania Hospital, 208 A.2d 193 (Pa. 1965)

Facts: Flagiello, a patient at Pennsylvania Hospital (“the Hospital”), sued the Hospital claiming
it was negligent in maintaining certain conditions on hospital property that resulted in her
injuring her ankle. The state trial court dismissed the suit because established common law
clearly exempted charitable institutions, such as the Hospital, from any liability related to its
negligence (called the charitable immunity doctrine). Flagiel
lo appealed claiming the doctrine was outdated and she was a paying customer.

Opinion: The Pennsylvania Supreme Court ruled in favor of Flagiello. The court acknowledged
the importance of stare decisis but also stated out the doctrine was not intended to apply when
societal norms dictate otherwise. Many states had abandoned the charitable immunity doctrine as
it was no longer necessary, and that public benefit and fairness demanded that injured parties
who are entitled to recover for their losses be allowed to purse a negligence action against a
charitable institution.

Case 1.4 South Dakota v. Wayfair, Inc. 138 S. Ct. 2080 (2018)

Facts: South Dakota taxes the retail sales of goods and services in the state and sellers are
required to collect and remit the tax to the state, if they do not then in-state consumers are
responsible for paying. Wayfair and other top online retailers with no employees in South

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Dakota did not collect the state’s sales tax. South Dakota sought a declaration that the South
Dakota law was valid and applicable to Wayfair, and Wayfair sought summary judgment arguing
that the law was unconstitutional.

Opinion: The South Dakota trial court granted Wayfair’s motion based on controlling precedent.
The state supreme court affirmed. South Dakota appealed to the U.S. Supreme Court. The U.S.
Supreme Court reversed and ruled in favor of South Dakota because the “physical presence” rule
created in the Quill precedent case was no out of date due to advances in the cyberspace
marketplace.

Case Questions

1. What is the “physical presence” test?

• Taxation of retail sales of goods and services for those businesses with a physical
presence in a particular state

2. Why did the Clourt overrule Quill and National Bellas Hess?
• The Court held that the physical presence rule was no longer workable due to the
advances in the cyberspace marketplace. Out-of-state sellers had an advantage over in-
state sellers with the Quill case
3. Focus on Critical Thinking: What other areas of the law might be affected by technology in
the future?
• This question is intended to spur discussion on areas of law such as intellectual property,
jurisdiction of courts over disputes, and health law.

1. If Flagiello had been a burglar who was breaking into the medical supply cabinet instead of a
patient when she injured her ankle, would the court have been willing to abandon the charitable
immunity doctrine? Why or why not?
• If Flagiello had been a thief, the court probably would not have abandoned the charitable
immunity doctrine. Fairness and public benefit would not demand that a burglar be
entitled to recover.

2. Do you agree with Flagiello’s argument that the hospital should not have immunity from
liability because she was a paying patient? Should standards of care be based on a patient’s
financial resources?
• Paying or not paying should not alter the standard of care. Defining a workable scale on
which patient could recover or not recover would be untenable.

3. Focus on Critical Thinking: Does this case mean that stare decisis may be discarded whenever
a judge perceives that following precedent will “shipwreck justice”?
• Students should consider the pros and cons of stare decisis. Stare decisis does create
consistency; however, society and technology change over time. A court should be able

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 to go discard stare decisis if the common law is no longer viable. Just as Congress can
amend laws, the courts can amend common law if necessary.

VI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 19-20]

Chapter Review Questions [p. 22-23] Note: Answers and explanations are provided at the
very end of the chapter.
Thinking Strategically Questions and Answers [p. 17-19]

1. In your view, is the noncompliance strategy always ethical?

• It is important to understand that strategy is a broad-based concept that identifies actions

taken by companies to advance their interest. It is equally important to identify strategies
that are not ethical and/or legal. It also provides a springboard for a discussion on the
social contract—do corporations have an obligation to abide by certain norms and rules?
(covered in detail in Ch. 2).

2. From an ethical perspective, what do you think of Pfizer’s tax inversion strategy?

• This question allows instructors to begin a discussion on two important questions: Are
actions that are legal also ethical? Are all actions that are ethical also legal? This includes
how and when can civil disobedience be justified. This may also be a springboard for the
notion of corporate social responsibility (covered in detail in Ch. 2).

3. Do you use Facebook, Twitter, Instagram, or some other social networking site? Look up the
“terms of use” of one of the websites and try to find at least one disclaimer or other limitation of
liability clause.

• This is an opportunity to introduce the concept of disclaimers and warranties. Here is the
relevant paragraph from Twitter’s Terms of Use:

4. Disclaimers and Limitations of Liability

The Services are Available "AS-IS"

Your access to and use of the Services or any Content are at your own risk. You understand and
agree that the Services are provided to you on an “AS IS” and “AS AVAILABLE” basis. The
“Twitter Entities” refers to Twitter, its parents, affiliates, related companies, officers, directors,
employees, agents, representatives, partners, and licensors. Without limiting the foregoing, to
the maximum extent permitted under applicable law, THE TWITTER ENTITIES DISCLAIM ALL
WARRANTIES AND CONDITIONS, WHETHER EXPRESS OR IMPLIED, OF
MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE, OR NON-INFRINGEMENT.

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The Twitter Entities make no warranty or representation and disclaim all responsibility and
liability for: (i) the completeness, accuracy, availability, timeliness, security or reliability of the
Services or any Content; (ii) any harm to your computer system, loss of data, or other harm that
results from your access to or use of the Services or any Content; (iii) the deletion of, or the
failure to store or to transmit, any Content and other communications maintained by the
Services; and (iv) whether the Services will meet your requirements or be available on an
uninterrupted, secure, or error-free basis. No advice or information, whether oral or written,
obtained from the Twitter Entities or through the Services, will create any warranty or
representation not expressly made herein.

5. Have you ever created any form of intellectual property? What was it? Did you create it on
your own, or is there a possibility that someone else has rights to it as well?

• Students sometimes have good answers to this based on experience in an internship or

summer job (work for hire). It is important to realize the difference between creating IP
for someone else d owning it yourself. They can also be made to realize that even their
notes for this course are a form of intellectual property (copyright).

Case Summary Questions and Answers [p. 20-21]

CASE SUMMARY 1.1 U.S. v. Alvarez, 567 U.S. 709 (2012)

1. In what ways does this case illustrate the concepts of constitutional permanence and
preemption?

• Permanence: The First Amendment is basic reflection of American principles of freedom

of speech and a restriction of government’s attempts to regulate political speech.
Preemption: The Constitution is the supreme law of the land and federal statutes that
conflict with the First Amendment are void.

2. Is the link between the statute and the government’s interest enough to satisfy any
constitutional scrutiny? Why or why not?

• The Court held that statute (criminalizing a false statement about the Medal Honor) and
the government’s interest (protecting the integrity of the Medal of Honor) were sufficient,
but the First Amendment prohibited any restriction by the government of political speech.

3. Could Congress have crafted a different law that would have survived a constitutional
challenge? How?

• This question helps students focus on other powers that Congress may have which might
achieve the same end. It would be difficult to pass a similar law because the restriction on
political speech by the government was the fundamental problem with the Stolen Valor
Act.

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CASE SUMMARY 1.2 Sokoloff v. Harriman Estate Development Corp., 754 N.E. 2d 184
(N.Y. 2001)

1. Can Harriman withhold the plans from Sokolff?

• The court concluded that there was no contractual provision that would allow Harriman
to withhold the plans from Sokoloff.

2. What legal theories or maxims would a court consider in deciding this case?

• The court considered specific performance as a potential remedy (Sokoloff’s request for
an equitable remedy was based on specific performance of turning the architectural plans
over to Sokoloff). Sokoloff claimed that money damages would be inadequate and that he
entitled to an equitable remedy.

3. How should the court rule and why?

• The court rejected Harriman's assertion that specific performance is an inappropriate

remedy because the architectural plans are not unique, and a dollar value can be placed
on the purchase of replacement plans. The court ruled that specific performance is a
proper remedy, however, where the subject matter of the particular contract is unique and
has no established market value.

CASE SUMMARY 1.3 Jones v. R. R. Donnelley & Sons Col, 541 U.S. 369 (2004)

1. Which statute of limitation governs and why?

• The federal statute of limitations applies. In a case where federal law conflicts with state
law, a plaintiff may choose the most favorable statute of limitations.

2. Will Jones be able to sue Donnelley?

• Yes. The Court ruled that the four-year statute of limitations for suits brought under acts
of Congress passed after 1990 apply to amendments of previously existing laws?

CASE SUMMARY 1.4 Kauffman-Harmon v. Kauffman, 36 P.3d 408 (Sup. Ct. Mont. 2001)

1. Should the court apply the clean hands doctrine here? Why or why not?

• The court did apply the clean-hands doctrine because this was a case in equity (Kauffman
wanted the stock transferred back to his name) and determined that the transfer was an
attempt to evade a judgment. Thus, Kauffman is not entitled to equitable relief.

2. Do the children have clean hands? Didn’t they accept the stock to help their father perpetrate
fraud?

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• It may be true that the children do not have clean hands, but it is irrelevant. Kauffman is
the one coming to court and asking for equitable relief. This relief is not available for
those without clean hands.

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 Chapter 2
Business, Societal, and Ethical Contexts of Law

CHAPTER OVERVIEW
This chapter covers how the law, ethics and corporate social responsibility guide business
decision-making and the various tools and frameworks that promote ethical decision-making.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Analyze how business organizations, law, and ethics are related. Application
Identify the three main ethical decision-making regimes. Knowledge
Analyze how corporate social responsibility (CSR) supports ethical decision Application
making and identify the three views of corporate social responsibility.
Identify how values management supports ethical decision making. Knowledge
Apply an ethical decision-making framework. Application
Identify the unique attributes of nonprofit and benefit corporations. Knowledge

Teaching Tip: Laws are not Ethics

Students often believe laws must be ethical. It is important to explain how some actions are
ethical but not legally required, whereas others are legal but may be unethical.

Teaching Tip: Laws, Ethics and Strategy

It is fundamental to get students to appreciate that legal strategy is often a powerful and effective
tool that is used to advance narrow business goals, however, if taken too far or without ethical
reflection it may lead individuals, companies, and society worse off. For example, corporate law
may be used to advance the narrow interests of stockholders ahead of employees, communities
and the environment, however, the recent Business Roundtable’s Statement on the Purpose of a
Corporation discusses how this narrow view might be harmful to society as a whole and the
fraying of the American Dream. See:
https://www.businessroundtable.org/business-roundtable-redefines-the-purpose-of-a-corporation-
to-promote-an-economy-that-serves-all-americans .

I. THE RELATIONSHIPS BETWEEN BUSINESS ORGANIZATIONS, LAW, AND

ETHICS [p. 25-27]
Points to emphasize:
• Ethics is the set of moral principles or core values for deciding between right and wrong.
• Justice should apply equally to all, contain enforcement mechanisms, and balance
competing interests.

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 • Ethical norms of behavior are well-accepted standards of action given a circumstance,
to resolve issues without resorting to the formal legal system.

II. ETHICAL DECISION-MAKING REGIMES [p. 27]

Points to emphasize:
• Morals are generally accepted standards of right and wrong in a given society or
community (based on law, religion, or personal belief systems).
• There are three approaches to ethics that influence business decision-making: principles,
consequences, and contracts.

A. Principles-Based Approach [p. 27]

Principle-based approaches are based on universal moral principles.

1. Religion
The first principle-based approach are ethical decisions based on religious tenants, such as the
Koran or Old Testament.

2. Virtue
The second principle-based approach are ethical decisions based on whether conduct promotes
good moral character, known as virtue ethics (Aristotle).

3. Natural Law
The third principle-based approach are ethical decisions based on the use of reason to ascertain
certain rights and moral values which are timeless and universal (Aquinas).

4. The Categorical Imperative

The fourth principle-based approach are ethical decisions based on a sense of duty to human
dignity, known as duty-based ethics (Kant). Categorical imperative means an action is moral
only if everyone should act the same way.

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 B. Consequences-Based Approach [p. 28]
A consequence-based approach focuses on the outcome of the decision. An ethical choice would
be one that provides the greatest good for the greatest number of people with the least harmful
consequences to the community. Under utilitarianism, an ethical choice is the one that benefits
the most people.

C. Contract-Based Approach [p. 29]

Originated by Rawls, the contract-based approach assumes a “veil of ignorance” meaning when
no one knows their position in society, each will negotiate ethical principles fair to all and in
favor of maximizing the prospects of the least well-off.

Case 2.1 Grimshaw v. Ford Motor Company

Facts: Using a cost-benefit analysis, Ford Motor Company released for sale the Ford Pinto
which they knew could explode upon a rear-end impact because the cost to redesign the car
would exceed the potential payouts to those injured or killed. A jury assessed $125 million in
punitive damages against Ford in a case involving death and personal injury due to the design
flaw.
Issue: Should punitive damages have been assessed without a finding of malice or corporate
responsibility for malice in the instant case?
Ruling: Punitive damages were properly awarded because the term “malice” does not just mean
intention to harm, but also conduct evincing “a conscious disregard of the probability that the
actor’s conduct will result in injury to others.” Choosing to go ahead with a design which was
known to cause injury or death in the possible scenario of a rear-end collision demonstrated such
a conscious disregard.

Case Questions
1. Which of the three major ethical decision-making traditions did the Ford managers apply in
their decision, and how would the issue have been resolved had they applied the other two
traditions? Under utilitarianism, an ethical choice is the one that benefits the most people. Ford
weighed the good against the harm and determined that more people would be benefited if the
car was released on the market because of the low number of potential deaths and the savings
that they thought would benefit the company’s stockholders.
2. How did ethics play a role in the court’s assessment of malice and the jury’s damage award?
The court used a principles-based approach to determine that human life should always be
chosen over profits, particularly when harm to human life and safety is foreseeable.
3. Focus on Critical Thinking: Which ethical tradition would you have applied in this scenario?
This question is meant to elicit a conversation applying the different ethical frameworks to the
Ford Pinto scenario.

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III. CORPORATE SOCIAL RESPONSIBILITY [p. 31]
Points to emphasize:
• Corporate social responsibility (CSR) is broader than business ethics in that it involves
important business and social issues and a critique of business organizations and
practices.
• There are three schools of thought on CSR: narrow view, moderate view, and broad view.

A. Major CSR Schools of thought [p. 32]

1. The Narrow View: “Greed Is Good”
According to Milton Friedman, a Nobel-winning economist from the University of Chicago, a
business’s only duty is to maximize shareholder value. Rather than considering all stakeholders,
decision-makers look only at the impact to the bottom line. Friedman opined that by pursuing
social initiatives with corporate dollars, managers were actually violating their fiduciary duty to
the business’s owners.
2. The Moderate View: Just Follow the Law
The moderate view merely requires that corporations follow the law because it is the
government’s duty to set the outer limits of corporate social responsibility.
3. The Broad View: Good Corporate Citizenship and a Social License to
Operate
• Business organizations committed to a broad view of CSR aim to achieve commercial
success in ways that honor ethical values and respect people, communities, and the
natural environment in a sustainable manner while recognizing the interests of
stakeholders.
• Stakeholders are any person or group impacted by a decision.
• This concept of “corporate citizenship,” means a business should strive to promote the
economic, legal, ethical, and philanthropic social responsibilities expected of it by its
stakeholders.
• The broadest view requires businesses to consider social responsibility above
profitability.
• Business ethicists also invoke the concept of a social license to operate, which includes
the demands on, and expectations for, a business that emerges from neighborhoods,
environmental groups, community members, and other elements of civil society.
• In any case, an integral part of the broad CSR perspective is the focus on what some
ethicists call the triple bottom line. Essentially, the triple bottom line emphasizes not
only the conventional creation of economic value (profits), but also a company’s creation
(or destruction) of environmental and social value.

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Case 2.2 Brooks Brother Group, Inc. v. Bubbles by Brooks, LLC

Facts: Brooks Brothers retail stores brought an action against a woman named Amy Brooks, a
cancer survivor, who had a small business selling non-irritating soap and skin care products to
cancer patients for attempting to register the trademark “Bubble by Brooks” claiming it infringed
on their trademark “Brooks Brothers.”

Opinion: Because the parties settled and Brooks Brothers withdrew their opposition to Amy’s
use of the phrase, the case was dismissed.

Case Questions

The Federal Rules of Civil Procedure, which govern the proceedings in federal litigation, state
that the rules “should be construed, administered, and employed by the court and the parties to
secure the just, speedy, and inexpensive determination of every action and proceeding.”

1. In light of the Federal Rules of Civil Procedure, do parties have an ethical duty to refrain
from lengthy litigation in certain cases? Under Rule 11, cases may not be brought for improper
purposes such as to “harass, cause unnecessary delay, or needlessly increase the cost of
litigation;” and that claims must be supported by nonfrivolous arguments. It would seem that
Brooks Brothers claim would violate this provision.

2. Which CSR approach did Brooks Brothers adopt in this case? How did this approach backfire
from a strategic perspective? Brooks Brothers adopted a narrow view seeking to prevent anyone
from using the term “Brooks” in their trademark. It backfired because of the perception that a
large retailer was attacking a cancer survivor.

3. Focus on Critical Thinking: Which CSR approach would you have chosen and why? This
question is meant to elicit a discussion on how the different CSR approaches would apply to the
instant case.

B. CSR and Litigation [p. 34]

Some companies look to CSR when dealing with litigation. For example, Wal-Mart has internal
CSR guidelines designed to encourage ethical conduct by its attorneys.

IV. VALUES MANAGEMENT AND COMPLIANCE DEPARTMENTS [p. 34]

Values management prioritizes moral values for the organization and ensures that employee and
manager behaviors are aligned with those values. This can be accomplished by establishing a
code of ethics. Compliance Departments are designed to assist an organization in following rules
and regulations and maintaining a spirit of ethics.

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 A. Business Ethics Challenges in Values Management [p. 34]
Points to emphasize:
• Business ethics in the workplace prioritizes moral values for the organization and ensures
that employee and manager behaviors are aligned with those values. This approach is
known as values management.
• A compliance department is a unit within the organization that is staffed by lawyers and
nonlawyers.

• One way to evaluate whether an action is ethical is to ask, “How would I feel if the
business decision was announced to the public on social media or the local and national
news?” (Broadcast news test).

B. Common Traits of Effective Values Management [p. 35]

One example of a way to implement values management is by adopting a code or ethics. Other
companies prefer a more general policy, such as Google’s “Don’t be evil.” An effective value
management program requires employees to report violations of the law or code of ethics to a
superior manager, in-house counsel, or the company’s compliance department.

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One of the primary benefits of a code of ethics is that employees have a set of rules to follow.

C. Compliance Departments [p. 36]

A compliance department is a unit within the organization that is staffed by lawyers and
nonlawyers.

Teaching Tip: Ethical Decision-Making

There are a number of Universities with Centers and Institutes for Applied and Behavioral
Ethics. The University of Texas has a number of short videos on their “Ethics Unwrapped”
website and the Santa Clara University’s Markkula Center for Applied Ethics has a large number
of business ethics cases that are suited for undergraduate business students.

V. ETHICAL DECISION MAKING: A MANAGER’S PARADIGM [p. 37]

Ethical dilemmas faced by managers are often complex, with no clear ethical choice. The use of
a paradigm in a flowchart (see Figure 2.1) can help business owners make ethical decisions more
consistently.

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Case 2.3 U.S. House of Representatives Staff Report on MF Global Prepared for the
Subcommittee on Oversight and Investigations – Committee on Financial Services
Facts: In order to finance its growth, MF Global invested in the sovereign debt of struggling
European countries. When these investments failed, MF Global was forced to file for
bankruptcy. Due to mismanagement and faulty internal risk controls, $1.6 billion in customer
accounts went missing during the process, triggering various lawsuits and a congressional
investigation.

Opinion: In suggesting an investigation into MF Global and strengthening of regulations in the

financial services industry, the Congressional Report noted that Corzine, the head of MF Global,
engaged in unacceptable risks with the European investments and prevented the company’s chief
risk officer from reporting to the Board of Directors.

Case Questions

1. What evidence existed that MF Global lacked a values management plan and that a culture of
ethics was lacking at the company?
• Corzine reported to no one and prevented his Chief Risk Officer from reporting his
investments to the Board of Directors.

2. Why did the board allow Mr. Corzine to reassign the chief risk officer’s reporting to the chief
operating officer? Would you have allowed that to occur as a board member? Explain.
• Boards are not responsible for the day-to-day management of a company and may not
have been aware of the reassignment. They also may have placed too much blind faith
and trust in Corzine.

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 3. Focus on Critical Thinking: Put yourself in Corzine’s position when the chief risk officer
voiced concern related to investment risk. Apply the ethical decision-making framework in
Figure 2.1 and discuss how you would address each step.
• This question is designed to elicit a discussion of how each ethical framework can be
applied to this scenario.

VI. COMMUNITY-BASED NONPROFIT AND BENEFIT CORPORATIONS [p. 39]

Points to emphasize:
• A community-based nonprofit is typically a tax-exempt entity created for the purpose
of serving the community
• A new type of hybrid organizational entity called a benefit corporation has been
authorized by most states. A benefit corporation resembles a traditional for-profit
corporation, and its directors and officers operate the business with the same authority as
in a traditional corporation.

VII. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [P. 43]

Chapter Review Questions [P. 46] Note: Answers and explanations are provided at the very
end of the chapter.
Thinking Strategically Questions and Answers [P. 41-42]

Teaching Tip: Ethical Decision-Making

The video news segment below (ABC News 20/20 with Diane Sawyer profiled the case featured
in this Thinking Strategically section. It might be a good resource to share with students or to
stimulate discussion in class/ online.

https://abcnews.go.com/WNT/video/dan-brown-claims-sears-stole-idea-bionic-wrench-
17722187

1. Did Sears behave unethically? Under these facts it appears Sears decided to disregard the
property rights held by LoggerHead Tools and cease doing business with them despite
expectations to the contrary solely to achieve greater profits. What tradition of ethics did Sears
appear to follow? This approach seems to be aligned most with the utilitarianism view of ethics
and the profit-centered view of the company.

2. What ethical arguments would support Sears’s actions? Sears might argue that if an action is
efficient and beneficial to its stockholders it is ethical to pursue that activity.

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3. What ethical arguments support LoggerHead Tools’s actions? LoggerHead Tools may argue
that property rights such as patents generate a moral categorical imperative and thus a duty on
everyone to respect the patent. LoggerHead complied with the legal system and relied on patents
and contracts a “Made in the USA” corporate social responsibility strategy that should have been
upheld and respected.

4. Was justice achieved in this case? The jury verdict sought to compensate LoggerHead Tools
for the harm and punished the defendants further due to their intentional behavior.

5. Is it fair to have to spend five years and millions of dollars to resolve a patent dispute of this
nature? Justice delayed is not justice. Some of the major difficulties our legal system faces are
the delays, costs and uncertainty of the system overall and this tends to disproportionately and
negatively impact those who have less resources or access to knowledge.

6. How would you have achieved an ethical resolution to this issue?

Sears may have decided to negotiate better terms to retain the business relationship with
LoggerHead Tools, or they could have decided to invent a tool that did not infringe upon the
patented technology. Either way, having an honest and civil discussion would have perhaps
avoided this issue or at least allowed the parties to explain their respective positions.
Case Summary Questions and Answers [p. 43-45]

CASE SUMMARY 2.1 Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 688 (1919)

1. Should a corporation act solely to maximize shareholder wealth? No, as stated by several
state courts including Delaware, the leaders of a corporation may consider non-stockholder
interests as long as there is a reasonable relation to the stockholders’ well-being. Also, some new
forms of organization such as benefit corporations allow businesses to prioritize interests other
than shareholder wealth. How should a corporation balance corporate social responsibility with
shareholder interests? Companies should consider various stakeholders as recently discussed by
The Business Roundtable’s Statement on the Purpose of a Corporation. The primary interest
should be the corporation’s well-being and the financial return of its stockholders; however, a
long-term and holistic view requires thinking about other critical stakeholders such as
employees, communities, suppliers and the environment.

2. Which moral philosophy approach describes Henry Ford’s stated actions? Explain. Since his
stated goal was to bring the benefits of the industrial system to the greatest number and lower
prices to make vehicles more affordable to many his ethics would seem to fall under
utilitarianism.

3. Although not an issue at trial, the Dodge brothers used their dividends to build their own
company, Dodge Brothers Company (Dodge Motors), which was later sold to, and became a part
of, Chrysler Motors. Many historians speculate that Henry Ford was actually trying to slow down
the formation of the Dodge brothers’ new company. If Henry Ford’s alleged motive was true,

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was he acting in an ethical manner? Ford’s ethics of utilitarianism would be assessed from a
consequentialist perspective if the greatest good was achieved for the greatest number. If his true
motive was selfish and strategic, on the other hand, this would call into question any other ethical
theories that he might have claimed to advance.

CASE SUMMARY 2.2 In Re: High-Tech Employee Antitrust Litigation, U.S. District Court,
Northern District California 11-cv-2509 (2013)

1. Was it ethical for these high-tech companies to agree not to hire each other’s employees?
Explain. No, this is a scenario that falls entirely outside of the Venn diagram at the beginning of
the chapter, that is, unethical and illegal behavior. The illegal nature of the behavior was trying
to get around the prohibition against non-compete contracts. The unethical activity is preventing
workers from joining a competitor to earn a higher salary.

2. Is it ethical to use legal means such as noncompete contracts to prevent workers from leaving
to join another business? Up to a point it can be, especially if it is to protect a legitimate business
interest such as unique knowledge gained by the employee, or investments in the employee
training. How is this case different? This case is different since there appears to be no legitimate
business interest other than protecting the bottom line of the various colluding companies solely
at the expense of their workers.

3. Which CSR view did the tech companies adopt in this case? The narrow view that greed is
good.

4. Which CSR view would you apply to this issue, and how would it be resolved under your
view? Either the moderate or broad view of CSR would have led to a better ethical and legal
result.

CASE SUMMARY 2.3 In Re: Volkswagen “Clean Diesel” Marketing, Sales Practices, and
Products Liability Litigation, U.S. District Court, Northern District of California MDL No. 2672
CRB (2017)

1. How would a values management plan have avoided the legal liability at Volkswagen? A
values management plan would have prioritized values ahead of profits or cutting costs. An easy
test is to ask what the result would be if this decision made the front page of a newspaper. In this
case the story broke and the results were devastating. Also, investments in an effective
compliance department and program made up of lawyers and non-lawyers would be an effective
resource to implement values management across the business.

2. Several individuals were charged with criminal violations in this case. Who should face
criminal prosecution and why? Criminal prosecution requires a high degree of knowledge and
intent so any managers who had direct knowledge and oversight of the illegal actions should face
liability.

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3. What should be the punishment for Volkswagen employees who engaged in illegal acts? The
law considers several factors in punishment for business-related crimes such as prior convictions,
cooperation with law enforcement and regulators, direct vs. indirect involvement, degree of
knowledge, level of seniority within the organization and the harms inflicted on others. In the
worst cases fines and imprisonment are justified.

4. Why do individuals risk facing legal liability on behalf of their employers? Ethics is a
difficult subject since there are always competing interests and money, status, cognitive blinders
(biases) and the desire to gain acceptance by peers and superiors are often involved in ethical
dilemmas. Good people sometimes do bad things because of the pressure or culture within an
organization. Sometimes individuals are ordered to do illegal acts and do not want to suffer
negative consequences due to disobedience. Other times individuals are blinded by greed or their
ego. Groupthink and rationalizations may also play a part.

CASE SUMMARY 2.4 Goswami v. American Collections Enterprise, Inc., 377 F.3d 488 (5th
Cir. 2004)

1. Is the letter misleading?

• Yes, it creates the impression of a final take-it-or-leave-it offer when in reality there is
plenty of room to achieve a settlement for up to 50% of the value of the loan.

2. Is it unethical to tell a partial truth as ACEI did here?

• It can be particularly unethical when one of the parties is vulnerable, weak, uninformed
or entitled to additional protection.

3. Is failure to disclose a fact the same as telling a lie?

• It depends on the situation, particularly when an ethical or legal duty mandates the full
disclosure of relevant and significant facts.

CASE SUMMARY 2.5 Luther v. Countrywide Home Loans Servicing, 533 F.3d 1031 (9th Cir.
2008)

1. Does Countrywide have an ethical obligation to not make risky loans?

• They may if they accept so much risk that they are going to damage the enterprise and its
stockholders. On the other hand, the company may strategically hedge risks as well or
price the risk through a higher interest rate.

2. Does Countrywide have an ethical obligation to verify the income of its loan applicants?

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 • Yes, the creditworthiness of a borrower depends on various factors and an important one
is ability to repay the loan based on their income. Not doing so is a reckless business
practice that can harm both the lender and the borrower.

3. What ethical duties do applicants have when applying for a loan?

• Applicants have a legal and ethical duty to be truthful and provide accurate information
to the lender. From an ethical perspective, borrowers should only seek to borrow within
their means and make good faith efforts to repay the debt.

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 Chapter 3
Business and the Constitution

CHAPTER OVERVIEW
This chapter surveys the U.S. Constitution and how it relates to businesses. Among other things, this
chapter begins with the structure of the Constitution, provides an overview of federal powers, explains
how commerce is regulated, surveys the rights contained in the first 10 amendments, including due
process and equal protection, describes how the constitution can be amended, and concludes with the
two theories of constitutional interpretation.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Understand the structure of the Constitution and the strategic system of Application
checks and balances.
Identify the main powers of each branch of the federal government Knowledge
Describe the broad scope of Congress’s power to regulate commerce under Application
the Commerce
Clause.
Identify the individual rights and guarantees protected by the Bill of Rights. Knowledge
Define and explain due process and equal protection. Application
List the methods and steps for amending the Constitution. Knowledge
Compare and contrast two major theories of constitutional interpretation: Critical
originalism and the living Constitution. thinking

Teaching Tip: International Students

If you have international students in your class, it is likely that they have little familiarity with the
structure of the U.S. government. It is thus a good idea to include a video and/or lecture-capture on the
structure of the U.S. government and post it in your course shell. You can indicate that it is available
for anyone wishing to have some background information on how the U.S. government is structured.

I. STRUCTURE OF THE CONSTITUTION [pp. 49-51]

Points to emphasize:
The Constitution was drafted in 1787 and contains a preamble, seven articles, and 27 amendments. The
first ten amendments are known as the Bill of Rights. (Refer students to Table 3.1 – Overview of the
Original Seven Articles of the 1787 Constitution.)

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 A. Federalism [pp. 49-50]
Points to emphasize:
• The U.S. has a federal system of government consisting of two distinct levels of government—
federal and state.
• The Constitution grants exclusive powers to the federal government, concurrent powers shared
by the federal government and the states, and powers reserved to the states. (Refer students to
Figure 3.1 – Visual Demonstration of the Relationship between the Powers of Government.)

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 B. Separation of Powers [p. 50]
Points to emphasize:
• The principle of separation of powers refers to the creation of multiple power centers within a
single level of government. With respect to the federal government, the legislative branch
consists of Congress, the executive branch consists of the President, and the judicial branch
consists of the federal courts.
• By creating a horizontal division of three branches and a vertical division of federal and state,
the Constitution creates an embedded system of checks and balances. (Refer students to Figure
3.2 – Visual Demonstration of Checks and Balances)

C. Strategic Digression: Checks and Balances [p. 50]

Points to emphasize:
• The complex structure of the Constitution provides for checks and balances where each level of
government can use its powers to monitor the other levels and branches of government.

II. OVERVIEW OF FEDERAL POWERS [pp. 51-53]

The federal government is divided into three coequal branches, and each branch is assigned a specific
set of powers.

A. The Congress (Article I) [pp. 51-52]

Points to emphasize:
• Article I of the Constitution establishes the House of Representatives and the Senate, who have
the power to make laws. It also provides a method for impeaching the president and federal

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 judges, and delegates a finite and specific set of enumerated powers to Congress. The
enumerated powers are found in Article 1, Section 8.
• Article I, Section 9 places limits on Congress – no ex post facto law (a law that retroactively
declares someone’s action to be criminal after it was committed) or bill of attainder (a
legislative act declaring a person or group of persons guilty of some crime) may be enacted.

B. The President (Article II) [p. 52]

Points to emphasize:
• Article II of the Constitution vests general “executive power” in the president.
• These powers include the position of commander-in-chief of the armed forces, the power to
enforce laws made by Congress, conduct foreign relations and negotiate treaties with other
countries, and appoint federal judges (subject to Senate approval).
• Presidents also have the power to issue executive orders (a presidential command or directive
addressed to an officer or agency of the federal government).

C. The Federal Courts (Article III) [p. 53]

Points to emphasize:
• Article III of the Constitution vests judicial power in one Supreme Court and in inferior federal
courts established by Congress.
• Judges have the power to interpret laws.
• The doctrine of judicial review, set forth in Marbury v. Madison, is the principle that courts
have the implicit authority to invalidate state or federal laws that are in direct conflict with the
Constitution.

III. REGULATION OF COMMERCE [pp. 53-55]

Points to emphasize:
One of the most significant sources of Congress’s powers is its enumerated power to regulate
commerce under the Commerce Clause (Article I, Section 8, Clause 3) which reads:
The Congress shall have Power to regulate Commerce with foreign Nations, and among
the several States, and with the Indian Tribes.

A. Scope of the Commerce Power [p. 54]

Points to emphasize:
• The Supreme Court has interpreted Congress’s commerce clause power very broadly.
• Congress can regulate the following aspects of commerce:
o Channels – canals and highways
o Instrumentalities – vehicles used to ship products
o Person and articles – passengers and goods moving between states
• Furthermore, because almost every activity potentially affects commerce in some way or
another, Congress can use its commerce power strategically to regulate almost any aspect of
business.

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 • The Supreme Court has also ruled that Congress can regulated purely intrastate conduct (taking
place within a state’s borders) IF the activity in the aggregate produces a substantial economic
effect on interstate commerce.

B. Negative Commerce Clause [p. 54]

Points to emphasize:
• The Commerce Clause not only has a “positive” aspect permitting Congress to regulate
interstate and foreign commerce; it also has a “negative” or “dormant” side, limiting the police
powers of the states.
• States may not discriminate against or unduly burden interstate commerce.

C. The Commerce Clause Today [p. 54]

Points to emphasize:
• In recent times, the Supreme Court has attempted to impose some outer limits on Congress’s
extensive and far-reaching commerce powers.
• In National Federation of Independent Business v. Sebelius, the Supreme Court (5-4) held that
the Affordable Care Act, which contained a controversial provision called the individual
mandate that required all persons to either purchase health insurance or pay a penalty, was a
constitutional use of the power to tax. A different 5-4 majority, however, held that the mandate
exceeded Congress’s power to regulate commerce.
• In U.S. v. Lopez, the Supreme Court used its judicial review power to invalidate the Gun-Free
School Zones Act of 1990, which made it a federal crime to possess a gun within a certain
distance from a school. By a narrow 5–4 margin, the Supreme Court declared the Act beyond
the commerce powers of Congress because gun possession was a noncommercial activity.
Congress was able to get around this ruling by adding language to the Act indicating that gun
possession in schools impacted economic productivity.
• In U.S. v. Morrison, a 5–4 majority of the Supreme Court struck down the Violence Against
Women Act (VAWA), which gave victims of gender-motivated violence the right to sue their
abusers in federal court for money damages. Congress again was able to get around this ruling
by adding language to the Act detailing the economic effect of gender-motivated crimes.

IV. THE BILL OF RIGHTS [pp. 55-63]

Points to emphasize:
• The Bill of Rights refers to the first ten amendments to the United States Constitution and is
just as important as the original Constitution.
• It was added to appease the –”anti-federalists" who were opposed to the Constitution due to
their fear that it gave too much power to the federal government.
• The Bill of Rights is form of a strategic precommitment, limiting federal powers by
enumerating state and individual guarantees and rights.
• The Bill of Rights was made applicable to the states by the ratification of the Fourteenth
Amendment.

A. First Amendment (Freedom of Speech, Assembly, and Religion) [p. 56]

Points to emphasize:
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 • The First Amendment protects individual liberties in three overlapping domains—religion,
speech, and association.
• Most of the protections in the Bill of Rights apply against the government, not against private
business firms. This means that a private business can terminate an employee for engaging in
offensive speech (unless same conduct violates a federal or state statute such as those that bar
discrimination based on political activity).
• The words of the Constitution often require interpretation. The Supreme Court has provided
lesser protection for commercial speech than for political speech.
• All three branches of government are engaged in this interpretative work. The federal
government, for example, has enacted statutes which also interpret the extent of these rights.
• Commercial Speech is the way a business communicates with the public via advertising through
print, television, radio, and the Internet. Commercial speech is protected as long as the speech is
truthful and concerns a lawful activity.
• Central Hudson Gas v. Public Service Commission establishes a four-part test that subjects
government restrictions on commercial speech to a form of intermediate-level scrutiny; under
this test, (1) the speech must concern a lawful activity and must not be misleading, (2)
government must show a substantial government interest in regulating the speech, (3) the
government restriction must directly advance this interest, and (4) the restriction must not be
more extensive than necessary.

Teaching Tip: Freedom of Speech

Because many countries do not permit free speech or may have a state-sponsored religion, the First
Amendment discussion can include why these rights were listed in the very first amendment.
Essentially, the new government wanted to provide certain freedoms of expression that were not
present in their countries of origin. You can also provide examples of other country’s censorship of
social media and ownership of media outlets to contrast against the U.S. paradigm.

B. Second Amendment (Arms) [p. 58]

Points to emphasize:
• The Second Amendment, which ostensibly protects the right to keep and bear weapons, is
perhaps the most controversial amendment in the entire Constitution.
• It has been interpreted as an auxiliary right supporting the right of self-defense and resistance to
oppression and the civic duty to act in defense of one’s country.
• The Supreme Court has interpreted this amendment as protecting an individual’s right to
possess and carry firearms (District of Columbia v. Heller).
• The Due Process Clause incorporates the Second Amendment against state and local
governments (McDonald v. Chicago).

C. Third Amendment (Housing of Soldiers) [p. 59]

Points to emphasize:
• The Third Amendment prohibits the government from quartering soldiers in private homes
without the homeowner’s consent.

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 • It is one of three amendments in the Bill of Rights protecting private property rights (along with
the Fourth and Fifth Amendment).

D. Fourth Amendment (Search and Seizure) [p. 59]

Points to emphasize:
• The Fourth Amendment prohibits unreasonable searches and seizures.
• Searches and seizures are to be conducted only upon issuance of a warrant, judicially sanctioned
by “probable cause,” supported by oath or affirmation, and the warrant must particularly
describe the place to be searched and the persons or things to be seized.
• The Exclusionary Rule holds that evidence obtained in violation of the Fourth Amendment is
generally inadmissible in criminal trials.
• A search occurs when a governmental employee or an agent of the government violates an
individual’s reasonable expectation of privacy.
• Seizures
o A seizure of a person occurs when the person is not free to leave.
o A seizure of property occurs when an individual’s possessory interest in property is
interfered with.
o The courts are split as to under what circumstances an electronic device can be searched.
• Exceptions to Warrant Requirement - To obtain a warrant, the government must first
demonstrate probable cause to a judge or magistrate that the proposed search or seizure is
justified under the law. However, no warrant is required if consent to search is given, the search
is incident to a valid arrest, items in plain view are seized, and during brief investigatory stops.
• The Fourth Amendment only applies to government action and does not apply where a person
does not have a reasonable expectation of privacy.
• Broadly speaking, business owners have a lesser expectation of privacy than homeowners.

E. Fifth Amendment (Property Rights) [p. 61]

Points to emphasize:
• The Fifth Amendment requires that felonies be tried only upon indictment by a grand jury; it
protects individuals from being compelled to be witnesses against themselves in criminal
cases; and it prohibits double jeopardy (i.e., acquittals are final).
• Due Process Clause – “nor be deprived of life, liberty, or property, without due process of
law”
• Takings Clause - The government may take private property for public use when just
compensation is paid to the property owner.
o Just compensation generally means fair market value at the time of the taking.
o Public use has been interpreted as permitting the government to take property on behalf
of a private entity as long as the use will benefit the public (Kelo v. City of New
London). Prior to this case, public use generally meant for highways, schools, and city
buildings.

F. Sixth Amendment (Criminal Trials) [p. 61]

Points to emphasize:

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 • The Sixth Amendment provides protections to criminal defendants because the Founding
Fathers were worried that the federal government might one day abuse its enumerated powers
under the Constitution to jail leaders of the opposition.
• These include the right to a speedy and public trial before an impartial jury in the state and
district where the crime was committed.
• Criminal defendants have the right to know the charges against them, confront their
witnesses, have the ability to subpoena witnesses, and the right to an attorney.

G. Seventh Amendment (Civil Trials) [p. 62]

Points to emphasize:
• Civil litigants have a constitutional right to a jury trial.
• Common law is a body of law developed by judges that encompasses many traditional areas of
law, including property, contract, and torts, just to name a few.
• Stare decisis is the principle that like cases should be decided alike (let the decision stand).

H. Eighth Amendment (Bail, Fines, and Punishments) [p. 62]

Points to emphasize:
• The Eighth Amendment prohibits the federal government from imposing excessive bail,
excessive fines, or cruel and unusual punishments.
• One area of disagreement as to whether something constitutes cruel and unusual punishment is
the death penalty.

I. Ninth Amendment (Unenumerated Rights) [p. 62]

Points to emphasize:
• The Ninth Amendment provides that the federal government may not infringe or take away any
rights belonging to the people, regardless of whether those rights are specifically listed or
enumerated in the Constitution.
• In other words, just because some rights are expressly stated in the Constitution and Bill of
Rights as belonging to the people does not mean that the list is exclusive. Individuals may have
additional rights even if not mentioned.

J. Tenth Amendment (Federalism and Popular Sovereignty) [p. 63]

Points to emphasize:
• The Tenth Amendment embodies the structural principle of federalism, the idea that the United
States contains two separate sources of political power: the states and the federal government.
• Federalism: Those powers not delegated to the federal government are retained by the states.
• Popular sovereignty: Powers not delegated to the government are retained by the people.

V. DUE PROCESS AND EQUAL PROTECTION [pp. 64-67]

Points to emphasize:
In addition to the many rights and protections enshrined in the Bill of Rights, the Constitution also
protects a person’s right to due process and to equal protection of the law.

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 A. Due Process [p. 64]
Points to emphasize:
• Both the Fifth and the Fourteenth Amendments to the Constitution declare that no person shall
be deprived “of life, liberty, or property, without due process of law.”
• Due process means that the procedures followed by the government must be fair.
• Procedural due process requires that any government decision to take life, liberty, or property
must be made using fair procedures.
• Substantive due process limits the ability of government to interfere with individual liberty.

B. Equal Protection [p. 64]

Points to emphasize:
• The Fourteenth Amendment provides that equal protection requires the government to treat
people who are similarly situated equally.
• The government may create different categories, but each individual in the category must be
treated the same (e.g., in-state and out-of-state students may fall into different categories and
pay different rates of tuition, but all in-state students pay the same tuition and all out-of-state
students must pay the same tuition).

C. Standards of Review [p. 65]

Points to emphasize:
• Judicial review – when a court reviews a government action, there are different standards of
review.
• Rational basis test - the government need only show that (1) its action advanced a legitimate
government objective (such as health, safety, or welfare) and (2) the action was in some way
related to the government’s objective (e.g., economic regulation and tax-related law).
• Intermediate scrutiny - the government need only show that (1) the action furthers an
important government objective and (2) the action is substantially related to the government’s
objective (e.g., gender discrimination).
• Strict scrutiny – if a government action impairs a fundamental constitutional right or is based
on a “suspect” classification (i.e., race, national origin, or religious beliefs), courts will tend to
apply a strict scrutiny standard in deciding whether to uphold the government action.

Teaching tip: Standards of Review

Students can benefit from reading the cases chosen by the Supreme Court for review in the coming
term. You can refer students to SCOTUSblog or to oyez.com to see the cases and issues being
considered.

VI. AN IMPORTANT DIGRESSION: AMENDING THE CONSTITUTION [pp. 67-68]

Points to emphasize:
The Constitution has only been amended 27 times since its ratification in 1789.

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 • An amendment may be proposed by a two-thirds vote in both the House of Representatives and
the Senate—or by a constitutional convention of states called for by two-thirds of the
legislatures of the states.
• An amendment must also be ratified by either the legislatures of three-quarters of the states or
by state ratifying conventions in three-quarters of the states.

VII. INTERPRETING THE CONSTITUTION: ORIGINALISM VERSUS THE LIVING

CONSTITUTION [pp. 68-69]
Points to emphasize:
There are two divergent viewpoints on how the constitution should be interpreted.

A. Originalism [p. 68]

Points to emphasize:
• Originalism means that the Constitution should be interpreted as the words were originally
used at the time of the document’s creation (the meaning of the Constitution is fixed and can
only be changed by amendment).
o Original intent – what the drafters intended it to mean.
o Original meaning – what a reasonable person at the time it was written would have
understood it to mean.

B. The Living Constitution [p. 69]

Points to emphasize:
• The other major approach to constitutional interpretation is called the living Constitution the-
ory, which permits modern interpretations of the language used (the Constitution is not fixed or
static but rather dynamic and flexible).

VIII. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [P. 71]

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Chapter Review Questions [pp. 74-75] Note: Answers and explanations are provided at the very
end of the chapter.
Thinking Strategically Questions and Answers [pp. 70-71]
1. Can you think of other precommitment strategies used in the business world?
• Anything involving a contract.
2. Have you ever used a precomittment strategy in your own life? Was it successful? Why or why not?
• Anything involving a promise.
3. What are the relative advantages and drawbacks to using a precommitment strategy?
• The main disadvantage of precommitment is that you have to limit your options ahead of time,
but at the same time, the main advantage of precommitment is that it allows you to build trust
with others.

Case Summary Questions and Answers [pp. 71-73]

CASE SUMMARY 3.1 Brown v. Board of Education II, 394 U.S. 294 (1955)
1. Why didn’t the Supreme Court set a deadline or impose any penalties for noncompliance with its
landmark desegregation decision?
• On its own, the Supreme Court lacks the power of the purse and the power of the sword, so it
does not have the ability to enforce its own decisions.
2. In your opinion, does the Equal Protection Clause prohibit classifications on the basis of sexual
orientation or gender identification?
• This issue could be argued either way. On the one hand, gender and sexual orientation are not
yet considered “suspect classifications” by the courts; but on the other hand, the actual text of
the Equal Protection Clause of the Fourteenth Amendment is worded broadly to include “all
persons.”
CASE SUMMARY 3.2 Executive Order 10730 (Desegregation of Central High)
1. Was President Eisenhower constitutionally required to send federal troops into Little Rock? Could a
court have ordered him to do so?
• This issue could be argued either way. On the one hand, no one is above the law, including the
President of the United States, but on the other hand, the President is the Commander-in-Chief
of the armed forces, and as a practical matter, how would the courts enforce any order directed
to the President?
2. If President Eisenhower had not sent federal troops into Little Rock, how would the federal courts
have enforced the Supreme Court’s desegregation decision?
• The point of this question is to emphasize the inability of courts to enforce their own decisions
against the states or against the other branches of government.
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CASE SUMMARY 3.3 Title IX
1. What if Congress had never enacted Title IX? Could the federal courts or the president have
prohibited discrimination in educational programs and activities? How?
• With respect to the courts, federal judges could have applied intermediate or perhaps strict
scrutiny to educational programs and activities. With respect to the president, he could have
issued an Executive Order ordering his officials to withhold federal funds from discriminatory
schools.
2. What is the source of Congress’s power to prohibit discrimination in educational programs and
activities?
• There are at least two possible sources of Congress’s power to prohibit discrimination in
educational programs and activities: (i) Section 5 of the Fourteenth Amendment, and (ii) the
Commerce Clause of Article I, Section 8 of the Constitution.
CASE SUMMARY 3.4 Mahanoy Area School District v. B.L, 594 U.S. __(2021)
1. Does a school’s disciplinary action against a student for speech that takes place outside of school
hours and away from campus violate the First Amendment?
• The US Supreme Court held that while public schools may have a special interest in regulating
some off-campus student speech, the special interests offered by the school are not sufficient to
overcome Ms. Levy’s interest in free expression and thus violated her First Amendment rights..
2. How should the courts determine whether a given speech act (such as Ms. Levy’s private Snapchat
post) materially and substantially disrupt the work and discipline of the school?
• The courts should look at factors such as where the speech occurred, the forum used for the
speech, the content of the speech, who the speech was directed at, and whether school
equipment was used.
3. Could wearing a red baseball cap with the words “Make America Great Again” materially and
substantially disrupt the work and discipline of a school?
• Unless the cap actually disrupts work, class, or some type of school discipline, it should not be
disruptive. The speech is not vulgar and isn’t directed at the school or an individual.
CASE SUMMARY 3.5 State v. DeAngelo, 930 A.2d 1236 (N.J. Supreme Ct. 2007)
1. Is the ordinance unconstitutional, or is it a valid (content-neutral) “time, place, and manner”
regulation?
• The Supreme Court of New Jersey split on this issue. Although a majority of the justices
concluded that the local ordinance was content-neutral because it applied to all inflatable signs
except for “grand opening” signs, one of the justices dissented from this part of the court’s
opinion, since the ordinance made an exception for “grand opening” signs.
2. What level of scrutiny will a court apply to the ordinance?
• The court will apply heightened or Strict Scrutiny to this case: the ordinance must be “necessary
to serve a compelling state interest and ... [it must be] narrowly drawn to achieve that end.”
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3. What if it were an election year and the labor union had placed the inflatable rat-shaped balloon in
front of the local chapter of the Republican Party or Democratic Party to protest either party’s political
platform?
• Given this new set of facts, the free speech issue could be argued either way, depending on
whether the courts are persuaded that the ordinance is content-neutral or not. On the one hand,
one could argue that the ordinance is content-neutral since it applies to all signs of a political
nature, but on the other hand, as the dissent pointed out in this case, the ordinance does not
apply to “grand opening” signs, so it does not appear to be content-neutral.
CASE SUMMARY 3.6 U.S. v. Alderman, 565 F.3d 641 (9th Cir. 2009)
1. Is the Body Armor Act constitutional?
• Although two judges on the three-judge appellate panel concluded that the Body Armor Act was
constitutional under the Congress’s power to regulate interstate commerce, one of the judges
dissented from this conclusion, arguing that Alderman’s conduct was purely intrastate in nature.
2. If Alderman purchased the body armor in the state where it was manufactured, how did his purchase
affect “interstate” commerce?
• This issue could be argued either way. On the one hand, one could take the position of the
dissenting judge in this case and argue that a single local purchase does not affect interstate
commerce, or in the alternative, one could focus on the cumulative effects of local purchases
and argue that the cumulative effect of purely local purchases does have an impact on interstate
commerce.
3. Suppose Congress enacts a prospective law prohibiting all private persons from purchasing or
owning body armor in the future. In your opinion, would such a law be constitutional?
The law would be constitutional so long as the Congress could establish a connection or rational
relation between interstate commerce and the purchase and possession of body armor.

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 Chapter 4
The American Judicial System, Jurisdiction, and Venue

CHAPTER OVERVIEW
The chapter provides students with a wide-ranging perspective of the structure and function of
American courts. Lawsuits are a reality in daily business operations and business owners and
managers should be prepared with a fundamental knowledge of the system. The chapter begins
with an explanation of how federal and state courts operate in tandem, examines how law is
developed via appellate courts, and concludes with coverage on jurisdiction and venue with
consideration of special jurisdiction issues in cyberspace.

Thinking Strategically Intro Subject: Forum Selection Clauses

KEY LEARNING OUTCOMES

Outcome Accreditation
categories
Explain the role of courts and the structure of the American Knowledge;
judiciary. Analysis
Differentiate state courts from federal courts . Knowledge;
Analysis
Identify the responsibilities of trial courts versus appellate Analysis;
courts. Critical
thinking
Articulate how courts apply precedent. Application
Differentiate between subject matter jurisdiction and personal Knowledge
jurisdiction.
Apply the minimum-contacts test in a cyber setting and Application
describe the importance of the Zippo sliding scale.
Recognize how rules of venue affect the location of a trial. Knowledge

TEACHING OUTLINE
A. Role and Structure of the Judiciary [p. 77-78]
Points to emphasize:
§ The judiciary is a collection of federal and state courts existing primarily to
adjudicate disputes and charged with the responsibility of judicial review.
§ State versus Federal Courts: State courts adjudicate matters dealing primarily with
cases arising from state statutory, common, or state constitutional law; while federal
courts are concerned with national laws, federal constitutional issues, and other cases
that are outside the purview of state courts.

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Teaching Tip: How the mechanism works
Once the discussion of federal and state courts begins, students become anxious to learn the nuts
and bolts of a trial. I have found it helpful to simply point out that we have to learn about the
structure of the mechanism first (in this chapter) and learn how the mechanism works to resolve
disputes in the next chapter.

o State Courts: All states have two types of courts: state trial courts and state
appellate courts, in which majority of court cases in the United States are
filed.
§ State Trial Courts: Where parties present their cases and evidence.
• State trial courts have either general authority (organized into
geographic districts) or limited authority (confined to a
particular type of dispute) to hear a particular type of case.
• For minor matters and cases with a dollar value that is
relatively low (typically less than $10,000), states provide local
courts.
• Trial courts are often divided into those that hear civil matters
and those that hear criminal matters.
Concept Summary: Precedent
§ State Appellate Courts: Primarily concerned with reviewing the
decisions of trial courts.
• Only appellate courts are considered courts of authority that
have the right to set precedent.
• States vary as to how state trial court judges are selected
(general elections, appointment process, or a combination).
• Assess the lower court rulings by reviewing the lower court’s
transcripts and rulings, reading briefs, and sometimes allowing
the attorneys to engage in oral argument.
o Federal Courts: Consist of U.S. district courts, the U.S. courts of appeal
(circuit courts of appeal, and the U.S. Supreme Court).
§ U.S. District Courts: Serve the same trial function as state trial courts,
but for issues involving federal matters or matters involving state law
when the parties are from different states and meet other jurisdictional
requirements.
§ Circuit Court of Appeals: The thirteen U.S. courts of appeal, each of
which reviews the decisions of federal district courts in the state or
several states within its circuit, are the intermediate appellate courts of
precedent in the federal system.
• The circuits are divided geographically - Figure : Map of the
U.S. Circuits

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 o U.S. Supreme Court: The nine justices of the Supreme Court are the ultimate
arbiters of federal law that has both original and appellate jurisdiction to
finalize a legal decision on any given case.

Teaching Tip: Use the Court

Students are fascinated by the inner-workings of the U.S. Supreme Court. Former Chief Justice
Rehnquist wrote an excellent book on the process used by the Court to select cases, conferences,
and oral argument (The Supreme Court: How it Was and How it Is). Audio recordings and
transcripts of oral arguments are available from the Court’s Web site and are an excellent tool for
generating interest and discussion. The nomination and confirmation process is also an excellent
catalyst for discussion.

§ The odds of getting to this level are slim; most of these cases involve
conflict among the circuits and relatively complex commercial matters
(Table: Supreme Court Case Acceptance Rate)
§ All federal judges are selected via the appointment process.

Chalk Talk: Federal and State Courts

This is an opportunity to give a little “local color” to your course by creating a grid and asking
students to give the specific name of a court from their home state. I use a diagram on the board
and fill in as I go along. This also helps students understand how courts operate in tandem. Here
is an example the diagram I use for the courts in Pennsylvania.

Federal State Local

Appellate U.S. Supreme Court PA Supreme Court N/A

Intermediate 3rd Circuit Court of Appeals PA Superior Court N/A

appellate

Trial U.S. District Court for Court of Common Pleas District

E.D. of Pennsylvania Justice

CASE 4.1: Canigula v, Strom, 141 S.Ct. 1569 (2021)

FACTS: During an argument with his wife, Edward Caniglia placed a handgun on the dining
room table and asked his wife to "shoot [him] and get it over with." His wife instead left the
home and spent the night at a hotel. The next morning, she was unable to reach her husband by
phone, so she called the police to request that they check on Caniglia’s welfare. Police officers
accompanied Caniglia's wife to the home where they encountered Caniglia on his porch.
Eventually, Caniglia agreed to go to the hospital for a psychiatric evaluation on the condition that
the officers not confiscate his firearms. But once Caniglia left, the officers located and seized his
weapons. Caniglia sued, claiming that the police had entered his home and seized him and his
firearms without a warrant in violation of the Fourth Amendment. The trial court ruled in favor

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of the police and the U.S. Court of Appeals for the First Circuit affirmed the trial court’s ruling.
The appellate court based their decision on a 1973 U.S Supreme Court case that created a
“community caretaking" exception to the Fourth Amendment's warrant requirement. Although
the case in which the exception was created involved a vehicle search, the First Circuit extended
it to households. Prior to the First Circuit’s decision in this case, both the Fifth Circuit and the
Eighth Circuit Court of Appeals had also extended the exception to households. However, the
Third, Seventh, and Ninth Circuit Courts of Appeal have held that the exception does not extend
to the home. The U.S. Supreme Court accepted the case to resolve the conflict among the
circuits.
ISSUE: Does the “community caretaking” exception to the Fourth Amendment extend to homes?
RULING: No. Neither the holding to logic of precedent cases justifies warrantless searches and
seizures in the home. The Court pointed out that although their previous cases held that a
warrantless search of an impounded vehicle for an unsecured firearm did not violate the Fourth
Amendment, the logic behind this decision was that officers who patrol the public highways are
often called to discharge noncriminal community caretaking functions, such as responding to
disabled vehicles or investigating accidents. The Court emphasized that searches of vehicles and
homes are constitutionally different and that their previous decisions repeatedly stressed that
point.

Case Questions:
1. What is the "community caretaking" exception to the Fourth Amendment?
A: While helping someone in distress, police may come upon evidence of a crime in plain view,
and it may be impracticable to obtain a warrant and return to perform a search. In such a case,
the police can seize the evidence without a warrant.
2. What is the primary reason that the U.S. Supreme Court reversed the decision of the First
Circuit?
A. Searches of vehicles and homes are constitutionally different.
3. Focus on Critical Thinking: What is the public policy behind the "community caretaking"
exception? Isn't it logical that the same public policy justification could be applied to a
homestead in addition to a vehicle? Explain.
A: This question is intended to generate discussion on public policy issues that surround the
“community caretaking” exception .

How the Law Develops

Points to emphasize:
State trial courts rule on certain points of state law and render a decision that is binding
on the parties, but no one else; only when an appellate court affirms or reverses this decision is
that point of law applied to all future cases.
Figure: Understanding State and Federal Courts

B. Applying Precedent

• Only courts of authority (appellate courts) can set precedent.

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 • Persuasive Value: In cases where no binding authority exists on a particular legal issue, courts
may look to decisions by either lower courts or appellate courts outside of their own geographic
authority for reasoning they find to be persuasive.
• Distinguishable Cases: If a lower court deviates from binding precedent on a settled legal issue,
the court must justify its decision by articulating an essential factual or legal difference from the
precedent case. To distinguish a case, a court shows that a prior case, cited as applicable to a
pending case, is actually inapplicable due to an essential difference between the two cases.

C. Jurisdiction and Venue [p. 84]

Points to emphasize:
§ Jurisdiction is a court’s authority to decide a particular case based on (1) who the
parties are, and (2) the subject matter of the dispute, while venue is a determination
of the most appropriate court location for litigating a dispute.
§ Jurisdiction and Business Strategy: The cost-benefit analysis involving jurisdictional
restrictions may affect the managerial decision-making process when a company or
individual contemplates filing a lawsuit.
§ Overview of Jurisdiction: Jurisdiction’s origins lie in the Constitution (Due Process
Clause of Fifth & Fourteenth Amendments), while appellate courts and legislatures
have shaped the framework used by modern courts to analyze jurisdiction questions.
o Two-Part Analysis: A court must have both (1) subject matter jurisdiction
(court’s authority over the dispute) and (2) personal jurisdiction (court’s
authority over the parties).
§ Subject Matter Jurisdiction: Authority over the Dispute: State statutes give state
trial courts general subject matter jurisdiction on virtually all matters involving a state
statute, state common law, or a state constitutional issue.
o Federal district courts have limited subject matter jurisdiction: issues
involving a federal question or issues in which the U.S. is a party in the
litigation.
o Federal courts also have subject matter jurisdiction in diversity of citizenship
cases when the amount in controversy is more than $75,000.
o Original versus Concurrent Jurisdiction: Courts that are authorized to
initially hear a case have original jurisdiction. When more than one court
may have jurisdiction over the same case this called concurrent jurisdiction.
o Choice of Forum: A party filing a lawsuit must take into account several
factors when choosing a forum (court location): costs, judges, juries, appeals,
and time.
Quick Quiz: Does a federal district court located in New Jersey have subject matter jurisdiction?

o Jurisdiction over Property: Courts may exercise their jurisdiction based on

property located within their jurisdictional boundaries. In rem jurisdiction
typically allows a court the authority to determine title to an object or real
estate. Quasi in rem jurisdiction occurs when a court uses its in rem

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 jurisdiction to compel a litigant to appear in court by attaching property that
belongs to the litigant.
§ Personal Jurisdiction: Typically, the focus of a personal jurisdiction analysis is on
the conditions of the controversy and the actions of the defendant.
In-State Defendants: Personal jurisdiction is obtained by the courts when the business or
individual is served with the complaint, initiating the lawsuit. Out-of-State Defendants: (1) The
court’s jurisdiction must be authorized by a state long-arm statute; and (2) the court must
ensure that exercising jurisdiction over an out-of-state defendant meets the constitutional
requirements of fairness and due process (determined by examining some level of minimum
contacts and a finding that the defendant purposefully availed themselves to the forum).

CASE 4.2 Goodyear Dunlop Tires Operation v Brown, 131 S.Ct. 2846 (2011)
Facts: Two 13-year-old boys from the state of North Carolina, Matthew Helms and Julian
Brown, had traveled to France to participate in a soccer tournament. The two boys were involved
in a bus wreck outside of Paris on their way back to the airport and died from injuries suffered in
the accident. The parents of the boys believed the accident was due to a defective tire
manufactured by a foreign subsidiary of the Goodyear Tire and Rubber Company (Goodyear
USA) and sued the parent company and three of its foreign subsidiaries in a state court in North
Carolina. Goodyear USA did not challenge personal jurisdiction, but the foreign subsidiaries
argued that the North Carolina court lacked jurisdiction over them and moved to dismiss the
complaint for lack of personal jurisdiction. The trial courts denied the motion and the North
Carolina Court of Appeals affirmed the trial court’s decision in favor of Brown. The Goodyear
foreign subsidiaries then appealed to the U.S. Supreme Court.

Issue: Did the appellate court have jurisdiction over Goodyear’s foreign subsidiaries?

Ruling: No. The U.S. Supreme Court reversed the decision of the appellate court and ruled in
favor of Goodyear. The Court concluded that specific jurisdiction was lacking in this case
because the foreign subsidiaries’ contacts with North Carolina were too limited. In addition, the
Court also ruled that general jurisdiction over the foreign subsidiaries did not exist either.

Answers to Case Questions

1. Why didn’t the parents of the boys in this case initiate their lawsuit against the foreign
subsidiaries of Goodyear USA in a French court?

A. Practical realities of costs and distance.

2. Does this decision mean that the boys’ parents are without any legal recourse against
Goodyear’s foreign subsidiaries?

A. No. Just that the contacts with North Carolina were not sufficient. Other states might
have additional contacts.

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 3. Focus on Critical Thinking: Why does the Court refer to the Due Process Clause in this
decision? Also, should courts automatically deem a foreign subsidiary to share the
“home” of its parent corporation for purposes of establishing personal jurisdiction over
the foreign subsidiary?

A. This question is intended to spur a critical thinking analysis: basic fairness questions.

o Injurious Effects: Courts will also consider if whether it was reasonably

foreseeable that the defendant’s actions would have an injurious effect on a
resident of that state (narrowly applied to cases involving intentional injurious
acts).
__________________________________________________________________
Case 4.3 Clemens v. McNamee, 615 F.3d 374 (5th Cir. 2010)
Facts: McNamee had been an athletic trainer who had worked for both the Toronto Blue Jays
and New York Yankees baseball teams and after authorities convinced McNamee that they had
sufficient evidence to convict him for injecting athletes with anabolic steroids, McNamee agreed
to cooperate with investigators in exchange for immunity from prosecution. During an interview
with investigators, McNamee admitted that he had administered the drugs to star pitcher Roger
Clemens both in Toronto and New York. McNamee repeated these allegations to Major League
Baseball investigators and to a reporter during an interview with Sports Illustrated. In 2008,
Clemens, a resident of Texas, filed suit against McNamee for defamation in Texas. The trial
court dismissed the suit due to lack of personal jurisdiction because the focal point of
McNamee’s statements was not in Texas. Clemens appealed.
Issue: Does the Texas court have jurisdiction over McNamee based on the injurious/harmful
effects on Clemens?
Ruling: The Court of Appeals for the Fifth Circuit upheld the trial court’s ruling in favor of
McNamee and dismissed Clemens’s complaint. The court analyzed McNamee’s contacts with
the state and Texas within the context of the alleged defamation claim and concluded that
McNamee did not have sufficient minimum contacts as required by the long-arm statute and due
process. The court held that to support personal jurisdiction a defamation claim, the forum must
be the “focal point” of the story.

Answers to Case Questions

1. What is the practical implication of this decision? Does it mean that Clemens cannot
bring suit for defamation in any court?

A. This decision simply means that Clemens cannot file suit in Texas.

2. If McNamee had claimed that he injected Clemens with the drugs while in Texas, would
that change the court’s analysis? How?

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 A. Perhaps. The Calder standard involves injurious effects for a defamation claim. Thus,
the focal point is the news story about Texas activities which may be enough for the
Texas court to have personal jurisdiction over McNamee.

3. Focus on Critical Thinking: Why didn’t Clemens sue McNamee in New York? Suppose
that McNamee claimed that he had injected Clemens with steroids in Texas. Would this
admission change the outcome of this case? How?

A. This question is intended to spur a critical thinking analysis: forum selection.

_________________________________________________________________
o Physical Presence: The physical presence of an out-of-state party in a
particular state is generally an automatic basis for jurisdiction over the
defendant by both that state’s courts and federal trial courts within that state.
o Voluntary: A court has personal jurisdiction if the parties agree to litigate in a
specific court.
§ Voluntary agreements are usually done through a forum selection
clause written in a contract between the parties (Shute v. Carnival
Cruise Lines).
o Figure Sample Forum Selection Clause
Concept Summary: Jurisdiction
§ Venue: The legal concept that defines the most appropriate location for the trial.
o Typically, state statutes provide that venue in a civil case is where the
defendant resides or is headquartered, while in a criminal case the venue is
ordinarily where the crime is committed.
__________________________________________________________________
Case 4.4 Franklin v. Facebook, No. 1:15-CV-00655 (N.D. Georgia 2015)
Facts: Ricky Franklin received a series of unsolicited text messages from Facebook on his cell
phone. Franklin sued Facebook in the United States District Court for the Northern District of
Georgia, alleging that Facebook violated the Telephone Consumer Protection Act (TCPA) as
well as Georgia law. In response, Facebook filed a Motion to Transfer Venue, requesting the
district court to enforce the forum of service, which every Facebook user must agree to when
creating a Facebook account, and to transfer the case to federal district court in Northern
California. Facebook argued Franklin was contractually bound to their terms of service. Franklin
opposed Facebook’s motion to transfer and combated that the forum selection clause in
Facebook’s terms of service was inapplicable to his case, since his complaint was not based on
his own use of Facebook but rather on the transmission of unsolicited text messages.

Issue: Does Facebook’s forum selection clause in their terms of service and motion to transfer
cover themselves from Franklin’s suing?

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Ruling: Yes. The U.S. District Court for the Northern District of Georgia ruled in favor of
Facebook and granted the motion to transfer. The court ruled that the forum selection clause in
Facebook’s terms of service was valid and applied to the facts of this case.

Answers to Case Questions

1. Are forum selection clauses always enforceable? Put another way, under what situations
will a court not enforce a forum selection clause?
• Where there is fraud or overreaching or public policy requires it, a forum selection
clause is not enforceable.

2. Franklin had alleged in his complaint that the text messages he received from Facebook
were unsolicited and thus not related to his own Facebook account. Given this allegation,
did the court decide the case correctly?
• The question is intended to spur discussion: unsolicited text messages.

3. In its order, the court refers to the “persuasive authority” of several district court
decisions involving Facebook users in previous cases. Nevertheless, was the judge
obligated as a matter of law to follow these previous decisions? Why or why not?
• No. Because this is a trial court and other trial courts cannot set precedent.

4. Focus on Critical Thinking: What if Franklin had posted the following “status update” on
his Facebook account right after signing up for Facebook for the first time:
I, Ricky Franklin, hereby agree to every provision in Facebook’s terms of use,
except for the forum selection clause. I do not agree to the forum selection clause
because I live in Georgia and I want a court in Georgia to resolve any dispute I
may have with Facebook in the future.
If Facebook had chosen not to deactivate or suspend Franklin’s account after he had
posted such a message to his Facebook account, would the forum selection clause still
have been enforceable?
• This question is intended to spur a critical thinking analysis: eliminating a forum
selection clause.
__________________________________________________________________

D. Minimum Contacts and the Internet

Points to emphasize:
§ How the Law Develops in Real Time: Courts tend to diverge over the sufficient
minimum contacts with the forum state to establishing personal jurisdiction over an
out-of-state defendant. Some have ruled a physical presence in the forum state is not
necessary (Costar Realty Information v. Meissner). Other courts have concluded that
e-mail communications alone are insufficient to establish personal jurisdiction
(Engineers Corp. v. Geometric Ltd).
o The Zippo Standard is a sliding scale approach (based on three points along
the scale: passive, interactive, and integral to the business model) for

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 measuring the amount of minimum contacts a party has based on the
interactivity of a Web site.
§ Passive: On one far end of the continuum, a party with a passive
Web site that provided information that could be accessed by any
Internet user cannot be the sole basis for personal jurisdiction.
§ Interactive: The middle of the continuum applies when a Web site
provides users with some interactive function where users may
exchange information, purchase products, download or upload
material via the Web site, or other uses that involve the user
activity beyond merely viewing the content of the Web site.
§ Integral to Business Model: The other far end of the scale is a
business where the use of the Web site is an integral part of a
business model and is used to accomplish commercial transactions
with residents in the state of the court’s jurisdiction.
o Zippo Manufacturing Company v. Zippo Dot Com, Inc.

o Soon after Zippo was decided, several other courts began to use the same type
of analytical framework.
Self-Check: Determine whether the court would have personal jurisdiction under the Zippo
standard.

Talking Points: Additional Discussion Questions on the Zippo standard

1. Does anyone in this class sell merchandise from a website?
2. If so, where does your transaction fall on the Zippo scale?
3. How could a business protect itself from being hauled into an out of state court on the basis of
their website?

CASE 4.5 Shisler v. Sanfer Sports Cars, Inc., 53 Cal. Rptr. 3d 335 (2006)
Facts: Sanfer Sports Cars, Inc. (Sanfer) is an auto dealership located and incorporated in Florida.
In its 32-year history, the overwhelming majority of cars sold by Sanfer were to residents of
south Florida. Sanfer has never owned or leased property in California, has never advertised
directly to residents of California, and has never intentionally focused on selling cars specifically
to residents of California. However, Sanfer does maintain a website that is, naturally, accessible
to any user in the world. The website was used by Shisler, a California resident, to locate a 2002
BMW M5 automobile. Shisler subsequently called and wrote Sanfer to inquire about price and
delivery terms. The parties agreed on price, and Shisler purchased the car and arranged to have
the car shipped from Florida to his home in California. When the car arrived in California, it was
not as Shisler expected. After the parties failed to resolve the dispute, Shisler filed suit in
California alleging deceptive trade practices. Sanfer requested that the California court dismiss
the suit because it lacked personal jurisdiction over him.
Issue: Did Sanfer’s maintenance of an interactive website that is used by California residents
result in sufficient minimum contacts to establish personal jurisdiction?

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Ruling: The California Court of Appeals held in favor of Sanfer and ruled that there was not
enough contact with California or its residents. The court applied the Zippo sliding scale and
concluded that the website did not target California residents and lacked interactive features. The
court explained that creating a website, like placing a product into the stream

Case Questions:
1. If Sanfer’s website featured methods for purchasing items from the dealership via credit card,
how would that change your analysis?
• Economic transactions tend to move a party towards the interactive side of the Zippo
scale.

2. How is it possible to “target” residents of a particular state through a website? Have you ever
seen an example?
• One example includes offering discounts to specific state residents.

3. Focus on Critical Thinking: Look up websites for merchants in your area. Are there any that
potentially target residents of other states? What is the difference in format, language, and
interactivity between these websites?
• This question is designed to have students assess the various levels of interactivity

E. Criticism of Zippo standard

Despite the widespread adoption of the Zippo standard, some courts have rejected it as too
vague. For example, the U.S. Court of Appeals has found that website interactivity alone is still
not sufficient for jurisdiction. In Snodgrass v. Berklee College of Music, the Seventh Circuit
found that no general personal jurisdiction existed in Illinois for a music school in Massachusetts
whose students and prospective students had thousands of online interactions and contacts on a
regular and systematic basis. The court indicated that the interactivity alone, with evidence that
they had targeted Illinois residents, was insufficient contact.

END OF CHAPTER FEATURES

Thinking Strategically [p. 97-98]
Perhaps the single greatest legal risk that all businesses face is the threat of litigation. Given the
relative ease for a business to enter into markets that cross state and national borders, there is a
real possibility of a lawsuit brought by an out-of-state or foreign plaintiff.
STRATEGIC SOLUTION: Forum shopping refers to a common strategic tactic by plaintiffs in
civil litigation. It occurs when a plaintiff strategically selects the most favorable legal forum in
which to initiate a lawsuit.

QUESTIONS
1. Is forum shopping ethical?

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 • This question is intended to spur discussion of forum shopping as an ethical matter.
Instructors may wish to have students re-read Chapter 2: Business, Societal, and
Ethical Contexts of Law

2. Should courts enforce forum selection clauses in business to consumer contracts like the
Facebook user agreement described here? Why or why not?

• This question allows a student to focus on what an “average” consumer should know
and what the law expects them to know.

3. Suppose Facebook did not have a forum selection clause in its user agreement. Would
Facebook be subject to the jurisdiction of every state court in the United States since it has
millions of users in every state?

• Perhaps. That is why strategic decision-making helps reduce risk. A forum selection
clause reduces the risk of having to litigate in hundreds of venues.
Case Summaries [p. 99-101]
Case Summary 4.1: Personal Jurisdiction: Bickford v. Onslow Memorial Hospital Foundation
1. Does the Maine court have jurisdiction over Onslow?
A: No. The Maine court lacks personal jurisdiction over Onslow unless it could be
shown that Onslow has sufficient minimum contacts with Maine according to Maine
long-arm statutes.

Case Summary 4.2: Jurisdiction: Forum Selection Clause: M/S Bremen v. Zapata Off-Shore Co.
1. Does the court in Tampa have jurisdiction?
A: No.

2. Why or why not?

A: The parties signed a forum selection clause that obligates the parties to litigate any
dispute arising out of the contract in an International Commercial Court in London.
3. Will the forum selection clause be enforced? Why or why not?
A: The forum selection clause would likely be enforced because Zapata, a non-resident
party, agreed to the jurisdiction of the International Commercial Court in London
when they did no alter that part of the contract prior to signing the agreement.

CASE SUMMARY 4.3 Mink v. AAAA Development LLC, 190 F.3d 333 (5th Cir.
1999) Minimum Contacts

CASE QUESTIONS
1. Where does the AAAA website fall on the sliding scale of the Zippo standard?

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 A: Non-interactive. More like a billboard advertisement (e.g., no transactions etc.).

2. As a practical matter, what happens to Mink’s case now? May he refile it in another court?
A: Mink may refile in another court. Assumedly a court would have jurisdiction
wherever AAAA is headquartered.

CASE SUMMARY 4.4 Toys “R” Us, Inc. v. Step Two, S.A., 318 F.3d 446 (3d Cir. 2003)
Minimum Contacts via the Web and the Zippo Standard

CASE QUESTIONS
1. Does the federal court in New Jersey have subject matter jurisdiction over this case?
A: Yes. It is a federal statute.

2. Has Step Two purposefully availed themselves in New Jersey, thus having the requisite
minimum contacts? Why or why not?
A: Probably not. Although they were interactive in terms of a website, they never
shipped their products or had a sales force in New Jersey.

3. Analyze this case under both the Zippo and Asahi frameworks. Describe the analysis and
potential outcome under each. Which is the correct test to use and why?
A: Zippo: Jurisdiction could be based on the interactivity of the website; Asahi: No
jurisdiction because there was no direct product shipped to New Jersey.

CASE SUMMARY 4.5 Estate of Weingeroff v. Pilatus Aircraft, 566 F.3d 94 (3d Cir. 2009)
Purposeful Availment

CASE QUESTIONS
1. Who prevails and why?
A: Pilatus prevailed because they had no minimum contacts with Pennsylvania. The
parts obtained from Pennsylvania were a small fraction of the overall purchases of the
manufacturer and Pilatus had no presence in Pennsylvania.

2. Suppose the plane had crashed and injured a pedestrian on the ground. Would the victim be
able to bring a case against Pilatus in a Pennsylvania (state or federal) court?
A: Perhaps. Under injurious effects.

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 Chapter 5
Resolving Disputes: Litigation and Alternative Dispute Resolution

CHAPTER OVERVIEW
This chapter covers the stages of litigation and their characteristics, as well as alternative forms
of dispute resolution, their advantages and disadvantages.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the impact of using civil litigation as a method of resolving business Application
disputes.
Name the stages of litigation and identify the characteristics and processes of Knowledge
each stage.
Identify the ways in which dispute resolution can be used in business Application
planning.
List the methods of alternative dispute resolution (ADR) and describe Application
potential advantages or drawbacks of using ADR.

Teaching Tip: Litigation and ADR

Although students are familiar with trial litigation from the movies, they often have no concept
of ADR. Although ADR is covered in detail at the end of the chapter, it is helpful to the students
to provide an explanation of ADR prior to going through the section on civil litigation. You can
explain how negotiations are usually held throughout the entire litigation process and the ADR is
usually used when required by contract or law.

I. CIVIL LITIGATION [p. 104-107]

Points to emphasize:
• Civil litigation refers to dispute resolution processes of civil (noncriminal) cases in
public courts of law.
• There are many varieties of business litigation.
• According to the U.S. Bureau of Justice Statistics, the total number of civil cases filed in
state and federal courts now exceeds 30 million cases annually.

A. Impact of Civil Litigation Dispute Resolution and Business Planning [p. 105]
Points to emphasize:
Dispute resolution is a crucial part of business planning and strategy that requires a thoughtful
cost-benefit analysis. Although lawyers can provide advice on strategy, it is up to the owners to
decide how to resolve disputes. When a dispute arises, there are multiple alternatives to consider
as indicated in Table 5.1.

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TABLE 5.1
Dispute Resolution Options for Classic Retail Outlets versus Sign Designs Company

Action Potential Benefit(s) Potential Costs Threats

Lawsuit Court-ordered resolution to Significant expenditures:
have the deposit refunded and legal fees; hard costs (such Loss at trial or loss upon appeal.
have SignCo pay additional as travel and fees for Legal fees may be higher than the
damages to compensate for the experts); human resources final judgment amount awarded.
cost of temporary signage. costs when time must be Possible countersuit by SignCo.
devoted to litigation Permanent damage to business
procedures; appellate relationship.
costs. Potential for bad publicity.

Nonjudicial dispute resolution

Arbitration, mediation, or hybrid
form. Enforceable resolution to have
the deposit refunded and have Moderate range in legal
SignCo pay additional damages fees, arbitration/ Loss at arbitration that is not
to compensate for the cost of mediation fees; limited appealable (if binding).
temporary signage. human resource Win in arbitration, but still have to go
expenditures; no chance of to trial (if nonbinding). Potential
appellate fees (if binding). damage to business relationship.

Low range of legal fees; Settlement negotiations may drag on

moderate human and CRO must find a new vendor.
Informal settlement Parties agree not to sue each resources investment; no
Cancel the contract, agree not to other. threat of litigation by
sue each other, and agree to a Potential exists to preserve the SignCo.
figure that (1) compensates CRO for business relationship. Time and
the temporary signage and (2) talent are not used to prepare
allows a percentage of the total fee for dispute resolution methods.
to compensate SignCo for time
invested in the project.

Transaction is completed Low range of legal fees; Potential litigation by SignCo and
(perhaps even at a profit) and moderate human potential for the new contract to
Revise contract, continue relationship
business relationship is resources. generate yet another dispute.
Make contract expectations clearer
preserved.
and revise payments that
compensate both parties for the
loss.

II. CLASS ACTION LAWSUITS [105-107]

Points to emphasize:
• A lawsuit where a group of people with the same or similar injuries sue for damages that
were caused by the same defendant.
• The allegations against the defendant are (1) illegal conduct, (2) involvement in an
unlawful transaction, or (3) sale of a defective product
• Defendants face a larger cumulative claim, while class members share expenses of
litigation.

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 A. Class Action Fairness Act [p. 106]
Points to emphasize:
• Provides federal courts with authority to scrutinize procedures for review of class
action settlements and changes the rules for evaluating settlements, often reducing
attorney fees.
• More judicial oversight of coupon settlements.
Case 5.1 In re Subway Sandwich Marketing and Sales Practices Litigation, T. Frank,
Objector; No. 16-1652 (7th Cir. 2017)
Facts: After it was discovered that Subway’s “footlong” sandwiches were only 11 inches, a class
action suit was brought against Subway under state consumer protection law. During discovery
Subway showed how although variations occur, most of their baked rolls were 12 inches. As a
result, a settlement agreement was entered requiring Subway to implement measures to ensure
that their sandwiches were at least 12 inches and provided fees for the plaintiff’s attorneys, but
no compensation for the plaintiffs. The trial court approved the settlement.
Issue: Should the class action settlement agreement have been approved when it provided no
benefit to the plaintiffs?
Ruling:. No, the settlement did not fairly protect the interests of the class and appears to have
been intended to enrich the attorneys. The class action suit should have been dismissed.
Case Questions
1. Why do you think the class representatives approved this settlement?
This question encourages the students to consider the legitimacy or class actions in terms of
attorney pressure. There are multiple possible answers.
2. The plaintiff’s counsel argued that the settlement did provide meaningful benefits to the class
because Subway has bound itself to a set of procedures designed to achieve better bread-length
uniformity. Is that a convincing argument? Why or why not? Students may also agree or
disagree as to the answers. If the sandwiches were uniformly below 12”, which was not the case
here, the new procedures would have made a measurable difference. However, if the parties
expected to be compensated for all of the sandwiches they previously purchased that may have
fallen short of 12 inches, then the attorneys’ arguments fail.
3. Focus on Critical Thinking: Could there be any remedies that the court would find
“meaningful”? If the Footlong sub was only 9 inches long, how would that impact the case? Is
there a baseline as to how much a merchant can deceive a consumer? This question is meant to
elicit a conversation regarding how injury is determined in a lawsuit and what types of remedies
are appropriate. How much of a difference between what is advertised and what is received is
required?

III. STAGES OF LITIGATION [p. 107-115]

Points to emphasize:
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• The stages of litigation include prelawsuit (pre-trial), pleadings, motions, discovery,
pretrial conference, trial, posttrial motions and appeals, and collecting the judgment.
• These stages may overlap.

A. Prelawsuit: Demand and Prelitigation Settlement Negotiations [p. 107-108]

Points to emphasize:
• When a dispute arises between two parties, one party typically will make an informal
demand of the other party to lay out the dispute and demand an action.
• In some states a formal demand is required. These discussions can lead to a resolution
prior to proceeding to trial. If not, the informal or formal demand serves as notice that the
party intends to file a lawsuit.

1. Standing [p. 108]

• In order for a party to bring a lawsuit, they must have standing to sue. This means that
the party asserting the claim: (1) must have suffered an injury in fact; (2) suffered harm
that is direct, concrete, and individualized; and (3) articulates what legal redress exists to
compensate for the injury.
• If multiple plaintiffs have the same injury, a class action may be permitted.

B. Pleadings Stage [p. 108-112]

Points to emphasize:
• A pleading is a document containing factual allegations that each party is required to file
in a lawsuit. The specific format, deadlines, and requirements of each pleading are set
forth in court rules known as the Rules of Civil Procedure.

1. Complaint and Summons [p. 108]

• The plaintiff initiates a lawsuit by filing a complaint with the court clerk.
• The complaint sets out the plaintiff’s version of the facts of the case, the damages that
have been suffered, and why the plaintiff believes that the defendant is legally
responsible for those damages.
• When filing the complaint, the plaintiff typically arranges for service of a summons
along with a copy of the complaint to the defendant.
• The summons requires the defendant to answer the complaint within a certain time period
and may be served by certified mail, deputy sheriff or process server.

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Figure 5.1 sets out a sample complaint for the CRO v. SignCo case described on page 109.

2. Answer [p. 110]

• Once the defendant is served with the complaint, she must provide a formal answer
within a prescribed time frame (normally within 20 days).
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 • The answer responds to each paragraph of the complaint. Failing to respond will result in
a default judgment against the defendant which means the defendant automatically loses
the case.
Figure 5.2 sets out a sample answer for the CRO v. SignCo case described on page 110.

3. Counterclaim [p. 111]

• If the defendant believes that the plaintiff has caused her damages arising out of the very
same set of facts as articulated in the complaint, the defendant files both an answer and a
counterclaim which sets forth the defendant’s theory of liability against the plaintiff. The
plaintiff then is required to reply to the counterclaim.
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 4. Cross-Claim [p. 111]
• The defendant also may file a cross-claim to bring in a third party to the litigation when
the defendant believes that a third party is either partially or fully liable for the damages
that the plaintiff has suffered.

5. Motions [p. 111]

• A motion is a document filed by one party that requests court action in a matter
pertaining to the litigation and can be filed at any time. Some of the more common
motions are described in Table 5.2.

Case 5.2 Hernandez et al. v. Yellow Transportation, 670 F.3d 644 (5th Cir. 2012) [p. 111-
112]
Facts: Hernandez brought a discrimination lawsuit against Yellow Transportation (Yellow)
alleging that the employer maintained a hostile work environment based on being called a
racially derogatory name by a co-worker on one occasion and seeing a poster or letter that was
derogatory toward Latinos on another. Yellow filed a motion for summary judgment alleging
that based on the facts, there was no genuine issue for the trial. The lower court granted yellow’s
Motion for Summary Judgment.
Issue: Was their evidence of personal racial harassment that was sufficiently severe or pervasive
as to affect his employment to create a hostile work environment?
Ruling: No, the summary judgement was granted because the evidence alleged showed that
there was no genuine issue of material fact as even the plaintiff alleged that the incidents were
inspired by personal animosity rather than racial discrimination. “Summary judgment is proper if
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the pleadings and evidence show there is no genuine issue of material fact and the moving party
is entitled to a judgment as a matter of law.”
Case Questions
1. Shouldn’t Hernandez be permitted to have his day in court? Why shouldn’t this case go to
trial?
• Because the plaintiff did not allege facts meeting the legal requirements to establish a
hostile work environment case there was no additional evidence required of the
defendant. Based on the complaint and plaintiff’s evidence, the case could be dismissed
under a summary judgement motion because there was “no genuine issue of material
fact” and the case could be decided as a matter of law. The case did not need to go to trial
because the facts were undisputed.
2. Hernandez alleged he was the victim of race-based harassment, in part because of an anti-
Latino poster that was located in the workplace. Isn’t that what discrimination laws are supposed
to prevent?
• A hostile work environment claim requires evidence of personal racial harassment
sufficiently severe or pervasive as to affect Hernandez’s employment. The evidence
presented was insufficient as only two incidents, including the poster, were alleged.
3. Focus on Critical Thinking: Given the court’s reasoning, what are some examples of incidents
that you think could have gotten Hernandez through the summary judgment stage? Have you
ever experienced harassment in the workplace?
• This question is meant to elicit a conversation regarding alternative allegations that could
give rise to a hostile work environment claim.

C. Discovery Stage [p. 112-113]

Points to emphasize:
• After the pleadings stage comes the discovery stage.
• Discovery is the legal process for the orderly exchange of evidence. Each side has the
right to know and examine the evidence that the other side has, including evidence that is
both inculpatory and exculpatory.
• Everything relevant to the case is discoverable unless protected by legal privilege.

1. Method of Discovery [p. 112-113]

• The Rules of Civil Procedure set out how this information is exchanged.
o Depositions are oral questions asked of a witness in the case and may be taken
from the plaintiff, the defendant, or any other witness in the case.
• Interrogatories are written questions to be answered by one of the litigants
(plaintiffs or defendants) involved in the case.

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 • Requests for production seek specific documents that the other party may
possession and could include documents, memoranda, reports, notes, calendars,
videotape, audiotape, e-mail, computer hard drives, and so on.
• Requests for admissions are attempts to obtain information that furthers the
objective of determining which facts are in dispute (and, thus, must be proved at
trial) and which facts both parties accept as true.

D. Pretrial Conference [p.113-114]

Points to emphasize:
• A pretrial conference is generally held between the attorneys for the parties and the
judge in the case, with no court reporter present in order to (1) encourage settlement, and
(2) resolve any outstanding motions, confirm that discovery is proceeding smoothly, and
dispose of any procedural issues that have arisen during the pleadings or discovery
stages.

E. Trial [p. 114]

Points to emphasize:
The trial generally takes place in front of a judge as the finder of law and with a jury as the
finder of fact.
• In the case both parties waive their right to a jury, the judge will serve as both finder of
law and finder of fact in a bench trial.

1. Jury Selection and Opening Statements [p. 114]

• Jury selection, known as voir dire, is the process of asking potential jurors questions to
reveal any prejudices that may affect their judgment of the facts.
• After the jury is selected, the attorneys present their theories of the case and what they
hope to prove to the jury in opening statements.

2. Testimony and Submission of Evidence [p. 114]

• After the opening statements, the plaintiff’s attorney asks questions, known as direct
examination, of the witnesses on the plaintiff’s list.
• The defendant’s attorney may then conduct cross-examination of the witnesses limited
to the topics brought out in direct examination.

3. Closing Arguments and Charging the Jury [p. 114]

• Once the testimony is completed and the evidence has been submitted to the jury, each
attorney making their closing arguments which attempts to persuade the jury to hold in
favor of her client.
• The judge then proceeds with the charging of the jury by giving the jurors instructions
on how to work through the process of coming to a factual decision in the case.
• The standard of proof in a civil case is a preponderance of the evidence.

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Teaching Tip: Burden of Proof

Although this chapter focuses on civil trials, it is a good time to explain how the burden of proof
differs between civil and criminal cases. The burden of proof in a civil case (preponderance of
the evidence) is much easier to meet than that in a criminal case (beyond a reasonable doubt).
The reason for the difference is that our justice system requires a higher standard in order to
deprive someone of their liberty.

4. Deliberations and Verdict [p. 114]

• After receiving the jury instructions, the jury retires to a private location to engage in
deliberations where they discuss the case and examine the evidence.
• If the jury reaches a decision it is given to the judge and known as a verdict.
• If the jury fails to reach a verdict, it is known as a hung jury and there will be a new
trial.

F. Posttrial Motions and Appeals [p. 115]

Points to emphasize:
• When the losing party tries to convince the original judge that the verdict was flawed, she
will file a posttrial motions. In addition, or in the alternative, the losing party may file an
appeal to a higher court to review the lower court’s decision.
• The appellate court can affirm, reverse, remand or modify the decision.

G. Collecting the Judgment [p. 115]

Points to emphasize:
• The winning party must then seek to collect the judgment which can be difficult if the
losing party’s assets are difficult to reach.
• The court may order the losing party’s employer to garnish their wages.
• The winning party is known as the judgment creditor and may pursue a case against the
defendant’s assets in court.

IV. ALTERNATIVE DISPUTE RESOLUTION [p. 116-123]

Points to emphasize:
• Alternative dispute resolution (ADR) refers to nonjudicial methods to resolve disputes.
• The two primary types of ADR are arbitration and medication.
• Given the risks of litigation, some businesses choose ADR over litigation for the
following reasons: (1) costs: ADR could potentially cost a fraction of normal litigation
costs, (2) Preserving the business relationship: ADR is less adversarial than litigation, (3)
Time: The time spent in ADR is much less than the two- to three-year (or more) period
normally associated with discovery, a civil jury trial, and possible appeal, (4) Expertise:
ADR can utilize the expertise of an industry expert to resolve the dispute who would
have knowledge in a complex case that a judge may not, (5) Privacy: There is generally
no public record of ADR, unlike most court cases.
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 A. Informal ADR [p. 113]
Points to emphasize:
• Informal ADR involves the parties negotiating face-to-face or through intermediaries for
(1) a settlement agreement, whereby one party agrees to a payment in exchange for the
other party’s promise not to sue, or (2) an agreement to cancel a contract or to revise an
existing contract.

V. FORMAL ADR METHODS [p. 117-119]

Points to emphasize:
• The most common formal ADR methods are arbitration, mediation, and expert
evaluation.
• Most state or federal courts require mediation or nonbinding arbitration prior to allowing
certain civil lawsuits to go to trial.
• Typically, in a business context, ADR is invoked either via contract or by mutual
agreement

A. Arbitration [p. 117-121]

Points to emphasize:
• Arbitration is the most formal type of ADR where an individual or panel of arbitrators
hear the dispute and issue a decision.
• There is no discovery and the rules of evidence do not apply.
• The largest arbitration provider in the United States is the American Arbitration
Association (AAA).
• After an application for arbitration is received, a tribunal administrator is appointed who
coordinates the case and informs the parties of the procedures and rules of arbitration.
• The arbitrator or panel functions like a judge. In binding arbitration, the arbitrator’s
decision is final.
• In non-binding arbitration either party may proceed to trial if they do not like the
arbitrator’s decision.

1. Legally Mandated Arbitration [p. 117]

• When the parties agree to an arbitration clause in a contract, this is known as a private
arbitration.
• When a court require a civil lawsuit to go to arbitration, it is nonbinding, and either party
may proceed to trial.

2. Federal Arbitration Act [p. 118]

• The Federal Arbitration Act (FAA) is a statute that requires state and federal courts to
enforce arbitration awards.
• The FAA also identifies the following four grounds when courts may set aside the award
of an arbitrator:
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 • The arbitration involves some degree of corruption or fraud,
• The arbitrator has exhibited inappropriate bias,
• The arbitrator has committed some gross procedural error (such as refusing to hear
relevant evidence) that prejudices the rights of one party, or
• The arbitrator has exceeded her explicit powers or failed to use them to make an
appropriate final award.

Case 5.3 American Express v. Italian Colors Restaurant, 133 S. Ct. 2304 (2013)
Facts: American Express (Amex) entered into agreements with Italian Colors Restaurant and
other merchants. The agreement had an arbitration clause which required all disputes between
Amex and the merchants be resolved through arbitration and prohibited any claim from being
arbitrated on a class action basis. When the merchants filed a class action against Amex, Amex
moved to compel individual arbitration. The merchants tried to argue that the clause was invalid
because the cost of expert analysis necessary to prove their antitrust allegations would greatly
exceed the maximum recovery for an individual merchant plaintiff. Although the trial court ruled
in favor of Amex, the appellate court reversed. Amex then appealed to the Supreme Court.
Issue: Was the clause was unenforceable because of the prohibitive cost structure?
Ruling: No, the U.S. Supreme Court reversed the appellate court’s ruling and held in favor of
Amex. The Federal Arbitration Act (FAA) does not permit courts to invalidate a contractual
waiver of legal rights based solely on the grounds that a plaintiff’s dispute resolution costs
exceed any potential amounts to be recovered. The FAA reflects the principle that arbitration is a
matter of contract and that courts had a responsibility to enforce arbitration agreements
according to their terms.
Case Questions
1. Was the waiver of class action arbitration by the merchants truly voluntary? Why or why not?
Although we do not have enough facts to determine if it was truly voluntary, the arbitration
clause was a matter of contract between two parties and was required to be enforced by the
courts.
2. If the costs of experts exceed the potential recovery amount in the absence of a class action,
doesn’t the arbitration clause in this case have the effect of shielding Amex from antitrust laws?
The government can bring antitrust actions.
3. Focus on Critical Thinking: Why did the Court interpret the Federal Arbitration Act so strictly
in this case? Should courts have more leeway when interpreting statutes? These questions are
meant to elicit a conversation regarding the limits of a court in interpreting contracts.
1. Arbitration Related to Sexual Assault or Sexual Harassment Claims [p. 119]

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 • FAA amended in 2022 to end forced arbitration of sexual assault and
sexual harassment claims.
• Contracts with mandatory arbitration clauses for these claims are invalid
and unenforceable.
• Option to pursue arbitration rather than litigation depends on the wishes of
the person alleging the assault or harassment. The choice rests with the
victim.

B. Employment and Labor Arbitration [p. 120-121]

Points to emphasize:
• Arbitration clauses are a central issue in the context of employment and labor
disputes.
• In these types of disputes, courts are highly deferential to a decision rendered by
an arbitrator because an arbitration clause is the product of negotiations between
employer and employee.
• Labor unions negotiate a contract on behalf of their members called a collective
bargaining agreement that frequently includes mandatory and binding arbitration.
• The Supreme Court has held that arbitration provisions in employment and labor
contracts are enforceable.

Case 5.4 National Football League Management Council v. Brady, No. 15-2801 (2d Cir
2016)
Facts: During a 2015 game between the New England Patriots and Indianapolis Colts, the
officials received a complaint from a Colts player to check the game balls’ inflation levels. All
eleven balls used by the Patriots were discovered to be underinflated and below the acceptable
range established by League rules. Of the four balls used by the Colts, each tested within the
permissible range. A law firm hired by the league conducted and investigations and concluded
that two equipment managers were responsible for the deflation and quarterback Tom Brady was
generally aware of the practice. As a result, the League suspended Brady for four games. Brady,
through his union, appealed the suspension and asserted his union contract rights to an arbitration
hearing. The arbitrator upheld Brady’s suspension. On appeal, a federal trial court vacated the
decision on the basis that Brady had not been provided adequate notice that suspension was
within the League’s range of punishments. The League appealed the trial court’s decision.
Issue: Was Brady provided adequate notice that suspension was within the League’s range of
punishments?
Ruling: No, the appellate court reversed the trial court’s decision, ruled in favor of the League,
and instructed the lower court to confirm the arbitration award. The court held that Brady had not
met the high standard required for courts to vacate arbitration awards.

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Case Questions
1. Why did the court reject the trial court’s conclusions? The appellate court ruled that the trial
court did not adhere to a basic principle that a federal court’s review of labor arbitration should
be narrowly circumscribed and highly deferential.
2. What standard should a court apply in deciding whether to vacate a labor arbitration award?
The question is designed to spur discussion on a court’s ability to reveres an arbitration
decision.
3. Focus on Critical Thinking: The union contract permits the League’s commissioner to serve
as sole arbitrator in a disciplinary suspension appeal. Could this impact the impartiality of the
arbitration? Why would the players’ union agree to that provision in its contract with the
League? These questions are meant to elicit a conversation regarding conflicts of interest.

C. Mediation [p. 121]

Points to emphasize:
• Mediation is a cost-efficient form of dispute resolution because it is relatively informal
and does not require as much time or preparation as arbitration.
• Unlike arbitration where the arbitrator makes a decision, a mediator merely facilitates
discussion in order to get the parties to reach an agreement.
• Mediation is sometimes required by statute or court procedure before a dispute can be
brought to trial.

D. Expert Evaluation [p. 121]

Points to emphasize:
• For parties involved in a business dispute with complex issues, and independent expert
conducts an expert evaluation (neutral fact-finding) and then recommends a settlement.
• The expert evaluator (1) reviews documents and evidence provided by each party that
give a full description of the events and circumstances leading to the claim and the
resulting loss, (2) ask questions or take witness statements, and (3) gives her opinion on
the merits, puts a value on the claim, or recommends a settlement amount.

E. Other Forms of ADR [p. 122]

Points to emphasize:
• With med-arb, a hybrid of mediation and arbitration, the parties submit themselves to a
short period of mediation, and if they are unable to agree upon a settlement, move to
binding arbitration.
• Summary judgment trials are abbreviated half- to full-day trial is conducted by a retired
judge in front of a jury, usually after discovery has been completed. Time limits may be
set regarding each facet of the summary trial. No live expert testimony is presented, and
the attorneys primarily conduct the proceeding through oral argument.

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 • A mini-trial is an abbreviated version of a trial held in front of an industry expert who
does not necessarily make a decision but can provide an expert opinion as to the likely
result if both parties proceed to trial.

VI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 124-125]

Chapter Review Questions [p. 127-128] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 123]

1. What are the benefits and drawbacks of the counter-claim strategy?

• Primary advantages include: 1) lower costs that can tip the cost-benefit analysis for
smaller disputes; 2) a sense of fairness for the customer/client involved in the dispute; 3)
time investment is lower. Disadvantages include: 1) limited opportunity to present
evidence or engage in discovery; 2) Enforceability (e.g., losing side fails to abide by
decision) of the resolution is still an issue and may not be worth the expense.

2. Could this matter have been resolved through Alternative Dispute Resolution (ADR)? What
are the benefits and drawbacks of using ADR?

• This matter could have been resolved through ADR and a discussions should be directed
towards why and what form of ADR might be most beneficial.

• Primary advantages include: 1) lower costs that can tip the cost-benefit analysis for
smaller disputes; 2) a sense of fairness for the customer/client involved in the dispute; 3)
time investment is lower. Disadvantages include: 1) limited opportunity to present
evidence or engage in discovery; 2) Enforceability (e.g., losing side fails to abide by
decision) of the resolution is still an issue and may not be worth the expense.

3. Was YSL’s counterclaim strategy ethical? Explain.

• A discussion on ethics and counterclaims would lead towards it was ethical and the court
somewhat agreed with the counterclaim by narrowly tailoring the trademark claim.

Case Summary Questions and Answers [p. 122-123]

CASE SUMMARY 5.1 Infinite Energy, Inc. v. Thai Heng Chang, 2008 WL 4098329 (N.D.
Fla. 2008)

1. Who prevails and why?

• The court denies Infinite Energy’s request. The court held it was outside the scope of
reasonable discovery.
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2. Is this information necessary for Infinite’s case? Why or why not?
• Certain information may be necessary and subject to discovery. However, the court held
that the request for all emails was overly broad at such an early stage of the litigation.

CASE SUMMARY 5.2 Bridgestone Americas Holding, Inc. v. Mayberry, 854 N.E.2d 355
(Ind. 2006)

1. If Bridgestone’s formula for the tire were already known to its competitors, would they have
been able to protect it from discovery? Why or why not?
• Bridgestone’s theory is that the formula is a trade secret. If the formula were already
known to its competitors, it would not be a trade secret and therefore not protectable in
discovery.

2. Under what circumstances would potential harm of disclosure outweigh the need for the
information in a trial?
• If the formula was protected by a patent and disclosure of patented information would
result in irreparable harm, it would outweigh the potential use by the plaintiffs at trial.
Still, it would be a high burden on the part seeking to prevent the disclosure if the
plaintiffs showed that the information was unable to be obtained any other way.

CASE SUMMARY 5.3 Massachusetts v. U.S. Environmental Protection Agency, 127 S. Ct. 1438
(2007)

1. Does a state have standing to sue a federal agency?

• States were found to have standing. The Court reasoned the states had a particularly
strong interest in the standing analysis.

2. Is the erosion of a coastline an “injury” in the same context as injuries suffered in other types
of cases (such as negligence or breach of contract)?
• Yes. The Court ruled that Clean Air Act defines air pollutant as any air pollution agent or
combination of such agents and that greenhouse gases fit well within the CAA's
definition of air pollutant as an injury.

CASE SUMMARY 5.4 Exxon Shipping Co. v. Exxon Seamen’s Union, 11 F.3d 1189 (3d
Cir. 1993)

1. Who prevails and why?

• The company prevailed. The court ruled that Exxon Seamen's Union appeals seeking
enforcement of an arbitration award that ordered Exxon Shipping Company to reinstate a
helmsman terminated for a positive drug test taken after his ship ran aground violated
public policy.

2. In what way is this case similar to a case you read in this chapter?
• This case is similar to the Brady case in a certain way (union contract), except that it is
important to note that there were no public policy issues involved.
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CASE SUMMARY 5.5 Hooters of America, Inc. v. Phillips, 173 F.3d 933 (4th Cir. 1999)

1. Who prevails and why?

• Phillips prevailed because the arbitration clause was a) inserted into employment
agreements (after the employee had been working for five years) without full disclosure
to the employee; b) was void as a matter of public policy.

2. Why do you think that Hooters chose to include a mandatory arbitration clause in its
employment contracts?
• Typically, companies with many employees use arbitration to keep litigation costs lower.
In some cases, it may also make it harder for an employee to pursue a claim by
preventing class actions.

3. Had Phillips been provided a copy of the rules when she signed the employment contract,
would this change your analysis? Why or why not?
• Perhaps. The fact that the company did not include a copy of the rules was relevant, but
the public policy matter (preventing employees from pursuing a claim) was equally
important.

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 Chapter 6
International Law and Global Commerce

CHAPTER OVERVIEW
This chapter discusses how multinational corporations navigate international business
relationships. In today’s global marketplace, an understanding of international law is important
to do business in the international global market. Students will gain an understanding of the
sources of international law; how international disputes are resolved and commercial and
intellectual property regulation in an international context.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Distinguish between international public law and international private law. Application
Give examples of and explain the various sources of international law. Application
Explain the role of the various international courts. Application
List the different categories of national legal systems used in the world and Knowledge
give an example of a country in each category.
Apply the standards of the Convention on the Recognition and Enforcement Application
of Foreign Arbitral Awards.
Explain the various methods of alternate dispute resolution in an international Application
context.
Articulate several specific laws that regulate international commercial law Knowledge
and understand when each law applies.
Identify the methods used to enforce the rights of intellectual property holders Knowledge
in foreign countries.

Teaching Tip:
Make sure students understand the difference between Public and Private Law. Also, the
student should grasp the differences in types of legal systems in the International Law
setting. One way to help students understand and visualize the differences would be an in-
class assignment. Students would be divided into teams and each team would be assigned a
different international legal system and students would explain their respective legal
system to their classmates. The differences in legal systems can be difficult for students to
understand and it can be hard to comprehend the differences of IP law under each system.

I. Definitions of International Law [p. 131]

Points to emphasize:
• International law has traditionally been defined in very broad terms; it is not limited
simply to rules that are applied to settle disputes in court.
• Rather, international law is influenced by a combination of law, religious tenets, and
diplomatic relations between nations.

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 • Most legal sources define modern international law as a body of rules and principles of
action binding on countries, international organizations, and individuals in their relations
with one another.
• Public Law versus Private Law
o One important distinction necessary to an understanding of international law is
that it may be categorized as either public international law, which primarily
addresses relations between individual countries and international organizations,
and private international law, which focuses on the regulation of private
individuals and business entities.

II. Sources of International Law [p. 131]

Points to emphasize:
• Treaties
A treaty is any agreement between two or more nations to cooperate in a certain manner.
Treaties may be related to defense, trade, extradition, and other matters between
countries. Although treaties have been in use since before the Roman Empire, most
existing modern-day treaties were created after World War II. More recently, the Vienna
Convention on the Law of Treaties, effective in 1980, has become one of the standards
used by courts and other tribunals when interpreting treaty law.

• Customary
Along with treaty law, customary international law is a primary source of law affecting
individuals and businesses engaged in international transactions. Customary law follows
the basic principle of international law that individual conduct is permitted unless
expressly forbidden. Therefore, prohibitions as well as affirmative practices must be
proved by the state relying on them

• Judicial Decisions
Most treaties and national laws recognize both an international tribunal, such as the
International Court of Justice (discussed later), and a ruling by a national court applying
international law principles. One important concept related to judicial decisions as a
source of international law is comity. Comity is the general notion that nations will defer
to and give effect to the laws and court decisions of other nations. However, comity is not
a legal doctrine that requires courts to accept the judgments of foreign courts. Rather, it is
rooted in the idea that reciprocal treatment is a necessary element of international
relations.

A. Yahoo v. La Ligue Contre Le Racisme- quote

III. International Organizations [p. 132]

Points to emphasize:

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 • International organizations play a unique role in the development of international law.
• These organizations are typically structured through use of multinational representation
and are created and regulated by treaty.
• Perhaps the most famous organization is the United Nations (UN), which was created
after World War II to facilitate common international concerns on defense, trade, the
protection of human rights, and other matters.
• The UN Commission on International Trade Law developed the UN Convention on
Contracts for the International Sale of Goods (CISG), which is used to set rules for
certain business transactions.

A. Other important international organizations include

• The World Trade Organization (WTO), which promotes and has certain authority over
disputes involving trade barriers.
• The International Monetary Fund (IMF), which is intended to promote stability of world
currencies and provide temporary assistance for countries to help prevent the collapse of
their economies.
• The Organization for Economic Cooperation and Development (OECD), which
coordinates aid to developing countries and takes steps toward eliminating bribery and
other corruption from developing economies

IV. International Courts [p. 133]

Points to emphasize:
• International courts play a role in the development and interpretation of international law,
but their power to enforce a ruling on sovereign nations can be tenuous and their
jurisdiction may be limited.
• The International Court of Justice (also known as the World Court) is the judicial branch
of the United Nations. It is based in the Netherlands and its main functions are to settle
legal disputes submitted to it by member states and give advisory opinions on legal
questions submitted to it by duly authorized international organs, agencies, and the UN
General Assembly.
• The United States withdrew from compulsory jurisdiction in 1986, and so it accepts the
court’s jurisdiction only on a case-by-case basis.
• The European Court of Justice sits in Luxembourg and is the final arbiter of the codes
governing European Union (EU) member countries. The court is composed of judges
from each EU member country and is structured in a civil law tradition, so most of its
procedures and decisions are based on treaties governing EU countries regarding
commercial regulations, protections, and guarantees.

A. Sovereign Immunity [p. 134]

Points to emphasize:

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 • One of the oldest doctrines of international law is that of sovereign immunity. In general,
this doctrine holds that, with some exceptions, nations are exempt from jurisdiction by
other nations’ courts.
• The Foreign Sovereign Immunities Act (FSIA) is a federal statute that incorporates this
concept by explicitly prohibiting U.S. courts from rendering judicial actions against
foreign nations or their government officials unless (1) the foreign nation has waived its
immunity either explicitly or by implication, (2) the foreign nation is engaged in some
commercial enterprise on U.S. soil, or (3) the foreign nation’s actions have a direct effect
on U.S. interests.

Case - Butters v. Vance International, Inc., 225 F.3d 462 (4th Cir. 2000) [p. 134]
Facts: Vance International is a U.S. company that provides security services to corporations and
foreign sovereigns, including the Kingdom of Saudi Arabia. Vance was hired to augment the
security provided to a princess of the Saudi royal family while the princess underwent medical
treatments in California. The Saudi military was responsible for protection, and Saudi military
officers supervised all security at the site.
Butters, a woman employed by Vance as a security officer, was assigned to the Saudi detail, and
on several occasions, Butters temporarily worked as an acting supervisor in a security command
post. Vance managers recommended to the Saudis that Butters be promoted to serving a full
rotation in the command post, but the Saudi authorities rejected that recommendation. Their
rejection was based on the Saudi military supervisor’s contention that the appointment of a
woman for that post was unacceptable under Islamic law and that Saudis would consider it
inappropriate for their officers to spend long periods of time in a command post with a woman
present.
Butters brought suit against Vance for gender discrimination in the loss of the promotion, and
Vance asserted immunity under the Federal Sovereign Immunities Act because it was carrying
out orders of the Saudi government. Butters argued that Vance fell under one of the exceptions to
the FSIA because the company was engaged in a commercial activity.

Opinion: The Fourth Circuit Court of Appeals ruled in favor of Vance. The court reasoned that
Vance was entitled to immunity from suit under the Foreign Sovereign Immunities Act because
Vance’s client, the Kingdom of Saudi Arabia, was responsible for Butters not being promoted.
The court held that the action here was not exempt from the FSIA as “commercial activities”
because the relevant act was quintessentially an act peculiar to sovereigns and that Vance was
entitled to derivative immunity under the FSIA because it was following Saudi Arabia’s orders
not to promote Butters.

Case Questions
1. What was the theory that Butters advanced as to why the lawsuit fell into an FSIA
exception?

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Answer- Vance fell under one of the exceptions to the FSIA because the company was engaged
in commercial activity.
2. How far does the FSIA immunity go? If one of Vance’s employees was ordered by Saudi
officials to physically detain Butters and she was injured, would Vance still be protected
by the FSIA against any liability resulting from Butters’s injury?
Answer-

3. Focus on Critical Thinking: When the court states that the “FSIA immunity presupposes
a tolerance for the sovereign decisions of other countries that may reflect legal norms and
cultural values quite different from our own,” what legal norms and cultural values is it
referring to?
Answer- Here, it reflected legal norms and cultural values consistent with Islamic law.

V. National Legal Systems [p. 135]

Points to emphasis:
• Legal systems of the world may be thought of as falling into one of the following broad
categories: civil law, common law, religious-based law (such as Sharia law or Talmudic
law), and mixed law systems (which refers not to a single system but to a combination of
systems).

A. Civil Law Systems [p. 135]

Points to emphasize:
• Countries using civil law systems have drawn their body of law largely from the Roman
law heritage, which uses written law as the highest source, and have opted for a
systematic codification of their general law.
• They rely heavily on written codes to define their laws and do not favor the notion of
courts filling in any gaps in the statutes. Rather, these courts apply the code law to
individual cases without the mandate of following cases that have been decided by
previous courts considering the same questions.
• Most European, Latin American, African, and Asian countries use civil law systems.

B. Common Law Systems

Points to emphasize:
• The common law system takes on a variety of cultural and legal forms throughout the
world. Although there are differences from country to country, this category generally
includes countries whose law, for the most part, is technically based on English common
law concepts and legal organizational methods that strongly favor the use of case law, as
opposed to legislation/statutes, as the ordinary means of expressions of general law.

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 • If there is no case law to guide the court, common law systems allow courts to fill in the
gaps not covered by statutes and create new law consistent with public policy.
• Common law jurisdictions adhere to the concept of judicial review, whereby a court may
strike down a law passed by the legislature if the law is found to violate some other
overriding principle of law (such as the U.S. Constitution).

C. Religious-Based Legal Systems [p. 136]

Points to emphasize:
• Religious-based legal systems are legal doctrines and guidelines directly based on certain
religious tenets. For example, the Sharia, derived from the Qur’an (the sacred text of
Islam), regulates many aspects of life for Muslims, including crime, politics, business
transactions, family, sexuality, and hygiene.

D. Mixed Legal Systems [p. 136]

Points to emphasize:
• Mixed legal systems (also known as hybrid or composite legal systems) include not only
political entities in which two or more systems apply cumulatively or interactively but
also entities in which there is a combination of systems as a result of more or less clearly
defined fields of application.
• For example, Saudi Arabia uses an Islamic-based set of laws to regulate the personal
conduct of its citizens and visitors and a civil law system to regulate business transactions
and other areas of the law.

VI. International Dispute Resolution [p. 136]

Points to emphasis:
• The parties to an international dispute are typically corporations or government entities,
rather than private individuals, while domestic dispute resolution can involve relatively
small claims by individuals.
• Many countries, recognizing that different considerations apply to international disputes,
have provided for a separate legal regime to govern international dispute resolution.

A. Arbitration
• Arbitration is considered international if the parties to the arbitration are of different
nationalities or the subject matter of the dispute involves a state other than the country in
which the parties are nationals.
• An international arbitration usually has no connection with the country in which the
arbitration is being held, other than the fact that it is taking place on its territory.
• The major difference between international and domestic arbitrations is that international
arbitration awards have very wide enforceability in many countries. This is largely
attributable to the acceptance of international treaties such as the 1958 Convention on the

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 Recognition and Enforcement of Foreign Arbitral Awards, which allows for the
enforcement of arbitration awards in many major countries, provided that the arbitration
is international.

B. International Arbitration Forums

• Prominent bodies that administer arbitrations include the International Chamber of
Commerce’s (ICC’s) International Court of Arbitration in Paris; the London Court of
International Arbitration (LCIA); and the American Arbitration Association (AAA). Each
of these institutions has formulated its own arbitration rules; namely, the ICC Rules of
Arbitration, the LCIA Rules, and the AAA International Arbitration Rules.
• All the institutional rules govern the commencement of the arbitration, the exchange of
arbitration pleadings, the appointment and removal of arbitrators, and the hearing and
interim measures of protection, among other rules. If the parties have not agreed on the
number of arbitrators, one arbitrator is appointed, although the arbitration institution may
appoint three arbitrators if it appears that the dispute warrants it.
• Under the ICC Rules of Arbitration, a document known as the Terms of Reference—
containing a summary of the parties’ claims, a list of issues to be determined, and
applicable procedural rules—must be drafted and submitted to the arbitrator and the
opposing party.

C. Ad Hoc Arbitration Rules

• Rules such as those set out in the U.N. Commission on International Trade Law
(UNCITRAL) Arbitration Rules serve to bridge the gap for parties who are unwilling to
incur the additional expense involved in using the services of an arbitration body but who
do not wish to spend time agreeing to the details of a procedure to govern their arbitration

VII. Alternatives to the ICC: The World Intellectual Property Organization [p. 138]
Points to Emphasize
• There are arbitration institutions other than the ICC, some with regional specialization
and some with subject matter specialization. The World International Property
Organization (WIPO) in Geneva, Switzerland, created an arbitration center for arbitration
related to intellectual property such as patents, trademarks, and copyrights. Some
advantages of the WIPO center are
• The WIPO lists best practices regarding nomination of arbitrators, including a list system,
thus encouraging the parties to agree on arbitrators based on their qualifications.
• The WIPO explicitly states that, when nominating arbitrators, it will take into account
any preferences expressed by the parties and it has created a mechanism to implement
this in practice: a database of names and detailed qualifications.
• The WIPO rules explicitly cater to multiparty arbitrations.

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VIII. International Mediation [p. 138]
Points to Emphasize
• Arbitration is considered international if the parties to the arbitration are of different
nationalities or the subject matter of the dispute involves a state other than the country in
which the parties are nationals. International and domestic arbitrations differ in that
international arbitration awards have very wide enforceability in many countries.
• Prominent bodies that administer arbitrations include the International Chamber of
Commerce’s (ICC’s) International Court of Arbitration in Paris; the London Court of
International Arbitration (LCIA); and the American Arbitration Association (AAA).
• There are arbitration institutions other than the ICC, some with regional specialization
and some with subject matter specialization. The World International Property
Organization (WIPO) in Geneva, Switzerland, created an arbitration center for arbitration
related to intellectual property such as patents, trademarks, and copyrights.
• Mediation and conciliation both involve a consensual (rather than adjudicative) process,
often with the involvement of a neutral third party. Such forms of dispute resolution may
be loosely described as third-party-assisted negotiation.

IX. International Commercial Law [p. 139]

Points to Emphasize

A. Foreign Corrupt Practices Act (FCPA)

The Foreign Corrupt Practices Act (FCPA) of 19773 was enacted principally to prevent
corporate bribery of foreign officials. This act has three major parts: (1) It requires corporations
to keep accurate books, records, and accounts; (2) it requires issuers registered with the
Securities and Exchange Commission (i.e., publicly traded companies) to maintain a responsible
internal accounting control system; and (3) it prohibits bribery by American corporations of
foreign officials.
The centerpiece of the FCPA is its antibribery provision. The law prohibits a company and its
officers, employees, and agents from giving, offering, or promising anything of value to any
foreign (non-U.S.) official with the intent to obtain or retain business or any other advantage.
This prohibition is interpreted broadly in that companies may be held liable for violating the
antibribery provisions of the FCPA whether or not they take any action in the United States.
Thus, a U.S. company can be liable for the conduct of its overseas employees or agents even if
no money is transferred from the United States and no American citizen participates in any way
in the foreign bribery.

Case 6.2 United States v. Esquenazi, 752 F.3d 912 (11th Cir. 2014) [p. 140]

Facts: Esquenazi was a co-owner/president of Terra Telecommunications Corp. (Terra), a

Florida company that purchased phone time from foreign vendors and resold the minutes to
customers in the United States. One of Terra’s main vendors was Telecommunications D’Haiti,

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S.A.M. (Teleco). In 2001 Terra contracted to buy minutes from Teleco directly. At that time,
Teleco’s director general was Patrick Joseph (appointed by then-President Jean-Bertrand
Aristide), and its director of international relations was Robert Antoine. In October 2001, Terra
contacted Teleco about $400,000 in past due accounts. According to testimony at trial, Antoine
agreed to reduce Terra’s future bills to Teleco in exchange for receiving from Terra 50 percent of
what the company saved. Antoine suggested that Terra disguise the payments by making them to
sham companies, which Terra ultimately did. According to Terra employees, Esquenazi was
fully aware of the arrangement and shared details of the deal in a meeting with executive
management. The following month, Terra began funneling personal payments to Antoine using
the subterfuge of sham consulting agreements. All told, while Antoine remained at Teleco, Terra
paid him and his associates approximately $822,000. During that time, Terra’s bills were reduced
by over $2 million.
Soon after, the U.S. Internal Revenue Service (IRS) began to investigate Terra and its
relationship with vendors, including Teleco. As part of the investigation, Esquenazi admitted he
had bribed Teleco officials. The government charged Esquenazi and other Terra officials with
several counts of violating the Foreign Corrupt Practices Act (FCPA). Esquenazi pleaded not
guilty, proceeded to trial, and was found guilty on all counts. On appeal, Esquenazi argued that
his conviction should be reversed because the FCPA did not apply to the Terra-Teleco payments
because they were paid directly to Teleco officials. Esquenazi claimed that Teleco officials did
not meet the FCPA definition for “foreign official.” The government countered that Haiti Teleco
was an “instrumentality” of the Haitian government and therefore Terra’s acts of bribery were
prohibited by the FCPA.

Opinion: The U.S. Court of Appeals for the 11th Circuit affirmed Esquenazi’s conviction. The
court rejected Esquenazi’s narrow definition of foreign official. Instead, the court adopted the
fact-based approach looking to questions such as who runs the company, who appoints the
management, where the company’s profits come from, and the extent to which the government is
involved in day-to-day decisions. The court cited evidence that 97 percent of the ownership of
Teleco was held by the Haitian government and that Teleco was considered a de facto
government entity because the Haitian government invests in the enterprise, appoints the board
of directors, hires and fires the principals, and exercises a monopoly function.

Case Questions

1. Why is it important to the court’s analysis that Antoine set up a sham company and
consulting agreements?

Answer-

2. If Esquenazi had not known about the bribes, would he still be guilty under the FCPA?

Answer- No, because there is a “knowing” standard under the FCPA

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3. Focus on Critical Thinking: This case was controversial because it was the first time that
an appellate court had interpreted the term “foreign official” in the FCPA so broadly. Critics
contend that the court inserted its own broad definition instead of using the more narrow
definition intended by Congress. Did the court go too far? If Congress had meant to include
public/private partnerships in the definition of a foreign official, wouldn’t they have added it into
the statute? Is this good public policy?

Answer- The answer to this question is an opinion of the students and intended to provoke
thought about the FCPA.

B. UN Convention on Contracts for the International Sale of Goods (CISG)

The UN Convention on Contracts for the International Sale of Goods (CISG) governs
transactions between any of its 91 ratifying countries (as of March 2013). Much like America’s
Uniform Commercial Code, the CISG exists to fill in the terms of a sale of goods contract when
the parties haven’t otherwise reached agreement. Parties are free to negotiate the allocation of
risk, insurance requirements, delivery, payment terms, choice of law, and the like to displace the
CISG principles. It is particularly important for managers to understand choice of law and forum
principles in international contracts because risk and expense of enforcement become
increasingly important factors that must be considered in arriving at appropriate pricing and
delivery proposals.
No Writing Required
The CISG has no formal writing requirement (such as the UCC’s statute of frauds) and
specifically provides that contracts are not subject to requirements as to format. A totality of the
circumstances, such as course of past dealing, evidence of oral or written negotiations between
the parties, and industry practice, may be sufficient to prove that an enforceable contract exists.

Case 6.3 Forestal Guarani S.A. v. Daros International, Inc., 613 F.3d 395 (3d Cir. 2010) [p.
143]

Facts: Forestal Guarani S.A. is an Argentina-based manufacturer of various lumber products,

including wood finger joints. Daros International, Inc., is a New Jersey–based import-export
corporation. In 1999, Forestal and Daros entered into an oral agreement for Daros to sell
Forestal’s wood finger joints to third parties in the United States. Pursuant to that agreement,
Forestal sent Daros the finger joints along with an invoice for $1.86 million. However, Daros
paid Forestal a total of only $1.46 million. When Forestal sued to recover the amount owed,
Daros admitted that it had paid Forestal $1.46 million in exchange for the finger joints but denied
that it owed Forestal any additional money. Daros argued that under the CISG, which governed
its relationship with Forestal, there was no liability because the absence of any written contract
precluded Forestal’s claims because Argentina had exercised its rights in an Article 96
declaration. The trial court granted a summary judgment claim in favor of Daros, finding that
Argentina’s declaration was sufficient to extinguish Forestal’s claim.

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Opinion: The U.S. Court of Appeals for the Third Circuit reversed the decision of the trial court
and ruled in favor of Forestal. Although the court acknowledged that the issue of whether a
contract must be in writing under these circumstances was a case of first impression, it rejected
the trial court’s conclusion that Forestal’s claim was extinguished by virtue of the Article 96
declaration. The court held that when one country has adopted an Article 96 declaration and the
other country has not, choice of law principles must be considered and the trial court should have
taken the course of past conduct into account before granting a summary judgment motion.

Case Questions

1. What evidence does the court cite that tends to show that a contract existed?

Answer- Forestal sold wooden finger-joints to Daros and that Daros gave Forestal money in
exchange. Furthermore, Forestal submitted an accountant’s certification, with supporting
documentation, as well as invoices, in an effort to substantiate its claim that it is owed
money. There is also deposition testimony indicating that the parties had a contract.

2. Do the advantages of a statute of frauds rule (e.g., certainty) outweigh the advantages of a
no-writing requirement (e.g., flow of commerce)?

Answer-Yes, but in the case of CISG, the parties are merchants, so looking at the totality of
circumstances, such as course of past dealing, evidence of oral or written negotiations between
the parties, and industry practice is reasonable.

3. Focus on Critical Thinking: After reading this case, do you think that the United States
should opt for an Article 96 declaration? Why or why not?

Answer- The question looks for an opinion from the student and is thus meant to provoke
thought about the CISG.

C. INCO: International Chamber of Commerce Terms

With respect to title, risk of loss, and delivery terms, sometimes the language barrier can lead to
confusion among the parties and to disputes regarding a loss. The International Chamber of
Commerce provides international abbreviations, known as INCO terms, to designate many of the
responsibilities. INCO terms are generally used in conjunction with the CISG. For example, in
the absence of any agreement between the parties, the CISG provides that risk passes at the point
at which the seller has delivered the goods to a carrier. If the goods are not to be delivered, the
risk of loss passes in accordance with the INCO term EXW (“ex works”). The INCO term EXW
has the universal meaning that the parties understand the goods will not be delivered or
transported by the seller. Rather, the seller need only make the goods available to the buyer at the
seller’s place of business and provide the buyer with appropriate documentation of title. There
are 11 INCO terms in all. Some of the more common ones are

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 • FCA (“free carrier”): This term means that the seller provides transportation at the
seller’s expense only to the carrier named by the buyer.
• FOB (“free on board”): This term is always accompanied by the name of a port (e.g.,
FOB New York) and applies only when transportation is via freighter ship. It means that
the seller’s expense and risk of loss end when the seller delivers goods “over the ship’s
rail” to the freighter ship. The buyer is responsible for the freighter delivery charges and
any losses occurring en route to delivery.

X. Enforcing Intellectual Property Rights Abroad

Points to Emphasize
While the laws of intellectual property protection are well settled in the United States, as U.S.
companies become increasingly dependent on foreign sales and operations, global agreements
have become increasingly important as well. The international law protection of intellectual
property rights has primarily taken the form of multilateral agreements. However, as a practical
matter, while many countries have improved intellectual property rights protection significantly
over the past several decades, these agreements are still voluntary.

A. Comprehensive Agreements
While U.S. firms are motivated to be committed to stronger intellectual property protection
abroad, some countries’ intellectual property trade agreements often lack a meaningful
mechanism to ensure that signatory countries are actually fulfilling their obligations. Thus, the
United States and other similarly situated countries have backed the adoption of multinational
minimal standards for intellectual property protection and an enforcement structure empowered
with the ability to allow trade embargoes and other remedies designed to ensure that signatory
countries comply with the agreement. As part of the General Agreement on Tariffs and Trade
(GATT), administered by the multinational World Trade Organization (WTO), the agreement to
set these standards is known as the Agreement on Trade-Related Aspects of Intellectual Property
(TRIPS). TRIPS covers minimum requirements and standards for all areas of intellectual
property protection and also provides an infrastructure for enforcement and dispute resolution.

B. Agreements on Trademarks
International trademark policy is governed primarily by two agreements: the Paris Convention
and the Madrid Protocol. The Paris Convention (discussed below) was the first multinational
agreement to establish minimum requirements for trademark protection, and a general agreement
by its signatories established protections against unfair competition. The Madrid Protocol, a
2003 agreement that was a descendant of the earlier Madrid Agreement, aims to help reduce the
burden of multinational companies that desire multinational protection of their trademarks by
providing a uniform, single-source process. Although important, these international agreements
are not so specific as to actually require fundamental enforcement from signatory countries, and

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thus trademark protection may still be dubious and uneven in certain regions. Efforts to
harmonize trademark laws on a regional level have been more successful.

C. Agreement on Copyrights
Copyright protection in foreign countries is covered in the Berne Convention agreement.
Fundamentally, this agreement requires that foreigners from signatory countries must be granted
protection via reciprocity (known as national treatment) under the copyright laws of any other
member country. For example, if Samuel, an American, distributes his novel in Great Britain (or
in any signatory country), British courts are bound by the convention agreement to protect
Samuel’s rights under British law in the same way as would apply if Samuel were a citizen of
Great Britain.

D. Agreement on Patents
The most important multilateral agreement on patents is the Paris Convention agreement. This
agreement requires the approximately 160 member countries that signed the agreement to protect
the same inventor rights under any member country’s patent laws as those enjoyed by citizens of
that member country. That is, each member agrees to extend national rights (or give full
protection) to foreign inventors. However, risks still remain for the foreign inventor because the
Paris Convention does not specify common standards for patentability. Also, some jurisdictions
may not allow certain inventions, which are patentable in the United States, to obtain patent
protection in their own country due to noncompliance with domestic law.

XI. End of Chapter Problems, Questions and Cases [p. 149-151]

CASE SUMMARY 6.1 TermoRio S.A. v. Electrificadora Del Atlantico S.A., 421 F. Supp.
2d 87 (D.D.C. 2006)

1. Under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards,
do the U.S. courts have authority to decide this case?

Yes, US court have an obligation to enforce Convention awards.

2. What do the ICC rules provide?

The ICC rules govern the commencement of the arbitration, the exchange of arbitration
pleadings, the appointment and removal of arbitrators, and the hearing and interim measures of
protection, among other rules.

CASE SUMMARY 6.2 Plaintiffs A, B, C v. Zemin, 224 F. Supp. 2d 52 (N.D. Ill. 2003)

1. May the federal court issue a default judgment against the defendants?

No, because the defendant Chinese government, is immune from the jurisdiction of US courts.

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2. What role does the doctrine of sovereign immunity play in this case?

It gave immunity to the Chinese government from being prosecuted in a US court.

CASE SUMMARY 6.3 Chateau des Charmes Wines Ltd. v. Sabate USA Inc., 328 F.3d 528
(9th Cir. 2003)

1. Is Chateau’s silence upon receiving the invoices binding on the company under the
Convention on Contracts for the International Sale of Goods?

Yes, but a totality of the circumstances, such as course of dealing, will be considered. Since the
first several orders were delivered without the forum selection clause, that will be considered.

2. Would your answer be the same under the UCC?

Yes, under the UCC, silence can be considered consent.

CASE SUMMARY 6.4 Republic of Austria v. Altmann, 541 U.S. 677 (2004)

1. Do sovereigns have immunity protection for actions prior to the FSIA’s enactment?

Yes.

2. Is it fair to allow Austria protection under these circumstances? Why or why not?

No, because at the time the acts were committed, the FSIA was not in effect.

CASE SUMMARY 6.5 DiMercurio v. Sphere Drake Insurance PLC, 202 F.3d 71 (1st Cir.
2000)

1. Who prevails? Explain.

Sphere Drake Insurance prevails because the arbitration provision is enforceable.

2. Give examples of types of agreements that you would consider too one-sided to be valid.

Students will have various answers to this question.

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 Chapter 7
Privacy Law and Information Management

CHAPTER OVERVIEW
This chapter discusses the background on privacy law protections and privacy rights under
various sources and levels of law as well as data privacy and legal issues related to managing
data. Finally, information security is discussed relative to the challenges associated with aspects
of crimes that are committed by using the computer as an instrument and when a criminal targets
a computer or network.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Analytical
Explain how privacy rights are protected at the constitutional level. Thinking
Knowledge
Identify four ways the right to privacy is protected by tort law. Application
List the major federal and state data privacy laws and identify how they are Knowledge
applied.
Knowledge
Identify ways in which criminals target computers of businesses. Application
Knowledge
Describe how criminals use computers to commit crimes. Application

Teaching Tip: Privacy Law and Information Management

Although students are familiar with the internet and some of the criminal activities, they often
have no concept on the types of criminal activities or the federal laws related to these activities.
It would be helpful to start out this section with a brief discussion with the students about what
they have seen in the news about this topic.

I. The Right to Privacy [p. 153-157]

A. U.S. and State Constitutions [p. 153]

Points to emphasize:
• The word privacy is not in the US Constitution.
• Through a series of cases, the US Supreme Court has interpreted the word liberty to
include the right to be left alone in one’s private life.
• State and federal laws that restrict privacy rights are subjected to the strictest judicial
scrutiny. Laws restricting privacy are valid only when (1) when there is a compelling
government interest, and (2) when the restriction is narrowly tailored to accomplish
such compelling purpose.

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CASE 7.1 Stanley v. Georgia, 394 U.S. 557 (1969) [p. 154]
Facts: During the execution of a search warrant at the home of Stanley, policy found three reels
of 8 mm film. Police watched the films using Stanley’s projector at his home and determined the
films to be pornographic. The films were seized and Stanley arrested, convicted. The Georgia
Supreme Court affirmed. Appealed to the US Supreme Court.
Issue: Did Stanley have a right to privacy, and if yes, was it violated by the police during the
execution of the warrant?
Ruling: The right of privacy protected an individual’s right to possess and view pornography in
his own home. Just because the state believed the films to be obscene, it was insufficient for a
drastic invasion of his privacy under the First and Fourteenth Amendments.
Case Questions:
1. What if the films in Stanley’s home had contained child pornography?
2. Is the right to privacy doing any real work in this case? That is, couldn’t the Supreme Court
have decided this case on First Amendment grounds alone?
3. Focus on Critical Thinking: The U.S. Supreme Court states that “[o]ur whole constitutional
heritage rebels at the thought of giving government the power to control men’s minds.” So, why
does the government have the power to ban cigarette ads?

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 • This question is intended to spur discussion on the right to privacy, and the First
Amendment right to free speech and the state’s power to regulate the health, safety,
morals of its citizens.

B. Invasion of Privacy Torts [ p. 154-155]

Points to emphasize:
• The right to privacy is also protected by tort law, through private lawsuits for money
damages for invasion of privacy.
• Four types of invasion of privacy torts
1. Intrusion Upon Solitude: occurs when a person or business intentionally and
without authorization interferes with another person’s right to solitude or
seclusion in such a way that is ‘highly offensive to a reasonable person’.
2. Public Disclosure of Private Facts: occurs when a person or business discloses
without authorization the details of another person’s private life that are not
generally known to the public that is highly offensive to a reasonable person
and are not of legitimate concern to the public.
3. Misappropriation: occurs when a person or business uses another person’s
name or likeness (image, voice or other personal characteristic) for
commercial purposes without permission.
4. False Light: occurs when someone publishes information about a
person/business that is either misleading or somehow distorts the truth. It must
be highly offensive to the average person and must have been published with
knowledge of or in reckless disregard of, whether the information was false or
would put the person/business in a false light. This is not the same as
defamation.

C. Postscript: The Law of Blackmail [ p. 156]

Points to emphasize:
• Privacy law also protect one from blackmail by imposing criminal penalties.
• Blackmail occurs when one person, the blackmailer, demands payment or another
benefit from another person, the victim, in exchange for not revealing compromising
or damaging secret information about them, even if that information is true.

II. Data Privacy, Regulation and Management [p. 157-165]

A. Definition and Norms [p. 157]
Points to emphasize:
• Companies rely on technology to capture, store, retrieve, share, use, and sell large
volumes of data to generate value.

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 • Some data is nonpublic personally identifying data which can be used to distinguish or
trace an individual’s identity.
• To capture data companies use techniques such as cookies to track online traffic, user-
submitted registration forms, sensors that monitor employee productivity, fitness apps
that track customer health, and cameras to detect facial patterns for use with facial
recognition software.
• Data privacy refers to domestic and international privacy laws and regulations meant to
preserve the confidentiality of nonpublic personally identifying data.
• Data governance refers to the business practice that promote ethical privacy norms and
compliance with privacy laws.
• There is a constitutional right to a “zone of privacy” that offers protection against
unreasonable government intrusions.
• The freedom of contract principle is generally upheld in private market transactions to
enforce contract terms negotiated among the parties.
• The Federal Trade Commission (FTC) plays an important role in the enforcement of
privacy and consumer protection laws.

CASE 7.2 In the Matter of Snapchat, Inc., a corporation, FTC Complaint File No. 132 3078
(2014) [p. 158
Facts: Snapchat allows users to post video and photo messages that disappear at a time
designated by the user. It became known that several techniques existed to store snaps
indefinitely.
Issue: Did Snapchat misrepresent the length of time video/photos would be available?
Ruling: The complaint and case were settled before the FTC. The FTC made a statement
regarding misrepresentations.
Case Questions:
1. What triggered liability for Snapchat in this case?
• Statements made about the period of time a video/photo was available.
2. Would the average consumer be deceived by Snapchat’s statements? Explain.
• Yes, one would assume that the statements made were true and rely upon those
statements.
3. Focus on Critical Thinking: How can a technology company avoid this kind of regulatory
action going forward?
• This question is intended to spur discussion on actions that a business can take to avoid
liability.

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 A. Federal Data Privacy Laws [p. 159-162]
Points to emphasize:
• There is a lack of a general legal framework to protect data privacy. The laws are a
patchwork of federal and state laws.
• The Fair Credit Reporting Act (FCRA): regulates credit reporting to promote the
accuracy, fairness, and privacy of sensitive personal information and repayment history.
Disclosure of the reports are limited. Reasonable procedures must be followed to prevent
unlawful disclosure of consumer information. An attempt to prevent identity theft. Both
the Federal Trade Commission (FTC) and Consumer Financial Protection Bureau have
enforcement jurisdiction.
• The Gramm-Leach-Bliley Act (GLB): regulates financial institutions and businesses
that are engaged in financial activities to protect consumers who obtain financial
products/services. The consumer’s nonpublic personally identifying information collected
by the financial institution. The FTC, federal banking agencies enforce.
• The Health Insurance Portability and Accountability Act of 1996 (HIPAA): national
standards to protect health information from disclosure without patient’s consent.
Protected health information is any identifying information created or received by a
covered entity which relates to the patient’s past, present, or future physical or mental
health. A covered entity is any insurance, billing, health clearinghouse, provider and
business associate. Must ensure confidentiality with training and safeguarding of
information, with only limited disclosure without the patient’s permission.
• The Children’s Online Privacy Protection Act (COPPA): limits the collection of
personally identifiable information for children 12 and under without parental consent.
The FTC enforces. Websites must post privacy policy, notify parents of child’s
information collection practices, and to obtain parental consent before collecting the
personal information from their child.
• The Electronic Communications Privacy Act of 1986 (ECPA): passed to protect
individuals’ privacy in the context of government searches of electronic communications.
The Constitution protects one’s reasonable expectation of privacy and requires a warrant,
similar to that for closed containers. Government agencies can subpoena an internet
service provider for messages, basic subscriber, session or billing information. A
subpoena is a notice to someone that they are required to appear in court or required to
supply certain documents.
• The Family Educational Rights and Privacy Act (FERPA): protects the privacy of
student educational records and applies to all schools receiving federal funds. Provides
parents with some rights with respect to their child’s educational records. Students 18+
are transferred these rights. There is the right to inspect and review the student’s
educational records and request corrections. Schools need written permission to release
student educational records. There are limited exceptions.
• The Video Privacy Protection Act (VPPA): provides a civil remedy against a “video
tape service provider” for “knowingly disclosing, to any person, personally identifiable
information concerning any consumer of the provider”.

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CASE 7.3 Yershov v. Gannett Satellite Information Network, Inc., 820 F.3d 482 (1st Cir.
2016) [p. 162]

Facts: Gannett produces news and entertainment programming, including the USA Today which
can be accessed through the USA Today Mobile App. News, entertainment, and videos can be
accessed. Gannett shared information about users to Adobe who in turn offered data analytics
and online marketing services to clients by collecting information about consumers and their
online behavior. Yershov filed a class-action lawsuit agains Gannett for violation of the VPPA.

Issue: Gannett did not seek consent from users prior to it sharing user activities to third parties.

Ruling: The trial court found the disclosed information to be personally identifiable information,
but that Yershov was not a renter, purchaser, or subscriber of Gannett’s video content, thus not a
consumer. On appeal, the appellate court agreed that the information was personally identifiable
information, but found that Yershov was a consumer under the VPPA because by downloading
the USA Today app on his phone he established access to the USA Today.

Case Questions:
1. Is the court correct in its determination that under the VPAA consumers include nonpaying
subscribers? Explain.
• Although consumers do not pay for the information received when purchasing a free app,
they are paying for the content in the original subscription. In addition, although the app
may be free, the real cost is in providing personal information which should be made
known to the customer via consent.
2. Should data brokers and analytics companies like Adobe have liability in these scenarios?
Explain.
• Data brokers and analytics companies should not have liability as they should be able to
rely that the information it receives from companies such as Gannett have already
obtained the consent from the customers.
3. Focus on Critical Thinking: The adage is that if you are not paying for a product you are the
product. How does this apply to this case?
• Even though Yershov did not pay for the app, he really did provide consideration in the
form of his valuable personally identifiable information. Thus, Yershov is the product, or
his information is the product.

C. State Data Privacy Laws [p. 163]

Points to emphasize:
• These laws fill in the gaps left open by federal law in each state.
• Illinois enacted laws requiring consent for use of biometric information, which
identifies individuals through physical or behavioral characteristics (fingerprints, faces,
retinas, and voice).

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 D. The European Union General Data Protection Regulation (GDPR) [p. 163]
Points to emphasize:
• The GDPR is a comprehensive data privacy law that applies to any business that operates
in the EU or collects data from EU residents. Many US companies are subject to the
GDPR.
• Rights are created for citizens/residents of their personal data such as the business will
ensure security, integrity, and confidentiality of the personal data. Also the right to know
what data is being collected and for what purpose.
• There are fines for noncompliance.

III. Information Security and Computer Crime [p. 165-173]

A. Crimes Targeting Computer Systems [p. 165-168]
Points to emphasize:
1. Malware and Data Breaches
• Malware is malicious software used to gain access to information stored on a
computer or computer network. The information is then stolen and sold for
fraudulent use.
• Ransomware is designed to encrypt files on a device, rendering the files and
system unusable. The cyber-criminal then demands ransom in exchange for
decryption. The threat is to sell or leak the information unless the ransom is paid.
• Trojan horses, viruses, and worms
o Trojan horse: launched when a user is fooled into clicking on an
innocuous looking email attachment or a provided form.
o Virus: program designed to copy itself and spread from one computer to
another and throughout the system without knowledge or permission. The
virus has reproductive abilities. It infects the computer when the virus’s
host is taken to the target computer by email attachment, DD, DVD, or
USB device. It corrupts or deletes data on the infected computer.
o Worm: can install a backdoor in an infected computer that puts the
computer that puts the computer under the control of the worm
perpetrator.
2. DoS Attacks
• Denial of Service attacks make a computer resource unavailable to it intended,
legitimate user through targeting either a specific computer/network or servers
on a hosted site.
3. Business and Government Responses
• Businesses and governments have created partnerships to combat cyber
criminals.

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 • Agencies provide resources for businesses.
• National Institute of Standards and Technology is part of the US Department of
Commerce and issued 5 cybersecurity functions, identify, protect, detect,
respond, and recover.
• The Federal Trade Commission provides information for businesses on steps to
take if its information has been compromised.
B. Cyber Crimes Using Computers [p. 168]
Points to emphasize:
• Cyber fraud involves use of the internet, a computer, or a computer
device/network to convey false or fraudulent information, to offer for sale to
consumers goods or services that do not exist or are different than what is
advertised, or to unlawfully transmit another’s money, access devise, or other
valuables to another’s control.
• Hacking is the exploitation of a weakness in a computer network for nefarious or
activist purposes by a hacker (one who accesses a computer network through
unauthorized means). This is criminal behavior. An example involves Edward
Snowden, a National Security Agency worker, who disclosed national security
information.
• Computer Fraud and Abuse Act: prohibits unauthorized use of computers to
commit crimes: (1) espionage, (2) accessing unauthorized information, (3)
accessing a nonpublic government computer, (4) fraud by computer, (5) damage
to computer, (6) trafficking in passwords, and (7) extortionate threats to damage
a computer.
o A controversy exists under the CFFA regarding “exceeds authorized
access”.
• Scam Apps: when cyber criminals design fake applications that are purchased
for use on a computer, tablet or smart phone.
• Child Pornography and Exploitation: also called child abuse imagery, occurs
when criminals use the internet to distribute and trade child pornography through
the Web, Internet Relay Chat and other online sources. This also involves sex
trafficking. Companies like Google, have become aggressive about eliminating
child pornography from their systems.

CASE 7.4 Van Buren v. U.S., 593 US – (2021) [p. 171]

Facts: An informant for the FBI asked Van Buren, a police sergeant, $5,000 to search the law
enforcement data base for a license plate number for a woman that the informant met at a bar.
Van Buren used his police car computer to access the information using his police credentials.
There was a department policy against obtaining information for non-law enforcement purposes.
Van Buren was charged with a violation of the DVAA because he exceeded authority. Van

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Buren was convicted, the Court of Appeals confirmed, and it was appealed to the US Supreme
Court.
Issue: Did the officer exceed authorized access of a computer that he was authorized to use when
he obtained the license plate information?
Ruling: The Supreme Court reversed the conviction and held that an individual only “exceeds
authorized access” when they accesses a computer with authorization but then obtains
information located in particular to the area of the computer, like files, folders or databases.
Case Questions:
1. Compare and contrast the competing theories of the case. In your view, which interpretation
(government’s versus Van Buren’s) is more consistent with the purposes of the CFFA?
• Government’s theory: department policy was violated, thus a felony violation under the
CFFA because he intentionally exceeding authorized access to the law enforcement data
base obtaining information that he was not authorized to obtain (license plate).
• Van Buren’s theory: he may have violated a department policy but he did not engage in a
criminal act under the CFFA because he was authorized to access the computer and data
base.
• The final part of the question is intended to spur discussion on interpreting the CFFA.
2. Why specifically does the Court hold that the government’s interpretation of the statute is
overly broad?
• The government’s position would attach criminal penalties to commonplace computer
activity.
3. Even assuming that Van Buren’s conduct did not violate the CFFA, was Van Buren’s conduct
ethical? Was it ethical for the federal government to spend its resources to prosecute Van Buren?
• This question is intended to spur discussion on ethics. An argument can be made that
both Van Buren, in not following the department policy, and the government, in
prosecuting Van Buren, both acted unethically.

IV. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 175-176]

Chapter Review Questions [p. 178-179] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [p. 174-175]

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1. Refer back to the frameworks discussed in this chapter: the Data Value Chain and the NIST’s
Cybersecurity Framework. How could Facebook have used these tools to prevent and manage
data privacy risks? Where did the key vulnerabilities lie in the case of Facebook?
• This question is intended to spur discussion on a strategy that Facebook could have used
to prevent the data privacy risks it created when it continued to make consumers’
personal data accessible to companies that developed apps used by consumers’ friends.
Facebook seemed to do the bare minimum to protect consumers’ personal data.
2. If you could design the data privacy policy and control systems of Facebook, who would you
designate as the primary overseers of this program? What factors would influence your decision?
• This question is intended to spur discussion on whether the Chief Privacy Officer is the
correct choice to be the primary overseer of Facebook’s program.
3. Aside from the $5 billion civil fine, what other costs does the company now face as a result of
its data privacy failures?
• Costs include expenditures to create, implement and run a program to monitor third-party
developers and access to consumers’ data privacy; hiring expert compliance officers;
implementation and maintenance of a privacy program; and hiring a third-party assessor
with broad powers to independently evaluate its privacy practices. Goodwill and
customer satisfaction are also costs.

Case Summary Questions and Answers [p. 176-178]

CASE SUMMARY: 7.1 Lawrence v. Texas, 539 U.S. 558 (2003)

1. Why does the concept of “liberty” in the Constitution include the right to privacy?
• The right to liberty under the Due Process Clause gives individuals the full right to
engage in their conduct without intervention of the government. Liberty means freedom
from arbitrary and unreasonable restraint upon an individual. Freedom from restraint
refers to more than just physical restraint, but also freedom to act according to one’s will,
creating a privacy right.
2. In his dissenting opinion, the late Justice Scalia accused the majority of inventing “a brand-
new ‘constitutional right’.” What do you think he meant by this?
• This question is intended to spur discussion on what is a new constitutional right or an
expansion of an existing constitutional right.
3. In your view, could there ever be a compelling government interest to regulate or prohibit
private sexual conduct among consenting adults? What about laws against prostitution or laws
against bigamy?
• This question is intended to spur discussion on what is a compelling government interest
related to specific situations.

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CASE SUMMARY 7.2: U.S. v. Lallemand, 989 F.2d 936 (7th Cir. 1993)
1. Could the victim in this case sue the defendant for invasion of privacy?
• It is likely that the victim could sue for invasion of privacy based on an intrusion upon
solitude. It would be highly offensive to a reasonable person to have someone video a
consensual sexual act without giving consent.
2. What if the defendant in this case had never recorded the sex act between him and the victim?
Would he still be guilty of the crime of blackmail if he had pretended that such a recording
actually existed?
• It is likely that the defendant would be successfully prosecuted for blackmail because he
demanded payment from the victim in exchange for not revealing compromising or
damaging secret in exchange for money.
3. What if the victim had consented to the recording of the sex act? Would the defendant in this
case still be guilty of the tort of invasion of privacy or of the crime blackmail?
• Consent is a defense to an invasion of privacy. However, although the recording was
made with consent, it’s subsequent use was not agreed upon, thus lacking in consent.

CASE SUMMARY 7.3: Tailford v. Experian Info. Solutions, Inc., No. SACV 19-02191JVS
(KESx), 2020 LW 2464797, at *7 (C.D. Cal. May 12, 2020)
1. Should the FCRA be so narrowly tailored to only cover information that “might be furnished,
or has been furnished, in a consumer report on that consumer”?
• This question is intended to spur discussion on whether information that doesn’t fall
within “might be furnished, or has been furnished, in a consumer report on that
consumer” is too narrow. There is likely other information that was disclosed that right
now might not be thought of as “might be furnished, or has been furnished” (or soon to
occur), but could be in the future. This future potential leaves this narrowly tailored.
However, there does need to be perimeters.
2. Should the decision have been different if the behavioral data was used to determine a
consumer’s eligibility for credit, insurance, or employment or furnished in a consumer report?
Explain.
• This question is intended to spur discussion on whether there would be damages to the
consumer if credit, insurance, or employment was negative due to the furnished
information.

CASE SUMMARY 7.4: Gonzaga University v. Doe, 536 U.S. 273 (2002)
1. If privacy is so important, why doesn’t FERPA create an “implied” private cause of action?

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 • This question is intended to spur discussions regarding the lack of a private cause of
action for violations by educational institutions under FERPA. Because FERPA’s penalty
provisions relate to a reduction or denial of federal funding, a private cause of action
might be considered taking the power away from the Department of Education.
2. If laws like FERPA do not give rise to a private cause of action, how is FERPA enforced?
• The Department of Education is responsible for the enforcement of FERPA. Parents or
eligible students that believe a violation has occurred can file a complaint with the
Department of Education.
3. Should the U.S. Congress amend FERPA to permit private causes of action?
• If Congress were to amend FERPA to permit private causes of action, there may be many
lawsuits for small violations that cause no harm. Most disclosures are unintentional in
nature.

CASE SUMMARY 7.5: US v. Nosal, 676 F. 3d 854 (9th Cir. 2012)

1. Based on your reading about the CFAA and Van Buren v, U.S. case, who prevails in this case
and why?
• Nosal should prevail in this situation. Employees had authorized access to the computer
data that was turned over to Nosal. This is similar to the Van Buren case. Violations of
company policy should be handled within the business. Perhaps a do not compete
agreement would have been useful.
2. Doesn’t Nosal have a right to compete with his former employer? Explain why or why not.
• Unless there is an agreement between the former employer and Nosal, he has the right to
compete with his former employer.
3. Should employers address the use of company information in their ethical codes of conduct?
How? Should the government be in the business of prosecuting employees who violate their
employer’s computer use policies?
• Employers should make clear in handbooks and ethical codes of conduct when
employees can and cannot use company information for personal use. Periodically,
employers should provide training regarding these policies.
• The government should not be in the business of prosecuting employers who violate
company computer use policies. Many people use company issued computers, phones,
and devices to access the internet during breaks, in off hours, and while working.
Criminal prosecution would burden the court system. Company policies are a better way
to deal with this from warnings, penalties, and termination.

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 Chapter 8
Contracts: Overview, Mutual Assent, and Consideration

CHAPTER OVERVIEW
This chapter provides a broad overview of contracts and examines the definition, purpose and elements
of a contract as well as the various types of contracts and their basic structure. Students will learn how
companies can strategically use contract law to increase market share and preserve competitive
advantage over time.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Identify the basic definition and purpose of a contract. Knowledge
List the basic elements of a valid contract. Knowledge
Distinguish various ways that contracts can be classified. Application
List the requirements for a valid offer and explain how offers are Critical
terminated. thinking
Articulate the rules for determining when acceptance is effective Knowledge
Apply the element of consideration in the context of contract formation. Application
Differentiate agreements that have consideration from those that do not. Application

Thinking Strategically Prompt: Use of contracts to increase market share and gain competitive
advantage.

Teaching Tip: Contract law in everyday life

Because contract law is a very complex topic, it is important to introduce the topic in a way in which
students can understand. Provide the students with examples of contracts they might enter into in their
daily lives. For example, buying a textbook or getting their car washed are examples of simple
contracts. A more advanced contract that students will likely be familiar with and willing to discuss
includes their apartment rental agreement.

• THE NATURE AND APPLICATION OF CONTRACTS [p. 129]

The U.S. Constitution reflects the important status of contracts in America. Article 1, Section 10 of the
Constitution limits government interference with contracts and says that “No State shall . . . pass any . .
. Law impairing the Obligation of Contracts.” Under the U.S. system of federalism, contract is
primarily the domain of state law.
Points to emphasize:
• A contract is a legally enforceable promise or set of promises.
• U.S. common law process of judicial decision making has resulted in contract principles that are
fair, are largely uniform, and facilitate trade across the various states. The Restatement
(Second) of Contracts, for example, is the model law that many state courts have adopted to
govern contracts involving services or real estate and the Uniform Commercial Code, is the
model code that every state has in whole or part for the sale of goods. Nonetheless, there are

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 some differences in contract law amount the states that impact businesses. (Refer students to
Figure 8.1 - relative level of noncompete contract enforcement across all 50 states)

• Contracts are vital to business because just about every aspect of business relies on contracts to
protect expectations and facilitate planning. Table 8.1 lists the core value chain activities in
most business and examples of contracts commonly associated with these business activities.

• Every contract is premised on the notion of good faith dealing.

Case 8.1 Teachers Insurance and Annuity Association of America v. Tribune Co. [p. 131]
Facts: Teachers Insurance and Annuity Association of America (TIAA) sued Tribune Co. (Tribune)
claiming that Tribune breached a commitment letter where it agreed to take a loan from TIAA,
subject to execution of final documents and approval by Tribune’s board of directors. Tribune
sought a loan that would allow them to employ off-balance-sheet accounting. TIAA sent Tribute a
commitment letter and a term sheet that included the major contract terms of the proposed loan.
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 Tribune signed and returned the letter. Neither the letter nor the term sheet mentioned any off-
balance-sheet accounting requirements. When Tribune learned that the off-balance-sheet nature of
the proposed loan would likely be unacceptable to regulators, it broke off negotiations.
Issue: Is a preliminary agreement binding on the parties?
Ruling: The trial court ruled in favor of TIAA holding that even though the parties had not settled
on all the contract terms, the preliminary agreement created a duty on both parties to negotiate in
good faith toward reaching a final contract.
Answers to case questions:
1. The court considered the circumstances and the language of the commitment letter and the term
sheet to determine that the parties intended to be bound to one another in a final loan contract.
Although the commitment letter had open terms, the two-page term sheet covered the economic
terms of the loan. The commitment letter also stated it “shall be come a binding agreement,” clearly
indicating the parties intended to be bound.
2. To avoid breaching the good faith requirement, Tribune should have added in its reply to TIAA
that acceptance was contingent upon its ability to employ off-balance-sheet accounting.
3. Critical Thinking. It is a good policy to impose a good faith requirement on parties when they
are still negotiating a final contract. While parties should be focusing on their own self-interests
during the negotiation stage, good faith means the parties are negotiating in a manner that is likely
to result in an agreement. Negotiating in bad faith means the parties are negotiating in a way that is
unlikely to result in an agreement. They are just wasting time going through the motions for the
sake of appearance.

• ELEMENTS OF A CONTRACT [p. 133]

Points to emphasize:
• A valid contract has four basic required elements:
o Mutual assent - an offer and an acceptance
o Consideration – both sides obtaining something of value (legal benefit) and giving up
something of value (legal detriment)
o Legality of purpose
o Capacity – both parties must have legal standing

• Contract status:
o Valid – a contract with all the required elements
o Void – an agreement which lacks a required element of a valid contract or was not
formed in accordance with the law
o Voidable – one or more parties have the right to cancel an otherwise valid contract
o Unenforceable - a valid contract that cannot be enforced by the court because of a legal
defense

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Teaching Tip: Confusing for students – void, voidable, or unenforceable
At this point in the chapter, students often have trouble understanding the difference between the terms
void, voidable, and unenforceable. Try using basic simple examples such as: void – a contract to burn
down a house; voidable – a contract entered into by a minor; and unenforceable – an otherwise valid
contract that violates the statute of frauds.

• Types of Contracts [p. 135]

Contracts can by categorized by type of contractual commitment, source of law, level of explicitness,
and the nature of the business relationships. These categories are not exclusive and may overlap.
Points to emphasize:
• Contracts categorized by contractual commitment:
o Bilateral contract – legal detriment is incurred through mutual promises (a promise for
a promise)
o Unilateral contract – one party’s legal detriment arises from its action or inaction (a
promise for an action)

• Contracts categorized by applicable source of law:

o Common law contracts – contracts for services or real estate (for example,
employment contracts or rental agreements)
o UCC sales contracts - contracts for the sale goods (for example, the purchase of
inventory or machinery)

• Contracts categorized by their level of explicitness:

o Explicit – terms are explicitly defined by parties, either orally or in writing
§ Example: A lease agreement
§ Statute of frauds – requires some contracts to be in writing to be enforceable
§ Businesses generally favor explicit written contracts to minimize risk.

o Implied – terms are implied by the parties’ behavior or through custom

§ Example: Buying a bottle of water from the campus store

• Contracts categorized by the nature of the business relationship:

o Transactional contracts – contracts arising from short-term, impersonal interactions
o Relational contracts – contracts arising from long-term relationships where the contracting
parties have strong interdependencies and prioritize norms such as trust, flexibility, and
fairness. These contracts often treat the formal aspects and language of a contract as a starting
point and are often strategic since they are difficult to replace and can be a source of long-term
competitive advantage.
o
Case 8.2 Dwayne D. Walker Jr., v. Shawn Carter (“Jay Z”) [p. 136]
Facts: Carter, Dash, and Burke co-founded Roc-A-Fella hip-hop record label. Dwayne D. Walker, the
plaintiff, claimed to have helped create the logo for Roc-A-Fella. In a handshake deal with Dash,
Walker asserted that he was promised $3,500 up front and two percent royalties for the next 10 years
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4
after the first year of use of the logo. He claimed he later wrote the deal on a piece of paper and Dash
signed it. The defendants did not admit to the existence of the alleged handwritten contract. Walker
cannot produce that written contract as he claimed to have lost it. When Walker was paid the $3,500
but not any royalties, he sued for breach of contract.
Issue: If a written contract is required under the statute of frauds but cannot be produced, is a plaintiff’s
oral testimony alone enough to prove the existence of the written contract?
Ruling: No. The court held that the contradictory, self-serving testimony of the plaintiff alone was not
sufficient enough to prove the existence of a contract. New York law requires a written and signed
agreement for contracts that cannot be performed in less than one year. In the absence of a written
agreement, there must be some basis to allege that a contract existed. Self-serving testimony alone is
not adequate to prove the existence of a written contract.
Answers to case questions:
1. Walker entered into a common law contract that was valid, bilateral, and explicit. All four essential
elements of a valid contract are present and it is bilateral because the legal detriment is incurred through
the mutual promises the parties made to each other. Even though the contract was oral, it was explicit
because the terms were explicitly defined by the parties.
2. If Walker wanted to ensure that the contract would be upheld against the defendants, he should have
obtained a written contract before delivering the logo, made copies of the contract, and then
safeguarded the contract. Under the circumstances in this case, Walker’s case would have been stronger
if the other parties had witnessed Dash signing the alleged handwritten contract even if the writing was
later lost.
3. Critical Thinking. Under the statute of frauds, states require certain contracts to be in writing to be
enforceable in order to prevent fraudulent claims. The rule is a good rule because it prevents the “he
said, she said” dispute from occurring. It provides tangible evidence of the specifics of the agreement.
The rule generally favors both parties. The writing requirement helps the party who wants to enforce
the contract, the plaintiff, prove the agreement existed and what its terms were; the writing requirement
also prevents the other party, the defendant, from fraudulent claims for terms which were not agreed to
or even the existence of the entire agreement.

• BASIC CONTRACT STRUCTURE AND TERMINOLOGY

Points to emphasize:
• A well-drafted contract avoids wordiness and overly technical legalese (for example: hereby,
sayeth, witnesseth) that are difficult to understand.
• Contracts should follow a well-established structure and logical sequences.
• Table 8.2 provides examples taken from a sales representative contract.

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• DRAFTING CONTRACTS WITH A STRATEGICALLY QUALIFIED ATTORNEY [p. 139]
Businesspeople should seek out the services of strategically qualified attorneys who have the
appropriate skills and qualifications to help generate opportunities and value for a business.
Points to emphasize:
• Businesspeople should seek out the services of strategically qualified attorneys who have the
appropriate skills and qualifications to help generate opportunities and value for a business.
• Legally astute managers have superior knowledge of the law it relates to their business, realize
there are substantial gray areas in the law, and work proactively with legal counsel to find
ethical business solutions.

• MUTUAL ASSENT [p. 146]

Points to emphasize:
• Mutual assent is the agreement of the parties; a meeting of the minds. The parties reach mutual
assent using a combination of an offer and an acceptance.
• The offeror makes a valid offer to the offeree, who must accept the offer in order to create a
binding contract.

• REQUIREMENTS OF AN OFFER [p. 147]

• Points to emphasize:
An offer is a promise or commitment to do (or refrain from doing) a specified activity.
An offer is also an expression of a wiliness to enter into a contract by the offeror’s promising an
offeree that she will perform certain obligations in exchange for the offeree’s counter promise to
perform.

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 A. Objective Intent [p. 147]
I. Points to emphasize:
An offeror’s must have objectively intended to make the offer. Would a reasonable person
conclude that the offeror is serious in her intent to contract? If not, not an offer.
Jokes or invitations to negotiate are not offers.

Case 8.3 Lucy v. Zehmer, 84 S.E.2d 516 (Va. 1954)

Facts: W.O. Lucy (Lucy) offered to buy A.H. Zehmer’s (Zehmer) farm for $20,000 but Zehmer
rejected. Seven years later, over drinks at a restaurant, Lucy offered to buy the farm again for $50,000.
Zehmer handwrote the following on the back of a pad: “We hereby agree to sell to W.O. Lucy the
Ferguson Farm complete for $50,000, title satisfactory to buyer.” Zehmer and his wife both signed the
writing. Before signing, the parties modified it several times over a 40-minute period. Lucy also signed
the writing. The next day, Zehmer denied there was a valid contract claiming it was all a drunken joke
and he never intended to sell the farm.
Opinion: The court ruled in favor of Lucy holding that although Zehmer subjectively did not intent to
be bound by the contract, objectively a reasonable person would have construed Zehmer’s actions and
words as a serious intent to contract.
Case Questions
1. What factors does the court focus on when deciding whether Lucy’s understanding of the contract
formation was reasonable?
The court used an objective, reasonable person standard. They looked at the appearance of the
contract and the fact that it was modified several times over a 40-minute timeframe.
2. What facts could you change in this case that would result in the court determining that no contract
existed?
If the contract was not signed by Zehmer or he could prove he was so drunk he did not
understand what he was signing, then the court would not have found a valid contract.
3. Focus on Critical Thinking: Look at the check in Figure 7.1. Did a meeting of minds actually occur
here? Should words written on the back of a restaurant check be enough evidence to indicate objective
intent? Why or why not?
Based on the description of the property, the amount, the parties’ names, and the signatures of
each party, it objectively appears that the parties had a meeting of the mind. A specific type of
paper is not required for there to be a contract. The writing in this case is only required to satisfy
the statute of frauds. The writing here satisfies that requirement because it is in writing and
signed by the parties against whom enforcement is sought.

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 I.

B. Advertisements as an Offer [p. 149]

I. Points to emphasize:
Most advertisements are not offers.
For an offer to be valid, it must be clear and definite.
The law recognizes mass advertisements as an invitation for a consumer to make an offer to the
seller to purchase the goods at a specified price.
Advertisements can be offers if the advertisement is specific enough to constitute a unilateral
contract. If an advertisement offers to sell a particular number of a certain product at a certain
price, it may be an offer (e.g., $100 computers to the first 5 consumers on Thursday). Or if the
advertisement invites the other party to accept in a particular manner, courts will treat this type
of advertisement as a valid offer (e.g., We will pay $100 to anyone who uses our product for a
week and is not satisfied).
Case 8.4 Leonard v. PepsiCo, Inc., 210 F.3d 88 (2d Cir. 2000) [affirming lower court decision and
reasoning in 88 F. Supp. 2d 116 (S.D.N.Y. 1999)]
A documentary on the Leonard v. PepsiCo (Case 8.4) will be aired on Netflix November 17, 2022.

Facts: Pepsi ran an advertisement on national television promoting its Pepsi Points program whereby
consumers could obtain points by purchasing Pepsi products or purchasing the points and then redeem
the points for certain apparel and other items. At one point in commercial, a high school student hops
out of a Harrier fighter yet and a subtitle flashed, “Harrier jet 7,0000,000 Pepsi points.” Leonard wrote
in “Harrier jet” on an order form in the Pepsi catalog and sent a check to Pepsi for $700,000, the
amount necessary to purchase the requisite points as stated in the advertisement. Pepsi refused to
transfer the title on the basis that no contract existed. The trial court ruled in favor of Pepsi and Leonard
appealed.
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8
Opinion: The advertisement was not sufficiently definite to constitute an offer because it reserved the
details of the offer to a separate writing, the catalog.
I. Case Questions
1. Are there any facts that support Leonard’s primary argument as to why this commercial was a
unilateral offer to contract?
No, the advertisement was not definite enough to be an offer. Advertisements are generally not
offers, but invitations to make an offer. If the commercial had said, “the first person to obtain
7,000,000 points by July 1st, can purchase the Harrier jet,” the outcome might have been
different.
2. Should a person seeing the television commercial reasonably believe that Pepsi would sell a $23
million Harrier jet for only $700,000?
Courts use an objective, reasonable person standard in deciding whether an offer was intended
or not. A reasonable person would not believe that you could purchase a $23 million jet for
$700,000.
3. Focus on Critical Thinking: If the wording on the catalog order form had allowed a consumer to
write in the time (rather than check a box next to the item), would that have changed the outcome of the
case?
The outcome likely would not change. The commercial was not definite and clear enough to be
an offer.

C. E-Contracts [p. 150-152]

I. Points to emphasize:
Traditional contract laws still apply to e-contracts.
Courts developed new applications and theories for electronic transactions.
1. Click-Wrap Agreements
A click-wrap agreement is based on an Internet transaction where a user accepts terms by clicking an “I
Accept” button located on the web page of the purchase. Click-wrap agreements are generally
enforceable.

2. Browse-Wrap Agreements
A browse-wrap agreement is one where the terms of an agreement are located on a website, but the
user does not have the opportunity to click “I agree.” Instead the terms are only posted via a hyperlink.
User consents simply by using the website. Courts will only uphold these agreements if the user was
given actual notice or constructive notice of the website’s terms and conditions.

3. Shrink-Wrap Agreements
Shrink-wrap agreements are formed when a purchaser opens the packaging after notification by the
seller via a printed notice on the packaging or on a document included with the package. The notice
provides that the purchaser agrees to the seller’s terms by opening the package and/or keeping whatever
is in the container for a certain period of time. These agreements are generally enforceable.

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• TERMINATION OF AN OFFER [p. 152-154]
Once a valid offer has been terminated, the offeree may no longer accept. An offer may be terminated
by action of the parties or by operation of law.

A. Action of the Parties [p. 152-153]

An offer may be terminated by actions of the parties in one of three ways: (1) revocation; (2) rejections;
and (3) counteroffer.
1. Revocation
I. Points to emphasize:
Revocation is the withdraw of the offer by the offeror prior to acceptance by the offeree.
It can be an express repudiation of the offer (e.g., I revoke my offer) or by some inconsistent act
that would give reasonable notice to the offeree that the offer no longer exists (e.g., offeree
becomes away that the property was sold to a third party prior to acceptance).
In the majority of states, revocation is effective upon receipt.
Some offers are irrevocable: (1) offers in the form on an option contract; (2) offers that the
offeree partly performed or detrimentally relied on; and (3) firm offers by merchants under the
UCC (Chapter 13).
Option Contract – if the offeror grants the offeree an option by agreeing to hold an offer open
for a period of time for consideration, then the offer cannot be revoked by the offeror.
Partial Performance -If an offeree begins performance on a unilateral contact, the offer is
irrevocable. There is still not a contract unless the performance is completed though (e.g., if you
offer your cousin $100 to run a marathon, you cannot revoke the offer after he has begun
running).
Detrimental reliance – If an offeree makes preparations prior to acceptance based on a
reasonable reliance on the offer, the offer may be rendered irrevocable (e.g., general contractor
relying on a subcontractor’s bid).

2. Rejection and Counteroffer

I. Points to emphasize:
An offer is terminated if the offeree rejects the offer or makes a counteroffer.
Under common law, the mirror image rule requires the acceptance to mirror the offer. Any
changes in the acceptance terminates the original offer and becomes a counteroffer. The poser
of acceptance is terminated.

B. Operation of Law [p. 154]

1. Lapse of time
If an offer has a time limit, once the time limit has expired, the offer is considered terminated (e.g., Bob
offers to paint Jill’s house for $1,000 stating she has 5 days to accept. If Jill does not accept in 5 days,
the offer is terminated). If no time limit, the offer will expire after a reasonable amount of time.
I.
2. Death or incapacity
Death or incapacity of the offeror or offeree before acceptance, automatically terminates the offer even
if the other party is unaware of the death or incapacity.

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 3. Destruction of the subject matter
Destruction of the subject matter before acceptance also terminates an offer (e.g., You offer to sell your
house but before the offer is accepted, it burns down. The offer is terminated).
4. Supervening illegality
If an offer is legal when made but becomes illegal before it is accepted, the offer is automatically
terminated (e.g., If one offers to sell a legal weapon but that weapon suddenly becomes illegal to sell
before acceptance, the offer is terminated).

• ACCEPTANCE [p. 155]

I. Points to emphasize:
A valid offer creates the power of acceptance for the offeree.
An acceptance is the offeree’s expression of agreement to the terms of the offer.
Only the party or parties for whom the offer is intended has the power of acceptance and may
accept.

A. Acceptance of an Offer: The Mailbox Rule [p. 155]

I. Points to emphasize:
The mailbox rule governs common law contracts and is the rule that determines when a
contract is considered to be accepted by the offeree, thus depriving the offeror of the right to
revoke the offer.
Acceptances are generally affective upon dispatch and not when the acceptance is received by
the offeror unless the offer specifies that it is not effective until received.
The time of acceptance depends on whether the offeror has specified a method of acceptance or
not.
Table 8.3 provides an illustration that summarizes the rules governing when an acceptance is
effective.

I.

I. Teaching Tip: Acceptance following a previous rejection

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11
Acceptances are generally effective upon dispatch and rejections are generally effective upon receipt.
However, it a rejection is mailed on day 1 and then an acceptance is mailed on day 2, the mailbox rule
does not apply. If the offeror receives the acceptance first, there is a contract. If the rejection is received
first, there is no contract.

B. Mistake [p. 156]

I. Points to emphasize:
A mistake is defined in contract law as a belief that is not in accord with the facts.
No all erroneous beliefs are mistakes.
A mutual mistake in which both parties are mistaken about a material fact (a basic
assumption), may be the basis for canceling the contract. For examples, mistakes regarding the
quality or the existence of the subject matter.
A unilateral mistake, where only one party has an erroneous belief about a basic assumption,
is not generally a basis for canceling a contract unless the other party had reason to know of the
mistake or caused the mistake.

I. Teaching Tip: Mutual mistake of value

A mutual mistake of value, not fact, is generally not a basis for canceling a contract. For example,
selling a locked chest for $20 and then later discovering it has $1,000,000 in it, is not a basis for
canceling the contract.

• ADEQUACY OF CONSIDERATION [p. 157-159]

I. Points to emphasize:
For a binding contract to exist, the agreement must be supported by consideration.
Consideration is the mutual exchange of benefits and detriments (e.g. money for service or
goods).
There must be a bargained-for exchange.
Forbearance, giving up a legal right, is consideration.

A. Legal Detriment [p. 158]

Consideration requires that the parties suffer some type of detriment that the law recognizes as
adequate. This is satisfied if the party promises to perform something that the party is not legally
obligated to do (e.g., promising to sell your mobile home for $15,000) or to refrain from doing
something that the party had a right to do (e.g., 21-year-old agrees not to drink alcohol).

B. Amount and Type of Consideration [p. 158-159]

Consideration exchanged does not need to be of equal value. Contracts may even be based on nominal
consideration, consideration that is stated in a written contract even though it is not actually
exchanged.

• AGREEMENTS THAT LACK CONSIDERATION [p. 159-160]

I. Points to emphasize:
Preexisting duty – doing or promising to do something a party already is legally obligated to
do is not consideration (e.g., police officer collecting a reward for catching a thief or modifying
a common law contract without adding any additional duties/obligations).
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 Exceptions to the preexisting duty – undertaking additional duties or facing circumstances
that were not reasonably participated by either party are exceptions to the preexisting duty rule.

A. Illusory Promises [p. 159]

Illusory promises are not consideration because they do not meet the bargained-for exchange aspect of
consideration. For example: (1) deathbed promises; (2) promises of a gift; (3) promises of love and
friendship; and (4) promises that by their terms are not binding (e.g., I will sell you my car for $500 if I
decide not to sell it to someone else).

B. Past Consideration [p. 159-160]

Past consideration, a promise made in return for a detriment previously made by the promisee, does
not satisfy the bargained-for exchange requirement and cannot support a contract. For example,
agreeing to pay your real estate friend a commission after she already sold your house without charging
you a commission.

C. Promissory Estoppel [p. 160]

I. Points to emphasize:
Under promissory estoppel, if one party justifiably relies on the promise of another to her
detriment, under certain circumstances, the relying party may recover costs of the reliance from
the promisor even though the original agreement lacked consideration.
The relying party may recover damages if (1) the promisor made a promise that was
reasonable; (2) the promisee actually relied on the promise and suffered an injury; (3) the
promisee’s reliance was reasonably foreseeable to the promisor; and (4) principles of equity
and justice are served by providing compensation to the reliant party.
For example, if a manager promises at-will employment to a party and then revokes the promise
before the start date, the court may award the innocent party any out-of-pocket costs incurred in
preparing for the employment.

• END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Thinking Strategically Questions and Answers [pp. 140-141]

1. What type(s) of contracts are used by Ticketmaster?

• These are common law, explicit, bilateral contracts for services that are relational in nature
since they create relationships over time based on trust and flexibility.

2. What is Ticketmaster’s source of competitive advantage?

• Ticketmaster was able to strategically use long-term contracts that granted exclusivity and
locked-in the venues and promoters with a fee-based rebate model.

3. How did Ticketmaster use contracts to preserve its competitive advantage?

• The contracts were key since they offered exclusivity for 3-5 years, during which time the
venues and promoters are unable to deal with anyone other than Ticketmaster. The contracts
also allowed the parties to build trust over time. By doing away with the inside charge the
contracts also uniquely transform Ticketmaster into a revenue-generating partner.
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4. If you had a superior electronic ticketing technology, how might you complete against Ticketmaster?

• You would have to convince the major players, that is the venues and promoters that they
should not renew the Ticketmaster contract upon expiration and show them how this new
technology will either create savings or revenues that exceed the value Ticketmaster offers. You
would also have to overcome the built-in advantages Ticketmaster has which is loyalty and a
strong brand among these players.

5. Is it fair for companies to be able to use contracts such as these to preserve their market leadership
position?

• Under freedom of contract the venues and promoters are free to contract with Ticketmaster even
if this imposes costs on the fans such as higher fees. As stated by Fred Rosen, the Ticketmaster
CEO (and a strategically-qualified attorney) who pioneered the rebate model, a ticket is a
commodity and will only fetch the highest price someone is willing to pay. Yet, Ticketmaster
was sued under antitrust law by bands such as Pearl Jam and fans for anticompetitive behavior
since bands and fans have limited ticketing options for live entertainment at major venues as a
result of these contracts. These suits all proved ineffective, however, from a legal standpoint.

6. Can you think of other businesses that employ the “rebate model” that Ticketmaster used in the
electronic ticketing industry? What role do contracts have in these industries?

• The food and beverage concession business such as those provided at sports events or on
college campuses follow a similar model. Contracts likely play a fundamental role in this
business as well.

Key Terms [pp. 141-142]

Chapter Review Questions [p. 144] Note: Answers and explanations are provided at the very end
of the chapter.

Case Summary Questions and Answers [pp. 141-143]

CASE SUMMARY 8.1 Forest Park Pictures v. Universal Television Network, Inc., 683 F.3d 424 (2d
Cir. 2012)

1. Who wins and why?

• The answer depends on whether the court will treat this as an implied contract. If so, Forest
Park may argue there was an understanding that he would be compensated for pitching the show
idea to the network. Since the parties are in business and in a complex industry that relies on
intellectual property negotiations it may be that the courts will assume the parties will enter into
explicit contracts to protect their interests and must do so to avail themselves to the protection
of contract law.

2. What allows Forest Park to argue that this is an implied contract?

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 • The fact that it is customary for show creators to pitch ideas to producers and networks for
compensation.

CASE SUMMARY 8.2 Rochon Corp. v. City of Saint Paul, 814 N.W.2d 365 (Minn. Ct. App. 2012)

1. The city claimed that it benefited the public by allowing the bid change because it resulted in
monetary savings for the city. Does this explanation justify the city’s disregard of established
precedent? Can the court of appeals disregard established state precedent?

• This explains the city’s choice to award the contract, however, it does not justify its disregard
for precedent.

2. Shaw-Lundquist was able to prove that its original bid was wrong due to a legitimate clerical error.
Should this have mattered?

• It matters in that a mistake was made and there was no intent to submit a low bid. The law
considers good faith and honest mistakes to treat a contract as voidable by the party who makes
an honest mistake. Still, it does not excuse the city’s disregard for precedent or state law.

3. Why is it good policy to not permit amendments of bids in competitive bidding situations?

• To prevent parties from resubmitting lower bids that may still win the contract.
•

CASE SUMMARY 8.3 Arizona Cartridge Remanufacturers Association v. Lexmark, 421 F.3d 981 (9th
Cir. 2005)

1. Can one party be deemed to accept an offer simply by opening a product box even if there is no
evidence that the party actually read the terms?

• Yes. This is akin to a shrink-wrap agreement and courts typically enforce such contracts as
accepted even if there is no evidence that one party actually read the agreement. If the contract
on the box contains language that makes clear that opening the package is an act of agreement,
the party opening the box is bound by the agreement.

CASE SUMMARY 8.4 Biomedical Systems Corp. v. GE Marquette Medical Systems, Inc., 287 F.3d
707 (8th Cir. 2002)

1. Can a party make a unilateral judgment as to mutual assent on a term of the contract when there is no
affirmative finding from a regulatory authority?

• No. GE attempted to assert the defense of no mutual assent due to illegality. The court rejected
that claim because GE was obligated to apply for FDA clearance under the Biomedical-GE
contract. Since the application for FDA clearance was not clearly illegal, GE cannot claim a
lack of mutual assent.

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15
2. If GE had gone ahead with the clearance process and the FDA had told GE that it was not the proper
procedure, would there be a meeting of the minds?

• Perhaps. This could have been a mutual mistake if both parties believed a fact that was not true
(FDA clearance procedures), and both parties could have renegotiated or rescinded the contract.
GE’s mistake was to simply make a judgment that it would follow a path that was not consistent
with their obligations under the contract.

CASE SUMMARY 8.5 Reed’s Photo Mart, Inc. v. Monarch, 475 S.W.2d 356 (Tex. Civ. App. 1971)

1. Who prevails and why?

• Monarch prevailed. The mistake was a unilateral one; it was made by Reed's, and Monarch fully
performed its part of the contract. The testimony established that the “MM” was an industry
standard and that because Monarch had already performed, there was no way to use equitable
relief as a remedy.

2. Is this a unilateral or mutual mistake? What’s the difference?

• This is a unilateral mistake. A unilateral mistake is where one party’s belief is not in accord
with the facts. A mutual mistake is when both parties hold an erroneous belief about a basic
assumption in the contract (such as quantity). Typically, unilateral mistake does not result in a
rescission of the contract unless the mistake was so obvious that the other party should have
known.

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16
Teaching Tip: Contract Vocabulary

Students should have a basic understanding of contract vocabulary before starting this chapter. Use
simple examples to illustrate the use of that vocabulary.

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I. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 162-163]

Chapter Review Questions [p. 164-165] Note: Answers and explanations are provided at the very
end of the chapter.
Thinking Strategically Questions and Answers [p. 161-162]

1. What other areas of daily life involve negotiation skills? Have you ever had to negotiate with a
family member? A roommate? What was the outcome?

• This question helps students focus on how common (and important) negotiation skills are used
in and out of business. Common topics are: 1) negotiations with a roommate over noise/study
time and habits, 2) negotiations with the College community—faculty, staff, Resident
Assistants, 3) summer jobs and internships negotiations regrading payment, work schedules
etc., 4) negotiations with family (car use, care of siblings, chores). Focusing on the outcome can
help students figure out whether they have used one of the methods listed in the Thinking
Strategically feature (listening skills, preparation, deal dynamics, etc).

2. When you negotiate, do you see it as a cooperative exercise or a zero-sum gain?

• Answering this question requires students to understand the concept of zero-sum gain and its
role in a successful negotiation. Thinking of negotiations as one clear winner and one clear loser
can be disastrous in the long term. Ask students to think about how they approach a negotiation:
is it win/win or winner take all? Students may also benefit from reading about negotiations in
other arenas (e.g., politics) and what kinds of parallels can be drawn to business negotiations.

3. What role does ethics play in negotiation strategy?

• Possible topics that students should be aware of is how ethical codes/standards influence the day
to day negotiations of a business. Is win/win a part of their business model or is it geared
towards a zero-sum gain? Does corporate social responsibility impact negotiation strategy?
Other potential ways to integrate ethics is to review the material from Chapter 2 on Ethical
Decision-Making Regimes.
Case Summary Questions and Answers [p. 163-164]

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 Chapter 9
Capacity and Legality

CHAPTER OVERVIEW
The previous chapter discussed the first two elements of a valid contract: mutual assent and
consideration. In this chapter, we will discuss the other two essential elements: capacity and legality. In
summary, the parties to a contract must have capacity to make a contract, and the contract itself must be
made for a lawful purpose. This chapter will explain the legal requirements of capacity and legality and
then survey some strategic aspects of the contracting process.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Articulate the legal requirement of capacity and identify the main categories Knowledge
of persons who do not have the full legal capacity to capacity to incur
contractual duties.
Distinguish between bright-line rules (such as the age of majority) and Application
flexible standards (such as the definition of mental competence).
Articulate the concept of legality, or lawful object. Knowledge

I. CAPACITY [p. 214]

Points to emphasize:
• Capacity is a legal doctrine used by courts to protect parties who may lack the ability to
understand the terms of an agreement.
• It is one of the four required elements of a valid contract as shown in Figure 9.1.

• Minors, mental incompetents, and intoxicated persons may lack the full capacity to make
legally binding contracts and promises made by such persons are voidable.
• A voidable contract is one that can be rejected or canceled by the person who lacked capacity at
the time of entering into the contract.
• A contract is voidable only by the person lacking full capacity, not the other party.

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Teaching Tip: Void versus voidable
At this point in the chapter, make sure to emphasize the difference between voidable and void.
Voidable contracts are contracts that can be canceled by the person lacking full capacity. Void contracts
are not even contracts in the eyes of the law.

A. Minors [p. 215]

Points to emphasize:
• Minors are persons younger than 18 years of age.
• Generally, contracts entered into by minors are voidable at the minor’s option.
• Minors may ratify a contract at the age of majority.
o Ratification is any act that indicates that the minor intends to be bound by his promise.
o Ratification can be expressed orally, in writing, or it can be implied.
• Minors may choose to disaffirm the contract, resulting in a rescission of the contract.
o Each party must return any consideration received by the other party.
o In the majority of states, a minor is still entitled to the return of the consideration with which
he parted even if the minor cannot return the consideration he received.
§ Exception: a minor cannot disaffirm a contract for “necessaries” or health and
welfare items and must pay a reasonable value for them.

CASE 9.1 C.M.D. v Facebook, Inc. [p. 216]

Facts: C.M.D. joined Facebook when he was a minor. When C.M.D.’s parents discovered
Facebook used his name and likeness in ads, they sued Facebook. The parents argued that because
C.M.D. was a minor when he joined Facebook, he could not consent to Facebook’s standard user
agreement, including the use of one’s likeness in advertising. Even after the suit, C.M.D. continued
to use Facebook.

Issue: Did filing the lawsuit constitute disaffirmance of the contract?

Ruling: No. The district court and the Court of Appeals ruled against C.M.D. and his parents.
C.M.D. did not disaffirm Facebook’s user agreement, since he continued to use Facebook after
filing suit. The court held that a party cannot keep beneficial parts of a contract and disaffirm
others.

Answers to case questions:

1. Would this case had been decided differently if C.M.D. had closed his Facebook account before
filing his lawsuit against Facebook?
If the minor had, in fact, closed his Facebook, then the court would have construed this action as a
disaffirmance of the contract and would not have granted the defendant’s motion to dismiss the case.
2. Section 4 of Facebook’s terms of use states: “You will not use Facebook if you are under 13.”
(See: https://www.facebook.com/legal/terms.) Suppose C.M.D. had been below the age of 13 when
he opened his account and brought his lawsuit against Facebook. Would this case had been decided
differently on these facts?
This scenario is what lawyers call a “close call” because on these facts the minor would have been in
violation of the terms of use.

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 3. Focus on Critical Thinking: In a footnote, the appellate court stated: “This disposition is not
appropriate for publication and is not precedent ....” Why did the court not want its decision to be
published or to have the force of binding precedent?
• There are several possible reasons why the court may not have wanted to publish its opinion
in this case. By way of example, (1) perhaps the court wanted to avoid creating a binding
precedent in this case because it was dealing with a relatively new technology, or (2)
perhaps the court, out of prudence, wanted to wait until the courts in other circuits had the
opportunity to decide this issue, or (3) perhaps, for reasons of public policy, it did not want
to tie its hands in future cases involving the use of social media by minors.

B. Mental Competency [p. 216]

Points to emphasize:
• Mental incompetents have limited capacity to contract; includes people:
o With metal disorders, dementia, or temporary mental incompetence.
o Who are highly intoxicated, severely depressed, or under severe or traumatic pressure.
o Who are unable to understand the nature and consequences of the contract or unable to
act in a reasonable manner in relation to the transition and the other party has reason to
know of the condition.
• Generally, a party who is lucid at the time of entering into a contract has contractual capacity.
• Some states differentiate between a person who has been legally declared incompetent and those
who are incompetent but have not been legally declared so.
o A contract entered into by a person already legally declared incompetent by a court is
void per se.
o A contract entered into by a person not legally declared incompetent is voidable by the
incompetent person.

CASE 9.2 Sparrow v. Demonico [p. 217]

Facts: Frances M. Sparrow (Sparrow) sued her sister, Susan Demonico, and Susan’s husband, David
D. Demonico (Demonicos), over ownership of their deceased mother’s home. Prior to the trial, the
parties had signed a settlement agreement resolving the dispute. However, the Demonicos refused to
abide by the agreement claiming that Sparrow lacked contractual capacity, thus rendering the contract
void. As evidence, the Demonicos cited some her behavior, such as crying and slurring her words. They
claimed that she was suffering a mental breakdown on the day she signed the agreement.

Issue: Can a party establish the lack of capacity to contract in the absence of evidence that one suffered
from a medically diagnosed, long-standing mental illness or defect?

Ruling: The court concluded the standard of contractual incapacity did not in all cases require proof
that a mental illness or defect was of some significant duration or that it was permanent, progressive, or
degenerative. However, in the absence of any medical evidence or expert testimony that the mental
condition interfered with Sparrow’s understanding of the transaction, or her ability to act reasonably in
relation to it, the evidence was not sufficient to support a conclusion that she lacked contractual
capacity.

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Answers to case questions:

1. What does the court say was missing from the Demonicos’ argument about capacity?
The court says that the Demonicos failed to provide actual medical evidence, such as a diagnosis or
other expert testimony, in support of their claim of mental incapacity.
2. What factors went into the trial court’s decision to void the settlement agreement?
The trial court emphasized Susan’s emotions and her state of mind when she entered the agreement and
focused on certain aspects of her behavior at that time as proof of her state of mind, such as her crying
and her slurring of words.
3. Focus on Critical Thinking: Under the court’s decision, are there any circumstances when
medical evidence would not be necessary? If one party was acting in a bizarre manner, such as
talking to oneself or making irrational statement, would that be sufficient to void a contract based
on capacity? Does public policy require that medical evidence support all claims of incapacity?
• These questions are designed to elicit discussion about the possibility of strategic behavior
by litigants, i.e. parties who pretend to be incompetent in order to get out of an unfavorable
contract after-the-fact.

C. Intoxicated Persons [p. 218]

Points to emphasize:
• Intoxication, whether through drugs or alcohol, can also affect contractual capacity.
• Court will use an objective standard to determine if a person was so intoxicated that he is unable
to act in a reasonable manner (i.e., did not understand the consequences of his actions).

II. BRIGHT-LINE RULES VERSUS FLEXIBLE STANDARDS [p. 219]

Points to emphasize:
• Bright-line rules are clear-cut and easy to apply.
• Below are two examples of bright-line rules:
o Age of majority.
o Speed limits.
• Flexible standards, by contrast, are not as clear-cut and provide a greater range of choice or
discretion.
• Below are two examples of flexible standards:
o Drive with care.
o Lucidity of a person entering into a contract.

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III. LEGALITY [p. 220]
The right to contract is fundamental but not absolute
Points to emphasize:
• For a contract to be enforceable, it must meet the requirement of legality or lawful object
• As a general rule, an illegal contract is automatically void

A. Statutes [p. 220]

Points to emphasize:
• If a contract violates a statute, it is generally unlawful and void
• Courts will not enforce contracts that violate a statute

B. Public Policy [p. 220]

Points to emphasize:
• Public policy is the common sense and conscience of the community extended and applied to
matters of public morals, health, safety, and welfare
• Courts have the power to declare certain contracts void on the ground that they are contrary to
public policy; i.e., injurious to the public or against the public interest, including:
o Agreements that unreasonably restrain trade or business.
o Agreements for the sale of, or traffic in, a public office.
o Agreements by public officers to accept greater pay that is fixed by law for the
performance of official duties.
o Agreements to procure government contracts by personal or political influence or
corrupt means.
o Agreements by or between public or quasi-public corporations that interfere with their
public duty.

CASE 9.3 Dorado Beach Hotel Corporation v. Jernigan [pp. 221-222]

Facts: Walter Alonzo Jernigan, a resident of Florida, lost $6,000 gambling at the Dorado Beach Hotel’s
casino in Puerto Rico, where casino gambling is legal. To pay for his losses, Jernigan wrote a check to

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5
the hotel but stopped payment of the check when he returned to Florida, where casino gambling is
illegal. The hotel sued Jernigan in Florida state court.

Issue: Can a gambling debt which is valid where it was created be enforced in Florida?

Ruling: No. The court held that it would not extend its judicial arm to aid in the collection of a casino
gambling debt as it would be contrary to public policy in Florida.

Answers to case questions:

1. What if the defendant in this case had returned to Puerto Rico? Could the hotel have sued him
again in a Puerto Rico court?
Had the defendant returned to Puerto Rico, the hotel could most likely bring a new action in Puerto
Rico, where gambling is lawful at authorized casinos.
2. In your opinion, which party acted the least ethically in this case: the casino for allowing
Jernigan to wager such large sums of money on credit or Jernigan for placing the stop payment on
his check?
One could argue that determining which of these two parties acted more unethically is really a matter of
personal opinion: on the one hand, Jernigan acted unethically by refusing to pay his gambling debt,
although that debt was incurred in a different legal jurisdiction; on the other hand, the casino acted
unethically by enticing tourists to place large wagers, even though the casino is in the business of
taking wagers.
3. Focus on Critical Thinking: If you were the manager of the casino at the Dorado Beach Hotel
when this case was decided, what steps, if any, would you take to reduce the risk of this scenario
happening again?
• Perhaps you could ask the casino’s lawyer to draft a contract (ideally, one with a forum
selection clause) for out-of-town gamblers to sign promising to repay any gambling debts
they incur in exchange for the opportunity to place wagers at the casino.

C. Exceptions to the Nonenforcement Rule [p. 222]

Points to emphasize:
• Generally, courts will not enforce illegal bargains; the law will leave the parties where it finds
them.
o If the contract is executory, neither party can enforce it.
o If the contract is executed, a court will not permit rescission and restitution.
o If only part of the contract is illegal, the court may enforce the lawful part if it can be
separated from the part that is illegal.
• Exceptions:
o If a party to the contract is a member of a class the law is designed to protect, he may be
able to enforce the contract or obtain restitution.
o Examples:
§ When a person buys bonds that are illegal because they conflict with blue-sky
laws, the buyer can elect to enforce the contract.
§ When an insurance policy is illegal because the company did not use an
approved form, an insured under that policy can enforce the policy.
§ When a party to an illegal contract repents and rescinds before any part of the
illegal purpose is carried out, he may have restitution of the money or goods he
has given in performance.
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 § When one party to the contract is not as guilty as the other party because he was
induced to enter into the bargain by fraud, duress, or strong economic pressure,
he may have restitution of that which he has given in performance.

IV. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Thinking Strategically Questions and Answers [pp. 223-224]

1. Are forum selection clauses ethical? Why or why not?
• This question is designed to elicit discussion on the relation between law and ethics. On the one
hand, one could argue that forum selection clauses are not ethical because they are an attempt to
“game the system” to one’s advantage, but on the other hand, one could also argue that forum
selection clauses are perfectly ethical (or at the very least, ethically neutral) because, by
determining ahead of time the location of any future litigation, the parties are able to avoid
strategic races to the courthouse door.

2. How would a forum selection clause figure into a cost-benefit analysis by a company? What are the
costs of litigating in another state versus your home state?
• Litigation can be a very expensive proposition, and litigating in another state can result in
additional costs, including the need to hire local counsel in the forum state, travel costs to and
from the forum state, and--perhaps most importantly--the loss of “home court advantage” (see
below).

3. What is “home court” an advantage in a particular court? Don’t all litigants have an equal chance at
justice?
• Facebook (Meta, Inc.) provides an excellent example of the importance of “home court
advantage” in litigation. Facebook, being a large and successful company, probably contends
with hundreds, if not thousands, of lawsuits on any given day. If Facebook relies the same
group of lawyers to represent it in all or most of these cases, and if all or most of these cases
have to be filed local courts, then Facebook’s lawyers will have a built-in advantage from day
one, since they will be familiar with the judges and local customs of these courts. In addition, if
any of these cases were to ever reach trial, local juries might be more sympathetic to a local tech
company than to out-of-state parties.

Key Terms [p. 224]

Chapter Review Questions [pp. 226] Note: Answers and explanations are provided at the very
end of the chapter.

Case Summary Questions and Answers [pp. 224-226]

CASE SUMMARY 9.1 Webster Street Partnership Ltd. v. Sheridan, 368 N.W.2d 439 (Neb. 1985)

1. Could the Landlord collect the unpaid rent from Sheridan?

• The correct answer depends on whether the apartment is deemed “necessary” for the minor’s
survival. Generally, things like food, clothing, and shelter are deemed “necessaries”, but in this
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7
 case, the court ruled that the rental of the apartment was not a necessary and so the minor had
the right to avoid all liability under the contract.

2. In answering the above question, should it matter that Sheridan had chosen to voluntarily leave his
parents’ home, with the understanding that he could return whenever he desired? What if Sheridan had
been an orphan with no home to go back to?
• If the minor had been an orphan, it is more likely that the court would have classified the rental
of the apartment as a “necessary” and so the minor would not have been allowed to avoid
liability under the contract.

CASE SUMMARY 9.2 Faber v. Sweet Style Manufacturing Corporation, 242 N.Y.S. 2d 763 (N.Y.
Sup. Ct., Nassau County, 1963)

1. How should the court in this case determine whether Faber lacked the capacity to purchase the
commercial property: by focusing on whether the terms of the deal were unreasonable under the
objective standard, or by focusing on Faber’s state of mind at the time he made the deal?
• Since it is usually impossible to know a party’s true state of mind with any degree of certainty,
courts generally use an “objective test” to determine whether a party had contractual capacity.

2. Unlike minors, a person with a psychological disorder can enter and exit his impaired state. How
should courts determine whether individuals with mental disorders are mentally capable of entering
into a contract?
• As mentioned above, courts generally use an objective standard to determine whether a party
had contractual capacity at a given point in time. The fact that a person with a psychological
disorder can enter and exit his impaired state at any given time makes the use of the objective
test all the more necessary.

CASE SUMMARY 9.3 Biomedical Systems Corp. v. GE Marquette Medical Systems, Inc., 287 F.3d
707 (8th Cir. 2002)

1. Can a party make a unilateral judgment as to illegality on a term of the contract when there is no
affirmative finding from a regulatory authority?
• A party could attempt to make such an argument, but the court would have the final say as to
whether the term was illegal or not.

2. If GE had gone ahead with the clearance process and the FDA had told GE that it did not use the
proper procedure, would the contract be void for illegality?
• The contract in this case required GE to obtain “clearance” from the FDA. If the FDA had told
GE that it did not use the proper procedure, then one could argue that GE was in violation of a
regulatory requirement, but at the same, one could also argue that where a party to the contract
is a member of the class of persons for whose protection the contract was made illegal, he may
enforce it or obtain restitution.

CASE SUMMARY 9.4 MGM v. Travelers, 57 So.3d 884 (Fla. Dist. Ct. App. 2011)

1. What factors should the court take into account in deciding whether or not to grant the summary
judgment?
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8
 • Factors to consider are whether there was fraud, duress, or strong economic pressure; if the
contract is executed; whether the contract is only illegal in part; is one of the parties lacking in
mental capacity; was a license required; and when did the license expire, if any.

2. From a strategic perspective, what step or steps could the Contractor or Subcontractor take to reduce
the risk of a breach of contract lawsuit?
• Discussion should be focused on what was expected by each party during the negotiation
process, including if a license was required.

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 Chapter 10
Enforceability

CHAPTER OVERVIEW
In previous chapters, we discussed the requirements for a valid contract; however, not all valid contracts are
enforceable. In this chapter, we discuss the legal doctrine of enforceability, including the requirement of genuine
assent and the scope of the statute of frauds.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Define the contract doctrine of enforceability. Knowledge
Application
Identify five types of “consent defects,” situations in which genuine assent Reflective
to a contract may be lacking. Thinking
Understand the strategic concept of asymmetric information and distinguish Analytical
between innocent misrepresentations and fraudulent misrepresentations in Thinking
contracts.
Apply the contract defenses of duress, undue influence, and Knowledge
unconscionability. Application
Articulate when contracts must be in writing under the statute of frauds. Knowledge
Application
Explain how courts use the parol evidence rule to interpret contracts. Analytical
Thinking

I. ENFORCEABILITY OF CONTRACTS [p. 228]

Points to emphasize:
• Even if a contract is valid, it is of little use if it is not enforceable in a court of law.
• Enforceability of a contract is determined by examining whether the contract is a product of genuine
assent and, under certain circumstances, is in writing.

II. CONSENT DEFECTS [p. 229]

Points to emphasize:
• For a contract to be enforceable, it must be the result of genuine assent.
• A lack of genuine assent occurs in cases of:
o Misrepresentation,
o Fraud,
o Duress,
o Undue influence, and
o Unconscionability.
• A party to a contract may use one of these consent defects as a defense to try to back out of a contract.

III. MISREPRESENTATION AND THE STRATEGIC PROBLEM OF ASYMMETRIC INFORMATION [p.

229]
Points to emphasize:
• Information asymmetry in a contract occurs when one party to a contract has more or better information
that the other party.
o Example: when one party makes a promise or misrepresentation of a material fact.

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 • Misrepresentation occurs when one party to an agreement makes a promise or representation about a
material fact that is not true.

A. Innocent Misrepresentation [pp. 229-230]

Points to emphasize:
• Innocent misrepresentation occurs when the misrepresenting party doesn’t actually know that the promise
or representation is false.
• An aggrieved party can use the defense of misrepresentation to avoid the contract if he can prove:
o The misrepresentation fact was material,
o Justifiable reliance on the misstatement, and
o The misrepresentation was one of fact, not opinion.
• The aggrieved party’s remedy is typically limited to actual out-of-pocket damages.

B. Fraud [pp. 231-232]

Points to emphasize:
• Fraudulent misrepresentation occurs when the misrepresenting party has actual knowledge that the
representation is false.
o Misrepresentation plus scienter (guilty knowledge).
o Simply referred to as fraud.
• The aggrieved party’s remedy is generally money damages for any losses incurred, plus:
o Additional damages for loss of future profits, and
o In some states, treble damages (three times the amount of actual damages).
• The differences between innocent and fraudulent misrepresentation are summarized in Figure 10.2:

Teaching Tip: Explaining scienter

Provide students with a simple fact scenario demonstrating innocent misrepresentation and then alter the facts
slightly to change it to fraudulent misrepresentation. For example, the buyer sells a painting to the seller truly
believing it was painted by Picasso. In reality, the painting is a really good forgery. This is an example of innocent
representation. Now assume the buyer knew the painting was a forgery but stated it was painted by Picasso. In the
second scenario, there is scienter (guilty knowledge). This is an example of a fraudulent misrepresentation.

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 C. Strategic Digression: Concealment of a Material Fact [p. 232]
Points to emphasize:
• Fraudulent misrepresentations arise out of both affirmative promises and concealment of material facts.
• While there is not general duty to disclose all information, some courts will allow the use of
misrepresentation as a defense when:
o A party has asserted a half-truth that leads to an overall misrepresentation,
o One party takes an affirmative action to conceal the truth from the other party, or
o One party fails to correct a past statement that the other party subsequently discovers to be untrue.
• Even if there is no general duty to disclose all facts, if a party undertakes to do so, he must disclose the
whole truth.

Case 10.1 Vokes v. Arthur Murray, Inc. [pp. 230-231]

Facts: J.P. Davenport, the defendant, owned and operated a franchised Arthur Murray Dance Studio in
Clearwater, Florida. Audrey E. Vokes, the plaintiff, entered the dance school in hopes of becoming an
“accomplished dancer.” Based on Davenport’s encouragement and continued positive feedback, Vokes entered
into several contracts for numerous dance lessons. In total, she paid $31,090.45 for 2,302 hours of dance lessons.
In the end, Vokes realized that her dancing had not improved, so she sued Davenport and Arthur Murray, Inc.,
alleging that Davenport’s representations were false and intended only to induce her into purchasing more dance
lessons. Davenport argued that his representations were statements of opinion, not fact.

Issue: Is a misrepresentation made by one party to induce the other party to enter into a contract actionable if it
based on opinion rather than fact?

Ruling: Yes. The court of appeals held that while generally a misrepresentation must be one of fact rather than
opinion to be actionable, the court identified four exceptions: (1) where there is a fiduciary relationship between
the contracting parties, (2) where there has been some artifice or trick employed by the representor, (3) where the
parties do not in general deal at "arm's length,” or (4) where the representee does not have equal opportunity to
become apprised of the truth or falsity of the facts represented. The court stated that Davenport had “superior
knowledge” as to Vokes dance potential, and while he did not have a duty to disclose all facts within his
knowledge or to answer questions regarding those facts, since he undertook to do so, he must disclose the whole
truth.

Answers to case questions:

1. Were Davenport’s misrepresentations about Mrs. Vokes’ dancing ability statements of fact or
statements of opinion?
• This question is designed to elicit a deeper discussion about the legal distinction between facts and
opinion. This case, for example, is (literally!) a textbook illustration of the difficulty of drawing a line
between facts and opinions.
2. The Court of Appeals identified four exceptions to the general rule that only statements of
fact are actionable as fraud. (See Synopsis of Decision and Opinion above.) Which one of the
four exceptions applies to this case?
• One of the ironies of this case is that none of the four exceptions identified by the court seems to apply to
the facts of this case!
3. Focus on Critical Thinking: In your opinion, why does the law make it so difficult for
plaintiffs to prove fraudulent misrepresentation? Why isn’t it enough just to show that a
defendant’s statements were false or deceptive, regardless whether such statements are about
matters of fact or opinion?
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 • This question is designed to elicit a deeper discussion about the relationship between law and ethics. By
way of example, one could argue that, even though it is morally wrong or unethical to tell a lie we may not
want deception, standing alone, to be a sufficient condition for proving fraud; otherwise, we could all be
open to legal liability every time we told a lie.

IV. ADDITIONAL CONTRACT DEFENSES [pp. 233-235]

A. Duress [p. 233]
Points to emphasize:
• Duress is a contract defense available when one party uses any form of unfair coercion to induce another
party to enter into or modify a contract.
• The law generally recognizes three categories of duress:
o Violence or threats of a violent act,
o Economic threats such as wrongful termination or threats to breach a contract, and
o Threats of extortion or other threats.
• Duress is based on the subjective belief of the parties.
• Example: forcing a party to sign a contract by holding a gun to his head.

B. Undue Influence [p. 234]

Points to emphasize:
• Undue influence is a contract defense available when one party has been induced to enter into a contract
through improper pressure of a trusted relationship.
• Court will grant relief if:
o The terms of the contract are unfair, and
o The parties had some type of relationship that involved a fiduciary duty or some duty to care for
the influenced party, such as:
§ attorney-client
§ caregiver-patient

C. Unconscionability [pp. 234-235]

Points to emphasize:
• Unconscionability is a contract defense available when one party suffers a grossly unfair burden that
shocks the conscience.
• Courts apply this defense very narrowly.
• Used as a defense when one party has been induced to enter a contract through oppressive terms and no
bargaining is possible:
o High-pressure sales tactics that mislead illiterate consumers.
o Some adhesion contracts (take-it-or-leave it).

Case 10.2 Williams v. Walker-Thomas Furniture Co. [pp. 235-236]

Facts: Williams, an unsophisticated buyer with low monthly income, purchased several home furnishings from
Walker-Thomas Furniture Company. She signed several standard form installment contracts that contained a
boilerplate clause stating “all payments now and hereafter made by [purchaser] shall be credited pro rata on all
outstanding leases, bills, and accounts due the Company by [purchaser] at the time each such payment is made.”
As a result of this clause, Williams maintained an outstanding balance on all items ever purchased. Thus, if she
defaulted on a single payment, the Walker-Thomas Furniture Co. would be able to repossess every item. When
Williams missed payments on a record player, Walker-Thomas tried to repossess all the furniture sold to her.
Williams objected and sued Walker-Thomas. The trial court dismissed her case and she has appealed.
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Issue: Are these contracts unconscionable, thus unenforceable, due to the boilerplate clause in the installment
contracts?

Ruling: The court of appeals applied the doctrine of unconscionability holding that genuine assent could be
absent if the circumstances indicate “gross inequality of bargaining power.” The court remanded the case to
determine whether, given the lack of bargaining power held by Williams and the unreasonable terms in the
contract, the installment contracts were unconscionable.

Answers to case questions:

1. In your opinion, was the installment contract in this case unfair or unconscionable?
• This question is designed to elicit a deeper discussion about the unconscionability doctrine and the ideal of
fairness. On the one hand, many students will no doubt feel sorry for Mrs. Williams, since it looks like the
furniture company was taking advantage of her by repossessing all of her furnishings because of a late
payment on one item, but on the other hand, one could easily defend the furniture company’s contract
terms; after all, many of the customers it did business with were high-risk customers, so the furniture
company needed some assurance that it would be repaid.
2. Should the bargaining power of the contracting parties be a relevant consideration in
determining whether the weaker party’s assent is genuine or not? Explain why or why not.
• This question is designed to elicit a deeper discussion about the meaning of consent in modern commercial
contracts between large business firms and consumers. For example, should it matter whether the furniture
company in this case was a small, independent, and locally-owned mom-and-pop business or a subsidiary
of a large corporate chain (like Ikea or Rooms To Go)? If so, where should courts draw the line in terms of
size?
3. Focus on Critical Thinking: Check out the standard terms of service of Facebook:
https://www.facebook.com/terms.php. In your opinion, which provision in Facebook’s terms
is the most “unconscionable” one?
• This question is designed to invite students to apply the unconscionability doctrine to a contemporary
standard-form contract involving a popular social media platform—one that many of our students may
have themselves agreed to at some point.

V. STATUTE OF FRAUDS [p. 237]

Points to emphasize:
• The statute of frauds is a law governing which contracts must be in writing in order to be enforceable by
a court.
• The main purpose of the statute of frauds is to prevent fraud by requiring written evidence of the existence
and terms of certain types of contracts.
• The statute of frauds applies to the following types of contracts:
o contracts that involve the sale of land,
o contracts that cannot under its terms be performed within one year (e.g., 3-year employment
contract),
o contract to pay the debt of another (e.g., loan surety),
o contracts made in the consideration of marriage (e.g., prenuptial agreement),
o contracts by the executor of a will to pay the debts of an estate with his own money, and
o contracts for the sale of goods for $500 or more and lease transactions for goods amounting to
$1,000 or more.
• No specific format of the writing is required (e.g., can be on a napkin and written in crayon).
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 • The writing must contain the signature of the party against whom enforcement of the contract is sought.

Teaching Tip: MY LEGS

Help students learns which types of contracts must be in writing by teaching them the following mnemonic:

M = contracts made in the consideration of marriage

Y = contracts for more than one year

L= contracts that involve the sale of land

E = contracts by the executor
G = contracts for the sale of goods for $500 or more
S = surety contracts

Teaching Tip: The statute of frauds and unenforceability

Make sure students understand that a contract that is unenforceable because of the statute of frauds can still be
voluntarily performed. It might meet all the requirements of a valid contract (mutual assent, consideration,
contractual capacity, and legality); however, a court cannot force a party to perform in the absence of a required
writing. The statute of frauds is a defense and cannot be used if the contract is fully executed.

VI. CONTRACT INTERPRETATION AND THE PAROL EVIDENCE RULE [p. 238]

Points to emphasize:
• Courts rely on various rules of interpretation in disputes involving written contracts.
• The parol evidence rule states that any writing intended by the parties to be the final expression of their
agreement may not be contradicted by any oral or written agreement made prior to the writing.
o Not applicable to evidence that does not contradict.
o Not applicable to agreements made after the writing.
• If there is an ambiguous term in a contract, the court generally construes it against the interest of the side
that drafted the agreement.
• Courts may also supply a reasonable term in a situation where the contract is silent or has omitted terms.

VII. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES

Key Terms [p. 240]

Thinking Strategically Questions and Answers [pp. 238-239]

1. Is it ethical for an employer to restrict an ex-employee’s career prospects? Would you sign a non-complete
clause upon starting a new job?
• This question is designed to elicit a deeper discussion about the relationship between law and ethics and
the difficulty of balancing competing values and interests. On the one hand, a business firm should be able
to take reasonable steps to protect its trade secrets and ensure the loyalty of its employees, but on the other
hands, employees should be free to pursue new career opportunities and to go in business for themselves.
2. Should certain professions be exempt from use of a non-compete clause? Should physicians be restricted in
where they can practice? Why or why not?

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 • This question is designed to elicit a deeper discussion about the rule of law as well as the role of public
policy in law. Should non-compete rules be the same for everyone, or should courts make exceptions
based on pragmatic or policy considerations.

Chapter Review Questions [pp. 243-245] Note: Answers and explanations are provided at the very end of
the chapter.

Case Summary Questions and Answers [pp. 240-242]

CASE SUMMARY 10.1 Professional Bull Riders, Inc. v. AutoZone, Inc., unpublished order and judgment dated
August 15, 2005 (10th Cir. 2005)

1. Could AutoZone use the statute of frauds as a defense in this case? Explain.
• This problem here that the two-year sponsorship agreement in this case was a verbal one, but it also
contained a provision that allowed one of the parties to terminate the agreement before the end of the first
year of the contract--further complicated by the fact that the other party waited until the second year to
cancel the contract. Does such a contract fall under the category of contracts that cannot under its terms be
performed within one year? In this case, the United States 10th Circuit Court of Appeals certified this
question to the Colorado Supreme Court, and the latter ruled that the statute of frauds did not apply to the
sponsorship agreement.

2. In your opinion, should the writing requirement set forth in the statute of frauds apply to all commercial
agreements as a matter of sound public policy? Explain why or why not.
• This question is designed to elicit a deeper discussion about whether all agreements should be in writing.
In short, many commercial arrangements, like the one in this case, are based on handshakes or verbal
understandings, and extending the statute of frauds to all such contracts will increase the costs of doing
business. The ultimate question, then, is whether this increased cost is worth it.

CASE SUMMARY 10.2 Alaska Packers’ Association v. Domenico, 117 F. 99 (9th Cir. 1902)
1. In your opinion, is the second agreement in this case the product of genuine assent or the product of unjustified
duress/coercion? Explain.
• This question is designed to elicit discussion about duress and the strategic problem of “opportunistic
behavior” in which one party “holds up” his performance under a contract to obtain more favorable terms
under that contract. On the one hand, one could argue that the fisherman are engaged in strategic or
opportunistic behavior because they waited until they were in Alaska to demand a higher salary, but on the
other hand, one could also argue that it is the APA who is engaged in strategic behavior, since they
provided the fisherman with shoddy equipment and are now trying to back out of their renegotiated deal
with them.

2. After season 4 of the hit HBO series show The Sopranos, actor James Gandolfini, who played lead character
Tony Soprano, refused to appear in any further episodes of the show unless his salary was increased from
$400,000 to $1 million per episode. In your opinion, was Mr. Gandolfini’s threatened walkout a form of duress or
undue influence? Explain why or why not.
• This question, like the previous one, is also designed to elicit a deeper discussion about duress, especially
the strategic problem of “opportunistic behavior” in which one party “holds up” his performance under a
contract to obtain more favorable terms under that contract. What if, for example, “The Sopranos” had

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 been a flop? If Mr. Gandolfini could demand a higher salary if the show turned out to be a success, why
can’t HBO pay Mr. Gandolfini a lower salary, or refuse to pay him altogether, if the show has been a flop?

CASE SUMMARY 10.3 Harley-Davidson Motor Co. v. PowerSports, Inc., 319 F.3d 973 (7th Cir. 2003)
1. In your opinion, were PowerSports’s misrepresentations to Harley-Davidson “material”? Explain why or why
not.
• This question is designed to elicit discussion about the materiality requirement. The courts in this case
were themselves divided, with the lower court ruling in favor of PowerSports and the appellate court
ruling in favor of Harley-Davidson.

2. What if PowerSports had gone public three years after it was awarded the Harley-Davidson franchise contract?
Could Harley-Davidson still sue for rescission? How about 10 years later?
• This question, like the previous one, is designed to elicit discussion about the materiality requirement as
well as a deeper discussion about the relationship between materiality and the passage of time.

CASE SUMMARY 10.4 Tafel v. Lion Antique Investments & Consulting Services, 773 S.E.2d, Supreme Court
of Georgia (2015)

1. What defense can Tafel assert that would make the note unenforceable?
• This question is designed to elicit discussion about the legal distinction between innocent
misrepresentation and fraudulent misrepresentation.

2. What must the note contain to make the note enforceable? Give an example.
• This question is designed to remind students of the requirements for misrepresentation, such as a material
misstatement of fact.

CASE SUMMARY 10.5 In re Arizona Theranos, Inc. Litigation, 308 F.Supp.3d 1026, (D. Ariz. 2018)

1. How does the massive fraud committed by Theranos affect the contractual relationships between Walgreens
and the plaintiffs in this case?
• This question is designed to elicit discussion about how retailers can get pulled into lawsuits regarding
products liability because they are in the chain of commerce.

2. From a strategic perspective, what is the real reason why Walgreens was sued in this case? After all, wasn’t
Walgreens as much a victim of the massive fraud committed by Theranos as the plaintiffs were?
• Thermos is probably bankrupt and unable to pay any damages, while Walgreens is a “deep pocket” and
thus an attractive litigation target..

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 Chapter 11
Performance

CHAPTER OVERVIEW
In this chapter, we discuss how the contracting parties end or terminate their legal duties under a valid contract.
The most common and desirable way to terminate a contract is by performing as promised in the agreement.
However, there are several other ways to legally terminate a contract without performance or complete
performance of the contract promises. This chapter will focus primarily on how a when a contract is legally
terminated, i.e., contract discharge.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Identify and categorize the three types of conditions. Knowledge
Application
Explain the doctrine of substantial performance and identify its effects on Analytical
the contracting parties. Thinking
Describe the four ways contracting parties can discharge a contract through Knowledge
mutual agreement. Application
Describe the three ways contracting parties can discharge a contract through Knowledge
operation of law. Application

I. THE NATURE AND EFFECT OF CONTRACT CONDITIONS [p. 246]

Points to emphasize:
• Performing the promises agreed-upon in the contract generally discharges contractual duties and legally
terminates a contract
• Parties can allocate or adjust a particular risk associated with performing a contract by attaching a
condition, which can alter the performance obligations
• There are three categories of conditions: condition precedent, condition subsequent, and condition
concurrent
o Condition precedent
§ Requires an event to occur before performance under a contract is due
§ For example, an employer hires a student for a job to begin after the student graduates. It
the student fails to graduate, the employer duty to perform (hire the student) is discharged
o Condition subsequent
§ Specifies an event that will discharge the parties’ contractual obligations if it occurs after
performance under the contract
§ For example, an employment contract stipulates that a party must obtain a professional
license within six months of being hired
o Condition concurrent
§ Occurs when each party is required to render performance simultaneously
§ For example, payment upon delivery of a good
• Courts often enforce strict compliance standards for conditions
• Table 11.1 summarizes the three types of conditions

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Case 11.1 Lucente v. IBM [pp. 248-249]
Facts: In 1991, Plaintiff Lucente worked for IBM for nearly 30 years. He retired largely because he believed he
was being ousted from the company by the top leadership. While at IBM, Lucente participated in several
incentive compensations plans from which he received stock options. These plans contained “forfeiture-for-
competition” provisions that allowed IBM to cancel the unexercised stock options if Lucente went to work for an
IBM competitor. In 1992, Lucente began working for Digital Equipment Corporation (“Digital”), an IBM
competitor. As a result, IBM canceled Lucente’s unexercised stock options. Lucente sued IBM for breach of
contract. The trial court granted summary judgment holding that IBM’s noncompete associated with the clawback
of Lucente’s retirement benefits was unreasonable since Lucente had been involuntarily terminated. IBM
appealed.
Issue: Whether Lucente left IBM voluntarily or involuntarily and if he was fired, whether the forfeiture
provisions were reasonable.
Ruling: The appellate court reversed. The court stated that under the “employee choice doctrine,” New York
courts will enforce a noncompete without regard to it reasonableness if the employee quit and was afforded the
choice between not competing and preserving the contract benefits versus competing and risking loss of those
benefits. The court found that the trial court disregarded evidence suggesting Lucente voluntarily left the IBM and
that the question of whether he had been fired should have been left for a jury to decide.
Answers to case questions:
1. The clawback is a condition subsequent since it would only be triggered after the employee joins a competitor
and discharges the employer obligations after performance.
2. Clawbacks are structured as conditions subsequent to apply retroactively after an important event, in this case
any condition the company feels is necessary to justify recouping payment to an employee.
3. As the court points out, the critical issue is to factually determine if Lucente quit or was terminated. If he was
pushed out and saw no other choice he may have technically quit, but for a good reason.

CASE 11.1 McDonald Corporation v. Stephen J. Easterbrook C.A. No. 2020-0658-JRS (Del. Ch. 2021)
Facts: McDonald discovered Easterbrook violated company policy when he engaged in a sexual relationship with
a subordinate employee. Initially he was going to be terminated for cause, but ultimately it was a separation
agreement which stated without cause and full release of claims against McDonald’s. Easterbrook received funds
under the agreement in exchange for leaving the company. It was later discovered that Easterbrook was engaged
in several such relationships even though he stated that there was just one during the separation agreement
negotiations. Easterbrook’s motion to dismiss the complaint was denied and the case went to trial.
Issue: Can the agreement be set aside because of the potential fraudulent statements by Easterbrook?

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Ruling: The court determined that under public policy, Delaware is “intolerant of fraud”, thus will not rely on
merger or integration clauses that do not clearly state that the parties disclaim reliance on an extra-contractual
statement.
Case Questions:
1. When a company seeks to “claw back” compensation for bad behavior that violates company policy is it an
example of a condition precedent, subsequent, or concurrent? Explain.
• A condition subsequent because the individual is entitled to the compensation, unless bad behavior is
discovered. Compensation is due unless bad behavior is discovered.
2. Why do courts such as the Delaware court require “clear and unambiguous” wording in a contract to release
parties from reliance on statements that later prove to be false?
• Courts do not want to uphold a contract where it is later discovered to be based on fraud as it is against
public policy.
3. Focus on Critical Thinking: This case eventually settled when Easterbrook agreed to return $105 million to
McDonald’s. As a result of the #MeToo movement, companies increasingly negotiate compensation agreements
with executives that include claw back policies related to inappropriate behavior that harms the company’s
reputation. Is this a good development? Explain.
• This is a good development because fraudulent and/or sexual harassment behavior has gone on too long
with companies settling with the victim in a nondisclosure agreement but the individual with the bad
behavior has not been held accountable.

II. DISCHARGING OBLIGATIONS THROUGH GOOD FAITH PERFORMANCE [p. 249]

Points to emphasize:
• If promises to perform in a contract are not conditional, the duty to perform is absolute
• Generally, good faith performance of agreed-upon duties discharges the contracting parties’ obligations
• Parties can agree to an assignment which occurs when one of the contracting parties transfers their rights
under the contract to another party
• Substantial performance occurs when one party fails to render perfect performance, but they have acted in
good faith and their breach is not material
o Triggers the other party’s obligation to perform
o Innocent party is entitled to collect damages to compensate for the imperfect performance
• Case 11.2 illustrates the doctrine of substantial performance

Case 11.2 Jacob and Youngs v. Kent [pp. 250-251]

Facts: Kent, the defendant, contracted with Jacob & Youngs, the plaintiff, to build a house using Reading
pipe. Inadvertently, the plaintiff installed pipe that was not Reading pipe but was substantially the same
quality. When the defendant discovered the error, he demanded that the work be redone, which would have
required the demolition and reconstruction of substantial parts of the house. When the plaintiff refused to
correct the error, the defendant refused to pay the balance on the contract. The plaintiff sued for the remaining
balance.
Issue: Was the defendant entitled to the cost of replacement of the pipe for the plaintiff’s breach of contract?

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 Ruling: No. Applying the doctrine of substantial performance, the court held the appropriate measure of
damages is the difference in value of the pipes, if any, not the cost of replacing the pipes. Under these
circumstances, requiring perfect performance, in the absence of fraud or willfulness, would be unfair.
Case Questions:
1. A dissenting opinion in this case pointed out that JY’s failure to use the correct pipe brand was grossly
negligent and JY should bear the costs of reinstalling the Reading pipe. Does that strike you as
convincing? Why or why not?
• Gross negligence is akin to recklessness, so this dissenting judge thinks failure to supervise a
subcontractor to meet the exact conditions of a contract is reckless. This is not likely to be the view
of many people.

2. If Kent had a vested interest in the use of Reading pipe (suppose Kent was the heir to the Reading pipe
fortune), what condition could he have inserted in the agreement that would have ensured the use of
Reading pipe?
• A condition subsequent could have been added indicating payment would not be made after
performance unless Reading pipe had been verified.

3. Focus on Critical Thinking: The house was completed in June 1914 at a cost of $77,000. The owner
inhabited the house and did not pay the remaining balance of $3,483 when he discovered the breach in
March 1915. Do these facts influence your view of the case? Explain.
• It seems a bit odd that Kent would inhabit the house and fail to make the last relatively small
payment based solely on this finding. Was inhabiting the house affected at all by the different
brand of pipe, or just an excuse not to pay the balance?

III. DISCHARGE BY MUTUAL AGREEMENT [p.252]

Points to emphasize:
• Under the principles of freedom of contract, the parties may agree to mutually terminate their original
contact
• Methods used to mutually terminate a contact:
o Rescission
o Accord and satisfaction
o Substitute agreement
o Novation
A. Rescission [p. 252]
Points to emphasize:
• Rescission – cancelation of a contract
o Each party to the contract gives up rights under the contract in exchange for the release by the
other party from performing their obligations
o A unilateral rescission is not permitted
o For example, Bob agrees to paint Lisa’s house for $1,000. Bob later decides he does not have time
to complete the project. Lisa agrees to release Bob from his obligation to paint her house. She

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 gives up her right to have her house painted and is relieved from her obligation to pay Bob. Bob
gives up his rights to payment and is relieved from his obligation to paint the house

B. Accord and Satisfaction [p. 252]

Points to emphasize:
• Accord and satisfaction occurs when one party agrees to render a substitute performance in the future
(known as the accord), and the other party promises to accept that substitute performance in discharge of
the existing performance obligation
• Satisfaction occurs when the substitute performance has been rendered
• If the accord performance is not rendered, the other party has the option to recover damages either under
the original contract or the accord contract
• For example, Bob has completed his obligations under a contract to Lisa and is owed $1,000. Lisa does
not have the $1,000. Lisa offers to pay Bob $1,100 in 60 days instead and Bob agrees. This is an accord.
Once Lisa pays the $1,100, the accord is satisfied
• Case 11.3 illustrates how an accord and satisfaction requires a good faith dispute of the amount in
question

Case 11.3 McMahon Food Corp. v. Burger Dairy Co. [pp. 253-254]

Facts: Burger Dairy Company (“Burger”) sold milk products to McMahon Food Corporation (“MFC”). A
dispute arose as to the total debt MFC owed to Burger. Burger’s representative, Byslma, and MFC’s
representative, McMahon, met to discuss the debt. Bylsma was later replaced by Carter as Burger’s
representative. Carter contacted McMahon about the still outstanding debt, $58,518.41. McMahon stated that
he and Byslma agreed to settle the debt for $51,812.98. McMahon promptly made out a check in that amount
writing “payment in full” on the voucher, which Carter also signed. After the meeting, Carter contacted
Byslma who denied settling the debt with McMahon. Carter held the check for several months and eventually
cashed the check, crossing out “payment in full.” McMahon contends that the cashing of the check constitutes
an accord and satisfaction relieving MFC from any further debt to Burger. The trial court found MFC in
arrears and awarded Burger damages in the amount of $58,518.41 plus interest and costs. MFC appealed.
Issue: Whether Burger’s cashing (negotiation) of the check completed the accord and satisfaction.
Ruling: No. The appellate court affirmed the trial court’s holding. The court held that no accord and
satisfaction existed because there was no honest dispute between the parties as to the amount due at the time
payment was tendered. The trial court found that McMahon did not act in good faith and misled Carter who
did not know the specifics of the meeting with Bylsma.
Case Questions:
1. Had there been good faith, would cashing the check have created an accord and satisfaction? Explain.
• Yes, it likely that it would have been an accord and satisfaction since the dispute would have been
honest and the check would have included the appropriate language indicating it was resolving the
disputed debt.
2. How can a party prove that the disputed amount is a good faith disagreement?
• First, there can be no evidence of bad faith such as deceit or fraud. Second, the dispute cannot be
arbitrary, there must be a reasonable and factually supported basis for the disputed amount.
3. Focus on Critical Thinking: What goals does the accord and satisfaction doctrine try to promote?
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 • This doctrine seeks to promote flexibility due to changed circumstances and the preservation of the
expectations both parties have with respect to the underlying agreement and value in light of new
circumstances. The doctrine supports freedom of contract and the ongoing ability of private parties to
negotiate terms of already existing contracts.

C. Substitute Agreement [p. 254]

Points to emphasize:
• Contracting parties may discharge their obligations by replacing the original contract with a substitute
agreement
• Generally used as a compromise when two parties have a dispute as to the performance of the contract and
wish to amend its terms
• A substitute agreement immediately discharges any obligations under the original contract and a party can
no longer recover damages under the original contract

D. Novation [p. 254]

Points to emphasize:
• A novation occurs when the parties agree to substitute a third party for one of the original parties to the
contract
• It revokes and discharges all of the replaced party’s obligations under the old contract
• For example, A and B enter into a contract. A later decides that he cannot perform the contract, however,
C is willing to take over his obligations. If all three parties agree, C can replace A as a party to the contract
and A is relieved of his obligations

IV. DISCHARGE BY OPERATION OF LAW [p. 254]

Points to emphasize:
• Courts may discharge a party’s contractual obligations through operation of law under circumstances
where fairness demands it using one of the following three doctrines:
o impossibility,
o impracticability, and
o frustration of purpose

A. Impossibility [p. 255]

Points to emphasize:
• If the contemplated performance of a contract obligation becomes impossible, it may be subject to
discharge
• Impossibility must be objective, i.e., it cannot be done
• Four intervening events used to support an impossibility defense:
o Destruction of the subject matter
o Death or incapacitation of one of the parties in a unique personal service contract
o The means of performance contemplated cannot be performed (i.e., supplier discontinues an item)
o Performance of the obligation has become illegal subsequent to the contract but prior to
performance
• The doctrine of impossibility generally operates to suspend, not discharge, the obligation to perform until
the impossibility ceases
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 • Some contracts add a force majeure (act of God) clause indicating which uncontrollable acts will impede
performance under the contract; for example: riots, threats of terrorism, fires, earthquakes, wars, and
embargos
• Case 11.4 discusses the doctrine of impossibility

Case 11.4 Holder Construction Group v. Georgia Tech Facilities [p. 256]
Facts: Holder Construction Group, LLC (“Holder”) entered into a contract with Georgia Tech Facilities
(“GTF”) for the construction of an apartment project. The contract was a construction-manager-at-risk
contract, under which Holder assumed all risks for performance deficiencies, construction delays, and cost
overruns. The contract also contained a force majeure clause. After the project began, Holder requested a 67-
day time extension due to an increase in steel prices and the late delivery of steel materials. GTF denied the
request. Because of the problems, Holder requested from the court an $1 million-dollar adjustment to the
contract. The trial court granted a summary judgment in favor of GTF and Holder appealed.
Issue: Whether the force majeure clause included late steel deliveries due to suppliers’ late performance or the
increased costs of materials.
Ruling: No. The Court of Appeals held that neither late steel deliveries nor increased costs of materials fell
under the Force Majeure clause, which was a standard clause recognizing “governmental preemption of
materials in connection with a national emergency,” “riot, insurrection, or other civil disorder,” and unusual
and extreme weather conditions constituting Acts of God.”
Case Questions:

1. How might Holder have avoided the risk of bearing the unforeseen and significant increase in steel prices?
• Holder could have added language in the contract that dealt with raw material supply interruptions or
added that scenario under the existing force majeure clause language.
2. If you were Holder, how would you rewrite this contract to avoid liability in the future?
• Add language in the contract that allows the contract performance date to be adjusted and material cost
increases to be factored into the final price adjustment if steel is not delivered on schedule due to no
fault of Holder.
3. Focus on Critical Thinking: If the parties had left out the force majeure clause, how would the case have
been decided?
• A court might find it impossible to complete the contract without the raw material and if this
interruption in the supply was unforeseeable then the impossibility defense may be asserted by Holder.

B. Impracticability [p. 257]

Points to emphasize:
• Courts may allow a burdened parties’ obligations to be discharged if performance becomes extremely
burdensome due to some unforeseen circumstances occurring between the time of agreement and the time
of performance
• The burden must be extreme and unforeseen

C. Frustration of Purpose [p. 258]

Points to emphasize:
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 • Courts may discharge a party’s performance under a contract if an event occurs that destroys the party’s
purpose in entering in the contract
• Frustration of purpose may be used if, after the parties enter into an agreement:
o a party’s principal purpose is substantially frustrated without her fault,
o some event occurs, when the nonoccurrence of the event was a central assumption of the both
parties when entering into the contract, and
o the parties have not otherwise agreed on who bears the risk of such an occurrence
• Burdened party must show the event was unforeseeable and extreme
• Parties may also be discharge through operation of law if:
o a contract is unilaterally altered by a party, the other party is discharged from performing;
o a party files bankruptcy and is entitled to discharge of the contract obligation; or
o the statute of limitations has expired

Thinking Strategically Questions and Answers [p. 260]

1. What types of contract conditions are these two items? Explain.
• Clause 1 is a condition concurrent whereas Clause 2 is a condition subsequent.
2. When would Jeffrey have a valid breach of contract claim against the hospital? Explain.
• When receipts exceed the total practice expenses, and these are not paid as a bonus at the end of the year.
3. Which particular contract terms worked against Jeffrey and why?
• Clause 1 is extremely vague. Physician-specific practice overhead and facility expenses are not defined,
and this allows hospital management to allocate just about any costs they see fit to this contract and argue
that expenses exceed receipts and that the employee is not entitled to a bonus.
4. How would you rewrite the contract so that Jeffrey ensure his receipt of a bonus under the incentive plan?
• Carefully define physician-specific practice overhead and facility expenses and provide a sample
methodology for how these costs are assessed in relation to receipts.

Key Terms [pp. 260-261]

Chapter Review Questions [pp. 263-264] Note: Answers and explanations are provided at the very end of
the chapter.

Case Summary Questions and Answers [pp. 261-262]

CASE SUMMARY 11.1 Sechrest v. Forest Furniture Co., 264 N.C. 216 (N.C. 1965)
1. What are the standards for being discharged through impossibility?
• The standard is one of objective impossibility in relation to the destruction of the subject matter that is the
basis of the contract.

2. Do they apply here? Why or why not?

• The standard does not apply here because the subject matter of the contract, the plywood, was not
destroyed.

CASE SUMMARY 11.2 1700 Rinehart, LLC v. Advance America, Cash Advance Centers, etc., 5D09-3759 (Fla.
5th DCA 2010)

1. The appellate court stated that the trial court had incorrectly applied the doctrine of frustration of purpose to
this case. Explain why this was a mistake.
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 • Frustration of purpose requires extreme and unforeseeable events. In this case, the city not granting the
permits does not fall under either category.

2. The landlord argued that the 90-day window applied to terminating the lease, not to obtaining a permit, and
that the tenant had failed to terminate the lease within 90 days. Based on the language in the contract, is this
persuasive?
• The language is somewhat vague, however, it gives the tenant the right to terminate the lease upon this
condition subsequent. This right contrasts with the duty to terminate the lease within 90 days, so the
landlord’s argument is weak.

CASE SUMMARY 11.3 Hearthstone, Inc. v. Dept. of Agriculture, CBCA 3725 (2015)
1. Why should the doctrine of impracticability not be applied to this case?
• Commercial impracticability should only apply when the event is unforeseeable and creates an extreme
burden. Higher prices or economic downturns do not fit this standard.
2. What conditions would allow the parties to successfully argue impracticability?
• The destruction of a factory, for example through no fault of either party due to unforeseeable
circumstances.

CASE SUMMARY 11.4 Wooden v. Synovus Bank, A13A0876 Ga. App. (2013)
1. What is necessary to create a novation?
• Both parties must agree to substitute a third party for one of the original parties.
2. Do the facts establish that a novation was created?
• No, the parties never agreed to the substitution.

CASE SUMMARY 11.5 Ed Wolfe Construction, Inc., v. Richard Knight and Luann Knight, 2014 IL App (5th)
1. Is a contractor required to perform work perfectly? What is required of a contractor?
• Perfect contract performance should be the goal, however, if the performance is in good faith and
substantial then the other party is not discharged from their obligations, however, they may sue for any
loss of value.
2. Do the facts in this case suggest Wolfe acted in good faith? Who should prevail in this case?
• They do. In this case Wolfe should be compensated minus any loss in value due to whatever immaterial
breach may have occurred.

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 Chapter 12
Breach and Remedies

CHAPTER OVERVIEW
This chapter covers the rights and duties of parties when one has failed to perform as promised,
which is known as a breach, the different types of breaches, the remedies for breaches, and the
duties of the nonbreaching party.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Define breach of contract and differentiate between a material breach and a Application
partial breach.
Explain the doctrine of anticipatory repudiation. Knowledge
Identify the appropriate form of money damages for each type of breach. Application
Differentiate legal remedies from equitable remedies. Application
Explain the duty to mitigate damages. Knowledge

Teaching Tip: Teaching remedies

One especially useful way to teach remedies is through problem-solving. Create a contract
example that you can continue to refer to throughout the chapter creating different remedies by
slightly changing facts. For example, you can create a situation where (1) the nonbreaching had
to pay more to obtain the component from another party (compensatory damages), (2) the
nonbreaching party was able to cover the contract with a lower priced item (no damages), and (3)
the nonbreaching party can only obtain the component from the breaching party (specific
performance). See Tracy A. Thomas, Teaching Remedies as Problem-Solving: Keeping it Real,
AKRON LAW PUBLICATIONS (2013), http://ideaexchange.uakron.edu/ua_law_publications/203

I. BREACH DEFINED [p. 265-267]

Points to emphasize:
• When a party to an agreement owes a duty to perform and fails to fulfill her obligation,
she has breached the contract.
• Material breaches are known as total breaches and entitle the nonbreaching party to
either suspend performance or be discharged from his obligations completely and sue for
damages.
• Compensation methods for breaches are known as remedies.

A. Material Breach [p. 266]

A material breach is a total breach that allows the nonbreaching party the right to suspend
performance or to be completely discharged from performance.

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 B. Partial Breach [p. 266]
Nonmaterial breaches are known as partial breaches. Although the nonbreaching party may not
be excused from performance, they may be entitled to damages.

C. Anticipatory Repudiation [p. 266]

When it becomes apparent that one party does not intend to perform under the contract, this is
known as an anticipatory repudiation (anticipatory breach). When a party threatens to
repudiate (threatens a material breach) the other party may file suit immediately. Modern courts
have held that repudiation occurs in one of three ways:
• A statement by one party of her intent not to perform.
• An action by the promisor that renders her performance impossible.
• Knowledge by the parties that one party may be unable to perform despite both parties’
best efforts.

Case 12.1 Central Park Capital Group, LLC v. Jeannette Machin et al., 189 A.D.3d 984
(NY App. Div. 2020)
Facts: Central Park Capital Group (Central Park) is a limited liability company that entered into
a contract with Machin for the “as-is” (i.e., no contingencies, etc.) purchase of a building located
in Brooklyn, N.Y. Prior to closing on the property, Central Park’s representative inspected the
property and shortly thereafter stated Central Park’s unwillingness to proceed with the purchase
of the property. Central Park’s attorney sent a letter to Machin's attorney demanding a
cancellation of the contract and the return of the down payment held in escrow, alleging, in
essence, that the property had been materially damaged since the signing of the contract. Machin
refused, and Central Park sued to recover the down payment. Machin asserted a counterclaim to
recover damages for breach of contract and demanded retention of the down payment. The trial
court ruled in favor of Machin and held that Central Park had committed an anticipatory breach
of contract which entitled Machin to retain the down payment. Central Park appealed.
Issue: Did Central Park commit an anticipatory breach of the contract?
Ruling: Yes, the appellate court upheld the trial court’s decision in favor of Machin. The court
pointed out that Central Park’s excuse for canceling the contract was invalid given that the
building was purchased “as is” and thus any risk of damage was borne by Central Park. The
court held that the letter from Central Park’s attorney was an unequivocal repudiation of the
contract by Central Park and that Machin was entitled to keep the down payment as damages.
Case Questions
1. Why did Central Park want to cancel the contract? Because it alleged that the property was
damaged after the contract was entered into.
2. What is an “as-is” contract and why is it important to this case? It means that the buyer is
purchasing with all faults and that the seller has no obligation to make repairs. Here, Central Park
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alleged that the property was different than when it entered into the contract, thus it was not
getting the property it bargained for.
3. Focus on Critical Thinking: What language could Central Park have included that would have
given them the right to cancel the contract? IT could have added an option period to allow it to
cancel the contract for any reason during the option period.

II. REMEDIES AT LAW (MONEY DAMAGES) [p. 268-269]

Points to emphasize:
• For most contracts, the remedy at law will be money damages awarded by the court to the
nonbreaching party.
• In a contract claim, money damages are primarily limited to (1) compensatory (also
called direct or actual) damages, (2) consequential damages, (3) restitution, and (4)
liquidated damages.

A. Compensatory Damages [p. 268]

Compensatory damages are actual damages meant to put the nonbreaching party in the same
position she would have been in if the other party had performed as agreed. This includes out-of-
pocket damages and even potential profits that would have been earned if performance had
occurred.

B. Consequential Damages [p. 268]

Consequential damages compensate the nonbreaching party for foreseeable indirect losses not
covered by compensatory damages. In other words, the breaching party must have known that
the loss would occur because of the breach.

C. Liquidated Damages [p. 269]

Liquidated damages are damages that the parties agree to ahead of time, usually in the contract
itself. For such provisions to be enforceable, courts have held that (1) the amount of harm caused
by the breach must be impossible or difficult to estimate, (2) damages also must be directly
related to the breach and be a reasonable estimate of the actual damages incurred, and (3) the
penalty clause (i.e., damages that are intended to penalize the breaching party rather than
compensate the nonbreaching party) cannot be disguised as a liquidated damages clause.

Case 12.2 Bunker et al. v. Strandhagen, Court of Appeals of Texas, Third District, No. 03-
14-00510-CV (2017)
Facts: Strandhagen and the other physicians separately entered two agreements as part of a sale
transaction: (1) individual employment agreements with AAT and (2) a separate internal
operating agreement among themselves (“operating agreement”) that, among other things,
created an advisory board tasked with certain responsibilities within the practice group. AAT
was not a party to the operating agreement. Strandhagen’s employment agreement with AAT
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specified the terms of her employment with AAT and provided for a seven-year term of
employment. The operating agreement included a liquidated damages provision if a physician’s
employment was terminated before the expiration of his or her employment term, Strandhagen
would be obligated to pay liquidated damages. When Strandhagen was terminated prior to the
end of the seven-year employment term, she sued for a declaratory judgment that the liquidated
damages clause was an invalid penalty clause. The court granted summary judgment for
Strandhagen, and the defendants appealed.
Issue: Was the liquidated damages clause an invalid penalty clause?
Ruling: No, the appellate court reversed the trial court’s decision. A liquidated damages
provision can be enforced if the court finds that (1) the harm caused by the breach is impossible
or difficult to estimate and (2) the amount of liquidated damages is a reasonable forecast of just
compensation. Strandhagen concedes the first element, namely, that the harm caused by early
termination was difficult to estimate at the time of contracting and the record did not show that
the liquidated-damages provision was unreasonable forecast of just compensation.
Case Questions
1. Why did Strandhagen concede “that the harm caused by early termination was difficult to
estimate at the time of contracting”? Because actual damages would depend on too many factors.
2. What business reasons support the use of a liquidated damages clause in this case? The
liquidated damages clause provides certainty as a set amount of risk in advance.
3. Focus on Critical Thinking: Liquidated damages clauses are everywhere. Can you find one in
a software license agreement or terms of service agreement in any contracts that you have
entered into? Did you know what liquidated damages were? Do most people? This question is
meant to elicit a conversation on how frequent these clauses are used and for what purposes.

III. EQUITABLE REMEDIES [p. 272-273]

Points to emphasize:
• Although the usual remedy for a breach of contract is money damages, there are some
instances when money damages are insufficient to compensate the nonbreaching party.
• In these cases, a court may grant equitable relief, which can include (1) specific
performance, (2) injunctive relief, or (3) reformation.

A. Specific Performance [p. 272]

Specific performance is an equitable remedy whereby a court orders the breaching party to
render the promised performance by ordering the party to take a specific action. This remedy is
available only when money damages would be insufficient because the subject matter of the
contract is so unique, such as with real estate or personal services agreements.

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 B. Injunctive Relief [p. 272]
Injunctive relief is a court order to refrain from performing a particular act. An injunction could
be used to prevent the sale of a building to a third party for a higher price.

C. Reformation [p. 272]

A reformation occurs when a court change the terms of a contract by rewriting it to conform to
the parties’ actual intentions. If, for example, a real estate contract names the wrong lot number,
the court could reform the contract by changing it to the correct lot number.

D. Restitution [p. 273]

Restitution is a remedy designed to prevent unjust enrichment of one party in an agreement. In
the event that one party is in the process of performing the contract and the other party commits a
material breach, the nonbreaching party is entitled to rescind (cancel) the contract and receive
fair market value for any services rendered.

Teaching Tip: Equitable remedies

Sometimes students have difficulty in understanding why someone would want an equitable
remedy instead of money. You can give an example where consequential damages would not be
awarded because the breaching party did not have knowledge of the potential. This could occur
when a supplier fails to provide a component that can only be sourced from that supplier and as a
result, the plaintiff loses the proceeds from a contract to sell the completed goods to yet another
party because they can no longer make the finished product. If the nonbreaching party paid
$10,000 for components which were never provided and as a result lost a contract worth
$100,000, the nonbreaching party would not want the $10,000 returned, but rather for the court
to order the supplier to provide the components.

IV. DUTY TO MITIGATE [p. 273-274]

If the nonbreaching party can avoid the damages with reasonable effort, without undue risk or
expense, she may be barred from recovery through a lawsuit. The rule preventing recovery for
reasonably avoidable damages is often called the duty to mitigate.

Case 12.3 Fischer v. Heymann, 12 N.E.3d 867 (Supreme Court of Indiana 2014)

Facts: The Heymanns entered into an agreement to buy a condominium from Fischer for
$315,000 which allowed them to terminate the contract if Fischer refused to fix any “major
defect” discovered upon inspection. One week after signing the Agreement, the Heymanns
demanded that Fischer fix an electrical problem after an inspection report revealed electricity
was not flowing to three power outlets. Fischer did not do so alleging that this was not a “major
defect.” When the Heymanns refused to close on the purchase, Fischer sued for specific
performance or money damages. The trial court found for the Heymanns and Fischer appealed.
The appellate court then reversed the decision and remanded the case back to the trial court for a
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determination of damages. On remand, the trial court concluded that Fischer fell short of
exercising reasonable diligence in mitigating her damages when she listed the condo at an
unreasonably high price from at least the beginning of 2007 to early 2011 and rejected a third-
party offer to purchase the condo for $240,000. The trail court on remand awarded Fischer
$93,972.18 representing the difference between the original $315,000 selling price and the
$240,000 offer, plus all carrying costs, expenses, and attorney fees that accrued from the moment
of breach until Fischer rejected the $240,000 offer.
Issue: Did Fischer adequately mitigate her damages?
Ruling: No, Indiana Supreme Court upheld the ruling in favor of the Heymanns and affirmed the
trial court’s conclusion that Fischer’s award should be reduced because she failed to mitigate her
damages. Fischer could have sold the condo in 2007 for $240,000, but instead waited until 2011
to seek damages. The court indicated that Fischer could only receive $75,000 in compensatory
damages—the difference between the Heymann deal ($315,000) and the $240,000 offer in 2007.

Case Questions
1. Was it reasonable for the Heymanns to consider the electrical problem a “major defect”? Why
or why not?
• It was not reasonable to allege that three nonworking outlets was a “major defect,
because it did not interfere with the Heymann’s use and enjoyment of the property, as
such would be the case if there was working electricity at the condo.
2. Why did the court use the Johnson offer to help calculate Fischer’s damages?
• Fischer could have sold her unit in 2007 to Johnson which would have permitted her to
sue the Heymanns for the difference.
3. Focus on Critical Thinking: Much of the court’s ruling turns on the fact that Fischer
unreasonably held onto the property instead of selling it. Should the law impute knowledge of
the real estate market to every seller? Wouldn’t it have been difficult for Fischer to anticipate
how far the value of her condo would fall in an extremely depressed housing market?
• This question is meant to elicit a conversation as to how far a plaintiff must go to mitigate
damages.

V. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 224]

Chapter Review Questions [p. 278-279] Note: Answers and explanations are provided at
the very end of the chapter.

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Thinking Strategically Questions and Answers [p. 275-276]
1. Can you think of conversations, words, or events that might lead one party to believe that the
other party might breach in the near future?
a) Conversations between a buyer and seller that indicate that the buyer cannot get
financing for a particular transaction, b) words: After a consultant signs a contract with a
client located on the east coast: “I have a client on the west coast that is taking up a lot
more time than I thought. I may not be as available as I initially believed, so we’ll just
have to work out something else.” c) actions: a buyer enters into a fulfillment contract for
widgets, but after two deliveries, the seller stops sending delivery trucks.

2. Why do you think the law provides a right for one party to suspend performance based on lack
of assurances?
• The law favors mitigation of damages. If one party begins to suspect that the other party
won’t perform, the law doesn’t require that the non-breaching party sit back and watch
the breach occur. Just the opposite: the non-breaching party should do what they can to
minimize losses.

Case Summary Questions and Answers [p. 277-278]

CASE SUMMARY 12.1 Pepsi-Cola Co. v. Steak ’n Shake, Inc., 981 F. Supp. 1149 (S.D.
Ind. 1997)
1. Should a court award damages to Pepsi even though the company admitted the damages could
not be calculated exactly?
• The court ruled in favor of Steak’n Shake because the damages were not legally
cognizable as all potential gains were purely speculative.

2. What other types of damages or relief could Pepsi seek?

• If the contract had a liquidated damages clause, Pepsi would be a position to claim money
damages. Otherwise, Pepsi could also seek equitable relief in the form of an order for
specific performance.

CASE SUMMARY 12.2 DiFolco v. MSNBC, 622 F.3d 104 (2d Cir. 2010)
1. Who prevails and why?
• DiFolco prevailed. The court ruled that an anticipatory breach had to contain
unambiguous language of the intended breach. Here, her emails that she wanted to part of
the team for a long time to come were contrary to any notion that she would breach.

2. If you received an e-mail from an employee that concerned her “exit,” would you believe she
was quitting? Is the situation with DiFolco any different?

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7
 • This question is intended to have students focus on the importance of language and the
various meanings of “exit.” Context and industry standards play an important role in
determining ambiguity. For example, in Difolco's case, exit could mean an exit from that
show or assignment rather than from employment.

CASE SUMMARY 12.3 Straits Financial LLC v. Ten Sleep Cattle Company and Richard
Carter, 900 F.3d 359 (7th Cir. 2018)
1. Should the Court reduce any money damages awarded to Carter due to his failure to mitigate
damages that resulted from the broker’s fraud? Explain.
• Yes, Carter should reasonably monitor his account and discover the fraud. By ignoring
the communications from Strait, he allowed his damages to increase.

2. What procedures or systems could Carter have implemented that would have detected the
fraud?
• Carter should regularly check his mail and monitor his accounts.

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8
 Chapter 13
Sales: Overview of Article 2

CHAPTER OVERVIEW
In this chapter, we discuss Article 2 of the Uniform Commercial Code (UCC), which applies to the contracts for
the sale of goods. It creates a series of standard default rules, and these rules help to promote commerce by filling
potential gaps in business contracts. The chapter also explains how contracts governed by the UCC differ from
those governed by the common law.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Identify which types of contracts are governed by Article 2 of the UCC. Knowledge
Application
Articulate the fundamental purpose of UCC Article 2 in commercial Reflective
transactions. Thinking
Explain the default rule and how default rules fill gaps in contracts. Analytical
Thinking
Define goods and merchants under Article 2 of the UCC. Knowledge
Application
Distinguish between common law contracts and UCC contracts. Analytical
Thinking

I. INTRODUCTION TO THE UCC [p. 281]

Points to emphasize:
• The Uniform Commercial Code (UCC) is a model statute that every state has now adopted either
completely or substantially
• Article 2 of the UCC governs the contracts involving the sale of goods

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 II. PURPOSE OF ARTICLE 2 OF THE UCC [p. 28]
Points to emphasize:
• Promote commercial efficiency and the completion of business transactions
• Provides simple and standardized procedures that merchants and consumers may rely upon in cases
involving unforeseen contingencies

III. DEFAULT RULES [p. 283]

Points to emphasize:
• Default rules fill in the “gaps” in business contracts (See Figure 13.2 for a general overview)
o Help courts resolve problems that were not anticipated or addressed in the contract
o Can be modified by the parties at the time they enter into their contract (as opposed to
mandatory rules which cannot be modified)
• Default rules support the notion of a complete contract
• Article 2 of the UCC mainly comes into play when the parties to a sales transaction have not expressly
agreed on certain terms

IV. UCC ARTICLE 2 COVERAGE AND DEFINITIONS [p. 284]

Points to emphasize:
• Article 2 of the UCC applies only to agreements for the sale of goods
• The UCC defines goods as property that is both:
o tangible
o movable from place to place
• The UCC does not apply to real estate or employment contracts
• Predominant purpose test is generally used for mixed contracts (i.e., contract involving a good and a
service)
o See Figure 13.3
o Courts determine whether the main purpose of the contract is the rendition of a service, with
goods incidentally involved, or whether the main purpose is the transaction of a sale, with labor
incidentally involved
• Special provisions of Article 2 apply only to merchants (i.e., anyone regularly engaged in the sale of a
particular good or anyone who employs a merchant as a broker, agent, or intermediary)
o The UCC imputes a certain level of knowledge and awareness to merchants
o Less necessity for safeguards intended for average customers

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Case 13.1 ProCD v. Zeidenberg [p. 285]
Facts: ProCD compiled information from more than 3,000 telephone directories around the world into a single,
searchable computer database. Matthew Zeidenberg purchased a CD-ROM consumer package of the database
which included a shrink-wrap license prohibiting the resale of the contents of the database. Zeidenberg opened a
business and began to resell the information in the database over the Internet in contravention of the license.
Issue: Is a shrink-wrap license valid and enforceable?
Ruling: Yes. The appellate court held the buyer must comply with the license. The UCC sec. 2-204(1) allows
parties to structure a contractual relationship in any manner sufficient to show an agreement. In this case,
Zeidenberg inspected the package, tried out the software, and learned of the license. If he was not in agreement,
he could have prevented the formation of the contract by returning the goods.

Case questions and answers:

1. Is ProCD’s license agreement a contract for the sale of goods or a contract for the provision of services.
• This question is designed to elicit discussion on how courts apply the predominant purpose test to classify
mixed contracts (i.e. contracts involving both the sale of a good and the provision of the service). In this
case, for example, although the creation and updating of the database by ProCD could be considered a
service, the database itself could be classified as a good.
2. How would you classify Zeidenburg, as a merchant or a consumer?
• This question is designed to elicit discussion about the consumer-merchant distinction. In this case, for
example, although Zeidenberg purchased the ProCD product off the shelf, he could easily be classified as
a merchant since he opened a business with the purpose of reselling the information contained in ProCD’
database.
3. Focus on Critical Thinking: Would the result in this case be the same under the common law instead of the
UCC?
• This question is designed to elicit discussion about the main differences between the UCC and the
common law regarding the sale of goods. If anything, since the purpose of the UCC is to promote
commerce, one could argue that it should be easier to prove the existence of a binding sales contract under
the UCC than under the common law.

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 V. UCC AND THE COMMON LAW [pp. 286-287]
Points to emphasize:
• Common law applies to contracts involving the provision of services
• Article 2 of the UCC applies to contracts involving the sale of goods
• The UCC preempts or displaces the common law when goods are being sold
• The UCC relaxes some of the stricter common law contract requirements, such as the doctrine of consideration

Thinking Strategically Questions and Answers [pp. 287-288]

1. Have you ever found yourself in a Prisoner’s Dilemma situation, for example, a transaction in which the
“temptation to defect” was strong? Describe the situation.
• This question is designed to promote discussion about the importance of trust and the risk of betrayal in
everyday life.

2. With reference to the UCC, now do the default rules contained in Article 2 of the UCC influence “the shadow
of the future” in contracts for the sale of goods?
• This question is designed to elicit discussion on the function of “default rules” and their relation to the
future. Broadly speaking, a default rule is a rule of law that is designed to fill “gaps” in business contracts,
that is, designed to deal with unexpected or unforeseen situations that might occur well into the future after
a deal is made.

Key Terms [p. 288]

Chapter Review Questions [pp. 289-2290] Note: Answers and explanations are provided at the very end of
the chapter.

Case Summary Questions and Answers [pp. 288-289]

CASE SUMMARY 13.1 Advent Systems Ltd. v. Unisys Corp., 925 F.2d 670 (3d Cir. 1991)

1. Do you find the court’s analogy between music and software persuasive? Why?
• This question is designed to elicit a deeper discussion about line-drawing in law and the use of analogies
by courts. In short, courts are often called to draw a line between “goods” and “services” and the use of a
good analogy can help courts draw a principled line.

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2. In your opinion, would the agreement still have been classified as a transaction involving the sale of goods if
Advent had not yet developed its software at the time it entered into its agreement with Unisys, or would it have
been classified as the provision of a service?
• This question is designed to elicit a deeper discussion about the temporal dimension of the distinction
between goods and services.

CASE SUMMARY 13.2 3L Communications LLC v. Merola, 2013 WL 4803532, Court of Appeals of
Tennessee (2013)

1. Is Merola a merchant under the UCC? Why or why not?

• This question is designed to elicit discussion about the consumer-merchant distinction and the problem of
line-drawing in law generally. In this case, for example, the Court determined that Merola was a merchant
because, even though she described herself as a “broker,” she was doing business as “NY Telecom Supply
and NY Telecom and Network Supply, L.L.C.” and held herself out as telecommunications equipment
merchant.

2. Either way, should someone who has minimal business experience or education be held to the standard of a
merchant?
• This question is designed to elicit a deeper discussion about fairness, legal risk, and the rule of law.
Specifically, should the law basically be the same for everyone (beyond the merchant-consumer
distinction), or should the law take into account one’s individual circumstances, such as age, experience,
or education.

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 Chapter 14
Sales Contracts: Agreement, Consideration, and the Statute of Frauds

CHAPTER OVERVIEW
This chapter surveys the elements required under Article 2 of the UCC for the formation of an agreement for the
sale of goods. The chapter will also delve deeper into the UCC by addressing the following: the consideration
needed for modification of a contract; the significance of the battle of the forms; and when contracts for the sale
of goods must be in writing.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Identify the elements required under the UCC to create an agreement for the Knowledge
sale of goods. Application
Compare and contrast the element of consideration under the common law Analytical
and under UCC Article 2. Thinking
Explain the battle of the forms. Analytical
Thinking
Articulate when sales contracts must be in writing and specify what the Knowledge
writing must contain to be enforceable under the statute of frauds. Application

I. FORMATION OF AGREEMENT FOR THE SALE OF GOODS [p. 292]

Points to emphasize:
• The UCC aims to promote the completion of business transactions.
• The formation elements for a sales contract are easier to meet and do not require the same level of intent
that is required for common law contracts.
• Article 2 allows an enforceable agreement to arise so long as the conduct of the parties indicates some
basis for a reasonable person to believe a sales contract exists.

A. Firm Offers by Merchants [p. 293]

Points to emphasize:
• A firm offer occurs when a merchant seller promises in a signed writing to keep an offer for the sale
of goods open for a period of time.
o Does not apply to nonmerchant sellers.
• The firm offer is irrevocable for the time stated in the offer but, if no time period is stated, then it will
stay open for a maximum of three months.
• The offeree does not have to pay any consideration.

B. Offers with Open Terms [p. 293]

Points to emphasize:
• Open terms (e.g., delivery, price, or payment terms) are acceptable under the UCC so long as there is
evidence:
o the parties intended to enter into a contract, and
o the other terms are sufficiently articulated to provide a basis for some appropriate remedy in
the case of a breach of contract.
• UCC fills gaps in the parties’ contract by providing default answers based on what terms are missing.

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 C. A Word about Quantity [p. 293]
Points to emphasize:
• Quantity is a term that is generally necessary to create an enforceable contract under both the common
law and the UCC.
• Two exceptions to the general rule under the UCC only:
o Output contracts:
§ The buyer agrees to purchase all of the goods that a seller produces.
§ The seller gives up the right to sell the goods elsewhere.
§ For example, a farmer agrees to sell all of the apples it grows in one season to one
grocery store and the grocery store agrees to buy all of the apples the farmer grows.
o Requirements contracts:
§ The buyer agrees to purchase all or up to an agreed amount of what the buyer needs for
a given period.
§ For example, a grocery store agrees to purchase all of the apples it needs in a season
from one farmer.

II. OTHER OPEN TERMS [p. 294]

Points to emphasize:
UCC provides the following gap-filling rules regarding missing terms:
• Delivery:
o If the place of delivery is not specified in the contract, the buyer takes delivery at the seller’s place of
business.
o If no time of delivery is specified, then the UCC provides for a reasonable time under the
circumstances.
• Payment:
o Due at the time and place where the seller is to make delivery.
o Payment may be made in any commercially reasonable form.
• Price:
o If no price is specified, the court determines a reasonable price at the time of delivery.
o Price is based on industry custom and market value.
• Acceptance:
o If the offeror does not specify a method of acceptance, the UCC allows an offeree to accept the offer in
any reasonable manner.
o Unlike under the common law, an acceptance may still be effective even if the acceptance does not
match the offer exactly (i.e., no mirror image rule under Article 2).

III. CONSIDERATION [p. 295]

Points to emphasize:
• Common law requires new consideration to modify a contract.
• The UCC allows contracts to be modified even without any additional consideration.
o Rationale: market conditions are not static.
o The parties may have a good faith reason for modifying a contract.
• For example, assume that Ernie sells 2,000 golf balls to Tiger on credit. Tiger agrees to pay Ernie $1,000
plus 6 percent interest on the principal still owed per month for a period of 24 months. After two months,
Tiger’s cash flow is impaired by an unexpected downturn in his business. Ernie and Tiger then agree to
modify the contract to allow Tiger to pay a smaller monthly payment ($500 per month) but at the same
interest rate until the balance is paid off in full. Later, Ernie runs into cash flow problems of his own and
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2
 demands that Tiger honor the original credit contract terms. Despite the fact that no additional
consideration was given for the modification, under the UCC the modified contract is fully enforceable and
the original contract is deemed canceled.

IV. BATTLE OF THE FORMS [p. 295]

Points to emphasize:
• Businesses frequently use preprinted forms containing some blanks for the particular negotiated terms
unique to sales transaction.
o A purchase order usually contains the offer from the buyer (see Figure 14.1).
o An invoice form (i.e., invoice) contains the terms from the seller (see Figure 14.2).

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3
 • If the purchase order and invoice form have conflicting terms (known as the battle of the forms), the UCC
provides guidelines on how to resolve the dispute.
• In the battle of the forms cases, the UCC provides:
o A document may constitute acceptance even though it states terms that are additional to or different
from those offered by the offeror, and
o In certain transactions the additional terms proposed in the acceptance may become part of the sales
contract.

A. Nonmerchant Transactions [p. 296]

Points to emphasize:
• In a battle of the forms case, if one of the parties to a sales contract is not a merchant, the contract is
formed as originally offered.
• The contract is considered accepted.
• The additional terms are not part of the contract.

B. Merchant Transactions [pp. 296-297]

Points to emphasize:
• In a battle of the forms case, if both parties to a sales contract are merchants, the contract is formed
automatically including the additional terms unless:
o The offeror has expressly and clearly limited acceptance to the original terms.
o The additional term is a material change that diverges significantly from those contained in the
offer.
o The offeror raises an objection to the additional terms within a reasonable time period
according to industry standards.
• The knockout rule is used if the terms in the purchasing order are different from terms in the invoice
form:
o Conflicting clauses knock each other out and neither clause becomes part of the contract.
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4
 o Courts then look to the UCC’s gap-filler provisions to supply the term.

Teaching Tip: Common law versus the UCC

This chapter discusses how the UCC is often more flexible than the common law with missing terms and
additional terms. Encourage students to always first classify a contract as common law or a UCC contract before
they begin addressing any issues in the contract.

V. STATUTE OF FRAUDS [p. 298]

Points to emphasize:
• Under the UCC, the statute of frauds requires any sales contract for goods with a total value of $500 or
more to be in writing.
• The writing helps ensure:
o The parties will take their agreement more serious and consider the consequences of a breach.
o One or both of the parties will not come into court and lie about the existence or terms of a
contract.
• Under the UCC statute of frauds provision, the writing must include:
o The quantity,
o The signature of the party against whom enforcement is sought, and
o Language that would allow a reasonable person to conclude that the parties intended to form a
contract.
• If the sales contract is between two merchants, a signed confirmation memorandum by one merchant
satisfies the UCC statute of frauds provision.
o The receiving merchant is bound by the memorandum just as if she had signed it, unless she
promptly objects.
o For example, two merchants orally agree over the phone to the sale of $600 of goods. The seller
sends a signed memorandum memorializing the conversation. The memorandum states the quantity
and the price of the goods. If the buyer does not promptly object, she cannot raise the statute of
frauds as a defense.
• The UCC recognizes electronic records and signatures.
• A federal court applies the UCC statute of frauds in Case 14.1.

Case 14.1 Rosenfeld v. Basquiat [p. 299]

Facts: Artist Jean-Michel Basquiat agreed to sell several of his original paintings to Michelle Rosenfeld, an art
dealer in New York City. Rosenfeld requested a receipt for the deposit. Basquiat created a receipt using a piece of
brown wrapping paper and a crayon. Both parties signed the wrapping paper which listed the names of the
paintings and the amount paid. Basquiat died before Rosenfeld took delivery of the paintings. Basquiat’s estate
refused to honor the contract stating that it was not formal enough and did not specify the delivery terms.
Rosenfeld sued and won damages. Basquiat’s estate appealed.

Issue: Does the signed brown piece of wrapping paper comply with the UCC’s statute of frauds provision?

Ruling: Yes. The appellate court held that the wrapping paper which was signed by both parties and included the
quantity, price, deposit amount, and the names of the goods sold complied with the statute of frauds. It further
held that the statute of frauds does not require delivery terms.

Answers to case questions:

1. What if Basquiat had not included the prices of the paintings in question? Would the sales contract still had
been enforced?
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5
 • Yes! This question is designed to remind students how flexible the UCC is regarding what terms must be
in writing. In particular, the UCC’s statute of frauds provision for sales is satisfied so long as the sales
contract contains in writing (1) the quantity, (2) the signature of the party against whom enforcement is
sought, and (3) language that would allow a reasonable person to conclude that the parties intended to
form a contract. All other terms and conditions may be proved by testimony concerning oral agreements,
past practices, and industry standard.

2. What if Basquiat’s estate had produced a more recent sales contract signed by Basquiat agreeing to sell the
same paintings for a higher price to another art dealer? Would this second contract be enforceable?
• No, given the existence of the original sales agreement, the subsequent agreement would not be
enforceable.

3. Focus on Critical Thinking: Should the law require sales contracts over $500 to be notarized? Why or why not?
• This question is designed to remind students of the UCC’s overall goal of promoting commerce, which
helps explain the UCC’s flexibility regarding sales contracts. Requiring notarization of large sales would
be inconsistent with the purpose of the UCC. Also, notarization does not necessarily lead to fewer
breaches of contract; see, for example this short film clip:
https://www.youtube.com/watch?v=HPYz2IzIii0.

Key Terms [p. 301]

Thinking Strategically Questions and Answers [p. 300]

1. Why does the battle of the forms pose a strategic risk to business firms?
• This question is designed to elicit discussion on litigation risk. In short, a battle of the forms between a
buyer firm and a seller firm can result in delay and confusion in the performance of a contract, and, in the
worst-case scenario, it could also lead to costly litigation.

2. How can business firms reduce this risk?

• The answer here depends on whether the firm is a seller or a buyer. For instance, if you are a seller of
goods or services and you want the contractual terms in your form to control the entire sales process, your
sales form should have a provision in it which makes acceptance by the buyer “expressly conditional on
the buyer’s assent to only the terms set forth in the Seller’s contract.” If, on the other hand, you are a
buyer, and you want your terms to control the purchase, you must state in your form/purchase order that
your acceptance is expressly conditional on the seller’s agreement to the additional or different forms set
forth in your form.

Chapter Review Questions [pp. 303-304] Note: Answers and explanations are provided at the very end of
the chapter.

Case Summary Questions and Answers [pp. 301-303]

CASE SUMMARY 14.1 Movado Group, Inc. v. Mozaffarian, 938 N.Y.S.2d 27 (N.Y. App. Div. 2012)

1. Was the forum selection clause an additional term, a different term, a confirmatory writing, or a term
incorporated into the document? Explain.
• The Court in this case concluded as follows (bold added): “Here, the forum selection clause was not an
‘additional or different term’ added to the contract, nor was it a confirmatory writing; rather, it was one of
the terms and conditions incorporated by reference into the contract at its inception.”
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6
2. In your opinion, does the fact that Mozaffarian never requested to see the extrinsic document have any bearing
on the outcome of this case? Why or why not?
• This question is designed to remind students of the UCC’s overall goal of promoting commerce, and how
this goal might conflict with other worthwhile legal goals, such as fairness to consumers.

CASE SUMMARY 14.2 Hebberd-Kulow Enterprises, Inc. v. Kelomar, Inc., Court of Appeals of California, 4th
District (2016)

1. Why didn’t HKE charge Kelomar the late interest charge until this dispute?
• This question is designed to elicit discussion on the relation between law and strategy. Here, HKE most
likely had a strategic incentive to NOT enforce the late interest charge (prior to its legal dispute with
Kelomar) for the sake of its ongoing commercial relationship with Kelomar, but once the parties were
embroiled in costly and protracted litigation, HKE’s strategic incentives changed. It then had an incentive
to enforce the late interest charge, perhaps to put additional financial pressure on Kelomar to force an out-
of-court settlement on favorable terms.

2. In your opinion, why did the court reject Kelomar’s argument that it was reasonable to think that HKE had
waived the late interest charge and was barred from recovering it? Should HKE be able to choose when it does
and when it doesn’t enforce the clause?
• This question is designed to elicit discussion on the division of labor between judges and juries, for in
reality, the court in this case sent this particular issue (i.e., whether it was reasonable to think that HKE
had waived the late interest charge) to the jury.

CASE SUMMARY 14.3 Daitom, Inc. v. Pennwalt Corp., 741 F.2d 1569 (10th Cir. 1984)
1. Should the court apply the knockout rule to this case? (Be sure to explain how the knockout rule works.)
• The facts of this case appear to be a textbook case (literally!) calling for the application of the knockout
rule. Under this rule, the conflicting clauses in the forms of both parties knock each other out and neither
set of conflicting clauses become part of the contract. Instead, the court will apply the relevant gap-filler
provisions in the UCC to supply the terms.

2. What steps could Daitom have taken to avoid a battle of the forms?
• This question is designed to elicit discussion on legal strategy—specifically, how a party can identify a
relevant legal risk (such as the possibility of a battle of the forms) and how it can take steps to minimize or
reduce this risk. In this case, since Daitom was the buyer, its purchase order should have clearly stated that
its acceptance was expressly conditional on the seller’s agreement to the additional or different forms set
forth in Daitom’s purchase order.

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7
 Chapter 15
Title, Allocation of Risk, and Insurable Risk

CHAPTER OVERVIEW
In this chapter, we discuss how title passes from seller to buyer. Title is the legal concept that implies
the ownership of property. However, under the UCC, title is just one the legal concepts of which
business owners and managers should have working knowledge. There is often a lapse of time between
signing of the contract and the buyer acquiring title to the goods. For instance, what happens if a good
is destroyed after the buyer signs the contract but before title is passed? To address questions like this,
the chapter will also discuss the concepts of identification of goods, insurable interest, and risk of loss.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Recognize the elements necessary to identify goods to a contract. Knowledge
Application
Demonstrate how title passes from the seller to the buyer. Knowledge
Application
Describe an insurable interest. Knowledge
Application
Compare the various shipment terms to determine who bears the risk of loss Analytical
during shipment. Thinking

I. INDENTIFICATION OF GOODS [p. 306]

Points to emphasize:
• Title is the legal term for a claim of ownership to property
• The UCC requires the following to occur before title to goods passes from the seller to the
buyer:
o Goods must actually exist
o Goods must be identified to the contract as the ones which will specifically be sold to
the buyer
§ For example, vehicle identification numbers or specific lot numbers
§ Parties may agree on any method they desire to identify the goods to the contract

II. ISSUES RELATED TO TITLE TRANSFERS [p. 306]

Points to emphasize:
• Parties may specify how title will be transferred when the goods exist and are identified
• UCC has default rules if the parties fail to specify how title will pass

A. Passing of Title [pp. 306-307]

Points to emphasize:
• UCC allows the parties to transfer title in any manner on which they agree
• UCC Section 2-401 default rules (See Figure 15.1)

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o If the goods are to be shipped, title passes to the buyer once the seller meets its
obligations to ship the goods as specified in the contract (i.e., when the seller delivers
the goods to the common freight carrier)
o If the goods are not shipped and remained stored, title passes when the seller delivers a
document of title (e.g., warehouse receipt or bill of lading) to the buyer
o If the contract does not require shipping or delivery of the documents of title, title passes
to the buyer when the contract is made effective and the goods are identified to the
contract

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 B. Good Faith Buyers
Points to emphasize:
• A good faith buyer is someone who acts honestly and provides reasonable value for the goods
• Must not know or suspect that the goods were obtained improperly
• Acquires valid title so long as the seller obtained a voidable title, not a void title
o A voidable title involves a purchase of goods through fraud or deceit
o A void title involves property obtained through theft
• Under the UCC, a good faith buyer in ordinary course of business may acquire a valid title to
goods that were entrusted to a merchant seller
• Case 15.1 addresses the concept of a good faith buyer

Teaching Tip: Good faith buyer

Use a simple example with slight variations to demonstrate when a good faith buyer obtains more rights
in a good than the original owner. For example, assume Bob sells a ring to Jill for $1,000. Jill pays with
a check that later bounces. In the meantime, Jill sells the ring to Lisa, a good faith buyer, who has no
knowledge of the bad check. When the check bounces, Bob wants the ring back. In this scenario, Bobs
only recourse is against Jill. He cannot get the ring back from Lisa because Jill had a voidable title and
Lisa was a good faith buyer. Lisa obtains a valid title. Now assume Jill stole the ring from Bob and then
sold it to Lisa who has no knowledge of the theft. Under these facts, Jill has a void title and Bob can get
the ring back from Lisa. Lisa does not obtain a valid title. Finally, assume Bob took his ring to a
jewelry store to have it repaired. The merchant accidently sells the ring to Lisa, a good faith buyer. In
this version, Bob cannot get the ring back from Lisa. Bob entrusted his ring to the jewelry store, a
merchant, and Lisa is a buyer in the ordinary course of business. Lisa has obtained a valid title.

Case 15.1 Hodges Wholesale Cars and Cleveland Auto Sales v. Auto Dealer’s Exchange of
Birmingham and Express Drive Away [pp. 308-309]

Facts: Doyle Alexander sold a car to an unidentified individual. The individual paid for the car with a
check which later was discovered drawn on an account with insufficient funds. The initial buyer then
resold the car to Express Drive Away who, in turn, resold it to Cleveland Auto Sales though an auction
conducted by Auto Exchange. Cleveland Auto Sales later sold the car to M&T Motors who ultimately
sold it to Rosa DeLara.
When Alexander discovered the check had insufficient funds, he told law enforcement the car was
stolen. Law enforcement retrieved the car from DeLara. M&T reimbursed DeLara and Cleveland
reimbursed M&T. Cleveland sued Express and Auto Exchange for breach of contract, fraud, and breach
of warranty of good title.
Issue: Did the sale of the car involve a voidable title allowing a good faith buyer to acquire a valid
title?
Ruling: Yes. The trial and appellate courts because the initial buyer had a voidable title, not void, he
could transfer a valid title to a good faith buyer for value. Express was a good faith buyer and as such,

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it acquired and transferred a valid title to Cleveland and was not liable for breach of contract, fraud, or
breach of implied warranty.

Teaching Tip: Good faith buyers

You may find it helpful to discuss this case using the following image of the value chain
representing the flow of title along the various parties. It is also helpful to point out how, in
circumstances when Alex is entitled to the property such as theft, each party must sue the party
who sold them the vehicle to be made whole. In cases where the good faith buyer retains title, as
in the case of fraud, Alex can only seek out Joe for liability and compensation.

Case questions and answers:

1. Was the car properly taken from Ms. DeLara by the police? Was it really
stolen?
• Yes, however, they did so because the police were acting under the
assumption it was stolen. Alex likely stated to the police that the car had
been stolen, hence why the police returned the vehicle.

2. Was M & T Motors legally or ethically obligated to refund the purchase

price to Ms. DeLara
• They were legally not required since they were also a good faither
purchaser and conveyed good title. They were ethically required to return
the purchase since the consumer is in a bad position to be reimbursed for
their loss. The business likely has insurance and also it is a smart business
decision to maintain good customer relations and goodwill with the
community.

3. Had Ms. DeLara been able to keep the car as a good faith buyer, who
would bear the risk of loss? Why is this a good or bad policy?
• Alex (the original seller) faces the liability under this UCC rule. It is a
seller-beware type of standard and it falls upon the seller to ensure or take
measures against fraud.

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 III. INSURABLE INTEREST [p. 310]
Points to emphasize:
• Insurance companies will not insure property unless the party seeking insurance has an
insurable interest
• An insurable interest exists when loss or damage to something or someone causes a person to
suffer a financial or other kind of recognizable loss
• A buyer can obtain an insurable interest in a good:
o if title has passed to the buyer, or
o when the goods are identified to the contract
• Both the buyer and the seller may have insurable interests in the same goods if the title has not yet
passed

IV. RISK OF LOSS [pp. 310-311]

Points to emphasize:
• The UCC allocates risk of loss from an accident, mishandling, or theft based on whether an
agreement is categorized as a shipment contract or a destination contract
• Shipment contracts require the seller to use a carrier to the deliver the goods
o Generally, contracts for the sale of goods are considered shipment contracts unless the
parties have agreed otherwise
o Seller completes performance by delivering the goods to the “hands” of the carrier
o Normally, the risk of loss is allocated to the seller until such time as the seller has
delivered the goods to the carrier
o If goods are destroyed after the seller delivers the goods to the carrier, the buyer bears
the risk of loss
§ Buyers recourse is against the carrier, not the seller
§ For example, S sells some goods to B under a shipment contract. S delivers the
goods to T, a carrier. The goods are then damaged while in shipment to B.
Because the risk of loss passed to B at the point S delivered the goods to T, B has
no course of action against S. However, B may have a claim against T
• Destination contracts require the seller to deliver the goods to a specified destination
o Seller completes performance when the goods have been tendered (delivery of
conforming goods) at the specified destination
o Risk of loss is allocated to the buyer at the time of tender if the goods are conforming
o If goods are destroyed in the “hands” of the carrier, the seller bears the risk of loss
§ For example, S sells some goods to B under a destination contract. S delivers the
goods to T, a carrier. The goods are then damaged while in shipment to B. S
bears the risk of loss because the goods have not been tendered to the buyer at
the destination
• The UCC protects the buyer when a seller has shipped nonconforming goods
o Risk of loss remains with the seller until the seller corrects the problem or the buyer
accepts the goods
o This protection also exists when the buyer rightfully revokes acceptance
• Table 15.1 lists the various International Chamber of Commerce shipping terms that allocate
the risk of loss
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Teaching Tip: Amazon’s generous loss policy

The following is taken from Amazon.com’s license agreement with customers and indicates that when
a consumer purchases goods on Amazon the contracts are “shipment” contracts.

This means the risk of loss passes to the carrier once they pick the goods up from Amazon’s
warehouse. However, Amazon has a fairly generous policy administered by their Claims Department
where they often will replace a stolen item, even though they are under no legal obligation to do so.
Most students shop on Amazon and this example may illustrate some of the concepts in this section.

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Thinking Strategically Questions and Answers [p. 313]
1. Peter would like to obtain an insurable interest upon signing the contract. Will he be able to do this?
Explain.
• Not until Peter obtains some documentation that the caviar has been removed from general
inventory such as lot numbers or package serial numbers.

2. Peter is concerned about the product arriving as quickly as possible due to the product’s spoilage
potential. What should he be concerned about? How can he mitigate this risk?
• Using road freight takes longer than say air so unless the trucks are refrigerated there is
potential for spoilage. Ways to mitigate this risk is to require Premium Seafoods to use dry ice
in their packaging, refrigerated trucking services, obtain appropriate insurance for these high-
value items, use air freight or any combination of these methods.

3. Peter runs a company search and learns that FlybyNight Trucking has a history of failing to maintain
adequate insurance. What should Peter do to minimize risk when dealing with FlybyNight Trucking?
• Peter should take out supplemental insurance since these goods are of higher-than-average
value, ask Premium Seafood to contract with someone else who has adequate insurance, or
change the contract so Peter can choose the carrier.

4. Given the nature of the goods, is there a better shipping method than the one specified in the
contract?
• Air may be a better option since the packages will not be too large and air will be much faster,
however, the cost of shipping will be considerably higher.

5. Which shipping terms would offer better security to High Rollers Casino?
• F.O.B. High Rollers Casino in Las Vegas, Nevada would offer better protection since the risk of
loss would fall on Premium Seafood until te goods arrive to the buyer.

Key Terms [p. 314]

Chapter Review Questions [pp. 316-317] Note: Answers and explanations are provided at the
very end of the chapter.

Case Summary Questions and Answers [pp. 314-316]

CASE SUMMARY 15.1 3L Communications v. Merola d/b/a NY Telecom Supply, No. M2012-
02163-COA-R3-CV, Court of Appeals of Tennessee (2013)

1. Was this a shipment contract or a destination contract? Explain.

• It is likely a shipment contract that used a common carrier.

2. Who bears the risk of loss in this case?

• Normally the buyer assumes risk of loss once the goods are handed to the carrier, however, if
the goods are rejected under UCC the Seller retains the risk of loss.

CASE SUMMARY 15.2 Frelinghuysen Morris Foundation v. AXA Art Insurance, 603015 (2009)

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1. Does the ownership of artwork create an insurable interest?

• Yes, as long as the title to the artwork is held by its owner.

2. If artwork is given to an art gallery to display and sell on behalf of the owners, and then the gallery
commits fraud against the art owners, does this fraud create an insurable interest?

• Only if the fraud committed against the owner is “fortuitous” or outside of the owner’s
knowledge and thus unforeseeable.

CASE SUMMARY 15.3 Jacq Wilson et al. v. Brawn of California, Inc., 1132 Cal. App. 4th 549 (2005)

1. Are these contracts shipment or destination contracts?

• This case involves C.I.F. terms which involve shipment contracts unless they specify a
destination (see case below).

2. How would buyers ensure that Brawn was responsible for insuring the goods until delivery to the
buyer?

• Buyers would have to draft the contract and its shipping terms, e.g. C.I.F. with a destination, as
clearly involving a destination contract.

CASE SUMMARY 15.4 St Paul Guardian Insurance Company et al. v. Neuromed Medical Systems &
Support, GmbH et al., 00 Civ. 9344 (SHS) U.S. Dist. Ct., S.D.N.Y. (2002)

1. Who bears the risk of loss if the court finds that the contract was indeed a CIF contract?

• A C.I.F. shipping contract with a named destination transfers risk of loss to the seller until the
goods arrive at the named destination.

2. Who should bear the risk of loss in this case and why?

• In this case, the C.I.F. terms referenced New York. When the goods arrived safely in New York
the seller’s risk of loss passed to the buyer. The buyer assumes the risk of loss in this case since
the goods were damaged in transit to the final destination in Calumet Illinois.

CASE SUMMARY 15.5 Windows, Inc., v. Jordan Panel Systems Corp., 177 F.3d 114 (1999)

1. Is this a shipment or destination contract?

• The presumption in the U.C.C. is that parties enter into shipment contracts unless there is clear
language and intent to enter into a destination contract. In this case, there was no specific
address nor the INCO terms that would normally create a destination contract, e.g. F.O.B.
[Buyer’s Address].

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2. Who should bear the loss of these broken windows?

• As a shipment contract the risk of loss falls on the buyer once he goods are taken by a carrier.

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 Chapter 16
Performance and Cure in Sales Contracts

CHAPTER OVERVIEW
This chapter discusses the general obligations owed by each party in a sales contract as well as
the specific obligations and rights of buyers and sellers of goods.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Define good faith and explain the duty for merchants to act in a commercially Knowledge
reasonable manner.
Differentiate between course of performance, course of dealing, and usage of Analytical
trade. Thinking
Explain the perfect tender rule in the context of obligations of the seller under Knowledge
the UCC. Application
Determine when a seller has a right to cure after the buyer has rejected goods. Application
Explain the buyer’s right of inspection under the UCC. Knowledge
Application

I. THE UCC AND GOOD FAITH [p. 318-319]

Points to emphasize:
• Unlike common law, the UCC provides the parties with maximum flexibility in how they
carry out their obligations.
• The UCC has a good faith provision that imposes a duty of good faith and commercial
reasonableness in all sales contracts. Good faith is defined under the UCC as “honesty in
fact in the conduct or transaction concerned.”
• Under the UCC, merchants have the duty to act in a commercially reasonable manner.
They must observe industry standards and practices that may be unique to a particular
industry.

II. PERFORMANCE, PAST DEALINGS, AND TRADE PRACTICES [p. 320]

Points to emphasize:
• The course of performance is a method to show what the parties intended through their
own actions in performing the specific contract in questions. For example, in an
installment contract, if the first installment is accepted, it will establish whether
subsequent installments meet the contract standards.
• Course of dealing refers to how the parties acted in past contracts, not the current
contract. For example, if a specific quality of good was accepted in a similar past
contract, it will provide a reference point for what quality the parties reasonable expected
in the new contract.

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 • Usage of trade refers to any general practice of method of performance that is specific to
a particular trade or industry.

Teaching Tip: Course of performance, course of dealing, usage of trade

Students may have trouble distinguishing between course of performance, course of dealing, and
usage of trade. Try using the following example to explain the differences. Wood Inc. contracted
to buy five hundred 4”x4” boards from Lumbar, Inc. in 5 installments. This is the 2nd similar
contract Wood and Lumbar have entered. Under the current contract, Wood accepts the first 2
installments and then discovers that the boards are actually 3 ½” x 3 ½”. Wood tries to reject the
3rd installment as nonconforming. Lumbar can refer to the first 2 installments, course of
performance, to show that the boards are acceptable and meet the expectations under the
contract. Lumbar can also refer to the previous contract, course of dealing, to show the boards
meet expectations. Finally, Lumbar can refer to the common understanding in the industry, usage
of trade, that 4”x 4” really means 3 ½” x 3 ½”.

III. OBLIGATIONS OF THE SELLER [p. 321]

Points to emphasize:
• The seller has an obligation to transfer and deliver conforming goods to the buyer.
• Conforming goods are the goods bargained for in the agreement.
• Under the UCC, the tender of delivery rule obligates the seller to have or tender the
goods, give the buyer appropriate notice of the tender, and take any actions necessary to
allow the buyer to take delivery.
• Absent an agreement between the parties, the UCC uses a reasonableness requirement to
govern the delivery process (e.g., reasonable hour).
• The perfect tender rule dictates that the seller tender goods in a manner that matches the
contract terms in every respect. If the seller fails to achieve perfect tender, the buyer has
three options: (1) Reject the entire shipment of goods within a reasonable time; (2)
Accept the shipment of goods as is; or (3) Accept any number of commercial units and
reject the rest of the goods in a reasonable time.

IV. RIGHTS OF THE SELLER [p. 321]

Points to emphasize:
• If the buyer rejects goods under the perfect tender rule, the seller has the right to
repair or replace the rejected goods so long as the time period for performance has not
expired.
• If the time to perform has not expired, the seller has the right to cure by (1) giving
notice of her intent to cure and (2) tendering conforming goods in replacement of the
rejected goods.
• The right to cure can exist even after the time period for performance has expired if
the seller reasonably believed that the nonconforming goods would be acceptable to
the buyer (e.g., seller delivered a higher quality of good than ordered). See Case 15.1.

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 Case 16.1 MRC Innovations, Inc. V. Lion Apparel, Inc., 152 N.E.3d 513 (Ohio Ct. App.
2020)
Facts: MRC is a manufacturer of specialized apparel and other products. Lion is a supplier that
provides personal protective and training gear for civilian and military use including firefighters
and other first responders. In March 2012, MRC and Lion reached an agreement for MRC to
manufacture the “glove shell component” according to Lion's specifications. Under the written
agreement, Lion was to purchase at least 7,000 pairs of glove shells at the price of $29 per pair.
In early 2013, after the parties had spent months working through modifications to the original
glove shell prototypes MRC produced sample glove shells that Lion approved.
In April 2013, MRC encountered ongoing problems with the production glove shells being
manufactured in China for Lion, including problems with quality and functionality of the gloves.
Among the many communications exchanged about the continuing production delays was an
email in which Lion informed MRC of the increasingly high demand for the gloves and
emphasizing Lion's need for prompt delivery of the pairs of glove shells on order. Eventually,
MRC shipped 2,000 glove shells by air, but the glove shells differed from the previously
approved samples and were stiff and lacking in dexterity. Lion rejected those glove shells as
nonconforming and immediately sought another manufacturer to produce the glove shells.
Among other claims, MRC sued Lion on the basis that Lion had not allowed MRC to cure as
required under Ohio’s Commercial Code because even as MRC quickly undertook to procure
replacement glove shells, Lion moved ahead to acquire the goods from another supplier without
informing MRC. On the issue of right to cure, the trial court ruled in favor of Lion and MRC
appealed.
Opinion: The Ohio Court of Appeals affirmed the trial court’s decision in favor of Lion. The
court ruled that under the UCC, certain conditions must be met in order for a seller to have a
right to cure after the buyer rejects goods the seller tendered—i.e., either the time for the
seller to deliver conforming goods has not yet expired or the seller must have had reasonable
ground to believe [the tendered goods] would be acceptable" to the buyer and be able to
furnish substitute goods within a reasonable time. Given that the timing of MRC’s delivery
of the gloves was well past the contemplated date of delivery and that the nonconforming
goods were substandard, MRC had no right to cure

Case Questions

1. According to the court, what two UCC factors must be considered in determining the
time frame allowed for the seller to cure when the seller has delivered nonconforming goods?
• Either the time for the seller to deliver conforming goods 'has not yet expired,' or the
seller must have "had reasonable ground to believe [the tendered goods] would be
acceptable" to the buyer and be able to furnish substitute goods within 'a reasonable
time…'

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2. The UCC uses the word “reasonable” in relation to the understanding between buyer and
seller. Define reasonable and provide examples of what may and may not be considered
reasonable by a court
• “Reasonable” means just, rational, appropriate, ordinary or usual in the
circumstances. Students will come up with their own examples of “reasonable.”
3. Focus on Critical Thinking: Is the court’s decision consistent with the underlying premise
of the UCC? Does it help promote fairness among merchants?
• This question gives the students an opportunity to discuss the fairness among
merchants
Commercial Impracticability
• The UCC excuses the seller’s performance when a contract becomes commercially
impracticable, i.e., when the delivery or non-delivery of goods has been made
impracticable by the occurrence of an unanticipated event, and the unanticipated
event directly affects a basic assumption of the contract. See Case 16.2.

Case 16.2 Hemlock Semiconductor Operations, LLC v. SolarWorld Industries, 867 F.3d
692 (6th Cir. 2017)

Facts: Hemlock Semiconductor Operations, LLC (Hemlock) and the SolarWorld Industries
(Sachsen) entered into a contract by which Hemlock in Michigan would supply Sachsen in
Germany with set quantities of polysilicon at fixed prices between the years 2006 and 2019.
After several years, the market price of polysilicon plummeted when the Chinese government
began subsidizing it national production of polysilicon materials. As a result, Hemlock
reached a temporary agreement with Sachsen to lower the price for one year. When the
agreement expired, Hemlock demanded Sachsen pay the contract price. Sachsen refused and
Hemlock sued for breach of contract. The trial court ruled for Hemlock and Sachsen
appealed based partially on commercial impracticability due to the Chines government’s
unforeseeable and extreme actions.
Opinion: The U.S. Court of Appeals for the 6th Circuit affirmed the trial court’s decision
holding that the commercial impracticability applies only if an unanticipated circumstance
has made performance of the promise vitally different from what should reasonable have
been with in the contemplation of both parties when they entered into the contract.

Case Questions

1. The court ruled that the Chinese government’s subsidization of polysilicon was not the
basis for a commercial impracticability defense. Is the economic turbulence caused by one of
the world’s largest economies and “unforeseen event”? Why or why not?

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 • Fluctuating markets are not unforeseen. Commercial impracticability is a very limited
defense. The parties assumed the risk that the market would go up or down. It was not
an unanticipated event.
2. What does the court suggest in saying, “such contracts are made for the very purpose of
establishing a stable price despite a fluctuating market”?
• Because markets fluctuate, the parties agree on a price and assume the risk that the
market price will go up or down. The parties enter these contracts for stability and
predictability. Market fluctuation is a basic assumption of the contract.
3. Focus on Critical Thinking: Is there any way of drafting a sales contract that does
consider market conditions? Try using a sliding-scale type of price agreement to adjust the
contract in this case. Would it work or not? Explain.
• This question helps students think of strategic solutions to legal dilemmas and gives
them a point of departure by using a sliding-scale. For example, perhaps an
agreement could be made so specific that it included economic factors that may be
foreseeable by naming them (e.g., In the event that a foreign government begins to
subsize X, the parties agree to Y) or students may come up with a sliding scale (e.g.,
In the event that the market price of X falls more than 20% in a one year period, the
parties agree to a 10% reduction in price for the following year” and so on.

OBLIGATIONS AND RIGHTS OF THE BUYER [p. 325]

Points to emphasize:
• Once the buyer has accepted to the goods, the buyer must pay for them in accordance
with the contract.
• In the absence of an agreement, the UCC provides that the buyer must make full
payment at the time and place that she receives the goods.
• If the parties agree on credit for payment, interest typically begins accruing 30 days
after shipment.

A. Buyer’s Right of Inspection: Acceptance or Rejection [p. 272]

Points to emphasize:
• Unless otherwise agreed upon, the buyer has a reasonable time period to inspect the
goods.
• After inspection, the buyer may (1) communicate to the seller that she has accepted the
goods; (2) do nothing, and thus be presumed to have accepted goods unless she gives
prompt notice of a rejection; or (3) notify the seller that she is rejecting the goods (or part
of the goods).
• If the seller has shipped conforming goods, the buyer has the duty to accept them.

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• If the seller has shipped nonconforming goods but the buyer is willing to accept them, the
UCC provides the buyer with the opportunity to later revoke acceptance only if the
nonconformity substantially impairs the value of the goods.
• The buyer has an obligation to affirmatively notify the seller of a rejection in a timely
manner so that the seller has an opportunity to cure or recover the goods.

Case 16.3 East Coast Restoration and Consulting Corp. v. SIKA Corp., 14 NY Slip Op
30361 (Supreme Court of New York 2014)

Facts: East Coast, a roofing contractor, entered into a series of purchase order agreements
with SIKA, a manufacturer of roofing and waterproofing materials. East Coast alleged that
the roofing material delivered by SIKA in one of the shipments was defective. SIKA
remedied the situation by making all repairs necessitated by use of the defective materials
and providing East Coast with credit as part of a settlement agreement. The settlement
agreement did not address the nondefective shipments. Soon after the settlement, East Coast
terminated its relationship with SIKA and declined to pay the balance for the nondefective
material. Instead, East Coast requested SIKA to pick up the nondefective material. SIKA
refused because East Coast failed to provide notice of rejection until 7 months after delivery.
East Coast sued for breach of contract, and SIKA countersued for the balance due.
Opinion: The New York Supreme Court ruled in favor of SIKA because East Coast had
failed to give timely notice of any nonconformity for the nondefective material.

Case Questions

1. What factors did the court consider in its analysis of whether East Coast’s rejection was
reasonable?

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 • The court considered the fact that the nondefective materials were not addressed in
the settlement and that East Coast waited 7 months to give notice.
2. Since East Coast gave notice of the rejection for Nondefective Materials, does SIKA have
the right to cure the defect?
• Under the UCC, SIKA would have the right to cure if the time period for performance
had not expired. However, in this case, East Coast did not give SIKA reasonable
notice that the goods did not conform; therefore, SIKA is entitled to the balance
owed. Each delivery is accepted separately and because East Coast did not timely
reject, they accepted the previous shipments.
3. Focus on Critical Thinking: How could the parties have avoided the dispute? Suggest
language for the original settlement agreement that would have made the obligations of the
parties clearer.
• The parties could have avoided the dispute by addressing the nondefective material in
the settlement agreement by stating either all previous deliveries are rejected or
accepted.

B. Special Rules for Installment Contracts [p. 327]

Points to emphasize:
• The UCC provides for delivery and billing to be done in two or more separate lots
through the use of an installment contract.
• Each lot must be accepted and paid for separately.
• A buyer can reject an installment only if the nonconformity substantially impairs the
value of that installment and the nonconformity cannot be cured.

V. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 328-329]

Chapter Review Questions [p. 331-332] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 328]

1. Have you ever ordered goods, but they were not what you were expecting? What did you do?
Accept them or return them?
• This question is intended to facilitate student discussion by asking students to share
their experiences with buying and selling goods. Students often have Amazon stories
about ordering a product and how easy or difficult it was to return the product via
Amazon locker etc.
2. Have you ever given a seller another opportunity to correct an order?
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 • This question is intended to spur discussion about students’ experiences using
websites such as E-bay or a retail store that shipped the wrong product or the wrong
size product etc. It may be helpful to focus students’ attention on the practicality of
returning goods for a replacement instead of a refund. What are the factors that
buyers use when determining whether to order a replacement versus wanting a
refund? Buyer’s need for the product? Seller’s reputation for quick
returns/replacements? Price? Discounts?
3. Are there any situations in which a buyer is better off accepting goods even when they are
nonconforming?
• This question helps students understand the letter of the law versus strategic reasons.
They may be entitled to a refund, replacement, or to cancel the contract, but how will
the buyer’s reaction impact that buyer’s operations (e.g., buyer’s ability to fulfill
orders, etc)? If the seller shipped a more expensive product, would that impact the
buyer’s decision? Why or why not?

Case Summary Questions and Answers [p. 329-330]

CASE SUMMARY 16.1 Ner Tamid Congregation of North Town v. Krivoruchko, 638 F. Supp.
2d 913 (N.D. III. 2009)
1. In its decision, the district court cited newspaper articles that discussed the volatility of the
economy and specifically the real estate market. Do these articles act in any way to support or
defeat Krivoruchoko’s claim?
• The newspaper articles tend to defeat Krivoruchoko’s claim because they illustrate
that volatility of the economy, and the real estate market are market forces that are not
the basis for commercial impracticability.
2. Should a defense of commercial impracticability be effective under circumstances in which
prices are affected by changes in the local or national economy? Explain.
• Courts have consistently held that commercial impracticability applies only if an
unanticipated circumstance has made performance of the promise vitally different
from what should reasonable have been with in the contemplation of both parties
when they entered into the contract. Downturns in the economy are part of market
forces and are reasonably foreseeable.
3. How might Krivoruchko have protected himself under this contract?
• Krivoruchko could make an agreement so specific that it included economic factors
that may be foreseeable by naming them. For example: “In the event that Buyer
cannot obtain financing at reasonable market rates (or better yet, name a specific
rate), the Buyer may terminate this agreement without any liability to Seller.” This is
common in residential real estate transactions and called a mortgage contingency
clause.
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CASE SUMMARY 16.2 General Motors Corp. v. Acme Refining Co., 513 F. Supp. 2d 906
(E.D. Mich. 2007)
1. Was Acme’s rejection lawful?
• No. The court granted summary judgment in favor of GM. In each of its October
2005 emails, Acme did not notify GM that it was rejecting the scrap materials.
2. Did Acme give seasonable notification of rejection?
• No. The court held that “there was no rejection of the subject scrap materials within a
reasonable time after Acme went to Dynamic Manufacturing and removed over-
850,000 gross tons of scrap material from that GM manufacturing facility.” Nor did
Acme provide any notice to GM that it was revoking its acceptance of the subject
scrap materials

CASE SUMMARY 16.3 Furlong v. Alpha Chi Omega Sorority et al., 73 Ohio Misc.2d 26
(1993)
1. Were the sweaters shipped by Furlong nonconforming goods as defined by the UCC? Explain.
• Yes. According to the court, the sweaters were non-conforming because the sweaters
failed “in any respect to conform to the contract” and that “the sweaters failed in at
least five respects.” Under the UCC, they were a nonconforming tender of goods
2. Did AXO properly reject the goods? Explain.
• Yes. The court found that on the same day that the sweaters arrived at the AXO house
the sorority’s president phoned Furlong and told him that the sweaters were not what
AXO had ordered. She stated the specifics as to why the sweaters were not as
ordered. Given this, AXO properly rejected the good.
3. Who prevails and why?
• AXO prevails. The court concluded that “AXO rightfully rejected the sweaters, after
having paid part of the purchase price: namely, $2,000. AXO is entitled to cancel the
contract and to recover the partial payment of the purchase price.”
CASE SUMMARY 16.4 Zion Temple First Pentecostal Church of Cincinnati v. Brighter Day
Bookstore & Gifts and Murphy Cap & Gown Co., 970 N.E.2d 441 (Ohio 2004)
1. Did Zion reject the goods, or did they revoke their acceptance? Does it make a difference?
Explain why or why not.
• The court held that Zion never accepted the robes within the meaning of the UCC, but
instead rejected them as not conforming to the contract. It makes a difference because
rejecting the goods may occur when any nonconformity (anything other than perfect
tender) is alleged by the buyers, but revocation of acceptance may occur only if the
nonconformity substantially impairs the value of goods.
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2. Did Zion have an obligation to allow Murphy to cure? Explain.
• Under the UCC, if the time for performance has not expired or if the seller shipped
“acceptable non-conforming goods” Murphy has the right to cure.
3. Who prevails and why?
• Although the trial court granted summary judgment to Seller, the appellate court
overruled the trial court’s decision and held that issues of fact existed on two fronts:
(1) Zion’s reasonable time to inspect and reject nonconforming goods and (2)
Murphy’s right to cure.

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 Chapter 17
Breach and Remedies in a Sales Transaction

CHAPTER OVERVIEW
This chapter discusses scenarios in which either the seller or the buyer has breached a UCC sales contract. The
chapter beings with examining the actions that trigger a breach of contract and then reviewing the remedies
available to the seller or the buyer.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the nature of the breach in a contract for the sales of goods. Knowledge
Application
Categorize the various remedies available to the seller as the nonbreaching Knowledge
party. Application
Categorize the various remedies available to the buyer as the nonbreaching Knowledge
party. Application
Describe the role and limitations of liquidating damages. Analytical
Thinking

I. DEFINITION OF A BREACH [p. 333]

Points to emphasize:
• Breach exists when one party to a contract has failed to perform her obligation under a contract
• The UCC provides relief to the nonbreaching party who acted in good faith and sustained damages
through no fault of their own
• Remedies are judicial actions that are intended to compensate an injured party in a civil lawsuit
o Monetary damages, or
o Equitable damages

A. Seller’s Breach [p. 334]

Points to emphasize:
• A seller’s primary duty is to deliver conforming goods to the buyer
• Conforming goods are goods that match what was bargained for in the agreement
• Seller may breach contract by delivering nonconforming goods
o Incorrect quantity
o Incorrect specification
• Seller may also breach the contract if he repudiates his performance
o Repudiation occurs if the buyer or the seller communicates in a way that is inconsistent with
performance under the contract (e.g., seller indicates he will be unable to deliver goods by the
due date)
o The UCC treats a repudiation as a breach of contract even if the performance is not yet due
• Seller may breach a contract by failing to the deliver the goods

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Teaching Tip: Repudiation example

Buyer and seller enter into a contract for the purchase of lumber on January 30th. The seller agrees to deliver the
lumber by March 1st. On February 10th the seller tells the buyer that he cannot deliver the lumber by March 1st
after all. This is a repudiation. The buyer can immediately hold the seller in breach of contract even though
performance is not due until March 1st. This concept allows the buyer to mitigate his damages. The buyer could
rely on the repudiation and find replacement lumber. However, if the buyer does not take any action and the seller
later indicates that he can make the delivery by March 1st, the buyer must allow the seller to perform.

B. Buyer’s Breach [p. 334]

Points to emphasize:
• The buyer’s primary obligation is triggered when the seller delivers conforming goods
• Once the buyer has accepted the goods, the buyer must pay for them in accordance with the contract (See
UCC § 2-301)
• The buyer must provide adequate facilities to receive the goods (See UCC § 2-503(b)(1))
• UCC §2-703: A buyer breaches the contract if she:
o repudiates the contract before the seller delivers the goods,
o fails to make payment,
o wrongfully rejects conforming goods, or
o wrongfully revokes her acceptance of conforming goods

C. Important Breach-Related Dates [pg. 334]

Points to emphasize:
• Four critical dates that impact the rights and duties of the buyer or seller and the availability of remedies to
either of them:
o The contract’s effective date
o The scheduled delivery date
o When the buyer rejects the goods
o When the buyer revokes his acceptance of the goods

• The above dates establish the following four general time periods that impact the duties, rights, and
remedies available to the buyer or the seller:
o Time Period 1: Time between the contract’s effective date and the delivery date
o Time Period 2: Time between the scheduled delivery date and when the buyer may reject the
goods
o Time Period 3: Time between when the buyer fails to reject the goods and when the buyer revokes
his acceptance of the goods
o Time Period 4: Time after the buyer is allowed to revoke his acceptance of the goods and
indicates he accepts the goods

II. SELLER’S REMEDIES [p. 335]

Points to emphasize:
• The UCC allows the seller more than one remedy if the buyer breaches so long as each remedy is
necessary to help the seller recover damages

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• Seller’s remedies in Time Period 1: Time between the contract’s effective date and the delivery date
o If buyer breaches before accepting conforming goods, the seller has the following options:
1. Stop or interrupt the delivery of the goods if they are already in transit
2. Cancel the contract and be discharged of its performance obligation
3. Resell the goods at fair market value to another party or dispose of the goods for recycling
in accordance with reasonable commercial standards
• If goods are nonperishable, commercial standards and state law may require a
public auction advertised over a period of time
• If goods are perishable, typical advertising requirements are not required in an effort
to mitigate damages
• Seller may recover the difference between the resale price and the contract price
4. Sue for the purchase price if resale is unsuccessful or not feasible due to the unique nature
of the goods
5. Sue for damages for nonacceptance; seller obtains the difference between the contract price
and the fair market value of the goods at the time of delivery
o Incidental damages (shipping, storage, advertising resale) are also available at any point if the
buyer breaches

• Seller’s remedies in Time Period 2: Time between the scheduled delivery and when the buyer rejects the
goods
o In this time period, the seller delivers conforming goods but buyer wrongfully rejects them and
fails to pay seller
o Seller has the following remedies available:
1. Seller may resell the goods in a commercially reasonable manner
• Private
• Public auction
• Must give buyer notice
2. Remedies 2 through 5 from the Time Period 1 are also available

• Seller’s remedies in Time Period 3: Time between when the buyer may reject the goods and when the
buyer revokes his acceptance of the goods
o In this time period, the buyer initially accepts the goods and then, wrongfully revokes the
acceptance
o Seller has the following remedies:
1. Seller may resell the goods in a commercially reasonable manner
2. Remedies 2 through 5 from the Time Period 1 are also available

• Seller’s remedies in Time Period 4: Time after the buyer fails to revoke his acceptance of the goods and
indicates that he will accept the goods
o In this time period, the buyer accepts conforming goods but does not pay for them as required in
the contract
o Seller’s only remedy is to sue for the purchase price
o Case 17.1 deals with a buyer who wrongfully rejected conforming goods

• Figure 17.1 illustrates the Seller’s Duties, Rights, and Remedies

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Case 17.1 Zippy Mart of Alabama, Inc. v. A&B Coffee Service, Inc., 380 So.2d 833 (1980)

Facts: A&B entereded into a contract to provide contract to sell in Zippy Mart stores throughout Alabama for 18
months. Zippy notified A&B that it was cancelling the contract after about a year. A&B sued Zippy for breach of
contract.
Issue: Were the damages properly computed for the breach of contract?
Ruling: The trial court awarded A&B damages based on the cost of machines and remaining purchase price of
materials for the remaining 6 months of the contract. However on appeal, the Alabama Supreme Court reversed
because A&B failed to prove that it had suffered damages, and if so, whether A&B had mitigated any damages by
attempting to resell the goods. The machines were to be discarded at the end of the 18-month period. The loss of
sale for the 6 month period for coffee and supplies would be the only potential damages. The court must
determine if A&B mitigated the damages by reselling the materials.

Case questions and answers:

1. Was the court correct to limit any potential damages to the coffee and related supplies? Explain.

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 • Yes, as the specially ordered coffee machines would have been discarded or sold elsewhere for
a very low cost, the only real damages are for the lost sales of coffee and coffee supplies.
2. Do you think it would have been commercially feasible for A&B to resell the coffee and supplies
in this case? Why or why not?
• It may have been feasible to resell the coffee and supplies at a reduced cost to
another vendor. It is unlikely that it would resell them for the same amount that
Zippy would have paid. A&B must show a reasonable attempt to resell.
3. Why does the law impose a duty on sellers to attempt to resell the goods as a way to mitigate
losses? Is this a good rule? Explain.
• A non-breaching party is entitled to seek damages less that which could be
minimized. Reasonable efforts to mitigation must be taken. If the goods cannot be
resold, then there is no duty to mitigate. The coffee and supplies could be resold, but
the coffee machine likely could not. The UCC encompasses good faith and fair
dealing and mitigation of damages falls within those principles.

III. BUYER’S REMEDIES [p. 338]

Points to emphasize:
• The UCC allows the buyer more than one remedy if the seller breaches so long as each remedy is
necessary to help the buyer recover damages
• In an installment contract, because each lot must be accepted and paid for separately, the buyer can
accept one installment without giving up the right to reject any additional installments that are
nonconforming
• Buyer’s remedies in Time Period 1: Time between the contract’s effective date and the delivery date
o In this time period, seller breaches the contract by repudiating, failing to provide assurances, or failing
to deliver the goods
o Buyer’s available remedies are:
1. Cancel the contract and be discharged of its performance obligation
2. Recover any down payment
3. Cover and purchase the same or a similar good from another seller
1. Must cover in good faith and without unreasonable delay
2. Can recover from the seller the difference between the cost of covering and the original
contract value but must deduct any saved expenses because of the breach
4. Sue for nondelivered damages
1. Buyer does not cover
2. UCC limits the damages to the difference between the market price at the time the buyer
learns of the breach and the contract price
5. Sue for specific performance (equitable remedy whereby a court orders the breaching party to
render the promised performance)

o Buyer may also recover incidental (e.g., shipping) and consequential damages (e.g., foreseeable
losses caused by the seller’s breach, such as lost profits) at any point due to the seller’s breach

• Buyer’s remedies in Time Period 2: Time between the scheduled delivery and when the buyer rejects the
goods

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 o In this time period, the seller delivers nonconforming goods that the buyer initially accepts, but then
rightfully rejects upon finding a defect
o Must notify the seller of the rejection within a reasonable time
o Remedies 1 through 5 from the Time Period 1 are available

• Buyer’s remedies in Time Period 3: Time between when the buyer may reject the goods and when the
buyer revokes his acceptance of the goods
o In this time period, the buyer accepts the goods but then revokes acceptance after discovering that the
goods are nonconforming or because the seller fails to cure a defect
o To effectively revoke acceptance, the UCC requires that the nonconformance substantially impairs
(substantial defect) the value of the goods
o Buyer must notify seller within a reasonable time after she discovers (or should have discovered) the
breach
o Remedies 1 through 5 from Time Period 1 are available to the buyer

• Buyer’s remedies in Time Period 4: Time after the buyer fails to revoke his acceptance of the goods and
indicates that he will accept the goods
o In this time period, the buyer accepts nonconforming goods
o Buyer receives damages equal to the difference between the goods as promised and those
delivered, plus any incidental or consequential damages
o Case 17.2 demonstrates the calculation of damages awarded to the buyer for covering

• Figure 17.2 illustrates the Buyer’s Duties, Rights, and Remedies

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Case 17.2 General Motors Corp. v. Acme Refining Co., 513 F. Supp. 2d 906 (E.D. Mich. 2007) [pp. 342-343]

Facts: General Motors (GM) owns manufacturing facilities that generate scrap metal, which GM then sells to
recyclers. In August 2005, GM invited Acme to bid on scrap metal. All bidders were given the opportunity to
inspect the metal and were given a sheet that indicated that the material was sold “as is” and that it might contain
nonmetallic packaging and/or contamination. Acme ultimately won the bid. After Acme brought the scrap
material back to its facilities, it informed GM that it believed the scrap to be of a substandard quality since it
contained cooper and oil. Acme wrote to GM indicating that it would not pick up any more loads from GM and
requested a lower price adjustment. As a result of Acme refusing to pick up the material, GM filed an action
alleging that Acme breached the contract.
Issue: Did Acme’s letter amount to either a rejection of nonconforming goods or revocation of its acceptance
entitling them to offset any amounts it owed under the contract with the actual fair market value of the
nonconforming goods?
Ruling: No. The court held that Acme never notified GM that it was rejecting the goods or revoking its
acceptance; they simply requested a modification to the price. Michigan law requires reasonable notice to the
seller of rejection or revocation of acceptance.

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7
Case questions and answers:

1. How could Acme have ensured a proper rejection of the goods?

• A proper rejection involves notifying the seller of the rejection and the reasons for doing so.
This must also be done in a commercially expedient manner or one that the court views fell
within a reasonable time frame. The UCC places the burden on contracting parties to minimize
harm and communicate issues promptly. Along these lines, ACME could have had a policy or
trained its employees to look for non-conforming issues and instruct them not to take delivery
of the goods in these cases and promptly notify superiors.
2. How could Acme have ensured a proper revocation of acceptance?
• A similar logic and policy as above hold for revocation of an acceptance. Likewise, ACME
should have clear guidelines and standards for when goods are non-conforming.
3. Had Acme properly rejected or revoked acceptance, would the case have been decided differently?
Explain.
• If a proper rejection or revocation of acceptance had occurred, it is possible ACME would have
been entitled to damages as explained in the next section of this chapter (“Buyer’s Remedies”).
However, the sold “As is” clause would have been asserted by GM to limited or prevent any
recovery.

IV. LIMITATION OF REMEDIES [p.343]

Points to emphasize:
• Parties may agree to remedies as express terms in the contract
• Liquidated damages
o Damages that the parties expressly define in the contract and agree will compensate the nonbreaching
party
o Must be reasonable in amount
o Must not be a penalty

Thinking Strategically Questions and Answers [pp. 345-346]

1. What actions, legal and nonlegal, should Rice-Ready take?

• Legal actions include seeking written assurances that the contract will be honored. Placing HealthyDrinks
on notice that March delivery would be unacceptable, and a material breach might also justify seeking
consequential damages if this leads to additional losses. Nonlegal actions might include discussing the
scenario with the counterparts at HealthyDrinks to find an amicable solution or doing the research to find
an alternate supplier.

2. If you were Rice-Ready, would you have added a “time is of the essence” clause and notified HealthyDrinks
of your contract with GreenValley? Explain.
• Yes, this would allow Rice-Ready to pursue consequential damages.

3. When and how was the contract breached?

• The contract is breached on November 1 since this can be viewed as an anticipatory repudiation on the
part of HealthyDrinks (see Chapter 11).

4. How would you minimize losses if you were in Rice-Ready’s position?

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 • Try to find a way to cover as soon as it is apparent that HealthyDrinks will not honor their promise to
deliver on time. The UCC places great weight on reasonable and diligent business practices that minimize
the harm to all parties.

5. What UCC remedies are available to Rice-Ready?

• Since this is an installment contract and the failure to deliver on time will substantially impar the value of
Order #109 RiceReady may terminate this installment and be discharged of any payment obligations. They
may also sue for covering and the difference in value along with any incidental damages or potential lost
profits if their contract with GreenValley is impaired. Also, they may treat the entire contract with
HealthyDrinks, not just the one installment related to Purchase Order 109, as having been materially
breached and pursue related damages with respect to the entire duration of the contract.

6. Assume that Rice-Ready has to cover with another supplier and incurs the cost of shipping with this new
supplier. What UCC remedies are best for Rice-Ready? Explain.
• The right to cover damage and incidental damages are likely the best options.

7. HealthyDrinks argues that each purchase order under the agreement constitutes a separate “offer” requiring
HealthyDrinks’s acceptance to create a contract and that because HealthyDrinks never “accepted” Purchase order
109, there was no contract. Is this argument valid?
• No, each installment under an installment contract is not a separate contract. Also, the acceptance under
the contract relates to Rice-Ready’s ability to (rightfully or wrongfully) reject the goods.

Key Terms [pp. 346-347]

Chapter Review Questions [pp. 348-349] Note: Answers and explanations are provided at the very end of
the chapter.

Case Summary Questions and Answers [pp. 347-348]

CASE SUMMARY 17.1 Glenn Distributors Corp. v. Carlisle Plastics, Inc. 297 F.3d 294 (3d Cir. 2002)

1. Did Glenn make reasonable efforts to cover?

• No, there were likely other makers of these products.

2. Should Glenn have to cover the lost profits by buying products other than trash bags? Why or why not?
• Only to extent that these other products are suitable substitutes. Otherwise, the liability for breaching a
supply agreement may unfairly fall on the non-breaching party and disrupt the expectations of the parties
under the original contract.

CASE SUMMARY 17.2 S.W.B. New England, Inc. v. R.A.B. Food Group, LLC, 2008 WL 540091 (S.D.N.Y
2008)

1. What are the specific requirements for a court to grant specific performance to SWB?
• The goods must be very unique and difficult to substitute.

2. Do the requirements in question 1 fit this case?

• If the trusted nature of the brand and limited availability of supply in the region for these products make
them unique it is possible that specific performance may be an adequate remedy.

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CASE SUMMARY 17.3 Swan Lake Holdings, LLC v. Yamaha Gold-Car Co., U.S. Dist. LEXIS 19684 (U.S.
Dist. Ct. North. Dist. Ind., S. Bend Div., 2011)
1. Why didn’t the resort reject the goods?
• Partly because Yamaha state dist. would repair them.

2. When should the resort have revoked its acceptance?

• Once the carts did not work properly even after Yamaha attempted to fix them.

CASE SUMMARY 17.4 Huntsville Hospital v. Mortara Instrument, 57 F.3d 1043 (11th Cir. 1995)
1. Why did the court rule in favor of the hospital?
• A buyer who rightfully revokes acceptance or rejects goods needs to hold the goods for the seller to
retrieve. A buyer may elect to ship the goods to the seller but this is optional.

2. What duties do buyers have when they rightfully reject nonconforming goods?
• To notify the seller promptly and hold the goods for the seller to retrieve.

CASE SUMMARY 17.5 Aero Consulting Corp. v. Cessna Aircraft Co., 867 F. Supp. 1480 (D. Kan 1994)
1. Why is the liquidated damages clause in the contract not unreasonably low?
• The liquidated damages amount totals roughly 10% of the value of the plane. An unreasonably low
amount would not compensate Cessna for the production cost of the plane and time lost. Although 10% of
the plane value is far less than the total contract amount it likely provides reasonable compensation for the
lost time dealing with a buyer who fails to accept the goods.

2. Why is the liquidated damages clause in this contract not unreasonably high?
• The liquidated damages amount totals roughly 10% of the value of the plane. An unreasonably high
amount would act a penalty to compel Aero’s performance under the contract and not bear a reasonable
relation to the harm suffered by Cessna. In this case, 10% of the plane value does not seem like a penalty
designed to compel the purchase of the plane.

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 Chapter 18
UCC Article 2A: Lease Contracts

CHAPTER OVERVIEW
This chapter focuses on leases of goods under Article 2A of the UCC. In this chapter, we discuss the following:
(1) the advantages of leasing; (2) the scope of Article 2A coverage; (3) the definition of lessor and lessee; (4) the
difference between sales and leases; (5) the difference between leases and secured transactions; (6) the institution
of finance leases; and (7) which lease agreements must be in wiring to be enforceable.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Articulate the advantages of leasing Knowledge
Application
Define what a lease is and the scope of coverage in UCC Article 2A Knowledge
Application
Distinguish between lessors and lessees. Analytical
Thinking
Distinguish between a lease and a secured transaction. Analytical
Thinking
Identify what types of warranties apply to leases. Knowledge
Application
Understand what a finance lease is. Analytical
Thinking
Explain which leases must be in writing under Article 2A. Analytical
Thinking

I. INTRODUCTION TO ARTICLE 2A OF THE UCC [p. 350]

Points to emphasize:
• State statutory laws that are modeled after Article 2A of the UCC govern contracts for the lease of goods.
• Many business firms prefer to lease personal property, such as machinery and heavy equipment.
• Leasing is often a more attractive alternative to purchasing because the business can avoid the large up-
front investment required to purchase a good.
• Leasing my also offer some tax advantages in some circumstances.

II. UCC ARTICLE 2A COVERAGE [p. 352]

Points to emphasize:
• Article 2A applies to the lease of goods (machinery, equipment, and vehicles).
• The UCC does not cover real estate leases.
• It is important to understand the difference between leases, secured transactions, and sales.
o A lease is “a transfer of the right to possession and use of goods for a term in return for
consideration, but a sale or retention of a security interest is not a lease.” (See UCC §2A-102.)
§ A lease does not transfer title to the lessee; lessor retains title.
§ Lessee acquires only the right to the use and enjoyment of the goods for a limited
amount of time.
§ Goods revert back to the lessor at the end of the lease term (sooner if lessee breaches
the terms of the lease).

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1
 o A security interest is a legal right granted by a debtor to a creditor over the debtor’s property.
§ Debtor’s property is usually referred to as collateral.
§ Creditor can take possession of the collateral if the debtor defaults.
o A sale transfers ownership, or title, to the goods from the seller to the buyer.
§ Seller does not retain any ties to the goods.
§ Seller has an action for the price of the goods but cannot repossess the goods if the
buyer defaults.
• Case 18.1 demonstrates the difference between a lease and a secured transaction

Case 18.1 In Re: Pillowtex, Inc., 349 F.3d 711 (3d Cir.2003) [pp. 352-353]

Facts: Pillowtex, Inc. is a textile manufacturing company and Duke Energy Corporation is an electric
power holding company. On June 3, 1998, the parties entered into an eight-year “Master Energy Services
Agreement” in which Duke Energy agreed to install energy-saving lighting fixtures at Pillowtex’s factory
in Columbus, Georgia. Under the agreement, Duke paid the costs of acquiring and installing the lighting
fixtures and Pillowtex agreed to pay Duke Energy on a monthly basis one-twelfth of Pillowtex’s annual
energy savings. In 2000, Pillowtex filed bankruptcy and stopped making payments to Duke Energy. Duke
Energy filed a motion to compel Pillowtex to make the lease payments on the equipment it provided to
Pillowtex under the Master Agreement. Pillowtex claimed the Master Agreement was not a lease. The
district court agreed and held that it was a secured financing agreement, not a lease. Duke Energy
appealed.

Issue: Was the Master Agreement a lease or a secured financing agreement?

Ruling: The appellate court applied the “economic realities test” to the transaction and held that, even
though the parties intended the Master Agreement to be a lease, the transaction was, in fact, a secured
financing arrangement. Removal of the lighting fixtures would be prohibitively expensive and the market
would not make it worth Duke’s while to reclaim them at the end of the Master Agreement’s term.

Answers to case questions:

1. The Court emphasizes the fact that Duke would not have wanted the lighting fixtures at the end of the
lease term. Why is fact so relevant to the Court’s conclusion?
Answer: This fact, standing alone, is strong evidence that the transaction in this case was not a
lease but rather a sale.
2. Why does the Court disregard the intent of the parties in deciding whether the transaction is a lease or
not?
Answer: Because the Court applied the economic realities test to this transaction, and this test
focuses on the substance of the transaction, not on the intent of the parties.
3. Which party is acting “strategically” in this case, and what strategy is it employing?
Answer: This question is designed to elicit discussion on the ubiquity of strategic behavior in
business transactions, for one could argue that both sides were acting strategically here.

III. SOME BASIC TERMINOLOGY: LESSORS AND LESSEES [p. 353]

Points to emphasize:
• True leases always involve two parties:
o The lessor, the party who owns the leased goods and is making them available for the lease; and
o The lessee, the party who acquires the right to the temporary possession and use of goods under a
lease.
• Figure 18.2 is a sample equipment lease contract:

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 IV. TRUE LEASES VERSUS SECURED TRANSACTIONS [p. 355]
Points to emphasize:
• A secured transaction passes conditional title to the buyer.
o The seller retains a security interest in the goods being sold.
o The buyer can retain the goods if the payment obligations are satisfied.
o The seller can repossess the goods in the event of default.
o Generally, the secured party must dispose of the goods and apply the proceeds to the outstanding
debt.
• A lessor may retake the goods following default by the lessee, but is not required to dispose of the goods.
• An apparent lease transaction for goods will create a security interest in the goods if the lessee (buyer) is
obligated to make payment on the goods for the entire term without a right to early termination, and if any
of the following is true:
o The lease term is equal to or greater than the remaining useful life of the goods;

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 o The lessee is required either to renew the lease for the remaining useful life of the goods or to
become the owner of the goods;
o The lessee has the option to renew the lease for the remaining useful life of the goods at no
additional charge or for a nominal charge upon compliance with the lease agreement; or
o The lessee has the option to become the owner of the goods for no additional charge or for a
nominal charge upon compliance with the lease agreement.
• If a transaction is in fact a secured transaction and not a lease, the “lessors” (actually, sellers) should file a
UCC financing statement with the appropriate government office to better protect their rights in the event
of the buyer’s bankruptcy.

V. WARRANTIES [p. 356]

Points to emphasize:
• A warranty is a guarantee or promise providing assurance by one contracting party to the other party that
specific facts or conditions are true or will happen.
• The UCC warranty rules for the sale of goods also apply to leases.
• The rules for the major types of warranties – express warranties, the implied warranty of merchantability,
and the implied warranty of fitness for a particular purpose – are nearly identical for sales and for leases.
• See Chapter 18, “Sales Warranties,” for further discussion of the rules regarding the exclusion of
warranties in lease contracts.

VI. FINANCE LEASES [p. 357]

Points to emphasize:
• A finance lease is a lease in which the lessor is not the fundamental supplier of the goods leased, but
leases goods to lessees as a means of financing its acquisition from the supplier.
• A finance lease involves a relationship amount three separate parties: the supplier, the lessee, and the
finance lessor (the party who is financing the lease).
• Article 2A relieves a finance lessor or any liability for implied warranties of qualify with respect to the
goods.
• To qualify as a finance lease, an agreement must, in addition to qualifying as a true lease, satisfy the
following three conditions:
1. The finance lessor cannot participate in selecting, manufacturing, or supplying the goods;
2. The finance lessor’s acquisition of the good must be “in connection with the lease”; and
3. One of four stated methods must be used to give the lessee advance notification of applicable
warranties and promises by the supplier.

VII. LEASES THAT MUST BE IN WRITING [p. 358]

Points to emphasize:
• The statute of frauds requires certain leases to be in writing in order to be enforceable.
• If the total payments to be made under a lease, excluding payments for options to renew or buy, are $1,000 or
more the lease must be in writing.
• Exception to the writing requirements:
o Specially manufactured goods.
o Goods that have already been received and accepted by the lessee.

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Thinking Strategically Questions and Answers [pp. 359-360]

1. In 2018, UPS owned 239 aircraft and leased or charted another 297 aircraft. Why do you think UPS owns some
aircraft and leases others?
• This question is designed to elicit discussion on the pros and cons of leases versus sales. In short, the
advantages of a lease versus a sale most likely depend on the individual circumstances of each transaction.

2. In deciding whether to buy or lease, which of the eight reasons set forth in the chart in Figure 18.4 do you
think is the most important one? Explain.
• This question, like the previous one, is designed to elicit discussion on the pros and cons of leases versus
sales. The fact, for example, that UPS owns 239 aircraft and leases another 297 aircraft shows there are
advantages and disadvantages with both types of transactions.

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Key Terms [p. 360]

Chapter Review Questions [pp. 362-363] Note: Answers and explanations are provided at the very end of
the chapter.

Case Summary Questions and Answers [pp. 360-361]

CASE SUMMARY 18.1 Cucchi v. Rollins Protective Services, 574 A.2d 565 (Penn. 1990)

1. In your opinion, was the transaction in this case a lease or a sale?

• This question is designed to elicit discussion on the distinction between leases and sales. The Court in this
case itself was divided on this question.

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2. Why do Article 2 and Article 2A have different writing requirements for leases and sales?
• This question is designed to remind students of that the statute of frauds provisions for sales and leases are
not the same. Under Article 2, sales contracts greater than $500 must be in writing, while under Article
2A, lease contracts whose total payments are greater than $1000 must be in writing.

CASE SUMMARY 18.2 Corporate Center Associates v. Total Group and Office Outfitters, 462 N.W. 2d 713
(Iowa Ct. App. 1990)

1. Was the transaction in this case a true lease or a secured transaction?

• This question is designed to elicit discussion on the distinction between leases and sales. As in the
previous case (see above), the Court in this case itself was also divided on this question.

2. Does the answer to the previous question depend on whether CCA or Office Outfitters has the legal right to
take possession of the office furniture that Total Group left behind?
• This question is designed to elicit discussion on how courts understand and apply the economic realities
test.

CASE SUMMARY 18.3 Brankle Brokerage & Leasing, Inc. v. Volvo Financial Services, 394 B.R. 906 (2008)
1. Was the transaction in this case a true lease or a secured transaction?
• This question is also designed to elicit discussion on the distinction between leases and sales.

2. Why would the parties want to “disguise” this transaction as a lease?

• This question is also designed to elicit discussion on the intersection of bankruptcy law and the UCC. In
summary, the Bankruptcy Code treats lessors differently than it does secured creditors. Secured creditors
can have their rights modified, and any shortfall in the amounts due them is generally nothing more than
an unsecured claim. Lessors, however, receive more favorable treatment. With respect to leases, the debtor
is limited to assuming or rejecting an unexpired lease, and pending that decision, except for a brief hiatus,
is generally supposed to perform all obligations under the lease, including making required payments, thus
effectively giving lessors an administrative or priority claim.

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 Chapter 19
Sales Warranties

CHAPTER OVERVIEW
This Chapter discusses the body of law that protects buyers under the Uniform Commercial Code
and those sections within the Code that require sellers to offer warranties and the circumstances
under which such warranties can be disclaimed.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Identify and describe the various types of warranties. Knowledge
Recognize the appropriate use of disclaimers. Application
Discuss the extent of third-party rights in breach of warranty Application
cases.
Identify the applicability of the Magnuson-Moss Warranty Act. Knowledge

Teaching Tip: Warranty coverage

It is helpful to explain how the UCC applies to the sale of goods and would not cover warranties
made in connection with the sale of real estate for example.

I. TYPES OF WARRANTIES [pp. 364-365]

Points to emphasize:
• A warranty is a seller’s promise to a consumer concerning an important aspect of the
goods.
• When the seller makes a promise regarding the goods or a representation of fact about the
goods, this is known as an express warranty.
• If the seller has not made a specific promise or representation about the product, the
buyer may still be protected by a UCC-imposed implied warranty.

A. Express Warranties [p. 365]

• Sellers often make verbal and/or written representations about the products they are
selling. Additionally, advertisements also contain representations about the quality or
functionality of products.
• Under UCC 2-313, if the products do not possess the qualities described, the buyer may
sue for breach of warranty. Puffery is a nonfactual statement commonly used in
advertising with such claims as, “This car gets great gas mileage.” Because of this
vagueness, these subjective statements do not constitute express warranties.

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 B. Implied Warranties [p. 365]
• Even without a seller making affirmative representations, the UCC imposes implied
warranties on sales transactions.
1. Implied Warranty of Title and Noninfringement [P. 366]
• Under Section 2-312 of the UCC, every seller (merchant and nonmerchant) must
guarantee to the buyer that the title to the goods are (1) free and clear of any claims by
others (to avoid claims that the seller obtained the goods by fraud or theft), (2) not subject
to any security interest or lien (to avoid the possibility of repossession from someone who
has a collateral interest in the goods) and (3) free from infringement (to avoid a claim that
software, for example, contains patented technology belonging to a third party.

Case 19.1 Pacific Sunwear of California, Inc. v. Olaes Enterprises, Inc. [p. 366]
Facts: Oleas sold t-shirts to PacSun which contained the phrase “Smile Now” on the front and
“Cry Later” on the back. A company called Smile Now Cry Later, Inc. sued PacSun for
infringement on their federal trademark for that name.
Issue: Does PacSun have a claim against Olaes under Section 2-312 of the UCC for breaching
their implied warranty of title that the goods were free from infringement?
Ruling: Yes, although the term “rightful claim” is not defined in the UCC, is intended to cover
non-frivolous claims of infringement, not just successful cases. In this instant case, even though
it was determined by a federal court in Hawaii that Olaes had a likelihood of winning the
trademark dispute against Smile Now Cry Later’s trademark, PacSun could proceed on its claim.
Case Questions
1. How could Olaes have prevented this lawsuit?
• Olaes could have contacted Smile Now Cry Later to obtain a license for the use of the
slogan or searched the federal trademark database and conclude it would be better to
design a non-infringing T-shirt.
2. What damages should PacSun try to recover against Olaes if its breach of warranty claim is
successful?
• The cost of defending the suit by Smile Now Cry Later.
3. Who should be liable if the goods infringe a third parties’ rights, such as a patent, copyright,
or trademark? Why?
• This question is meant to encourage discussion on what obligations businesses have to
determine potential infringement. Potential answers may include the party who is in the
best position to prevent infringement or avoid the liability at the lowest cost, i.e. the seller

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 2. Implied Warranty of Merchantability [p. 367]
• Under UCC Section 2-314, the implied warranty of merchantability applies to every
sale of a product from a merchant seller to a buyer and requires the seller to warrant that
the product is fit for its ordinary use.
• Section 2-104(1) of the UCC defines a merchant as one who is regularly engaged in the
sale of that product or who holds himself out as having knowledge or skill peculiar to the
practices or goods involved in the transaction.
Case 19.2 Birdsong v. Apple, Inc.
Facts: Apple sells iPods with a warning that hearing damage can occur if earbuds are used at a
high volume. Birdsong brought a class action suit against Apple indicating that because the iPod
can produce 115 decibels, Apple breached their implied warranty of merchantability because the
earbuds used at this high decibel level resulted in hearing damage in the plaintiffs.
Issue: Did Apple violate its implied warranty of merchantability due to the ability of the earbuds
to play music at a high volume?
Ruling: No, the iPods were fit for their ordinary purpose of playing music. Just because the iPod
is capable of playing music at 115 decibels does not require users to use them in this risky
manner. The product could be used at safe decibels and thus did not lack a minimum level of
quality.
Case Questions
1. If the iPod can play at a certain level of sound, isn’t it foreseeable that users would assume
that a high level of sound was “ordinary” use?
• The iPods contained a warning regarding the danger of listening to music at high
decibels which explained the exact injury suffered.
2. If Apple did not provide the warning, how would that impact your analysis?
• A court would need to determine if it was common knowledge that playing music at
115 decibels could cause hearing loss. If so, it would be assumption of risk. If not,
there was a failure of duty to warn.
3. Do you believe that most consumers know that earbuds cause more hearing loss than
earphones? Should the court have considered the knowledge of the “average” consumer?
• This question is meant to encourage discussion on what businesses can assume
customers should know and what they can do to avoid lawsuits. Since many students
listen to music and are Apple device consumers this will stimulate a lively exchange.

Teaching Tip: You can tie in this case to the chapter on torts regarding failure to warn –
products liability cases. Students like to hear about the humorous failure to warn cases like the
Overton v. Anheuser-Busch case where the plaintiff sued the beer company because (1) the

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fantasies in the advertisements did not come true for him, and (2) for failure to warn about the
risks of alcoholic beverages.

3. Implied Warranty of Fitness for a Particular Purpose [p. 368]

• Under UCC Section 2-315, an implied warranty arises when a seller (merchant or
nonmerchant) promises that the product is fit for a particular purpose. For this
warranty to exist, the buyer must prove that the seller knew of the buyer’s desire to
use the product in a specified way (not necessarily in its ordinary way) and the buyer
relied on the seller’s advice and recommendation.

Teaching Tip: Another relevant example related to the one used in the text is to distinguish the
sale of hiking equipment for an ordinary camping expedition vs. mountain-climbing equipment
for high altitude climbs such as Mt. Everest. The sale of equipment for the latter will involve the
warranty of fitness for particular purpose. This is another example that that students will find
relatable.

DISCLAIMERS AND LIMITATIONS [p. 369]

Points to emphasize:
• The UCC allows a seller to avoid the risks associated with warranties and disclaim both
implied and express warranties under certain conditions.
• Disclaimers must be conspicuous – capital letters, bold print, larger than rest of text.
• Courts have held that phrases such as “with all faults” or “as is” are sufficient to disclaim
the implied warranties of fitness for a particular purpose and noninfringement.
• Sellers may not disclaim express warranties. Out of fairness for buyers, once an express
warranty has been made it cannot be limited by sellers through disclaimers.
• Although sellers may limit the remedies a buyer may seek in certain circumstances, it
may not limit damages resulting from personal injury due to a defective product.
• Section 2-316(3)(b) of the UCC allows a seller to disclaim defects by making the goods
available to the buyer for inspection (this applies even if the buyer chooses not to
inspect).
• The Magnuson-Moss Act restricts certain disclaimers and limitations of remedies by
sellers.

II. THIRD-PARTY RIGHTS [p. 370]

Points to emphasize:
• The law has evolved to protect consumers and largely eliminate the privity of contract
requirement. Under the privity of contract requirement, someone could only sue the party
he contracted with.

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 • Privity of contract dealing with the distribution chain is referred to as vertical privity,
and most states have done away with this requirement.
• Section 2-318 of the UCC deals with horizontal privity, or the extension of a warranty
to someone other than the buyer (which most states recognize).

III. MAGNUSON-MOSS WARRANTY ACT [p. 372]

Points to emphasize:
• The Magnuson-Moss Act regulates warranties given by a seller or lessor to a consumer.
A consumer is defined as one who purchases or leases a good with the intent of using it
for personal reasons rather than for resale or use in a business.
• Although the Magnuson-Moss Act does not mandate that sellers provide warranties to
consumers, if the seller or lessor does offer a written express warranty, the transaction
is subject to the provisions of the statute.
• Although the Magnuson-Moss Act does not create new implied warranties, it does give
consumers the ability to bring cases in federal court for breach of warranties implied by
state statutes.

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 • A full warranty label must provide repair or replacement of products costing in excess of
$10 and include the term of duration. A limited warranty is a warranty that cover less
than a full warranty would.
• Under the Magnuson-Moss Act written express warranties must be written conspicuously
and in plain and clear language and may not disclaim implied warranties.

IV. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES [p. 370]

Key Terms [p. 374]
Chapter Review Questions [pp. 376-377] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [pp. 373-374]

Teaching Tip: Airborne was sued under a class action lawsuit alleging among other things
breach of warranty. The following article details how Airborne settled the case for $23 million
and changed its packaging to avoid liability in the future:
https://boingboing.net/2009/05/27/lawsuit-losing-airbo.html
Showing students the changes in packaging made below and referenced in the article helps bring
to light the strategic legal aspects of product sales/ packaging/ advertising and marketing.

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Teaching Tip: It is fun and interactive to ask the students how the new packaging on the right
minimizes liability from the false claim that Airborne would help cure or prevent the cold.
Answers include:
• New packaging has no reference to germs;
• Lady is no longer coughing;
• Lady is no longer coughing;
• Man is no longer sneezing; and
• The statement that Airborne helps boost your immune system in now replaced with: “Helps
Support Your Immune System”

1. Did Airborne offer any warranties?

• Yes, Airborne’s statement that the product would help boost the immune system is a
statement of fact and a promise. Any statement of fact or promise must be true or else the
UCC imposes liability for breach of express warranty.
2. What types of warranties did Airborne offer?
• An express warranty.
3. Are the statements made by Airborne puffery? Explain.
• No, stating that the product will help boost the immune system can be verified
objectively. Scientific studies showed the product had no measurable impact on the
immune system.
4. What liability arises if Airborne breached a warranty?

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 • Breach of warranty liability under the UCC. This can lead to economic damages and
likely the refund of the purchase price. Under a class action lawsuit these damages are
significantly multiplied and a settlement was reached that totaled $23 million.
5. How should Airborne avoid this liability moving forward?
• Airborne should stop making statements of fact that are false or promises it cannot fulfill.
This involves changing its advertising and packaging to refer to statements of opinion
that are subjective and that no reasonable consumer would accept as a promise or as a
fact, i.e. puffery.

Case Summary Questions and Answers [p. 375-376]

CASE SUMMARY 19.1 Giles v. POM Wonderful, LLC, No. 10-32192 (Cir. Ct., 17th Jud. Cir.,
Broward County, Fla., filed August 6, 2010)

1. Are the claims made by POM Wonderful express warranties?

• Yes, this case is similar to the Airborne case in the Thinking Strategically section.

2. How could POM Wonderful reduce this potential liability?

• They would have to stop making factual statements that are untrue and stop making
promises that cannot be fulfilled.

CASE SUMMARY 19.2 Mennonite Deaconess Home & Hospital, Inc. v. Gates Engineering
Co., 219 Neb. 303, 363 N.W.2d 155 (1985)

1. Was an express warranty created? Explain.

• Yes, an express warranty was created when the watertight conditions of the roof were
detailed by the sales representative.

2. Were any implied warranties created? Explain.

• The UCC automatically imposes several implied warranties in a sale. In this case, the
implied warranty of merchantability would apply since the goods would be warranted to
be of at least average quality in the trade. Also, relying on the skill, knowledge and
expertise of the seller would likely trigger the implied warranty of fitness for particular
purpose.

CASE SUMMARY 19.3 City of LaCrosse v. Schubert, Schroeder & Associates, 72 Wis. 2d 38,
240 N.W.2d 124 (1976)

1. Who would the City have to sue to recover damages?

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 • Privity of contract dealing with the distribution chain is referred to as vertical privity ,
and most states have done away with this requirement. A few states, such as Wisconsin,
still require privity of contract, however, in suits seeking damages for economic losses
(as opposed to property or personal injury losses) related to nonconforming goods. The
City would therefore have to sue the contractor since that is the party with whom it had a
contract.

2. Does this ruling make sense? Explain.

• A strong argument can be made that retaining vertical privity in these cases triggers
numerous, expensive and wasteful lawsuits and that removing the privity requirement is
more efficient.

CASE SUMMARY 19.4 Consumers Power Co. v. Mississippi Valley Structural Steel Co., 636
F. Supp. 1100 (E.D. Mich. 1986)

1. Does this case involve horizontal or vertical privity of contract?

• This case involves vertical privity since it deals with the chain of distribution.
2. Does this ruling make sense? Explain.
• Yes, the trend among most states is to remove privity of contract in cases involving non-
conforming goods and economic damages. As with the prior case, A strong argument can
be made that retaining vertical privity would trigger numerous, expensive and wasteful
lawsuits along the distribution chain and that removing the privity requirement is more
efficient.

CASE SUMMARY 19.5 Webster v. Blue Ship Tea Room, Inc., 198 N.E. 2d 309 (Supreme
Judicial Court of Massachusetts, 1964)
1. Should chefs have to ensure that a dish like fish chowder is free of any fish bones?
• An argument can be made that fish bones in the chowder indicate it is authentic chowder.
If chowder of at least average quality in the ordinary trade has some bones then sellers
need not worry about the implied warranty of merchantability. Sellers would have
liability if they make a promise the chowder is bone-free or a statement of fact to that
effect.
2. Do you agree with the court’s decision? Explain.
• There is room for interpretation here since the trial court found in favor the
customer/plaintiff but the appellate court reversed on the grounds discussed above.
Interestingly, the appellate court reviewed the history of chowder making and found that
there was no evidence that cooks ever removed all the fish bones for this recipe.

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 Chapter 20
Negotiable Instruments: Definition, Creation, and Categories

CHAPTER OVERVIEW
This chapter covers the basics of negotiable instruments. A negotiable instrument is a
transferable, signed document that promises to pay the bearer a sum of money at a future date or
on demand.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Describe the features of a negotiable instrument. Knowledge
Categorize the types of negotiable instruments. Application
Explain the steps necessary to negotiate and indorse an instrument. Application
Summarize how negotiable instruments relate to securitization in Application
debt capital markets.

Teaching Tip: The confusing world of negotiable instruments

Students seem to have a lot of difficulty understanding how negotiable instruments work. Make
sure to provide a lot of examples and explain how these are essentially written IOUs that have
specific rules to indicate who has to pay on it and when. The Instrument is the document.
Negotiable means it can be transferred.

I. FEATURES OF A NEGOTIABLE INSTRUMENT [P. 380]

Points to emphasize:
• A negotiable instrument is:
1. An unconditional promise or order;
2. To pay a fixed amount of money;
3. That must be in writing;
4. Signed;
5. Made payable “to order,” “to bearer,” or “to cash;” and
6. Made payable either on demand or at a definite time in the future.
• The above listed elements are what make an instrument negotiable – transferable. They
must all be present in the “four corners” of the instrument.
• Negotiable instruments serve two commercial purposes: (1) they serve as a substitute for
cash, and (2) they facilitate the financing of transactions.

A. Unconditional Promise [P. 381]

Points to emphasize:

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 • The UCC defines a promise as “a written undertaking to pay money signed by the party
undertaking to pay.” To qualify as a negotiable instrument, the promise must not be
conditioned on any other occurrence. It may reference another document (per the
contract) but may not be conditioned on another other document (subject to the contract).

B. Order [P. 381]

Points to emphasize:
• A negotiable instrument can be an unconditional promise to repay or it can be an order
to pay. An order is a written instruction of one party to another to pay a third party.
• In Figure 20.1, if Ben owes Francisco $50, and Francisco owes Maggie $50 for cat-sitting
services, Francisco can order Ben to pay Maggie. This paper would be considered a
negotiable instrument.

C. Fixed Amount [P. 382]

Points to emphasize:
• The UCC requires that a negotiable instrument identify a fixed amount of money.
• Money is defined as a medium of exchange authorized or adopted by a domestic or
foreign government. It would not include gold or other nonmonetary items of value.

D. In Writing and Signed [P. 382]

Points to emphasize:
• The UCC requires that a negotiable instrument be in writing (handwritten or typed) and
signed by the party obligated to repay the debt or the person issuing the order to pay.

E. Payable to order or to Bearer [P. 382]

Points to emphasize:

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 • Negotiable instruments must either identify the party to whom payment will be
made or specify that the person who possesses the negotiable instrument is the
party to be paid.
• In the first case, the negotiable instrument is payable to order and will require
the words “pay to the order of [name].”
• In the second case, the negotiable instrument is payable to bearer and will
require the words “pay to bearer” or “pay to cash.”
• The use of the specific terms “pay to the order of,” “pay to bearer,” or “pay to
cash” are referred to as the magic words of negotiability and are a strict
formality required by the UCC if those promises or orders are to be considered
negotiable instruments.

F. Payable on Demand or at a Future Time [P. 382]

Points to emphasize:
• A negotiable instrument must be either payable on demand or at a definite time.
• An instrument that is payable upon demand can be presented for payment at any
time by its holder.
• An instrument that is payable at a definite time, on the other hand, will be repaid
on any given date or range of dates.

Case 20.1 Smith v. Vaughn

Facts: Vaughn signed a document acknowledging borrowing $9,000 from the Smiths and
obligating Vaughn to repay the debt “when you can.”
Issue: Is this writing a negotiable instrument under the UCC?
Ruling: No, it included neither a definite date to repay nor payable on demand language.

Case Questions:

1. Why is the “when you can” repayment term a condition that destroys negotiability?
•
It is possible that Vaughn would never be able to repay the loan using that
language.
2. How could the Smiths have ensured this paper was a negotiable instrument and payable
upon demand?
• Rather than stating “when you can,” the note should have stated “upon demand”
or a definite date by which repayment was to be made.

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 3. Focus on Critical Thinking: How would you interpret a contract that stipulates
“repayment when you can”? Is there a date that can apply to this statement? What are the
risks of entering into a loan contract with such a term?
• This question is designed to elicit discussion on language required in negotiable
instruments.

II. TYPES OF NEGOTIABLE INSTRUMENTS [P. 383]

Within the general categories of orders and promises, there are different types of negotiable
instruments. An Order to pay can be a draft or a check. A promise to pay can be a CD or
promissory note. See Figure 20.2.

A. Draft [P. 383-384]

Points to emphasize:
• A draft is a written order to pay money signed by the person giving the order.
• The drawer is the party issuing the payment order (Francisco), and the drawee (Ben) is
that party who is being ordered to pay the person to receive the funds, the payee
(Maggie).
• A draft may be either a time draft, which is payable at a determined future date, or a
sight draft, which is payable at any time upon demand once it is presented to the drawee.

B. Check [P. 384]

Points to emphasize:
• A check is a specialized type of order and draft payable on demand and drawn on a bank.
• In Figure 20.3 the Drawer is the company that authorized Francisco to sign the check.
The Drawee is the bank being ordered by Francisco to make the payment to the Payee,
Maggie.

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 C. Certificate of Deposit (CD) [P. 385]
Points to emphasize:
• A certificate of deposit is a written note that indicates a bank has received money as a
loan and promises to repay the amount in the future with interest, typically at a higher
rate than that offered by a savings account.

D. Promissory Note [P. 385]

Points to emphasize:
• A promissory note is any type of loan (personal or commercial) whereby one party
offers to lend a specific amount of money with repayment in the future. See Figure 20.4.
• A maker is the party who receives the loan and promises to repay.
• The payee is the party who extends credit and is entitled to repayment.
• Time notes are payable at a definite time.
• Demand notes are payable at any time upon the request of the payee.

Answers to Quick Quiz provided at the end of the chapter. [p. 395]

III. STEPS TO NEGOTIATE AND INDORSE AN INSTRUMENT [P. 386]

Points to emphasize:

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 • The term negotiable in negotiable instruments means transferable. A negotiation is,
therefore, the various steps used to transfer a negotiable instrument from party to party
through a legally defined process.
• For example, referring to Figure 20.1, because the draft qualifies as a negotiable
instrument, if Maggie owed Wendy $50, Maggie could negotiate (transfer) the instrument
by indorsing it over to Wendy permitting Wendy to collect the $50 directly from Ben.
• A holder is a person who legally has possession of a negotiable instrument and is entitled
to enforce it.

A. Negotiation of Order Paper [P. 387]

Points to emphasize:
• If the instrument is order paper (payable to an identified person), its negotiation requires
that the identified party physically transfer the instrument and indorse the instrument to
its new holder.
• An indorsement is a signature, other than that of a signer as maker, drawer or acceptor of
the instrument, for the purpose of negotiating the instrument.

Case 20.2 Danco, Inc. v. Commerce Bank/Shore

Facts: Because San-Fran owed money to Danco, the parties agreed that future checks to be
received to San-Fran would be made out to both San-Fran and Danco permitting Danco to
recoup the money owed it and providing any overages to San-Fran. At issue are 3 checks made
out to “San-Fran Plumbing, Inc./Danco Plumbing, Inc.” which San-Fran cashed without Danco’s
indorsement.
Issue: Was the bank in error by cashing the checks without Danco’s indorsement?

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Ruling: No, the “/” could be interpreted as or and thus either party’s indorsement was sufficient.

Case Questions

1. Do you agree that a slash symbol indicates either party may indorse? Why or why not?
• This question is meant to elicit conversation regarding how to name payees.
2. How would the court have decided this case if it had found that there was ambiguity with
respect to payment?
• According to the annotated UCC, “In the case of ambiguity persons dealing with the
instrument should be able to rely on the indorsement of a single payee.”
3. Focus on Critical Thinking: How could Danco have avoided this problem altogether?
• Danco could have required (1) that San-Fran indorse all checks received over to Danco
until the debt was paid in full, or (2) that checks to be received by San-Fran indicated that
the payee was “San-Fran Plumbing, Inc. AND Danco Plumbing, Inc.”

Teaching Tip: Helping students with visual aids

It is helpful for students to see examples of indorsements. You could draw the several backs of
checks on the whiteboard and let the students create the indicated indorsements. For example, a
blank indorsement could be “Sally Student.” A special indorsement could be “Sally Student,
payable to the order to Shen Student.” A restrictive indorsement could be “For mobile deposit
only.” A nonrestrictive indorsement would just be the student’s signature. A qualified
indorsement could be “Without recourse, Sally Student.” An unqualified indorsement would be
the student’s signature.
1. Blank or Special Indorsements
Points to emphasize:
• A blank indorsement consists solely of the indorser’s signature and nothing else
and has the effect of converting order paper to bearer paper.
• A special indorsement specifically identifies the party to whom the instrument is
to be payable.
2. Restrictive or Nonrestrictive Indorsements
Points to emphasize:
• A restrictive indorsement is one that seeks to limit the negotiability of an
instrument or impose a condition on the payee. See Figure 20.5.
• A nonrestrictive indorsement lacks any type of language that seeks to limit the
negotiability of an instrument or conditions to its payment or transfer.

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 3. Qualified or Unqualified Indorsements
Points to emphasize:
• A qualified indorsement adds language such as “Without recourse” to limit the
indorser’s loss exposure due to nonpayment.
• An unqualified indorsement does not include any language that limits the
indorser’s nonpayment liability

B. Negotiation of Bearer Paper [P. 389]

Indorsement is not necessary for bearer paper. When an instrument is payable “to bearer” or “to
cash” negotiation occurs when the holder physically transfers possession of the instrument to its
new holder.

IV. NEGOTIABLE INSTRUMENTS AND SECURIZATION IN DEBT CAPITAL

MARKETS [P. 389]
Points to emphasize:
• Transferability (negotiability) of instruments is important in debt capital markets because
it allows instruments to be packaged and sold.

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• The process of packaging promissory notes and negotiating their sale to investors is
called securitization.

• For example, a bank or an auto financing company can make loans to a large number of
auto purchasers and combine all of those notes and transfer them together to a special
purpose vehicle (SPV). The SPV sells bonds secured by the notes to investors. The bank
then receives a percentage of what it is owed on the loans up front from the SPV
permitting it to make additional loans. See Table 20.1 and Figure 20.6.

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V. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES [P. 392]

Key Terms [P. 393-394]

Chapter Review Questions [P. 395-396] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers

1. Convert the invoice presented above into a promissory note that has all the required
elements of a negotiable instrument.

Promissory Note

Hampton Market, Inc. hereby promises to pay $351,000.00 to the order of Fabulous Leather
Creations, LLC on September 1, 2019.

John Q. Hampton
____________________

John Q. Hampton
Chief Financial Officer
Hampton Market, Inc.

a. Should this negotiable instrument specify any promises other than the promise to pay?
Why or why not?
• No, since a negotiable instrument should not be conditioned on any other event or diction
of another writing.

b. Should the note be payable to order or to bearer? Explain.

• It should be payable to the order of Fabulous Leather Creations, LLC to ensure its proper
negotiability to the investor and avoid the risk of it being improperly used by anyone else.

c. Should the note be payable on demand or at a specific date in the future? Explain.
• The note should be payable 90 days into the future since those are the new financing
terms. Otherwise, the investor who negotiates and purchases this promissory note would
be able to collect from Hampton Market before that date.

d. What other requirements are necessary for the note to be a negotiable instrument?

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 • The note must specify a fixed amount of money (in this case $351,000), must be in
writing, and signed.

2. How would Fabulous Leather Creations negotiate the promissory note to First Finance
Factoring?
• They would have to indorse the paper to First Finance Factoring.

3. Explain whether any indorsement should be:

a. Blank or special.
• The indorsement should be special and indicate First Finance Factoring to avoid the
paper becoming bearer paper.

b. Restrictive or unrestrictive.
• The only restrictive condition should be the standard bank language “for deposit only” as
a risk management practice to protect First Finance Factoring.

c. Qualified or unqualified.
• Fabulous Leather Creations would prefer to not have to pay First Finance Factoring in the
event that Hampton Market does not pay the promissory note. To do that the indorsement
would be qualified.

4. What would Fabulous Leather Creations have to do to avoid guaranteeing the payment to
First Finance in case Hampton Market fails to pay for the leather goods?
• Fabulous Leather Creations would add a qualified endorsement that says: “Without
recourse”.

Case Summary Questions and Answers [P. 340-341]

CASE SUMMARY 20.1 Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A. v. William H.

Bailey, 710 F. Supp. 737 (C.D. Cal. 1989)

1. Do you agree with the court that “pay to the order to” was equivalent to “payable to the order
of”? Why or why not?
• As stated by the court: “In this context, the phrase "pay to the order to" can plausibly be
construed only to mean "pay to the order of." While other explanations are possible, none
are realistic. To hold otherwise would, in this Court's opinion, set an overly technical
standard that could unexpectedly frustrate legitimate expectations of negotiability in
commercial transactions.”

2. What do you think motivated the court’s decision in this case?

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 • The Court wanted to infer intent, preserve the expectations of the parties and avoid overly
technical requirements that would frustrate negotiability.
CASE SUMMARY 20.2 In re AppOnline, Inc., 321 B.R. 614; 2003 U.S. Dist. LEXIS 26258
(2003)

1. Was the notes’ reference to the existence of a separate agreement a conditional promise? Why
or why not?
• No, since that separate agreement did not impact the nature of the unconditional promise
nor did it alter the fixed amount of payment that was due.

2. When does a separate agreement not affect the negotiability of an instrument?

• When it does not change any of the essential elements of a negotiable instrument,
including: an unconditional promise to pay a fixed amount of money that is evidenced by
a signed writing that includes the required words of negotiability and that is payable on
demand or at a specific date.

CASE SUMMARY 20.3 Blasco v. Money Services Center, 352 B.R. 888 (N. Dist. Ala. 2006)

1. Who should prevail in this case? Why?

• Money Services should prevail since any ambiguity in the writing is clarified by the
numbers on the check. It was the expectation of the parties that the check would be
negotiable and holding otherwise frustrates this purpose due to an overly technical rule.

2. Should words or numbers take priority in cases where there is ambiguity? Explain.
• According to the UCC words take priority over numbers when there is a discrepancy. But
here, there was simply ambiguity no direct discrepancy between amounts, so the numbers
actually help clarify the ambiguity.

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 Chapter 21
Negotiation, Indorsements, and Holder in Due Course

CHAPTER OVERVIEW
This chapter covers process used to transfer the instrument from one party to another, the Holder
in Due Course (HDC) rule, and the impact of federal regulation intended to protect consumers
from unscrupulous merchants and creditors.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the process a holder follows to negotiate a negotiable instrument. Knowledge
Explain the requirements for holder in due course (HDC) status and the Knowledge
shelter rule.
Articulate the third-party defenses from which a holder in due course is Knowledge
insulated.
Articulate the third-party defenses from which a holder in due course is Application
insulated.

Teaching Tip: Holder in Due Course rule

Students have difficulty with negotiable instruments and all of the attendant rules and exceptions.
Make sure they have fully mastered the previous chapters on negotiable instruments prior to
introducing them to the concept of a holder and a holder in due course. It helps to provide lots of
examples keeping in mind that most students have never used a checkbook. Remember to tell
your accounting students that there will most likely be questions on the CPA exam on the holder
in due course rule.

I. NEGOTIATION [p. 397-398]

Points to emphasize:
• Negotiation is how an instrument is transferred from one party to another.
• Negotiation includes various steps that determine the roles and rights of the parties.
• The steps involved in a negotiable instrument begin with the issuance of the instrument
by the party promising to make a payment and ends with presentment of the instrument
by the party seeking to receive payment.

A. Holder [p. 398]

• A holder is (1) someone in actual physical possession of a negotiable instrument that is
bearer form (i.e., the instrument is payable to cash or to any party that is in possession of
the instrument) or (2) the instrument was made payable to a specific party and that party
is in possession of the instrument (called an order instrument). A holder of an instrument

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 has only limited rights against the possible liability to a third party, and this carries an
inherent risk.

B. Negotiation and Transfer [p. 398]

• The transfer of a negotiable instrument to another party results in that party becoming a
holder, regardless of whether the instrument was negotiated to an original holder or the
original holder transferred the instrument to third party.
• A transfer can occur through physical delivery (i.e., handing or mailing the instrument) to
the holder or through electronic transfer. A negotiable instrument may only be transferred
to the party the transferor intended as a holder.

II. HOLDER IN DUE COURSE (HDC) STATUS [p. 399]

Points to emphasize:
• A holder gains a sort of super status if she meets the Article 3 requirements as a holder in
due course (HDC).
• This super status protects the HDC from certain claims by other parties related to the
enforceability or validity of the negotiable instrument.
• The holder of a negotiable instrument is an HDC if the holder has taken the instrument:
(1) for value; (2) in good faith; and (3) without notice of it being overdue, fraudulent, or
subject to claim by another party.

A. Value [p. 399]

• The first step in an HDC analysis is to determine whether the negotiable instrument was
issued or transferred for value. If the holder took the instrument without providing
anything in exchange (such as with a gift or if the instrument was found) she is not an
HDC.
• Article 3 of the UCC requires that a negotiable instrument be taken for value by the
holder for a promise that has already been performed. Table 21.1 illustrates the status of
the parties in the example on page 400.

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 B. Good Faith [p. 400]
• Article 3 of the UCC provides a two-part definition that describes good faith as “honesty
in fact and the observance of reasonable commercial standards.”
• Honesty in fact, means that parties did not conceal or misrepresent any aspect of the
transaction.
• Reasonable commercial standards requires a court to determine whether the conduct of
the holder was within the boundaries of that particular industry or commercial setting.

CASE 21.1 Banco Bilbao Vizcaya Argentaria v. Easy Luck Co., 208 So. 3d 1241 (Fla. Dist.
Ct. App. 2017

Facts: JAMS agreed to purchase $43,337 worth of shoes from Easy Luck. At the time of the
transaction, JAMS owed an outstanding debt to Easy Luck in the amount of $77,000. Easy Luck
told JAMS that it would ship the shoes to JAMS only if it received payment in advance. JAMS
gave an instrument for $85,000 to Easy Luck issued by BBVA bank on Lanco’s account. After
the check cleared Easy Luck’s account as SunTrust, BBVA discovered that the instrument was
fraudulent and demanded SunTrust reverse the deposit. SunTrust refused and BBVA filed suit
against Easy Luck. The trial court ruled in favor of Easy Luck as holders in due course. BBVA
appealed arguing that Easy Luck did not meet the HDC’s good faith requirement.
Issue: Was Easy Luck an HDC?
Ruling: Yes, the trial court’s ruling was affirmed. Easy Luck took the instrument in good faith
with reasonably commercial standards of fair dealing as Easy Luck attempted to verify the
authenticity of the draft with BBVA and did not ship the shoes until the draft. Also, Easy Luck
had no actual knowledge that the draft was fraudulent until the lawsuit was filed by BBVA.
Case Questions
1. Should Easy Luck have accepted the third-party negotiable instrument as payment in the first
place given that it was issued by Lanco and not JAMS? Does that arrangement strike you as
having a potential for fraud? Why or why not?
• There is always a risk when accepting a third-party instrument, however, it is not unheard
of. A greater potential for fraud does occur when you do not have prior dealings with the
third party.
2. Another issue in the case was whether the Lanco negotiable instrument was accepted for
value by Easy Luck as required for HDC status. Did Easy Luck accept the instrument for value?
Name the specific exchanges for value in this transaction.
• Article 3 of the UCC requires that a negotiable instrument be taken for value by the
holder for a promise that has already been performed. In this case JAMS already owed

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 Easy Luck $77,000 for shoes previously shipped. Easy Luck had not already performed
on the $43,337 in shoes.
3. Focus on Critical Thinking: While the court ruled that Easy Luck did not have any legal
obligation to repay BBVA, does Easy Luck have an ethical obligation to do so? Given that its
customer, JAMS, perpetrated the fraud, shouldn’t Easy Luck share in the losses? Explain your
answer.
• This question is meant to elicit a discussion on the ethics of discovering fraud.

C. Without Notice [p. 401]

• The without notice means that the holder did not have actual notice (either firsthand
knowledge or notice by a third party) that the instrument was overdue, defective,
fraudulent, or subject to a claim by another party and that given all the facts and
circumstances known by the holder at the time, no reasonable person would question
whether the instrument was overdue, defective, fraudulent, or subject to a claim by
another party. Table 21.2 provides an overview of the “without notice” factors.

CASE 21.2 Triffin v. Pomerantz Staffing Services, 851 A.2d 100 (N.J. Super. 2004)
Facts: Friendly Check Cashing Corp. was presented with 18 counterfeit checks, in amounts
ranging between $380 and $398, purporting to have been issued by defendant Pomerantz
Staffing Services on its account with Bank of New York. printed on the face of each check was a
warning: “THE BACK OF THIS CHECK HAS HEAT-SENSITIVE INK TO CONFIRM
AUTHENTICITY.” Without examining the checks as suggested by this warning, Friendly

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cashed the checks, which the bank returned unpaid as counterfeit. Friendly assigned its rights to
Triffin, who filed suit against Pomerantz. The trial court ruled in favor of Pomerantz, and Triffin
appealed claiming, among other things, that he was entitled to payment as a holder in due course.
The trial court ruled for Pomerantz and Triffin appealed.
Issue: Was Triffin an HDC?
Ruling: No, the trial court’s ruling was affirmed. Friendly’s (and Triffin’s as its assignee) failure
to examine the checks to determine whether they had heat-sensitive ink prevented them from
becoming a holder in due course because they failed to meet the “without notice” requirement. It
was not commercially reasonable for a check checking service to not examine both sides of the
check.
Case Questions
1. Aren’t Friendly/Triffin innocent parties in this transaction? If so, why should they bear the
risk that the checks were counterfeit? If not, why not? In order to prevent fraud those receiving
checks have a duty to behave reasonably in determining the authenticity of an instrument.
2. Why does the court consider it important that Friendly was a check-cashing business? Would
the result be different if it was another type of business? Explain. A check cashing business has
experience with many checks. A cash business, for example, would not. What would be
commercially reasonable for a check cashing business would be different than for a cash
business.
3. Focus on Critical Thinking: How far should one have to go to meet the “without notice”
requirement? What methods could be used to ensure that a business qualifies as an HDC and
does not face the same fate as Friendly/Triffin? This question is meant to elicit a discussion on
what steps are necessary to discover fraud.

D. The Shelter Rule [p. 404]

• The shelter rule provides that the transferee of an instrument acquires the same rights
that the transferor had, which can include any upstream party.

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III. DEFENSES AND THIRD-PARTY CLAIMS [pp. 405-406]
Points to emphasize:
• The HDC’s rights to enforce a negotiable instrument (i.e., the right to demand payment)
are part of an HDC’s super status, which provides insulation from certain defenses that
may be asserted by the drawer/maker, acceptor, financial institution, or indorser (personal
and/or claims in recoupment).
• While HDC status provides immunity from personal defenses or claims in recoupment, it
does not protect an HDC from being subjected to any real defenses.

A. Real Defenses [p. 405]

• An HDC is not protected against real defenses such as fraud in the essence (e.g., tricking
a party into signing a document), bankruptcy, forgery, material alterations of a completed
instrument, and infancy (i.e., the party is a minor).

B. Personal Defenses [pp. 405-406]

• An HDC is insulated from personal defenses which are any “defense of the obligor that
would be available if the person entitled to enforce the instrument were enforcing a right
to payment under a simple contract.”
• This includes defenses associated with formation of a contract (e.g., illegality, duress,
lack or failure of consideration, or mental capacity) and defenses associated with

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 enforceability (e.g., unauthorized completion or materially altering the instrument, fraud
in the inducement, or breach of contract).
• Note that fraud is both a real defense and a personal defense. Even though an HDC is
immune from fraud in the inducement (personal defenses) but not from fraud in the
essence (real defenses).
o Fraud in the inducement covers fraudulent misrepresentations of material facts by
one party that another party relied on when entering into a contract
o Fraud in the essence is when the fraudulent behavior is intended to obtain an
individual’s signature on a document without the signer’s knowing or having a
reasonable opportunity to discover what the document contained (e.g., the maker
is tricked into signing a note believing it to be a mere receipt).

C. Claims in Recoupment [p. 406]

• An HDC is also protected against claims in recoupment which center on the notion that
the amount owed by the obligor should be reduced by some amount due to an offsetting
claim the obligor can assert for the same transaction.
• Claims of recoupment is not classified as a real or personal defense.

Teaching Tip: Consumer and Commercial transactions

Before covering the section on HDCs and consumers, it may be helpful to cover the reasons why
we would want to protect commercial financers against claims. If a business could assert any
defense against a note holder that it had against a seller, financers would be very unlikely to
extend credit inhibiting business transactions. On the other hand, consumers are treated
differently than commercial parties as a matter of public policy.

IV. HDC AND CONSUMERS [pp. 406-407]

Points to emphasize:
• Although the HDC rule allows negotiable instruments to be transferred and provides
reasonable protections to the holders of the instruments in the context of commercial
transactions (e.g., flexibility and ease of commerce), it can have the effect of inhibiting a
consumer’s right to assert rightful claims against the HDC limiting their action to the
original payee (against whom a claim can be asserted).

A. Holder Rule [p. 407]

• Although state consumer protection law provided exceptions to the HDC rules, they have
mostly been replaced by the FTC’s holder rule.
• Based on public policy, as between an innocent consumer and a third party financer, the
holder rule removes a third party financer’s HDC status and permits the consumer to
assert claims and defenses that it may have against the seller of goods and services
against the third party financer.

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 • A creditor or assignee of the credit contract is subject to all claims and defenses that the
consumer could assert against the seller.

B. Requirements [p. 407-408]

• Only transactions between a consumer and a merchant who is regularly engaged in the
sale/lease of the products or service at issue are covered by the Holder Rule.
• Under the Federal Trade Commission Act, consumer notes must contain a notice that the
credit contract is subject to all claims and defenses that the consumer could assert against
the seller.
• The holder rule does not authorize an independent cause of action (i.e., the right to sue)
for an aggrieved consumer; it merely restores personal defenses and any claims in
recoupment as a defense by a consumer against a holder demanding payment.

CASE 21.3 Hemmings v. Camping Time RV Centers and Bank of America, No. 1:17-CV-
1331-TWT (D. Ct. N.D. Georgia 2017)
Facts: Hemmings purchased an RV from Camping Time with BOA holding a promissory note
for the financing of the RV, which qualified as a consumer credit contract subject to, among
other regulations, the Holder Rule. Because of numerous mechanical problems with the RV,
Hemmings sought to return the camper and receive all monies paid refunded. When the RV was
still not fixed, Hemmings filed suit against Camping Time and BOA who both requested that the
case be dismissed.
Issue: Did the holder rule apply to this transaction?
Ruling: No, although the court found in favor of Hemmings on the claims related to the defects,
it dismissed the Holder Rule claims against both Camping Time and Bank of America because
(1) Camping Time was not a holder of a consumer credit contract, and (2) the holder rule does
not provide a private cause of action against the holder, BOA.
Case Questions:
1. What does the court mean by “derivative claims”? How does that impact the court’s analysis?
• Because the primary claim is against Camping Time for the defective camper, the claim
against BOA is derivative. The case must be dismissed against BOA because independent
claims against the holder are not permitted.
2. Should Bank of America be responsible for providing Hemmings with a full refund for the
RV camper?
• No, the refund, if any should come from Camping Time.

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3. Focus on Critical Thinking: Should the FTC or Congress enhance the Holder Rule to provide
consumers with an independent cause of action in federal courts for Holder Rule violations?
What would be the impact of such a protection on sellers, creditors, and consumers? Explain.?
• This question is meant to elicit a discussion on whether independent claims would
impede the negotiability of instruments.

V. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 410]
Chapter Review Questions [p. 412] Note: Answers and explanations are provided at the
very end of the chapter.

Thinking Strategically Questions and Answers [p. 409-410]

1. Use your favorite search engine to find out more about fraud-detection software marketed by
SAS, NEC, and Kofax. How do they compare? Look for firms that sell fraud-detection software
that caters to smaller businesses. What are the advantages and disadvantages to deploying fraud
detection via artificial intelligence?
• This question requires students to look up various fraud-detection software. One way of
comparing is to have students use a chart to map out costs, availability, experience in the
field, and industry standards. Advantages: It takes the human mistake element out of the
authenticity process and avoids the problem illustrated in Case 20.2 (Triffin).
Disadvantages: Expense for small business owner may be prohibitive.

2. Based on your own experience, what would you look for when determining whether a check
was authentic? Explain.
• a) alterations in “corruptible numbers” for the amount of the check (e.g., making a 7 into
a 9 etc); b) examining watermarks and other evidence of authenticity; c) checking
signatures with other specimens of signature (such as similar instruments in the past).

Case Summary Questions and Answers [p. 411]

CASE SUMMARY 21.1 Carter & Grimsley v. Omni Trading, Inc., 716 N.E.2d 320 (Ill.
App. Ct. 1999)

1. Did Carter take the instrument for value as defined in Article 3? Why or why not?
• No. The court ruled that “an executory promise is not value.” Carter & Grimsley had not
yet performed any legal services for Country Grain and therefore they did not meet the
Article 3 requirement of “value.”
2. Who prevails and why?

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 • Omni prevailed. Carter & Grimsley were not protected as an HDC because the value
prong of the test requires value by the holder for a promise that has already been
performed. This was given to Carter & Grimsley as a retainer for future services and not
for services already rendered.

CASE SUMMARY 21.2 Any Kind Checks Cashed, Inc. v. Talcott (Fla. Dist. Ct. App. 2002)

1. If Any Kind sues Talcott for claiming HDC status, what will the result be? Explain.
• The court held that the check cashing store was not a holder in due course. They reasoned
that the procedures it followed with the $10,000 check did not comport with reasonable
commercial standards of fair dealing. The fact that they did use a verification system for
the $5,700 check does not allow HDC status for both checks.
2. Does the fact that the check was part of a fraudulent scheme impact your analysis? How?
• It does in the sense that an HDC has to take the check “without notice” that the
instrument is defective or fraudulent in some way. This means that the holder has to use
some reasonable effort to verify that the check is valid.

CASE SUMMARY 21.3 Zener v. Velde, 17 P.3d 296 (Idaho Ct. App. 2000)

1. Is the Zeners’ claim a real defense, personal defense, or recoupment?

• Recoupment. The Zeners’ claim is best characterized as a claim to reduce the amount
owing on a note. This makes it a claim in recoupment under Article 3.
2. Is Velde an HDC? Why or why not?
• Velde is an HDC. He took the check for value, in good faith, and without any notice of it
being overdue, fraudulent, or subject to claim by another party. The court pointed out that
the Zeners’ allegations about the removal of trees were made after the note had been
negotiated to Velde.
3. How does Velde’s HDC status impact the Zeners’ claim?
• Because Velde is an HDC, he is not subject to a defense by the maker of the note (the
Zeners) since the claim is classified as recoupment.

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 Chapter 22
Liability, Defenses, and Discharge

CHAPTER OVERVIEW
This chapter delves deeper into negotiable instruments focusing on liability issues; namely,
signature liability, warranty liability, and who may be discharged from liability.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Differentiate between primary and secondary signature liability on Application
a negotiable instrument.
Articulate the UCC’s procedures for presentment and dishonoring Knowledge
an instrument.
Explain how agency principles operate in the context of negotiable Application
instruments.
Articulate the basic rules of warranty liability. Knowledge
Identify which defenses always apply against a holder of an Application
instrument.
Describe the main ways in which an instrument can be discharged Knowledge
or terminated.

Teaching Tip: Students without checkbooks

It may be helpful for students to get hands-on experience with checks as some student may have
never owned a checkbook. You can print out fake blank checks and have them fill out the front,
indorse them, and hand them to one another. This can help them with the many terms associated
with negotiable instruments.

I. LIABILITY ON THE INSTRUMENT [p. 414]

Points to emphasize:
• With a negotiable instrument the maker/drawer promises to pay a sum of money.
• When a holder’s efforts to be paid are unsuccessful, Article 3 of the UCC addresses
enforcement. Payment liability comes down to:
• Who is entitled to enforce the instrument?
o A holder is the party that is in actual physical possession of the instrument and
who is authorized by law to enforce the terms of the instrument or to transfer it to
a third party.
• Against whom may it be enforced?

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 o A person is not liable on an instrument unless (i) the person signed the instrument,
or (ii) the person is represented by an agent who signed the instrument and the
signature is binding on the represented person.
o This is known as signature liability. Signature liability may be either primary or
secondary depending on the status of the signer (e.g., maker versus indorser).
• The UCC provides a broad definition of “signature” that includes any signature that is
affixed to the instrument.

A. Primary Liability [p. 416]

Makers and acceptors of drafts are considered to have primary liability for payment of an
instrument. This means that both makers and acceptors are liable for the amount of the
instrument as soon as it is issued and are required to pay the instrument as soon as it is presented
for payment. A maker is the person who signs a check, draft, promissory note, or other
negotiable instrument and is authorized to do so. An acceptor, or drawee, is the person that
accepts a negotiable instrument and agrees to be primarily responsible for its payment or
performance.

An example of signature liability of an acceptor (State Street Bank) is when a bank certifies a
maker’s (Donna Corrate’s) check. The bank has become an acceptor and is now liable to the
holder (Hydro Mat Company). The drawer (Donna Corrate) is no longer liable. See Figure 22.1.
In an alternate scenario, Andrews (maker) writes a check on his account at Big Bank (drawee) to
CCC (holder) for $1,000 and a note for $4,000. When CCC tries to cash the check, Big Bank
refuses to honor it. Andrews then cancels the check on the Big Bank account and writes a
replacement check for $1,000 on his NCU account which NCU then certifies (acceptor).

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Andrews then provides the NCU check to CCC. Figure 22.2 represents each party’s liability in
the transaction.

Case 22.1 Affiliated Health Group v. Healthcare Services Corp. d/b/a Blue Cross Blue
Shield of Illinois, 2017 Ill. App. 161049 (Ill. App. Ct. 2017)
Facts: Two employees of a medical practice (AHG) opened up fraudulent bank accounts at
Devon Bank with account names similar to AHG and deposited checks from BCBS (Insurer)
meant for AHG into these fraudulent accounts. Insurer’s bank cleared all of the checks to the
accounts held by Devon Bank (fraudulent accounts). AHG sued Insurer arguing Insurer was still
liable for the amounts of the checks under UCC Art. 3.
Issue: Did Insurer’s liability cease once the checks were accepted by the bank?
Ruling: Yes, the Insurer’s bank cleared the checks extinguishing the Insurer’s liability.
Case Questions
1. Who is the acceptor in this case, and why is this question important?
• The depositing bank is the acceptor. This is important because a drawer (AHG) is
discharged from liability once a draft is accepted by a bank.
2. Why is the concept of “acceptance” a primary factor in the court’s decision in this case?
• An acceptor agrees to become liable for payment of a negotiable instrument.
3. Focus on Critical Thinking: AHG sued Insurer. Why didn’t it sue the bank?
• This question is designed to facilitate discussion on liability of all those involved in a
transaction.

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 B. Secondary Liability [p. 418]
Unlike primary liability, secondary liability is conditional, arising only if the primarily liable
party fails to pay. The two parties that can become liable through secondary liability are the
drawer (the party that signed the instrument ordering payment) and the indorser (the party who
signs an instrument to either restrict payment, negotiate payment, or incur the liability). Parties
with secondary liability are responsible to pay the amount of an unaccepted instrument to any
subsequent holder so long as: (1) the instrument was dishonored and, in some cases, (2) notice of
dishonor is given to the drawer or indorser.

II. PRESENTMENT [p. 418]

Points to emphasize:
• Presentment is the process used by a holder to demand that the drawee pay the
instrument. It requires (1) that the instrument is presented to the appropriate party, (2) in
accordance with the instrument’s terms and conditions, and (3) in a reasonably timely
manner.

A. Instruments that Are Dishonored [p. 419]

An instrument is considered dishonored if the instrument is fraudulent or the drawer does not
have sufficient funds to cover the check in which case the drawee may refuse to pay. The holder
must then seek payment from secondarily liable parties. Authority: A holder may be required to
exhibit the instrument and provide reasonable identification and/or authorization to present the
instrument.

B. Banking Day [p. 419]

Article 3 sets a daily 2:00 p.m. cutoff deadline after which a party to whom presentment is made
may treat the presentment as occurring on the next business day.

Case 22.2 Messing v. Bank of America, 821 A. 2d 22 (Md. Ct. App. 2003)
Facts: Messing received a check payable to him written by Burruss and tried to cash it at
Burruss’s bank (BoA). When BoA discovered that Messing did not have an account there, they
requested Messing to provide a thumbprint for identification, which Messing refused. Messing
then sued BoA claiming that a thumbprint was not “reasonable identification” and could not be
required of him.
Issue: Is a thumb print a reasonable form of identification?
Ruling: Yes, additionally because a thumbprint can constitute a signature, it does not violate
privacy rights.
Case Questions
1. Why did Messing believe that the thumbprint requirement was unreasonable?

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 • Messing felt the thumbprint was unreasonable because he had already provided
identification.
2. What alternatives did Messing have for receiving payment on the check?
• Messing could have taken the check to his bank. The only reason the thumbprint was
requested was because Messing did not have an account at BoA.
3. Focus on Critical Thinking: Messing argued that the BoA teller, by placing the check in the
slot of her computer, and the computer then printing certain information on the back of the
check, accepted the check as defined in Article 3 and could not subsequently dishonor it. Does
that strike you as a compelling argument? Explain.
• This question is designed to facilitate discussion on what constitutes acceptance.

III. AGENCY ISSUES [p. 420]

Points to emphasize:
• Businesses often designate individuals as agents for the purpose of signing instruments.
• Under Article 3, a represented person means the principal, while representative means
the agent.
• The principal is bound to the instrument’s terms and conditions when the agent signs the
instrument in conformance with the express authority given by the principal to the agent.

IV. WARRANTY LIABILITY [p. 421]

Points to emphasize:
• In addition to the liability that applies to someone who signed an instrument, liability can
also accrue to someone who receives payment on an instrument: warranty liability.

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 • Warranty liability applies when someone receives payment on an instrument that has
been forged, altered, or stolen.
• Warranty liability can be summed up in two rules:
o Rule #1: The wrongdoer is always liable. The person who forges, alters, or steals
a check is always liable for the value of the instrument and for any other expenses
or lost interest resulting from the wrongdoing.
o Rule #2: The drawee bank (the bank named in the forged check or instrument) is
also liable if it pays a check on which the drawer’s name is forged.

Answers to Quick Quiz provided at the end of the chapter [p. 379]

A. Transfer Warranties [p. 422]

By operation of law, when someone transfers an instrument for consideration (i.e., in exchange
for something of value), the transferor automatically makes the following five implied transfer
warranties: (1) The transferor is the legitimate owner of the instrument. (2) All signatures on the
instrument are authentic and authorized. (3) The instrument has not been wrongfully altered in
any way. (4) No defense or claim can be asserted against the holder of the instrument. (5) As far
as the transferor knows, the issuer of the instrument is solvent (i.e., has the ability to pay it).
These warranties run with the instrument meaning that any transferee or subsequent holder who
take the instrument in good faith, can sue a prior party for beach of any of the above warranties.

B. Presentment Warranties [p. 423]

By operation of law, anyone who presents a check for payment makes the three following
presentment warranties: (1) The presenter is the legitimate owner of the check. (2) The check

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has not been wrongfully altered in any way. (3) The presenter has no reason to believe that the
drawer’s signature is forged. The payer has no general right to a refund unless any of the above
warranties is not true.

Case 22.3 National Metropolitan Bank v. United States, 323 U.S. 454 (1945)
Facts: A civilian clerk, Foley, has 144 checks issued in the names of various Marines, without
their knowledge, by submitting false vouchers for reimbursement in their names. Foley then
forged their signatures and added his own name as second indorser and deposited the checks in
Anacostia Bank. Anacostia Bank, without investigating the genuineness of the signatures,
indorsed and transferred the checks to National Metropolitan Bank which collected on them from
the federal government.
Issue: Was the presentment warranty breached obligating the refund of the amounts of the
forged checks to the federal government?
Ruling: Yes, presentation of a government check to it for payment with an express guaranty of
prior indorsements amounts to a warranty that the signature of the payee was genuine. Breach of
that warranty, by presenting a check on which the payee’s signature is a forgery, gives the
government a right to recover from the guarantor when payment is made.
Case Questions
1. In your opinion, was this decision (requiring the bank to refund the government) a just one? In
other words, did the court decide this case correctly?
• This question is meant to elicit discussion on how presentment warranties work.

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2. According to National Metropolitan Bank, it was the government who breached its implied
warranties when it issued the 144 checks in the first place. Specifically, the bank argued that the
issuance of the checks by the government was a warranty that they were not fictitious, but
genuine and issued for a valuable consideration. Is the bank right?
• Presentment warranties apply to the party presenting the check, in this case the bank.
3. Focus on Critical Thinking: Why didn’t the government sue Foley, the actual mastermind
behind this two-year fraudulent scheme?
• This question is meant to elicit the concept of deep pockets – that Foley most likely did
not have the funds to make restitution.

V. DEFENSES AGAINST HOLDERS OF NEGOTIABLE INSTRUMENTS [p. 425]

Points to emphasize:
• A holder is a person who legally obtains a negotiable instrument, with his or her name on
it as payee.
• Although the holder has the right to receive payment according to the terms of the
instrument, the maker or issuer of the instrument may assert any of the following
defenses against a holder at any time: (1) The signature on the instrument is forged, (2)
The amount on the instrument was altered after the maker signed it, unless the maker
left the instrument blank, or (3) The instrument itself is not valid under the common law
of contracts.

VI. DISCHARGE [p. 425]

Points to emphasize:
• The expiration or death of a negotiable instrument is called discharge and can occur in
the ways described below.

A. Discharge by payment [p. 425]

Making payment to the holder will generally discharge the obligation even if the payor knew of
another person with a claim to the instrument.

B. Discharge by Tender [p. 426]

Tendering full payment to a holder on or after the date due discharges any subsequent liability to
pay interest, costs, and attorneys’ fees.

C. Discharge by Cancellation or Renunciation [p. 426]

Marking the face of the instrument or the indorsement, destroying the instrument, or striking out
the party’s signature, by the holder will discharge the obligation to pay on the instrument.

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 D. Discharge by Material and Fraudulent Alteration [p. 426]
Materially and fraudulently altering an instrument by the holder discharges any party affected.

E. Discharge by Certification [p. 426]

All prior indorsers are discharged when a drawee certifies a draft for a holder.

F. Discharge by Acceptance Varying a Draft [p. 247]

If the holder assents to an acceptance varying the terms of a draft, the obligation of the drawer
and of any indorsers who do not expressly assent to the acceptance is discharged.
Quick Quiz Answers are found at the end of the chapter. [p. 379]

G. Notice Requirement [p. 375]

Notwithstanding the above, no discharge of any party operates against a subsequent holder in
due course unless she has notice when she takes the instrument.

VII. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES [p. 375]

Key Terms [p. 428]
Chapter Review Questions [pp. 430-432] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers
1. Based on what you have learned in this chapter, aside from Mr. Abagnale, which other parties
could incur liability for Mr. Abagnale’s fake checks?
•In addition to Mr. Abagnale, the drawee banks (the banks named in Abagnale’s forged
checks) could also incur liability. At the same time, however, a drawee bank can recover
from the payee (the person to whom the forged check is payable to) if the payee himself
had reason to suspect the forgery.
2. What steps, if any, could these parties have taken to avoid liability on Mr. Abagnale’s forged
checks?
• Legally speaking, there is little the banks could have done to avoid liability. This question
is meant to elicit discussion on how to identify legal risks and what steps can be taken to
mitigate or reduce those risks.
Case Summary Questions and Answers [pp. 428-430]
CASE SUMMARY 22.1 Bank of Nichols Hills v. Bank of Oklahoma, 196 P.3d 984 (Okla. Civ.
App. 2008)
1. Which presentment warranty is at issue?

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 • By operation of law, anyone who presents a check for payment makes the following three
presentment warranties: (i) the presenter is the legitimate owner of the check; (ii) the
check has not been wrongfully altered in any way; and (iii) the presenter has no reason to
believe that the drawer’s signature is forged. Arguably, all three warranties were at issue
in this case.
2. Who prevails and why?
• Both the lower court and the appeals court ruled for the defendant (Bank of Oklahoma),
holding that the plaintiff bank’s negligence contributed to forgery in this case.
CASE SUMMARY 22.2: Flatiron Linen v. First American State Bank, 23 P.3d 1209 (Supreme
Court of Colorado 2001)
1. What is Flatiron’s best theory as to why it should prevail under Article 3?
• Flatiron’s best theory is that First American State American, as the acceptor or drawee
bank, incurred primary liability in this case.
2. Is the cashier’s check an indication that First American is an acceptor? Explain.
• Absolutely. A common example of primary liability of an acceptor is when a bank
certifies a check. When a bank certifies a check, this certification acts as notice of the
drawee bank’s acceptance. The bank this becomes an acceptor and is now liable to the
holder of the check.
CASE SUMMARY 22.3 Cooper v. Union Bank, 507 P.2d 609 (Supreme Court of California
1973)
1. In your opinion, who should win this case, and why?
• This question is meant to elicit discussion on the proper scope of warranty liability of
drawee banks.
2. Did Ruff breach any transfer or presentment warranties in this case? If so, why wasn’t she
sued?
• This question is meant to elicit discussion on the strategic problem of “judgment-proof”
defendants.
CASE SUMMARY 22.4 Cooper v. Union Bank, 507 P.2d 609 (Supreme Court of California
1973)
1. Are the defenses available to the collector banks and to the payor banks the same or different?
What are these defenses?
• The defenses available to both types of drawees or acceptors are generally the same.
2. Who will prevail in this case? Stell or the banks?

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 • It is worth noting that the courts themselves were divided on this question: the payor and
collecting banks prevailed in the lower courts, but Stell prevailed in the California
Supreme Court.
CASE SUMMARY 22.5 1409 West Diversey Corp. V. JPMorgan Chase Bank, 2016 WL
4124293 (N.D. Ill. 2016)
1. Who prevails and why, the employee, Chase Bank, or currency exchange?
• The court ruled for the bank but this question is meant to elicit discussion on primary
liability.
2. Should the employer’s common law claim for negligence preempt the UCC rules on
presentment, or should the UCC rules preempt common law?
• This question is meant to elicit discussion on the conflict between the UCC and common
law that can occur.

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 Chapter 23
Checks, Deposits, and Financial Institutions

CHAPTER OVERVIEW
This chapter discusses checks, electronic payments, mobile payment apps, and cryptocurrencies,
which are all alternatives to cash.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain how checks are used in commercial transactions. Application
Summarize the various methods of electronic payment and the laws Application
that apply to each one.
Identify the various types of mobile payment apps and the laws that Knowledge
apply to each one.
Apply UCC state law to determine who faces liability when a check is Application
forged, stolen, or altered.

Teaching Tip: Students are experts in electronic payments

Although many students do not use check books, they are familiar with online banking and
electronic payments. As in the previous chapter, it may be helpful to print out fake blank checks
for the students to complete and negotiate. To help familiarize them with the discussion on
electronic payments, have them tell you which ones are already on their phones. Students will
usually have apps like Venmo and Apple Pay at the ready.

I. CHECKS IN COMMERCIAL TRANSACTIONS [p. 433]

Points to emphasize:
• Checks are negotiable instruments. Because checks are orders rather than promises
(notes), they are also referred to as drafts.
• A cashier’s check is a check issued by a bank with funds drawn from the bank’s own
account.
• A certified check is a check drawn from a personal account that the bank guarantees will
clear with sufficient funds.

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• The owner of a checking account is the drawer. The bank at which the checking account
is located is the drawee. See Figure 23.1.
• A check may be made out (1) to the order of a specified person, the payee, (2) to the
bearer of the instrument, allowing anyone who physically possesses the check to cash it,
or (3) to cash, which transforms the check into a bearer negotiable instrument, allowing
anyone with possession to cash it, even if obtained by theft.
• A check may be transferred (negotiated) by the payee to another party, through
indorsement and physical transfer of the check. (See examples of indorsements in
Chapter 20 pages 332-335).

• Article 4 of the UCC governs the processing of checks by banks. The depositor, the
person seeking to cash the check, generally will deposit the check into her own account
which authorizes her bank, known as the depository bank, to collect the proceeds from
the drawee bank. See Figure 23.2.

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 • Computers today take an image of a check and scan the line of digits at the bottom
known as the magnetic-ink character recognition (MICR) code to decode the drawee
bank’s routing number and the drawer’s checking account number.
• The drawee bank has two business days to decide whether to rightfully dishonor the
check due to an inactive account, insufficient funds, or a stop payment order placed on
the check.
• In some cases, a bank may wrongfully dishonor a check that is properly payable. The
bank will only be liable to its banking customer (the drawer) for the damages incurred,
not to the party who received the “bounced” check.

Case 23.1 Fetter v. Wells Fargo Bank Texas

Facts: Wells Fargo had a policy of paying the highest dollar checks for presentment on a
depositor’s account first which had the potential to cause many more overdraft fees to its
customers. Fetter sued Wells Fargo arguing that doing so violates its duty of good faith to its
customers.
Issue: Did Wells Fargo’s policy violate the law?
Ruling: No, not only did the language in the customer agreement permit Wells Fargo to cash
higher dollar checks first, the UCC permits banks to cash checks in any order.

Case Questions
1. Why will banks benefit from the internal rule of paying checks from highest amount to lowest
amount?
• Assuming a $35 overdraft fee, if five checks are presented in the amounts of $500, $300,
$100, $50, and $25, and the customer only has $500 in the account, if the bank were to
pay the checks from lowest to highest, the only check to be considered an overdraft
would be the $500 check with a resulting $35 charge to the customer. Paying out the
highest to the lowest checks would result in the greatest amount of fees to the bank. If the
bank paid the $500 check first, the other four would be considered overdrafts for which
the bank could collect $140 in fees ($35 x 4).
2. What arguments can Wells Fargo make that paying checks from highest to lowest is actually
best for customers?
• Chances are the larger checks are for more important items like a mortgage or car
payment.
3. Focus on Critical Thinking: What policy arguments do you think the drafters of the UCC had
in mind when they drafted Section 4-303(b)? Would you have drafted a different rule? Why or
why not?

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 • This question is designed to elicit a discussion on why the UCC permits banks to
determine their own rules.

II. ELECTRONIC PAYMENT SYSTEMS [p. 437]

Many monetary transactions occur electronically and are growing in use. See Figure 23.3.

A. Debit Cards [p.437]

Points to emphasize:
• A debit card is a card linked to the cardholder’s checking account that is used at the
point of sale with a merchant allowing for instantaneous transfers of funds from the
cardholder’s account to the merchant.

B. Credit Cards [p. 438]

Points to emphasize:
• A credit card allows a cardholder to make purchases through an electronic network on
pre-negotiated credit terms with the card-issuing bank.
• The merchant is credited within a few days for the purchase and the cardholder receives a
statement about once per month noting the amount due for all of the purchased made in
the prior periods.

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 • To be accepted as a type of payment, the card must participate in a technology platform
called an interbank network, of which Visa and Mastercard are the largest participants.

C. Automated Clearing House (ACH) Transactions [p. 438]

Points to emphasize:
• An ACH transaction uses an electronic interbank network to process direct payments
(such as a recurring mortgage payment) and deposits (such as direct deposit of paychecks
from employers).

D. Electronic Funds Transfers (Wires) [p. 439]

Points to emphasize:
• Commercial wires are used among businesses and typically involve large sums
of money.
• In a commercial wire, the originator sends a payment order instruction to his or
her bank (the originating bank) to send funds to a beneficiary’s bank account.
Table 23.1 describes which laws govern each of the electronic payment systems.

III. MOBILE PAYMENT APPS AND THE BLOCKCHAIN [p. 440]

Teaching Tip: Blockchain and bitcoin

Students are very interested in blockchain and bitcoin. It is important to explain that although the
federal government has not, as of this printing, enacted any laws regarding blockchain or
cryptocurrencies, several federal agencies have created guidance for these transactions including

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the SEC, CFTC, FTC ad IRS. Additionally, several states have exempted cryptocurrency from its
state securities laws.

A. Mobile Payment Apps [p. 440]

Points to emphasize:
• A mobile payment app is software that is loaded on a mobile device that allows users to
track expenses, pay bills, and send money to or receive money from businesses or
personal bank accounts.
• Other apps known as digital wallets, such as Google Pay, allow users to pay using a
contactless point-of-sale system. Digital wallets are encrypted and can be connected to
either credit card or bank account. In some cases, a digital wallet can be funded in
advance of use with a set amount of money.

B. Blockchain [p. 441]

Points to emphasize:
• Bitcoin is a type of cryptocurrency.
• A cryptocurrency is a software-based currency that is created using encryption techniques
and accounted for through an online peer-to-peer ledger system known as the
blockchain.
• Although Bitcoin is viewed by many as a speculative investment, its original purpose was
to serve as an online, decentralized, and unregulated currency and payment system.
• It is not currently regulated by the Federal Reserve or other regulatory institutions, but
Bitcoin has been declared property by the IRS.
Case 23.2 United States v. Robert M. Faiella, a.k.a “BTCKing,” and Charlie Shrem
Facts: Faiella (BTCKing) sold bit coin on the Silkroad website to facilitate the purchase of
illegal goods and services.
Issue: Was Faiella operating an unlicensed “money” transmitting business in violation of the law
(Section 1960)?
Ruling: Yes, (1) bitcoin coalifies as money under the plain meaning of the statute, (2) even
though Faiella was not charging for money transmitting services, in selling bitcoin itself in
exchange for cash, he was “transmitting” money under the statute, (3) FinCen Guidelines
indicate that operators of virtual currency exchanges are “money transmitters” under the law.
Case Questions
1. Was Faiella a money transmitter in the traditional sense? Why or why not?

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 • A traditional money transmitter would be Western Union or PayPal. These businesses
facilitate the transfer of money to individuals and businesses. Faiella was not facilitating
the transfer money to anyone, but rather exchanging money for bitcoin which the
customer could then use to obtain goods or services.
2. If an online merchant such as Amazon accepts Bitcoin for payment, is the merchant a money
transmitter and therefore subject to Section 1960 regulation? Why or why not?
• Accepting bitcoin would not make Amazon a money transmitter. If Amazon were to sell
bitcoin or were to serve as a middle entity receiving bitcoin and transferring bitcoin to
third parties, it could be considered a money transmitter under the law.
3. Focus on Critical Thinking: Should Bitcoin be considered money? What arguments exist that
it should not?
• This question is designed to elicit conversation regarding how money is defined and how
and why transfers should be regulated.

IV. FRAUD RULES RELATED TO CHECKS AND ELECTRONIC PAYMENT

SYSTEMS [p. 443]
Points to emphasize:
• Banks must comply state UCC law to determine who faces liability when a check is
forged, stolen, or altered.
• Under state law generally, a drawee bank that pays on a forged or stolen check must
assume liability.
• If a fraudster alters the name on a check or the dollar amount, the rule is that the
depositor bank incurs the liability.
• If a fraudster indorses a forged or stolen check and a party negotiates the forged or stolen
check to someone else, the party who negotiated it must assume liability.
• If a debit card holder notifies a bank within 2 days of learning of the loss or theft of a
card, the cardholder’s liability is limited to $50.
• When credit card companies started using EMV chips in their cards, this permitted them
to shift liability for fraud to merchants who did not implement this more secure electronic
payment system.

V. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES [P. 446]

Key Terms [pp. 444-445]
Chapter Review Questions [pp. 446-447] Note: Answers and explanations are provided at
the very end of the chapter.

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Thinking Strategically Questions and Answers
1. Who is liable for the forged check? What is the relevant law?
• Liability for a forged check falls on the drawee bank that accepted the check. The
relevant law is the UCC.
2. Was Peggy careless in failing to secure her checks? Should that matter in the liability
determination?
• If Shandy opened a door to enter a private room, she was not careless. Leaving checks
out in the open, however, would be careless when hosting a large gathering. The UCC
does not consider these issues however to determine liability.
3. Did BankUSA rightfully or wrongfully dishonor check number 157? Explain your answer.
• The bank rightfully dishonored the check since it lacked sufficient funds. The bank has
the ability to determine which checks to dishonor due to insufficient funds.
4. Does Sarah have recourse against anyone? Who and why? What damages would she be able
to claim, if any?
• Sarah is in a difficult position since, due to no fault of her own, her paycheck has been
properly dishonored. She now faces late payment penalties and overdraft fees. Sarah can
seek recourse against Peggy for the fees and for a new paycheck that will be honored.
She can also cooperate with Peggy and her bank to seek recourse against Shandy.
5. If you were Peggy, how would you address this scenario? What safety procedures would you
advise her to take to minimize her risk in the future?
• I would keep all checks under lock and key to avoid unauthorized access and use. She
may also want to set up automatic payment through an ACH system for direct deposit to
avoid the risk of fraudulent checks.
Case Summary Questions and Answers [P. 445-445]
CASE SUMMARY 23.1 Wachovia Bank, N.A. v. Foster Bankshares, Inc., 457 F.3d 619, 60
U.C.C. 2d 1126 (7th Cir. 2006)
1. If the court had found that the check was altered through a chemical wash, which bank would
face liability?
• The chemical wash involves an alteration of the check so the depositor bank would face
liability in this case Foster Bank.
2. If the court had found that the check was forged, which bank would face liability?

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 • A forgery results in the drawee bank facing liability, in this case Wachovia bank.
CASE SUMMARY 23.2 Halifax Corp. v. First Union National Bank, 26 Va. 91, 546 S.E.2d
696, 44 U.C.C. 2d 661 (2001)
1. What duty does Section 4-406 impose on the bank customer?
• The duty to report to the bank a stolen or unauthorized signature on a check within one
year of the check being reported or made available on a statement.
2. What kind of controls should a company have in order to avoid this kind of liability?
• Companies should review bank statements carefully, preferably by someone in the
accounting and internal control area who is not the same person who is authorized to sign
checks.
CASE SUMMARY 23.3 TME Enterprises, Inc. v. Norwest Corp., 124 Cal. App. 4th 1021
(2004)
1. Who faces liability in this scenario?
• TME faces liability in this scenario.
2. Do you agree with the effects of UCC § 4A-207? Why or why not?
• This rule places a great deal of responsibility on the party making the wire transfer to
verify that it will be deposited to the right account and largely absolves the receiving
bank of liability. Arguments can be made either way on the desirability of this rule.

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 Chapter 24
Secured Transactions

CHAPTER OVERVIEW
This chapter provides an overview of the legal requirements necessary to create a secured
interest in property. Various examples will be given on techniques for creating a security
agreement, interest and ways to protect this interest through perfection.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Identify the classifications of collateral in a secured transaction. Understand
Describe the steps necessary to create a security interest. Understand
Compare the ways a security interest can be perfected. Analyze
Apply the priority rules to a scenario in which several parties have Apply
competing claims to collateral.
Explain the consequences of a borrower’s default. Understand

Teaching Tip: Secured transactions can be a nebulous concept for students to initially grasp.
Some simple and relatable examples introduced early in the lecture will go a long way to
illuminate the concept. Most students will be familiar with pawn shops or car financing and
“repo” individuals as vivid examples.

I. CLASSIFICATIONS OF COLLATERAL IN A SECURED TRANSACTION [p. 448]

It is important to first classify the type of collateral to ensure the property may be used in this
manner.

Points to emphasize:
• Secured transactions are governed by Article 9 of the UCC.
• Article 9 sets forth a classification schedule for various items of collateral.
• Table 24.1 is a useful resource to use in class with students.
• These categories are mutually exclusive and will help students later apply priority rules to
the various types of collateral.

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Answers to Quick Quiz are provided at the end of the chapter.

II. THE STEPS TO CREATE A SECURITY INTEREST [p. 451]

Two steps must be followed to create a valid security interest.

Points to emphasize:
• The first step is to create an agreement or contract with the lender that defines and creates
a security interest.
• Security interests or the property used as collateral can be narrowly defined or very
broadly defined as with a floating lien that covers future items of property.
• Leases fall outside of security agreements since under a true lease the lessor retains title
to the property during the entirety of the lease agreement and can always regain
possession of the property.
• The second step is to attach a security interest to property. This is achieved when value
has been given, the debtor has rights in the collateral (usually possession and usage
rights), and a security agreement has been executed by the parties. An oral agreement is
allowed in some jurisdictions, however, the most prudent thing to do is execute the
security agreement in writing signed by both parties.

Teaching Tip: Inform students about the protections afforded to buyers in the ordinary course of
business. This raises a potential danger to a secured lender who has a security interest in
inventory. Conversely, warn students that security interests travel with goods that are classified
as equipment and thus not purchased under the ordinary course of business.

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Case 24.1 Morgan County Feeders, Inc. v. McCormick

Facts: Morgan County Feeders (“Morgan”) signed and perfected a security agreement against
Neil Allen. The security interest included a floating lien “after acquired property clause” that
included any equipment purchased by Allen. Allen operated a dude ranch and purchased 45
longhorn cattle and one bull. He later sold the cattle to McCormick. When Allen defaulted on his
loan to Morgan, Morgan sued to take possession of the cattle. The trial court held that the cattle
were equipment under the UCC and that, because they were classified in this manner,
McCormick could not be classified as a buyer in ordinary course of business (BOCB).
McCormick appealed.

Issues: Are cattle equipment or inventory when the cattle are used principally for recreational
cattle drives.?

Ruling: When cattle are used principally for recreational cattle drives they are to be classified as
equipment. A buyer of the cattle is thus not a buyer in the ordinary course of business and the
security interest extends to the cattle.

Answers to Case Questions:

1. There is a sound basis to conclude the cattle were primarily used as equipment for the
dude ranch.
2. McCormick could have asked Allen if the cattle were subject to a security interest and
avoided the purchase altogether.
3. This question is meant to elicit critical thinking responses from the students.

III. PERFECTING A SECURITY INTEREST [p. 454]

It is important to discuss how perfecting a security interest is important to have priority over
other secured lenders who may also have overlapping security interests in the same property. For
example, some unethical business people may strategically try to obtain loans and use the same
property as a security interest for various loans. There are four main ways to perfect a security
interest to protect oneself from these overlapping claims.

IV. Perfection by Filing [p. 454]

Points to emphasize:
• Secured lenders may file a UCC-1 Financing statement with the Secretary of State where
the borrower resides.
• These typically last 5 years and may be renewed.
• Deposit accounts may not be perfected in this manner. Goods, equipment, inventory and
financial products (except deposit accounts) may be perfected in this manner. Certain
intangibles such as patents and trademarks must be perfected in this manner.

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Teaching Tip: A fun, interactive and revealing exercise may be to walk the students in class
through a UCC-1 search at the website of the Secretary of State where you reside. The
search may be to find any secured transactions in which your university is a secured lender
or borrower.

V. Perfection by Possession [p. 456]

Points to emphasize:
• This method may be used for certain tangible and movable items such as artwork or
jewelry. Financial products with a certificate may also be perfected in this manner. The
priority date is when possession occurs.

A. Automatic Perfection [p. 456]

Points to emphasize:

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 • If a merchant or lender offers financing to purchase goods a purchase money security
interest (PMSI) is created. In the consumer context this achieves automatic perfection.

B. Perfection by Control [p. 456]

Points to emphasize:
• Certain financial products and accounts (typically those without certificates) can be
perfected through control. The control is achieved through a custodian or transfer agent.

VI. PRIORITY AMONG CREDITORS’ CLAIMS TO COLLATERAL [p. 457]

Points to emphasize:
• Multiple parties may have a security interest on the same property.
• The general rule is that whoever perfected the security interest first or filed a UCC-1
statement has priority.
• The general ranking of claims is:
o PMSI
o First to perfect a security interest
o Secured lender without a perfected security interest
o Unsecured lender

VII. THE CONSEQUENCES OF A BORROWER’S DEFAULT [p. 458]

Points to emphasize:
• A borrower who breaches a contract with the lender is said to be in default.
• Lenders typically do not seek to immediately repossess the property but rather seek to
refinance or find an alternative solution.

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Case 24.2 Stephanie Ann James and Roland James v. Ford Motor Credit Co.

Facts: The plaintiffs purchased a Ford vehicle that was financed and secured by Ford. When the
plaintiffs fell behind on their car payments, Ford sent them a notice of repossession. The
plaintiffs contacted Ford and objected to any repossession efforts. On June 29, 1992, Ford’s
“repo man,” Robert Klave, took possession of the car from a public parking lot. Approximately
one hour later, Stephanie James noticed the vehicle parked with Klave in it. She entered the
vehicle, and an altercation ensured whereby James took control of the vehicle and drove away.
Klave reported the vehicle stolen, and when the authorities apprehended James on July 8, 1992,
Klave regained possession of the vehicle. James sued, claiming that her objection to the
repossession and the manner in which it was conducted resulted in an unlawful repossession
because it had breached the peace.

Issues: Is a repossession wrongful after a repo agent secures the collateral in a manner that does
not originally breach the peace?

Ruling: The property had been properly repossessed and any breach of the peace after that does
not invalidate the repossession.

Answers to Case Questions:

1. When the agent exercises dominion over the property. In this case when the agent takes
physical control of the vehicle. As long as the control of the property was properly
obtained, the secured lender will win the case.
2. Because the lender’s agent would not be in trespass at that point.
3. This question is mean to elicit critical thinking responses from the students.

Thinking Strategically Questions and Answers

1. Should Erin approve the loan based on this collateral? Why or why not?

•A strong argument can be made that the loan for $1,000,000 should not be made
based on this collateral. A real estate company is likely not going to have
extensive computer equipment and it is likely not going to be worth enough to
cover the value of the loan. If the company has proprietary software then that
might change things but more research is required.
2. Before offering the loan, what should Erin do to ensure that First Arizona Bank & Trust
will have priority with respect to this collateral?

• They should ask Kitchell if the property is used as collateral with any other
lender. To be safe they should also do a UCC-1 financing statement search in the
Arizona Department of State database.

3. Visit the Arizona Secretary of State website and conduct a UCC lien search of the state’s
publicly accessible database. Search for UCC-1 filings under the organization name

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 “Kitchell.” What did you find? How will this impact whether First Arizona Bank & Trust
will offer the secured loan? What should Erin do now?

• The website address is: https://apps.azsos.gov/apps/ucc/search/

• There are a few financing statements issued with this company as a borrower.
Two of these statements deal with equipment and one in particular deals with all
computer equipment.
• This will likely negatively impact the loan if it conditioned on this security
interest. Erin should contact Kitchell to find out if another security interest may be
provided since this one has already been perfected by another lender.

4. Erin contacts the Kitchell CFO and mentions that her bank will require another type of
collateral. The CFO mentions that Kitchell has “valuable artwork in the office and
$750,000 sitting in a low-interest- bearing money market account at Sun Valley National
Bank.” How can First Arizona Bank & Trust perfect these assets if they are used as
collateral to obtain priority over any other creditors?

• To obtain a perfected security interest in the artwork Erin should obtain

documentation that the artwork is owned by Kitchell and an independent appraisal
estimate of the art. Then she should search the UCC-1 financing statements to see
if this artwork is used as collateral. Note that the artwork is likely used a
equipment to decorate offices. So, if there are any prior UCC-1 financing
statements that broadly cover all equipment this will also extend to the artwork
and another lender will have priority and perfected a security interest ahead of
First Arizona! If none of this is an issue, Erin should file a UCC-1 financing
statement on the artwork as soon as possible and also seek to obtain physical
control of the artwork. For the deposit account, she should obtain bank statements
to verify the amount of the accounts and the ownership of the funds. Then, she
should perfect through control of the account. The best way to do this is to request
Kitchell transfer the money to a deposit account at First Arizona Bank & Trust
and restrict the use of the funds until the $1,000,000 loan is satisfactorily paid
back. Otherwise, whoever holds the deposit account as custodian or transfer agent
should be instructed to place the funs in a separate loan collateral account and
place a stop transfer order (freeze) on the funds to prevent the money from being
used in any manner not authorized by First Arizona.

Case Summary Questions and Answers

CASE SUMMARY 24.1 In re Estate of Joseph M. Silver, 2003 Mich. App. LEXIS 1389
1. What would Conti have to do for the law to consider these paintings consumer
goods?
• Conti would have to be in the business of buying and selling artwork to
consumers.

2. How could the Silver Trust have avoided this outcome?

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 • They could have searched any UCC-1 financing statements to find the one filed
by Wilson.

CASE SUMMARY 24.2 In re Pfautz, 264 B.R. 551 (W.D. Miss. 2001)

1. How can an investment product be perfected?

• Investment products can be perfected through possession (if there is a certificate)

or control (if there is no certificate). Financial products except deposit accounts
may also be perfected using a UCC-1 financing statement.

2. Did Liberty Bank perfect its security interest in the mutual fund shares? Who should get the
proceeds from the collateral and why?

• Yes, they exercised complete control over the shares since they segregated the
shares in a separate account and the transfer agent was instructed to not allow the
shares to be sold without Liberty Bank’s permission.

CASE SUMMARY 24.3 In re Piknik Products Co., 346 B.R. 863 (Bankr. M.D. Ala. 2006)

1. Was Piknik in possession of the goods even though the equipment was not operational? Why
or why not?

• Yes, when the goods were delivered to Piknik this is enough for the lender to
conclude the property is in the lender’s possession.

2. Had Crouch filed a UCC-1 financing statement within 20 days, would it have priority over
Wachovia’s security interest? Why or why not?

• Yes, the PMSI Crouch obtained would have been perfected ahead of any other
security interests had this been done.

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 Chapter 25
Creditors’ Rights

CHAPTER OVERVIEW
This chapter discusses a creditor’s perspective on sales transactions. It discusses the rights
creditors have against third parties who provide payment assurances on behalf of the debtor, the
role of liens in business transactions, and options available to creditors for collecting unsecured
debt.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the role of a personal guaranty in the context of a debtor-creditor Knowledge
relationship.
Provide examples of the rights that creditors have against sureties and Application
guarantors.
Differentiate between various types of liens. Analytical
Thinking
Explain methods available to creditors to collect unsecured debt. Knowledge

I. PERSONAL GUARANTIES [pp. 464-466]

Points to emphasize:
• A creditor may agree to allow a debtor to substitute a personal guaranty instead of
collateral to assure that a loan will be paid back if the debtor defaults on payment.
• Creditors may wish to make the debtors more accountable by securing a business loan
with both a security interest in certain collateral and a personal guaranty.
• Personal guaranties may also occur in a commercial least context. See Case 25.1.

Case 25.1 Triple T-Bar, LLC v. DDR Southeast Springfield, LLC, 769 S.E.2d 586 (Ga. Ct.
App. 2015)
Facts: In November 2006, Triple T-Bar, LLC entered into a six-year agreement to lease a
commercial property in Georgia. The lease was signed by both Todd and Barbara Blackwell
(Blackwells) as officers of Triple T-Bar, and the Blackwells were identified in the lease as the
guarantors. Their personal guarantees were attached to the lease and incorporated into the lease.
During the 2nd and 3rd year of the lease, Triple T-Bar failed to pay rent and then made its last rent
payment in October 2008. Triple T-Bar closed in businesses in February 2009 and vacated the
premises without the landlord’s consent. The landlord filed suit against Triple T-Bar and the
Blackwells and the trial court ruled in favor of the landlord. The Blackwells appealed arguing
that the guarantee was incomplete (no date) and the Blackwells did not intend to be personally
liable for the lease.
Issue: Were the Blackwells liable as guarantors?

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Ruling: The Court of Appeals of Georgia affirmed the ruling of the trial court against the
Blackwells holding that the lease and guarantee identified the Blackwells as the guarantors and
the guarantee induced the landlord to enter into the lease with a business that had no assets at the
time.
Case Questions
1. The court points out that the guaranty served as an inducement for the landlord to enter into
the agreement. What does the court mean by that and why is it important?
• At the time of the lease, Triple T-Bar did not have any assets to serve as collateral for the
lease. Without the personal guarantees of the Blackwells, the landlord likely would not
have entered into the lease agreement.
2. Why did the court reject the Blackwell’s argument that the lack of a date on the guaranty
made it invalid?
• The guaranty was incorporated into the lease which was dated.
3. Focus on Critical Thinking: Could the Blackwells have strategically negotiated terms of the
lease that could have either prevented or limited any liability? What language would you suggest
that may accomplish that?
• The Blackwells could have avoided personal liability by not personally guaranteeing the
lease. They could have included language in the contract that would allow the landlord to
share in future profits and/or later acquired assets.

II. RIGHTS AGAINST THIRD PARTIES [p. 466]

Points to emphasize:
• A creditor may also permit a debtor to secure a loan by asking a third party to back up the
promises made by the debtor regarding repayment of the loan.
• When a party agrees to be primarily liable (e.g., creditor doesn’t have to go after debtor
first) to pay the loan, she is known as a surety.
• When a party agrees to be liable only if the debtor actually defaults, she is known as a
guarantor.

Defenses [p. 467]

• Surety/guarantor agreements are a form of contract.
• Sureties/guarantors are entitled to assert defenses that would relieve them of payment
liability. The surety/guarantor not only can have defense against the creditor directly,
they can assert any defenses the debtor has on the underlying contract.
• Under the statute of frauds, surety/guarantor agreements must be in writing.

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 Teaching Tip: Guarantors
Use a simple example to which students can relate. If a student rents an apartment, the
landlord usually requires their parent to be a guarantor because the student lacks
creditworthiness. If the student cannot pay the lease, the landlord can collect from the parent.

III. LIENS [p. 467]

A lien is an interest in property that gives the holder of the lien the right to possession of some of
the debtor’s property if the debtor fails to perform its obligation (e.g., fails to pay back a loan).

A. Judicial Liens [p. 467]

Points to emphasize:

• A judicial lien is one that arises from a judicial proceeding, most commonly a lawsuit filed
by a creditor.
• A judgment by a court is judicial recognition that the creditor is owed a certain sum of
money by the debtor. The judgment must be executed to obtain the lien.

B. Statutory Liens [p. 468]

Points to emphasize:

• A statutory lien is a lien on a debtor’s property authorized by a state statute or, less often,
state common law.
• The most common statutory liens are statute statutes that provide contractors and
subcontractors who work on real estate an interest in the labor and materials used to improve
the property.
• State statutes also offer parties that provide service and materials to repair equipment with a
statutory lien of the repaired real/personal property (e.g., a mechanic could get a lien on a car
if a customer did not pay for the repairs).
• See Figure 25.1 for a sample of a statutory lien.

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 C. Fraudulent Liens [p. 468]
Points to emphasize:

• Many states statutes include penalties (actual and punitive damages) for creditors that file
fraudulent liens.
• Fraudulent liens include a creditor filing a lien (1) for an amount that exceeds what the
property owner actually owes or (2) for work that was not actually performed on the
property.
• Case 25.2 in an example of a fraudulent lien claim.

Case 25.2 Father & Sons Home Improvement II, Inc. v. Stuart, 2016 IL App 143666
(ILL. App. Ct. 2016)
Facts: Stuart entered into a written construction agreement with Fathers & Son for
construction of a deck, garage, and basement in his home. Eight months before construction
was completed, Fathers & Son filed lien with an affidavit signed by the president of the
company stating the project was complete and Stuart owned $2,700 for extra work. The
balance of the lien was $46,200. Fathers & Son filed a lawsuit and signed admitted the work
was actually completed in June 2010 and not September 2009, as the sworn and signed
affidavit attached to the lien attested. Stuart asked the court to dismiss the case arguing that
Father & Son committed constructive fraud by mispresenting the work performed and the
amount due at the time the lien was recorded. The trial court ruled in favor of Stuart and
dismissed the case. Father & Son appealed.
Issue: Did Father & Sohs commit constructive fraud by misleading in its mechanic’s lien and
other documents?
Ruling: The Court of Appeals for Illinois affirmed the lower court’s holding in favor of
Stuart. The court held that while the overstatement is not sufficient regarding constructive
fraud, the sworn and signed affidavits containing intentionally false information are.
Case Questions
1. What conduct did the court consider to be evidence of constructive fraud?
• The signed and sworn affidavits by the officer of the company containing false
information.
2. What role did the “Final Completion Certificate for Property Improvements” play in this
case?
• The affidavit attached to lien stated the project was completed on September 2009;
however, the last certificate was not signed until May 2010. They are evidence that
the president lied in the affidavit.
3. Focus on Critical Thinking. Should Stuart be entitled to damages from Father & Sons as a
result of the fraudulent lien? Should he be awarded attorney fees? Explain.

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 • Stuart should be entitled to his out-of-pocket expenses; he should be made whole.
Some states allow the awarding of attorney’s fees; some do not. The court could also
award punitive damages to Stuart which are intended to punish the other party and
deter similar future behavior.

D. Consensual Liens [p. 471]

Points to emphasize:
• A consensual lien is created when the owner of property grants a line to a creditor.
• A consensual lien attached to personal property is called a security interest and is
governed by Article 9.
• A consensual lien attached to real estate that is being used to collateralize the loan allows
a creditor to take an interest in the collateral through the use of a mortgage.
• A mortgage is a written document that specifies the parties and the real estate and is filed
with a state and/or local government agency, thereby becoming a public record that gives
notice to other parties that there is a lien of the property.
• The creditor is the mortgagee; the borrower is the mortgagor.

IV. COLLECTING UNSECURED DEBTS [p. 472]

Unsecured debts are not tied to any collateral.

A. Obtaining and Enforcing a Judgment [p. 472]

Points to emphasize:

• The process for collecting an unsecured debt begins with the plaintiff creditor filing a
complaint to start the judicial process. Obtaining the judgment is the first step.
• A judgement proof defendant is one that is without any assets or one whose assets are
statutorily outside the reach of the creditor.

B. Garnishment [p. 473]

Points to emphasize:

• A judgment creditor has obtained a judgement against the debtor and is now entitled to
enforce the judgement.
• Without any collateral, the creditor can look for other assets, such as cash, which can be
reached through the process of garnishment. A garnishment document is served on a third-
party holding funds belonging to the debtor. It directs the third party (e.g., bank) to pay the
judgment creditor rather than the debtor that own the account.
• Some states allow garnishment of wages.

C. Levy [p. 473]

Points to emphasize:

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• A levy is a court order that authorizes the sheriff to take possession of the defendant’s
(debtor’s) personal property on behalf of the judgment creditor in order to preserve the
property from being transferred or sold by the debtor.
• If the property is real estate, the sheriff (or in some states the judgment creditor) files notice
with the county recorder of deeds.
• Many states exempt real estate (up to a certain dollar value) used by the debtor as a primary
residence from levy.

D. Discovery [p. 473]

Points to emphasize:

• To assist the judgment creditor in her efforts to collect the judgment, she is entitled to
conduct discovery.
• Discovery involves having the debtor testify under oath to discover (1) what assets the debtor
owns and (2) the location of the assets.

E. Sale of Property [p. 473]

Points to emphasize:

• At a sheriff’s sale the sheriff can sale the levied property. Notice of the sale is typically
published in the local newspapers and online and is held as an auction.
• If the auction does not produce enough revenue to pay off the debt, the creditor continues to
search (or wait) for assets and must levy any real property as they become know to the
judgment creditor.
• If the auction produces more money that required to pay the judgment, the surplus goes to the
debtor.

F. State Exemption Laws [p. 474]

Points to emphasize:

• State statutes on garnishment and levy provide certain exemptions that place assets (related
to the safety and well-being of the debtor) outside the reach of an unsecured judgment
creditor.
• The most common full exemption is the debtor’s primary residence.
• State statutes provide partial exemptions (up to a certain dollar value) for items such as cars,
furniture, clothing, and designated retirement funds.
• Case 25.3 considers an exemption question.

Case 25.3 Roup v. Commercial Research, LLC, 349 P.3d 273 (Colo. 2015)
Facts: Commercial Research, LLC (Commercial) filed a judgement they obtained against
Roup in a Colorado court and began collection proceedings against Roup’s assets. One asset
of Roup’s was an HSA that Roup claimed was exempt from attachment or garnishment
because it was a retirement plan. Under the Colorado statute, retirement plans are exempt

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 from levy and sale. The trial court ruled in favor of Commerical ruling that the HSA was not
a retirement plan. Roup appealed.
Issue: Was the HSA an exempt asset?
OpinionRuling: The Colorado Supreme Court upheld the trial court’s decision holding that
an HSA is not a retirement plan using the plain and ordinary meaning of a retirement plan.
Case Questions
1. According to the court, what is the difference between an HSA and a retirement plan?
• An HSA allows individuals to defer income on a tax-exempt basis to pay medical
expenses. A retirement plan is a systematic arrangement established by an employer
for guaranteeing an income to employees upon retirement.
2. How did the court “apply the principles of statutory construction” in this case?
• The statute did not define “retirement plan” so the court used the plan and ordinary
meaning of a retirement plan.
3. Focus on Critical Thinking: If the underlying policy goal for exemptions is a protection
of the debtor’s safety and welfare, how does this decision square with that goal? Aside from
the retirement plan exemption, should HSAs be exempt? Why or why not?
• If the legislative intent in Colorado was to exempt HSAs, it would have included
them in the statute. Some states do exempt HSAs for the protection of the debtor’s
safety and welfare.
Key Terms [p. 476]
Chapter Review Questions [p. 478-479] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 475-476]

1. Try to find the lien statute in your state. It may be as simple as using your favorite search
engine to locate a “lien law.” Who is covered by that statute? What terminology do they use (i.e.,
mechanic’s lien, construction lien, or artisan’s lien)?
• A great source to share with students is www.lienitnow.com. It provides the full lien law
for all 50 states and allows them to compare such things as: 1) the name of the law in
their state, 2) who is covered and who is not (e.g., only certain subcontractors are
eligible), 3) the prohibition and consequences of filing a false claim.
2. Statutory liens often center on construction projects, but many states have lien laws for a
broader range of providers. Besides contractors, what types of providers might also have the
right to file a lien?

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 • States vary, but common ones include innkeepers, auto mechanics, suppliers of raw
materials for construction, storage space owners (or any space leased by a customer to
store equipment), furniture repair, landscapers,
3. Suppose that you’re a provider and the owner objects to you filing a lien. Are there any
alternatives that may help assure payment?
• The best way to assure payment in lieu of a lien is to use a secured transaction (if
collateral is available) or to use an unsecured promissory note for the debt owed (if no
collateral is available). The downside risk is that the creditor/provider will have to go
through the process for collecting the debt (obtain judgment, garnishment, levy etc).

Case Summary Questions and Answers [pp. 477-478]

CASE SUMMARY 25.1 Anthony DeMarco & Sons Nursery, LLC v. Maxim Construction
Service Corp., 130 A.D.3d 1409 (N.Y. Sup. Ct. App. Div. 2015)
1. Is this case of a fraudulent lien? Explain.
• Although there is not a specific part of the state statute that defines fraudulent liens, the
New York Lien Law allows beneficiaries of the statute, such as unpaid contractors or
subcontractors, to demand a verified statement of the trust, itemizing all monies it has
received and all monies it has spent on the project. In this case, the court ruled that the
contractor’s verified statement failed to set forth the dates and amounts of the trust assets
receivable, trust accounts payable, trust funds received, or a sufficiently detailed
breakdown of the total amount of payments made with trust funds, all of which are
required under the statute.
2. What options did LeChase have once DeMarco filed the lien?
• If the contractor’s verified statement fails to fully account for the funds it received on the
project, there is a statutory presumption of a wrongful diversion of assets, thereby
exposing the contractor to liability for the unpaid amount of the subcontractor’s claim.
CASE SUMMARY 25.2 On the Level Enterprises, Inc. v. 49 East Houston LLC, 2013 NY Slip
Op. 01614 [104 A.D.3d 500]
1. Does the fact that McGrath could not support many of the charges render the lien invalid
automatically? Why or why not?
• This case was a motion to dismiss LLC’s claim against McGrath and the court ruled in
favor of the LLC. They held that the LLC's failure to prove conclusively that McGrath
willfully exaggerated its lien did not require dismissal of its cross claim pursuant to lien
statute since McGrath likewise failed to establish that it did not willfully exaggerate the
lien. McGrath was unable to support many of the charges appearing on the mechanic
lien's breakdown list. Given the foregoing, a determination as to whether McGrath's

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 exaggeration of the lien was due to its principals' willfulness, versus their ignorance,
should be left to a trier of fact.
2. What kind of evidence would McGrath need to supply to support his lien claim?
• The court pointed out that there were no affidavits from either of McGrath's two
principals. This could help establish that they bore no ill will when they calculated the
lien and that any errors were the result of ignorance or honest mistake.
CASE SUMMARY 25.3 Assevero v. Rihan, 144 A.D.3d 1061 (App. Div. Sup. Ct. of NY 2016)
1. Who prevails and why?
• Assevero prevails on the personal guaranty by Rihan. The court ruled that the evidence
Rihan submitted demonstrated that his failure to submit the affirmation of a witness,
which indicated that he had erroneously signed the personal guarantee, constituted mere
neglect, which cannot be accepted as a reasonable excuse.
2. Is Assevero a secured creditor? Explain.
• Assevero is a secured creditor to Home Pros as evidenced by a mortgage note. As a
practical matter, since Home Pros defaulted on the payments, Assevero had only the
personal guaranty of Rihan as a recourse to recover money owed by Home Pros under the
note.
CASE SUMMARY 25.4 Barrie-Chivian v. Lepler, 87 Mass. App. Ct. 683 (2015)
1. Who prevails and why?
• The court ruled in favor of Barrie-Chivian. They held that the fact that Lepler’s personal
guaranty assurances were not reduced to writing did not prevent Barrie-Chivian from
prevailing based on the statute of frauds. The court applied the doctrine of promissory
estoppel whereby “a party may be estopped from asserting the Statute of Frauds defense
if, through its own representations or conduct, it induces detrimental reliance.”
2. Why is the statute of frauds so important in resolving this dispute?
• While admitting that he had made the promises, Lepler argued that they were
unenforceable under the statute of frauds, which requires certain types of agreements,
such as wills, contracts for the sale of land, and personal guarantees, to be in writing or
otherwise the contract is unenforceable.

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 Chapter 26
Bankruptcy and Alternatives

CHAPTER OVERVIEW
When a business venture no longer has adequate assets to maintain its operations and can no
longer pay its bills as they become due in the usual course of trade and business, it is considered
insolvent. This chapter covers the options in dealing with the venture’s debts.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain how the Bankruptcy Code is organized and the effect of the Application
automatic stay
Articulate the steps in a Chapter 7 liquidation bankruptcy Application
Differentiate between Chapter 7 and Chapter 11 of the Bankruptcy Code Knowledge
Describe the process of a Chapter 13 filing and the impact of the means test Knowledge
on the debtor
Describe the process of a workout and the role of a turnaround advisor as an Knowledge
alternative to bankruptcy.
Explain why an assignment for the benefit of creditors or an out of existence Application
filing are alternatives to bankruptcy.

I. BANKRUPTCY CODE [p. 481]

Points to emphasize:
• There are circumstances when a debtor’s best alternative is to file for protection under
one of the chapters of the bankruptcy code.
• Congress amended the Bankruptcy Code in 2005 with the Bankruptcy Abuse Prevention
and Consumer Protection Act, which imposed additional requirements on those seeking
protection under the Bankruptcy Code.

A. Automatic Stay [p. 481]

Points to emphasize:
• Once a bankruptcy petition is filed, an automatic stay is issued prohibiting creditors
from continuing or initiating debt collection activities against the debtor or her property.
• This is a great relief to the debtor as all lawsuits, collection calls, and foreclosure actions
are halted.

B. Bankruptcy Trustee [p. 481-482]

Points to emphasize:

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 • The Bankruptcy Code provides for the appointment of a bankruptcy trustee in certain
cases: (1) Chapter 7 - where the debtor seeks liquidation and discharge of debts and (2)
Chapter 13 - where the debtor is a consumer attempting to repay much of the debt over a
period of time.
• The trustee collects the debtor’s available assets, known as the bankruptcy estate, which
it then liquidates for cash to make distributions easier.
• Voidable transfers are transfers made by the debtor which give an unfair advantage of
one creditor over another. For example, a preferential transfer occurs when the debtor
makes a payment to satisfy a prebankruptcy petition debt to a creditor within 90 days
before filing the petition. The trustee may void these transactions and force the creditor to
return the asset to the bankruptcy estate.

II. CHAPTER 7: LIQUIDATION [p. 483]

In a Chapter 7 bankruptcy, the debtor’s property is liquidated, and the cash is distributed to
creditors. The debtor’s remaining debts are then discharged.

A. Bankruptcy Petition and Stay [p. 483]

Points to emphasize:
• A voluntary bankruptcy petition is filed by the debtor and includes the names of
creditors; a list of debts; and a list of the debtor’s assets, income, and expenses.
• An involuntary bankruptcy petition is one that is filed against a debtor by a group of
three or more creditors with an unsecured aggregate claim of at least $15,775 who claim
that the debtor is failing to pay the debt as it comes due.

B. Order for Relief and Trustee Appointment [p. 483]

Points to emphasize:
• After the petition for bankruptcy is filed, the court determines its legitimacy, an order for
relief is granted, the automatic stay becomes permanent, and an interim trustee is
appointed.
• At the first creditor’s meeting, a permanent trustee is appointed, and the bankruptcy
estate is created. The trustee represents the court, not the debtor or creditors.

C. Creditors’ Meeting and the Bankruptcy Estate [p. 483]

Points to emphasize:
• Within 30 days of the order of relief, the court calls for a meeting of creditors. The debtor
(usually along with an attorney) must appear and submit to questioning by the creditors
regarding the debtor’s assets, financial affairs, and any attempt to conceal assets or
income.
• The trustee then collects all of the property which constitutes the bankruptcy estate (that
which was owned by the debtor at the time of the filing, not any after-acquired assets).

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 • The Trustee will separate exempt and nonexempt property, recover any improper
transfers of funds before or during the filing of the petition, sell or otherwise dispose of
the property, and finally distribute the proceeds to creditors.
• In a Chapter 7 bankruptcy, the debtor is allowed to retain exempt assets – property that
by law are not included in the bankruptcy estate such as a certain amount of equity in the
debtor’s residence depending on state law – this is known as a homestead exemption.

Case 26.1 Kelley v. Cypress Financial Trading Co. [p. 484]

Facts: An investor in a Ponzi scheme was paid $11.4 million by PCI. After PCI filed for
bankruptcy, Kelley, the bankruptcy trustee, sued Cypress to recover the $11.4 million as a
fraudulent transfer. Cypress then filed a petition for bankruptcy itself.

Issue: Could Cypress legally file for bankruptcy protection?

Ruling: No, (1) the first pillar of bankruptcy protection – the discharge of the debtor – could not
be achieved because as a corporation, Cypress could not obtain a discharge from a Chapter 7
filing. (2) the second pillar of bankruptcy – the satisfaction of valid claims against the estate –
could also not be obtained because Cypress had no assets. Thus, Kelley’s motion to dismiss the
Cypress bankruptcy filing was affirmed.

Case Questions:

1. Why did Kelley believe that Cypress acted in bad faith?

• Because there was no legitimate reason to file for Cypress to file for bankruptcy, the only
effect it would have would be to delay and frustrate the PCI bankruptcy case of which
Kelley was the trustee.

2. Why did Kelley sue Cypress in the first place?

• Kelley sought to obtain the funds stolen by PCI and given to Cypress from whomever the
funds ultimately went to (possibly the owners of Cypress).

3. Focus on Critical Thinking: Isn’t Cypress a victim here? If there was no indication that
Cypress knew that Petters was running a Ponzi scheme, should it be held responsible for paying
back any money it received? Is it fair to the other investors who lost all of their money in the
scheme if Cypress is allowed to keep the money it received?

• These questions are designed to elicit a discussion on the purpose how fraudulent
transfers play into a bankruptcy and what bankruptcy law is actually intended to do and
whom it protects.

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 D. Distribution and Discharge [p. 485]
Points to emphasize:
• Once the trustee has administered the bankruptcy estate, the trustee then distributes the
proceeds to creditors in an order of priority set by the Bankruptcy Code.
• Secured creditors are paid first and in full so long as the value of the collateral equals or
exceeds the amount of their security interests. Unsecured creditors are paid from the
remaining proceeds if any.
• Some debts are considered nondischargeable, such as claims for federal state or local
taxes. See Table 26.1.

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III. CHAPTER 11: REORGANIZATION [p. 486]
In a Chapter 11 bankruptcy, temporary protection from creditors is provided to a corporation
while the corporation continues its business while planning how its debts can be paid.

A. Debtor in Possession [p. 486]

Points to emphasize:
• Similar to Chapter 7, a Chapter 11 petition is filed either voluntarily or involuntarily; the
automatic stay provision is triggered; and, if the petition is proper, the order of relief then
sets the reorganization process in motion.
• Unlike a Chapter 7 proceeding, the debtor generally continues to operate the business in a
Chapter 11 case.
• This process, known as debtor in possession (DIP), gives great power to the debtor to
rehabilitate the business entity because of the automatic stay.

B. Strong-Arm Clause [p. 486]

Points to emphasize:

• A huge advantage in a chapter 11 filing is that the DIP has the power to void prepetition
preferential payments and to cancel or assume prepetition contracts (including leases,
supplier contracts, and service contracts).
• The so-called strong-arm clause of the Bankruptcy Code allows the DIP to avoid any
obligation or transfer of property that the debtor would otherwise be obligated to perform.

Teaching Tip: Famous Chapter 11 cases

While filing for chapter 11 is not guarantee of the continuation of the corporation, such as in the
case of Enron and WorldCom, there have been a number of high-profile come-back stories that
students most likely have heard of that can be used as examples: Marvel Entertainment in 1996,
Six Flags in 2009, Sbarro in 2011 and 2014.

C. Reorganization Plan [p. 487]

Points to emphasize:
• A reorganization plan is usually filed by the debtor and contains its plan to come back
from its financial distress.
• Creditors are given the opportunity to accept or reject the plan, but if they reject the plan,
the Bankruptcy Code allows the debtor to request that the court force the creditors to
accept the plan (the wording in the code is known as the cram-down provision).
• If the plan is fair and feasible, the court will usually affirm it. In some cases, however, the
Chapter 11 is converted to a Chapter 7 and the company is then liquidated.

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IV. CHAPTER 13: INDIVIDUAL REPAYMENT [p. 487]
In a Chapter 13 bankruptcy if the debtor has a regular source of income, all collection
activities are stayed which may permit the debtor to catch up on its payments. The debtor keeps
his or her assets and agrees to a repayment plan that can be achieved based on their income. The
paycheck goes to the trustee and the trustee pays off the creditors usually over a five-year period.

A. The Fraud Exception [p. 487]

Points to emphasize:
• The Bankruptcy Code contains a fraud exception which prevents debtors from
abusing the system by preventing debts obtained by fraud from being discharged.

Case 26.2 Sauer Inc. v. Lawson (In re Lawson) [p. 487]

Facts: In anticipation of a state court judgment of $168,351 for a debt owed to Sauer, James
transferred $100,150 to an LLC formed by his daughter Carrie, who then transferred $80,000
from the LLC to herself. Shortly thereafter, James filed for bankruptcy. Sauer then sued the LLC
and Carrie and won a judgment for the monies transferred. Carrie then filed for bankruptcy.
Sauer filed an objection to the discharge of the judgment under the fraud provisions of the state
bankruptcy code in Carrie’s bankruptcy case.

Issue: Is it a fraudulent transfer if the transferee (Carrie) knew it was a fraudulent transfer but
did not herself make any fraudulent misrepresentations in the transfer?

Ruling: Yes, a fraudulent misrepresentation by a debtor to a creditor is not an essential element

of a fraudulent transfer. Her actions constituted actual fraud in that she intended to cheat Sauer of
its judgment.

Case Questions:

1. Why did the trial court dismiss Sauer’s adversary proceeding that objected to the discharge of
Ms. Lawson’s debt?

• The trial court misapplied that requirements of the fraud provisions to require that
Carrie made a fraudulent misrepresentation to Sauer, which she did not.

2. How did the legislative history of the Bankruptcy Code affect the court’s decision?

• Because the Bankruptcy Code was amended to both actual fraud and false
representations as grounds for denying a discharge, fraudulent intent can be inferred
from Carries’ actions and did not require an actual representation on her part.

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3. Focus on Critical Thinking: Could there be any legitimate and ethical reason for the transfers?
Why or why not? If the appellate court had agreed with the trial court that fraud cannot exist with
misrepresentation, what ethical considerations might be triggered?

• These questions are designed to elicit a conversation regarding under what

circumstances transfers can be made in anticipation of a judgement and what
constitutes fraud.

V. WORKOUTS [p. 429-431]

Points to emphasize:
• When a business defaults on a secured loan, the bank may foreclose on its collateral or
file a lawsuit against the business to collect the amount owed.
• When the business agrees to a plan to repay the creditor, this is known as a workout.
• In a workout, creditors are normally repaid through one or more of the following sources:
(1) future cash flow, (2) new financing, or (3) equity infusion, with future cash flow
being the most preferable.

B. Turnaround Advisors [p. 429-430]

• A turnaround advisor (TA) (also called a turnaround manager or turnaround
professional) is an individual or group of individuals who assist management in the
workout process.
• The hiring of a TA may be required as part of a workout or as an interim executive who
stays only as long as needed to achieve the turnaround.
• TA firms typically use a five-stage process to define the problem and pursue a solution:
(1) evaluating and assessing the organization, (2) resolving acute needs, (3) restructuring
internal and external causes of insolvency, (4) stabilizing financial and human resources,
and (5) revitalizing the organization.

C. Workout Models [p. 430]

• A retrenchment model involves a wide range of short-term actions intended to stabilize
the company as quickly as possible. Retrenchment centers on strategically reducing the
scope and size of the business’s operations (selling assets; focusing its efforts on smaller,
profitable markets; shrinking the labor force; and developing outsourcing processes).
• A replacement model in when top-level management is replaced with an interim team
while a search for new top-level managers is conducted. This is used when the TA
concludes that the established leaders do not recognize that a change in the business
strategy is necessary to keep the company viable.
• The renewal model involves significant restructuring of the business’s organizational
chart and a specific focus on removal of inefficient practices and using resources for
innovation.

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 D. Workouts versus Bankruptcy [p. 430]
A workout is often an effective tool in preventing creditors from taking legal action against the
business in exchange for a partial or complete repayment of the delinquent debt. A significant
disadvantage to a workout, however, is that the business has no ability to involuntarily bind any
unwilling creditor that may refuse to consent to the workout plan.

VI. ASSIGNMENT FOR THE BENEFIT OF CREDITORS (ABC) [p. 431-435]

Points to emphasize:
• Either as part of a workout plan or as a stand-alone transaction, another alternative to a
bankruptcy filing is an assignment for the benefit of creditors (often called an ABC).
• When a business venture can no longer meet its debts, its options are: (1) reorganization
under the bankruptcy code, (2) liquidation bankruptcy, or (3) ABC.
• An ABC can be an alternative in certain cases to overcome a short-term cash crunch
when a business may still be viable in the long term.

Assignment Agreement [p. 431]

• The first step in ABC involves the business and the creditor (as assignee) entering into a
formal assignment agreement.
• The company provides the assignee with a list of creditors, shareholders, and other
interested parties.
• The assignee then gives notice to any creditors of the assignment, setting a bar date for
filing claims with the assignee that is between five and six months later.
• If a claim is not filed before the bar date, the claim normally will be disallowed.

CASE 26.3 Akin Bay Company, LLC v. Von Kahle, 180 So.3d 1180 (Fla. Ct. App. 2015)
Facts: In 2012, ItalKitchen hired Akin Bay as its financial adviser in connection with its
restructuring. ItalKitchen executed an assignment for the benefit of creditors (“ABC”) in favor of
Von Kahle as assignee. Pursuant to the assignment, Von Kahle took possession of all the assets
of ItalKitchen, which included all claims and demands that ItalKitchen had against third parties.
In 2014, Von Kahle filed a lawsuit against Akin Bay alleging that it had breached its fiduciary
duty to ItalKitchen and that Akin Bay had been the recipient of fraudulent transfers by
ItalKitchen prior to the date of the ABC. Von Kahle filed a motion to dismiss alleging that the
ADR clause was unenforceable because (1) he was not a party to the Akin Bay-ItalKitchen
agreement and (2) the claims alleged in the complaint did not “arise out of or relate to” the
agreement executed by Akin Bay and ItalKitchen. The trial court held in favor of Von Kahle, and
Akin Bay appealed.
Issue: Was Von Kahle bound by the agreement between ItalKitchen and Akin Bay?

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Ruling: Yes, the appellate court reversed the trial court’s dismissal. “The assignee stands in the
shoes of the assignor for this purpose. For this reason, with minor exceptions prescribed by the
statute, the assignee cannot stand in any better position than his assignor. Accordingly, the
mediation and arbitration clause in the agreement in this case is enforceable against Von Kahle
despite the fact that he was not a signatory to the agreement”

Case Questions
1. What was the basis for Von Kahle’s lawsuit in the first place?
• Von Kahle filed a lawsuit against Akin Bay alleging that it had breached its fiduciary
duty to ItalKitchen and that Akin Bay had been the recipient of fraudulent transfers by
ItalKitchen prior to the date of the ABC.
2. What does the court mean that Von Kahle “is in no better or worse position than his
assignor”? Why is that important to the case?
• Von Kahle could allege no rights as assignee than the assignor would have. This is
important because Von Akin was not a signatory to the Akin Bay and ItalKitchen
agreement.
3. Focus on Critical Thinking: The court points out that the state legislature could have limited
the ability of third parties to assert their contractual right to enforce arbitration clauses during the
assignment for benefit of creditors’ liquidation process but did not. As a matter of fairness,
should the state legislature limit the rights of the parties in connection to arbitration? Should the
legislature reform any other part of the ABC process? Explain.
• This question is meant to elicit a discussion of fairness in ABC assignments.

E. Distribution [p. 493]

• Upon resolving all claim disputes, the assignee distributes the funds first to any creditor
that has a valid lien on assets, second to pay the fees and costs associated with
administering the transaction, and third to pay priority unsecured creditors.
• Any cash remaining is distributed back to pay the owners of the business.
• If the funds are not sufficient to pay a particular class of creditors in full, the creditors in
that class receive pro rata payments, and the classes junior to that class (e.g., unsecured
creditors) do not receive payment.
The following figure 26.1 demonstrates the timeline.

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 F. ABC Statutory Requirements [p. 493]
While some states, such as New Jersey, require a filing with a state court or state agency to either
initiate or complete an ABC, others, such as California and Florida, do not. Given the speed at
which a nonjudicial ABC can be done, it can permit a going concern (i.e., a business still
operating) sale to be achieved. States use judicial oversight to be sure that no favored creditor is
paid at the expense of other creditors.

CASE 26.4 Penske Truck Leasing Co. v. Cool Trans NJ, LLC, and Bierman, No. A-3684-
14T4 (N.J. Super. Ct. App. Div. 2016)
Facts: Bierman was the owner of Export Transportation Co (Export) which leased trucks from
Penske. After Export failed to make required lease payments, Penske filed a suit against Export
and obtained a $548,028.51 default judgment. According to its ABC agreement, Export had
dozens of other creditors and was over $2.5 million in debt. In November 2013, Bierman formed
Cool Trans NJ, a single-member limited liability company which served many of Export’s
former clients. As part of the ABC agreement, Bierman prepared a “verified inventory and list of
creditors,” which listed Penske’s judgment against Export as a debt of the corporation. Bruck, as

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10
assignee, provided notice of the filing to Penske. Once Bruck had completed the statutory
requirements of an assignee, he submitted a proposed settlement agreement to the appropriate
state court, which approved it in 2015. Penske then filed a complaint against Bierman and Cool
Trans arguing that the settlement agreement should not have been approved and seeking to hold
Bierman and Cool Trans liable to Penske for the judgment it held against Export. Penske
appealed.
Issue: Were Bierman and Cool Trans successors to Export and could the settlement agreement
be set aside due to breach of fiduciary duty and fraudulent transfer?
Ruling:. No, the trial court’s ruling was affirmed. The court pointed out that under the state ABC
statute, the assignee has a dual capacity. First, the assignee stands in the shoes of the assignor
with general powers to act in his stead as successor. Second, the assignee also represents the
assignor’s entire creditor constituency. Bruck, the assignee, followed the statutory procedure and
made a reasonable calculation about the best method for preserving and distributing the assets.
Thus, Penske’s complaint was barred by the assignment for the benefit of creditors statute. The
settlement of all claims for $50,000 was reasonable under the circumstances.

Case Questions
1. Why did Penske object to the settlement that was proposed by the assignee?
• Penske objected to the $50,000 settlement as it was only a fraction of what was owed.
2. What were some of the reasons that Bruck as assignee chose to settle with “only a fraction of
the possible claims against Bierman and Cool Trans”?
• The business entities had little or no assets, it would save the cost of litigating its possible
claims and defending against Bierman’s claims, and would deter Bierman and the
business entities from initiating a bankruptcy proceeding, all of which would jeopardize
the ability of the creditors to recover anything from Export’s assets.
3. Focus on Critical Thinking: Why do you think that Bierman formed Cool Trans when he did?
Was Bierman’s conduct ethical? Is he using the ABC law as a shield against his own
misconduct? Explain.?
• This question is meant to elicit a discussion on the ethics of ABC transactions.

G. Shareholder and Director Approval [p. 495]

• As a matter of corporate law, businesses require both board and shareholder approval for
an ABC because it involves the transfer to the assignee of substantially all of the
corporation’s assets.
• This makes ABCs impractical for publicly held corporations and for privately held
corporations with a large number of shareholders.

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11
 • Because there is no automatic stay in an ABC, creditors may still pursue their claims.
• The realistic prospect of a buyer in the near term may influence whether our hypothetical
company should choose an ABC or another approach because the assignment process
removes from the board of directors and management of the troubled company the
responsibility for and burden of winding down the business and disposing of the assets.

VII. OUT OF EXISTENCE [p. 496]

Points to emphasize:
• Out of existence (also known as the “lights-out option”) is a nonstatutory option in
which a venture simply ceases operations without paying creditors.
• Creditor may pursue a debt collection lawsuit to collect any available cash or assets to
satisfy the debt and some states require that all creditors be notified before the business.
• If the debtor has no assets, no personal guaranties exist, and the debt is not substantial
enough to make legal methods to collect economically viable for creditors, the lights-out
option is the quickest and least expensive option.

Teaching Tip: Personal Guarantees

It may be helpful to explain how personal guarantees would impact the choice of a workout,
assignment for the benefit of creditors (ABC) or an out-of-existence option. Any guarantors of
the debts of the business would still be liable for the debts. Out of existence is a particularly
dangerous option if the debt has been secured through a personal guaranty by principals of the
business (discussed earlier). However, if the debtor has no assets, no personal guaranties exist,
and the debt is not substantial enough to make legal methods to collect economically viable for
creditors, the lights-out option is the quickest and least expensive option.

Figure 26.2 is a sample of an out-of-existence certificate required by state authorities.

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 Source: Pennsylvania Department of Revenue

VIII. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [P. 499]

Chapter Review Questions [P. 502-503] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [P. 498-499]

1. What are some scenarios where a CTP or CTA might be brought in to assist a company?
• Scenario 1: A business has a solid business model but lacks the financial expertise to
fully execute it and runs short on cash. Scenario 2: The business has future revenue
expected but is short on cash and cannot pay its creditors as bills become due. Scenario 3:
The business model is solid, but the management team is not able to execute the business
operations because management lacks the experience or expertise to lead. Scenario 4:
Lenders are pressuring the business to make changes as a condition of renegotiating a
loan or obtaining a new loan.

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2. Use your favorite search engine to find the Turnaround Management Association’s website.
What specific services do CTPs provide? What is the difference between a CTP and a CTA?
• The Certified Turnaround Professional (CTP) and Certified Turnaround Analyst (CTA)
distinctions are objective measures that show the holder possesses the experience,
knowledge, and integrity necessary to conduct corporate renewal work. They provide
services such as:
• Assessing and Changing Management
• Analyzing the Situation
• Implementing an Emergency Action Plan
• Restructuring the Business
• Bridge back to a Return to Normal
3. Look up a turnaround firm using the TMA’s database. What types of services do they
provide? What kinds of backgrounds, education, and certifications do their CTP/CTAs have
(e.g., accounting, law, financial)?
• According to their website, CTP/CTAs come from various areas of professional fields:
• 43% - Turnaround practitioners who consult with or participate in helping troubled
companies in the recovery process, including interim corporate managers, financial and
operating advisors, accountants
• 20% - Attorneys
• 14% - Lenders and bankers/workout officers
• 3% - Investors, including equity investors, investment bankers, venture capitalists
• 20% - Other related professionals, including receivers, appraisers, trustees,
auctioneers/liquidators, factors, academics/students, government/judges, and recruiters

Teaching Tip: Other types of bankruptcies

Although this chapter covers the most common types of bankruptcy filing (Chapters 7, 11, and
13), you should also mention that there are special filings for farmers (Chapter 12) and
municipalities (Chapter 9).

Case Summary Questions and Answers [P. 500-501]

CASE SUMMARY 26.1 In re Fehrs, 391 B.R. 53 (Bankr. D. Idaho, 2008)

1. Why do you think Fehrs sold the lot to her son?
• To avoid her creditors. The fact pattern described here has all the trappings of a
fraudulent conveyance.

2. What can the trustee do to make sure Axtman gets all he is owed?

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 • The trustee should ask the court to void the transfer under the voidable transfer doctrine.
CASE SUMMARY 26.2 Ellison v. Commissioner of Internal Revenue Service, 385 B.R. 158
(S.D. W. Va. 2008)
1. Will Ellison have to pay these taxes, or can they be discharged?
• Claims for federal, state, and local taxes (including fines and penalties related to the
taxes) within two years of the bankruptcy petition filing are not dischargeable.

2. Does the IRS have any defense to pursuing the debt during the automatic stay period?
• No, because the automatic stay legally prohibits creditors from either initiating or
continuing any debt collection action against the debtor or her property.

3. If Ellison wins, what does that say about the power of an automatic stay?
• It shows what a powerful legal tool the automatic stay is, since it stops all collection
efforts, even from the tax authorities.
CASE SUMMARY 26.3 In re Richie, 353 B.R. 569 (Bankr. E.D. Wis. 2006)

1. Should Richie be forced to relocate or work in another field in order to use bankruptcy laws?
• This question is designed to promote discussion about the concept of abuse of process
and where the courts should draw the line.

2. Richie lacked the ability to pay because she had not engaged in a broad employment search,
did not wish to work outside her chosen field, and did not wish to work within her chosen field
outside her geographic area. Should her creditors bear the burden of her choices?
• This question is designed to elicit discussion about line-drawing, moral luck, and the
allocation of risk. On the one hand, one could argue that one’s creditors should not have
to bear the risk of one’s voluntary choices, but on the other hand, one could also argue
that creditors are routinely required to take extra precautions as a matter of bankruptcy
law if they want to avoid the risk of insolvency.

CASE SUMMARY 26.4 In re Jones, 392 B.R. 116 (E.D. Pa. 2008)

1. Who prevails and why?

• In this particular case, the bankruptcy court concluded that the debtor was healthy and
employable and so would be able to pay back his student loans; nevertheless, this
question is designed to elicit discussion about the scope and meaning of the “undue
hardship” standard

2. If Jones had been unable to work due to illness or injury, would that be sufficient to meet the
undue hardship standard set out by the court?

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 • This question, like the previous one, is designed to elicit discussion about the scope and
meaning of the “undue hardship” standard.

3. Note that one court did not find undue hardship enough to discharge student loans for a “46-
year-old part-time legal secretary, raising her 14-year-old child and living with her sister, and
who had psychiatric problems and had twice attempted suicide” [In re Brightful, 267 F.3d 324
(3d Cir. 2001)]. Why would Congress and the courts be reluctant to allow the discharge of
student loans without meeting this difficult test?
• This question is designed to encourage discussion about the problem of strategic behavior
by debtors, but what about strategic behavior by creditors? That is, if it is too easy for
students to discharge their student loans, creditors might be less likely to provide student
loans in the first place, but at the same time, maybe creditors should be more careful to
whom they provide student loans.

CASE SUMMARY 26.5 Moecker v. Antoine et al., 845 So.2d 904 (Fla. Ct. App. 2003)

1. Are the Antoines creditors? Explain.

• Yes. Under FL state ABC statutes, they are considered creditors.

2. What is Moecker’s objection to the claim?

• That an assignment is seen as a cooperative effort which can benefit creditors by
affording prompt and relatively inexpensive resolution of claims.

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 Chapter 27
Choice of Business Entity and Sole Proprietorships

CHAPTER OVERVIEW
This chapter gives an overview of the forms of business entities and factors used to determine the
best choice of entity for a given business. It also focuses on the law governing the sole
proprietorship.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Articulate the factors that business owners should consider when selecting a Knowledge
business entity.
Identify the advantages and drawbacks to the sole proprietor form of entity. Knowledge
List the choices available to capitalize a sole proprietorship. Knowledge
Explain how proprietorships are managed and taxed. Knowledge
Describe the impact of terminating a sole proprietorship Knowledge
Application
Recognize the role of franchises in business. Knowledge

I. CHOOSING A BUSINESS ENTITY [p. 460-508]

Points to emphasize:
• Principals, owners of the business, should consider the formation (cost and ease),
liability of owners, capitalization, taxation of income, and the management and operation
of a business when choosing a form of business entity.
• The appropriate choice of business entity varies widely depending on the type of business
and the nature of the liabilities associated with its business activities.
• Initial choice of entity is not set in stone.
• The most common forms of business entities are described in Table 27.1.

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II. SOLE PROPRIETORSHIPS [p. 508-511]
Points to emphasize:
• A sole proprietorship is the easiest single-person ownership entity to form and maintain.
• It only requires a minimum fee, straightforward filing with the appropriate state or county
government authority, and typically requires no annual filings.
• If an individual plans to conduct a sole proprietorship under a trade name, they will need to
file a “doing business as” certificate (fictious name).
• A biggest disadvantage to the sole proprietorship is a complete lack of protection of the
principal’s personal assets for unpaid debts and liabilities of the business (unlimited liability).
All debts and liabilities of the business are also personal debt and liabilities of the principal.
• Sole proprietors often purchase comprehensive liability insurance for the business in amounts
sufficient to cover potential tort liabilities.
• Figure 27.1 is a sample of a sole proprietor filing required in Florida and Case 27.1 deals
with the impact of the sole proprietorship form of business on a contract transaction.

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Case 27.1 Lewis v. Moore (Tenn. Ct. App. 2017)
Facts: In 2012, Moore convinced Lewis, a longtime friend and former business colleague, to
purchase Moore’s Hillsboro Road Property so that Moore could avoid defaulting on a
construction loan. Moore contracted with Lewis to repurchase the property within one year
and give Lewis a percentage of Moore’s business operation (Moore Media) as part of the

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 transaction. If Moore Media closed and Moore begin the majority owner in a new business,
Lewis would still be entitled to 10% of the profits from the new business.
Ten months later, Moore repurchased the property and made payments to Lewis from
Moore Media for 10% of the business’s monthly property. In 2013, Moore asked Lewis to
conclude their arrangement and allow her to repurchase his interest in Moore Media, but
Lewis declined. In 2014, Moore sent Lewis a letter informing him that she had closed Moore
Media and formed Sandcliffs Media, LLC. Moore only had a 49% interest in the new LLC,
so she informed Lewis that he was no longer entitled to 10% of the profits. Lewis filed suit
claiming that the 2012 agreement formed an implied partnership between Lewis and Moore,
and he was entitled to ongoing payments. The trial court held for Moore and Lewis appealed.
Issue: Did a partnership exist between Moore and Lewis?
OpinionRuling: The Tennessee Court of Appeals affirmed the trial court’s decision in favor
of Moore. The court held that because Moore was a sole proprietor, no other individual could
have had an ownership interest in Moore Media and Moore was free to dissolve the business
at any time.

Case Questions

1. Why did the court reject Lewis’s theory that an implied partnership existed between
Lewis and Moore?
• The court reasoned that Moore Media was a sole proprietorship and was one with the
owner, Moore. As such, Lewis could not obtain a 10% interest in the business and
become a partner.
2. Why does the court point out that a sole proprietorship doesn’t have a “separate legal
existence”?
• Another person cannot obtain a 10% interest in another person. Because a sole
proprietorship and the owner are one in the same, another person cannot hold a 10%
interest in a sole proprietorship.
3. Focus on Critical Thinking: Was this a good strategy by Moore? Why or why not? Was it
ethical? Was the court’s decision fair, or did Moore use the law to shield her from a bad
business deal?
• Students can discuss the ethical implications and the fairness of this case. The fact is
that Moore complied with the agreement. The agreement was not well written.

III. CAPITALIZATION [p. 511-512]

Points to emphasize:

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 • Sole proprietorships are limited in their options for raising money.
• Proprietors can use their personal resources and may also finance their business through
debt (private loans and commercial loans).
• Private loans typically come through family or friends who negotiate such items as
interest rate directly with the proprietor.
• Commercial loans are more formal and involve a commercial lender such as a bank. The
interest rate is set and usually not negotiable. Commercial lenders typically require
collateral (asset of the proprietor to secure payment of the loan).
• A line of credit allows the proprietor to draw against a predetermined credit limit, as
needed, instead of receiving the full loan amount at one time. A line of credit typically is
secured by collateral.
• Sole proprietors can also unsecured credit (e.g., credit card) to finance operations.
• Table 27.2 summarizes a sole proprietor’s options for raising capital.

IV. TAXATION [p. 512]

Points to emphasize:
• Sole proprietorships are not subject to corporate income taxation and no tax return is filed
on behalf of the business.
• The principal/owner reports the business income and expenses on their own individual
tax return and pays taxes on the business income (or deducts losses) based on their own
individual rate. This is illustrated in Figure 27.2.
• The proprietor has sole discretion over management and organization of the business.

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V. TERMINATION [p. 512-514]
Points to emphasize:
• Sole proprietorships are terminated either by an express act of the principal or by
operation of law (e.g., death or personal bankruptcy of the proprietor).
• The proprietor’s ownership interest in a sole proprietorship cannot pass to her heirs
through gift or an estate.

Case 27.2 Biller v. Snug Harbor Jazz Bistro of Louisiana, LLC, 99 So.3d 730 (4th Cir. 2012)
Facts: Brumat was the sole proprietor of Snug Harbor Jazz Bistro of New Orleans. In July 2007,
Brumat died and left most of his property to his niece, Luana Brumat (Luana). In September
2007, Luana registered Snug Harbor, LLC, as a Louisiana limited liability company. In 2009,
Biller obtained an $80,000 judgment against Snug Harbor for an accident that occurred in April
2007. Seeking to enforce the judgment, Biller filed a petition alleging that the Snug Harbor,
LLC was a successor in interest to Brumat’s Snug Harbor and the LLC should be liable for
Brumat’s debt. Snug Harbor, LLC denied liability arguing that the original Snug Harbor was a
sole proprietorship that terminated upon the death of Brumat and that Snug Harbor, LLC was a
separate and distinct entity. The trial court ruled in favor of Snug Harbor, LLC and Biller
appealed.
Issue: Is Snug Harbor, LLC a successor in interest to Brumat’s sole proprietorship?
Ruling: Opinion: No. The Court of Appeals for the Fourth Circuit affirmed the lower court’s
decision holding that the business entity owned by Brumat terminated upon his death because it
was a sole proprietorship. Snug Harbor, LLC was a separate and distinct business entity created
by Luana Brumat and a former bookkeeper.

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Case Questions

1. What evidence did Biller claim indicates that the LLC was a continuing entity and not a
separate entity? Why did the court reject his theory?
• Biller argued that it was a continuing entity because Luana was the niece of Brumat and
the bookkeeper of the original Snug Harbor and was just continuing the business. The
court rejected this holding that the original Snug Harbor was run as sole proprietorship.
The owner cannot pass his interest in his will; it terminates at death. The LLC was
created after the death of Brumat and after the accident. The LLC entered into new
leases and new contracts.
2. The court pointed out that there was no evidence of fraud in the formation of the new entity.
Why is that important? What kind of fraud could be committed in this context?
• A finding of fraud allows a court to pierce the “corporate veil” and attach personal assets
of an owner. There was not evidence that the LLC was hiding personal assets of Brumat
or business assets of the original Snug Harbor.
3. Focus on Critical Thinking. Is this a case of business owners using the law as a shield against
a legitimate claim? Is it ethical to use the LLC as a way to escape liability? Is this fair to Biller?
• This is a chance for the students discuss the concept of limited liability. While it may
promote the creation a LLC because it offer protection for the owners, it may also
encourage greater risk taking that might not be fair to the creditors.

Teaching Tip: Sole proprietorship v. LLC

While LLCs are not discussed in this chapter, it would help students to generally compare the
advantages and disadvantages of the sole proprietorship and the LLC so they may understand
the above case better.

VI. FRANCHISES: A METHOD RATHER THAN AN ENTITY [p. 514-515]

Points to emphasize:
• A franchise is a method of conducting business that centers on a contractual relationship
rather than as a business entity.
• Existing entities use franchises to distribute its products to a broader market without the
overhead costs of retail space, equipment, and employees.
• Federal statutes define franchises as an arrangement of a continuing commercial
relationship for the right to operate a business pursuant to the franchisor’s trade name or
to sell the seller’s branded goods.
• A franchisor is the established business entity and assists the franchisee with financing,
supplies, training, and other aspects of running a successful operation.

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 • A franchisee contracts to have the right to operate the business and use the franchisor’s
trade secrets, trademarks, products, and so on.

A. Franchise Agreements [p. 514-525]

The franchisor and franchisee enter a franchise agreement that usually covers (1) the time limit
of the agreement; (2) franchise fees and payment terms; (3) territory rights; (4) commitments on
training and advertising; (5) commitments from the franchisee to follow operating protocol; (6)
royalties; and (7) termination and/or cancellation policies.

B. FTC Regulation [p. 515]

Points to emphasize:

• The Federal Trade Commission (FTC) is the federal regulatory authority that oversees the
regulation of franchisors.
• The regulations are very detailed, but almost all focus on mandatory disclosures such as
the financial condition of the franchise and the success rates.

C. State Regulation [p. 515]

Points to emphasize:
• Most states have their own franchise rules and minimum disclosure requirements that
supplement federal legislation.
• Most states require registration with a state regulatory agency.

Key Terms [p. 516]

Chapter Review Questions [p. 518-519] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [p. 515-516]
1. One of the reasons that umbrella coverage is an excellent choice is that it is inexpensive. Do
some Internet research and try to determine what the approximate cost of a $1 million policy
would be.
• A general search using any favored search engine will reveal many companies that
offer umbrella coverage. One good website is
https://www.embroker.com/services/commercial-umbrella-insurance/. This also
explains the factors used to calculate the cost of the premium: type of industry,
number of employees, net worth of the principals, and size of the company all factor
into the premium calculation.

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2. Although CGL policies and umbrella coverage reduce some risks, they do not cover cases in
which losses are due to an alleged breach of contract. What are some legal or business strategies
for avoiding that specific risk?
• First, business owners can use contracts strategically to reduce financial risks of
personal injury to customers (e.g., waivers). Second, contracts that are drafted with a
strategically qualified attorney (see Ch. 6) help to minimize risk and add value.
3. Based on the legal strategies you learned in Chapter 1, what category of legal strategy does
umbrella coverage fall into? Why?
• Prevention is the most obvious category as the idea is to reduce risk. However, this
question may help open up a discussion about the concept of the use of contracts for
value creation and how not all attorneys are aligned with business strategy when
drafting contracts. Value proposition contracts are discussed in Chapter 1 and use of a
strategically qualified attorney to draft contracts is in Chapter 6.

Case Summary Questions and Answers [p. 516-517]

CASE SUMMARY 27.1 Vernon v. Schuster, 688 N.E.2d 1172 (Ill. 1997)

1. Who prevails and why? Name a case from this chapter that supports your answer.
• Schuster prevails because a sole proprietorship’s interest terminates upon the death of
the proprietor. Therefore, death of Schuster was the end of any promises (e.g.,
warranties) that Schuster had made to customers of his sole proprietorship. This case
is like Biller v. Snug Harbor (case 27.2).
2. If Jerry Schuster changed the name of the business but still used the tools he inherited, how
would that impact your analysis?
• Probably not. Although there may be some notion that the use of tools indicates that
he “took over” his father’s business, as a legal matter the entity does when the
proprietor dies and thus the entity has no liability no matter who inherited tools,
equipment etc.
3. As an ethical matter, should a son honor the commitments of his father in these
circumstances?
• This case could be analyzed from an ethical decision-making perspective: principles-
based approach, consequences-based approach, or a contract-based approach. As a
strategic matter, Schuster refusal to honor his father’s warranty may result in poor
customer relations and poor social media ratings.

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CASE SUMMARY 27.2 Nazi v. Jerry’s Oil Co. (Tenn. Ct. App. 2014)

1. Is Nazi a sole proprietor or a manager?

• Nazi is a sole proprietor. The court ruled that John Nazi executed the contractual
documents as the proprietor of the Handy Peddler in 2007. When the documents
were executed, John Nazi clearly held himself out as the owner of the Handy Peddler.
2. Is Nazi personally liable for the amounts under the promissory note? Why or why not?
• Yes. As the court held “an individual may carry on business as sole proprietor… If
there are losses, the proprietor must bear them alone, to the extent of business and
personal resources. If there are profits, the proprietor does not have to share them,
absent any agreement to compensate employees, the landlord, or the money
lender with a share of profits in lieu of fixed wages, rent, or interest.”

CASE SUMMARY 27.3 Clayton v. Planet Travel Holdings, Inc., 988 N.E.2d 1110 (ILL. App.
Ct. 2013)

1. Is Fuener liable under the consumer protection law as a sole proprietor? Why or why not?
• Yes. The court ruled that Fuener was operating as a sole proprietor and subject to the
consumer protection law at the time of the Clayton transaction.
2. Does the fact that Fuener incorporated his business after the violations have any impact on
your analysis?
• No. The violations occurred while Fuener was a sole proprietor and the court held
that the “proprietor’s corporate maneuvers did not shield him from liability.”

CASE SUMMARY 27.4 England v. Simmons, 757 S.E.2d 111 (Ga. 2014)

1. Who prevails and why?

• The court rule din favor of Simmons and the other long-time employee. Although it
was true that Haege’s business was a sole proprietorship when he died, the court held
that any property that was owned by the sole proprietorship became Haege’s personal
property and that even if no business interest could pass, the property interest could
pass through the will.
2. Can Haege pass the assets of Traditional Fine Art through his will? Why or why not?
• Yes. The court makes a distinction between a sole proprietor’s business interest
(which cannot pass through a will as it terminates on the proprietor’s death) and the
sole proprietorship’s business assets (which can pass through a will).

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 Chapter 28
Partnerships

CHAPTER OVERVIEW
This chapter explains the general characteristics of partnerships and the differences between
general and limited partnerships.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Identify the necessary elements of partnership formation. Knowledge
Summarize the main differences between the RUPA and the UPA and Knowledge
explain their role as legal default rules.
Describe how partnership law governs the internal and external aspects of a Application
partnership.
Recognize several important rights of partners. Knowledge
Recognize several important duties of partners. Knowledge
List several important partnership agreement provisions. Knowledge
Explain the distinguishing attributes of limited partnerships and family Application
limited partnerships.
Articulate the legal protections from personal liability afforded to the Knowledge
principals in an LLP.
Describe the various methods for partnership dissolution. Knowledge

Teaching Tip: Tying partnerships to other chapters

Given the risks involved in general partnerships; joint and several liability, fiduciary duties,
default provisions of the RUPA, it is a perfect time to discuss contract law and how crafting a
partnership agreement is like creating a prenuptial agreement. An idea for an exercise is to have
the students lists every potential harm that could arise in the business, how to address it, and
what they would like to happen in the event one of the partners wishes to leave the partnership.
You can also refer students to the chapters on corporations (chapter 30) and contract damages
(chapters 10 and 11).

I. GENERAL PARTNERSHIP INFORMATION [p. 521]

Points to emphasize:

• A general partnership is legally defined as: (1) an association of two or more people (2)
who are co-owners and co-managers of the business and (3) who share in the profits of
their ongoing business
• In a term partnership, partners may set a specific future date or event for when the
partnership will be dissolved and may agree to extend this date if necessary.
• In a partnership at will, on the other hand, the partners agree to continue their
association indefinitely.

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 • Most partnerships are express partnerships, in which the principals agree orally or in
writing to form an ongoing business relationship.
• Nonetheless, the law will recognize their relationship as an implied partnership as long
as the three required elements are present.

Case 28.1 Waddell v. Rustin [p. 521]

Facts: In 1999, Waddell and Rustin entered into a romantic relationship and soon after started
working together in the Christmas store Rustin owned with his brother. Waddell indicated that
although their relationship began as personal, it became a business partnership in both the
Christmas store and a construction business. Rustin denied that they were ever express or
implied business partners. Waddell claimed that she had management and oversight over
Rustin’s business projects, access to the company checkbook, paid company bills, helped Rustin
choose construction projects, and changed the store's name to improve sales. When the couple
broke up, Waddell sued Rustin claiming that she was entitled to a percentage of the profits as an
implied partner.

Issue: Was an implied partnership created entitling Waddell to one-half of the profits?

Ruling: No, because there was no written partnership agreement between Waddell and Rustin,
Waddell bore the burden of proving the existence of a partnership by clear and convincing
evidence. Waddell had neither construction experience, nor did she contribute equipment or
capital.

Case Questions:

1. What was Waddell’s theory of the case as to why an implied partnership existed?
• Waddell’s theory of the case was that she and Rustin shared in the management of the
businesses and did not receive a paycheck as an employee would.

2. Could a personal relationship ever be considered a partnership? At what point does a

personal relationship create an implied partnership?
• A personal relationship could turn into an implied partnership if the parties show that
they shared profits and losses and co-managed the business.

3. Focus on Critical Thinking: Given the court’s ruling, what could Waddell have done
differently to ensure that she would have had partner status?
• This question elicits a discussion of the importance of a written partnership agreement.

II. OVERVIEW OF THE REVISED UNIFORM PARTNERSHIP ACT (RUPA) AND THE
UNIFORM PARTNERSHIP ACT (UPA) [p. 522]

Points to emphasize:

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 • In the absence of a written partnership agreement, the Revised Uniform Partnership
Act (RUPA) is likely to govern a general partnership (40 states).
• States that have not yet adopted the RUPA operate under the RUPA’s predecessor, the
Uniform Partnership Act (UPA).
• RUPA treats a partnership as a separate legal person distinct from its partners, while the
UPA does not.
• RUPA and the UPA serve to provide default rules when the partners have not expressly
agreed how to operate their partnership.

III. GENERAL PARTNERSHIPS IN THE CONTEXT OF BUSINESS [p. 523]

Points to emphasize:

• Many businesses start out as general partnerships when two or more people start doing
business together. Partners may opt out of RUPA and UPA by entering into a written
partnership agreement.
• Although partners may change the relationship between one another with a written
agreement, it will not alter their relationships with third parties.
• For example, an important rule under the RUPA that distinguishes general partnerships
from other types of business associations is that all partners face joint-and-several
liability for contract and tort-related obligations.
• As with a sole proprietorship, a partnership is a pass-through entity. This means that the
partnership entity pays no level of corporate tax and reports its profits and losses on their
personal tax returns.

IV. THE RIGHTS OF PARTNERS [p. 524]

As mentioned, in the absence of a partnership agreement, either RUPA or UPA will spell out the
rights of the partners as default rules. The following are the default rules imposed when there is
no written partnership agreement. See Figure 28.1.

A. Right to Share Profits and Losses Equally [P. 525]

The default rule is that without regard to each partner’s involvement in the business, profits and
losses are equally.

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 B. Right to Partnership Property [p. 525]
The default rule is that each partner has an equal right to partnership property but may not use
partnership property for their personal gain.

C. Right to Co-manage the Business [p. 525]

The default rule is that each partner has the right to co-manage the business. Each partner is
authorized to enter into contracts in the ordinary course of business binding the partnership.

D. Right to Indemnity [p. 525]

The default rule is that each partner has a right to reimbursement for expenses made on behalf of
the partnership.

E. Right to Vote [p. 526]

The default rule is that each partner has an equal vote with majority rules. In the event of a tie
that cannot be resolved, the partnership is dissolved. A unanimous vote is required, however, for
admission of a new partner, acts outside the ordinary course of business, and amending the
partnership agreement.

F. Right to Be Informed [p. 526]

The default rule is each partner has the right to be informed of any partnership business
(including the right to review partnership contracts, minutes taken during meetings, and financial
information).

The answers to the Quick Quiz are found at the end of the chapter on page 545.

V. THE DUTIES OF PARTNERS [p. 526]

Points to emphasize:

• Parties owe each other special duties, known as fiduciary duties, to ensure that each
partner is acting in the partnership’s best interests. See Figure 28.2.
• These duties found in RUPA cannot be completely eliminated with a written partnership
agreement.

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 A. Duty of Loyalty [p. 527]
The duty of loyalty prohibits a partner from competing with the partnership and from taking
personal advantage of a business opportunity that would have benefitted the partnership.

Case 28.2 Meinhard v. Salmon [p. 527]

Facts: Meinhard and Salmon formed a general partnership to lease the Bristol Hotel. They
agreed to split the renovation costs, split the profits and losses evenly, and for Salmon to have
sole authority to manage the business affairs of the partnership and lease. This partnership
proved to be very profitable for both individuals, and the lease was set to expire on April 20,
1922. In January of 1922, the Bristol property owner offered Salmon a plan to lease the Bristol
property and several adjoining lots permitting Salmon to demolish the hotel and build a larger
commercial structure. Without disclosing this to Meinhard, Salmon signed a new lease with
Bristol on January 25, 1922. Meinhard sued to have the new lease transferred over to the
partnership.

Issue: Did Salmon breach his duty of loyalty?

Ruling: Yes, by usurping the business opportunity for himself, Salmon breach his duty of
loyalty.

Case Questions:

1. Did it matter to the court that Meinhard and Salmon’s partnership was near its end? Explain.
• No, the duty exists until the partnership ceases.

2. Was Salmon justified in his view that the new lease was a different business opportunity
altogether? Explain.
• No, although Salmon may have felt that as manager, he had the ability to seek out other
opportunities, in fact as long as the partnership existed, he still had a duty to his partner.

3. Focus on Critical Thinking: How could Salmon have avoided the liability and still taken
advantage of the lease?
• This question encourages the students to consider what the duty of loyalty looks like,
when a partner has a duty to disclose business opportunities to the other, and whether or
not waiting until after April to sign a new lease would have worked.

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 A. Duty of Care [p. 528]
Partners must also exercise a duty of care in handling the affairs of the partnership and treat
business affairs with diligence. Under this standard, partners are not liable if they make a
business decision that results in harm due to an ordinary mistake of judgment.
B. Duty of Good Faith [p. 528]
Partners also have a duty of good faith which requires them to exercise appropriate discretion in
dealing with other partners and third parties concerning the partnership’s business. Full
disclosure is required between partners (such as in the Meinhard case).

Teaching Tip: Give students a heads-up that fiduciary duties will be covered in later
chapters

This is a good time to foreshadow the chapter on corporations and alert the students that directors
and officers also have duties to one another and the corporation.

VI. THE PARTNERSHIP AGREEMENT [p. 529]

In order to avoid the default rules, partners may enter into a partnership agreement spelling out
their rights, duties and obligations. The following are important terms to include in a partnership
agreement. See Figure 28.3.

A. Capital Contributions [p. 529]

Points to emphasize:

• The capital contribution lists how much value each partner has contributed to their
individual capital accounts.
• By law this amount must be returned to each partner when the partnership assets are
liquidated.
• Services or knowledge that will be offered to the partnership cannot be recognized as a
capital contribution.

B. Property Provision [p. 530]

Points to emphasize:

• Because property used for the partnership business may become partnership property,
partners who wish to keep their property separate should identify that in the agreement.

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 C. Profits and Losses [p. 530]
Points to emphasize:

• If the partners wish to structure profits and losses other than equally (such as according to
capital contributions), this should be included in the partnership agreement.

D. Salary [p. 530]

Points to emphasize:

• If any partners are to receive a salary in addition to the share of the profits, this should be
included in the partnership agreement.

E. Management Rights [p. 530]

Points to emphasize:
• Depending on the circumstances, the partners may wish to delegate management
authority to one partner or someone they hire.
• Additionally, if the parties wish to require a something other than majority rules, this
should be included in the partnership agreement.
• The following management authority may be limited by requiring a unanimous or
majority approval from the other partners: (1) Signing a contract that is longer than one
year in length, (2) Signing a contract that exceeds a certain dollar amount, (3) Borrowing
money on behalf of the partnership, or (4) Selling partnership property.

F. Buy-Sell Agreement [p. 531]

Points to emphasize:

• A buy-sell agreement allows the remaining partners to purchase the partnership interest
of a withdrawing partner.
• This provision helps ensure the continuity of the partnership business and can avoid legal
disputes if a valuation methodology is provided.

VII. LIMITED PARTNERSHIPS AND FAMILY LIMITED PARTNERSHIPS [p. 531]

Points to emphasize:

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 • A limited partnership is an entity that exists by virtue of a state statute that recognizes
one or more partners as managing the business while other partners participate only in
terms of contributing capital or property.
• A limited partnership has at least one general partner (managing principal) and at least
one limited partner (investing principal). In the absence of an agreement, the Revised
Uniform Limited Partnership Act (RULPA) governs a limited partnership.

A. Formation [p. 532]

Points to emphasize:

• To form a limited partnership, the general partner files a certificate of limited

partnership with the state government authority (usually the secretary of state’s office)
which usually includes the name, address, and capital contribution of each partner. See
Figure 28.4.

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 B. Personal Liability of Principals [p. 532]
Points to emphasize:

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 • Each general partner in a limited partnership is personally liable for all of the
partnership’s debts and liabilities, just as if the general partners were in a general
partnership.
• Limited partner’s liability is limited to the amount of their capital contribution, unless the
limited partner acts negligently or illegally within the scope of his or her partnership
duties.

C. Capitalization [p. 532]

Points to emphasize:

• Limited partnerships are generally funded either through debt (e.g., by borrowing money
from the principals or a commercial lender) or through a sale of equity (e.g., by selling a
percentage of ownership rights in the partnership and any profits of the business).
• When limited partnership shares are sold to the public, they are subject to federal and
state securities laws (blue-sky laws).

D. Taxation of Partners and Partnership [p. 532]

Points to emphasize:

• Like general partnerships, limited partnerships are pass-through entities permitting

partners to report profits and losses on their personal tax returns.
• The general partner is responsible for filing an information return with taxing authorities.

E. Management and Operation of the Partnership [p. 534]

Points to emphasize:

• General partners manage the business and are permitted to bind the partnership.
• Limited partners may not participate in daily management of the business, do not have
authority to bind the partnership, and remain primarily investors.
• Limited partners who do engage in daily management and operations jeopardize their
limited partnership status.
• Although limited partners are referred to as silent partners, they do have the right to
access partnership information such as business or financial records.
• The default rule for partners in a limited partnership is that they share profits and losses
in accordance to their capital contributions (which have not been returned).
• In Figure 28.5, because Frida had $10,000 of her capital contribution returned to her,
rather her share becomes 35%.

F. Family Limited Partnerships [p. 534]

Points to emphasize:

• A family limited partnership is a limited partnership that is used for estate planning
for families of considerable wealth.
• The purpose of a family limited partnership is to enable wealthy members of one
generation to distribute assets (in the form of an IRS-recognized gift) to heirs using a

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 method that allows the distributing generation to claim a much lower market value than
the actual market value of the gift.

VIII. LIMITED LIABILITY PARTNERSHIPS (LLPs) [p. 536]

Limited Liability Partnership (LLP) statutes provide general partnerships with the right to
convert their entity to an LLP and gain the protective shield ordinarily afforded only to limited
partners or corporate shareholders.

A. Formation [p. 536]

Points to emphasize:

• Limited liability partnerships are formed when a general partnership files a statement of
qualification with the appropriate public official.
• The conversion of the partnership must be approved by a majority of the ownership.
• The statement includes the name and street address, an affirmative statement electing to
become an LLP, an effective date, and the signatures of at least two of the partners.
• Some states also require a filing to inform tax authorities of the existence of the entity.

B. Liability [p. 536]

Points to emphasize:

• Although all partners in an LLP have limited liability protection, most state statutes
provide that in the case of a partner who has engaged in some misconduct or tortious
conduct (such as negligence), the LLP acts to shield only the personal assets of other
partners—never the partner who committed the misconduct or negligence.
•

Case 28.3 Dillard Department Stores, Inc. v. Damon J. Chargois and Cletus P. Ernester [p.
536]

Facts: Chargois & Ernster (C&E) formed an LLP for their law practice and created a website
which infringed on Dillard’s trademarks. Dillard sued the LLP and during litigation C&E
dissolved the partnership. On November 2, 2004, Dillard obtained a judgment for $143,500
against the LLP, but sought to hold the two principals personally liable, jointly and severally, for
the 2004 final judgment entered against the LLP. Chargois and Ernster argued that they were
shielded from personal liability under the state’s LLP statute.

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Issue: Were Chargois and Ernester shielded from personal liability due to the liability being
incurred while the LLP was in legal existence?

Ruling: No, the debt was not incurred until the judgment was entered at which time the LLP no
longer existed thus provided no limited liability protection.

Case Questions:

1. Why did the court rule that the two partners were personally liable for the debt?
• Because the LLP had been dissolved at the time of the judgment.

2. Could it be argued that the debt actually was incurred once C&E had notice that it had
infringed on Dillard’s trademark? Why or why not?
• Knowledge of the infringement could lead to liability, but the actual liability was not
incurred at until the entry of the judgment.

3. Focus on Critical Thinking: Is it sound public policy to require that two partners who have
agreed to separate be forced to continue the LLP’s existence for a certain period of time? Is it
necessary to protect creditors? Is there any other way to accomplish that goal?
• This question is meant to encourage discussion about the purpose of limited liability
statutes and policy which permitted those harmed to recover.

C. Taxation [p. 538]

Points to emphasize:

• Like other partnerships, an LLP is a pass-though entity and profits and losses are
reported on the partner’s personal tax returns.

D. Capitalization [p. 538]

Points to emphasize:

• LLPs are capitalized in the same way as a partnership: through debt via private or
commercial lenders or by a sale of partnership equity for ownership in the LLP itself.
• The partnership agreement may contain a capital call which is the procedure for
collecting additional capital form the partners.

IX. PARTNERSHIP DISSOCIATION AND PARTNERSHIP DISSOLUTION [p. 539]

Points to emphasize:

• The RUPA uses the term dissociation and RULPA uses the term withdrawal to
describe the situation when a partner chooses to leave the partnership.

A. Dissociation under the RUPA [p. 539]

Points to emphasize:
• The RUPA lists 10 specific events of dissociation, but the majority of dissociations are
the result of one of the following three events: (1) voluntary separation from the

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12
 partnership, whereby one partner gives specific notice to withdraw from the partnership;
(2) expulsion by the unanimous vote of the other partners; or (3) the partner’s inability to
carry out her duties to the partnership (as in the case of incapacity or death) or inability to
have an economic stake in the business (as in the case of an individual partner filing for
bankruptcy protection).
• When a partner exercises a rightful dissociation, she is no longer liable for the debts and
liabilities incurred by the partnership, only for pre-dissolution liabilities. With a wrongful
dissolution, the wrongfully dissociated partner “is liable to the partnership and to the
other partners for damages caused by the dissociation.”
• When a partner dissociates, the partnership does not automatically dissolve. The
remaining partners may choose to buy-out the dissociated partner (the cost is usually a
formula set in the partnership agreement).
• If the remaining partners wish to dissolve the partnership, the process of winding up
begins.
• Windup is the period of time necessary to settle the affairs of the partnership and includes
activities such as discharging the partnership’s liabilities, settling and closing the
partnership’s business, marshaling the assets of the partnership, and distributing any net
proceeds to the partners.

Case 28.4 Robertson v. Mauro et al. [p. 540]

Facts: Mauro operated a business conducting seminars to teach people how to trade in foreign
currency. Robertson alleged that in January 2010, he and Mauro orally agreed to form a
partnership that included an agreement to evenly divide profits. Robertson was to manage the
business, while Mauro would conduct the seminars. In early 2011, Mauro allegedly stated to
Robertson that he “needed a break” temporarily from teaching the seminars but would resume
the partnership later that year. Robertson alleged this statement was false, and that instead of
taking a break, Mauro continued with the business without him. Robertson filed suit against
Mauro for wrongful dissociation because neither party expressed the intent to dissolve or wind
up the partnership, yet Mauro’s actions essentially accomplished a disintegration of the
partnership without Robertson’s consent.

Issue: Did Mauro’s actions constitute a wrongful dissociation?

Ruling: No, because there was no partnership agreement, the arrangement was a partnership-at-
will. Thus, either party would terminate at any time without it being a wrongful dissociation.

Case Questions:

1. What was Robertson’s theory of the case?

• Because neither party expressed an intent to wind up the partnership, this was a wrongful
dissociation by Mauro.

2. Why is it important that the partnership was “at will”?

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 • Because at-will partnerships can be terminated at any time by either partner.

3. Focus on Critical Thinking: In addition to the wrongful dissociation claim, Robertson alleged
Mauro committed other wrongs related to their business relationship. Can you guess what they
are? What other areas of law could be implicated in this case?
• This question is meant to encourage a discussion on why written partnership agreements
are so important and what types of provisions should be included.

B. Withdrawal under the RULPA [p. 541]

Points to emphasize:

• Because the overwhelming majority of limited partnerships operate under a

partnership agreement that spells out detailed rules for withdrawal of a general or
limited partner, the RULPA does not play as significant a role as does the RUPA for
general partnerships.
• Under RUPLA, a general partner may withdraw at any time without causing
dissolution of the partnership provided that (1) the partnership still has at least one
remaining general partner and (2) all of the partners (both general and limited) agree in
writing to continue the partnership.
• If the partner’s withdrawal does not result in dissolution of the partnership, the
partnership must pay the departing partner the fair market value of her interest in the
limited partnership within a reasonable time after withdrawal.
• In contrast, limited partners are subject to restrictions on withdrawal. Absent an
agreement in writing to the contrary, the general rule is that limited partners may not
withdraw from a partnership before the partnership termination time agreed on by the
partners.

C. Other Events of Dissolution [p. 541]

Points to emphasize:

• A partnership may also be dissolved when the partnership has reached its agreed-upon
term (a specific date set out in the filings and/or partnership agreement); when
dissolution is mandated by court order; or, in the case of a general partnership, when
agreed to by unanimous consent of the partners.

X. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [P. 543-544]

Chapter Review Questions [P. 545-546] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers

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1. How would you respond to Zuckerberg’s actions if you were a partner in the ConnectU
team?

• Zuckerberg has clearly indicated he has competing interests with the launch of Facebook
and his delays on developing the code. If amicable resolutions or mediation cannot yield
a settlement then litigation is likely necessary.

2. Given these facts, was Zuckerberg a partner of ConnectU? Explain how the three elements of
partnership relate to your answer.

• There is evidence of a general partnership since there was: (1) an association of two or
more people (2) who are co-owners and co-managers of the business and (3) who share in
the profits of their ongoing business

3. If a partnership was created, would it be classified as an express or an implied partnership?

• It would be classified as an implied partnership since there was no general partnership

agreement.

4. Which of the fiduciary duties would ConnectU claim that Zuckerberg violated? Explain
whether you think this duty was violated.

• The duty of loyalty. If Zuckerberg owed this duty then yes, the duty was violated when
he started a competing business since his undivided loyalty was to his partnership and
partners at ConnectU.

5. Who benefited from the fact that a partnership agreement was never created between the
parties?

• Zuckerberg benefited since he could later claim he was never a partner. Without a written
agreement this fact is more difficult to prove.

6. The ConnectU founders eventually sued Zuckerberg and Facebook. The case then settled. If
you were Facebook, why would you settle? How much would you pay to settle this case? Would
your settlement offer change if Facebook were contemplating a public stock offering? Explain.

• Facebook would want to settle since there appear to be enough emails, meetings and
witnesses willing to state that Zuckerberg joined the ConnectU team as a partner. Taking
this case all the way to a jury might lead to a loss of control of Facebook and high
damages for breach of fiduciary duty. The valuation of Facebook at its initial public stock
offering was $104 billion. This case actually settled for $65 million going to the
Winklevoss twins. It is likely Facebook paid this amount to settle the case and not have
the issue lingering before the company went public.

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Case Summary Questions and Answers [p. 544-545]

CASE SUMMARY 28.1 Conklin v. Holland, 138 S.W.3d 215 (Tenn. Ct. App. 2003)

1. Was there a partnership?

• There may have been an implied partnership (however, the court later dismissed the
claim since the liability under partnership arises from partners acting as agents, and in
this case the activities were beyond any intended partnership business).

2. What was the partnership formed to do?

• To rehab the property and sell it at a profit.

3. As a practical matter, why would Conklin’s estate sue Holland instead of Lewis for
partnership liability?
• Probably due to the joint-and-several liability under partnership law, and the deep pocket
scenario where only one of the partners has assets to pay a claim.

CASE SUMMARY 28.2 Rahemtulla v. Hassam, 539 F. Supp. 2d 755 (M.D. Pa. 2008)

1. What duties did Hassam owe Rahemtulla?

• As a partner all the fiduciary duties involving good faith, loyalty and care.

2. Does it matter that Rahemtulla made foolish decisions when he trusted his friend?
• Only if they impact the duty of care owed to the partnership.

3. What potential conflict arose when Hassam created a partnership to lease from another
partnership he was part of?
• Hassam is now a fiduciary to two partnerships that are dealing against one another. His
loyalties are thus divided.

CASE SUMMARY 28.3 In re Spree.com Corp., 2001 WL 1518242 (Bankr. E.D. Pa. 2001)

1. Who prevails and why?

• It depends if the information regarding Spree’s lack of cash was public information or
not, creating a duty of confidentiality. Breaching that duty could trigger duty of care or
loyalty issues.

2. Does this case show potential problems with venture capital firms as limited partners?
• It does in so far as venture capital firms usually want to have direct involvement in the
direction and affairs of the companies they invest in, usually as board members. Once
they are board members, they cannot act a limited or silent partners.

3. Was TCV in “control” of Spree.com because it held the purse strings?

• Control is achieved through ownership and whoever controls financing may also have
ownership control.

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 Chapter 29
Limited Liability Companies

CHAPTER OVERVIEW
This chapter explains how to form an LLC, the advantages of LLCs, and how they differ from
other types of business entities. See Figure 29.1.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Define what a limited liability company (LLC) is. Knowledge
Identify the sources of laws that govern LLCs. Knowledge
Explain the steps required to form an LLC. Knowledge
Identify the primary methods for capitalizing LLCs. Knowledge
Explain the function of an operating agreement. Application
Articulate the legal protections from personal liability afforded to the Application
principals in an LLC.
Identify the tax treatment alternatives available to an LLC. Application
Compare and contrast dissolution and dissociation. Critical Thinking

Teaching Tip: Students tend to believe corporations are always the best choice

Students are often surprised to learn about LLCs because they assume businesses are always
incorporated. If you use the example of five friends wanting to form a business, it is easy to
demonstrate the areas in which certain LLCs are superior to corporations (less formality,
favorable tax treatment, the operating agreement can address all of their concerns about working
together in advance, each member gets an equal vote, etc.). Explain how the five friends would
each want a voice in the management of the business, but not personal liability.

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I. OVERVIEW OF THE LLC [p. 549]
Points to emphasize:

• A limited liability company (LLC) is a flexible type of business entity that offers its
owners many advantages, including easy formation, flexible operation, limited legal
liability of the owners, and pass-through taxation.
• The owners or principals of an LLC are called members.

II. LAWS GOVERNING LLCs [p. 549]

Points to emphasize:

• The LLC is a more recent vehicle for business formation and provides the benefits of a
partnership, but with limited liability for the owners.
• The Uniform Limited Liability Company Act (ULLCA) is a model statute designed to
promote uniformity among various state LLC laws; however, in practice LLC statutes
can vary considerably from state to state. All 50 states recognize LLCs.
• Some states have begun to adopt statutes based on the Revised Uniform Limited
Liability Company Act (RULLCA), which modifies the original model act in the areas
of formation, organizational matters, and the operating agreement, and it attempts to
clarify some of the more technical aspects of LLC governance, such as the handling of
deadlocks and the rights of members who depart the LLC.

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III. FORMATION OF THE LLC [p. 550]
Points to emphasize:

• An LLC is formed by filing articles of organization (or certificate of organization) with

the designated public official in that state (usually the secretary of state or the state’s
corporation bureau).
• The articles of organization contain only basic information, such as the name of the
entity, the location of its principal place of business, and the names of its owners (called
members). See Figure 29.2.
• Some states also require a contemporaneous filing with tax authorities to notify them of
the existence of the LLC.

Teaching Tip: Articles of Organization

To help students understand the difference between the articles of organization for an LLC and
the articles of incorporation for a corporation, you can pull up blank forms from your state’s
corporation bureau or secretary of state’s office and have the students figure out what goes in
each blank depending on whether it is an LLC or corporation.

IV. CAPITALIZATION OF THE LLC [p. 550]

Points to emphasize:

• Unlike a corporation, an LLC does not issue shares.

• In general, LLCs are capitalized primarily through debt via private lenders or commercial
lenders or through the sale of equity ownership in the LLC itself.

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V. THE OPERATING AGREEMENT [p. 551]
Points to emphasize:

• Some states require members to enter into an operating agreement, similar to a

partnership agreement.
• An operating agreementcovers many of the internal rules for the actual operation of the
business and offers a great deal of flexibility:
o Structure of governance and voting rights: The operating agreement typically sets
forth a structure for managing the entity through a single member or a group of

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 “managing members” (akin to a board of directors), and it defines their day-to-
day responsibilities. The agreement will also spell out voting rights and
procedures.
o Death, incapacity, and dissolution: Members often use operating agreements to
spell out the preferred procedures in the event the death or incapacity of a
member. These agreements usually permit the remaining members to continue the
LLC or the procedures for dissolution should they choose to disband.
o RULLCA: The revised model LLC statute (1) establishes the primacy of the
operating agreement in evidencing the relationship among the limited liability
company and its members, the rights and duties of any managers, and the
activities and affairs of the company, (2) it lists those matters that are not subject
to change by the operating agreement by setting forth 17 nonwaivable statutory
provisions related to liability of the entity and its members, and (3) it confirms
that an operating agreement may include specific penalties or other consequences
if a member fails to comply with its terms or upon certain events specified in the
operating agreement.
• Most LLC statutes require the entity to choose to be a member-managed LLC or
manager-managed LLC.
o In a member-managed LLC, the management structure of the entity is similar to
that of a general partnership, with all the members having the authority to bind the
business.
o In a manager-managed LLC, a named manager (or managers) generally has the
day-to-day operational responsibilities, while the nonmanaging members typically
are investors with little input on the course of business taken by the entity except
for major decisions (such as a merger). The new RULLCA eliminates the term
managing member in favor of authorized representative.
• The managers and controlling members of an LLC owe fiduciary duties of care and
loyalty to the other members of the LLC. See Figure 29.3.
• Nevertheless, the modern trend is to specifically eliminate any liability for a breach of the
duty of care through the operating agreement. This trend has been a source of
controversy, and courts have been strict about requiring unambiguous language in the
operating agreement that limits any fiduciary duty.
o The RULLCA does not allow any manager or member to avoid personal liability
under any circumstances in which the liability was the result of the member’s bad
faith or willful misconduct.
• In any case, managers and controlling members (i.e., members with ownership sufficient
to decide or veto internal operational matters) must adhere to the duty of loyalty, are
prohibited from self-dealing, and must act in good faith when dealing with the LLC’s
business matters.

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Case 29.1 AK-Feel, LLC v. NHAOCG, LLC, 62 A.3d 649 (Del. Ch. 2012) [p. 553]

Facts: Feeley was the managing member of AK-Feel, LLC, and formed a new entity with
several investors, all of whom organized as a separate entity called NHAOCG, LLC (NHA).
After a series of business discussions among the parties, the principals of the two LLCs formed a
new entity, called Oculus. AK-Feel and NHA each owed 50% of the member interest, but AK-
Feel (through Feeley) was the managing-member. Because NHA felt that Feeley’s incompetence
resulted in a significant loss in an aborted real estate transaction, it decided to end its business
relationship with Feeley and take over Oculus. Feeley and AK-Feel filed suit in which they
sought to block NHA’s attempt and establish their continuing control. NHA filed a countersuit
for, among other things, breach of fiduciary duty and sought damages that it suffered as a result
of Feeley’s gross negligence. The parties resolved the control issue, but NHA did not drop its
countersuit.

Issue: Did the Operating Agreement limit Feeley’s fiduciary obligations?

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 Ruling: No, the Operating Agreement did not unambiguously limit any fiduciary duties of the
managing member.

Case Questions

1. Why does the court state that the language in the operating agreement actually recognizes the
“continued existence” of the fiduciary duties?

• The language itself in the Operating Agreement actually recognized the “continued
existence” of the fiduciary duties. If the agreement had eliminated them, there would be
no reason to include exceptions to them.

2. Should NHA have agreed to the structure of the Oculus entity? How could it have been more
pro-active during the structuring of the entity?

• No, it gave one member too much power. NHA could have asked for a member-managed
LLC.

3. Focus on Critical Thinking: As explained in the text, the RULLCA limits the right of
managing members to eliminate their fiduciary duty to the other members. Which approach do
you agree with and why? Is the operating agreement a contract or a set of rules? If it is a
contract, shouldn’t the parties be able to negotiate whatever terms they wish?

• This question is intended to stimulate discussion about whether fiduciary duties should be
as negotiable as other parts of a contract.

VI. LIMITED LIABILITY OF THE OWNERS [p. 555]

Points to emphasize:

• LLC members are insulated from personal liability for any business debt or liability
(contract or tort) if the venture fails.
• Two important factors moderate this limited liability, (1) creditors often require a
personal guarantee from the members of an LLC whereby the members pledge personal
assets to guarantee payment of the business venture’s obligations, and (2) a court may
discard the protection in a case where the court finds that fairness demands that the LLC
members should compensate any damaged party when the entity is without resources to
cover the full amount owed, such as a case where the members engaged in fraud.
o Also note that the RULLCA imposes personal liability in cases where authorized
members consent to an improper distribution (a distribution of money made when
the LLC is insolvent).
The answers to the Quick Quiz are found at the end of the Chapter [p. 513].

VII. TAXATION OF THE LLC [p. 556]

Points to emphasize:

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 • Although many LLCs are treated as pass-through entities, LLC members instead may
elect to be taxed as a corporation if they consider the corporate tax structure to be more
favorable.
• Pass-through taxation, however, has two major advantages: (1) investors can assume the
tax deductions and losses that are typically generated by an emerging company or a
company with significant up-front debt, and (2) the business can distribute earnings to its
owners without incurring double taxation—without having a tax imposed on both the
entity and its members.

VIII. DISSOLUTION VERSUS DISSOCIATION [p. 556]

Points to emphasize:

• LLC laws define dissolution of an LLC as a liquidation process triggered by an event

that is specified in the operating agreement (such as the death of a key member) or by the
decision of the majority of members (or the percentage called for in the operating
agreement) to dissolve the company.
• By contrast, dissociation occurs when an individual member decides to exercise the right
to withdraw from the partnership.

Case 29.2 Kirksey v. Grohmann, 754 N.W. 2d 825 (Sup. Ct. S.D. 2008) [p. 557]

Facts: Four sisters inherited an equal ownership interest in their family’s land and formed the
Kirksey Family Ranch, LLC. One sister lived on the land and managed the LLC, while another
sister leased the land for livestock grazing. The other two sisters, however, lived in the city a
great distance away and wanted to dissolve the LLC. A majority vote is generally required for
dissolution, but not only were the sisters evenly divided. Because the operating agreement did
not contain a provision in case of deadlocks, the city sisters petitioned a court for a judicial
dissolution of the LLC

Issue: Can the court order the dissolution of the LLC when the members cannot come to an
agreement?

Ruling: Yes, in the present case the economic purpose of the LLC was being unreasonably
frustrated, and the LLC’s business could not be carried on in conformity with its articles of
organization and operating agreement. Because the members would not communicate with one
another, the members did not have an equal right to manage the LLC.

Case Questions

1. Should the court grant the request of the city sisters? Why or why not?
• It would seem that the purpose of the LLC was the continuation of the family’s
ownership and operation of the ranch. Dissolving an LLC due to lack of communication

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8
 seems drastic. However, one could argue that there was no other choice if all were unable
to have equal management rights as is intended by forming an LLC.

2. The tracts of land owned by the LLC had been in the Kirksey family for over 100 years.
Should that fact be relevant to the court’s resolution of the dissolution issue?
• Yes, in order to continue the ranch, the court could have ordered a partition or a buy-out
addressing the city sisters’ concerns. It is possible that this was done, but it is not
included in the case opinion.

3. Focus on Critical Thinking: The court emphasized the fact that the sisters refused to
communicate with each other directly, except through their attorneys. Is this fact relevant to the
outcome of this case? If so, should this fact work in favor of the city sisters or the farm sisters?
• This question is meant to provoke discussion on why operating agreements are so
important and what provisions should be included (especially when you have an even
number of members).

IX. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES [p. 509]

Key Terms [pp. 558-559]

Chapter Review Questions [pp. 560-561] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 558]

1. Facebook was launched in February 2004. From a legal perspective, the company began as a
sole proprietorship, then morphed into a general partnership before becoming a limited liability
company in April 2004. Why do you think the founders of Facebook decided to structure their
company as an LLC so early in the company’s history?

As explained in this Thinking Strategically section, three of Mark Zuckerberg’s classmates had
accused Zuckerberg of stealing their idea and had threatened to sue Zuckerberg over his alleged
intellectual property theft. As a result, this significant risk of litigation, along with the fact that a
strong case can be made that Zuckerberg did steal the idea for Facebook, probably explain why
the founders of Facebook decided to restructure their business as a limited liability company
(i.e., to avoid personal liability).

Case Summary Questions and Answers [p. 559-560]

CASE SUMMARY 29.1 Kaycee Land and Livestock v. Flahive, 46 P.3d 323 (Supreme Court of
Wyoming 2002)

1. Can the court disregard the LLC entity in this situation to hold Flahive personally liable?
• Yes, in this case, since the LLC had no assets, the court may pierce the corporate veil and
hold Flahive personally liable. Ordinarily, however, in the absence of any fraud by the
LLC, courts may not disregard the LLC entity.

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2. Should it matter that Flahive’s LLC was a single-member LLC?
• No, it should not matter, assuming the formalities of the LLC form were respected (e.g.,
separate bank accounts) and assuming the owner of the LLC was not engaged in any
fraud. Indeed, this feature is one of the advantages of LLCs: even the personal assets of
an owner of a single-member LLC are protected.

CASE SUMMARY 29.2 Emprise v. Rumisek, 26 Kan. App. 2d. 760 (Court of Appeals of
Kansas 2009)

1. Does the bank have to wait until the litigation is complete to enforce the personal guarantees
against the remaining physicians? Why or why not?
• The bank may enforce the personal guarantees immediately as per the terms of these
guarantees.

2. What is the impact of the departing physicians’ dissociation from the LLC?
• Upon the dissociation of the departing doctors, the remaining members of the LLC may
decide to either continue the LLC or trigger dissolution of the LLC.

CASE SUMMARY 29.3 Lamprecht v. Jordan, LLC, 75 P.3d 743 (Supreme Court of Idaho
2003)

1. May the other LLC members force Lambrecht to withdraw from the LLC?
• Yes, as per the terms of their operating agreement.

2. Is it fair to base the payment on the capital account balance (typically very small) rather than
on the fair market value of the LLC (typically a larger amount) when the withdrawal is forced?
• This question is meant to provoke discussion on ethics, though the operating agreement
controls which of these two methods of payment is to be used.

CASE SUMMARY 29.4 Lieberman v. Wyoming.com, LLC, 82 P.3d 274 (Supreme Court of
Wyoming 2004)

1. How should the court rule?

• The court itself in this case was divided. The majority ruled that the remaining members
of the LLC were not required to buy out Liberman’s equity interest, since the operating
agreement contained no such buy-out provision. The dissent, however, argued that the
LLC should be required to buy-out the departing member’s equity share.

2. Could the Mossbrooks have avoided having to pay any money to Lieberman had they simply
voted to reject his “notice of withdrawal”?
• Unless this scenario is spelled out in the operating agreement, whether a majority vote
rejecting an LLC member’s withdrawal would have this effect is up for debate, since a
member of an LLC generally has the right to withdraw or disassociate from the LLC
whenever he wants.

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 Chapter 30
Corporations: Formation and Organization

CHAPTER OVERVIEW
This chapter covers the formation, liability, and capitalization of corporations, and the roles,
rights, and duties of shareholders, officers, and directors.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Articulate the concept of the corporation as a legally independent entity and Knowledge
identify the sources and level of law governing formation and internal
corporate matters.
Categorize a corporate entity based on its operating objectives. Application
Explain the process of corporate formation and liability of promoters. Knowledge
Explain the primary methods for financing a corporation. Knowledge
Identify circumstances under which a court will pierce the veil of a Application
corporation to access the personal assets of its principals.
List the three major groups that form the structure of a corporation and Knowledge
describe the roles of each group.
Define the term fiduciary duty and apply the various fiduciary duties in the Application
context of a corporate transaction.

Teaching Tip: Corporations

Students often assume businesses have to be incorporated. It can be helpful to review the
alternate forms of business entities available and how there is no-one-size-fits-all solution. It is
also a good time to remind them of how important following corporate formalities is so that the
corporate veil is not pierced, and the owners maintain their limited liability status.

I. CORPORATION AS AN ENTITY [p. 564]

Points to emphasize:

• A corporation is a fictitious legal entity that exists as an independent individual separate

from its principals.
• State statutes vary in their corporate formation and governance rules, but these business
corporation laws address such matters as the structure of the corporation, oversight of
the activity of the corporation’s managers, rights of the principals in the case of the sale
of assets or owner- ship interests, annual reporting requirements, and other issues that
affect the internal rules of the business venture.

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 • Over half of the states have adopted all or substantial portions of a model act known as
the Revised Model Business Corporation Act (RMBCA) drafted by the American Law
Institute.

II. CLASSIFICATIONS OF CORPORATIONS [p. 564]

Points to emphasize:

• Corporations are classified into one or more categories that reflect their overall purpose,
capitalization (how they are funded), location, and structure.
• The two major categories are corporations are privately held corporations (owned by a
group of investors) and publicly held corporations that sell their ownership interest via
public stock exchanges.

A. Privately Held versus Publicly Held [p. 564]

• The most common type of corporation is a privately held corporation.

• Privately held corporations have substantial flexibility in terms of their internal operating
procedures such as the ability to use a unanimous consent resolution to elect directors or
issue stock in lieu of an annual meeting.
• Many states also give privately held corporations the option of electing to become a
closely held or family held entity both of which limit who can become a shareholder.
• When a privately held corporation wishes to fund capitalization through the sale of
ownership interest to the general public and commercial investors, the principals pursue
an initial public offering (IPO) and become a publicly held corporation.
• The company’s stock then is traded on a public stock exchange and is highly regulated.

B. Other Categories [p. 565]

Besides being classified as publicly held or privately held, corporations may fall into one of the
following categories:

• Domestic – a business operating in the state in which it was incorporated,

• Foreign – a business operating in a state other than the one it was incorporated,
• Alien – a business incorporated in another country and operating in the U.S.,
• Nonprofit and benefit – a company serving a public service for which it does not seek a
profit,
• Public – a corporation operated by the government, and
• Professional – corporations whose ownership is limited to a specific profession.

III. FORMATION AND START-UP ISSUES [p. 566]

Points to emphasize:

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• To form a corporation, articles of incorporation are filed with the secretary of state’s
office in the state of incorporation which set out the corporation’s name, purpose, number
of shares issued, and address of the corporation’s headquarters.

A. Pre-incorporation Activity: Liability of Promoters [p. 566]

• In most cases, an individual, known as a promotor, begins to carry out a business

venture’s activities before filing the articles of incorporation including arranging for
necessary capital through a loan, recruiting personnel, leasing property, and arranging to
have the business incorporated.
• If the promoter makes a contract on behalf of a not-yet-formed corporation, the promoter
can be personally liable if she knows (and the other party has no reason to know) that the
corporation is not in existence on the day of the signing.
• A promoter’s personal liability ceases at the moment that the corporation is formed and
has adopted the contract.

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Case 30.1 Branch v. Mullineaux et al., 2010 N.Y. slip op. 31850(U), Supreme Court of New
York County

Facts: Branch agreed to provide $75,000 in short-term financing to three individuals (MGS) for
the purposes of starting a business. Branch entered into an agreement with MGS whereby it was
agreed that the yet-to-be-formed venture would pay back the money to Branch at an interest rate
of 10 percent over four months. Although MGS formed the corporation, it did not ratify the loan

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agreement with Branch. When the business stopped making payments on the loan, Branch sued
MGS as individuals under a theory of promoter liability. MGS defended by claiming that the
$75,000 was an investment and therefore the entire amount was at risk without any liability on
MGS’s part.

Issue: Was MGS personally liable for the loan?

Ruling: Yes, MSG signed the loan agreement as a promotor. The corporate entity did not exist
at the time of signing the loan agreement, and after it was formed, did not ratify the contract.
Thus, the promotor is personally liable.

Case Questions

1. What steps should Mullineaux, Gefter, and Satsky have taken to help limit their promoter
liability?

• MGS should have had the corporation immediately ratify the contract upon formation.

2. What steps could Branch have taken to limit his losses?

• Branch could have made sure the corporation ratified the contract and obtained personal
guarantees from MGS.

3. Focus on Critical Thinking: Isn’t Branch’s loss a risk of doing business? Why should
Mullineaux, Gefter, and Satsky be individually liable?

• This question is meant to encourage a discussion on under what circumstances business

owners should be liable for start-up costs.

B. Choice of State of Incorporation [p. 568]

• Most corporations with a relatively small number of principals choose to incorporate in

the state in which they will locate their principal office and operate the business venture.
• Many publicly held corporations choose to incorporate in Delaware because the
Delaware statutes give their officers and directors wide latitude in decision making that
does not require shareholder consent and provide additional protections to officers and
directors against shareholder suits.
• Contrary to popular belief, Delaware does not provide a tax advantage to out-of-state
businesses who incorporate there.

C. Tax Matters [p. 569]

Before selecting an appropriate form of entity, the parties try to anticipate the best way to
minimize taxes while maintaining an appropriate degree of liability protection.

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 1. C Corporations [p. 569]

Every C corporation is considered a legal, taxable entity that is separate from the owners for
income tax purposes. As such, corporations pay tax on their earnings, and then shareholders pay
tax on any corporate earnings distributed to them in the form of dividends. This system is known
as double taxation.

2. S Corporations [p. 569]

Corporations that qualify for and elect Subchapter S treatment according to IRS rules offer pass-
through (also known as flow-through) tax treatment. All shareholders must agree to the Sub S
status.

D. Initial Organizational Meeting [p. 569]

After filing the articles of incorporation, the principals typically hold an organizational meeting
to address the following:

• Adopt bylaws – which typically specify the date, time, and place for the annual
shareholders meetings; the number of officers and directors of the corporation; the
process for electing the board of directors; and a listing of each officer along with a
description of that officer’s duties.
• Elect the board of directors and officers – unless already set forth in the Articles of
Incorporation.

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 • Issuance of shares – certificates of stock are then issued to the owners (shareholders) and
contain the owner’s name and the number of shares issued. The issuance of shares is
usually recorded in a stock register and kept by the secretary of the corporation along
with other corporate records of the business (such as meeting minutes, resolutions, etc.).

E. Corporate Formalities [p. 570]

Officers and directors have a responsibility to comply with state statutory requirements
(corporate formalities) regarding shareholders/directors’ meetings, filing annual reports, and
disclosures to shareholders, and they must use their best efforts to keep corporate records and
bylaws up to date. Failing to attend to corporate formalities can result in a loss of limited liability
protections.

IV. SOURCES OF FINANCING [p. 571]

Points to emphasize:

• Corporations may be funded through debt or through the selling of equity (ownership
interests) in a variety of forms.

A. Debt [p. 571]

• Corporations often borrow money from either commercial lenders (such as banks) or
private investors to fund day-to-day operations, usually evidenced by loan agreements
and promissory notes. However, bonds and debentures typically have lower interest rates.
• Bonds are debt money issued by a corporation to the general public with promises to pay
the bondholders back at a specified rate of interest for a specified length of time and to
repay the entire loan upon the expiration of the bond (known as the maturity date) and are
secured with specific corporate assets.
• Debentures function essentially the same as bonds, but instead of pledging some specific
piece of property, debentures are issued on the strength of the general credit of the
corporation

B. Equity [p. 571]

Corporations also sell equity to private investors or groups of investors to capitalize their
operations. These transactions are generally covered by securities laws as covered in the next
Unit.

C. Venture Capital Firms [p. 571]

When a corporation seeks a more significant amount of capital, the corporation may turn to a
venture capital firm. A venture capital firm consists of professional investors who will insist on
substantial control (board seats and officers) in exchange for their investment. They will also

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require an “exit strategy” (such as when the company goes public) and substantial return on their
investment.

D. Public Offerings [p. 571]

Privately held corporations may also choose to go through the expensive and time-consuming
process of an initial public offering (IPO) where its shares are listed on a stock exchange and
sold to the public and financial institutions.

V. CORPORATE VEIL PROTECTION [p. 572]

Points to emphasize:

• In general, shareholders, directors, and officers of a corporation are insulated from

personal liability in case the corporation runs up large debts or suffers some liability.
• This liability protection is often referred to as the corporate veil.

A. Piercing the Corporate Veil [p. 572]

• A court will sometimes pierce the corporate veil when it believes that fairness demands
it and hold the shareholders personally liable for the corporation’s debts.
• If at least two of these factors are present, a court is more likely to pierce the corporate
veil:
o Inadequate capitalization - When a corporation is merely a shell with nothing
invested, or the investment is siphoned off by the shareholder.
o Nature of the claim - When the claim involves some sort of tort such as
negligence by the corporation’s employees or even by the principals themselves.
o Evidence of fraud or wrongdoing - If the shareholders, officers, or directors have
committed fraud or have engaged in some type of serious and willful wrongdoing.
o Failing to follow corporate formalities – Where there is not proper separation
between the corporation and the individual shareholder(s), no stock certificates
were ever issued, no shareholders meetings were ever held, and no proper
corporate records (such as minutes of the meetings, resolutions, or stock register)
were maintained.
• Courts rarely disregard the corporate entity’s limited liability protection.

Case 30.2 Trefoil Park v. Key Holdings et al., Civil Actions: 3:14-CV-00364 (Dist. Ct.,
Conn. 2016)

Facts: Trefoil leased commercial space to Key, a corporation. Two of Key’s principals made
representations about their financial commitment to the project. The lease contained no personal
guarantees from the principals. Key stopped paying rent 45 days into the lease and terminated
operations at the leased premises. Trefoil sued to pierce the corporate veil and collect over

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$500,000 owed to it as the corporation had no remaining assets claiming that the principals’
misrepresenting their commitment to the project constituted fraud.

Issue: Should the court pierce the corporate veil?

Ruling: No, piercing the corporate veil is an extreme remedy to be used to prevent an injustice
or fraud. In this case the verbal representations of the principals were insufficient to meet the
requirements of fraud. The court pointed out that (1) Hamlin and Levine invested and lost nearly
$450,000 in Key in total, (2) Key adhered to all corporate formalities, and (3) neither Hamlin nor
Levine removed funds for personal use or intermingled Key funds with their personal funds.
Summary judgment was granted for Key.

Case Questions

1. Why is it significant that Key’s principals never removed funds for personal use or
intermingled Key funds with their personal funds?

• This is evidence that the unavailability of funds to pay the lease was due to business
failure rather than bad acts on the part of the shareholders.

2. What is your interpretation of the court’s language that the decision “may seem harsh”?
Harsh on whom? Why?

• The decision not to pierce the corporate veil seemed harsh to Trefoil due to the
combination of the large amount of money spent up front by them and the short amount
of time it took for Key to breach the lease.

3. Focus on Critical Thinking: Are Key’s principals hiding behind the law? If the corporate veil
did not exist, how would that impact entrepreneurs interested in starting up new ventures? Is it
ethical to sign a 10-year lease and then breach it in one month? How could Trefoil avoid this
type of catastrophe in the future?

• This question is meant to elicit a discussion on why corporations provided limited

liability protection to owners.

B. Personal Guarantees [p. 574]

Because creditors are fully aware of the limited liability provided by the corporate veil, they
often seek personal guarantees from the shareholders. These personal guarantees are frequently
in addition to any collateral that is pledged by shareholders or the corporation itself.

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Case 30.3 De Lage Landen Financial Services v. Picasso Aesthetic and Cosmetic Dental
Spa, Civil Action No. 14-2240 (E.D. Pa. 2015)

Facts: Picasso, a professional corporation, entered into a loan agreement with De Lage for
$25,000 to be repaid with interest over a 5-year period. Rubin, the sole principal of Picasso,
executed a personal guarantee “absolutely and unconditionally guarantee[ing]” all payments
under the loan agreement. Shortly thereafter, the parties entered into a finance agreement under
similar terms, including a personal guarantee by Rubin, to finance office equipment. When
Picasso stopped paying on both the loan and finance agreements, De Lage repossessed the office
equipment and brought a lawsuit against both Picasso and Rubin. Rubin argued that De Lage
could not proceed against him personally until after an accounting had been completed of the
repossessed equipment.

Issue: When does the right to proceed on the personal guarantee accrue?

Ruling: Once Picasso stopped making payments on the loan and finance agreement and failed to
cure the default, De Lage had the right to proceed against both Picasso’s corporate and Ruben’s
personal assets. The court granted summary judgment for De Lage.

Case Questions

1. Why do you suppose De Lage required Rubin to sign a personal guarantee for the loans and
lease?

• The lender most likely sought a personal guarantee from the principal of the corporation
due to the limited assets of the entity combined with its corporate veil.

2. Read over the language of the guarantee that Rubin signed. How could the language be
modified to make it more favorable for Rubin?

• The language could have been changed to require De Lage to proceed against the
corporation prior to bringing suit against Rubin and then only for the deficiency.

3. Focus on Critical Thinking: Is it possible that Rubin may not have realized the impact of a
personal guarantee? He was a trained dentist and testified that he did not have an attorney review
the documents. Should state legislatures pass disclosure and protection laws for small-business
owners that are modeled on consumer protection laws for home mortgage loans? Could such
regulation result in a decreased number of loans offered to small-business owners?

• This question is designed to encourage discussion on how small businesses may be at risk
for not understanding how guarantees work.

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VI. SHAREHOLDERS, DIRECTORS, AND OFFICERS [p. 576]
Points to emphasize:

• Shareholders are the owners of the corporation and act principally through electing and
removing directors and approving or with- holding approval of major corporate decisions.
• Directors are responsible for oversight and management of the corporation’s course of
direction.
• Officers carry out the directors’ set course of direction through management of the day-
to-day operations of the business.

A. Shareholders [p. 576]

• Shareholders are the owners of the corporation, who assuming a majority of ownership
consent, have the power to elect and remove directors at the annual shareholders
meetings.
• State statutes also give rights to shareholders to veto any fundamental changes to the
corporation that are proposed by the directors and officers.
• They do not have a right to manage the day-to-day operations of the corporation.
• Voting stock may be issued to those who wish to control the corporation with nonvoting
stockholders having a right to receive payments when the corporation makes a profit.

B. Board of Directors [p. 577]

The board of directors is responsible for setting the strategy and policies of the corporation. They
also have an important oversight function, and state statutes require that the body be independent
from the shareholders and officers.

1. Election of Directors [p. 577]

• Shareholders elect directors.

• The bylaws also set the procedures and requirements for an election in terms of time and
date, notification to shareholders, and how many shareholders must be present to hold a
vote (known as the quorum requirement).
• Some states require at least three directors, except in the case of a closely held
corporation where the number of directors is equal to the number of shareholders

2. Removal of Directors [p. 577]

Directors may be removed by a shareholder vote, with or without cause, or, less frequently, by a
court order for cause only. This is a rare event, but it would be necessary in the event that the
director at issue is also a shareholder with sufficient voting power to defeat removal votes by
minority shareholders

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 3. Meetings [p. 578]

Acts of the board of directors take place only at official meetings that occur at a regular annual or
semiannual time as specified in the corporation’s bylaws or by a statute or by unanimous
consent. Special meetings can be held in between the annual meeting with notice as specified in
the bylaws.

4. Committees [p. 578]

Much of the board’s work is done through committees (such as the audit committee), which are
small groups of board members who are charged with oversight or to perform a given task and
make a recommendation to the full board.

C. Officers [p. 578]

The corporation’s officers are appointed by, and may be removed by, the board of directors. The
officers carry out the day-to-day operations of the corporation and execute the strategy and
mandates set out by the board of directors. Officers have both express authority (which comes
from the bylaws or by a board of directors’ resolution) and implied authority (as agents of the
corporation).

1. President [p. 578]

Traditionally, the president of a corporation has the implied power to bind the corporation in
ordinary business operation transactions and has oversight of nonofficer employees.

2. Vice President [p. 578]

Depending on the size and scope of the corporation, the vice president may have some limited
implied authority.

3. Treasurer [p. 579]

Aside from the routine tasks of collecting the accounts receivable and paying the accounts
payable, the treasurer has little or no other implied authority.

4. Secretary [p. 579]

The secretary has the implied authority to certify the records and resolutions of the company.

VII. FIDUCIARY DUTIES OF OFFICERS, DIRECTORS, AND CONTROLLING

SHAREHOLDERS [p. 579]
Points to emphasize:

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• Officers and directors (known as insiders) owe the corporation’s shareholders several
well-defined fiduciary duties: the duty of care and the duty of loyalty.
• Breaching these duties can result in personal liability.
• The business judgment rule protects officers and directors from liability for decisions
that may have been unwise but did not breach the duty of care provided they acted in
good faith.

A. Duty of Care [p. 579]

• Officers and directors must exercise the degree of skill, diligence, and care that a
reasonably prudent person would exercise under the same circumstances.
• To meet the duty of care, the officer or direct must have acted in good faith, using the
care that an objectively prudent person in a like position would exercise under similar
circumstances, and in a manner that is reasonably calculated to advance the best interests
of the corporation.
• The following are ways in which an officer or director may breach their duty of care:
o Negligence - When a director does not read reports, financial records, or other
information provided by the corporation, or doesn’t attend meetings.
o Failure to act with diligence - Directors have an obligation to question any
suspicious activity, obtain the advice of outside experts, and monitor the inner
workings of the corporation.
o Rubber stamp - Directors have the duty to be sure that any transaction proposed
by the officers (or other directors for that matter) is, from the best information
available to them at the time, in the best interest of the corporation and is not
imprudent If the director disagrees with a decision being made by the other
directors, they must register their dissent in the record of the meeting.
• Under the RMBCA, directors still fulfill their duty of care even if they do not personally
verify the records or other information provided to them by officers or outside experts.
Directors may rely on opinions, reports, statements, and financial records that are
presented by the officers of a corporation, whom the director “reasonably believes to be
reliable and competent in these matters.

B. Business Judgement Rule [p. 580]

• The business judgment rule protects officers and directors from liability for decisions
that may have been unwise but did not breach the duty of care.
• This rule insulates directors from liability when, based on reasonable information at the
time, the transaction or course of action turns out badly from the standpoint of the
corporation.
• Most courts define good faith by requiring directors and officers to clear three hurdles to
obtain the protection of the business judgment rule:
o No private interest - The director must have had no financial self-interest in the
disputed transactions or decision.

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 o Best information - Directors and officers have a duty to be diligent in
investigating any proposal, decision, or transaction; this includes consulting
outside experts when appropriate.
o Rational belief - The third requirement that directors and officers must meet to be
protected under the rule is that the decision or approval of the transaction must
have been the product of some reasoned decision making based on rational
beliefs.

Case 30.4 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)

Facts: Van Gorkom was an officer, director, and shareholder of Trans Union Corporation. Trans
Union’s stock was traded on the New York Stock Exchange (NYSE) and had never sold for
higher than $39 per share. Prior to announcing his retirement, Van Gorkom sought to sell his
shares to Pritzker, an individual investor, for $55 per share. The other directors initially voted
against the sale because the price was “too low,” but later approved the sale after pressure from
Van Gorkom. After the shareholders brought suit for breach of duty of care in approving the sale,
the directors sought protection under the business judgment rule.

Issue: Could the directors receive protection under the business judgment rule?

Ruling: No, the directors failed to obtain all of the needed material information in order to make
a decision. They did not investigate the transaction, review the Van Gorkom-Pritzker agreement,
or seek expert advice.

Case Questions

1. Assume that the directors were highly sophisticated business executives. Should they have
been required to consult others about issues where they already have sufficient knowledge (such
as a company’s valuation)? If they were highly sophisticated business executives with financial
valuation knowledge, they would not need to seek an expert’s opinion.

2. What else should the directors have done to satisfy their fiduciary duties? They should have
requested an extension to vote on the issue and sought an independent assessment of the value of
the stock.

3. Focus on Critical Thinking: In response to Smith v. Van Gorkom, many states (including
Delaware) passed statutes that extended the scope of the business judgment defense. Should the
business judgment rule protect directors even when they fail to verify the statements of internal
management concerning a corporate transaction that is being touted to officers as advantageous
to the corporation? These questions are meant to encourage a discussion on what the business
judgment rule requires and when it should apply.

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 C. Duty of Loyalty [p. 582]

An additional fiduciary duty owed to shareholders by officers, directors, and controlling

shareholders is the duty of loyalty. It is primarily focused on providing protection to shareholders
when a transaction occurs in which there is a possibility of self-dealing.

1. Prohibition against Certain Self-Dealing [p. 582]

Self-dealing occurs when an officer, director, or controlling shareholder has some personal
financial stake in a transaction that the corporation is engaged in and the officer, director, or
shareholder helps to influence the advancement of the transaction. The RMBCA provides that a
self-dealing transaction is not a breach of the duty of loyalty so long as a majority of
disinterested parties (those with no self-interest conflicts) approve it after disclosure of the
conflict.

2. Corporate Opportunity Doctrine [p. 583]

The duty of loyalty also requires disclosure and good faith when an insider (i.e., director, officer,
or controlling shareholder) learns of a potentially lucrative business opportunity that could enrich
her individually but is related to the corporation’s business. an insider may not usurp for herself
a business opportunity that belongs to the corporation or would benefit the corporation in some
direct way. Courts use several factors to determine when an opportunity belongs to a corporation
and is therefore off-limits to insiders who are officers, directors, or controlling shareholders
unless they have followed specific disclosure steps:

1. Did the corporation have a current interest or expected interest in the opportunity (such as an
existing contract to purchase a piece of property)?

2. Is it fair to the corporation’s shareholders to allow another to usurp a certain interest?

3. Is the opportunity closely related to the corporation’s existing or prospective business

activities?

Case 30.5 Ebenezer United Methodist Church v. Riverwalk Development Phase II et al., 42
A.3d 883 (Md. Ct. App. 2012)

Facts: Synvest’s business involved holding undeveloped property in its own name while it
arranged construction financing, then transfering the property to a newly created entity once the
funds had been secured. Synvest transferred certain property to an entity known as River Walk
Development (Riverwalk I). In 2002, Ebenezer United Methodist Church (EUMC) purchased a
50 percent interest in Riverwalk I for $250,000, and construction commenced soon afterwards. In
the meantime, Synvest formed Riverwalk II and a third entity which along with Riverwalk I had
obtained a line of credit for the development of the parcels. Synvest bought EUMC out of

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15
Riverwlk I with EUMC receiving $30,000 in addition to the repayment of their initial
investment. EUMC sued Synvest claiming that it should have shared in any profits of Riverwalk
II. The trial court ruled in favor of Green/ Riverwalk II, and EUMC appealed.

Issue: Did the duty of care require Synvest to include EUMC in Riverwalk II?

Ruling: No, the appellate court affirmed the trial court’s decision holding that the corporate
opportunity (Riverwalk II) was not usurped because the only connection to Riverwalk I was the
joint financing.

Case Questions

1. Why did EUMC believe that it was entitled to become a partner in Riverwalk II?

• Because the Riverwalk II and I were both connected through a line of credit.

2. EUMC reaped a substantial profit from its River- walk I investment. Should that be a
factor in the court’s analysis? Why or why not?

• It probably did influence the judges. Had EUMC lost money on Riverwalk I, there
may have been a different result.

3. Focus on Critical Thinking: What other fiduciary duties may Green have breached given
these facts? Explain. Could Green assert the business judgment rule as a defense?

• These questions are designed to elicit a conversation on how fiduciary duties and
the business judgment rule are related.

3. Duty to Disclose [p. 585]

Officers, directors, and controlling shareholders who become aware of an opportunity belonging
to the corporation must disclose the opportunity to the corporation in total. If the board, for
whatever reasons, rejects the opportunity, the insider is then free to pursue the opportunity with
no fear of liability

VIII. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES [p. 587]

Key Terms [p. 587-588]

Chapter Review Questions [p. 589-590] Note: Answers and explanations are provided at
the very end of the chapter.

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Thinking Strategically Questions and Answers [p. 585-586]

1. Why is it important to take steps to preserve the corporate veil?

• One of the greatest benefits of a corporate form of entity is the separation between
the corporation and its principals. The corporate veil protects the personal assets
of principals for debts and liabilities of the business. However, since a corporate
veil can be pierced by a court in certain circumstances, the prevention strategy
helps to keep the corporate veil strong, and courts are less likely to discard it for
lack of attention to corporate formalities.

2. What kinds of methods and systems could be put into place to ensure that these corporate veil
protection steps take place on a systematic basis? Who should be responsible?
• This question requires students to pull information from the Thinking
Strategically feature related to corporate formalities. Specifically:
o Designate a specific person responsible for record keeping and
communicating with counsel.
o Creating an effective record-keeping system to maintain (and update)
corporate records such as articles of incorporation, by-laws, corporate
resolutions.
o Establish a regular time for an annual shareholders meeting and document
any decisions or important discussions in the corporate minutes.
o File and amend required corporate filings including tax returns and annual
reports required by the corporation’s state of incorporation.
o Be aware of the purpose of “arms-length” transactions.
o Use a corporate designator on all corporate correspondence and
documents.

Case Summary Questions and Answers [p. 225-226]

CASE SUMMARY 30.1 Miner v. Fashion Enterprises, Inc., 794 N.E.2d 902 (III. App. Ct.
1999)

1. Who prevails and why?

• The appellate court held that the principals could be liable for the debts of the
corporation because the principals had not acted as a corporation in that they did
not adhere to corporate formalities.

2. What factors would the court weigh in deciding whether to pierce the veil?

• The court weighs 1) maintenance of corporate records such as a meeting minutes,

stock certificates issued, 2) the actions of the principals to maintain a corporate

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17
 identity (separate bank account etc), and 3) whether the transactions were “arm’s
length.”

CASE SUMMARY 30.2 Village at Camelback Property Owners Association v. Carr, 538 A.2d
528 (Pa. Super. 1988)

1. Which factors weigh in favor of the court piercing the corporate veil?

• Factors in favor: 1) comingling of funds, 2) failing to keep corporate records, 3)

nonfunctioning board of directors, 4) inadequate capitalization. Factors against:1)
no fraud or crime was committed, 2) no personal injury, 3) properly incorporated.

2. Should Carr be able to avoid liability even if he was the sole shareholder?

• The fact that he was a sole shareholder may be a factor (especially if fraud is
involved), but it is not determinative. A corporation can be properly maintained
by a single shareholder.

CASE SUMMARY 30.3 Goodman v. Darden, Doman & Stafford Associates 670 P.2d 648 (Wa.
1983)

1. Was Goodman acting as a promoter when he negotiated the contract?

• The court held that as a general rule where a corporation is contemplated but has
not yet been organized at the time when a promoter makes a contract for the
benefit of the contemplated corporation, the promoter is personally liable on it,
even though the contract will also benefit the future corporation.

2. When, if ever, does Goodman’s liability as a promoter end?

• The liability of a promoter end when the corporation has been formally
recognized by the appropriate authority (e.g., state corporation bureau) and the
corporation adopts a resolution which ratifies the contract.

CASE SUMMARY 30.4 In Re the Dow Chemical Company Derivative Litigation, Cons. Civil
Action No. 4349-CC. (De. Ct. Chancery 2010)

1. Who prevails and why?

• The court ruled in favor of the directors because “substantive second-guessing of

the merits of a business decision, like what plaintiffs ask the Court to do here, is
precisely the kind of inquiry that the business judgment rule prohibits.”

2. Are the directors seeking protection by the law for their own negligence? Explain.

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18
 • With respect to the fiduciary duty claims arising from the Dow board’s approval
of the acquisition of R&H, the court considered whether there was reasonable
doubt that either (1) a majority of the directors who approved the transaction in
question were disinterested and independent, or (2) the transaction was the
product of the board’s good faith, informed business judgment. The court found
that a majority of the directors were disinterested and independent. According to
the court “without an interested director the independence of the remaining
directors need not be examined.”

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 Chapter 31
Corporate Transactions: Acquisitions and Mergers

CHAPTER OVERVIEW
This chapter covers mergers and acquisitions (M&As), strategic business transactions where the
ownership of companies is transferred or combined. It explains the differences between mergers
and acquisitions, the role of strategy in the M&A context, the fiduciary duties related to M&As,
and the various corporate transactions including hostile takeovers.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Distinguish between mergers and acquisitions. Application
Identify some strategic aspects of mergers and acquisitions. Knowledge
Articulate the successor liability doctrine. Knowledge
Understand the fiduciary duties of board members in corporate Knowledge
transactions.
Define a hostile takeover. Knowledge
Summarize the nuts and bolts of corporate transactions. Knowledge

Teaching Tip: Helping students understand the differences

• Mergers and acquisition can be a little difficult to understand for undergraduate students.
It may help to begin the lesson by explaining why a company would want to acquire
another company (to expand their operations geographically) or merge with another
company (consolidate resources to better compete with larger competitors--such as the
proposed T-Mobile and Sprint merger which would allow them to better compete with
ATT and Verizon). With the acquisition, the initial company absorbs the acquired
company. With a merger, a new third company is usually formed. See Figure 31.1.

I. TYPES OF CORPORATE TRANSACTIONS [p. 591]

Points to emphasize:
• A merger occurs when two or more companies combine to form a new entity altogether,
and neither of the previous companies remains in existence.
By contrast, an acquisition (or takeover) is the purchase of one company by another company:
the acquiring corporation takes over the target corporation by stepping into the shoes of the
target, while the target company disappears by operation of law. The acquiring company can
purchase either the stock or the assets of the target company.
o In 2006, for example, Google acquired YouTube in a stock purchase acquisition.
See Figure 31.2.
o In 2012, Facebook acquired Instagram in a stock purchase acquisition. See Figure
31.3.
o In 2018, AT&T and Time Warner merged. See Figure 31.4.

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II. SOME STRATEGIC ASPECTS OF MERGERS AND ACQUISITIONS [p. 594]
Points to emphasize:
• Corporate acquisitions can be characterized as either stock purchases or asset purchases.
o In a stock purchase, a buyer buys the shares, and therefore control, of the target
company. Because the company is acquired intact as a going concern, this form of
transaction carries with it all the legal liabilities accrued by that business over its
past and all of the risks that company faces in its commercial environment.
o In an asset purchase, a buyer buys the assets of the target company. This type of
transaction leaves the target company as an empty shell if the buyer buys out all
of its assets. The buyer may structure a transaction as an asset purchase in order to
cherry-pick the assets that it wants and leave out the assets and liabilities that it
does not. This strategy can be particularly important when some of the assets are
attached to foreseeable liabilities.
• The term acquisition usually refers to a purchase of a smaller firm by a larger one. Some-
times, however, a smaller firm will acquire control of a larger or longer-established
company and retain the name of the latter for the post-acquisition combined entity. This
type of transaction is called a reverse takeover.
• Another type of acquisition is the reverse merger, a form of transaction that enables a
private company to be publicly listed in a relatively short time frame.
• There are also a variety of structures used in securing control over the assets of a
company, which have different tax and regulatory implications. The terms demerger,
spin-off, and spin-out are sometimes used to indicate a situation where one company
splits into two, generating a second company that may or may not be listed separately on
a stock exchange. When these transactions do not involve “all or substantially” all of the
corporation’s assets, shareholder approval is usually not required.

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Case 31.1 Gimbel v. Signal Companies, Inc., 316 A. 2d 619 (Del. 1974) [p. 595]

Facts: Signal was a large business conglomerate that started out as an oil company which sold
the stock of an oil subsidiary to another company. This sale was approved by the board of
directors, but not submitted for a shareholder vote. The subsidiary constituted 41% of Signal’s
net worth, 26% of Signal’s total assets, and 15% of Signal’s total revenue and earnings. Louis
Gimbel III, a stockholder of Signal, sued Signal in a Delaware court to stop the sale and require
shareholder approval of the sale under Delaware General Corporation Law § 271(a).

Issue: Did the sale of the oil subsidiary constitute “all or substantially” all of Signal’s assets
requiring a shareholder vote?

Ruling: No, although the statute does not provide a mathematical formula, by three different
calculations, the sale constituted less than half of the assets of the corporation.

Case Questions

1. In your opinion, was the sale of the oil subsidiary a sale of “all or substantially all” of Signal’s
business? Why or why not?
• On the one hand, one could argue “yes,” given the subsidiary’s high net worth, but on the
other hand, one could argue “no,” since 85% of Signal’s revenue came from other
subsidiaries.

2. Why doesn’t the law require shareholder approval every time a board decides to sell or
transfer a part of the company’s business?
Requiring shareholder votes takes time and money. When selling off assets, especially if the
proceeds are designated for another purpose, such as purchasing another company, time is of
the essence. The Board of Directors is charged with long-term planning and have fiduciary
obligations to the corporation. Shareholder may be focused on the return on their investment.
Allowing a Board to make a decision on the sale of assets is in line with its duties.
3. Focus on Critical Thinking: Why doesn’t the court just adopt a fixed numerical cutoff or
simple quantitative rule to determine whether a sale constitutes “all or substantially all” of a
company’s assets?
• This question is designed to elicit thought on the difference between bright-line rules and
general standards; for example, how multiple considerations much be made in
anticipation of a divestiture, how assets valuations are different in a tech company than a
manufacturing company, and how the entire picture must be taken into consideration.

III. SUCCESSOR LIABILITY [p. 596]

Points to emphasize:
• One reason for choosing to purchase the assets of a company rather than the stock is that
a stock purchase includes all of a firm’s liabilities.
o In a merger or consolidation the liabilities of the acquired corporation are
assumed by the buyer.

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 • The general rule is that a company that acquires a seller’s assets is not responsible for the
seller’s liabilities simply due to the ownership of those assets.
o There are four general exceptions to the general rule against successor liability in
asset purchase transactions:
§ Where there is an express or implied agreement on the part of the buyer to
assume the liabilities of the seller.
§ The de facto merger doctrine, which applies to a transaction that is
essentially a merger or consolidation between the buyer and seller. The
courts will consider the following four factors: (1) Continuity of
management, personnel, physical location, and general business
operations, (2) Continuity of ownership, (3) Dissolution of the seller as
soon as possible after the transaction, and (4) Assumption by the buyer of
the seller’s obligations necessary for uninterrupted operation of the
business.
§ The mere continuation exception, which applies when the asset buyer is a
“mere continuation” of the seller. The courts will look for common
ownership between the buyer and seller, as well as the common identity of
officers or directors, etc.
§ If the asset transaction appears to be a fraudulent transaction to evade
liability for debts, such as if the seller was insolvent at the time of the
transfer, if inadequate consideration was paid, or if the seller was
undercapitalized. Generally, however, if a transaction is conducted at
arm’s length and is reasonable it will not be considered fraudulent.
o Also, even in purchase an asset , the buyer may become liable for some liabilities,
such as taxes.

IV. FIDUCIARY DUTIES [p. 597]

Points to emphasize:
• In general, members of the board of directors have a fiduciary relationship to the
shareholders of the corporation, including a duty of loyalty and duty of care. These duties
are explained in Chapter 30.
• These fiduciary duties are especially relevant when a board is considering whether to
approve or reject a proposed merger or acquisition.

Case 31.2 Paramount v. QVC Network, Inc., 637 A. 2d 34 (Del. 1994) [p. 597]

Facts: When Viacom proposed to acquire Paramount, Paramount was discouraged by the
contract from soliciting competing offers. (Paramount would have to pay a substantial penalty to
Viacom if it accepted a competing offer.) After QVC made a competing offer, Paramount raised
its counteroffer to Viacom but did not otherwise eliminate the penalties in the offer agreement.
QVC sued Paramount based on its board’s refusal to negotiate with QVC. The lower court ruled
in favor of QVC and issued an order stopping the Viacom-Paramount merger. Paramount
appealed to the Delaware Supreme Court.

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Issue: In applying the “enhanced scrutiny test,” did the Paramount’s board act reasonably and
with adequate information?

Ruling: No, the board did not act reasonably in rejecting the higher offer from QVC as to
process or result. While a court may not second guess a board’s decision, under the enhanced
scrutiny test may, it may examine whether the board’s decision was in the realm of
reasonableness. The key features of an enhanced scrutiny test are: (a) a judicial determination
regarding the adequacy of the decision-making process employed by the directors, including the
information on which the directors based their decision; and (b) a judicial examination of the
reasonableness of the directors’ action in light of the circumstances then existing. The directors
have the burden of proving that they were adequately informed and acted reasonably, which they
could not in this case.

Case Questions

1. Did the Paramount board of directors breach its fiduciary duty to Paramount’s shareholders
by refusing to pursue the better offer from QVC? Why or why not?
• They court held that they did, but there is an argument that the substantially high penalty
which would have been imposed by Viacom and the potential resulting litigation reduced
the attractiveness of accepting the QVC offer.

2. Paramount argued that it had a contractual duty not to consider competing offers, but at the
same time, Paramount’s directors have a fiduciary duty to act in the best interests of
Paramount’s shareholders. In your opinion, which of these two duties should prevail when
they are in conflict with each other?
• Fiduciary duties should prevail when in conflict with a contract, otherwise contracts
could require businesses to engage in unethical conduct or conduct contrary to the
corporation’s interests.

3. Focus on Critical Thinking: Should all merger or acquisition decisions by a board be

subjected to the “enhanced scrutiny test”? If so, is there any possible way a board’s decision
can pass this judicial test? If not, why does the court apply this test to the facts of this case?
• This question is meant to elicit a discussion on the limits of a board’s discretion.

Teaching Tip: Hostile Takeovers

Students love learning about hostile take-overs and asserted defenses. Some fun ones to talk
about include Elon Musk’s surprise announcement in April 2022 to purchase the popular social
media app Twitter; InBev’s hostile take-over of Anheuser-Busch, where InBev sued to have the
entire board of Anheuser-Busch fired; and Icahn Enterprises’s attempted take-over of Clorox in
which Carl Icahn sent a letter which included provisions in ALL CAPS to Clorox’s board. Hint –
it was not very nice.

V. THE LAW OF HOSTILE TAKEOVERS [p. 598]

Points to emphasize:

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 • A hostile takeover occurs when the board of a target company has no prior knowledge of
an acquirer’s purchase offer.
• Ordinarily, most corporate transactions occur in a so-called “confidentiality bubble” in
which the flow of information is restricted pursuant to confidentiality agreements. In the
case of a friendly transaction, the companies cooperate in negotiations. But in the case of
a hostile deal, the board or the management of the target company is unwilling to be
bought or the target’s board has no prior knowledge of the offer. If the acquirer is able to
obtain endorsement for the takeover from the board of the target company, the transaction
can become friendly.
• If the board does not endorse the deal, there are a number of defense strategies which can
be initiated. See Figure 31.6.

Case 31.3 Unitrin, Inc. v. American General Corp., 651 A. 2d 1361 (Del. 1995) [p. 599]

Facts: American General wanted to initiate a tender offer for a sufficient proportion of Unitrin’s
stock in order to initiate a merger with Unitrin. The board of directors of Unitrin, however, felt
that the tender offer price was too low. Deeming American General’s tender offer a “hostile
takeover,” Unitrin’s board initiated two proactive defensive measures to prevent the takeover: a
poison pill shareholder’s rights program and an open-market stock repurchase program.
American General and some of Unitrin’s stockholders sued Unitrin to stop it from instituting
these defensive measures and the lower court agreed.

Issue: Were Unitrin’s poison pill and open-market stock repurchase program reasonable?

Ruling: Yes, given the low tender offer and potential antitrust issues which could have resulted
from the takeover, the board’s perception of danger was reasonable. Among other factors the
court felt that the presence of a majority of outside independent directors materially enhanced the
evidence of reasonableness.

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Case Questions

1. How should the court determine whether the defensive measures approved by the board were
reasonable?
• The court should look to see if there is any self-interest influencing the board’s decision.
If there is not, and the fears explained are reasonable, the board’s decision should be
honored.

2. In general, board members owe a fiduciary duty to the shareholders of the corporation. That
means board members must act in the shareholders’ best interests. As such, when there are
divergent views between shareholders and the board over a tender offer, whose views should
prevail?
• One could argue that, because shareholders are often concerned only with their return on
investment, a board’s decision in line with its fiduciary responsibility should prevail.

3. Focus on Critical Thinking: Why doesn’t the court apply the enhanced scrutiny test in this
case? Doesn’t the decision in this case totally contradict the decision in the Paramount case
(Case 31.2)?
• This question is meant to encourage a discussion on under what circumstances a board’s
decision is subject to enhanced scrutiny.

VI. NUTS AND BOLTS OF CORPORATE TRANSACTIONS [p. 600]

Points to emphasize:
• A corporate transaction usually begins with a letter of intent followed by a process of
due diligence in which the acquirer reviews the financial state of the target company and
identifies any potential or actual legal liabilities of the target. While a letter of intent does
not bind the parties to complete the transaction, it sets up the terms under which it can go
forward and usually includes exclusivity and confidentiality provisions.
• The actual merger agreement, share purchase agreement, or asset purchase agreement are
usually 80-100 pages long and include the following provisions.
o Conditions, such as regulatory approvals, which must be satisfied before the
parties are obligated to complete the transaction.
o Representations and warranties by the seller, such as the amount of its net
working capital, which must be true at both the time of signing and of closing.
o Covenants, such as the obligation to pay taxes, which govern the conduct of the
parties both before and after closing.
o Termination rights, which may be triggered by a breach of contract, by a failure to
satisfy certain conditions, or by the passage of a certain period of time without
consummating the transaction, and which may include break-up fees.
o A legal approval clause requiring the parties to obtain approvals required under
state or federal law or per the contract.
o An indemnification clause, which provides that an indemnitor will indemnify,
defend, and hold harmless the indemnitee(s) for losses incurred by the

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9
 indemnitees as a result of the indemnitor’s breach of its contractual obligations in
the purchase agreement.

VII. END OF CHAPTER PROBLEMS, QUESTIONS, AND CASES

Key Terms [p. 603]

Chapter Review Questions [pp. 605-606] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [pp. 601-602]

1. From the perspective of reducing the risk of successor liability, how could you improve the
sample asset purchase agreement in Figure 31.7? In particular, what if the asset to be purchased
consists of intellectual property, such as the rights to a trademark or a patent? What specific steps
could the buyer of such an intangible asset take to protect its interests in the event a third party
were to challenge the trademark or the patent?
• From the buyer’s perspective, one possible solution is to include an “indemnification
clause” in the asset-purchase agreement. Note that this thinking strategically is designed
to elicit discussion about how to identify legal risks and how to use contracts to minimize
or reduce such risks.

Case Summary Questions and Answers [pp. 603-604]

CASE SUMMARY 31.1 Bernard v. Kee Manufacturing Co., Inc., 409 So. 2d 1047 (Fla. 1982)

1. In your opinion, should the court impose successor liability based on the facts of this case?
Why or why not?
• Ordinarily, the liabilities of the seller will not be imposed on the buying successor
company unless one of four exceptions applies: (1) the successor expressly or impliedly
assumes obligations of the predecessor, (2) the transaction is a de facto merger, (3) the
successor is a mere continuation of the predecessor, or (4) the transaction is a fraudulent
effort to avoid liabilities of the predecessor.

2. Would your answer to question 1 change if New Kee had chosen a different name for its
business?
• This question is meant to encourage a wider discussion about “form versus substance.”
On the one hand, the name of the successor business should not matter to our analysis of
successor liability, but on the other hand, a name change might be part of a fraudulent
effort to avoid the liabilities of the seller.

CASE SUMMARY 31.2 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)

1. Is the board’s decision to approve the buyout protected by the business judgment rule (i.e.,
made in good faith) under these facts? Why or why not?

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 • Given the hasty nature of its decision and the lack of expert input, one could argue that
the decision is not protected by the business judgment rule. Indeed, the court in this case
concluded that the business judgment rule did not apply to these facts and that the board
of directors breached the duty of care that it owed to the corporation's shareholders.

2. How likely is it that a court will apply the enhanced scrutiny test to these facts?
• To the extent the actions of the board of directors were not reasonable, it is more likely
that the court will apply the enhanced scrutiny test to the facts of this case.

CASE SUMMARY 31.3 In re Riverstone National, Inc. Shareholder Litigation, C.A. No. 9796-
VCG (Del. Ch. 2016)

1. Did the directors of Riverstone breach their fiduciary duties to the corporation when they
acquired an ownership interest in Investment Homes? Why or why not?
• Since the directors of Riverstone individually invested in a multi-billion dollar home
rental company that Riverstone helped to cultivate without pursuing investment options
for Riverstone itself, a prima facie case can be made that the directors breached their
fiduciary duties to Riverstone.

2. How likely is it that a court will apply the enhanced scrutiny test to these facts?
• To the extent the actions of the directors were not reasonable, it is more likely that the
court will apply the enhanced scrutiny test to the facts of this case.
CASE SUMMARY 31.4 Terry v. Penn Central Corp., 668 F.2d 188 (3d Cir. 1981)

1. Should the court apply the de facto merger doctrine to the facts of this case? Why or why not?
• The appellate court as well as the lower court both refused to apply the "de facto"
doctrine to this case because the shareholders never offered proof of fraud.

2. Should the law permit triangular mergers?

• This question is meant to encourage a wider discussion on the ethics of the strategic
exploitation of loopholes by business firms.

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 Chapter 32
Overview of the Securities Market: Definition, Categories, and Regulation

CHAPTER OVERVIEW
This chapter focus on business entities that raise capital from investors via the public markets by
either: (1) selling a percentage of ownership of the venture (equity) to investors who are
interested in receiving a return on their investment based on the success of the business; or (2)
issuing debt instruments to public investors who wish to receive a fixed rate of return regardless
of the profitability of the business entity.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the factors that differentiate the primary and secondary securities Knowledge
markets.
Identify the parties that participate in securities transactions and their specific Knowledge
roles.
Apply the legal test for what constitutes a security. Application
Distinguish between classifications of equity and debt instruments and given Knowledge
an example of each. Application
Recognize the fundamental reason behind securities regulation and Analytical
demonstrate a working knowledge of federal securities law. Thinking
Describe the role of the Securities and Exchange Commission (SEC) in Knowledge
securities law.
Explain the impact of state securities regulations relative to issuers, Knowledge
compliance, and enforcement.

I. FUNDAMENTAL OF SECURITIES TRANSACTIONS [p. 609]

Points to emphasize:
• Securities transactions occur in two settings: (1) original and reissuance of securities by a
business to raise capital (known as the primary market), and (2) the purchase and sale of
issued securities between investors (known as the secondary market).
• Both the primary market and the secondary market are governed by federal and state
securities law and regulations.
• Issuing securities to the public markets for the first time is known as an initial public
offering (IPO).
• The federal laws, regulations, and exemptions governing the primary market are found in
the Securities Act of 1933 (Chapter 33).
• The secondary market is largely regulated through the Securities Exchange Act of 1934
(Chapter 34).

II. ROLE OF THE PARTIES IN A SECURITIES TRANSACTION [p. 610]

Points to emphasize:
• Investors seek a return from their investment based on the value of the security (e.g.
individuals).

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 • Issuers are those institutions and entities that sell securities to investors (e.g.,
corporations).
• Intermediaries are financial institutions that provide services for investors and issuers
related to securities transactions (e.g., broker-dealers).

III. DEFINING A SECURITY [p. 611-612]

Business owners and managers need a working knowledge of securities laws.

A. Federal Securities Law [p. 611]

Points to emphasize:
• The following are examples of securities that are regulated by federal and state law:
stocks, bonds, partnerships interests, stock options, warrants, agreements to invest,
participation in a pool of assets, use of crowdfunding resources, and certain types of
promissory notes.
• A security is an investment that involves a person giving something with an expectation
of profit through the efforts of a third party.
• The SEC v. W.J. Howey Co., 328 U.S.293 (1946), test articulates a four-part test as a
framework for defining a security.

B. Modern Application of the Howey Test [p. 612]

Points to emphasize:
• The Supreme Court clarified the Howey test in United Housing Foundation v. Forman,
421 U.S. 837 (1975).
• Courts now apply a more sweeping standard on what constitutes a security including the
investment itself, commonality, profit expectations, and the efforts of others.
o Investment: May be cash or noncash where the investing party receives only the
speculative promise of a return and not any tangible commodity or assets.
o Commonality: This requirement is satisfied either through horizontal commonality
(multiple investors have a common expectation of profit) or via vertical
commonality (single investor has a common expectation of profit with the
promotor).
o Profit Expectations: The expectation of a return on investment must be the
primary reason for the investment.
o Efforts of Others: The efforts of the promoter(s) or agents of the promoter(s) must
be the primary sources of revenue that resulted in the profits (modern trend:
limited passive involvement by the investor is allowed).

C. Family Resemblance Test [p. 612]

Points to emphasize:
• In Reves v. Ernst & Young, 494 U.S. 56 (1990), the Supreme Court used a family
resemblance test in order to determine whether a promissory note fell under the
jurisdiction of securities laws.

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 • There is a presumption that promissory notes are securities unless the issuer shows that
the promissory note has a strong resemblance to a category of instrument that is not
classified as a security (e.g., a mortgage).

Case 32.1 SEC v. Thompson et al. 732 F.3d 1151 (10th Cir. 2013)

Facts: Thompson was among a group of principals who founded Novus as a vehicle for his
business ventures in China. Novus needed to raise $12 million to facilitate a transaction
involving selling biodiesel reactors to a Chinese company. In order to capitalize Novus to a
point where it could take advantage of the opportunities in China, its principals issued a series of
instruments that they labeled as “unsecured promissory notes” (Notes). The Notes promised that
Novus would repay the principal plus interest after a term of six months. However, they also
included a provision that gave Novus the option to extend the term. On the face of the Note, it
said it was not a security.

The SEC filed a complaint against Novus for selling unregistered securities and obtained
a temporary restraining order against Novus. The trial court granted the SEC’s motion for
summary judgment against Novus and its principals. Novus appealed.

Opinion: The Court of Appeals for the 10th Circuit ruled in favor of the SEC holding that the
Notes were securities under the family resemblance test.

Case Questions

1. Should the court have given more weight to the fact that the Notes were plainly marked with a
disclaimer?
• The fact that the Notes were marked as not securities is not significant; otherwise, a bond
certificate could also say it is not a security when bonds clearly are. You have to look at
the family resemblance test and the modern Howey test to determine if something is a
security or not.

2. The SEC intervened in this transaction even though no investors lost money. Did the SEC
overstep its bounds?
• The SEC is there to make sure appropriate disclosures are made to protect the investing
public whether or not the security makes or loses money.

3. Focus on Critical Thinking. The SEC claimed that the Notes could be considered investment
contracts under Howey, but the court did not reach that issue. Do you agree with the SEC’s
position that the Notes were investment contracts similar to that in Howey? Why or why not?
• The students should discuss whether or not this meets the four-prong test in Howey.
However, the promise of a return was not speculative; the investors received interest.

D. Defining a Seller of Securities [p. 613]

Points to emphasize:

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 • In some cases, it is difficult to discern if an investment opportunity clearly falls within the
definition of a security.
• Case 32.2 addresses whether a real estate opportunity is a security and who qualifies as a
seller of securities.

Case 32.2 San Francisco Residence Club, Inc. v. Amado, 773 F. Supp. 2d 822 (N.D. Cal.
2011)

Facts: Broda, the founder and CEO of Aspire Real Estate and Aspire Investments, was an
investment advisor for Donahue and his family. Donahue formed San Francisco Residence Club
(SFRC) as a California corporation for purposes of managing real estate investments. Broda
contacted Donahue about a real estate opportunity in White Sands Estate involving the
development of unimproved real estate in Hawaii, by Amado, a real estate developer. According
to Broda he simply was acting as a referral, but Donahoe contended that Broda advised him to
invest in White Sands and made representations about its profitability.

Donahue used SFRC to purchase an interest in White Sands which used the investment
and loans to purchase the unimproved real estate. Amado paid Broda a fee for arranging the
SFRC-White Sands transaction. White Sands quickly became insolvent, and the lenders
foreclosed on the property.

SFRC brought suit against Broad, Amado, and others alleging that Broda’s solicitation of
Donahue constituted an unregistered and nonexempt offering under the Securities Act of 1933.
Broda filed a motion for summary judgment claiming he merely gave advice and was not a
seller, only a referral agent.

Opinion: The U.S. District Court ruled in favor of SFRC and denied summary judgment. The
Court held that a reasonable factfinder could conclude that the SFRC transaction could be
classified as an “investment contract” under the Howey standard. The court also found that Broda
and Amado could also fit the statutory definition of a seller.

Case Questions

1. Compare the SFRC-Broda transaction to the standards used in the modern Howey test. Was
this an investment contract? Why or why not?
• Using the standards in the modern application of the Howey test, this is an investment
contract. The investing party received only a speculative promise of a return based on the
efforts of others. There was horizontal commonality and the expectation of a return on
investment was the primary reason of the investment.

2. How does that fact that Broda received a fee from Amado impact your analysis under the
Howey test? Could it have been a thank-you gift from Amado as Broda contends?
• Under the Howey test, Broda is the promotor or agent of the promoter. If there had been
any profits, the efforts of Broda would have been a primary source of the revenue. The

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 court reasoned that the payment was not a thank-you gift because Broda’s involvement
did not end with the “referral”. He solicited other investors as well.

3. Focus on Critical Thinking. In hindsight, is this a case of fraud? The investors had experience
in real estate investing and access to all the White Sand’s financial information. If they had
made money on White Sands, the investors never would have brought this suit. Does this
strike you as fair? Would the required disclosures under securities law have made any
difference in the investor’s decision?
• Based on facts, it would be hard to prove there was intent to defraud. Some investments
are not profitable. Even if the disclosures had been made, Donahue may still have
invested in White Sands; however, it would have been a more informed decision and
taken some of the liability off of Broda.

Teaching Tip: Securities

At this point, it is important to point out to students how important it is to work closely with an
attorney when considering raising capital. The investment opportunity they offer could
constitute a security and require them to comply with regulations. It is also eye-opening to
students to learn that a business plan can be considered a security if it is a solicitation for money.

E. Stock Market Games [p. 616]

Points to emphasize:
• Internet-based stock market simulators (stock market games, virtual stock exchanges, or
investment games) are programs/applications that reproduce some features of a livestock
market so that a player can simulate a particular strategy or method and compare the
performance of several different models.
• The transactions (buying and selling) in a stock market game are imaginary.

F. Crowdfunding [p. 616]

Points to emphasize:
• Crowdfunding is asking a large number of people to invest or donate a defined amount of
money for a specific cause.
• Figure 32.1 lists the top 10 crowdfunding companies based on Internet traffic.

G. Blue-Sky Laws: State Securities Law [p. 616]

Points to emphasize:
• State securities laws are commonly known as blue-sky laws.
• In theory, these state statutes are intended to cover intrastate securities offerings.

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IV. CATEGORIES OF SECURITIES [p. 617-619]
Securities generally fall into one of two general categories: equity or debt.

A. Equity Instruments [p. 617]

Points to emphasize:

• Equity instruments represent ownership interests whereby financial return on the

investment is based primarily on the performance of the venture that issued the securities.
• Equity holders have no specific rights or guarantees on the investment.

1. Common Stock [p. 617]

• Most common form of equity instrument which entitles the equity owner to payments
based on the current profitability of the company (dividends).
• Common stock typically has voting rights.
• Common stockholders bear the greatest risk of loss because they are typically subordinate
to all creditors and preferred stockholders if the company goes bankrupt.

2. Preferred Stock [p. 618]

Preferred stockholders have preference rights over common stockholders in receiving
dividends, and when trying to recover their losses from liquidation proceeds.

B. Debt Instruments [p. 618]

Points to emphasize:

• Holders of debt instruments (e.g., promissory notes) expect a fixed rate of return through
pay back of principal and interest.
• Debt instruments are senior in priority in bankruptcy than preferred and common stock.
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 • The investor does not share in the success of a venture.

1. Bonds [p. 618]

A bond is a debt instrument secured by a specific asset.

2. Debenture
A debenture is a debt instrument secured by a corporation’s general credit.

C. Peer-to-Peer Lending [p. 618]

Points to emphasize:

• FinTech firms leverage innovative technology in order to lower overhead costs and
provide higher levels of service to users. It is a new financial sector model that has
become an increasingly popular alternative to traditional lending.
• One of the most successful FinTech models centers on peer-to-peer (P2PL) in which a
firm offers a web-based platform to match borrowers with investors.
• Loans by peer-to-peer lenders are securities.

V. SECURITIES REGULATION [p. 619]

Points to emphasize:

• The Securities Act of 1933 regulates the issuance of securities to public investors by
requiring that companies file certain information intended to inform investors who are
considering entering into a securities regulation.
• The Securities Exchange Act of 1934 regulates the trading of previously issued
securities primarily by setting out ground rules for the buying and selling of securities.
• Regulations requires disclosures that are intended to protect the investors and assure
public confidence in the integrity of the securities market.
• Securities laws do not provide insurance for losses or punish a venture’s principals
simply because the business did not generate a profit.

VI. THE SECURIITES AND EXCHANGE COMMISSION [p. 620-621]

Points to emphasize:

• As part of the Exchange Act, Congress created the Securities and Exchange
Commission (SEC) to be the federal administrative agency charged with rulemaking,
enforcement, and adjudication of federal securities laws.
• The SEC is an independent agency with 5 commissioners appointed by the president and
approved by the Senate.
• The SEC has executive power including the power to investigate potential violations of
securities laws and regulations.
• The SEC has legislative authority to draft and publish securities regulations and
interpretations of statutes, rules, and court decisions.

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• The SEC’s judicial powers are primarily rooted in its role as hearing tribunal for
enforcing certain securities violations. It has the power to suspend or revoke the
professional licenses of brokers and other regulated by securities laws.
• EDGAR is a SEC computer database that services a national clearinghouse for public
corporation disclosures and filings required by federal securities laws.
• Figure 32.2 shows the SEC’s organizational structure.

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VII. STATE REGULATION OF SECURITIES [p. 622]
Points to emphasize:

• State securities laws are referred to as blue-sky laws.

• The National Securities Markets Improvement Act allows states to regulate securities
only when the security is intrastate. States are restricted from regulating any security
listed on a stock exchange, mutual funds, or certain offerings that are exempt under
federal securities law.
• Some states use a risk capital test (investor’s funds are subject to the risk of the business
venture as a whole and the investor has no control over the risks) to determine whether an
investment falls under state law.

Key Terms [p. 624]

Chapter Review Questions [p. 626-627] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 623]

1. If you were considering investing in a start-up venture and wanted to limit your personal risk,
what option(s) would fit best?

• For an equity investment, an investor may consider preferred stock since it gives the
investor a better chance of recovery (over common stockholders) if the business fails or
files for bankruptcy. For a debt investment, a secured promissory note would return a
fixed rate of return, but the investor has no ownership in the event that the venture is
successful over the long term.

2. If you were the owner of a business that had substantial assets, which options would you
consider for financing the research and development of a new product line? Why?

• A business with substantial assets has the opportunity to issue a debt instrument
(debenture or bond) to finance research and development. The advantages are a) lower
interest than on a commercial loan, b) the equity of existing principals is not diluted by
selling additional ownership in the venture.

Case Summary Questions and Answers [p. 624-625]

CASE SUMMARY 32.1 Mark v. FSC Securities Corporation, 870 F.2d 331 (6th Cir. 1989)

1. Should Mark prevail?

• Mark prevailed. The court also held that evidence as to the manner of the offering
showed that numerous broker-dealers undertook to sell interests in the Malaga offering.
In documents filed with the SEC, IBC listed four separate broker-dealers authorized to
sell the Malaga offering in eleven different states. The court ruled that these factors, taken

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 together, indicate a wide-ranging sales effort and suggest a public, rather than a private,
offering.

2. Is it relevant that FSC never reviewed the subscription agreement?

• It is relevant, but not necessarily determinative. It was an important factor in the court’s
analysis that exemptions are based on whether an offering is to those who are shown to
be able to fend for themselves. The focus of inquiry should be on the need of the offerees
for the protections afforded by registration. The court held that FSC offered no evidence
as to the actual number of offerees, let alone their individual characteristics that would
lead to a statutory exemption.

CASE SUMMARY 32.2 SEC v. ETS Payphones, Inc., 408 F.3d 727 (11th Cir. 2005)

1. Analyze the ETS investment contracts in terms of the Howey test. What factors favor
Edward’s position?
• The court ruled that the SEC had jurisdiction under the Howey test. (1) the transactions
involve an investment of money (favors the SEC’s position); (2) a common enterprise.
The government pointed out that investors were dependent upon Edwards's ability to
attract new business to realize profits. Ninety-nine percent of investors leased back the
phones they bought from one of Edwards's companies to another company of his. Thus,
investors evidently had no desire to perform the chores necessary for a return on their
investment; (3) the fixed rate of return demonstrates that the investors had an expectation
of profits (favors SEC position) and; (4) the expectation of profits to be derived solely
from the efforts of others. The more control investors retain, the less likely it becomes
that the contract qualifies as a security. ETS investors retained minimal control over the
telephones. Once an investor leased the phone back to ETS (which ninety-nine percent
did), that investor relied on ETS (and Edwards) for profits.

2. Is the fact that Edwards continued to seek investors to cover losses enough to satisfy the
“commonality” requirement that the investors’ fortunes be tied together in some way?
• Yes. That test requires the movant to "show that the investors are dependent upon the
expertise or efforts of the investment promoter for their returns. ETS had to attract an
ever-expanding number of investors to meet its obligation to existing investors. Investors
were dependent upon Edwards's ability to attract new business to realize profits.

CASE SUMMARY 32.3 Eberhardt v. Waters, 901 F.2d 1578 (11th Cir. 1990)

1. Who prevails and why?

• The court ruled in favor of Eberhaldt. Th transaction involved: (1) an investment of
money, (2) in a common enterprise (the court ruled it was “unlikely that an average
investor would be in a position to assume or maintain any substantial degree of control
over the investment.” Consequently, Eberhardt had no desire to perform the chores
necessary for a return, and was attracted to the investment solely by the prospects of a

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 return; and (3) an expectation of profit solely from the efforts of others (the court rule that
an “investor needed to rely on Waters and ICE in order for the venture to be a success.
Furthermore, because of the technical nature of the embryo operation and Eberhardt's
inexperience, any control granted to the investors in ICE's brochures was illusory and
insufficient to disqualify the investment as a security.”

2. If the court finds in favor of Eberhardt, what remedies are appropriate?

• The appropriate remedy is a rescission of the investment contract offered to Eberhardt.

CASE SUMMARY 32.4 Foltz v. U.S. News and World Report, Inc., 627 F. Supp. 1143 (D.D.C.
1986)

1. Can a noncontributory profit-sharing plan be a security under the Howey test? Why or why
not?
• The court ruled that a noncontributory profit-sharing plan could not be a security
regulated by the ’33 Act. To be deemed an investor, “one must choose to give up a
specific consideration in return a separable financial interest with the characteristics of a
security." Because the employees received, in return for their labor, an "indivisible
compensation package," part of which included pension benefits, they could not be said
to have made an investment, for neither did the compensation package as a whole exhibit
the characteristics of a security, nor did the employees' individual decisions to accept and
retain covered employment have any direct relationship to perceived possibilities of a
future pension. Id.

2. If employees were required to purchase the interests, would that change your answer in
Question 1? Why or why not?
• Probably not. The U.S. News employees simply did not invest in the Plan when they
began service with the Company. The court ruled that “[r]eceipt of Plan benefits—as
measured by the value of the Plan assets— was merely an incident of employment.
Moreover, participants in the Plan could be said to have chosen Plan participation only to
the extent that they could have forgone receipt of benefits entirely. Such a choice lacks
the element of voluntariness characteristic of an investment decision.”

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 Chapter 33
Regulation of Issuance: The Securities Act of 1933

CHAPTER OVERVIEW
This chapter covers the requirements to registration of securities, disclosures mandated by
federal and state securities law, and registration exemptions for certain offerings, as well as
statutory anti-fraud protections for investors and covers defenses and safe harbors that are
available to issuers that are alleged to have made misrepresentations in their statements and
disclosures.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Recognize the fundamental underpinnings of securities issuance regulation. Application
Exhibit a working knowledge of the legal process leading to issuance of Application
original securities under the Securities Act of 1933.
Compare the requirements for various exemptions from the statutory Analysis
registration requirements and apply the exemptions within fact scenarios.
Describe special rules for raising capital through crowdfunding. Knowledge
List and discuss remedies and penalties for violation of the Securities Act of Knowledge
1933.
Explain the impact the Private Securities Litigation Reform Act of 1995 and Application
the Securities Litigation Uniform Standards Act of 1998 have on issuers and
investors.
Identify when and how issuers assert defenses of materiality and the bespeaks Application
caution doctrine.

Teaching Tip: Securities laws

Begin by briefly explaining the difference between the Securities Act of 1933 and the Securities
Exchange Act of 1934 which will be covered in the next chapter. .

THE SECURITIES ACT OF 1933 [p. 629]

Points to emphasize:

• The Securities Act of 1933 (the ’33 Act) is the regulation of original issuance (and
reissuance) of securities to investors by business venture issuers.
• The ’33 Act mandates: (1) a registration filing for any venture selling securities to the
public, (2) certain disclosures concerning the issuer’s governance and financial condition,
and (3) regulatory oversight over the registration and issuance of securities.
• The goal of the ’33 Act is to promote transparency to investors and provide remedies in
the event of fraud.
• The ’33 Act was the first of several pieces of legislation enacted after the financial
collapse in 1929, which resulted in stocks losing more than half their value by 1933.

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 THE PROCESS OF A PUBLIC OFFERING [p. 629]
Points to emphasize:
• Section 5 of the ’33 Act makes it illegal to sell any security by use of mail or facilities of
interstate commerce unless the security has been registered or unless the security fits into
one of the statutory exemptions.
• Section 5 also requires that the registration statement become “effective” prior to the
actual sale of a security.
• What is commonly referred to as a public offering is actually a process of registration and
disclosure mandated by the ’33 Act (the exempt nonpublic offerings are known as private
placements).
• The ’33 Act separates the registration process into three stages related to the issuance of a
security—the prefiling period, the waiting period, and the post - effective period—and
sets out statutory requirements for each.

A. Preregistration Documentation [p. 630]

• The ’33 Act and the SEC regulations require extensive documentation even before the
registration statement is filed typically prepared by highly specialized attorneys.
• These documents include (1) a letter of intent, (2) comfort letters, and (3) an underwriting
agreement.

B. Registration [p. 630]

• After the preregistration documentation is prepared for the public offering, the prefiling
period begins. The actual registration statement consists of two parts: (1) the prospectus
- which is intended to give investors a realistic view of the issuer’s business, risk factors,
financial position, financial statements, and disclosures concerning directors, officers,
and controlling shareholders; and the (2) the packet of supplemental information that
documents and supports the prospectus.

C. Filing the Registration Statement and Waiting Period [p. 630]

• After the registration statement is filed, the SEC begins its review for incomplete or
misleading disclosures and may issue one or more “letters of comment” known as
deficiency letters.
• Prior to the filing of the registration statement, the issuer may not market or sell the
securities to the public.
• The registration statement becomes effective 20 days after the filing date unless the SEC
issues a refusal order.
• Even after the SEC’s review period has expired, the SEC may issue a stop order
suspending the registration if it determines there was a defect in the disclosures.
• During the review period, the issuer may begin marketing the securities to the public,
although any offers to buy during this period are not binding.

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 1. Materiality
• The U.S. Supreme Court has defined a fact as material under federal securities laws if
“there is a substantial likelihood a reasonable investor would consider it important” in
making a securities-related decision.
• The materiality requirement uses an objective standard to test whether misinformation is
likely to have induced the investor to purchase the securities and protects the issuer by
distinguishing between misinformation that is important and misinformation that lacks
significance.
• Materiality is typically raised as a defense by the issuer when the investor (or the SEC)
alleges that statements in the prospectus or other offering materials were misleading.

D. Postregistration [p. 631]

• Once the registration statement has become effective, the securities are permitted to be
sold to the public, but the prospectus and marketing materials are still subject to the
SEC’s oversight.
• The final prospectus with all price adjustments and underwriting information must be
sent to any purchaser either before or at the time she purchases the securities.

EXEMPTIONS FROM REGISTRATION [p. 632]

Points to emphasize:

• Because registering securities for a public offering is so onerous and expensive, the ’33
Act contains a number of exemptions for smaller issuers.
• Most businesses offer their securities on an exempt basis.
• Section 3 of the ’33 Act exempts certain securities, whereas Section 4 exempts certain
transactions.
• The most common exemption is for nonpublic offerings to a limited number of
sophisticated investors who have prior business relationships with the issuer or who
privately negotiate their securities purchases.
• Another common exemption, known as a regulatory safe harbor, involves offerings with
specified dollar limitations and/or limitations on the number of nonaccredited investors.
• Exempt offerings must still provide certain disclosures to the prospective investors.
• The following are common examples of securities that are exempt from full registration
requirements:
o Commercial paper (such as promissory notes that are purchased by
sophisticated investors and investment banks) with a maturity date of less
than nine months.
o Securities of charitable organizations.
o Annuities and other issues of insurance companies.
o Government-issued securities such as municipal bonds.
o Securities issued by banks and other institutions subject to government
supervision.

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 o Securities that qualify as exempt under SEC Regulation D, Regulation A,
and Regulation Crowdfunding (explained next).

A. Regulation D: Private and Small Transactions [p. 632]

• Regulation D exemptions are for limited offers of a relatively small amount of money or
offers made in a limited manner known as private placements.
• The exemption is grounded in an assumption that certain investors are sophisticated
enough that they do not need the level of protection afforded by the ’33 Act’s full
disclosure requirements.

Teaching Tip: Private Placements/Special Purpose Vehicles

It may be helpful to introduce the students to the case study at the end of the chapter: Facebook’s
Special Purpose Vehicle at this time. You can explain the limitations on disclosures as between
public and private offerings and why and when a special purpose vehicle can be used and what
the effect on Facebook’s registration was. This case study is found in the Thinking Strategically
section at the end of this chapter.

1. Accredited Investors [p. 633]

• Rule 501 of Regulation D sets out various ways in which investors may be categorized as
accredited.
• Institutional investors (e.g., banks, mutual funds), corporations with assets exceeding $5
million, venture capital firms, and key insiders of the issuers (e.g., officers, directors,
partners) are automatically considered accredited investors.
• In order for individual investors to be accredited, they must have (1) a net worth of over
$1 million or (2) income in excess of $200,000 (or joint income with a spouse of
$300,000) in each of the two most recent years and a reasonable expectation of reaching
the same income level in the current year to meet the accredited investor criteria.

2. Rule 504: Smaller Offerings [p. 633]

• Rule 504 exemptions are for relatively small offerings (up to $5 million in any 12-month
period) through which privately held, noninvestment companies seek to raise capital for a
specific purpose.
• There are no disclosure requirements, the prospectus is not required to be registered,
there is no limit on the number of investors, and there is no requirement that the investor
be accredited.
• The offering cannot be publicly advertised or accomplished through widespread
solicitation and the issuer is required to take steps to be sure that there are no resales of
the securities to the public).

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 3. Rule 506: Larger Private Placements [p. 633]
• Rule 506 exempts two types of private, noninvestment company offerings in unlimited
amounts that are not generally advertised or available to the general public known as
private placements.
• Rule 506(b) placements may be offered to an unlimited number of investors who qualify
as accredited under SEC rules with up to 35 nonaccredited investors who qualify as
“sophisticated.”
o This means that the issuers must reasonably believe that the investors have sufficient
experience, business savvy, and knowledge of the market that the law imputes a
certain cognizance of investment risk and the ability to protect their own interests.
o Additionally, Rule 506(b) requires issuers to give any nonaccredited investors
disclosure documents that generally contain the same type of information that is
provided in a registered offering.
• Rule 506(c) provides issuers with the right to broad general solicitation and
advertisement of a security to an unlimited number of accredited investors only.
o The SEC requires the issuer to take reasonable steps in order to ensure that investors
are accredited.

B. Regulation A: Large Exempt Offerings [p. 634]

• Regulation A allows large offerings to be exempt from registration, although these
offerings are more closely regulated than either Rule 504 or Rule 506 exemptions.
• Regulation A is split into two tiers: (1) Tier 1, for securities offerings of up to $20 million
in a 12-month period (no qualifications on investors), and (2) Tier 2, for securities
offerings of up to $50 million in a 12-month period (purchasers must be accredited
investors or subject to certain limitations on their investment).

C. Disclosures Required [p. 635]

• It is important to emphasize that exempt private placement offers under Rules 504 and
506 are still required to make important anti-fraud-related disclosures to potential
investors about the business and its principals through a private placement memorandum.

REGULATION OF CROWDFUNDING [p. 635]

Points to emphasize:

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 • The Jumpstart Our Business Startups (JOBS) Act of 2012 required the SEC to carve out a
niche in securities laws that permitted crowdfunding as a fundraising tool for small
businesses.
• Known as Regulation Crowdfunding, the SEC’s rules are similar to the Regulation D
exemptions discussed earlier in that the SEC imposes less onerous disclosure rules on the
issuer than are required by the ’33 Act and sets limits on investments.

Teaching Tip: Crowdfunding

There are many types of crowdfunding sites: reward crowdfunding, debt crowdfunding, and
equity crowdfunding. With reward crowdfunding you promise the investors a small gift if they
pledge a certain amount. With debt crowdfunding you agree to pay back what you receive. With
equity crowdfunding you give the investor a small stake in your business. You can direct
students to the website https://www.thebalancesmb.com/best-crowdfunding-sites-4580494 which
explains the differences between crowding funding apps such as Kickstarter and GoFundMe.
Crowdfunding is often used by small start-ups before they seek out venture capital.

A. Rules for Issuers [p. 635]

• A company issuing securities in reliance on Regulation Crowdfunding (the issuer) may
raise a maximum aggregate amount of $1,070,000 during a 12-month period and is
required to file periodic reports.
• Additionally, the issuer must electronically file its offering statement on SEC Form C,
which discloses:
o biographical information about officers, directors, and owners of 20 percent or more
of the issuer;
o a description of the issuer’s business and the use of proceeds from the offering;
o the price to the public of the securities or the method for determining the price;
o the target offering amount and the deadline to reach the target offering amount;
o whether the issuer will accept investments in excess of the target offering amount;
and
o the issuer’s financial condition and financial statements.

B. Rules for Investors [p. 636]

The SEC rule also sets limits on how much individuals may invest through crowdfunding based
on an investor’s annual income and her net worth. (See Table 33.1).

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 LIABILITY FOR VIOLATIONS [p. 637]
Points to emphasize:
• The ’33 Act imposes both civil and criminal penalties on issuers and sellers of securities
who violate the Act’s provisions.
• Investors who purchased unregistered securities are entitled to rescind the investment and
to be paid back in full.
• In cases of misrepresentations or omissions, investors have an automatic right of action to
sue the issuer for damages.
• Penalties also include civil penalties, fines, and incarceration for egregious cases.

A. Section 11: Misrepresentations in the Registration Statement [p. 637]

Section 11 is the primary anti-fraud provision of the ’33 Act which creates a civil remedy for
purchasers of a registered offering if the investor can prove that the issuer made a material
misrepresentation or omission in the registration statement. There are a number of defenses that
the issuer can pursue.

1. False Statements [p. 637]

Section 11 distinguishes between statement of fact and opinions by exposing issuers to liability
only for untrue statements of fact, not for untrue statements (or opinions).

2. Omissions Clause [p. 637]

If a registration statement omits material facts about the issuer’s inquiry into or knowledge
concerning a statement of opinion, and if those facts conflict with what a reasonable investor
would take from the statement itself, then the statement violates Section 11’s omissions clause.

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CASE 33.1 Omnicare, Inc. v. Laborers District Council Construction Industry Pension
Fund et al., 575 U.S. ___(2015)

Facts: Omnicare filed a registration statement with the SEC in connection with a public offering
of its common stock. Two sentences in the registration statement expressed Omnicare’s view of
its compliance with legal requirements: [Statement 1] We believe our contract arrangements with
other healthcare providers, our pharmaceutical suppliers, and our pharmacy practices are in
compliance with applicable federal and state laws. [Statement 2] We believe that our contracts
with pharmaceutical manufacturers are legally and economically valid arrangements that bring
value to the healthcare system and the patients that we serve. They also provided two caveats
relating to these statements: [Caveat 1] There are several state-initiated “enforcement actions
against pharmaceutical manufacturers” for offering payments to pharmacies that dispensed their
products. [Caveat 2] Laws relating to that practice might “be interpreted in the future in a manner
inconsistent with our interpretation and application” and that federal regulators have expressed
“significant concerns” about the rebates. Several investors [Funds] brought suit alleging that the
company’s two opinion statements about legal compliance give rise to liability under Section 11
of the ’33 Act. While the trial court dismissed the suit indicating that the statements were only
actionable if known to be untrue when made, the appellate court reversed holding that the Funds
had to allege only that the stated belief was “objectively false.”

Issue: What constitutes a false statement under Section 11?

Ruling: According to the Supreme Court, neither the trial nor appellate court applied the correct
standard. The Court held that an issuer could be held liable for opinion statements under Section
11’s omissions clause if an objectively reasonable investor would be misled by the statement and
remanded the case for further proceedings. According to the omission clause of Section 11, an
issuer making a statement of opinion about legal compliance must (1) believe it true at the time
made, and (2) the opinion must align with information in the issuer’s possession at the time
made. Thus, if a registration statement omits material facts about the issuer’s inquiry into or
knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable
investor would take from the statement itself, then Section 11’s omissions clause creates
liability.”

Case Questions

1. What is the difference between the objective standard and the subjective standard in this case?
Why is it important to the outcome of this case?
• A substantive standard would permit a issuer to say “I believed the statement to be true.”
An objective standard requires that there be actual facts known to the issuer to support
the statement. It matters in this case because neither the trial court nor the appellate court
examined whether the omitted facts made the statement misleading.

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2. Since one of Omnicare’s attorneys had concern about the company’s business model, should
Omnicare have disclosed that in its registration statement? Is failing to include that single
legal opinion an omission?
• Lawyers often provide disclaimers to their legal opinions. In fact, every case has two side
due to differing interpretations of the law. A registration statement would not require that
every opinion be outlined.

3. Focus on Critical Thinking: Could Omnicare’s statements constitute a breach of contract? Is

this good or bad for the investment community? Explain.
• These questions are designed to elicit a discussion on other legal theories.

B. Section 12(a)(2): Misrepresentations in Public Offerings [p. 639]

• Section 12(a)(2) is a provision of the ’33 Act that complements Section 11 by providing
for rescissionary liability of issuers that are engaged in public securities transactions
meaning that the transaction is cancelled and the parties are put back to their
pretransaction position.
• Section 12(a)(2) does not apply to private transactions or aftermarket transactions (i.e.,
trading). The focus of Section 12(a)(2) is typically on whether statements made in the
prospectus and/or any oral statements by the issuers were materially false or misleading.

1. Scope [p. 639]

• In 1995, the U.S. Supreme Court clarified the scope of Section 12(a)(2) in the landmark
case Gustafson v. Alloyd Co. holding that it did not apply when there was no prospectus
as defined in the Act (i.e., a written communication that offers a security for sale, is
widely distributed to the public, and “must include information contained in a registration
statement.”).

2. False Statements and Omissions [p. 640]

• As is the case with many securities law protections, investors must show either a material
untruth or the omission of a material fact necessary to make what is said not misleading.
Liability under Section 12(a)(2) attaches only when the misinformation was instrumental
in the sale.

C. Section 17(a): Liability for Negligent Misrepresentation [p. 640]

• One of the SEC’s most powerful weapons in enforcing anti-fraud provisions is the broad
coverage provided by Section 17(a), which applies to public, private, and exempt
offerings of securities (and is similar to Rule 10(b)5 of the Securities Exchange Act
discussed in the next chapter).
• Section 17(a) is a broad-based prohibition of the sale of securities that obtain money
through fraud, material misstatements, or misleading omissions and assesses liability for
sellers whose misstatements or omissions are a result of negligent misrepresentation and
does not require proof of intent by the seller to mislead.
• Section 17(a) does not create any right of private lawsuit for the misled investor

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 D. Penalties and Remedies [p. 640]
The primary remedy for defrauded or misled investors is rescinding the sale transaction and
requiring the seller to pay back the investor the transactional amount. Table 33.2 sets out a basic
structure of penalties and remedies under the ’33 Act.

SAFE HARBORS AND OTHER DEFENSES [p. 641]

Points to emphasize:
• An issuer accused of fraud under the ’33 Act may avoid liability or penalties by
successfully asserting that both the transaction and issuer are immune from liability
through a statutory safe harbor.
• Additionally, the issuer may avoid liability through the common law defenses of
materiality or the bespeaks caution doctrine.
• If the violator is not actually the issuer of the stock but a third party involved in the
transaction (such as an underwriter), that party may avoid liability by proving she acted
with due diligence in verifying the veracity and completeness of the required disclosures.

A. Safe Harbors: The Private Securities Litigation Reform Act of 1995 [p. 641]
• In response to the drastic increase in shareholder suits, Congress passed the Private
Securities Litigation Reform Act of 1995 (PSLRA).
• The PSLRA imposed significant procedural rules and substantive standards that made it
more difficult to pursue litigation under the securities laws based solely on written or oral
statements by the company’s officers and directors.
• The PSLRA defines suits as frivolous if the “shareholder derivative actions [are] begun
with [the] hope of winning large attorney fees or private settlements, and not with
intention of benefiting [the] corporation on behalf of which [the] suit is theoretically
brought.”
• Exclusions from the protection of the PSLRA include initial public offerings, partnership
offerings, and transactions that bring a public company back to privately held status.
• The safe-harbor provision shields the issuer from liability based on statements and
forecasts contained in the prospectus or made by executive management and authorized
spokespersons of the issuer.

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 o It is typically used to halt a claim of misrepresentation under Section 11 and/or
Section 12(a)(2) and the anti-fraud provisions of the Securities Exchange Act of
1934.
o There is no “state of mind” requirement.
o It protects issuers from private investor lawsuits by shielding the issuer from
liability related to forward-looking statements in its prospectus or made orally by
its officers or directors (including projections of total revenues, income, or
income losses; projections of earnings/losses per share, capital expenditures, or
capital structure; and statements of the plans or objectives of management for
future operations.
o The forward-looking statement must:
§ be identified as “looking ahead” and accompanied by meaningful
cautionary language, and
§ if the investor’s claim does not establish that the statement was made with
actual knowledge that the statement was false or misleading, the statement
falls under safe-harbor protection.

1. Securities Litigation Uniform Standards Act of 1998 [p. 642]

After shareholder suits were initiated under state securities statutes, Congress passed the
Securities Litigation Uniform Standards Act of 1998 which requires that class actions
involving allegations of securities fraud by a publicly traded company under any securities
statute be litigated exclusively in federal courts.

MATERIALITY AS A DEFENSE [p. 642]

Points to emphasize:

• The other major defense is materiality, which can also be asserted by issuers not covered
by the PSLRA.
• Materiality means that an objectively reasonable investor would require that fact to make
a decision in purchasing a security.
• Courts use a “total mix” test to determine whether or not an omission or representation is
material.
o Even when the most important information is omitted from the prospectus, an
omission cannot be considered material if the total mix of information was
already reasonably available to the investing public.
o If an investor should have known about a particular fact that was available in the
total mix of information, she cannot later claim that the undisclosed fact was a
material omission.

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CASE 33.2 Lowinger v. Pzena Investment Mgmt., 341 F. App’x 717 (2d Cir. 2009)

Facts: Plaintiff, Lowinger, purchased stock in Pzena during an initial public offering (IPO).
Pzena’s prospectus included statements related to their assets under management (AUM)
holdings, which are an important indicator of an investment firm’s profitability. The statement
articulated Pzena’s strategy for increasing its AUM, but also included warnings and cautionary
statements about the risk of the impact of market depreciation and fluctuation on its AUM and
Pzena’s potential revenue. Plaintiffs claimed that the statements were misleading in that they
created an inaccurately positive image of Pzena’s operations. Lowinger filed suit against Pzena
under Sections 11 and 12(a)(2) of the Securities Act of 1933 alleging that Pzena was liable for
misleading statements in its prospectus. The trial court dismissed the complaint ruling that the
statements were not materially misleading and that the warnings were sufficient to cause a
reasonable investor to take note of the risk. Lowinger appealed.

Issue: When does liability for misrepresentation under Sections 11 and 12(a)(2) accrue for
statements made in a prospectus?

Ruling: According to the court, liability will accrue if either the registration statement or
prospectus includes: (1) any untrue statement of a material fact or (2) an omission of a material
fact that is necessary to make the statements found therein not misleading. An omission is
material only if there is a substantial likelihood that the disclosure of the omitted fact would have
been viewed by the reasonable investor as having significantly altered the total mix of
information made available. In this case, “the prospectus fulfilled [statutory obligations] by
disclosing the market-depreciation-driven decline in Pzena’s AUM for the quarter prior to the
IPO and warning that this development could be expected to result in withdrawals from Pzena’s
investment strategies and lower revenues and income.” As such, the dismissal was affirmed.

Case Questions

1. What was Lowinger’s theory as to why the statements in the prospectus were misleading?
Since Lowinger conceded that the statements were true, how could they prove that the
statements were misleading?
• Lowinger alleged that Pzena’s failure to specifically disclose the decline in the John
Hancock Classic Value Fund even though the loss in the AUM was disclosed in
subsequent filings.

2. What standard did the court use to determine whether the statements were materially
misleading? In your view, did the court apply the standard correctly? Why or why not?
• An omission is material only if there is a substantial likelihood that the disclosure of the
omitted fact would have been viewed by the reasonable investor as having significantly
altered the total mix of information made available. A court could have found either way
with regard to the lack of specific information on John Hancock. However, since the

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 prospectus contained appropriate warnings overall, it seems that this was the correct
result.

3. Focus on Critical Thinking: The court attempts to draw a legal line for materiality by using
the “average investor” as the standard for considering what is important enough to disclose.
Who is the average investor? Should the same standard apply to weekend investors (i.e.,
nonprofessional investors who buy and sell stocks based on their own research) that applies
to large institutional investors (such as mutual funds)? If “average investor” is not a fair one-
size-fits-all standard, what would be fair?
• These questions are designed to elicit a discussion on the impact of investor knowledge.

1. Buried Facts Doctrine [p. 644]

• Although omission of material facts is the most frequent allegation in an anti-fraud case
against an issuer, too much information may also trigger liability under the buried facts
doctrine.

B. Bespeaks Caution Doctrine [p. 644]

• The bespeaks causation doctrine allows an issuer who included specific and narrowly
tailored cautionary disclosures in their prospectus to negate any allegedly misleading or
overly optimistic prediction (unless the cautionary statements were overly broad or too
general).
• The key consideration is whether the cautionary statements are directly tied to the overly
optimistic statement.

CASE 33.3 In re Donald J. Trump Casino Securities Litigation—Taj Mahal

Litigation, 7 F.3d 357 (3d Cir. 1993)

Facts: Trump and his co-defendants offered securities to the public in order to finance the Taj
Mahal Casino. The prospectus stated: “The Partnership believes that the funds generated from
the operation of the Taj Mahal will be sufficient to cover all of its debt service (interest and
principal).” The prospectus also contained numerous cautionary statements including the intense
competition in the casino industry, the absence of an operating history for the Taj Mahal, and the
possibility that the enterprise might become unable to repay the interest on the bonds in the event
of a mortgage default and subsequent liquidation of the Taj Mahal. When Trump went to file for
bankruptcy, the investors sued for fraud due to material misstatements and omissions in the
prospectus. The trial court ruled in favor of Trump and held that the cautionary statements that
surrounded each representation barred any misrepresentation claim. The investors appealed.

Issue: Were the cautionary statements contained in the prospectus sufficient to invoke the
bespeaks caution doctrine?

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Ruling: Yes, the language in the warnings not only contained general cautionary statements
about the industry, but also specifically noted the potential inability to pay the interest on the
bonds. As such, the trial court’s decision was affirmed.

Case Questions

1. Do issuers have a duty to disclose all negative information in the prospectus? How does the
definition of materiality apply to statements by issuers that may be considered negative
disclosures?
• Issues only have a duty to disclose material negative information. An omission is material
only if there is a substantial likelihood that the disclosure of the omitted fact would have
been viewed by the reasonable investor as having significantly altered the total mix of
information made available.

2. What specific material fact did the investors claim that the prospectus failed to disclose?
What specific cautionary statements did the court find to be tailored to that material fact?
• The specific material fact at issue was whether the issuer could repay the bonds. The
cautionary statement the court relied on was: “the possibility that the enterprise might
become unable to repay the interest on the bonds in the event of a mortgage default and
subsequent liquidation of the Taj Mahal.”

3. Focus on Critical Thinking: Is the bespeaks caution doctrine consistent with the ’33 Act’s
public policy goal of transparency and disclosure in a securities issuance? Why or why not?
How could the doctrine be modified to be more favorable to the public investor community?
• These questions are designed to elicit a discussion on the purpose of the ’33 Act and how
defenses come into play.

END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 646]

Chapter Review Questions [p. 648-649] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 645-646]

1. What type of legal strategy did Goldman Sachs employ? Is it avoidance or value creation?
Could it be a combination of both? Why?
• This is a great question to illustrate that certain legal transactions and decisions can cross
over in terms of strategy. The special purpose vehicle was controversial because some
commentators branded it as “avoidance” akin to offshoring by U.S. companies to avoid
taxes. At the same time, understanding the that special purpose vehicles did provide
shareholders with a value-added solution.

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2. Although experts agreed that the special purpose vehicle did adhere to securities regulations,
some commentators criticized Goldman Sachs’s approach as undercutting the transparency
requirements that make U.S. securities markets appealing to investors. Is that criticism fair? Is it
possible that the special vehicle arrangement follows the letter of the law but not the spirit of the
law? If the plan is legal, does that mean it is ethical as well?
• This question allows students to use critical thinking skills to evaluate competing
interests. An important underlying policy reason behind securities regulation is a
protection of investors which would translate into confidence in the public markets. At
the same time, is the special purpose vehicle, as a practical matter, impacting that
confidence? Another angle to use of this question is to have students debate/discuss: are
all ethical actions legal vs are all legal actions ethical. This question can also be an
effective research and writing assignment if students are tasked with reading articles that
are pro and con and having them analyze the merits of each side.

Case Summary Questions and Answers [p. 647-648]

CASE SUMMARY 33.1 In re The Vantive Corporation Securities Litigation, 110 F. Supp.
2d 1209 (N.D. Cal. 2000)

1. Were the forecasts sufficient to constitute a material misstatement of fact and an

omission that violated securities laws? Explain.
• The forecasts were not a material misstatement as defined by securities laws. The court
applied a deliberate recklessness standard to the allegedly misleading statements made by
company and held that the plaintiffs had not proved that Vantive’s forecasts were
deliberately reckless.

2. Is Vantive protected by the PSLRA?

• Yes. In fact, the court remarked that this is precisely the activities that the PSLRA
addresses. According to the court, “in addition to a deliberate recklessness threshold, the
PSLRA creates a safe harbor for statements that are forward-looking statements. A
defendant is not liable for statements identified as forward looking if they are
accompanied by meaningful cautionary statements identifying important factors that
could cause actual results to differ materially from those in the forward-looking
statement.”

CASE SUMMARY 33.2 Mark v. FSC Securities Corporation, 870 F.2d 331 (6th Cir. 1989)

1. Should Mark prevail?

• The court held in favor of Mark. They ruled that the evidence indicated a wide-ranging
sales effort and suggested a public, rather than a private, offering. The evidence
concerning sales procedures did not qualify as an exempt offering.

2. Is it relevant that FSC never reviewed the subscription agreements?

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 • Yes. The policy behind subscription agreements is to provide the issuer with some
evidence of the sophistication of the investor. If FSC never reviewed the subscription
agreements, they could not have known whether or not the investors were qualified to
invest in an exempt offering.

CASE SUMMARY 33.3 P. Stolz Family Partnership L.P. v. Daum, 355 F.3d 92 (2d Cir.
2004)

1. Were Smart World’s disclosures sufficient to bar the investor’s claim under the
bespeaks caution doctrine? Why or why not?
• No. The court held that the bespeaks caution doctrine does not apply to “historical or
present fact-knowledge within the grasp of the offeror. Such facts exist and are
known; they are not unforeseen or contingent.” According to the court “it would be
perverse indeed if an offeror could knowingly misrepresent historical facts but at the
same time disclaim those misrepresented facts with cautionary language.”

2. Give an example of specific language that Smart World could have used to increase the
likelihood that the statements would negate any alleged misrepresentations?
• The problem was not with the language as much as it was with a misrepresentation about
existing facts. The bespeaks caution doctrine may be used in forward-looking statements
about revenue etc, but not about facts that existed historically. Standard language, for
example, to accompany revenue forecasts is: 1) This estimate is based on forecasts that
assume a growth in the company’s market share by 10%. 2) This market is highly
competitive and unanticipated competitive pressures may result in a lower than expected
revenue.

CASE SUMMARY 33.4 Panther Partners v. Ikanos, 681 F.3d 114 (2d Cir. 2012)

1. Should Ikanos have disclosed the chip defect more specifically in its registration statement
and prospectus? Why do you think it did not?
• In questions on whether to disclose, the underlying analysis must focus on whether or not
this information would impact an investors decision to buy the offerings because the facts
was reasonably likely to have a material impact on the company’s financial condition.
Since a defect in a major component would have an impact on an investor’s decision, it
should have been disclosed. One can only speculate why they did not disclose it, but
clearly management was concerned that the investor community would lose confidence
in the company and pass up any investment opportunity.

2. What is Panther’s likely theory of the case?

• Panther’s theory of the case was an allegation that Ikanos and various of its officers,
directors, and underwriters violated §§ 11, 12(a)(2), and 15 of the Securities Act by
failing to disclose known defects in the Company's VDSL (very-high-bit-rate digital
subscriber line) Version Four chips.

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3. Is Ikanos’s language related to a caution about defects and bugs sufficient to assert the
bespeaks caution doctrine?
• No. The court held that the Registration Statement's generic cautionary language that
“[h]ighly complex products such as those that [Ikanos] offer[s] frequently contain defects
and bugs” was incomplete and does not fit the bespeaks caution doctrine. The brevity and
generalization of the statement “did not fulfill Ikanos's duty to inform the investing public
of the particular, factually-based uncertainties of which it was aware in the weeks leading
up to the offering.”

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 Chapter 34
Regulation of Trading: The Securities Exchange Act of 1934

CHAPTER OVERVIEW
This chapter focuses on the secondary securities market and examines disclosure, transparency,
and anti-fraud rules for securities offered to the public after their issuance. This chapter also
covers the Exchange Act’s anti-fraud provisions.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the primary scope and objectives of the Securities Exchange Act of Knowledge
1934.
Identify factors that trigger SEC reporting requirements. Knowledge
Articulate the fundamental anti-fraud provisions of Section 10(b) and Rule Knowledge
10b-5.
Differentiate and apply the legal tests for traditional insider trading, the Analytical
misappropriation theory, and the tipper-tippee liability. Thinking
Explain how Section 16 restrictions work in tandem with Rule 10b-5 liability. Application
Identify defenses to fraud allegations. Knowledge

THE SECURITIES EXCHANGE ACT OF 1934 [p. 652]

Points to emphasize:

• The Securities Exchange Act of 1934 (Exchange Act) establishes a system of oversight
over the self-regulation of securities exchanges and trading industry practices. It also
mandates extensive disclosures for publicly traded companies.
• The Exchange Act regulates the sale of securities between investors after an investor has
purchased them from a business entity issuer. Thus, the Exchange Act’s authority is over
brokers, dealers, securities associations, brokerage firms, and other business entities that
are engaged in the sale of securities between investors.
• The Exchange Act requires registration with the SEC for issuers who wish to have their
securities offered on a national exchange (e.g., the New York Stock Exchange), and
compels all sellers of securities to fully disclose all pertinent details to potential investors.
• The Exchange Act also regulates the relationship between existing stockholders and the
corporation by requiring disclosure of information concerning: (1) the financial
performance of the company, (2) corporate governance procedures, and (3) any changes
that increase or decrease risk that have occurred since the last report.

REPORTING COMPANIES [p. 652]

Points to emphasize:

• Companies whose securities (equity or debt) are listed on a national exchange are subject
to extensive regulatory requirements.
• A company becomes a reporting company subject to the Exchange Act if (1) a class of its
equity securities (other than exempted securities) is held by either 2,000 investors or 500

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1
 investors who are not accredited investors, and 2) on the last day of the issuer’s fiscal
years, its total assets exceed $10 million (15 U.S.C. §12 (g)).
• Also, a company that files a registration statement under the Securities Act of 1933
becomes a reporting company (15 U.S.C. §15 (d)).

MANDATORY DISCLOSURES AND RECORDS [p. 653]

The Exchange Acts mandates (1) regular disclosure reports; (2) record-keeping requirements; (3)
restrictions on proxy voting; (4) disclosure of tender offers; and (5) disclosure requirements and
trading restrictions for officers, directors, and shareholders owning more than 10 percent of the
stock.

A. Section 13: Periodic Disclosure [p. 653]

Points to emphasize:

• Section 13 of the Exchange Act requires public companies to file regular reports with the
SEC in order to maintain their registration and to provide the public with ongoing
disclosures via annual, quarterly, and special reports.
• The SEC is required to perform regular and systematic reviews of the filings of each
company at least every three years.
• Annual reports are filed using Form 10-K and contain extensive disclosure requirements.
• Quarterly reports are filed using Form 10-Q with 45 days of the close of the company’s
financial quarter and serve as an interim report.
• Special reports are filed using Form 8-K and are required when material events occur
(e.g., changes in corporate control).

B. Section 14: Proxies [p. 654]

Points to emphasize:
• A proxy is a device used by a shareholder to grant another shareholder the right to vote
on his or her behalf.
• Section 14 of the Exchange Act requires that anyone who solicits a proxy from a
shareholder must file a proxy statement with the SEC and distribute that proxy to
shareholders. It must contain disclosures and relevant information about the issues being
voted on.

C. Tender Offers [p. 654]

Points to emphasize:
• A tender offer is an offer in which the investor is attempting to purchase enough stock in
a single transaction to establish a controlling interest in the company.
• The Exchange Act imposes disclosures and regulatory requirements on any person (or
group) that acquires more than 5 percent of the public company’s equity securities.

D. Delisting [p. 654]

Points to emphasize:
• Delisting from an exchange results in the termination of the statutory requirements.
• The company delists by filing a Form 25 with the SEC. The company must give notice of
its intention to file the form and issue a press release announcing that intention 10 days
prior to filing the form.
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 ANTI-FRAUD PROVISIONS [p. 655]
Points to emphasize:

• Section 10(b) of the Exchange Act is the primary anti-fraud provision covering the
trading of securities.
• Section 10(b) makes it a criminal offense to engage in any fraud, directly or indirectly, in
connection with the purchase and sale of any security.
• Rule 10b-5 prohibits: (1) employing any devise, scheme, or artifice to defraud; (2)
making any untrue statement of a material fact or omitting to state a material fact
necessary in order to make the statements made, in the light of the circumstances under
which they were made, not misleading; and (3) engaging in any act, practice, or course of
business that operates or would operate as a fraud or deceit upon any person in
connection with the purchase or sale of any security.

A. Material Fact [p. 655]

Points to emphasize:
• A material fact is one that, if known to an investor, would impact her decision as to
whether or not to invest in the security.
• Material facts can be related to any event that may increase the investor’s risk.

B. Right of a Private Suit [p. 655]

Private citizens have the right to file a lawsuit against companies and individuals for violations
of Rule 10b-5.

Teaching Tip: Section 10(b) and Rule 10b-5

It is important to emphasize to students that anyone involved in the buying or selling of securities
is subject to the anti-fraud provisions regardless of whether the company is registered under the
Exchange Act.

INSIDER TRADING [p. 656]

Points to emphasize:

• The Insider Trading and Securities Fraud Enforcement Act was passed in 1988 and it
raised the criminal and civil penalties for insider trading, increased the liability of
brokerage firms for wrongful acts of their employees, and gave the SEC more power to
pursue violations of Rule 10b-5.
• An investor is liable for insider trading under 10b-5 if the investor (1) bought or sold
stock in a publicly traded company, (2) possessed nonpublic information that was
material and was significant to the decision of the investor, and (3) had a special
relationship with the source of information as an insider or as a “tippee” if he received
information from an insider.
• Insiders include executives, managers, corporate or outside counsel, consultants,
manages, brokers, internal or external accountants, vendors, partners, and even majority
shareholders. Even lower-level employees can be insiders.
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 • The U.S. Supreme Court has recognized three complementary theories for insider
trading: (1) traditional insider trading, (2) misappropriation, and (3) tipper-tippee
liability.

A. Traditional Insider Trading [p. 656]

Points to emphasize:
• Traditional insider trading is when an insider trades in securities based on material,
nonpublic information learned as an insider who owes a duty either to abstain from
trading or to disclose the inside information publicly.
• In Case 34.1, a court applies a traditional insider trading theory.

Case 34.1 United States v. Bhagat, 436 F.3d 1140 (9th Cir. 2006)

Facts: NVIDIA, a publicly traded corporation, employed Bhagat as an engineer. On Sunday,

March 5, 2000, the chief executive officer of NVIDIA sent an e-mail to all company employees
announcing that NVIDIA had entered into a contract with Microsoft to develop and manufacture
3-D graphics for Microsoft’s Xbox. The e-mail made a prediction that the deal would result in
nearly $2 billion in revenue over the next 5 years. The next day, the management sent out
several emails indicating that the deal should be kept confidential and imposed a trading
blackout.

Twenty minutes after the trading blackout e-mail was sent, Bhagat purchased a large
quantity of NVIDIA stock. He also told two friends about the deal who also bought stock. After
the news about NVIDIA’s contract with Microsoft was released, NVIDIA’s stock rose sharply,
and Bhagat reaped a substantial profit. The SEC investigated the trade, and Bhagat claimed he
had read his e-mail only after he had already bought the stock, and by the time he tried to cancel
the transaction, he was told it was too late. Bhagat was convicted of insider trading, securities
tipping, and lying to SEC investigators. Bhagat appealed.

Opinion: The U.S. Court of Appeals for the Ninth Circuit upheld Bhagat’s convictions. The
court held that even without direct evidence that Bhagat read any of the e-emails prior to
purchasing the stock, the jury was allowed to infer Bhagat’s insider knowledge by virtue of the
fact that he had probably read his company e-mail upon entering the office as normal, reasonable
person would.

Case Questions

1. Is Bhagat liable as an insider even though he was just an employee? Why?

• Lower-level employees who learn inside information as part of their employment are
considered insiders.

2. What role did Bhagat’s credibility play in this case?

• The court did not believe that Bhagat tried to cancel the transactions because he could
not remember the branch of the brokerage house he called, nor the name or gender of
the representative to whom he spoke.

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4
3. Focus on Critical Thinking. Given that NVIDIA had access to this confidential information,
should the company have taken more precautions than simply sending out an e-mail and
imposing a trading blackout on employees? Is it possible that Bhagat did not know at the
time that his conduct was illegal? Does that matter? Were his actions ethical? Why or why
not?
• NVIDIA should not have sent out a companywide e-mail. If they had not done so,
then this case likely would not have happened. Whether Bhagat knew or did not
know about the illegality does not matter. Ignorance of the law is not a defense and
clearly, he had to know this behavior was at least unethical. Students should discuss
whether they think Bhagat’s actions were ethical or not.

B. Misappropriation Theory [p. 657]

Points to emphasize:

• Under the misappropriation theory, deceptive trading is performed by an outsider who

owes not duty to shareholders but does owe some type of duty to the source of the
information.
• Rule 10b-5 is violated under the misappropriation theory because the misappropriator
engages in deception by pretending loyalty to the principal while secretly converting the
principal’s information for personal gain.
• In Case 34.2, the court analyzes whether the misappropriation theory applies absent any
fiduciary duty owed to the source.

Case 34.2 United States v. McGee, 763 F.3d 304 (3d Cir. 2014)

Facts: Timothy McGee, a financial advisor, met Christopher Maguire while attending an
Alcohol Anonymous (“AA”) meeting. For almost a decade, McGee informally mentored
Maguire in AA. They shared intimate and confidential information with each other.

During this same time, Maguire was a member of the executive management at
Philadelphia Consolidated Holding Corporation (“PHLY”), a publicly traded company. In 2008,
Maguire was involved in negotiations to sell PHLY and experienced sporadic alcohol relapse.
During a conversation with McGee, Maguire blurted out inside information about PHLY’s
imminent sale. McGee agreed as usual to keep the information confidential.

After this conversation, McGee bought a substantial amount of PHLY stock on borrowed
funds without disclosing to Maguire his intent to use the inside information. After the public
announcement of the sale, McGee sold his shares at a profit. In 2012, a jury found McGee guilty
of violating insider trading laws under Rule 10b-5. McGee appealed arguing there was no
fiduciary relationship between him and Maguire.

Opinion: The U.S. Court of Appeals for the Third Circuit ruled against McGee and upheld his
conviction for insider trading. The court held that a fiduciary relationship was not required. Any
duty of loyalty, confidentiality, trust, or confidence would suffice for “recognized duties” to
establish misappropriation liability.

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Case Questions

1. Why was this considered a misappropriation theory case rather than a traditional insider case?
• A traditional insider case occurs when an insider uses insider information. McGee was
not an insider. Misappropriation occurs when deceptive trading is performed by an
outsider who owes not duty to shareholders but does owe some type of duty to the source
of the information.

2. If McGee had disclosed his trading to Maguire, would that have relieved him from liability?
Why or why not?
• Disclosure would not have relieved him of liability. It was shared in a confidential
relationship. In fact, if Maguire did not report it, it could be argued that they were both
liable under the Tipper-Tippee theory.

3. Focus on Critical Thinking. Was McGee’s conduct what Congress intended to prohibit, or
has Rule 10b-5 been applied to broadly? Isn’t the underpinning of the Exchange Act’s
section 10(b) to prevent insiders from using confidential information to profit? Why should
that apply to outsiders such as McGee? If McGee had overheard the information while
Maguire told someone else, would that change your analysis? Was McGee’s conduct ethical?
Why or why not?
• The Exchange Act’s section 10b-5 was intended to apply to any seller or buyer, not just
insiders. This fraud provision was meant to be broad. If McGee had overheard the
information told to someone else, he would still be liable. He still violated Rule 10b-5
because he engaged in deception by pretending to be loyal to Maguire while secretly
converting Maguire’s information for personal gain. Regardless, the behavior was
unethical as it violated the trust between mentor-mentee.

C. Tipper-Tippee Liability [p. 658-659]

Points to emphasize:
• Tipper-tippee liability is where an insider or misappropriator tips another who trades on
the information.
• Tipper liability under Rule 10b-5 is triggered if: (1) the tipper had a fiduciary duty or
other type of duty to keep material nonpublic information confidential, (2) the tipper
breached that duty by intentionally or recklessly relaying the information to a tippee, and
(3) the tipper received a personal benefit from the tip.
• Tippee liability requires that: (1) the tipper breached a duty by tipping confidential
information, (2) the tippee know or had reason to know that the tippee improperly
obtained the information, and (3) the tippee, while in knowing possession of the material,
nonpublic information, used the information by trading or by tipping someone else for
her own benefit.
• Personal benefit to the tipper is defined by courts to include not only financial gain but
also a nonfinancial benefit obtained from making the tip as a gift or favor to a relative or
friend who trades based on the tip. If made to a nonrelative, burden is on the government
to show that the potential benefit is an objective benefit.
• In Case 34.3, the U.S. Supreme Court distinguishes between trading relatives and
nonrelative acquaintances.
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 D. Personal Benefit Test [p. 659]
Points to emphasize:

Courts define personal benefit to the tipper to include not only financial gain, but also
nonfinancial benefit obtained from making the tip a gift or favor to a relative or friend who
trades based on the tip. Recent case law has divided personal benefits into two categories: (1)
when the tipper makes the gift to a nonrelative acquaintance, or (2) when the tipper makes the
tip a gift to a relative who later trades on the information (trading relative).

Case 34.3 Salman v. United States, 137 S. Ct. 420 (2016)

Facts: Maher Kara (Maher) was an investment banker in Citigroup’s health care investment
banking group. He dealt with highly confidential information about mergers and acquisitions. He
began sharing inside information with his brother, Michael. Without Maher’s knowledge,
Michael began sharing the information to others -including Michael’s friend, Salman. Neither
Maher nor Michael received any gifts or payments from Salman for the information. Eventually,
the authorities caught on and Salman was convicted and sentenced to 36 months and over
$730,000 in restitution. Salman appealed arguing that a close family relationship is not sufficient
to satisfy the personal benefit test required in a tipper-tippee insider trading theory.

Opinion: The U.S. Supreme Court upheld Salman’s conviction for insider trading. The Court
held that the tipper in this case benefits personally because giving a gift of trading information is
the same thing as trading by the tipper followed by a gift of proceeds – a violation of insider
trading laws.

Case Questions

1. Identify the tipper and all tippees in this case.

• The tipper at one point was Maher as far as his relationship with Maher. However,
Maher (as a misappropriator) is the tipper for this actual case with Salman because Maher
wasn’t aware of the sharing of the information. Salman and Maher’s brother-in-law are
the tippees.

2. What duty was breached by the tipper in this case?

• Michael was a misappropriator who breached a duty of confidentiality with his brother,
Maher. He also, through Maher, breached a duty of trust and confidence to Citigroup by
trading on insider information.

3. Focus on Critical Thinking. If Maher had no knowledge of his brother’s use of the
information, would that mean he did not engage in insider trading? Why or why not?
• Maher still engaged in insider trading. He was a tipper, and Michael was a tippee.

SECTION 16 RESTRICTIONS [p. 662]

Points to emphasize:

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7
 • Section 16 of the Exchange Act imposes restrictions and reporting requirements on
ownership positions and stock trades made by certain corporate insiders named in the
statute.
• Fundamentally, it provides transparency of all stock trades by insiders and prohibits
insiders from earning short-swing profits.
• Section 16(a) classifies any person who is an executive officer, a director, or a
shareholder with 10 percent or more of ownership of the total stock as an insider and
requires these insiders to file regular reports with the SEC disclosing stock ownership and
trading of their company’s stock.
• Section 16(b) includes a clawback provision that allows a corporation to recapture any
profits earned by an insider on the purchase and the ale of the company’s stock that
occurred within a six-month period (short-swing profits). It is a strict liability statute and
does not require the use of any insider information.

SCIENTER [p. 664]

Points to emphasize:

• Under the Exchange Act, investors must prove scienter as an essential element of a fraud
case.
• Scienter in a securities fraud context means that the seller of the securities either knew or
believed the facts represented to be untrue.
• Scienter may also be established if the seller lacked a reasonable basis for the
representation.

END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 665]

Chapter Review Questions [p. 667-669] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 664-665]

1. In response to cases of severe domestic loss (e.g., the 9/11 attacks or the BP-Deepwater
Horizon oil spill), Congress and other parties have created special victim compensation funds.
Should a special fund be set up for victims of financial crimes (such as Madoff’s scam)? Why or
why not?
• This question may be used to discuss equitable distribution in the cases of mass losses.
The dilemma is that a finite amount of money exists to distribute to victims. Students
may benefit from considering what kind of standards or multipliers may be used by a
special master: a) amount of money loss, b) harm suffered (wealth of victim), c) mental
state of victim, d) timing of claim. More controversial: a) age and health of victim, b)
victim’s assumption of risk. The other issue is where the money should come from.
Should it come from other Madoff clients who got out of the scheme in time? Students
might learn more about a bankruptcy trustee by reading this Reuters article

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8
 https://www.reuters.com/article/us-madoff-settlement/madoff-trustee-recoups-687-
million-in-biggest-settlement-since-2011-
idUSKCN1BH2TC#:~:text=Madoff%20trustee%20recoups%20%24687%20million%20i
n%20biggest%20settlement%20since%202011,-
Jonathan%20Stempel&text=Madoff%20Investment%20Securities%20LLC%20in,U.S.%
20Bankruptcy%20Judge%20Stuart%20Bernstein.

2. Madoff was effectively given a life sentence for his crimes. Should financial crimes be treated
the same as crimes against persons (assault) or property (theft)? Why or why not?
• The debate posed in this question is a public policy debate. Although Madoff went to jail
for life, other financial fraudsters are not treated as harshly. Students benefit from doing
some of their own research on the kinds of punishment that are considered “victimless”
crimes (e.g., drug use or prostitution) and the impact of those crimes on society versus
financial crimes.

3. Have you ever used noncompliance as a strategy in your daily life? What was the result?
• This question is a logical starting point for students examining and forming their own
ethical lens in the context of legal strategy. A great primer question is: is noncompliance
an ethical strategy? Are there cases in which a strategy is lawful, but not ethical? Ethical,
but not lawful?

Case Summary Questions and Answers [p. 618-620]

CASE SUMMARY 34.1 Dirks v. SEC, 463 U.S. 646 (1983)

1. Under the tipper-tippee liability, could Dirks be liable as a tipper or as a tippee? Why or why
not?
• Dirks could potentially be liable as a tippee. Under the standards used under current law,
he is part of a tipping chain and so long as he received a personal benefit, he could
potentially have liability for insider trading.

2. Is Dirks considered an insider?

• Dirks received material nonpublic information from "insiders" of a corporation with
which he had no connection. He disclosed this information to investors who relied on it in
trading in the shares of the corporation. Thus, he could not be liable under a traditional
insider trading theory but could be liable (subject to the personal benefit test) for insider
trading.

CASE SUMMARY 34.2 United States v. Nacchio, 519 F.3d 1140 (10th Cir. 2008)

1. Who prevails in this case and why?

• Nacchio was convicted at trial. Specifically, the jury found that Nacchio's sales from
January to May 2001 were on the basis of inside information, “because he had material
nonpublic information about Qwest — specifically that the company was relying heavily
on the sales of a certain product, a non-recurring source of revenue to meet its first and
second quarter public guidance, and that the company had not made the needed shift to
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9
 recurring revenue which placed the company at substantial risk of not meeting its year-
end guidance.” [Note that Nacchio’s conviction was reversed based on a procedural issue
regarding expert witnesses.]

2. Are all of the elements of insider trading met here?

• Yes. Nacchio was a traditional insider (CEO), who had access to non-public and material
information (that his company’s finances were in serious jeopardy) and traded based on
that information (sold personal stock of the company to avoid losses).

CASE SUMMARY 34.3 United States v. Chestman, 947 F.2d 551 (2d Cir. 2008)

1. Who prevails and why?

• Although Chestman was convicted by the trial court, the appellate court reversed the
ruling because no fiduciary relationship or equivalent relationship of trust and confidence
existed between Keith and the Waldbaum family or his wife, Susan, to make him liable
as a misappropriator under Rule 10b-5. “Because Chestman can only be liable for aiding
and abetting Keith in the purchase of Waldbaum stock if Keith is a misappropriator,
Chestman is not liable under Rule 10b-5.”

2. Should the rules for insider trading among family members be different? Why or why not?
• The rules for insider trading cannot be different for family members because the purpose
of insider trading prohibition is confidence by investors in the public markets. As a policy
matter, the rules have to apply universally.

CASE SUMMARY 34.4 SEC v. Switzer et al., 503 F. Supp. 756 (W.D. Okla. 1984)

1. Who prevails and why? Do you believe that the SEC prosecuted Switzer because of his high
profile?
• Switzer prevailed. This is a classic law school hypothetical that comes to life: overheard
information. Think about how many conversations are overheard by strangers on Amtrak
trains, taxicabs, airline flights. Trading on overheard information is not a tipper-tippee
case if no personal benefit existed for the tipper.

2. Although Platt did not intend to disclose the information to Switzer, could Platt’s choice to
discuss confidential corporate matters with his spouse in a public place where one could
easily overhear him constitute the requisite breach of duty required for a tipper-tippee case?
• The issue was whether any personal benefit existed. The court held that “absent some
personal gain, there has been no breach of duty to stockholders. And absent a breach by
the insider [to his stockholders], there is no derivative breach [by the tippee]. Chatting
about business with one’s spouse in a public place may be careless, but it is not a breach
of one’s duty of loyalty.

3. Did Switzer’s partners have a legal and/or ethical duty to inquire about the source of
Switzer’s information? Why or why not? Did their actions affect the overall market? Other
investors?

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10
 • Perhaps an ethical duty. Any time that one is asked to invest “blindly” there may be some
implications as to where the information came from. It is not known whether their trades
impacted the overall market, but certainly other investors lost money because they did not
have the same information as Switzer.

CASE SUMMARY 34.5 SEC v. Obus et al., 693 F.3d 276 (2d Cir. 2012)

1. What kind of insider trading occurred here?

• The SEC alleged that the investors were liable under both the traditional and
misappropriation theories of insider trading. Under the traditional theory, the SEC alleged
that one investor (Strickland) owed a fiduciary duty to SunSource as an insider (even if
just temporarily) not to disclose confidential information about the acquisition. Under the
misappropriation theory, the SEC claimed that Strickland breached a duty he owed his
employer, GE Capital, to keep information about SunSource’s acquisition confidential.
Finally, Obus of the last of a tipper-tippee chain.

2. Did Strickland violate a duty? If yes, to whom? Why or why not?

• The court held that Strickland had violated his duty to his employer, GE Capital, to keep
the information related to SunSource’s acquisition confidential.

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11
 Chapter 35
Regulation of Corporate Governance and Financial Markets

CHAPTER OVERVIEW
This chapter covers the internal and statutory constraints on corporate governance including
Sarbanes-Oxley (passed in 2002 in response to corporate wrong-doing) and the Wall Street
Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Articulate the major provisions of the Sarbanes-Oxley Act of 2002 and Application
explain how they apply to public corporations.
Identify and explain the corporate governance provisions of the Dodd-Frank Knowledge
Act.
Differentiate between whistleblower provisions of the SOX and Dodd-Frank Analytical
Acts, Thinking
Define what a financial market is. Application
Distinguish between primary and secondary capital markets. Application
Identify the participants in capital markets and the role played by each one. Knowledge
Explain how the Dodd-Frank Act regulates financial markets, Application
Articulate the problem of systemic risk. Application

Teaching Tip: Corporate Governance

This content of this chapter can be connected to many other chapters. You can refer to ethics,
corporate social responsibility, fiduciary duty, and securities laws. It may be helpful to introduce
the students to the Thinking Strategically case study at the end of the chapter on Cybersecurity
and Disclosures. As you progress through the chapter you can make connections to other
material covered in the textbook.

I. GOVERNANCE OF PUBLIC COMPANIES [p. 671-675]

Points to emphasize:
• Public companies have been subject to regulatory safeguard requirements since the
Exchange Act of 1934 was enacted.
• The Sarbanes-Oxley Act of 2002 (SOX Act) was passed in response to multiple corporate
fraud and malfeasance scandals that began to emerge in 2000—most memorably those
involving Enron, MCI WorldCom, Global Crossing, HealthSouth, and Tyco—to address
the public outcry and lack of investor confidence in corporate financial disclosures.

II. THE SARBANES-OXLEY ACT OF 2002 (SOX ACT) [pp. 671-675]

Points to emphasize:

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 • The SOX Act provided a sweeping and comprehensive amendment to the ’33 and ’34
Acts to address the corporate misdeeds that became public in 2000.
• The SOX Act was intended to impose stricter regulation and controls on how
corporations do business through regulation of three broad areas: auditing, financial
reporting, and internal corporate governance.
A. Reforms in the Accounting Industry [p. 672]
• As various corporate fraud and mismanagement scandals came to the public’s attention,
Congress replaced the accounting industry’s self-regulation of auditing with a new
federal agency called the Public Company Accounting Oversight Board (PCAOB) which
was charged with establishing regulations that standardized certain auditing procedures
and ethical parameters.
• Accounting firms are required to register with the PCAOB.
• The SOX Act seeks to increase auditor independence through setting mandatory rotation
of auditing partners, banning accounting firms from providing nonauditing consulting
services for public companies for which they provide auditing, and restricting accounting
firm employees involved in auditing from leaving the auditing firm to go to work for an
audit client.
B. Financial Reporting [p. 672]
• The SOX Act makes key corporate officers more accountable for financial reporting by
requiring that chief executive officers and chief financial officers personally certify the
accuracy of all required SEC filings.
• The SOX Act also provides standardized financial reporting formats and restrict certain
types of accounting methods that are not transparent to auditors, such as using special
offshore tax entities to hold corporate assets
C. Corporate Governance [p. 672]
The SOX Act requires that public companies maintain audit committees composed entirely of
independent directors who are responsible for (1) engaging, monitoring, and terminating the
company’s outside auditing firm; (2) implementing a system of controls that involves a
comprehensive examination of the audit reports and methods used by the company and outside
auditors to properly report information that truly reflects the financial condition of the company;
and (3) establishing a structure that facilitates communication directly between the audit
committee and the auditors (not using corporate officers as a go-between).
1. Code of Ethics Required [p. 672]
• The SOX Act requires public companies to establish a code of ethics and conduct for its
top financial officers and prohibits certain practices such as a public corporation lending
money to its officers and directors (with some narrow exceptions).
• Officers and directors are obligated to disclose their own buying and selling of company
stock.

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2
 • Executive performance bonuses are required to be retroactively forfeited back (known as
a clawback provision) to the company if the bonuses were tied to any financial reports
that later were deemed to be false or to have been issued without appropriate controls.
D. SOX Act Enforcement [p. 672]
The SOX Act also greatly expanded the scope and methods of enforcing securities law.
E. Emergency Escrow [p. 673]
• Recognizing that many of the remedies in the SOX Act are largely useless if the
corporation’s assets have been looted by insiders engaged in fraud, the law specifically
gives the SEC the authority to intervene in any extraordinary payments made by a
company that may be the subject of an SEC investigation.
• With approval of a federal court, the SEC to force any extraordinary corporate payouts
into a government-controlled emergency escrow fund that is held pending further
investigation by authorities.
• No formal allegation of wrongdoing is a prerequisite for this intervention,
• The term extraordinary payment is controversial as to what evidence is sufficient for the
SEC’s deployment of the escrow.

1. Substantial Penalties
Violators of the SOX Act are subject to both civil penalties and criminal prosecution up to $5
million in fines and 20 years of incarceration.
2. Whistleblowers
Parties that communicate information relating to illegal conduct in financial reporting or
corporate governance are protected against retaliation by the company
3. Document Destruction Rules
The SOX Act creates new provisions to punish anyone who alters, destroys, or conceals relevant
documents is subject to up to 20 years of incarceration.
4. Conspiracy to Commit Fraud
The definition of securities fraud was expanded by the SOX Act, and the creation of a new
federal criminal law outlawing conspiracy to commit fraud has made it substantially easier for
government prosecutors to pursue criminal fraud charges against officers and directors.

CASE 35.1 SEC v. Gemstar-TV Guide International, Inc., 401 F.3d 1031 (9th Cir. 2005)

Facts: In 2002, Gemstar filed its annual disclosures with the SEC for 2001 which were signed by
its CEO, Yuen, and its CFO, Leung. Four days prior to disclosing negative information in the
filings, Yuen sold 7 million shares of Gemstar stock. At the same time Yuen and Leung were
negotiating with the Board to leave their executive positions but remain employees and receive
payments in cash from Gemstar—$29.48 million to Yuen and $8.16 million to Leung—plus
large shares of stock and stock options. While the SEC was investigating Gemstar for fraud it
placed the $37 million that was to go to Yuen and Leung in escrow. The parties appealed the

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order on the basis that the payments were negotiated and therefore not extraordinary as required
under the SOX statute.
Issue: Did the SEC have the authority to intervene in Gemstar’s governance and finances?
Ruling: Yes, the appellate court held that the payment to two executives who were under fire for
the substantial revision of earnings statements coupled with the fact that insiders were departing
the company in wake of the scandal was sufficient to give the SEC intervention rights for any
authorized payments by the board of directors because they constituted extraordinary payments.
“In the context of a statute aimed at preventing the raiding of corporate assets, ‘out of the
ordinary’ means a payment that would not typically be made by a company in its customary
course of business.”
Case Questions

1. According to the court, what was “extraordinary” about these payments?

• Given the potential wrongdoing of the executives it seems unusual that they would be
financially rewarded with huge payouts.

2. Why did the SEC take action before its formal investigation was concluded?
• The SEC wanted to make sure the money was still available to pay any fines incurred.

3. Focus on Critical Thinking: Is the SEC’s power to create an emergency escrow too
overreaching? Why or why not? Could the law contain a “safety valve” that provides a hearing
prior to escrow?
• These questions are meant to elicit a discussion on the rights and limits on the
government’s power to intervene in internal corporate affairs.

III. THE DODD-FRANK ACT [p. 675-678]

Points to emphasize:
• As the financial crisis that began in 2008 unfolded, increasing fears of a disastrous global
financial meltdown and substantial public pressure caused Congress to provide loans to
key industries to get them through the crisis.
• Congress also imposed tighter restrictions on public corporations, financial markets, and
the extent to which firms engaged in risky investment transactions (Dodd-Frank).
A. Troubled Assets Relief Program (TARP) [pp. 675-676]
• Once it was apparent that several key industries were in financial jeopardy, Congress
authorized direct government loans to corporations that were most acutely impacted by
the crisis (primarily in the financial and insurance sectors).
• The loan program and its mandates were created by the American Recovery and
Reinvestment Act of 2009, which established the Troubled Assets Relief Program
(TARP) to administer the loans.

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 • As a condition of the loan, these companies had to abide by corporate governance and
executive compensation mandates.
1. TARP Today
The restrictions imposed on recipients of TARP funds have led several recipients to repay the
funds as soon as possible. The government wound up receiving a profit on the loans.
B. Financial Stability Oversight Council [p. 676]
The creation of a Financial Stability Oversight Council (FSOC) as a new independent body with
a board of regulators was intended to provide that stability to financial markets.
C. Expansion of SEC Jurisdiction and Enforcement [p. 676]
Dodd-Frank expanded the SEC’s jurisdiction and provided it with more money and mechanisms
for investigation and enforcement of securities law violations. Additionally, the federal Freedom
of Information Act no longer applies to the SEC; the SEC can refuse to supply documents it
deems to be part of its regulatory and oversight activities.
D. Corporate Governance [p. 676]
Although much of Dodd-Frank is related to financial regulation, some of its provisions impose
new corporate governance regulations on other types of public corporations and provides some
relief from SOX to smaller public companies. Dodd-Frank’s corporate governance provisions
center on transparency for the investment community and disclosures to the SEC, primarily in
the areas of compensation and board structure.
1. Executive Compensation [p. 676]
Dodd-Frank requires companies to adopt a “say-on-pay” policy asking shareholders whether to
approve compensation or severance agreement provisions (i.e., golden parachute) for their
executive management. It also requires that each reporting company’s annual statement explain
the relationship between executive compensation and the company’s financial performance.
2. Compensation Clawbacks [p. 676]
Under Sarbanes-Oxley, in the event a corporation is obliged to restate its financial statements
due to “misconduct,” the CEO and CFO must return to the corporation any bonus, incentive, or
equity-based compensation they received during the 12 months following the original issuance of
the restated financials, along with any profits they realized from the sale of corporate stock
during that period.
3. Employee-CEO Pay Ratio Disclosure Requirement [p. 677]
In 2015, the SEC issued a rule required by the Dodd-Frank Act that requires a company to
disclose (1) the median of the annual total compensation of all its employees except the CEO, (2)
the annual total compensation of its CEO, and (3) the ratio of those two amounts.
4. Board Structure Disclosure [p. 677]
Rules mandated by Dodd-Frank require companies to disclose their board leadership structure in
their SEC filings - whether the company uses a split structure (i.e., two different persons holding

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CEO and board chair positions) or a combined structure (i.e., same person for the CEO and chair
positions).
E. Dodd-Frank Whistleblower Provisions [p. 677]
An important part of the new regulatory scheme is the protection of whistleblowers who report
illegal conduct committed by employees, directors, and executives of the company. Additionally,
whistleblowers may be awarded money if their information leads to an SEC enforcement action
in which certain sanctions are levied.
1. Whistleblower Controversy [p. 677]
One significant legal controversy surrounding the whistleblower provision was created when the
SEC defined a whistleblower as anyone who reported the illegal conduct to the SEC, to another
federal agency, or to the company’s internal management.

Teaching Tip: Enron Whistleblower

Students may benefit from hearing about the story of Enron whistleblower, Sherron Watkins.
Her story demonstrated how few protections whistleblowers had prior to Sarbanes-Oxley and
Dodd-Frank. She documents her experience in Power Failure, the Inside Story of the Collapse of
Enron. Students may also find the documentary and/or the book – The Smartest Guys in the
Room – really interesting. Enron is described as a “microcosm of all that is wrong with American
business today.” The documentary is quite compelling.

CASE 35.2 Digital Realty Trust v. Somers, 583 U.S. ______ (2018)

Facts: Somers, Vice President of Digital Realty, reported several suspected securities violations
to senior management resulting in his termination. Somers did not report his concerns with the
SEC prior to being fired. Somers then sued Digital Realty alleging violations of state and federal
laws, including the anti-retaliation protections created by the Dodd-Frank Act. Digital Realty
argued that because Somers did not report the possible violations to the SEC, he was not a
whistleblower under the law. The trial court and appellate court held that the protections of the
Dodd-Frank Act extended to all who make disclosures of suspected violations, regardless of
whether the disclosures are made internally or to the SEC.
Issue: Can whistleblowers receive the protections of the Dodd-Frank Act if they have not
reported the suspected violations to the SEC?
Ruling: No, the U.S. Supreme Court reversed the lower court’s decision and ruled in favor of
Digital Realty. Dodd-Frank explicitly defines a whistleblower as any individual who provides
information on possible securities violations to the Commission, and this definition is
corroborated by Dodd-Frank’s purpose to aid the SEC’s enforcement efforts by incentivizing
people to tell the SEC about violations.

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Case Questions

1. Why didn’t the Court defer to the SEC’s interpretation?

• The statute contained an actual definition.

2. Why does the Court examine Dodd-Frank’s “core objective”?

• The “core objective” of Dodd-Frank is to motivate people who know of securities law
violations to tell the SEC not to protect whistleblowers. This is consistent with protecting
only those who report conduct to the SEC.

3. Focus on Critical Thinking: Somers argued that the Court’s interpretation creates “an
incredibly unusual statutory scheme in that identical misconduct—i.e., retaliating against an
employee for internal reporting—will go punished or not based on the happenstance of a separate
report to the SEC, of which the wrongdoer may not even be aware.” Is that a compelling
argument? Is the Court going too far in enforcing the letter of the law rather than the public
policy behind the whistleblower provisions?
• These questions are meant to elicit a discussion on how the wording of the law may lead
to inconsistent results.

IV. TYPES OF FINANCIAL MARKETS [p. 679-689]

Points to emphasize:
• Focus on financial markets and the problem of systemic risk.
• A financial market is a highly regulated institution where people and firms trade
securities (such as stocks and bonds), commodities (such as precious metals and
agricultural commodities) and domestic and foreign currencies (such as the U.S. dollar
and the British pound) at prices that reflect both supply and demand, and publicly and
privately available information.
• Financial markets are most often referred to as capital markets, markets that specialize in
long-term debt and equity financing of business ventures. Capital markets consist of stock
markets and bond markets.
• Other types of markets: commodity markets, futures markets, money markets, derivative
markets, and foreign exchange markets.

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 A. Primary and Secondary Capital Markets [p. 680]
• Capital markets consist of primary markets and secondary markets.
• In the primary market, firms (issuers) raise capital buy selling securities in public
markets (to the general investment community) or in private placements (to limited
groups of investors such as venture capitalists or institutional investors).
• An initial public offering occurs when securities are issued to the public for the first time,
called “go public”. A mandatory registration statement discloses facts and risks to
potential investors.
• A public market is the New York Stock Exchange (NYSE).
• The secondary market is the trading of already issued securities and does not raise
capital for the issuing business. Investors sell to investors to make a profit.
• Liquidity is the ability to convert a security into cash, a crucial aspect of securities traded
in the secondary market.
• Firms that do business in financial markets are regulated by federal laws and regulations
enforced by the Securities and Exchange Commission, the Federal Reserve, the Office of
the Comptroller of the Currency, and the Federal Trade Commission.

B. Capital Markets Participants [p. 681]

• Investors seek a return from their investment based on perceived values of securities in
which they invest, including both individual investors and institutional investors.
• Issuers are those institutions and entities that sell securities to investors, and include
business corporations, state and local governments, and other entities.
• Intermediaries are financial institutions that provide services for investors and issuers
related to securities transactions, commonly brokerage firms (broker-dealers) that buy
and sell securities on behalf of a client.

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 C. Dodd-Frank and Regulation of Financial Markets [p. 682]
• Enacted by Congress in response to the 2008 financial crisis and the problem of systemic
risk
• Named after it’s sponsors in Congress, Senator Chris Dodd and Representative Barney
Frank.
• This law made large changes including expanding SEC enforcement powers, creation of
new Financial Stability Oversight council, and a new bounty plan for whistleblowers.

1. Expanded SEC Jurisdiction and Enforcement [pp. 682-683]

• SEC is an independent agency with 5 commissioners appointed by the president, working
in 11 regional offices across the U.S.
• It enforces federal securities laws and regulates all aspects of U.S. capital markets.
• Companies that issue publicly traded securities in primary and secondary markets must
submit quarterly and annual reports to the SEC used by investors to make pre-investing
decisions.
• These reports (1) create confidence in financial markets, (2) maintain the integrity and
stability of financial markets, and (3) secure the appropriate degree of protection for
investors.
• New tools created for the SEC by Dodd-Frank are (1) secret investigations, (2) fiduciary
duty of broker-dealers, and (3) hedge fund registration by advisors.

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 2. Financial Stability Oversight Council [p. 683]
• FSOC was created by Dodd-Frank, a new and independent body with a board of
regulators to address dangerous risks to global financial markets posed by risky
investments or the actions of large, interconnected financial institutions.
• Chaired by the Secretary of the Treasury and has 10 voting members who are the heads
of various agencies involved in the financial system.
• The FSOC exercises its oversight function over financial markets by (1) risk analysis, (2)
early warning of threats to the financial markets, and (3) identification of financial risk in
firms.

CASE 35.3: STATE NATIONAL BANK OF BIG SPRING v. SECRETARY OF THE

TREASURY, 795F.3d 48 (D.C. Cir. 2015)
Facts: The Bank challenged the constitutionality of the new Financial Stability Oversight
Council provision in Dodd-Frank, particularly its authority to impose on certain financial
companies that are “to big to fail” additional regulations to minimize risk that such a company’s
financial distress will threaten the stability of the U.S. economy.
Issue: Is the FSOC unconstitutional due to its broad powers to decide which companies should
face additional regulation? Does the Bank have standing?
Ruling: The Bank does not have standing because its claims were not ripe as there was no direct
harm. The Bank was not yet designated as “too big to fail”.

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Case Questions:

1. According to State National Bank, how was it harmed when the FSOC designated GE Capital
as “too big to fail”?
• Because GE Capital was designated for additional regulation and supervision by the
FSOC, indirectly State National Bank because GE Capital receives a reputational
subsidy as a result of the FSOC designation allowing it to raise funds at a lower cost,
which harms State National Banks ability to compete for the same finite funds.

2. Why didn’t the court allow State National Bank to challenge the constitutionality of the
FSOC?
• The indirect harm received by State National Bank was not enough standing and
complaining about the FSOC designation of another financial institution was not enough.
State National Bank had not itself received the designation.

3. Critical Thinking: If this case had been ripe for judicial review and not moot, would State
National Bank have won on the merits? In other words, do you agree with the Bank that the
FSOC’s powers are too broad?
• Discussion should focus on whether the ability of the FSOC to designate a financial
company as “too big to fail” is constitutional.
____________________________________________________________________________

3. CEO Pay Ratio Disclosure Rule [p. 685]

• Dodd-Frank requires publicly traded corporations to disclose the pay ratio between the
company’s median employee and the company’s chief executive officer or other
principal executive officer.

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 4. Say-on-Pay on Executive Compensation [p. 687]
• When shareholders vote on the approval of executive compensation this is referred to as
say-on-pay.
• Dodd-Frank requires that this vote happens at least once every three years.
This shareholder votes on pay are not binding on either the issuer or on the issuer’s
board of directors.

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CASE 35.4: DENNIS v. HART, 724 F.3e 1249 (9th Cir. 2013)

Facts: Despite reporting negative net income and negative class flow in 2010, PICO Holdings,
Inc. increased executive compensation. Sixty-one percent of the shareholders’ advisory vote was
against the board’s compensation package. The board did nothing based on the say-on-pay vote.
Shareholders filed a derivative action in California against PICO and its board. Ruling: The case
was removed from state to federal court; the court ordered the case back to state court and the
board members appealed the order to the court of appeals.
Issue: Did the actions of the board create a breach of fiduciary duty?
Ruling: The Court of Appeals ruled that the state court is the proper court to determine breach of
fiduciary duty issues because this is not a federal issue. Attorney fees were awarded to the
shareholders.
Case Questions:

1. Who won this case and why?

• At this stage the plaintiff shareholders won the case because they wanted it heard in state
court and the court of appeals agreed.

2. Why did the defendant board members want to argue this case before a federal court instead
of a state court? By the same token, why did the plaintiff shareholders want to argue this case
before a state court instead of a federal court?
• The board members wanted the court to use Dodd-Frank to determine that the board did
not have to follow the say-on-pay vote of the shareholders.
• The shareholders wanted the state court to rule that the board members had violated their
fiduciary duty to the shareholders and corporation.

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3. Critical Thinking: Under Dodd-Frank, shareholder say-on-pay votes are not binding. Should
they be?
• Discussion should focus on the pros and cons of non-binding versus binding votes.

4. Consumer Financial Protection Bureau

• Dodd-Frank created the Consumer Financial Protection Bureau “to provide a single point
of accountability for enforcing federal consumer finance laws and protecting consumers
in the financial marketplace.”
• The CFPB had direct oversight authority over companies that provide mortgages, credit
cards, savings accounts, and annuities directly to consumers.
• The CFPB can regulate requiring mandatory disclosures, fees, and restrictions on certain
consumer lending practices.
• CFPB core functions are (1) rooting out unfair, deceptive, or abusive acts or practices; (2)
enforce laws to prevent discrimination in consumer finance; (3) receive consumer
complaints; (4) financial education; (5) research the consumer experience of using
financial products; and (6) monitor financial markets for consumer risks.

V. SYSTEMIC RISK [p. 688]

Points to emphasize:
• Financial markets include business firms and financial institutions that are highly
interconnected.
• A firm that is highly interconnected with others can be a source of systemic risk, which
is the possibility that an event at the firm could trigger sever instability in financial
markets or the collapse of an entire industry/economy.
• Governments and monitoring institutions put policies and rules in place to safeguard the
interests of the market as a whole. Companies viewed as “too big to fail”, which are large
companies relative to their market or make up a large part of the overall economy.
• Don’t confuse systemic risk with market, or price risk, which is specific to the item being
bought or sold which can be mitigated with hedging strategies.

VI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 691]

Chapter Review Questions [p. 693-694] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 690-691]

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14
1. Have you ever been the victim of fraud because of a data breach? How did the business notify
you of the breach and what did they do to remedy the situation?

• This question may be used to start a conversation on how ubiquitous data breaches are in
everyday life. Having students share their experiences provides the opportunity to
illustrate how different responses are to data breaches in terms of notification and
remedies. Once students have identified a breach, compare the response to the Strategic
Solution provided in the Thinking Strategically feature.
2. Should every business have a cybersecurity strategy? In what ways could small business
owners tailor the above strategy to fit their own needs?

• Small business owners can use an advisory committee (instead of a corporate board) for
oversight and advice in planning for a data breach. Emphasize that, based on the
evidence, investing both time and money into cybersecurity provides a solid return on
investment. Small business owners should also address insurance issues related to data
breaches in terms of coverage and any special policies or endorsements that may help
reduce the risk of a catastrophic financial event.

Case Summary Questions and Answers [p.-692-693]

CASE SUMMARY 35.1 SEC v. Platforms Wireless, 617 F.3d 1072 (9th Cir. 2010)

1. Was the stock transfer an extraordinary payment under the SOX Act?

• The court ruled that the transfer was an extraordinary payment. They pointed to the
SEC’s specific evidence that Martin continued to act in his official capacity as
Intermedia’s President and CEO after the ownership transfer.
2. If it were shown that the stock transfer was a legitimate transaction, how would that affect
your analysis?

• Although Platform’s officers may have committed other securities law violations (such as
insider trading), the disgorgement would not be the appropriate remedy since the
payments could not be classified as extraordinary.

CASE SUMMARY 35.2 Leon v. IDX Systems Corporation, 464 F.3d 951 (9th Cir. 2006)

1. Is Leon protected under the SOX Act even if there is no evidence that he actually had
information about unlawful IDX activities?

• No. The court ruled that Leon’s actions of deleting relevant files from his hard drive
made it impossible for a court to determine if he could have whistleblower protection.
Instead, the court dismissed the case against IDX as a sanction for hiding what may have
been relevant evidence.

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15
2. Could Leon be in violation of the SOX Act document destruction rules for deleting files?

• Yes. In fact, the trial court ordered Leon to pay IDX a monetary sanction of $65,000,
which was IDX's submitted cost of investigating and litigating the deleted evidence issue.

CASE SUMMARY 35.3 MetLife, Inc. v. Financial Stability Oversight Council, 177 F.
Supp. 3d 219 (2016) (sealed opinion)

1. Should Congress itself define key terms in the laws it enacts, or should Congress have the
discretion to delegate the definition of key terms to administrative agencies?

• Discussion should focus on who should define key terms and why Congress defining the
key terms would have the force and effect of law and if administrative agencies define
them they will not be law but might be molded to fit many different situations and
arbitrarily applied.

2. In your opinion, were the actions of the FSOC in this case consistent with the concept of rule
of law?

• The rule of law restricts the arbitrary of exercise of power by subordinating it to well-
defined and established laws that are publicly promulgated, equally enforced, and
independently adjudicated.

CASE SUMMARY 35.4 PHH Corporation v, Consumer Financial Protection Board, 839
F.3d 1 (D.C. Cir. 2016)

1. In your opinion, should the president have the ability to fire the director of the CFPB? Why or
why not?

• According to the U.S. Supreme Court, “the CFPB’s leadership by a single individual
removal only for inefficiency, neglect, or malfeasance violates the separation of powers.”
The director must be removable by the President at will.

2. Other federal agencies created by Congress, like the FCC and FTC, have multiple directors.
Why do you think Congress created a single-director structure for the CFPB when it enacted
Dodd-Frank?

• Discussion should be based on the creation of the agency to insure its independence. The
director is appointed by the president and confirmed by the U.S. Senate.

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16
 Chapter 36
Agency Formation, Categories, and Authority

CHAPTER OVERVIEW
This chapter examines the definitions, categories, and sources of law that govern agency
relationships.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Recognize, define, and give examples of an agency relationship and Knowledge
transaction. Application
Explain the process for creating an agency relationship. Knowledge
Classify agents as either employees or independent contractors by applying Knowledge
the direction and control tests. Application
Articulate the ABC test factors used by state courts. Knowledge
Explain how agency relationships are terminated. Knowledge

DEFINITIONS AND SOURCES OF AGENCY LAW [p. 697]

Points to emphasize:
• Agency is a legal relationship in which the parties agree that one party will act as an
agent for another party, called the principal, subject to the control of the principal.
• A common form of agency is an employer-employee relationship.
• Much of agency law exists on the state statutory level and is based on the Restatement
(Third) of Agency.
• Business owners and managers depend on agents to carry out the daily operations of a
business.

CREATION OF AN AGENCY RELATIONSHIP [p. 698]

Points to emphasize:
• Agency is a fiduciary relationship that results when the principal manifest consent to an
agent to act on the principal’s behalf subject to the principal’s control.

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 • The agent must act with a high level of integrity and good faith in carrying out the best
interests of the principal.
A. Manifestation and Consent [p. 698]
Points to emphasize:
• Principal must manifest some offer to form an agency.
• Consent occurs when an agent agrees to act for the principal.
• The courts use an objective standard when determining if manifestation and consent
exists.

B. Control [p. 698]

Points to emphasize:
• The principal is in control of the relationship.
• The principal should define the tasks and objectives of the agency relationship.

C. Formalities [p. 698]

Points to emphasize:
• No formalities are required to create an agency relationship.
• Most agency agreements do not have to be in writing (exception: equal-dignity rule)

Case 37.1 Bosse v. Brinker Restaurant Corporation d/b/a Chili’s Grill and Bar

Facts: Bosse was part of a group of four teenagers who ordered and ate a meal at Chili’s
restaurant in Dedham, Massachusetts. The check for the meal came to $56, but the group left
without paying. A regular patron of the restaurant saw the group leave without paying and
followed them in his own car. The patron did not wear any Chili’s insignia and his car was not
marked with any insignia.
Eventually, a high-speed chase ensued through residential streets. During the chase, the
patron used his cell phone and called an employee of Chili’s who then called 911. In the course
of this high-speed pursuit, the teenagers collided with a cement wall and were injured. The
pursing patron fled the scene and was never identified.
Bosse sued the restaurant owner, Brinker Restaurant Corporation arguing that the patron
was an agent of the restaurant. Brinker filed for summary judgment claiming there was no
evidence that the patron was an agent.
Opinion: The Massachusetts Superior Court granted Brinker’s motion of summary judgment.
The court held that an agency relationship requires three elements: (1) the principal must give
consent, (2) the principal must maintain the right of control, and (3) the agent’s conduct must
benefit the principal in some way. In this case, there was insufficient evidence. Brinker had no
chance or desire to control the patron. It was not a consensual relationship.

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Case Questions

1. If the pursuing patron had been an off-duty employee of Chili’s, how would that impact your
agency analysis? Bosse’s case would have been stronger. However, Chili’s had a policy against
this behavior and the employee is off duty. The actions of the employee would most likely be
seen as out of the scope of employment (i.e., out of the scope of the agency relationship).
2. When the pursuing patron called Chili’s employee with a description of the pursuit, and that
employee in turn called the police, isn’t that an act of consent by Chili’s? The Chili’s employee
was not consenting to the chase but reporting the crime to the police.
3. Focus on Critical Thinking. What facts would you change in this case that might change the
court’s ruling? If an on-duty employee participated in the high-speed chase, the court most likely
would have found an agency relationship and thus, Chili’s would have been liable.

CLASSIFICATION OF AGENTS [p. 699]

Agents are classified into one of three broad categories: (1) employee agents, (2) independent
contractors, or (3) gratuitous agents.

A. Employee Agents [p. 699-700]

Points to emphasize:
• Employee agents are employees who are authorized to transact business on behalf of the
employer/principal.
• Principals are liable for the actions or omissions of employee agents.
• Not every employee is an agent.

B. Independent Contractors [p. 700]

Points to emphasize:
• An independent contractor is not considered an employee and does not have legal
protections for employees such as minimum wage and overtime compensation.
• A principal generally had no liability for actions and omissions of an independent
contractor.

C. Gratuitous Agents [p. 700]

Points to emphasize:
• Gratuitous agents are agents who act on behalf of a principal without receiving any
compensation.
• Generally, the rights and duties of a gratuitous agent are the same as those of a paid agent
except the duty of care applicable to the gratuitous agent is not as great.
D. Employee Agents versus Independent Contractors: Direction and Control [p. 700]
Points to emphasize:

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• The status of an agent is based not on what the parties agreed to but on the actual working
relationship between the principal and the agent.
• Courts apply the substance over form analysis to determine if an agent is an employee or
an independent contractor.
• The most important factor is classifying an agent is the amount of direction and control
the principal has over the agent’s work.
• In Case 37.2, a federal court analyzes the agency status of a telemarketer.

Teaching Tip: Employee versus Independent Contractor

Give the students a relatable example to show the difference between an employee and an
independent contractor. For example, a student may be currently working as an employee at a
grocery store. Explain how the employer sets her hours and controls how she does her duties.
Compare this to a plumber who fixes a leak at her house. The student does not provide the
plumber, an independent contractor, with the tools or control how he repairs the leak.

Case 37.2 Jones v. Royal Administration Services, Inc., 866 F.3 1100 (9th Cir. 2017)

Facts: Royal Administrative Services, Inc. (Royal) sells vehicle contracts (VSCs). VSCs are
a type of extended warranty on an automobile. Royal sells its VSCs to card dealers and
marketing vendors. The marketing vendors sell Royal’s VSCs through direct mail or
telemarketing. All American Auto Protection (AAAP), one of the marketing vendors, used
telemarketing to contact Charles Jones (Jones). Jones claimed that AAAP’s telemarketers
violated a federal law that prohibits telemarketers from calling consumers who have signed
the National Do Not Call Registry. Jones brought suit against Royal claiming that AAAP was
acting as their agent. The trial court dismissed the case and Jones appealed.
Opinion: The U.S. Court of Appeals for the Ninth Circuit upheld the trial court’s decision in
favor of Royal holding that AAAP was not an agent of Royal.
Case Questions

1. Why did the court hold that AAAP was not an agent of Royal?
• The court found that AAAP was an independent contractor because Royal did not
have the right to control the hours the telemarketers worked or the number of sales
calls they made.

2. Although Royal provided AAAP with scripts, the court ruled that these scripts were not
enough to transform an independent contractor into an agent. Do you agree? Why or why
not?
• Royal could not assert enough control over AAAP with the scripts alone. They could
not control when the calls were made, who made them, to whom they were made, or
the number of calls made.

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 3. Focus on Critical Thinking. Why do you suppose that Jones chose to bring suit against
Royal rather than directly against AAAP? Was the decision to name Royal in the lawsuit
strategic? Why or why not?
• Plaintiffs sometimes choose to sue the defendant with deeper pockets. Royal probably
had more assets than AAAP.

ABC TEST [p. 701]

Points to emphasize:
• Many states have adopted the ABC test as a standard for determining agency status.
• The ABC factors typically created a presumption that the agent is an employee unless
three tests are satisfied: (1) the individual is free from direction and control; (2) the
service is performed outside the usual course of business of the employer; and (3) the
individual is customarily engaged in an independently established trade, occupation,
profession, or business of the same nature as that involved in the service performed.
• In Case 37.3, the court applies the ABC test.

Case 37.3 Avanti Press v. Employment Department Tax Section, 274 P.3d 190 (Or. Ct.
App. 2012)
Facts: Waiau entered into an agreement to sell greeting cards, etc. for Avanti. The agreement
provided that Waiau would be the exclusive sales representative in southwestern Oregon. It also
stated that Waiau did not have the authority to bind Avanti; Avanti reserved the right to establish
and change prices, products, and any other conditions or terms of sale; and Waiau had the
authority to hire, fire and train her own sales associates. Waiau was to pay all employee taxes
and all her own expenses.
In exchange for her services, Waiau was paid a commission. During that time, Waiau
maintained a home office, used her personal vehicle for business travel, and deducted home
office expenses on her personal income tax return. Avanti did not reimburse Waiau for her
expenses or control the hours she worked.
After Waiau sought unemployment insurance benefits claiming she was an employee
rather than an independent contractor, the state’s labor agency and an administrative law judge
determined she was an employee, thereby making Avanti liable for unemployment taxes.
Opinion: The Oregon Court of Appeals reversed the findings of the administrative law judge
and ruled in favor of Avanti. The court held that Avanti did not have sufficient direction and
control over Waiau and that she should be classified as an independent contractor.
Case Questions

1. If Waiau had been paid a salary in addition to her commission, how might that impact the
court’s analysis?

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 • If Waiau had been paid a salary, it would have strengthened her case. Method of payment
is a factor to consider when deciding whether someone is an employee or an independent
contractor.
2. Although the Agreement did not prohibit Waiau from working for another company, as a
practical matter she was working full-time for Avanti. Shouldn’t that be a factor in the court’s
analysis? Why or why not?
• An employee can have a full-time job and another job. This is not a significant factor.
Control and direction over how someone does her work are controlling factors.
3. Focus on Critical Thinking. Is there a danger that employers will opt to create independent
contractor positions rather than employee positions in order to avoid liability and taxes? Is it
ethical to generate revenue based on the efforts of sales representatives but not provide them
with benefits available to employees such as managers and clerical workers?
• While there is a danger that employers will opt to create independent contractor positions,
the title of the position is not relevant. If the employer sufficiently controls the worker,
he will be deemed an employee. Also, if employers use independent contractors, they
give up control that they may not want to give up.

A. California’s Independent Contractor Law [p. 703-704]

Points to emphasize:
• California uses the ABC test; thus, agents are classified as employees by default unless
the employer establishes each of the three prongs of the test.
• Under California labor law, there is an affirmative burden on businesses to prove that
independent contractors are properly classified.
• Certain workers are exempt from the ABC test: doctors, dentists, veterinarians, lawyers,
architects, engineers, private investigators, accountants, securities broker-dealers and
investment advisers, travel agents, marketers, graphic designers, grant writers, fine artists,
certain photographers or photojournalists, and certain freelance writers and editors.

B. IRS Three-Prong Test [p. 704]

Points to emphasize:
• The IRS has devised a three-prong test to determine an agent’s status in the employment
tax context.
• The IRS considers: the behavioral aspect, the financial arrangements, and the type of
working relationship the parties have in terms of benefits and promises of continuing
employment.

C. Liability for Misclassification [p. 705]

Points to emphasize:

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 • The consequences for misclassifying an employee can be severe: back employment taxes
plus a penalty, and interest.
• The Department of Labor audit would likely follow to determine the compliance with
federal labor and wage statutes.

TERMINATION OF AN AGENCY RELATIONSHIP [p. 706]

Points to emphasize:
• Termination of the agency relationship also terminates the principal’s duties and
obligations to the agent and to third parties.
• Some third parties must be notified to avoid future liability.
• An agency relationship is terminated through express acts or through operation of law.

A. Express Acts [p. 706-707]

Points to emphasize:
• Typically, both the principal and the agent have the power to dissolve the agency at any
time by simply communicating the desire to terminate the relationship.
• Termination by the principal is known as revocation.
• Termination by the agent is known as renunciation.
• The legal power to terminate is not synonymous with the legal right to terminate (e.g.,
terminating a 3-year contract after 1 year could result in damages).
• An agency relationship may also terminate by expiration (e.g., end of time period) or the
agency’s purpose has been accomplished.

B. Operation of Law [p. 707]

Points to emphasize:
• Agency may also be terminated as provided by statute or through certain common law
doctrines.
• Generally, an agency relationship is automatically terminated by destruction of the
subject matter, or the principal or agent dies, files for bankruptcy, or does not have the
requisite mental capacity to continue the relationship.
• Some state statutes create exceptions to automatic termination.

END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 709]

Chapter Review Questions [p. 711-713] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [p. 708-709]

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1. If you went to work for a business and believed you were misclassified as an independent
contractor rather than as an employee, how would you handle the situation?
• This question allows instructors to bring some practical negotiation approach skills into a
classroom discussion. Students are very often concerned with their classification for an
internship, co-op, or summer employment. A discussion could include approaches from
consulting with a similarly situated colleague/intern to how to address a supervisor to the
whistleblower approach.
2. What are some of the ethical dimensions to agent classification? Do some employers try to
use an avoidance strategy by classifying workers as independent contractors, so they don’t have
to pay employment taxes? Is that ethical? Explain.
• This question encourages students to evaluate the ethics behind the avoidance strategy in
the context of agent classification. How are the incentives aligned? Focus on issues like
self-employment taxes, workers’ benefits (e.g., workers’ compensation, FLSA) to be sure
that students understand why an employer might intentionally misclassify. Then, use the
framework set out in Chapter 2 to generate a discussion on ethical decision-making
regimes (principles-based, consequences-based, and contract based) as well as
implications for corporate social responsibility.

Case Summary Questions and Answers [p. 710-711]

CASE SUMMARY 37.1 Futrell v. Payday California, Inc. et al., 190 Cal. App. 4th 1419 (8th
Div. 2010)
1. How compelling is the evidence that Futrell supplied (i.e., timecards, W-2 forms, etc.) that
Payday was his employer and he was not an independent contractor? Does tax status help
determine agency status?
• The court ruled in favor of Payday and held that Futrell’s agency status was properly
classified as independent contractor. The court rejected Futrell's argument that an
employer-employee relationship for purposes of the Labor Code wage statutes may be
based on any one particular factor, e.g., payroll and tax-related documents. Although tax
status may be used as one factor, the test for employee vs. independent contractor
requires more than a single factor to be considered in the direction and control analysis.
2. How much direction and control did Reactor have over Futrell? Was it sufficient to indicate
an agency status?
• The court held that there was “no evidence in the record showing Payday exercised any
control over Futrell's hours or working conditions. Reactor hired Futrell and arranged
and supervised the location shoots.” The production company, Reactor, controlled the
shots. This means the only possible linchpin for finding that Payday was Futrell's
employer is whether Payday “exercised control over his wages.”

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CASE SUMMARY 37.2 Harris v. Vector Marketing Corp., 753 F. Supp. 2d 996 (D.C.N.D. Cal.
2009)
1. Using the direction and control analysis, determine whether Harris was an employee or
independent contractor.
• Most likely the Sales Representatives were independent contractors. However, the court
ruled that even assuming that Sales Representatives were, once they completed the initial
training, independent contractors, “that does not necessarily bar them from getting paid
for their time spent in initial training (i.e., they could still be considered employees for
purposes of FLSA for the limited purpose of the time spent in initial training).”
2. If Vector had a written agreement with each sales representative that made clear that the
agency relationship was an independent contractor relationship, how would that impact your
analysis?
• Substance over form is the best way to explain that written agreements cannot, in and of
themselves, be determinative of an agent’s status. The question is not what the agreement
contained, the analysis focuses on the action of the parties and the working relationship
between the parties.

CASE SUMMARY 37.3 A. Gay Jensen Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (Minn.
1981)
1. Is it possible for Warren to consent to an agency without doing so expressly?
• The court ruled that a lender who merely exercises veto power over the business acts of
his debtor by preventing transactions above specified amounts does not automatically
become a principal. However, if a lender takes over the management of the debtor's
business either in person or through an agent and directs what contracts may or may not
be made, they establish themselves as a principal. The court held that the “point at which
the creditor becomes a principal is that at which he assumes de facto control over the
conduct of his debtor.”
2. Compare this case to Bosse v. Brinker (Case 37.1). Should the Bosse court reasoning apply
here, or are they different circumstances?
• This is distinguishable because it involves a debtor-creditor relationship. Although the
court ruled that Brinker was not a principal because there was no consent, an implied
consent by a creditor by virtue of the creditor control of business decisions of the debtor
can give rise to a principal-agent relationship.

CASE SUMMARY 37.4 Estrada v. FedEx Ground Package System, Inc., 64 Cal. Rptr. 3d 327
(2007)
1. Should the drivers be classified as independent contractors?

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 • The court held by virtue of the FedEx standard agreement and its policies and procedures,
the drivers were employees and not independent contractors.
2. What tests should the court apply to determine the status of the drivers?
• The court ruled that FedEx exercised control over the drivers in four ways: 1) FedEx has
the right to and actually controls the appearance of its drivers, including their clothing,
from their hats down to their shoes and socks, as well as their hair and hygiene, 2) FedEx
can and does control its drivers’ vehicles, including the color of the paint that their
vehicles must be and the requirement that they display the distinctive FedEx logo, 3)
FedEx can and does control the times its drivers can work, even though the Operating
Agreement specifies that FedEx has no right to set specific working hours; “it is clear
from the [Operating Agreement] that FedEx has a great deal of control over drivers’
hours, structuring their workloads so that they have to work 9.5 to 11 hours every
working day. 4) FedEx can and does control aspects of how and when drivers deliver
their packages. It assigns each driver a specific service area, which it “may, in its sole
discretion, reconfigure.”

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 Chapter 37
Duties and Liabilities of Principal and Agents

CHAPTER OVERVIEW
This chapter focuses on how the law of agency impacts three parties: principals, agents, and third
parties. It examines how obligations and liabilities arise when the principal and agent interact
with a separate unrelated individual or business.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Identify the relationship between principals, agent, and third parties. Knowledge
Identify the fiduciary duties that arise from an agency relationship. Knowledge
Analyze scenarios in which an agent may create contract liability for a Critical Thinking
principal.
Demonstrate cases in which an agent is liable to a third party in a Application
contract.
Analyze scenarios in which an agent may create tort liability for a Critical Thinking
principal

Teaching Tip:

Agency is not something that students can often intuitively grasp, so the use of concrete
examples helps. An example students can relate to is giving your roommate the authority to
check your mail, or sell your television while you are on vacation.

I. PRINCIPAL, AGENTS, AND THIRD PARTIES [p. 715]

The law of agency includes how obligations and liabilities arise when the principal and agent
interact with a separate individual or business known as a third party.

Points to emphasize:
• Agency law is a useful legal concept because it allows businesses as principals to grow
and transfer authority to agents within the organization’s chain of command.

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 • A start-up corporation is the principal that delegates general day-to-day management
responsibilities to its chief executive officer (CEO), a superior agent. As an agent with
broad authority, the CEO may decide to hire and supervise other agents who can carry
out more specialized responsibilities.
• The CEO may hire a CFO to handle finances, a COO to handle logistics and
manufacturing, and a CLO to handle the company’s legal affairs. The CEO may
authorize these “C-level” executives (subordinate agents) to hire additional agents
within each of their departments.
• The CEO is a superior agent and the C-level executives are subordinate agents. The C-
level executives may be superior agents if they hire and oversee employees within their
departments.
• Agency allows responsibility and authority to be delegated throughout the organization.
• All of these individuals are co-agents of the principal business.
• The agents may create liability to the principal in contract and tort.

II. Fiduciary Duties [p. 715}

Teaching Tip:

Since so much time is spent discussing contracts, where the duties between contracting
parties is generally one of good faith and stops at arms-length-bargaining (each side is
trying to gain as much as possible), it might be good to compare fiduciary duties with this
standard since fiduciary duties involves the parties standing "together" and involves a duty
to put one's selfish and financial interests aside to ensure the interests of the other party are
prioritized.

The relationship between the principal and agent is a fiduciary relationship.

Points to emphasize:
• A fiduciary relationship is a relationship based on trust and under this standard, an
agent has a fiduciary duty to act loyally for the principal’s benefit in all matters
connected with the agency relationship.
• Agent must put the principal’s interest first, must obey all reasonable and lawful
instructions, and to exercise due care.

III. A PRINCIPAL’S LIABILITY FOR THE AGENT’S CONTRACTS [p. 716]

Principals create agency relationships to give agents the power to enter into contracts with third
parties that will legally bind the principal.

Points to emphasize:
• Example: A property owner owns an apartment building. As the principal, the property
owner may decide to devote her time and skill to investing in properties. She decides to

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 transfer the authority to manage the apartment building to a separate real estate
management company. The real estate management company will interact with third
parties (tenants and maintenance companies) and will oversee leasing, rent collection,
and property maintenance.
o The property owner is the principal who will transfer authority to the real estate
management company as the agent to execute contracts (leases) that will bind the
property owner with third parties (tenants).
o An example college apartment lease agreement indicates that Sunshine Properties
(the principal property owner) has authorized DiPaolo Properties to act as its
leasing and management agent.
o THIS LEASE AGREEMENT (“Agreement”) made and entered into this 1st day
of July, 2018 (the “Effective Date”), by and between DiPaolo Properties and
Investments, LLC, a Florida limited liability company, as the authorized leasing
and management agent of Sunshine Properties (“Landlord”), which owns that
certain real property being, lying and situated in Leon County, Florida, and having
a street address of 123 Call Street Tallahassee, Florida (“The Premises”) and the
undersigned individuals below collectively the (“Tenant”) . . .

• An agent’s power to bind a principal in contract is derived from the agent’s authority.
This authority arises from (1) actual authority, (2) apparent authority, and (3) ratification.

A. Actual Authority [p. 716]

• An agent’s power to bind the principal in contract is through actual authority which
arises in one of two ways.
• First, a principal may grant express authority through a written or oral statement that
describes the authority granted to an agent. This can be done either formally (contract) or
informally (verbal authorization to act).
• Second, the law attaches implied authority in every instance where there is actual
authority. Implied authority is the authority that is reasonably necessary to further the
principal’s objectives, or based on custom, or the course of past dealings.
• Example: Sunshine Properties gave express authority for DiPaolo to sign lease contracts
with tenants on its behalf. DiPaolo never mentioned its position with respect to renters
with pets. DiPaolo would have implied authority to decide whether pets would be
allowed and it would be binding on Sunshine.

B. Apparent Authority [p. 716]

• Agents may act in an unauthorized manner without actual authority but still bind the
principal to a contract.
• When a third party relies on a statement or action of the principal that creates a false
appearance of an agent possessing authority this is referred to as agent authority.
• Key to understanding apparent authority is to determine whether a third party was
objectively reasonable in the belief that the apparent agent is in fact authorized to act for
the principal.
• It arises from the actions of the principal that lead the third party to believe that an agent
has authority to act on the principal’s behalf.

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Case 37.1 GGNSC Batesville, LLC d/b/a Golden Living Center v. Johnson, 109 So. 3d 562
(Miss. 2013) [p. 717]

Facts: Johnson, as personal representative of her brother’s estate, filed a wrongful death lawsuit
against GGNSC Batesville (Golden Living) which alleged negligence against Golden Living for
the death of her brother, Moses Cooper. He was a former resident of Golden Living nursing
home. Golden living moved to compel arbitration based on an arbitration clause in its standard
admission agreement. The trial court denied the motion and ruled that no valid contract existed
because Johnson, not Cooper, signed the agreement during the nursing home’s admission process
and Johnson had no legal authority to act as Cooper’s agent.

Issue: Was Johnson Cooper’s agent?

Ruling: To prove that Johnson had apparent authority over Cooper, Golden Living must put
forth sufficient evidence of (1) acts or conduct of the principal indicating the agent’s authority,
(2) reasonable reliance upon those acts by a third party, and (3) a detrimental change in position
by the third party due to the reliance. The record did not contain any acts or conduct by Cooper
indicating that Johnson was his medical health care agent. There is no need to look at the second
or third prong of the test. Johnson did not have apparent authority to bind Cooper to the contract.

Answer to case questions:

1. The ruling creates liability for Golden Living since it removes the option
to arbitrate, which as covered in Chapter 5 of the text, is usually a more favorable
venue for businesses.

2. No, since a reasonable person would likely rely on a legal document or

relationship to indicate this level of authority to act on one’s behalf in this
important area of life. A conversation without enough detail concerning the
agency is not enough. The necessary words would include, for example, “my
brother is authorized to make healthcare decisions on my behalf.” Moreover, it
would be prudent for Golden Living to rely on a formal proof of such agency such
as a power of attorney.

3. The law of contract is also applicable. It is sound public policy insofar as

someone should not be held accountable for the contracts of others who act
without authorization.

C. Ratification [p. 718)]

Points to emphasize:
• Ratification can provide an agent with retroactive (after-the-fact) power to bind a
principal and it occurs when the principal affirms a previously unauthorized act.
• The after-the-fact authority can occur by the principal occurs by (1) expressly ratifying
the transaction or (2) not repudiating the act.
• Example: DiPaolo hires Greenpanels to install an expensive solar energy paneling system
on Sunshine’s apartment properties to reduce power consumption. This has not been done

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 before between these two parties. DiPaolo incorrectly tells Greenpanels that DiPaolo has
authority to enter into a contract on Sunshine’s behalf. During the monthlong installation,
Sunshine notices the workers on the site and asks DiPaolo for an explanation. At this
point the contract is either ratified or repudiated. No express authority was given to
DiPaolo for this contract and there was a lack of prior dealings. No implied or apparent
authority exists. Sunshine may like this contract and ratify it. If Sunshine does nothing,
then it is ratified by inaction.

Case 37.2: In re The Walt Disney Company Derivative Litigation [p. 718]

Facts: The CEO of Disney, Michael Eisner, fired the company’s president, Michael Ovitz, after
a power struggle. The firing triggered a multimillion-dollar severance payment to Ovitz. The
shareholders of Disney sued the board to prevent the firing and large severance payment to
Ovitz, claiming that Eisner lacked the authority to fire Ovitz without first obtaining the board’s
approval.

Issue: Did the board grant authority to Eisner?

Ruling: Disney’s governing instruments do not vest the removal power exclusively in the board,
nor do they expressly give the Board Chairman/CEO a concurrent power to remove officers. The
extrinsic evidence clearly supports the conclusion that the board and Eisner understood that
Eisner, as Board Chairman/CEO had concurrent power with the board to terminate Ovitz as
President. The testimony of new board members was powerful that as Chairman and CEO,
Eisner was empowered to terminate Ovitz without board approval or intervention. Many
company officers were terminated and no board actions were ever taken. Eisner possessed and
exercised the power to terminate Ovitz, thus the court determined that the Chancellor correctly
concluded that the new board was not required to act in connection with that termination.

Answer to Case Questions:

1. The argument can be made it was based on ratification since the Board
failed to object to the firing.

2. Yes, giving the CEO the authority to hire a President seems to imply the
authority to remove the president is reasonably related to the authority granted t
hire.

3. The Board could have either changed the bylaws to give themselves
excusive authority to fire the president or repudiated the firing immediately.

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IV. AGENT’S CONTRACT LIABILITY TO THIRD PARTIES [p. 720]

An authorized agent who enters into a contract with a third party binds the principal because the
third party may legally enforce the contract against the principal. However, there are times where
the agent may be held liable to perform the contract in the event the principal fails to perform.
An agent’s liability to third parties in a contract hinges on whether the agency relationship is
fully disclosed, partially disclosed, or undisclosed.

Points to emphasize:

A. Fully Disclosed Agency [p. 720]

• A fully disclosed agent occurs when the third party entering into the contract is aware of
the principal’s identity and knows the agent is acting on behalf of the principal in the
transaction.
• In this situation, only the principal is contractually obligated to the third party for
authorized acts. The agent has no liability and the third party has no legal recourse
against the agent if the principal fails to meet contractual obligations.

B. Partially Disclosed Agency [p. 721]

• A partially disclosed agency occurs when the third party know that the agent is
representing a principal bud does not know the actual identity of the principal.
• In a partially disclosed agency relationship, both the principal and the agent may be liable
for the obligations under the contract.
• Because the principal is not identified, the third party must rely on the agent’s good faith
dealings and credit. Thus, the law imposes liability on the agent in the event the principal
does not perform the contractual obligations.
• The agent may be able to proceed against the principal for indemnification, unless the
agent exceeds the authority in the transaction.

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 C. Undisclosed Agency [p. 721]
• An undisclosed agency occurs when the third party is completely unaware of an agency
relationship and believes that the agent is acting on her own behalf when contracting.
• The agent if fully liable to perform the contract.
• In some states the third party can pursue the principal.
• If the agent is made to pay under the contract, the agent has the right to indemnification
from the principal if the agent acts in an authorized manner.

V. A PRINCIPAL’S LIABILITY FOR THE AGENT’S TORTS [p. 723]

Points to emphasize:
• A principal may face joint-and-several liability for an agent’s tort, most commonly the
tort of negligence, even though the principal has not engaged in any wrongful conduct.
This is particularly true when the agent is an employee.
• Liability for agents who are classified as employees is derived from the doctrine of
respondeat superior. Employers are liable for the negligent acts of employee agents. It
is a form of vicarious liability because it involves one party’s liability for the act of
another party.
• Principals are usually not liable for the negligent acts of independent contractors.
• Respondeat superior liability is yet another reason the correct classification of agents by
business owners and managers is crucial to managing risk.

A. Physical Injury Requirement (p. 679)

• Parties who suffer purely economic losses a result of another’s negligence may only
recover if those losses were a result of injury to person or property. This is important in
the arena of respondeat superior.
• If the employee’s misconduct causes physical harm to a third party’s person or property,
the employer is liable for both the injury and any related economic losses.
• If the employee’s negligent misconduct results in harm only to emotional state,
reputation, or a purely economic loss, respondeat superior does not apply.

A. Scope of Employment [p. 722]

• In order for a principal (employer) to be liable for the employee’s tort, the act must have
occurred within the employee’s scope of employment.
• Respondeat superior is a powerful tool for an injured third party because under a “deep
pocket” scenario, it allows the injured party to recover damages from the employer under
the assumption that the employer’s resources and insurance coverage are higher than the
employee agent who committed the negligence.
• The scope of employment rule places some limitations on the principal’s vicarious
liability.
• A principal is liable for the agent’s tortious conduct if (1) it is related to the duties as an
employee of the principal, (2) occurred substantially within the reasonable time and space
limits, and (3) been motivated, in part, by a purpose to serve the principal.
• Another exception to the principal’s liability occurs when an agent, during a normal
workday, does something purely for personal reasons unrelated to the employment.

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 During this time, the employee’s conduct is thought of as being outside the zone that is
governed by respondeat superior.
• This activity is considered a frolic and protects the principal against any harm suffered as
a result of an agent’s negligence while on a frolic. The time of a frolic is a gray area.
• If the conduct is a small-scale deviation that is normally expected in a workday, it is not a
frolic, but a simple detour. A detour is considered within the responsibility of the
employer.
Courts look at each case independently.

Case 37.3 Riley v. Standard Oil Co. of New York, 231 N.Y.301 (N.Y. 1921) [p. 723]

Facts: Standard Oil employed Million as a driver and directed him to travel from the company-
owned mill to the freight yard 2.5 miles away. He was supposed to load some barrels of paint
onto his truck and immediately bring them back to the mill. Million arrived as the freight yard
and picked up the paint. He also loaded some scrap wood onto his truck. Instead of returning
back to the mill as instructed, Million decided to drop the scrap wood at his sister’s house four
blocks away from the freight yard in the direction opposite from the mill. Million dropped off the
wood at his sister’s house and approached the freight yard as he was making his way back to the
mill. Close to the freight yard he struck and injured a child named Riley. The trial court ruled in
favor of Riley; the appellate court reversed and dismissed the complaint. The high court reversed
the appellate court and ordered a new trial because the jury should decide.

Issue: Was the employee acting on behalf of his employer at the time of the accident?

Ruling: There is no fixed formula to determine whether at a particular moment a particular

employee is engaged in the employer’s business. It is a case-by-case determination. What must
be considered is what the employee was doing, and why, when, where and how he was doing it.
Is the trip to the sister’s a new and independent journey on his own business, distinct from that of
his employer or a mere deviation from the general route? Considering the short distance and little
time involved, the truck was loaded with the employer’s goods to be delivered to the mill, the
general purpose was to pick up and deliver the goods, it is a good question of fact for a jury
decision.

Answer to Case Questions:

1. This is an important factor and many courts are likely to determine at this
point Million was on a frolic for his own personal pursuit, so the case would be
decided in favor of Standard Oil and they would not face respondeat superior.
2. Companies can have clearly articulated job descriptions to put employees
on notice of what they are expected and not expected to do, screen employees to
hire responsible individuals, and in today’s world of technology use technology to
monitor employee usage of company resources.
3. Million’s action would be analyzed as a potential frolic since it was not a
deviation normally expected during the workday. The point of this case is to
illustrate that courts will not likely apply a mechanical or bright-line rule in the

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 frolic cases but instead look at various factors and each case independently. The
important factors are the general direction of travel, the use of company resources
and time, the instructions given to the agent, and the length of time or distance of
the personal activity.

B. Traveling to and from Work [p. 724]

• What happens in the situation where the employee causes an injury while traveling to or
from the workplace?
• Many courts have adopted the going-and-coming rule where employers are generally
not liable for torts committed by employees while on their way to and from work. The
law shields the employer from liability because employees are considered outside the
course and scope of employment during their daily commute. The employment
relationship is suspended from the time the employee leaves or returns to the workplace.
• An exception to the going-and-coming rule is when the employee’s use of her own car
gives some incidental benefit to the employer, known as the required-vehicle exception.
It applies if the use of a personally owned vehicle is either an expressed or an implied
condition of employment, or if the employee has agreed, expressly or implicitly, to make
the vehicle available as an accommodation to the employer.

C. Intentional Torts [p. 724]

• As a general rule, intentional torts by an agent (like assault and battery in the workplace)
are considered to be outside the scope of employment and employers are not liable for the
conduct unless the tort has a close connection to serving the principal.
• An example is a case where a state supreme court ruled that a sales associate employed
by Nabisco who had physically assaulted the manager of a store in his territory was
acting within his scope of employment because the original dispute involved shelf space
at the store where the assault took place. The court held that because the employee agent
was in the store pursuant to Nabisco’s business and the injury stemmed from his job as a
sales associate, even an intentional tort such as battery could be covered by respondeat
superior.

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 D. Negligent Hiring Doctrine [p. 725]
• The negligent hiring doctrine is recognized in a majority of states for employer liability
when the employer had reason to know that the employee might cause intentional harm
within the scope of employment. It requires employers to take reasonable steps to protect
third parties (customers and other employees) from harm at the hands of an employee.
• Criminal background investigations and reference checks are considered reasonable
steps.
• Courts hold employers liable where (1) the employees are required to have a high level of
public contact, as occurs with service and maintenance personnel, real estate agents, or
delivery persons; or (2) the employees are entrusted with caring for the sick, elderly, or
other particularly vulnerable populations.
• Negligent hiring occurs when, prior to the time the employee is hired, the employer knew
or should have known of the employees’ unfitness. The focus is on the employer’s
methods of determining suitability for the position.
• An example case: Abbott v. Payne where the company’s management failed to run a
criminal background check on an employee who subsequently sexually assaulted a
customer during a home service call. The employee had a record of multiple arrests for
sexually related crimes. The employer had a duty to screen the employee for any
information that might show that the employee should not have been placed in a position
of trust with regular access to customer information and contact with the public on the
employer’s behalf.
• The doctrine includes negligent retention of an employee once after the hiring process the
employer should have been given notice of the potential to cause harm.

E. Independent Contractors [p. 725]

• As a general rule, principals are not liable for the negligent acts or omissions of an
independent contractor.
• An exception is when the principal has been negligent in hiring which is based on the
peculiar risk doctrine. It requires a principal to take reasonable steps to determine the
fitness of an independent contractor to perform an inherently dangerous task (ex.
demolition company).
• The ride-sharing app company Uber has been the subject of many agency-related
lawsuits.

Teaching Tip:

Uber drivers have been categorized as employees in some jurisdictions, for example California,
whereas in others they are considered legally to be independent contractors such as in Florida.
This provides an interesting example that students can relate to for a good discussion regarding
the independent contractor factors most courts apply and that are depicted in Figure 37.4. A good
team-based or online exercise may be to ask students to argue whether Uber drivers are
employees or independent contractors and cite to the facts that support their decision.

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VI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES [p. 727]

Thinking Strategically Questions and Answers [p. 727]

1. Do Al or any of the gas station employees have authority to sign the

delivery documents? If so, what is the nature of that authority?

• The gas station employees have the authority to sign the delivery
documents since it was given by a district manager and routinely do so as
part of their job. The nature of this authority is actual express authority.

2. What arguments can Kirkland make to claim that Al lacked authority and
therefore hold Gulf Oil responsible for liability in the event their negligence
causes injury?

• Krikland can argue that Al and other similar employees lack actual or
implied authority to negotiate the liability release terms on these
documents. That their sole authority is to acknowledge the delivery of the
gas and sign for these reasons, but not to negotiate or provide for a release
of liability. Apparent authority is also lacking since a reasonable person
would not assume gas station attendants have the authority to do this.

3. How would you proceed if you were in Pam’s situation? What steps can
she take to protect her company?

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 • A prudent step would be to meet with the legal department to assess the
risk and determine how to negotiate the transfer of risk to Gulf Oil. One
way to do this would be to erase the indemnification/release of liability
language altogether or create a Master Service Agreement between the
two companies that negotiates this point and then simply transforms the
document to be signed by gas station employees as delivery documents.
Another solution is to memorialize the express authority to negotiate the
release of liability that rests with Pam (in writing), alert all district
managers of this and to place Gulf Oil on notice that any signed
documents at the gas stations will not have the legal effect of releasing
Gulf Oil from liability. Yet another step is to obtain insurance for this type
of liability and negotiate the cost of this with Gulf Oil as part of the cost of
doing business.

Key Terms [p. 728]

Chapter Review Questions [pp. 730-731]

Case Summary Questions and Answers [pp. 728-729]

CASE SUMMARY 37.1 Hannington v. University of Pennsylvania, 809 A 2d. 406 (Pa. Super.
Ct. 2002

1. Who prevails and why? Did Hannington’s attorney have apparent authority?

• Penn prevails since hiring an attorney gives a third party (Penn) the
reasonable belief that the attorney is authorized to offer a settlement on
behalf of the client-principal. Hannington’s attorney had apparent
authority.

2. Since Hannington never actually signed the agreement, was it reasonable for Penn to
assume that Hannington’s attorney had obtained his express consent to the terms? Has the
court effectively deprived Hannington of his right to proceed to trial? Explain your
answers.

• Yes, it was reasonable for Penn to assume Hannington’s attorney had

express consent to the terms. To some extent the court has deprived
Hannington of the right to trial, yet as the appellate court stated in this
case: “where one of two innocent persons must suffer, the loss should be
borne by him who put the wrongdoer in a position of trust and confidence
and thus enabled him to perpetrate the wrong. Accordingly, we find that
that the trial court did not err by enforcing the settlement agreement.”

CASE SUMMARY 37.2 Estrada v. FedEx Ground Package Systems, Inc., 64 Cal. Rptr. 3d
3267 (2007)

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12
 1. Should the drivers be classified as independent contractors? Why or why not?

• They are likely employees since they are subject to exclusive work with
FedEx and strict oversight (they were expected to wear a FedEx uniform,
worked full time under hours set by FedEx and were forbidden to refuse a
delivery).

2. What tests should the court apply to determine the status of the drivers?

• The courts should use a balancing of factors test related to the level of
control.

CASE SUMMARY 37.3 Edgewater Motels, Inc. v. A. J. Gatzke and Walgreen Company, 277
N.W.2d 11 (Minn. 1979).

1. Was Gatzke’s negligent smoking outside the scope of his employment/ Why or why not?
• The act of smoking is likely going to be treated as a detour and some
courts will hold that an employee does not abandon employment while
temporarily acting in this personal manner especially when it only
involves a slight deviation from work. The smoking was within the scope
of employment since Gatzke’s job was a 24-hour job and he was filling
out an expense report while travelling for work reasons.

2. If the evidence showed that Gatzke had intentionally tried to commit arson, how would
that impact the court’s analysis?

• It would impact the court’s analysis since this would involve an intentional
act that is unrelated to the business and would likely remove respondeat
superior liability for the employer.

3. Suppose that Gatzke had been writing out personal postcards rather than filing out an
expense report when he started the fire. Would Walgreen be liable? Why or why not?

• This would make a close case and would depend if the court weighed the
fact that he was a 24-hour employee more heavily than the personal nature
of the postcards.

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 Chapter 38
Employment at Will

CHAPTER OVERVIEW
This chapter discusses common law and statutory law affecting employment relationships.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Explain the fundamentals of the employment-at-will doctrine and the impact Application
of an express or implied contract on an employee’s status.
List and apply common law exceptions to the employment-at-will doctrine Application
Articulate federal and state statutory protections for at-will employees. Knowledge
Discuss the requirements for protection under federal and state whistleblower Knowledge
laws.
Explain the “separate and independent” defense to a whistleblower claim. Knowledge

Teaching Tip: Employment at will

Students may benefit from an explanation on how employers may terminate the employment of
anyone for any reason unless the reason violates the law (such as for reporting the company’s
violation of securities law or due to discrimination). Students often believe that they cannot be
terminated from employment without a reason.

I. EMPLOYMENT-AT-WILL DOCTRINE [p. 732-733]

Points to emphasize:

• The starting point for analyzing the legal relationships between employers and employees
is the employment-at-will doctrine that exists in some form in every U.S. jurisdiction.
• The employment-at-will doctrine permits an employer to terminate an employee with or
without advance notice and with or without just cause, subject to certain exceptions.
• The employment-at-will doctrine does not apply in cases where (1) the employee has an
express contract, (2) there is a common law exception, or (3) some specific statutory
protection exists.

A. Express Contacts [p. 733]

One major exception to the employment-at-will rule is when an employee has an express
contractual relationship which may require “good cause” for termination or otherwise limit the
reasons for termination.

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 B. Labor Contracts [p. 733]
Collective Bargaining Agreements between a labor union on behalf of employees and a business
entity provide protection by prescribing a process the employer must follow before terminating
an employee.

II. COMMON LAW EXCEPTIONS [p. 733]

Points to emphasize:

• The employment-at-will rule is pro-employer, and courts have recognized that a strict
application can result in unfair treatment of employees.
• There are three common law exceptions that help to limit the harshness of the rule: (1)
the public policy exception, (2) implied contract protection, and (3) the covenant of
good faith and fair dealing.

A. Public Policy Exception [p. 734]

The most widely used exception to the employment-at-will rule is when the termination violates
public policy (i.e., the welfare of the general public). The exception protects employees from job
termination if they are exercising some legal right.

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 1. Narrow Doctrine [p. 735-736]
Many courts have been reluctant to expand the public policy exception. Absent a specific
statutory protection (such as a whistleblower law), the threshold for relief using a public policy
justification is very high. Some examples include refusing to commit an illegal act (such as filing
a false tax return), exercising a legal right (such as refusing to take a polygraph test), or
performing an important act (such as the protection of children as discussed in the Jasper case).

CASE 38.1 Jasper v. H. Nizam, Inc., 764 N.W.2d 751 (Iowa 2009)

Facts: Jasper was hired as the director of Kid University (“KU”), a childcare facility in Johnston,
Iowa. She was paid an hourly wage, and there were no specific terms of employment. After
Jasper complained about the staff-to-child ratios at the childcare facility and declined to work in
the classroom, she was terminated. Jasper brought a wrongful discharge suit and lost at trial
because the court felt that an administrative regulation did not create public policy. The appellate
court reversed the lower court’s decision that adequately staffing a childcare facility would be a
clear public policy deserving of protection.
Issue: Are administrative regulations a reliable source of public policy?
Ruling: The Supreme Court of Iowa affirmed the appellate court decision. The administrative
regulations in this case were a direction by legislature to the Department of Human Services to
establish rules concerning proper staff-to-child ratios as a means to ensure the health, safety, and
welfare of children in childcare facilities. Any termination that resulted from Jasper’s insistence
that the ratios be maintained was a violation of public policy and an exception to the
employment-at-will rule.
Case Questions

1. KU pointed out that there was no evidence that it actually violated the regulation during
Jasper’s period of employment. Should an employer have to “act” before any public policy
concerns justify an exception to the employment-at-will rule? Why or why not?
• The employment at will exception to protect public policy only requires that the
employee believed the regulation was violated.
2. Does the court’s ruling mean that all state administrative regulations are now the source of
public policy considerations? Explain.
• No, just the ones that concern a fundamental public interest.
3. Focus on Critical Thinking: Is the court overreaching in establishing that administrative
regulations can be the basis for a public policy exception? Where should the ultimate
responsibility for establishing public policy lie? Are there any disadvantages to tying
administrative regulations to the public policy exception?
• These questions are meant to elicit a discussion of why there is a public policy exception.

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B. Implied Contracts [p. 736]
In addition to express contracts as discussed earlier, an employment-at-will relationship may be
converted to a contract relationship if the employer acted in a manner that would lead a
reasonable person to believe that the employer intended to offer an employee protection from
termination without cause.

CASE 38.2 Smothers v. Solvay Chemicals, 740 F.3d 530 (10th Cir. 2014)

Facts: Smothers was employed for approximately 18 years as a surface maintenance mechanic at
a mine owned by Solvay. Although he had previously received positive employment reviews his
absenteeism (due to a medical condition) beginning in 2005 resulted in poor performance
reviews. In 2008 Smothers was terminated after violating the safety standards for using
hydrochloric acid in the workplace. Smothers sued Solvay for, among other claims, breach of an
implied contract allegedly created by Solvay’s employee handbook. The trial court awarded
summary judgment to Solvay on all claims, and Smothers appealed.
Issue: Did Smothers immediate termination for failing to follow safety standards violate the
implied employment created by the employee handbook?
Ruling: No, the appellate court affirmed the lower court decision because even though the
employment handbook did create an implied employment contract, it permitted immediate
termination for serious offense, including safety violations.
Case Questions

1. Could Smothers claim that the real reason he was fired was his absenteeism rather than a
safety violation? Was his termination arbitrary in your view? Why or why not?
• Smothers could argue that his absenteeism was protected under disability law, however,
violating a safety standard would fall outside of that protection.
2. Is it fair to leave sanctions for safety violations entirely to the employer? Should employers be
able to decide how they administer sanctions on a case-by-case basis? Explain.
• Yes, violations of safety standards not only affect the employee violating them but could
also harm other employees and result in a fine to the company.
3. Focus on Critical Thinking: What public policy implications are presented in this case?
Should the law support a sanction as harsh as termination for any safety violation? What other
types of violations would call for such a sanction? How should society balance safety versus
fairness to an employee?
• These questions are meant to elicit a discussion on the balance between workplace
violations and fairness.

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C. Covenant of Good Faith and Fair Dealings [p. 737-738]
The covenant of good faith and fair dealing, adopted by a minority of states, represents a
significantly different approach to the employment-at-will relationship. States that recognize this
exception protect employees from job termination (1) without just cause or (2) in bad faith or
with malicious intent.
D. Common Law Tort-Based Exceptions [p. 738]
Some states recognize tort-based exceptions to the employment-at-will rule, such as tortious
interference with contract or defamation.

III. STATUTORY PROTECTIONS FOR AT-WILL EMPLOYEES [p.739-740]

Points to emphasize:
• Certain federal and state statutes displace common law employment-at-will rules.
• These include discriminatory motivations such as race or gender, absence due to jury
duty, or for attempting to form a union.

A. False Claims Act [p. 739]

The False Claims Act is a federal statute that contains an anti-retaliation provision that protects
employees who disclose that their firm has committed fraud in dealing with contracts with the
federal government. The reporting party stands to receive a portion of any monetary recovery
that is tied to the fraud (typically 15 to 25 percent of the judgment).
B. State Laws [p. 739-740]
Thirty states and the District of Columbia have enacted their own versions of the False Claims
Act under state law. While some follow the federal law, others extend protections such as
providing arbitration rights to challenge termination.

IV. WHISTLEBLOWER STATUS [p. 740]

Points to emphasize:
• Perhaps the most important statutory prohibition of employer termination is provided by
federal and state statutory protection of whistleblowers.
• A whistleblower is an employee or agent who reports an employer’s unlawful conduct or
a statutory violation to the authorities.
• Federal employees are protected from retaliation for whistleblowing by the
Whistleblower Protection Act of 1989.
• The Fair Labor Standards Act (regulation of wages and hours) and the Sarbanes-Oxley
Act (regulation of corporations) also provide whistleblowers with specific statutory
protections for reporting or testifying against their employer in an investigation, hearing,
or trial.

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A. State Whistleblower Laws [p. 740]
State whistleblower laws are more complex because each state has its own whistleblowing
statute, and they vary widely from state to state. Most states require that the whistleblower must
suffer an adverse employment action to be covered under the statute.

CASE 38.3 Wurtz v. Beecher Metro District, 848 N.W.2d 121 (Mich. 2014)

Facts: Wurtz was hired by the Beecher Metro District (District) as the district administrator for a
10-year period, as spelled out in a contract between the District and Wurtz. Wurtz alleged a
number of violations against both the District and its Board of Directors. Although the Board
members were charged due to the complaint, they were all acquitted. When the District failed to
renew Wurtz’s contract, Wurtz sued the District under the Michigan Whistleblower Protection
Act (WPA). The trial court dismissed the claim reasoning that Wurtz had not suffered any
“adverse employment action” as required for recovery under the WPA. The appellate court
partially reversed, and the parties appealed to the Michigan Supreme Court.
Issue: Is the failure to renew an employment contract an “adverse employment action?”
Ruling: No, the WPA does not apply to job applicants, nor those seeking a contract renewal. The
law only applies to current employees. Wurtz was no longer an employee.
Case Questions

1. If the District had terminated Wurtz’s contract before it expired, how would that change the
court’s analysis?
• Wurtz would meet the definition of a current employee who had suffered an adverse
employment action.
2. Suggest language that could have been in the contract that would have given the District more
leverage in dealing with Wurtz. Suggest language that could help Wurtz be classified within the
purview of Michigan’s WPA.
• “This contract is subject to renewal for additional periods of ten years each.”
3. Focus on Critical Thinking: What is the underlying public policy for protecting
whistleblowers? Is the court’s holding that prospective employees are not covered by the WPA
consistent with public policy objectives? Is there any other legal (e.g., tort-based) theory that
Wurtz could have used? Should whistleblowers who give false information be punished?
• These questions are designed to encourage a discussion regarding the purpose of
whistleblower statutes.

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B. Separate and Independent Defense [p. 742]
Employers may terminate employees who are whistleblowers if they can show that the
termination was for reasons that are separate from and independent of any whistleblowing.

CASE 38.4 McQueary v. The Pennsylvania State University, Pa. Ct. of Common Pleas, No.
2012-1804 (2016)
Facts: Mike McQueary, an assistant football coach at Penn State, was terminated after providing
grand jury testimony which led to the indictment of football coach Jerry Sandusky, athletic
director Tim Curley, and Vice President Gary Schultz for various violations of criminal sex
abuse laws. McQueary filed a claim under the Pennsylvania Whistleblower Act. Penn State
defended the whistleblower claim by asserting that McQueary was an employee at will whose
appointment was not renewed after the new incoming head football coach determined there was
no room for McQueary to continue as part of the team’s new coaching staff.
Issue: Was McCreary’s termination due to the grand jury testimony or due to “separate and
legitimate” reasons?
Ruling: McCreary was awarded $5 million in damages plus $1.7 million in legal fees under the
Pennsylvania Whistleblower Act. The court held that McQueary’s good faith reporting of the
sexual abuse to his supervisors qualified under the statute as a protected act of whistleblowing
because the firing was contemporaneous to the discovery of the grand jury testimony.
Case Questions

1. What does the court mean when it calls this “a case where actions speak louder than words”?
• It is not a defense to merely provide an alternative reason for an employee’s termination;
it must be supported by the employer’s actions.
2. If the new head football coach had interviewed McQueary, reviewed his personnel file, and
then concluded that he was not qualified for the job, would that have affected McQueary’s
whistleblower claim? Why or why not?
• Yes, if there was an actual reason why McQueary was not qualified for the job, this could
have provided a defense for Penn State.
3. Focus on Critical Thinking: In addition to his whistleblower claim, McQueary also filed suit
against Penn State for intentional torts. What other claims might McQueary have against Penn
State? McQueary reported the sexual abuse to his supervisors but not to any law enforcement
agency. Did he have an ethical obligation beyond reporting it to Penn State administrators?
Should he have reported it directly to law enforcement authorities? Should he have intervened
when he witnessed the abuse? Explain.

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 • These questions are meant to encourage a discussion regarding the possible claims that
whistleblowers might allege.

V. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 745-746]

Chapter Review Questions [p. 747-749] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [p. 744-745]

1. Have you ever had a job or internship where an employee handbook or manual was used?
Was there any language related to implied contracts? If so, did you understand what it meant at
the time? Explain.
• This question allows students to share experiences as interns or employees and can help
to illustrate that employee handbooks and manuals come in various forms. Some are
extensive and provide for a progressive system of discipline and some are just a list of
nuts-and-bolts policies (e.g., amount of holiday and sick time). This may also be an
opportunity to use your college/school/university’s version of a handbook and point out
language in the handbook (if any) that disclaims implied contracts etc.

2. Are there other methods to communicate policies and procedures to employees that do not
involve the distribution of a handbook? Could these other communication methods give rise to
an implied contract theory?
• In addition to Handbooks and Manuals, employers may also use memoranda, general
orders, resolutions and even email to officially communicate employment policies. Ask
students to provide some examples of policies that need to be communicated at the
moment rather than in the Handbook (e.g., change in procedures for calling in sick or
telecommuting during the Covid-19 crisis).

Case Summary Questions and Answers [p. 746-747]

CASE SUMMARY 38.1 Brundridge v. Fluor Federal Services, Inc., 164 Wash. 2d 432
(2008)

1. What exceptions could the pipe fitters assert to displace the employment-at-will doctrine?
• The pipefitters could use a) the public policy exception (public safety), or 2) Covenant of
Good Faith and Fair Dealing (if recognized in their state), or 3) Whistleblower
protections (if state statute provides protection based on safety considerations.

2. What theory would be best advanced by the pipe fitters? Explain.

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 • The trial court found that Fluor had engaged in retaliation against the pipe fitters who
complained about the safety conditions. An appellate court affirmed and held that under
Washington state law, the pipefitters me their burden of providing wrongful discharge in
violation of public policy because “discouraging the Plaintiffs from raising safety
concerns jeopardizes public policy.”

CASE SUMMARY 38.2 Haynes v. Zoological Society of Cincinnati, 652 N.E.2d 948 (Ohio
Ct. App. 1995)
1. Should Haynes be prevented from asserting a whistleblower claim because she is a member of
a union?
• The court held that the whistleblower statute in Ohio is an exception to the employment-
at-will doctrine. Thus, in order for an employee to bring a cause of action as a
whistleblower, that employee must have been an employee at will. As a member of a
union, the terms of Haynes’s employment relationship were governed by a collective
bargaining agreement. That agreement specifically limited the power of the zoo to
terminate Haynes and, as a result, took her outside the context of employment at will.
Because she was not an employee at will, she is outside the class of employees entitled to
whistleblower protection.

2. Could Haynes be protected from termination by a common law exception?

• Unlikely. However, if the incident was determined to be a public safety issue, the public
policy exception (public safety) could apply. If recognized in Ohio, the Covenant of
Good Faith and Fair Dealing may apply.

CASE SUMMARY 38.3 Gardner v. Loomis Armored, Inc., 913 P.2d 377 (Wash. 1996)
1.Should the law prevent Loomis from terminating the guard in this case? Why or why not?

• The court held that Gardner should not be terminated for his actions in preventing an
armed criminal from committing a criminal act. However, the court emphasized that this
was not a new public policy doctrine exception, but rather the application of a narrowly
defined exception. Gardner was in a unique position to prevent violent crime.

2.Was there a well-defined and clear public policy in this case? If so, what was it?
• The court acknowledged that the "situation presented by this case does not fit neatly into .
. . the categories of public policy tort cases previously considered by this court," but
nevertheless found the driver had a cause of action for wrongful discharge based on the
public policy in favor of protecting human life.”

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 Chapter 39
Employment Regulation and Labor Law

CHAPTER OVERVIEW
This chapter provides an overview of laws that protect employees from oppressive or unfair
workplace practices. These employment protection laws are intended to safeguard the welfare of
individual workers who have little or no bargaining power in the employer-employee
relationship. Federal and state laws work together to regulate employers in the areas of minimum
wage, overtime pay, use of child labor, sudden job loss, workplace injuries, workplace safety,
and medical leaves. Supervisors and human resource managers should take care to ensure
compliance of their business with these laws and regulations.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the principal aspects of the Fair Labor Standards Act and state laws Application
that protect workers.
Identify the laws that regulate retirement and health benefits. Knowledge
Demonstrate how a worker becomes entitled to workers’ compensation. Critical
Thinking
Describe how a worker becomes entitled to benefits under the Family and Critical
Medical Leave Act (FMLA). Thinking
Discuss the circumstances under which an employer is liable for invading an Critical
employee’s privacy. Thinking
Summarize the process for forming a collective bargaining unit. Knowledge
Identify the role of professional licensing in the workplace. Knowledge

Teaching Tip: Federal laws are sometimes hard to understand. Students may find it helpful if
sections of the actual statutes are presented as part of the discussion.

I. THE FAIR LABOR STANDARDS ACT AND STATE LAWS [p. 751]
The Fair Labor Standards Act (FLSA) is a major piece of federal legislation enacted in 1938
that regulates several important employment matters.
Points to emphasize:
• The Industrial Revolution and the Great Depression were major events that brought to
light several issues in the chapter.
• The Industrial Revolution occurred during the 19th and 20th centuries where great
advances in science and technology took place. Societies transitioned from being
primarily agrarian to primarily industrial economies. Factories and large-scale
manufacturing became prominent, and Henry Ford, Andrew Carnegie, and John D.
Rockefeller amassed wealth as leaders of vast businesses. Working conditions in factories
were often dangerous and harsh.

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 • After the Great Depression, greater pro-labor sentiment among the U.S. and organized
labor represented by unions led to New Deal legislation advanced by President Franklin
D. Roosevelt. One law was the FLSA, which President Roosevelt stated at its signing, “I
do think that next to the Social Security Act it is the most important Act that has been
passed in the last two years.”
• The FLSA applies to all employees of enterprises that employ workers engaged in
interstate commerce; produce goods for interstate commerce; or handle, sell, or otherwise
work on goods or materials that have been moved in or produced for such commerce.
• FLSA mandates (1) payment of a minimum wage, (2) a maximum 40-hour work week,
(3) overtime pay, and (4) restrictions on children who work in certain occupations and
during certain hours.
• The U.S. Department of Labor administers and enforces the FLSA.
A. Minimum Wage [p. 751]
Points to emphasize:
• The FLSA establishes a minimum wage to be paid to every employee covered under the
act.
• Current federal minimum wage is $7.25.
• States can set a higher minimum wage level for employees working within their
jurisdiction.
• Legal issues surround whether the FLSA wage and hour provisions applies to employees
for time in the workplace that is not directly related to the employee’s job duties.
Congress amended the FLSA with the Portal-to-Portal Act to provide guidelines
regarding what constitutes compensable work.
• The Portal-to-Portal Act-unless the activity is integral and indispensable to their principal
job, employees are not entitled to compensation for (1) time spent traveling to and from
the actual place of employment or (2) time spent performing activities before or after the
principal activities in a workday.
• The Supreme Court has decided, (1) time battery-plant employees spent showering and
changing clothes was compensable because the chemicals in the plant are toxic to
humans; (2) the time meatpackers spent sharpening their knives was compensable
because dull knives would slow down production on the assembly line and affect the
appearance of the meat, cause waste, and lead to accidents; (3) a claim by poultry-plant
employees that time spent waiting to don protective gear was not compensable because
the waiting was two steps removed from the production activity on the assembly line.

Case 39.1 Integrity Staffing Solutions v. Bank [p. 752]

Facts: Integrity provides warehouse staffing to Amazon throughout the U.S. Jesse Busk worked
as an hourly employee at Integrity’s warehouses in Nevada. Busk retrieved products from the
shelves and packaged them for delivery to Amazon customers. Integrity required is employees to
undergo a security screening before leaving the warehouse at the end of each day. During the
screening, employees removed wallets, keys, and belts from their persons and passed through
metal detectors. In 2010, Busk and another employee sued Integrity for violating the FLSA and
Nevada labor laws claiming entitlement to compensation for the time spent waiting to undergo
and actually undergoing the security screenings. They alleged that the time was about 25 minutes

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each day and the screenings were to prevent employee theft which was for the sole benefit of the
employer and their customers. The trial court ruled in favor of the employer and the appellate
court reversed because the screenings were compensable because they were required by the
employer, necessary to the primary work as warehouse employees, and done for the employer’s
benefit. Integrity appealed.

Issue: Was the pre-screening and screening time compensable under the FLSA?
Ruling: The U.S. Supreme Court reversed the appellate court decision and found in favor of
Integrity. The lower court erred by focusing on whether the activity was required by the
employer. The appropriate test was based on whether the activities were the principal activity or
activities that the employee was employed to perform. The security screenings were not integral
and indispensable to the employees’ duties as warehouse workers.

Answer to case questions:

1. An argument can be made that this factor should not be controlling since it would create a
requirement that an employer always use the most efficient means for non-principal yet
uncompensated activities.
2. The lower court erred by focusing on whether the activity was required by the employer,
not the principal activity.
3. These questions are designed to elicit responses that demonstrate critical thinking from
the students.
B. Maximum Workweek and Overtime Compensation [p. 753]
Points to emphasize:
• The FLSA sets a standard workweek at 40 hours in a seven-day period.
• An employee is entitled to overtime compensation for any hours worked in excess of
the standard workweek.
• Overtime compensation is calculated by multiplying the hourly base rate of the
employee times one and one-half.
• Employees are not entitled to overtime pay based on an eight-hour workday.
• The FLSA does not cover exempt employees.
• A premise of the FLSA is to level the playing field for employees who are in an
untenable bargaining position with employers. The law assumes a certain level of
bargaining power for professional and management-level employees, thus they are
exempt from the FLSA.
• Workers without significant managerial or supervisory roles and who perform repetitive
tasks or manual labor are considered nonexempt employees and are legally entitled to
overtime pay.
• Originally the division between management and labor was clear and based on salary
thresholds. However, today it is blurred due to the rise of the information age and the
general rise in the skill, education, and wages of workers.
• In 2019, the U.S. Department of labor issued a rule to update the annual salary threshold
below which workers qualify for FLSA protection. To be considered exempt, an

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 employee must make a minimum salary of $35,568/year, or $684/week. Those earning
more than $107,432 are classified as highly compensated employees and are always
presumed to be exempt.
• Workers paid by the hour are not exempt and entitled to overtime pay. Being paid a
salary does not automatically make an employee exempt. Exempt duties can be classified
as executive, administrative, or professional and are usually paid an annual salary, not
hourly.
• The following factors must be considered (duties test): (1) education, skill level, or
certification required for the position; salary level; and compensation method; (2) amount
of physical labor required; (3) amount of repetitive tasks; and (4) degree of supervision
required by the employer.
• A good human resources compliance practice is to document exempt versus nonexempt
positions in a company handbook.
• Unless an employee is clearly exempt from FLSA coverage, the employee should be
classified as covered (nonexempt) employee under the FLSA.

Case 39.2 Madden et. al. v. Lumber One Home Center [p. 754]

Facts: Madden, O’Bar, and Wortman were hired buy Lumber One to serve as supervisors and
managers in a new Lumber One store. The employees were salaried, labeled as executives, and
classified by Lumber One as exempt from overtime pay under the FLSA. In anticipation of the

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new store opening, Madden and O’Bar assembled shelves and received merchandise. Once the
store opened, Madden and O’Bar completed data entry tasks and helped out with customers,
unloading trucks, and collecting trash when needed. Wortman worked in the lumberyard and
waited on customers, helped unload trucks, and on occasion directed the truck drivers regarding
where to make deliveries. The parties agreed that the three worked overtime while employed at
Lumber One. Because Lumber One classified them as executives, the employees were not paid
overtime. Plaintiffs filed suit claiming they were improperly classified and should have been paid
overtime under FLSA. The jury found in favor of Lumber One, but the trial court overturned the
jury’s verdict and ruled in favor of the employees. Lumber One appealed.
Issue: Were the employees nonexempt employees?
Ruling: The U.S. Court of Appeals for the Eighth Circuit ruled in favor of Madden and O’Bar,
but it reversed the trial court’s ruling for Wortman. In order for the employees to qualify for an
executive exemption, Lumber One must show that the exempt employees had authority to hire or
fire employees or that their recommendations regarding personnel decisions were given weight
by the decision maker. The owner of Lumber One made all the hiring and firing decisions
without consulting Madden or O’Bar so the “authority” test or “particular weight” was lacking.
Wortman was involved in at least one recommendation for hiring a driver.

Answer to case questions:

1. That the employees influenced hiring and firing decisions through the informal
information solicited by the owner regarding job candidates.
2. The distinction was that Wortman provided input regarding a job candidate that was duly
considered by the owner.
3. These questions are designed to elicit responses that demonstrate critical thinking from
the students.
C. Child Labor [p. 757]
Points to emphasize:
• The FLSA outlaws sending school-age children to work instead of going to school by
imposing strict restrictions on hiring workers under 18.
• Children in family agricultural jobs and child actor are not subject to FLSA
restrictions, but state statutes require educational standards be met through the use of
tutors and homeschooling.
• States have passed child labor statutes to supplement federal laws.
• All employers are required to post a notice explaining the act where employees can
readily read it (e.g., in the workplace kitchen or mailroom).

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 D. State Laws [p. 757]
Points to emphasize:
• States have enacted laws that protect employees that fall into four general categories.
• Minimum paid rest periods—based on a ratio of rest period versus hours worked.
• Minimum paid meal periods—21 states require employers to provide a certain period of
time, typically 30 minutes, for a meal break during a normal work day.
• Payday requirements—regulation of the frequency of paydays for employees.
• Prevailing wage requirements—a majority of states require that whenever taxpayer
money is involved in a construction project above a certain threshold, the contractor must
pay the prevailing wage (the hourly wage, usual benefits, and overtime paid in the largest
city in each county to the majority of workers, laborers, and mechanics.

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6
II. RETIREMENT AND HEALTH CARE BENEFITS [p. 759])
Employers are not required to establish retirement plans for their employees, but many do to
attract and retain high-quality employees.
Points to emphasize:

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 • Employer may offer retirement benefits, like a pension or through a tax-deferred
retirement savings account such as a 401(k) plan.
• In a pension plan, the employer promises to pay a monthly sum to employees who retire
from the company after a certain number of years of service based on the length of
service and the salary rate as of the date of retirement.
• In a retirement savings account, the employee commits to saving a certain percentage of
base pay in an account that is controlled directly by the employee, not the employer. The
employee can allocate savings via investment vehicles that range from very safe to high
risk. Some employers match the employee’s contribution by paying an extra amount into
the account based on a certain percentage of the employee’s base salary.
• There is not a tax liability until the employee is ready to make retirement withdrawals
from the account.
A. Regulation of Pensions and Retirement Accounts [p. 760]
Points to emphasize:
• The regulation of pension funds and retirement savings plans is under the federal statute
called the Employee Retirement Income Security Act (ERISA) of 1974.
• ERISA requires employers to make disclosures related to investment risk, providing
transparency for plan beneficiaries.
• ERISA establishes rules for conflict of interest and imposes fiduciary standards for
investing and managing pension plans or administering retirement savings plans. There
are recordkeeping regulations and all employees must be treated the same for vesting
rules.
• ERISA authorizes the Department of Labor to monitor pension and retirement savings
plan administration.
B. Social Security [p. 760]
Points to emphasize:
• Social Security Act (SSA) provides retirement income from the federal government.
• Funded by mandatory employment taxes paid by both the employer and the employee
into a trust fund administered by the federal government.
• The employment taxes are mandated by the Federal Insurance Contributions Act (FICA).
• Employees are entitled to retirement benefits based on how many credits they have
earned during their working life.
• SSA provides for payments when a worker becomes disabled, and provides survivor
benefits for spouses and children upon the death of a worker.
C. Health Care Benefits [p. 760]
Points to emphasize:
• The Patient Protection and Affordable Care Act (PPACA or ACA) went into effect on
March 23, 2010 and was amended/added to a week later by the Health Care and
Education Reconciliation Act (HCERA).
• Both acts overhauled the US health care system.
• Employers with 50 or more full-time employees must purchase health care insurance for
their employees or face a penalty. It also offers small-business owners (fewer than 25

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8
 full-time employees) tax incentives if they offer health care coverage to their employees
and pay at least 50% of the total costs for the employees’ coverage.
• Individuals not covered must purchase health care insurance from a health care exchange
set up by each state.
• If an employer provides a health care plan, the Health Insurance Portability and
Accountability Act (HIPAA) sets administrative rules and standards designed to protect
the medical records of the employee from disclosure to third parties. The Consolidated
Omnibus Budget Reconciliation Act (COBRA) mandates that employers provide
continuous coverage for up to 18 months to any employee who is terminated at cost to the
employee.

III. WORKERS’ COMPENSATION AND UNEMPLOYMENT BENEFITS [p. 761]

All states have workers’ compensation statutes that establish a structure for an injured
employee to be compensated through a statutorily mandated insurance program as the exclusive
remedy for workplace injuries or illnesses.
Points to emphasize:
• Employees with job-related injuries/illnesses are paid based on a percentage of the
employee’s salary at the time of the occurrence.
• The employee is usually paid regardless of any issues related to fault or negligence of the
employee, the employer, or any third party. Some defenses to payment of the claim may
be asserted by the employer.
• Employees are barred from suing the employer based on negligence for the injury.
A. Defenses to Workers’ Compensation Claims [p. 762]
Points to emphasize:
• In most states, in injured worker is not entitled to workers’ compensation if the injury
was intentionally self-inflicted or resulted from (1) a knowing violation of safety rules by
the employee, (2) the employee’s willful misconduct or horseplay not condoned by the
employer, or (3) the employee’s intoxication or illegal drug use.
• Employees must give the employer timely notice of the claim or the claim is lost and
failure to bring a claim within the time provided in a statute of limitations will bar a
claim.
• Employers should defend against unjustified claims to avoid paying higher premiums due
to claims history.
B. Intentional Actions or Recklessness of the Employer [p. 762]
Points to emphasize:
• Two exceptions to the workers’ compensation laws are cases in which (1) an
employer has engaged in actions that intentionally create conditions that result in
harm or (2) an employer acts with reckless disregard for the safety of its employees.
• The injured employee can directly sue the employer for a full recovery including
punitive damages.
• Practically, due to the delays and uncertainties in litigation and immediate
compensation through workers’ compensation, employees file workers’
compensation claims rather than pursue litigation.

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 C. Course of Employment [p. 762]
Points to emphasize:
• Protection under workers’ compensation laws requires that the injury be (1) accidental
and (2) occurred within the course of employment.
• Accidental injuries occur without any intent to cause harm or injure.
• The scope of employment is defined broadly and in favor of the injured employee.
• Cases where the employee is injured on the job at the worksite during regular work hours
are clearly covered.
• Off-premise activity is also covered as long as it is sufficiently related to the worker’s
employment. Even injuries indirectly related to the employee’s job responsibilities have
been deemed covered by workers’ compensation by the courts.
D. Regulation of Workplace Safety [p. 762]
Points to emphasize:
• The Occupational Safety and Health Act (OSHA), passed in 1970, is a federal statute
intended to prevent workplace injuries.
• The objective of OSHA statutes and regulations is to make the workplace as safe as
possible for workers engaged in business operations by (1) setting national safety
standards, (2) mandating information disclosure and warnings of hazardous working
areas and assignments, and (4) imposing a general duty on employers to keep a
workplace reasonably safe.
• Almost every private is covered by OSHA, except not federal, state and local
governments.
• The OSHA statute created the Occupational Safety and Health Administration which is
under the jurisdiction of the Department of Labor.
• It administers and enforces the OSHA statute with expansive enforcement authority to
carry out the provisions of the law, including routine and unscheduled worksite
inspections.
• Ultrahazardous industries (like mining) are highly regulated by OSHA rules.
• OSHA investigates employee complaints about violations of safety standards by
employers.
• OSHA’s whistleblowing provisions protect employees who make complaints from
retaliation by the employer.
• Many OSHA regulations are industry specific.
• Some provisions of OSHA apply to all employers. Employers with 11 or more employees
are required to maintain company safety records and to document the investigation of any
accidents. The reports must be available for OSHA inspection without the need for
subpoena or advance notice. If employees are killed in a work-related accident or if 3 or
more employees are hospitalized in one event, the employer must notify OSHA as soon
as possible or no later than 8 business hours after the accident. OSHA will then dispatch
an inspector to investigate the accident. Appropriate enforcement action will take place
including fines, issuing cease and desist orders, and even pursuing criminal charges
against the company and its officer.
• Under OSHA rules, employees have a limited right to walk off the job when faced with a
hazardous workplace condition. In Whirlpool v. Marshall, the Supreme Court held that
the OSHA statute permits this right when (1) the employee faces a condition that he

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10
 reasonably believes will result in serious injury or death and (2) the context makes it
impractical for the employee to contact OSHA inspectors.
E. Unemployment Compensation [p. 763]
Points to emphasize:
• Because of the Great Depression of the 1930s and high unemployment rates, Congress
passed the Federal Unemployment Tax Act (FUTA) in 1935 which provides limited
payments to workers who have been temporarily or permanently terminated from
employment through no fault of their own.
• State administered funds provide payment to workers who have suffered sudden job loss
due to economic difficulties. Rules vary by state regarding eligibility standards and
procedures, and payments are usually much less than normally paid at work.
• Only the employer pays FUTA taxes.
• To obtain benefits, the employee must actively seek new employment and may need to
retrain in a different field.
• It does not reward employees who are terminated for cause.

IV. THE FAMILY AND MEDICAL LEAVE ACT (FMLA) [p. 764]
In response to pressures on the workforce to care for a family member, in 1993 Congress passed
the Family and Medical Leave Act (FMLA), which sets our basic protections for workers who
need a brief leave from work to care for themselves or an immediate family member.

A. FMLA Scope and Coverage [p. 764]

Points to emphasize:
• Administered by the Department of Labor and applies to employers with 50 or more
employees within 75 miles.
• To be eligible for FMLA benefits an employee must have worked for the company for at
least 12 months and have worked 1,250 hours during the past 12 months.
• Employers must provide up to 12 weeks of unpaid leave to employees for purposes
related to family medical matters during any 12-month period.
• Includes care for a newborn or newly adopted child or when a serious health condition
affects the employee or the employee’s spouse, child or parent.
• To be eligible for FMLA leave, the serious health condition must require continued
treatments by a health care provider and must be severe enough to render the person
unable to care for herself for three consecutive days. 30 days-notice is required unless an
emergency arises.
• All conditions must be properly documented by a physician and are subject to periodic
reevaluation at the employer’s request.
• Some states have extended coverage to reduce the size of the companies covered, to
include organ donation and bone marrow transplants, and to include the care of
grandparents, domestic partners and others.

B. FMLA Protections [p. 765]

Points to emphasize:

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 • The employer must maintain the employee’s health care benefits uninterrupted
throughout the leave period.
• The FMLA also provides protections related to job security: (1) employers cannot take or
threaten any adverse job action against the employee because of FMLA leave, (2)
employees are guaranteed employment in the same or a similar job at the same rate of
pay upon returning from leave, and (3) employers must reinstate an FMLA-leave
employee immediately upon the employee’s notification that the leave is over.
• FMLA does not require that the returning employee be credited with the accrual of
seniority for time on leave.
• Two theories of recovery (1) interference/entitlement theory and (2)
retaliation/discrimination theory.
• The interference/entitlement theory applies when an employee alleges the employer
denied him the right to use FMLA.
• The retaliation/discrimination theory applies when an employee uses FMLA benefits and
then the employer takes adverse action against that employee.

Case 39.3 Jaszczyszyn v. Advantage Health Physician Network [p. 765]

Facts: Advantage hired Jaszczyszyn in 2008 as a part-time employee and she later became a
full-time employee. Due to back pain Jaszczyszyn missed work. She was advised to take FMLA
and completed the forms. The forms indicated that she suffered from a serious medical condition
and a need for intermittent FMLA leave. Jaszczyszyn took it as continuous, open-ended leave.
She attended Pulaski Days and pictures were taken of her dancing and laughing that were posted
on Facebook. Advantage’s management saw the pictures, questioned Jaszczyszyn and she could
not explain the discrepancy between her claim of complete incapacitation and the activity in the
photos. She was terminated. She alleged that she was fired due as retaliation for exercising her
FMLA leave. She sued, the trial court granted Advantage’s summary judgement motion, and
Jaszczyszyn appealed.
Issue: Did Advantage retaliate?
Ruling: Retaliation due to the use of FMLA benefits did not occur. There was evidence of fraud
which was sufficient justification for her termination, and it was not related to her legitimate
rights under FMLA.

Answers to case questions:

1. Yes, since credible testimony related to her fraudulent activities that evening can be
treated as sufficient cause for termination.
2. Advantage can have adequate human resources practices and interviews with employees
to let them know what is allowed.
3. These questions are designed to elicit responses that demonstrate critical thinking from
the students.

C. Key Employees [p. 766]

Points to emphasize:

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 • Under the FMLA a key employee has a salary in the top 10 percent of all salaries in the
company.
• Key employees are entitled to FMLA protections, but employers have a right to not
reinstate an employee if reinstatement would cause a “substantial and grievous economic
injury”.
• Courts apply this exception narrowly.
• Employers must follow the notice and procedures in the statute, including notice to the
employee that the employee is a key employee.

V. EMPLOYEE PRIVACY [p. 768]

Many employers monitor employee behavior at the workplace or at off-site places while the
employee is performing work-related tasks. Employee privacy is a growing concern. Monitoring
of e-mails, video surveillance, social media monitoring, phone and voicemail, and drug/alcohol
all contain privacy concerns.

A. Monitoring of E-mail, Internet Usage, and Social Media [p. 768]

Points of emphasis:
• An employee’s activities while using the employer’s computer system are not protected.
• All computer use subject to employer monitoring, includes the right to (1) track websites
visited by employees, (2) count keystrokes and mouse clicks, (3) block employees from

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 visiting specific Internet sites, and (4) limit the amount of time an employee may spend at
a specific website.
• Laws in many states prevent employers from requiring employees to provide usernames
and passwords to social media accounts.
• A company’s IT services may look to see if an employee’s use of e-mail violates
company policies.
• Management teams may include compliance officers.
• Companies want to limit their risk to vicarious liability (liability for the act of an
employee) in areas such as defamation and employment discrimination.

B. Telephone and Voicemail [p. 769]

Points to emphasize:
• Employees have some protection for telephone calls and voicemail under the Electronic
Communications Privacy Act (ECPA).
• The ECPA updated existing wiretap laws and restricts an employer from monitoring an
employee’s personal calls without the employee’s consent.
• Employers may monitor business calls but must disconnect when they recognize that a
call is personal.
• Consent must be obtained to access an employee’s office voicemail.
• There are two exceptions: (1) the business-extension exception permits an employer to
monitor employee electronic communications on company-owned devices as long as it is
done in the ordinary course of business, and (2) an employer avoids liability if the
employee consents to the monitoring.
• This consent is often a condition of employment.

C. Drug and Alcohol Testing [p. 769]

Points to emphasize:
• State law governs in this area and it varies from state to state.
• Some states allow employee testing as long as the employer follows procedural
safeguards intended to ensure confidentiality, safety, and accuracy.
• Other states permit testing only when the employee’s job carries a great deal of risk to the
employee or the public or when a worker has been involved in a work-related accident
where drug use is suspected.
• Drug and alcohol testing raise important issues regarding the rights of an employee under
the Americans with Disabilities Act (ADA).
• The ADA prohibits discrimination based on a physical disability.
• If the testing uncovers a former drug addiction (or current alcoholism), under certain
circumstances the employee is protected from discipline or termination.
• The ADA restricts medical examinations and tests. A medical examination can only be
required after a job offer has been made. The job offer can be contingent on passing the
medical test.
• If an employer requires medical testing, it must be administered to all prospective
employees and may not be used to target those with disabilities or to determine whether
women are pregnant.

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 • Data obtained from medical testing must be kept in a separate file and only accessible to
those with a demonstrable “need to know”.

Case 39.4 Leonel v. American Airlines [p. 727].

Facts: Job offers were made contingent on passing background checks and medical
examinations to Leonel and two other applicants. Before background checks, each applicant was
required to complete a medical questionnaire where they did not disclose that they were HIV
positive. The medical blood tests revealed that the applicants were HIV positive. American
rescinded the job offers stating that the applicants did not disclose this on the questionnaires. The
applicants sued stating a violation of the ADA. The trial court ruled in favor of American. The
Court of Appeals for the Ninth Circuit reversed.
Issue: Did American violate the ADA when the medical exams were performed prior to the
background checks?
Ruling: Both the ADA and the California state statutes prohibited the use of medical testing
prior to the completion of the application process. Because the offers of employment were
contingent on both passing both medical and non-medical conditions, and the medical
examinations were to be immediately completed, these were not real job offers. The medical
exam process was premature. American cannot penalize the appellants for failing to disclose
their HIV-positive status, unless American can establish that it could not reasonably have
completed the background checks before subjecting the applicants to medical exams. It did not
do so. American stated that it needed to minimize the time in the hiring process to compete for
applicants. This was not by itself a good reason to contravene the ADA’s and California statute’s
mandates to defer the medical component until everything else is complete.
Answers to case questions:

1. Because medical conditions may be used to screen out candidates early in the
applications process.
2. Because the court likely believed American would screen out employees with certain
medical conditions.
3. This question is designed to elicit responses that demonstrate critical thinking from the
students.

D. Polygraph Testing [p. 770]

Points to emphasize:
• The Employee Polygraph Protection Act (1988) prohibits most private sector
employers from requiring a polygraph (lie detector) test as a condition of employment.
• Employers are prohibited from taking or threatening actions against current employees
who refuse to take the test.
• Employers may use polygraph tests when investigating losses attributable to theft or other
economic loss or when the employee is in the security or pharmaceutical industry.
• The law does not apply if the employer is a federal, state, or local government entity.

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VI. LABOR LAWS AND UNION MEMBERSHIP [p. 771])
Labor unions peaked in the 1950s when 1/3 of American workers were unionized. By 2021,
10.3% of wage and salary workers were members of a union (down from 11.8% in 2011).
The most common unions are the American Federation of Labor and Congress of Industrial
Organizations (AFL-CIO) and the Change to Win Federation which split from the AFL-CIO in
2005.

A. Labor Law [p. 771]

Points to emphasize:
• The National Labor Relations Act (NLRA) of 1935 provides general protections for the
rights of workers to organize, engage in collective bargaining, and use economic
weapons (strikes) in the collective bargaining process.
• Collective bargaining is the process of negotiating an agreement on behalf of an entire
workforce as opposed to individuals negotiating privately on their own behalf.
• The statute contained an enabling provision that formed the National Labor Relations
Board (NLRB) to administer, implement, and enforce the law’s provisions.
• The NLRB performs traditional administrative agency duties of implementation and
enforcement, and also monitors union elections for fraud and sets guidelines for
employers and unions in regard to fair labor practices.
• The NLRA covers all employers whose business activities involve some aspect of
interstate commerce.
• Some employers are specifically exempted, such as railroad and airline employees.
• To ensure fairness to both labor and management to resolve differences certain practices
are illegal making them unfair labor practices.

B. Labor Management Relations Act [p. 772]

Points to emphasize:
• The Labor Management Relations Act (1947) amended the NLRA to limit some union
practices and rights.
• Employers and employees are prohibited from agreeing that union membership is
required as a condition of employment.
• Right-to-work laws are authorized by the states which make it illegal for employers to
agree with unions that union membership is required for continued employment.
• Under right-to-work laws, employees who are not union members also do not have to
contribute a portion of their salary to union membership dues.
• The law also made clear that employers had the right to voice their reasons for opposition
to formation of a union and gave specific authorization for the president of the United
States to suspend a strike for up to 80 days in times of national emergency.

C. Labor-Management Reporting and Disclosure Act [p. 772]

Points to emphasize:
• In response to allegations of corruption in major trade unions, Congress enacted the
Labor-Management Reporting and Disclosure Act (1959), which established a system
of reporting and checks intended to uncover and prevent fraud and corruption among
union officials.

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 • The law (1) regulates internal operations of unions, including election processes,
procedures and rights of members at membership meetings and officer meetings; (2)
requires financial disclosures by unions; and (3) expands the jurisdiction of NLR for
internal union governance.

D. Union Formation [p. 772]

Points to emphasize:
• The NLRA has set process for forming a union for employers that do not already have a
recognized union and a group of employees want to form a collective bargaining unit to
deal with labor-management matters.
• A group of employees organizes an effort to have other workers sign authorization
cards indicating they wish to form a local union or join an existing union. At least 30%
of the authorization cards must be signed by employees in a certain bargaining unit.
Parties must have a mutuality of interests in order to bargain collectively.
• Upon receipt of authorization cards from at least 30% of the members of a bargaining
unit, these are filed with the NLRB. The formal union certification process begins when a
date for election has been set. Campaigns are permitted and employers can limit union
activities that take place during the regular workday as long as they can justify that the
limits are based on business reasons (mot to stop the unionization). Employees cannot
threaten members to convince others to unionize. Misconduct during the campaign
process is an unfair labor practice which the NLRB can set aside or enforce. Employers
can campaign against unions but there are restrictions against the use of economic
pressure to influence employee voting.
• After an election, a simple majority of pro-union votes is required for the NLRB to
certify the collective bargaining unit as a union. The employer must recognize the union
as the exclusive bargaining representative of the workers.

E. Collective Bargaining [p. 774]

Points to emphasize:
• Collective bargaining is the process of negotiating the terms and conditions of
employment for employees in the collective bargaining unit.
• The NLRA regulations set out guidelines for which terms must be negotiated (wages,
benefits, work hours, overtime procedures, promotion systems, procedures for handling
disciplinary violations, suspensions, terminations, layoffs) and which ones are not.
• Parties must negotiate in good faith, that they are engaged in moving toward an
agreement.
• Tactics to delay, stall or hinder are considered an unfair labor practice.

F. Grievances [p. 774]

Points to emphasize:
• Union contracts usually specify the means of arbitrating union grievances against an
employer action or practice. An individual employee of the union files an employee
grievance. The union is given the exclusive authority to invoke the arbitration provisions
of the agreement.
• An arbitrator’s decision is always subject to review by the courts that apply federal
standards of fairness and good faith.

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• Courts give great deference to arbitration and will only set aside an arbitrator’s decision if
fundamental unfairness in process of substance has occurred.
• Individual union members are not authorized to sue the employer to enforce the contract.
Unions have broad discretion in seeking arbitration.
• The NLRA authorizes strikes to induce the employer to concede certain contract terms
during collective bargaining.
• Some occupations may be restricted from striking by statute if it would significantly
jeopardize public health or safety (air traffic controllers, law enforcement, or emergency
services).
• NLRA provides for strike guidelines. Most strikes occur when negotiations have reached
an impasse. Union members vote for “strike authorization” to be given to leadership if the
employer refuses to continue the bargaining process.
• During a strike, union members receive no pay, medical benefits, and other
compensation.
• Employers do not have to rehire striking workers or to provide retroactive pay.
• If a strike was called due to unfair labor practices, the striking employees are entitled to
immediate reinstatement with back pay once they unconditionally return to work.
• Strikes can result in significant economic harm to the employer.
• Strikers have the right to peacefully picket the employer’s facilities, but no right to be on
the actual site owned by the company.
• Picketing cannot interfere with the operations of the employer and cannot be used to
prevent or harass customers or non-striking employees.
• Boycotts of the employer’s product or services may occur as a method of pressuring
management to engage in negotiations or concede a disputed point.

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Case 39.5 National Labor Relations Board v. Midwestern Personnel Services [p. 776]]

Facts: MPS provided drivers to River City for a project at a union job site. MPS obtained driver-
employee signatures on union authorization cards for an out-of-state union and told workers it
was required for them to keep their jobs. Drivers became unhappy with the union, so they formed
their own local union. MPS didn’t recognize this local union. The workers went on strike, MPS
refused the unconditional offer of the workers to return to work and hired replacement workers.
Issue: Was the actions of MPS an unfair labor practice rather than an economic dispute? Should
the drivers be reinstated with back pay?
Ruling: The 7th Circuit Court of Appeals ruled in favor of the employees and affirmed the
NLRB’s findings. The strike was clearly based on MPS’s unfair labor practices, so the
employees were entitled to be reinstated and given back pay.
Answers to case questions:

1. Because there is no indication the out-of-state union was supported by the workers.
2. No, since that dispute over wages would amount to an economic strike.
3. This question is designed to elicit responses that demonstrate critical thinking from the
students.

VII. EMPLOYMENT LICENSING REQUIREMENTS [p. 778]

Point to emphasize:
Many professions require state licensing where workers complete training, pass an exam, and
pay a fee to acquire the license. The employee must be licensed to legally work.
Thinking Strategically Questions and Answers [p. 778]
1. Is Miguel’s job exempt from overtime? Why or why not?
• Likely not. Miguel has little or no bona fide managerial, executive or supervisory
duties. His salary is also below the thresholds for federal overtime exemption.
Also, as a Under the four-factor test this is also likely to be the case.
2. Would reclassifying Miguel as an employee make his work exempt from overtime? Why
or why not?
• No, this was done solely to avoid paying overtime. Workers paid by the hour are
generally entitled to overtime. Even salaried full-time employees are entitled to
overtime if they lack managerial duties.
3. Would adding the administrative duties to his job description make Miguel’s work
exempt? Why or why not?
• No, these are trivial duties and not bona fide managerial duties with real
oversight.
4. Is Banco Libertad exempt from the New York law? Why or why not?
• Yes, unless a court declares that the bank is a mercantile establishment.

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19
 5. What actions should Gladys take to ensure compliance with the FLSA and the New York
statute?
• Gladys should offer to pay Miguel a salary that guarantees at least a minimum
wage and overtime pay for any work that exceeds 40 hours a week. Appropriate
records and timesheets should be maintained to ensure full compliance with the
law. Even though the N.Y. statute may likely not apply to the bank, it is a good
management and ethical practice to give employees at least one day of rest.
6. What is a good business solution that complies with the law and allows Banco Libertad to
meet its deadline with the regulation?
• Gladys can hire Miguel and also supplement additional part-time workers or
“temps” as needed to complete the task.

Key Terms [pp. 779-781]

Chapter Review Questions [pp. 782-783]

Case Summary Questions and Answers [pp. 781-782]
CASE SUMMARY 39.1 Sisco v. Quicker Recovery, Inc., 180 P.3d 46 (Or. Ct. App. 2008)
1. Suppose Sisco’s altercation had occurred while he was en route to his house during an
unpaid one-hour lunch break. Would he still be eligible for compensation? Why or why
not?
• He may since courts favor extending rights to offsite locations that are sufficiently
related to the worker’s employment.
2. Would Sisco have been better served trying to articulate a negligence claim? Explain.
• Probably not, since most states provide extensive levels of immunity to police
officers. The negligence claim against the employer would likely fail since
resisting arrest has no connection to the employer.
CASE SUMMARY 39.2 Sullivan v. U.S. Postal Service, 2011-3220 (Fed. Cir. 2012)
1. Even though Sullivan supplied a physician’s certification, did the agency have the right to
require a second medical evaluation? Explain.
• It appears the agency did since the law allows employers to reevaluate the medical
condition periodically.
2. How could Sullivan have avoided this conflict and qualified for leave?
• Sullivan could have submitted to the second reviewing physician’s medical
examination.
CASE SUMMARY 39.3 Bonilla v. Baker Concrete Construction, 487 F.3d 1340 (2007)
1. Who prevails and why?
• The employer prevails on the claim regarding transportation since this is excluded
under Portal-to-Portal act. The employer also prevails on the security screening
since this activity is not “integral and indispensable” to the work.

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20
2. Explain your analysis and construct a hypothetical situation in which the losing party
might have prevailed.
• This question is designed to elicit creative and critical thinking skills from the
students.

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 Chapter 40
Employment Discrimination

CHAPTER OVERVIEW
This chapters discusses the definition, sources, and statutory framework of discrimination law. It
also discusses the role of affirmative action in the workplace and additional workplace
antidiscrimination protections in state statutes.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Define the term employment discrimination, articulate the origins of Knowledge
antidiscrimination law, and explain the role of the Equal Employment
Opportunity Commission (EEOC).
Describe the protections afforded under the major federal antidiscrimination Knowledge
statutes and identify the protected classes and theories of discrimination under
Title VII.
Identify two theories of discrimination in the context of sexual harassment. Knowledge
List remedies available under Title VII. Knowledge
Explain antidiscrimination laws that apply to age, disabilities, and equal pay. Knowledge
Apply the major defenses available to employers in a discrimination claim Application
and explain the role of affirmative action in the context of employment
discrimination.
Explain the role of state law in employment discrimination cases. Knowledge

I. DEFINITIONS AND SOURCES OF LAW [p. 785]

Points to emphasize:
• Employment discrimination encompasses work-place discrimination that includes (1) the
hiring process; (2) treatment of employees in terms of promotions and demotions, work
schedules, working conditions, or assignments; (3) disciplinary action such as
reprimands, suspension, or termination.
• The Civil Rights Act of 1964 includes the most sweeping antidiscrimination protections
for workers.
• Some states have statutes that provide additional antidiscrimination protection in the
workplace.

A. Equal Employment Opportunity Commission (EEOC) [p. 785]

Points to emphasize:
• The Civil Rights Act of 1964 created the Equal Employment Opportunity Commission
(EEOC) which is the administrative agency charged with carrying out federal workplace
antidiscrimination laws.

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 • The EEOC is a five-member commission whose members are appointed by the president
with the approval of the Senate.
• The EEOC uses its rulemaking authority, investigatory powers, and enforcement action
to administer the statutory mandates established by Congress.
• The EEOC plays two important roles: (1) Filing a complaint with the EEOC is the first
step for a party claiming unlawful discrimination; and (2) in certain cases the EEOC will
sue on behalf of the aggrieved employee.
B. Asserting a Discrimination Claim [p. 785]
Points to emphasize:
• First, an aggrieved employee must file a complaint against the employer with the local
office of the EEOC (generally within 180 days of the adverse job action).
• Then the EEOC notifies the employer and commences a preliminary investigation.
• During and immediately after the investigation, the EEOC is required by statute to
engage in conciliation negotiations.
• If negotiation fail, the EEOC may file suit against the employer or take no action at all.
• After 180 days after the complaint has been filed, the employee may demand that the
EEOC issue a right-to-sue letter so that the employee can file a lawsuit in a federal court.

II. PRIMARY FEDERAL WORKPLACE ANTIDISCRIMINATION STATUTES [p. 786-

788]
Points to emphasize:
• The primary federal antidiscrimination statutes are (1) Title VII of the Civil Rights Act
of 1964 and its subsequent amendments; (2) the Age Discrimination in Employment
Act (ADEA) of 1967; and (3) the Americans with Disabilities Act (ADA) of 1990.
• The Equal Pay Act of 1963 also contains antidiscrimination provisions.

Teaching Tip: Prescott v. WidgetCo.

To relate to the students, use realistic examples of discrimination to teach the laws. For
instance, as a means of illustrating the federal discrimination laws, the textbook uses a
hypothetical case throughout the chapter. Prescott is seeking employment as an internal
accountant and provides a resume and supporting applications materials to WidgetCo, a
manufacturing firms with 50 employees. In the chapter, Prescott will face different situation
that call for application of antidiscrimination statutes.

A. Title VII [p. 787]

Points to emphasize:
• Title VII applies to any private sector employer with 15 or more full time employees as
well as to labor unions, employment agencies, state and local governments, and most
federal employees.

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 • The law prohibits discrimination in the workplace on the basis on an employee’s race,
color, national origin, gender, or religion (i.e., the protected classes). Pregnancy was
added as a protected class in 1978.

B. Protected Classes [p. 787]

Points to emphasize:
• Not all discrimination is illegal.
• Title VII only protects those who have been discriminated against based on their
membership in a protected class.

C. Sexual Orientation [p. 787-789]

Points to emphasize:
• In 2015, the EEOC issued a ruling that recognized sexual orientation as a form of sex
discrimination.
• The federal courts are split on whether discrimination based on sexual orientation is
covered under Title VII.
Case 40.1 Bostock v. Clayton County, 140 S.Ct. 1731 (2020)

Facts: This was a consolidation of three cases. In each case, the employer allegedly fired a
long-term employee simply for being homosexual or transgender. Each employee sued,
alleging sex discrimination under Title VII of the Civil Rights Act of 1964. In one case, the
appeals court held that Title VII does not prohibit employers from firing employees for being
gay. In the other two cases, however, the appeals courts allowed the cases to proceed. The
US Supreme Court agreed to hear the cases to resolve the split in the Circuit Courts.
Opinion: The U.S. Supreme Court held that an employer who fires an individual merely for
being gay or transgender violates Title VII. The Court held that it makes no difference if
other factors besides the plaintiff’s sex contributed to the decision or that the employer
treated women as a group the same when compared to men as a group.
Case Questions

1. What does the Court mean by “discrimination based on homosexuality or transgender

status necessarily entails discrimination based on sex? The Court states that discrimination
cannot occur without homosexuality or transgenderism.
2. Why does the Court compare their decision in this case to their previous ruling related to
sexual harassment? Because while harassment is not discrimination, it also entails sex.
3. Focus on Critical Thinking. The dissent in this case pointed out that Congress had ample
opportunity to add sexual orientation into the statute but did not. The dissent accused the
majority of filling in a portion of Title VII that the court found lacking, but the legislature has
not changed the law in decades. Is that a compelling argument? Why or why not? Did the

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 court “legislate from the bench”? The court was interpreting a statute. If Congress does not
agree with the interpretation, Congress can take action.

D. Theories of Discrimination [p. 789-792]

The three most common discrimination theories are: (1) disparate treatment, (2) mixed motives,
and (3) disparate impact.

1. Disparate Treatment [p. 790]

Points to emphasize:
• Disparate impact is overt and intentional discrimination under Title VII.
• Disparate impact is when an employer treats an employee (or potential employee)
differently based on her membership in a protected class.
• Overt discrimination does not have to be done with discriminatory intent in order to
trigger liability for the employer.
• In Case 41.2 the U.S. Supreme Court analyzes Title VII’s provisions relating to
discrimination and whether the employer had actual knowledge of the discrimination.

Case 40.2 Equal Employment Opportunity Commission v. Abercrombie & Fitch Stores,
Inc., 135 S. Ct. 2028 (2015)

Facts: Abercrombie & Fitch Stores (Abercrombie) operates several lines of clothing store.
Abercrombie has a policy that governs employees’ dress (the Look Policy) which prohibits
“caps” as too informal. Elauf is a practicing Muslim who, consistent with her religion’s
requirements, wears a headscarf. She applied for a position in an Abercrombie store and the
interviewer gave Elauf a rating that qualified to be hired. However, the interviewer was
concerned that the headscarf (hijab) would conflict with the no “caps” policy and consulted
with a district manager. The manager concluded that the headscarf would violate the Look
Policy, so Elauf was not hired. The EEOC sued Abercrombie claiming that refusing to hire
Elauf violated Title VII. The trial court ruled in favor of the EEOC. The U.S. Court of
Appeals for the Tenth Circuit reversed holding that an employer cannot be liable under Title
VII for failing to accommodate a religious practice until the applicant provides the employer
with actual knowledge of his need for accommodation. The EEOC appealed to the U.S.
Supreme Court.
Opinion: The U.S. Supreme Court reversed the appellate court and ruled in favor of the
EEOC. The employer does not need to have actual knowledge of the employee’s need for
religious accommodation. An applicant need only show that his need for an accommodation
was a motivating factor in the employer’s decision.
Case Questions

1. Why does the Court conclude that “actual knowledge” is not necessary?

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 • There was no language in Title VII that required actual knowledge to trigger liability.
2. What strategies should employers deploy to reduce their liability for violating the
religious accommodations requirement in Title VII?

• Students should discuss different strategies that employers can use. A company’s
policies should take into consideration possible disparate treatment issues.
3. Focus on Critical Thinking. Just before the decision in this case was announced,
Abercrombie changed its policies relating to how employees look and dress. This was a
significant change to its business model. To what extent should business owners and manager
consider legal doctrines when designing or redesigning their business models? Are that any
other areas of law that should be taken into consideration by businesses when designing
policies related to the business models?

• Owner and managers should have a close working relationship with attorneys when
creating a business model. Not only should discrimination laws be taken into
consideration, but also contracts, negligence, international law, jurisdiction,
intellectual property, and other employment laws.

• McDonnell Douglas Test is a test crafted by the U.S. Supreme Court (McDonnell
Douglas Corp. v. Green) that plaintiffs could use to obtain relief under Title VII. It has
three stages: (1) the plaintiff must establish a prima facie case of discrimination, (2) the
burden of proofs shifts to employer, who must then articulate a legitimate,
nondiscriminatory reason for firing the plaintiff; and (3) the burden then shifts back to the
employee to show that the reason given by the employer is not the actual reason, but a
pretext, for the employment action.
• To establish a prima facie case under the McDonnell Douglas standard, the plaintiff must
establish that (1) she is a member of a protected class; (2) she applied for and was
qualified for the job (or promotion, etc.) and met the employer’s legitimate expectations;
(3) she was rejected by the employer; and (4) the employer continued to seek applicants
or filled the position with a person outside the protected class.

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 2. Mixed Motives [p. 793]
Points to emphasize:
• Under the mixed motive theory, an employee is protected under Title VII in a case where
legitimate motives are mixed with illegitimate motives if the employee proves the
protected class membership was a substantial factor in the decision-making process.
• If the employee proves that the protected class membership was a substantial factor, the
burden shifts to the employer

3. Disparate Impact [p. 794]

Points to emphasize:
• In Griggs v. Duke Power Co., the Supreme Court recognized that intent was not always a
necessary element to prove discrimination and that certain evaluation techniques for
employee selection, promotion, and assignment could be administered uniformly to all
candidates yet still impact certain protected class members adversely.
• Facially neutral policies and procedures could be discriminatory in their impact.
• The plaintiff must prove a prima facie case by showing that certain methods resulted in
statistically significant differences that adversely impacted members of a protected class.
• Once the prima facie elements are established, the burden of proof shifts to the employer
to provide evidence that the challenged practice is job related for the position in question
and is a business necessity. Even then, the plaintiff may still prevail if the employer
refused to adopt an alternative practice what would satisfy the employer’s interest
without having the adverse impact.

III. SEXUAL HARASSMENT [p. 796-798]

Unwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of
a sexual nature are considered violations of Title VII if the conduct is (1) in the context of
explicit or implicit conditions of an individual’s employment or as basis for any employment

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6
decisions or (2) unreasonably interfering with an individual’s work performance or creating an
offensive work environment.

A. Theories of Sexual Harassment [p. 796]

Points to emphasize:
• Quid pro quo theory (“something for something else”) – the harasser demands sexual
favors as a condition of continued employment or a prerequisite for a promotion or pay
raise, for example.
• Hostile work environment theory – a violation of Title VII occurs when the conduct of
the harasser(s) is of such severe and crude nature, or is so pervasive in the workplace, that
it interferes with the victim’s ability to perform her job responsibilities.
• In Case 41.3, the court considers whether certain conduct in a workplace is sufficiently
“severe” or “pervasive” enough to constitute a hostile work environment.
Case 40.3 Morris v. City of Colorado Springs d/b/a Memorial Health System, 666 F.3d
654 (10th Cir. 2012)

Facts: Morris was a registered nurse at Memorial Health System (“Memorial’). She was
also a member of the “Heart Team” with Dr. Bryan Mahan (Mahan), a surgeon. During the
time Morris was on the Heart Team with Mahan, she contends that he harassed her on
multiple occasion and during one surgery, through heart tissue at her which hit her leg.
Mahan claims he was just throwing it on the floor. In response, Memorial suspended Mahan
from the operating room and required him and the other members of the Heart Team attend
team-building training. Morris and Mahan worked together for three months after the
training. When Morris indicated she was filing a claim, Memorial moved her off the Heart
Team so that her work environment was comfortable.
Still, Morris filed suit against Memorial in federal district court. Morris asserted a claim
under Title VII alleging that Mahan engaged in unlawful gender-based harassment and
created an abusive and hostile working environment. The trial court dismissed ruling that
Morris could not establish that the alleged harassment was based on her gender or that it was
sufficiently “severe” or “pervasive” to affect her working environment. Morris appealed.

Opinion: The Court of Appeals for the Tenth Circuit ruled in favor of Memorial and
affirmed the trial court’s dismissal of the case. The court held that Mahan’s conduct did not
rise to the level of a hostile work environment.

Case Questions

1. Why did the court find that Mahan’s conduct did not rise to the level necessary to create a
hostile work environment? Do you agree?

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7
 • There was no evidence it was based on gender or that it occurred over a long-time
period. It didn’t include any sexual propositions or multiple incidents of hostile and
physically threatening conduct.

2. What type of conduct is required for harassment to be considered severe or pervasive?

Given an example of hypothetical conduct by Mahan that may have led the court to
believe that Morris had met her burden of proof.
• It should happen over a longer period of time and might include Mahan sexual
propositioning her.

3. Focus on Critical Thinking. Could Morris pursue other legal avenues against Mahan for
his conduct? Is there any civil liability tort? Could Morris purse a breach of contract
claim against the hospital for reassigning her from the Heart Team?
• Morris could sue for Mahan for assault and battery; however, those are intentional
torts and intent would be hard to prove. She could argue retaliation or breach of
contract for her move but Memorial had a legitimate reason to move her and there is
no indication that it was a demotion of any sort.

B. Same-Sex Harassment [p. 798]

The Supreme Court held that Title VII was gender-neutral and recognized sexual harassment as a
form of discrimination regardless of the gender of the victim or the harasser.

C. Vicarious Liability of Employers [p. 798]

Points to emphasize:

• Under certain circumstances, vicarious liability will be extended to employers for sexual
harassment.
• An employer can be vicariously liable for sexual harassment by an employee when a
nonsupervisory co-worker is the harasser if the employee can prove that the employer
was negligent in either (1) discovering the conduct or (2) failing to respond to the sexual
harassment complaint made to a supervisor.

D. Strict Liability for Harassment by Supervisor [p. 798]

Points to emphasize:

• If the harassing employee is a supervisor, then the employer is strictly liable for any
sexual harassment claim if the harassment culminates in a tangible employment action
such as termination or transfer to a less desirable job.
• If the harassment does not result in a tangible employment action, employers may avoid
liability via the Faragher/Ellerth defense by proving that a system was in place that was
intended to deter, prevent, report, and correct any harassment. The employer must also
prove that the employee failed to take advantage of the preventive or corrective
opportunities that the employer provided.

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 E. Impact of #MeToo Movement [p. 798]
The #MeToo Movement used social media to bring to the forefront of the world’s consciousness
the magnitude and severity of sexual harassment in all aspects of society.

IV. REMEDIES [p. 799]

Points to emphasize:
• Injunction – a court order to cease engaging in a particular unlawful practice or an order
compelling a party to act.
• Reinstatement
• Compensatory damages in the form of back pay.
• Retroactive promotions
• Punitive damages – intended to deter future conduct of employers if the plaintiff proves
the employer acted with malice, in retaliation, or with reckless disregard for the
employment discrimination laws.
• Requirements that the employer take certain actions in order to remedy patterns or
practices resulting in discrimination.

V. AGE DISCRIMINATION [p. 800-801]

Points to emphasize:
• Under the Age Discrimination in Employment Act (ADEA), employers are prohibited
from discriminating against employees on the basis on their age once an employee has
reached the age of 40.
• Plaintiffs may only make ADEA claims based on (1) protected class membership, (2)
satisfactory job performance, (3) adverse job action such as termination or demotion, (4)
replacement with or more favorable treatment toward someone substantially younger, or
(5) other evidence that indicates that it is more likely than not that the employee’s age
was the reason for the adverse employment action.
• The ADEA also prohibits most mandatory retirement policies. If an employer can prove a
bona fide occupational qualification (BFOQ), age may be taken into consideration
regarding mandatory retirement.
• Federal courts may follow the general rule that the age difference must be at least 10
years in order to qualify as substantially younger.
• It is irrelevant whether the younger employee is a member of the protected class or not.

VI. AMERICANS WITH DISABILITIES ACT [p. 801-802]

Points to emphasize:
• The American Disabilities Act (ADA) seeks to eliminate discriminatory employment
practices against disabled persons that would prevent otherwise qualified employees from
obtaining or continuing employment, being promoted, or obtaining benefits available to
nondisabled employees.

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 • The ADA requires an employer with 15 or more employees to make reasonable
accommodations for a disabled employee in the workplace so long as the accommodation
does not cause the employer to suffer an undue hardship.

A. Documented-Disability Requirement [p. 801]

Points to emphasize:

• To qualify for an accommodation, the employee must have a documented disability.

• Disability is defined as a physical or mental impairment that substantially limits a
person’s ability to participate in major life activities (e.g., blindness, cancer, etc.)

B. ADA Amendments Act of 2008 [p. 802]

Points to emphasize:

• The ADA Amendments Act of 2008 (ADAAA) expanded the statutory protections to
specifically cover disabilities that had been excluded from coverage by the virtue of the
Supreme Court’s ADA case law.
• The ADAAA requires courts make a determination of one’s disability without regard for
the ability to correct the condition with “medication, artificial aids,” and other “assistive
technology.”

C. “Regarded-as” Test [p. 802]

Points to emphasize:

• The “regarded-as” test is used with an individual does not meet the definitional
requirements of disability under the ADA.
• The regarded-as standard applies with an employee is regarded as having an impairment
by her employer (e.g., chronic medical condition).

D. Qualified Individual [p. 802]

Points to emphasize:

• A qualified individual is someone who, with or without reasonable accommodation, can

perform the “essential functions” of the employment position that such individual holds
or desires.
• In Case 40.4, the court interprets the essential functions requirement.

Case 40.4 Samson v. Federal Express Corporation, 746 F.3d 1196 (11th Cir. 2014)

Facts: Richard Samson applied for a position as a technician with Federal Express. After his
interview, FedEx offered him the position upon successful completion of a medical examination
because technicians were occasionally required to test-drive FedEx fleet vehicles (a fact not in
the job description).

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 Samson was an insulin-dependent diabetic and was automatically disqualified from operating
a commercial motor vehicle. Thus, FedEx withdrew his job offer. Samson filed suit alleging
FedEx violated the ADA by failing to hire him because of his diabetes. He argued that test-
driving was not an essential function of the job. The trial court granted FedEx’s motion for
summary judgment, ruling that test-driving was an essential element of the job.
Opinion: The Court of Appeals for the Sixth Circuit reversed the trial court’s ruling and held in
favor of Samson. It reasoned that there was a genuine issue of fact as to whether the test-driving
requirement was truly “essential” to the job.
Case Questions

1. Is it reasonable to conclude that the online job description implies that test-driving is part of
the job? Why or why not?
• The online job description said a successful candidate would provide timely, quality
maintenance for the vehicle fleet and ground support equipment. It did not mention
driving of any sort.

2. What steps could FedEx take to avoid liability for a similar incident in the future?
• The test-driving should be included in the job description and perhaps have the
technicians test-drive more often.
3. Focus on Critical Thinking. Is the court interfering with FedEx’s legitimate safety concerns
in its own business operations? Is this a concern for public safety? Why or why not?
• FedEx’s safety concerns are legitimate, and Samson should not drive; however, someone
else can test-drive the vehicles.

VII. EQUAL PAY ACT [p. 804-805]

Points to emphasize:
• The Equal Pay Act (EPA) makes it illegal for employers to pay unequal wages to men
and women who perform substantially equal work.
• The EPA is an amendment to the Fair Labor Standards Act.
• To establish a prima facie case, a plaintiff must demonstrate that: (1) the employer pays
different wages to employees of the opposite sex; (2) the employees perform equal work
on jobs requiring equal skill, effort, and responsibility; and (3) the jobs are performed
under similar working conditions.
• The employer can defend by proving that the wage differential is justified by a
preponderance of the evidence under one of the four affirmative defenses: (1) a seniority
system, (2) a merit system, (3) a system pegging earnings to quality or quantity of
production, or (4) any factor other than sex.
• Lilly Ledbetter Fair Pay Act of 2009- this effectively reversed a US Supreme Court
decision. Ledbetter sued her employer on the grounds that she learned that for 18 years,

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11
 her male counterparts earned more than her for the same job. The Court held that she
should have filed suit within 180 days of receiving her first unfair paycheck. The statute
declares that each discriminatory paycheck resets the time that an employee can bring a
claim.

VIII. EMPLOYER DEFENSES [p. 805-807]

A. Faragher/Ellerth Defense [p. 806]

Points to emphasize:
• The Faragher/Ellerth defense is a judicially created affirmative defense whereby an
employer may avoid vicarious liability by proving that a system was in place that was
intended to deter, prevent, report, and correct any harassment.
• The employer must also prove that an employee failed to take advantage of the
preventive or corrective opportunities that the employer provided.

B. Business Necessity Defense [p. 806]

Points to emphasize:

• The business necessity defense requires the employer to justify discrimination on the
basis that it is legitimately necessary to the business operations of the company.
• This defense is used to rebut a disparate impact claim when a certain practice or
procedure has impacted a particular protected class.

C. Bona Fida Occupation Qualification [p. 806]

Points to emphasize:

• Federal antidiscrimination statutes allow employer to hire and employ on the basis of
religion, gender, or national origin when the classification is a bona fide occupational
qualification (BFOQ) that is reasonably necessary to the normal operation of the
particular business.
• Race cannot be used as a BFOQ.
• BFOQ cannot be based on paternalism (protecting women from work in potentially
dangerous positions).
• Example: hiring a man for a male role in a movie or hiring a woman to work in a
women’s locker room.

D. Seniority [p. 807]

Points to emphasize:

• In order to assert this defense, the seniority system must be based on objective elements
of seniority (actual number of years on the job), and the employment decisions must have
been made in good faith.

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 • The employee/plaintiff has the burden of proving improper motivation behind the
employer’s adoption or use of the system.

E. Employee Misconduct [p. 807]

Points to emphasize:

• When an employee commits an act of misconduct, so long as that act has been identified
to the employee as misconduct, employers may discipline the employee in accordance
with the company’s general practices without liability for discrimination.
• The U.S. Supreme Court has even extended this protection to employers when the
employer discovered the misconduct after the adverse employment action.

IX. AFFIRMATIVE ACTION PROGRAMS [p. 807-808]

Points to emphasize:
• Affirmative action includes outreach attempts to recruit minority applicants, special
training programs, and the reevaluation of the effect of selection criteria.
• Certain affirmative action plans apply to private employers as a condition to contracts
with the federal government.
• State and local government affirmative action programs are constitutional so long as they
(1) attempt to remedy an actual past practice of discrimination and (2) do not employ a
system of quotas.
• The strict use of quotas is not only prohibited under affirmative action but is
unconstitutional.

X. STATE ANTIDISCRIMINATION STATUTES [p. 808-809]

Points to emphasize:
• States have their own antidiscrimination statutes and their own administrative agencies.
• State statutes tend to cover more employers and have expanded protected class
membership.

XI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 810-811]

Chapter Review Questions [p. 813-815] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [p. 809-810]

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13
1. Have you ever had a job or internship where the employer distributed a handbook or a
manual? Did the handbook have a sexual harassment provision? If so, how does it compare to
the steps outlined in Thinking Strategically (above)? Explain.
• This question allows students to share real world experiences from internships and jobs.
Ask students, if possible, to bring in a sample of an employee manual they have used (or
they can obtain a sample one online) and use the checklist provided in the Thinking
Strategically feature. Is it better, worse, or about the same? What provisions would help
to prevent liability for the employer, and which could be improved? Students may also
have experience in witnessing or being a victim of sexual harassment. This is a sensitive
topic, of course, but the discussion may lead to a more educated workforce and fewer
instances of sexual harassment in the workplace.

2. Why is the Faragher/Ellerth defense important to this strategy for limiting employer liability?
• The Faragher/Ellerth defense is a judicially created affirmative defense whereby an
employer may avoid vicarious liability by proving that a system was in place that was
intended to deter, prevent, report, and correct any harassment. The employer also must
prove that the employee failed to take advantage of the preventive or corrective
opportunities that the employer provided. Although the defense initially was created in
the context of sexual harassment claims, courts have allowed employers to use the
defense in other types of harassment cases such as racial harassment.

3. Do you have a sexual harassment policy on your campus? How is the policy distributed? How
does it compare to the steps outlined in Thinking Strategically (above)? Explain.
• This question helps students understand their campus as a workplace. It may be useful to
take excerpts from the Student Handbook or a university employment manual in order to
compare them with the checklist provided in the Thinking Strategically feature. Is it
better, worse, or about the same? What provisions would help to prevent liability for the
employer, and which could be improved?

Case Summary Questions and Answers [p. 811-813]

CASE SUMMARY 40.1 Dumas v. Union Pacific Railroad Co., 294 Fed. App. 822 (5th Cir.
2008)

1. Does Dumas have a valid employment discrimination claim?

• The court ruled that Dumas satisfied some of the elements for a prima facie case of
discrimination, they held that Union Pacific proffered reason for the dismissal (falsifying
records and negligence) did not meet the pretext standard (“that the defendant’s reason is
not true, but is instead a pretext for discrimination”).

2. If so, what theories would best be advanced by Dumas?

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 • Either disparate treatment or mixed motives are palpable theories of discrimination.
However, given the facts related to Dumas’s failure to inspect the tracks, he is unlikely to
prevail under any theory.
CASE SUMMARY 40.2 Harding v. Careerbuilder, LLC, 168 Fed. App. 535 (3d Cir. 2006)
1. Does Harding have a claim for employment discrimination under ADEA? Why or why not?
• The court ruled against Harding. The evidence suggested that 100 other employees in
defendant's sales group were fired at that time, and Harding fails to reference their
respective ages and ability levels, even though he has not disputed that they were in fact
terminated. Thus, the court concluded that Harding’s statistical evidence is insufficient
for a reasonable factfinder to find that discrimination was more likely than not the
determinative cause of the termination.
2. Would you answer change if Carey was 24, 49, or 41? Explain
• If Harding was able to make out a prima facie case under the ADEA, the age does matter.
You’d have to be at least 40 and the 10-year rule would also have to be applied.

CASE SUMMARY 40.3 U.S. Airways, Inc. v. Barnett, 535 U.S. 391 (2002)

1. Does Barnett have a cause of action under the ADA? Why or why not?
• The court held that an employer’s showing that a requested accommodation conflicts
with seniority rules is ordinarily sufficient to show, as a matter of law, that an
“accommodation” is not “reasonable.” However, the employee remains free to present
evidence of special circumstances that makes a seniority rule exception reasonable in the
particular case.

2. Has USA fulfilled its duty of reasonable accommodation?

• The court ruled that analogous case law has recognized the importance of seniority to
employee-management relations, finding, e.g., that collectively bargained seniority
trumps the need for reasonable accommodation.

CASE SUMMARY 40.4 Aquino v. Honda of America, Inc., 158 F. App’x 667 (6th Cir. 2005)

1. Who prevails and why?

• Honda prevailed. Even if Aquino was able to make out a prima facie case of disparate
treatment, Honda offered a legitimate, non-discriminatory reason for his termination
(vandalism). Because Aquino was unable to provide any evidence of pretext, he cannot
prevail in a discrimination case.

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2. Why did Aquino have the burden of proving that Honda’s reason for discharging him was a
pretext? Didn’t he already prove a prima facie case?
• The burden shifting scheme for disparate treatment is such that once a prima facie case is
made, the burden shifts to Honda to provide a nondiscriminatory reason for the job
action. Once Honda provides a reason, the burden shifts back to the employee to offer
any evidence of pretext.

3. Considering the criminal charges against him were dropped, what would Aquino need to have
shown in order to meet his burden of proof that Honda’s reasons for dismissing him were
pretextual?
• The best method for showing pretext is to present evidence that a similar situation
occurred in the past and that the employer did not take any disciplinary action or treated
one employee differently from another.

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 Chapter 41
Torts and Products Liability

CHAPTER OVERVIEW
This chapter on tort law and product liability law describes how and when business owners will
be held liable for the intentional and accidental conduct of their employees who cause harm to
another.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Articulate a basic definition of a tort and identify the source of law Knowledge
governing various types of torts.
Determine the classification of tort based on the conduct of the wrongdoer. Application
Discuss defamation, trade libel, and product disparagement in the context of Comprehension
the business environment.
Distinguish business competition torts from other intentional torts and Application
understand their applicability in commercial relationships.
Explain the elements of negligence Knowledge
Identify potential defenses to a negligence claim. Knowledge
Reach a conclusion based on a strict products liability analysis and Evaluation
applicable defenses.

Teaching Tip: Torts

Because students will identify some of the terminology in this chapter with criminal law, it is
important to spend some time explaining how one action can result in two court cases. For
example, if a student were to drink and drive and injure someone, the state could bring a criminal
action against the student. However, the injured party would only be a witness in that case. They
would not be entitled to any compensation. The injured party could bring a civil tort case for their
damages. You could also explain the difference between the burdens of proof in a civil and
criminal case.

I.OVERVIEW OF TORT LAW [p. 819]

Points to emphasize:
• A tort is a civil wrong in which one party has acted, or in some cases failed to act, and that
action or inaction causes a loss to be suffered by another party.
• One who commits a tort is known as the tortfeasor. The tortfeasor’s wrongful conduct is
described as tortious conduct.

A. Sources of Law [p. 819]

For the most part, tort law is governed by state common law principles. Courts look to rules
articulated by the American Law Institute (ALI) known as the Restatement of Torts.

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 B. Products Liability [p. 819]
Product liability laws come from state common law or state statutes that expressly impose
liability for injuries that result from products. These statutes are based primarily on the
Restatements and are relatively uniform from state to state.

II.TORT CLASSIFICATION [pp.819-820]

Points to emphasize:
• An intentional tort is one in which the tortfeasor is willful in bringing about a particular
event that causes harm to another party.
• Negligence is an accidental (without willful intent) event that causes harm to another party.
The difference between the two is the mind-set and intent of the tortfeasor.
• Strict liability torts, in which a tortfeasor may be held liable for an act regardless of intent
or willfulness, apply primarily in cases of defective products and abnormally dangerous
activities (such as major construction demolition).

III.INTENTIONAL BUSINESS-RELATED TORTS [pp. 820-826]

Points to emphasize:
• Some intentional torts are more important to business owners and managers because they
have the potential to impact business relationships and operations (defamation, trade libel
and disparagement, fraudulent misrepresentation, negligent misrepresentation, and false
imprisonment).

A. Defamation [p. 820]

The law imposes liability on any party that makes false and defamatory statements affecting
another party’s reputation. Written defamation is known as libel and oral (spoken) defamation as
slander.
In order to recover for a defamation action, the plaintiff must prove four elements:

1. Defamatory statement
A false statement concerning a party’s reputation for honesty or a statement that subjects a party
to hate, contempt, or ridicule and having a tendency to harm the reputation of the plaintiff. The
defamatory statement is one that must be provable as false, thus, pure opinion, would not be
defamatory.

2. Dissemination to a third party

The statement must reach the ears or eyes of someone other than the tortfeasor and the victim. A
false statement made directly to the victim without a third party hearing it is not defamatory as the
dissemination element is missing.

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3. Specificity
The statement must be about a particular party, business, or product. A general statement about a
profession as a whole cannot constitute defamation, but a false statement about a specific company
can be the basis of a reputation claim.

4. Damages
The aggrieved party must be able to prove that they suffered some pecuniary harm (i.e., lost
revenue or profits, both actual and potential).

Teaching Tip: Defamation

There are many examples of defamation cases involving the internet. The Electronic Frontier
Foundation has an excellent website on cases involving the internet. https://www.eff.org/ It also
has a defamation question and answer section that students may find useful.
https://www.eff.org/issues/bloggers/legal/liability/defamation

B. Public Figure Standard [p. 821]

If the victim is a public figure, such as a candidate for political office, the defamation must have
been committed with malice or reckless disregard for the truth. In New York Times v. Sullivan, the
Court ruled that, in order for a public figure to prevail in a defamation case, the plaintiff must
provide evidence that the defamer either had “actual knowledge” that the statement was false or
had “reckless disregard for the truth.”
CASE 41.1: Turner v. Wells, 879 F.3d 1254 (11th Cir. 2018)

Facts: The NFL hired a law firm to investigate allegations of bulling within the Miami Dolphins
organization. Jonathan Martin, an offensive lineman with Miami, alleged he was bullied and left
the team during the 2013 season. He sought psychological treatment. A 144-page Report was
created by the law firm concluding bullying within the team and a culture of bullying. James
Turner (offensive line coach) was fired and filed a defamation lawsuit against the investigator
(Wells) and the firm. The trial court ruled the Report as opinion (not actionable) and that the coach
was a public figure (lack of malice).
Issue: Was a sports figure a public figure for purposes of proving malice?
Holding: The court ruled in favor of Wells and Turner appealed. The Appellate court ruled in
favor of Wells finding the Report contained opinion-based content and Turner was a public figure,
and thus malice must be proven. The coach put himself in the public arena due to his position and
due to his participation with the 2012 of Hard Knox on HBO.
Case Questions:

1. Why is it important that the court concluded that the Report was largely the opinions of Wells
and his colleagues?

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 • An element of defamation is that the statement be false. An opinion is not a false
statement.

2. Why is malice an important factor in analyzing the case?

• When the victim is a public figure, the defamation must have been committed with
malice or reckless disregard for the truth.

3. Focus on Critical Thinking: Why is there a special standard for public figures? Is that good
public policy or does it prevent public figures from pursuing claims?
• These questions are meant to elicit a discussion on the public policy behind the need for
malice when the plaintiff is a public figure.

C. Privilege Defenses to Defamation [pp. 822-823]

A defendant may avoid liability if the defamatory statement falls into a category of privileged
statements. It is divided into two categories: absolute privilege, whereby the defendant need not
offer any further evidence to assert the defense, and qualified privilege, whereby the defendant
must offer evidence of good faith and be absent of malice to be shielded from liability.

1. Absolute Privilege
Courts generally recognize three categories of absolute privilege:
• Government officials
• Judicial officers/proceedings
• State legislators

2. Qualified Privilege
Courts also recognize certain qualified privileges that are grounded in public policy:

• Media
• Employers

CASE 42.2 Nelson v. Tradewind Aviation, 111 A.3d 887, Appellate Court of Connecticut
(2015)

Facts: Tradewind Aviation (TA) employed Nelson as a pilot for a small commercial airline.
Despite complaints from his seniors, he was never given a written warning, disciplined, or
suspended. TA’s human resources office completed necessary paperwork indicating that Nelson
was laid off due to “lack of work.” In December 2007, Nelson was offered a job by Republic
Airways (Republic). As part of his initial interview, Nelson signed authorizations that gave TA
permission to verify his employment with TA and to release all of his employment records to
Republic. This authorization also required TA to send copies of these records to Nelson so that he
had an opportunity to submit written comments to correct any inaccuracies. TA never sent the
records or letter to Nelson. Republic subsequently revoked its job offer. Nelson sued TA for,

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among other claims, defamation. The jury awarded the plaintiff a total of $307,332.94 in damages.
TA appealed, asserting the employer reference privilege.
Issue: Did the employer’s qualified privilege apply?
Holding: No. Appellate Court of Connecticut affirmed the jury’s verdict in favor of Nelson and
rejected TA’s argument that Nelson had not proven that TA’s statements rose to the level of
maliciousness. The court held that a qualified privilege in a defamation case may be defeated if it
can be established that the holder of the privilege acted with malice in publishing the defamatory
material. Based on the facts in this case, the jury’s conclusion that the statements were made with
malice was reasonable.
Case Questions:

1. What statements by TA, specifically, do you consider to be malicious? Why?

• TA faxed Republic a letter stating that Nelson was terminated “after he failed to perform
to company standards” and that, prior to that date, “he was given several opportunities to
discuss the need for improvement as well as additional training to help him perform at the
levels we needed.” These statements indicate poor performance.

2. How could TA’s management have prevented the defamation from occurring?
• TA’s management could have simply confirmed the dates of employment and title.

3. Focus on Critical Thinking: What is the public policy behind the employer reference
privilege? Is it fair to the employee, who may have a different perspective on the circumstances
of his or her termination? Have you ever heard an employer defaming an ex-employee?
• These questions are meant to elicit a discussion on the public policy behind the employer
reference privilege.

D. Trade Libel and Product Disparagement Laws [pp. 824-825]

In cases where a competitor has made a false statement that disparaged a competing product, an
injured party may sue for trade libel.
This tort requires that the statement: (1) be a clear and specific reference to the disparaged party
or product (e.g., using the actual brand name of the product), (2) be made with either knowledge
that the statement is false or shows reckless disregard for the truth, and (3) be communicated to a
third party (similar to defamation).
Some states have passed product disparagement statutes intended to protect the interest of a
state’s major industries, such as agriculture, dairy, or beef.

E. Fraudulent Misrepresentation [p. 825]

In cases of fraudulent misrepresentation, the law allows the innocent party to recover if: (1) the
misrepresentation was a material fact known to be false by the tortfeasor (or a reckless disregard
for the truth); (2) the tortfeasor intended to persuade the innocent party to rely on the statement

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and the innocent party did, in fact, rely on it; and (3) damages were suffered by the innocent party.
Under contract law, a contract may be canceled if fraudulent misrepresentation is shown.

F. Negligent Misrepresentation [p. 825 ]

Courts also allow recovery for misrepresentations that are not intentional but are negligent
misrepresentations. In these cases, the parties typically have some type of previous business
relationship. Any statement made by a party that turns out not to be accurate may still allow the
innocent party to recover if the tortfeasor’s statement was negligent.

G. False Imprisonment [p. 826]

The tort of false imprisonment is defined by the Restatements as the “intentional infliction of a
confinement upon another party.” In the business context, a merchant most commonly encounters
these circumstances in cases of suspected retail theft. The merchant’s privilege shields a merchant
from liability for temporarily detaining a party who is reasonably suspected of stealing
merchandise. In order to gain protection under the merchant’s privilege, the merchant must follow
certain guidelines:
• Limited detention. The privilege only applies for a short period of time under the
circumstances. The detention may last the amount of time necessary to confront the
accused party, recover any goods stolen, and wait for the authorities to arrive (if
necessary).
• Limited to premises. The privilege only applies if the suspected party is confronted
on the merchant’s premises or an immediately adjacent area (such as a parking lot).
• Coercion. The merchant or merchant’s agent (such as a store security guard) may
not attempt to coerce payment, purport to officially arrest the detained party, or
attempt to obtain a confession.
Table 41.1 provides an overview of other types of intentional torts and examples of each.

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IV.BUSINESS COMPETITION TORTS [pp. 827-828]
Points to emphasize:
• Tort law also provides for the promotion of fairness in business dealings and for the
reimbursement of a party that has suffered some damages as a result of a competitor’s
tortious acts.
• These common law torts arise when a tortfeasor interferes with an existing contract or
hinders a prospective contract between two parties.

A. Tortious Interference with Existing Contractual Relationship [p. 827]

When one party induces another party to break an existing contract with another party, the inducing
party may be liable for any damages suffered by the innocent party as a result of breaking the
contract. In order for the injured party to recover damages, the tortfeasor must have, (1) had
specific knowledge of the contract, (2) actively interfered with the contract, and (3) caused some
identifiable damages (losses) to the injured party.
Contract interference torts often arise with restrictive covenants (a restriction against working for
competitors in an employment contract) or in defending an allegation of interference when a new
employee is hired away from a competitor.

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 B. Tortious Interference with Prospective Advantage [p. 828]
The law also protects against interference with potential contract (prospects) or other business
relationships. Because no contract actually exists, courts only allow recovery for this tort under
limited circumstances where the tortfeasor’s conduct was highly anticompetitive.

V.NEGLIGENCE [pp. 829-838]

Points to emphasize:
• Negligence occurs when a party creates an unreasonable risk of harm, even if that party
did not intend for harm to occur.
• The negligent party is liable for any injuries or damages suffered by another party as a
result of the unreasonable conduct.

A. Elements of Negligence [p. 829]

The law requires that specific elements be proven in order to recover in a lawsuit against a
tortfeasor for negligence. The injured party must prove five fundamental elements by answering
certain questions about the conduct in question:
• Duty: Did the tortfeasor owe a duty of care to the injured party?
• Breach of duty: Did the tortfeasor fail to exercise reasonable care?
• Cause in fact: Except for the breach of duty by the tortfeasor, would the injured
party have suffered damages?
• Proximate (legal) cause: Was there a legally recognized and close-in-proximity
link between the breach of duty and the damages suffered by the injured party?
• Actual damages: Did the injured party suffer some physical harm that resulted in
identifiable losses?

1. Duty
The initial consideration in a negligence analysis is whether the tortfeasor owed the injured party
a legal duty. The law imposes a general duty on all parties to act reasonably and not to impart
unreasonable risk to others, and in certain cases, some parties owe a special (heightened) duty of
care.
a) General Duty of Reasonable Conduct
• The law imposes a general duty on every party to act as a reasonably prudent
person would under the circumstances. In other words, everyone owes a duty to
everyone else to act in a manner that does not impose unreasonable risk.
• The reasonably prudent person standard emphasizes that the conduct must be
objectively reasonable. This means that a fact finder (such as the jury) at trial could
conclude that a reasonably prudent person in the same circumstances should have
realized that certain conduct would be risky or harmful to another person.
• In general, the scope of that duty is defined by foreseeability. The scope of duty
frequently is defined by a particular industry or occupation. For example, the level

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 of duty for a physician is defined by what a reasonably prudent physician would
have done under the circumstances.
b) No General Duty to Act
There is no general duty to act or to rescue another. Tort law allocates liability based on a
fundamental difference between some act by one party that harms or endangers another party,
known as misfeasance, and the failure to act or intervene in a certain situation, known as
nonfeasance.
• While injured parties generally may recover for misfeasance, they may not hold a
defendant liable for failing to act unless the parties had a special relationship to
each other (such as a common carrier to its passengers, innkeepers to guests,
employers to employees, a school to students, and a landlord to tenants).
• A business does have a duty to warn and assist any business visitors or patrons in
terms of potential danger or harm (such as a slippery floor) on business premises.
Therefore, businesses have a special relationship with visitors and patrons that
would allow recovery even in cases of nonfeasance.

CASE 41.3 James v. Meow Media, Inc., 300 F.3d 683 (6th Cir. 2002)

Facts: A rrampage shooting by 14-year-old Michael Carneal at his high school resulted in the
deaths of three of his classmates. The parents and estate administrators of the victims (collectively
“James”) filed a negligence lawsuit against several companies that produced or maintained certain
movie, video game, and Internet websites (collectively “Meow Media”), claiming that these
contributed to Carneal’s homicidal state of mind. James argued that these activities “desensitized”
Carneal to violence and caused a lethal state of mind that led to the shooting spree. The district
court dismissed the case under both negligence and strict liability theories.

Issue: Could a company that makes movies, video games, and Internet websites be held liable for
Carneal’s actions?

Ruling: The appellate court upheld the trial court’s ruling in favor of Meow Media. The court used
a negligence analysis finding that the harm to the injured party resulting from the defendant’s
negligence was not foreseeable. The court also upheld the dismissal of the products liability claims
against Meow Media because Kentucky law does not recognize video game cartridges, movie
cassettes, and Internet transmission as sufficiently tangible to constitute “products” in the sense of
their communicative content.

Case Questions:
1. Why did the court hold that Meow Media could not have foreseen the damages caused by
Carneal?
• Millions of people interact with movies, video games, and Internet websites and do not go
on shooting rampages.

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9
2. Was there a special relationship duty in this case? Why or why not?
• Meow Media was not a common carrier, innkeeper, employer, a school, or a landlord, all
of whom have a special duty.

3. Focus on Critical Thinking: What type of evidence might bolster the plaintiffs’ theory of the
case? If they could prove that scientific evidence existed that there was a correlation between the
video games, the desensitization, and violence, would that be enough? Why or why not?
• This question is meant to elicit a discussion on what would be required to establish a duty
on the part of those who make movies, video games, and Internet websites.

c) Landowners
Landowners owe a general duty to parties off the land from any unreasonable risks to them caused
by something on the land and a special duty to certain parties based on categories spelled out in
the Restatements. Where a tenant is in possession of leased space, the tenant has the same special
duties and level of liability that is imposed on landowners.
d) Assumption of Duty
Another exception to the no general duty to act/rescue doctrine is when one party voluntarily
begins to render assistance even when there is no legal obligation to do so. This is known as
assumption of duty, and it requires that the party rendering assistance must proceed with reasonable
care. This includes the duty to continue rendering aid and to take care not to leave the injured party
in a worse position.

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10
CASE 41.4 Yost v. Wabash College, Phi Kappa Psi Fraternity et al., 3 N.E.3d 509 (Ind.
2014)

Facts: Brian Yost was an 18-year-old first-year student at Wabash College (“Wabash”) and a
pledge at the local Phi Kappa Psi fraternity (“Local Fraternity”). In September 2007, Yost and his
pledge brothers confronted some of the Local Fraternity’s member brothers in an attempt to toss
one of these members, Yost’s Pledge Father, into a nearby creek. Several Local Fraternity brothers
retaliated by attempting to forcibly place Yost in the shower. During this attempt, several Local
Fraternity member brothers were carrying Yost to the shower when one of the fraternity members
put him into a headlock that rendered Yost unconscious. The other member brothers panicked and
dropped Yost to the ground. Yost suffered significant physical and psychological injuries from the
incident that caused him to withdraw from college. Yost filed suit against both Wabash and the
Local Fraternity alleging his injuries were a result of negligence. The trail court granted summary
judgment in favor of Wabash and the Local Fraternity. Yost appealed.

Issue: Were either Wabash or the Local Fraternity negligently responsible for Yost’s injuries?

Ruling: The Indiana Supreme Court affirmed the summary judgment for Wabash but reversed the
summary judgment for the Local Fraternity. In the case of Wabash, the court reasoned that a
landlord has no liability to tenants or others for injuries on the property when the tenant is in full
control of the leased premises. In the case of the Local Fraternity, the court held that there was
sufficient evidence to reasonably conclude that Yost may be able to show that the Local Fraternity
undertook to render supervisory services intended to reduce the risk of harm to members like Yost,
that upon which supervision Yost relied, and further that by failing to exercise reasonable care the
local fraternity increased the risk of harm to Yost, resulting in Yost’s injuries.

Case Questions:
1. What factors did the court use to determine that the Local Fraternity may have assumed a duty
here? Do you agree? Why or why not?
• Yost was living at the local fraternity, subject to the mentorship of a Pledge Father from
the local fraternity, participating in traditions maintained at the local fraternity, was
involved in the pledgeship program being run by local fraternity members, and, therefore,
at least partially under the control and direction of the local fraternity.

2. Why did the court find that Wabash College had no liability for this incident?
• Wabash was the Landlord which created a special duty to prevent unreasonable risks of
harm caused by something on the property. However, the Local Fraternity, as tenant was
in possession of the leased space, and therefore took on the special duties and level of
liability that is imposed on landowners and created the risk of harm.
3. Focus on Critical Thinking: One of Yost’s unsuccessful arguments against Wabash centered
on a doctrine called in loco parentis (i.e., in place of the parent). The doctrine has largely
disappeared from higher education since 1961. Yost claimed that the college had a duty to
protect him and should have had a system in place to prevent fraternity pranks from becoming
dangerous. Do you agree? Should an 18-year-old college student have full responsibility for his

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11
own safety while in a college-owned facility? Should colleges and universities have in loco
parentis liability?
• These questions are meant to provoke a discussion on how to allocate liability between
colleges and fraternities.

2. Breach of Duty [p. 834]

Once it has been established that one party owes another party a general or special duty, the next
factor is to assess whether or not that party has fulfilled her obligations. Failing to meet these
obligations is known as a breach of duty. Duties include (1) general obligations to act in a
reasonable manner so as not to put another in harm’s way; (2) special duties to certain parties,
including the duty to inspect or duty to warn of defects; and (3) assumption of duty. While the
Restatements don’t actually list events of breach, courts traditionally have looked to certain
guideposts to determine whether a breach of duty has occurred.

a) Violation of Safety Statute

If the legislature has passed a statute intended to promote safety and one party violates the statute,
there is a strong presumption that the party violating the statute has also breached her general duty
to those who are protected by the law. This is known as negligence per se.
b) Common Law Standards of Behavior
For situations where the state legislature is silent, the courts have developed common law to
identify the standards of behavior that may be used in judging whether a breach has occurred.
Standards related to maintenance of property (such as when ice must be cleared) and safety
measures (such as keeping one’s car in good repair if driving on public roads) are examples of
nonstatutory standards for reasonable behavior.
c) Res Ipsa Loquitur
The doctrine of res ipsa loquitur (a Latin phrase meaning “the thing or matter speaks for itself”)
allows an injured party to create a presumption that the tortfeasor was negligent by pointing to
certain facts that infer negligent conduct without showing exactly how the tortfeasor behaved.

Teaching Tip: Res Ipsa Loquitor

A helpful case in explaining res ipsa loquitor is the 1863 English case of Byrne v. Boadle, in which
a pedestrian was struck by a flour barrel that fell from a warehouse owned by the defendant.
Although the injured party could not actually show how or why the barrel fell, the court held that
the facts themselves were sufficient to impute a presumption of negligence. The court wrote, “A
barrel could not roll out of a warehouse without some negligence, and to say the plaintiff who is
injured by it must call witnesses . . . is preposterous.”

3. Cause in Fact
After establishing that a breach of duty has occurred, the injured party also must prove that the
tortfeasor’s conduct was the cause in fact of the damages suffered by the injured party. Thus, the
question that must be answered is: “But for (except for) the breach of duty by the tortfeasor, would

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12
the injured party have suffered damages?” If the answer is no, then there is a link between the
tortfeasor’s conduct and the harm suffered by the injured party.
a) Scope of But-For Test
One problem in applying the but-for test is its overreaching broadness. Because its application may
result in holding a tortfeasor liable for injuries that occurred well beyond the foreseeable scope of
the wrongdoing, there is an additional step to establish liability known as proximate (or legal)
cause.

4. Proximate (Legal) Cause

In addition to showing that the tortfeasor’s breach of duty was the cause in fact of the damages,
the injured party also must prove that (1) the tortfeasor’s conduct was also the closest-in-proximity
cause of the damages and (2) the tortfeasor’s liability wasn’t canceled due to a superseding cause.
These proximate cause concepts protect tortfeasors from liability for far-reaching and out-of-the-
ordinary injuries resulting in damages from the tortious act.
a) Closest-in-Proximity
The majority of courts favor using foreseeability to define the scope of the risk. The Restatements
define proximate cause as that which helps draw the line that determines when a tortfeasor is “not
liable for harm different from harms whose risk made the [tortfeasor’s] conduct tortious.”

LANDMARK CASE 42.5 Palsgraf v. Long Island Railroad Co., 162 N.E. 99 (Ct. App. N.Y.
1928)

Facts: Palsgraf bought a railroad ticket for Rockaway Beach, New York, and was waiting on
the platform for her train. A different train arrived on a platform 100 yards away, allowed
passengers to board, and began to depart from the station. Running to catch the departing train,
two commuters grabbed onto the side and tried to hoist themselves up and into the moving car. To
aid one of the men, the conductor on the train pulled him onto the train but dislodged a package
covered in newspaper that the passenger was carrying. The package, which turned out to be
fireworks, fell to the platform and exploded. The blast shook the station with sufficient force that
large iron scales (used to weigh freight on various trains) hanging over Palsgraf fell on her,
resulting in a severe injury. Palsgraf sued the Long Island Railroad for the conductor’s negligent
conduct of pulling the commuter onto the train, which caused the explosion and her injury from
the falling scales.

Issue: Was the the Long Island Railroad responsible for the explosion and injury?

Ruling: In a famous opinion written by Judge Benjamin Cardozo (who would later serve on the
U.S. Supreme Court), the New York Court of Appeals ruled in favor of the Long Island Railroad.
Cardozo reasoned that because the conductor could not have known the man he was helping onto
the train was carrying a package full of fireworks, the action of the conductor was not a proximate
enough cause to incur liability for Palsgraf’s injuries because such injuries were not foreseeable.

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13
Case Questions:
1. Are all the other elements of a negligence tort satisfied in this case?
• Yes, the Long Island Railroad was a common carrier with a special duty, the duty was
breached by an employee of the railroad by engaging in unreasonable conduct by fulling a
passenger onto a moving train, this act was the actual cause of the injury to the plaintiff.

2. Who else might Palsgraf have sued? For what?

• The plaintiff could have sued the man carrying fireworks onto the train as engaging in an
unreasonably dangerous activity.

3. Focus on Critical Thinking: Context is always important. This case was decided before any
federal or state benefits for health care or lost time from work. The dissenting opinion in this
case argued that public policy demanded that the railroad pay for the injury because it was in the
best position to pay and that some correlation existed between conduct and injury. In the 1928
context, does that strike you as a convincing argument? Why or why not?
• These questions are meant to elicit a discussion on how to allocate liability as between the
public and businesses.

b) Superseding Cause
Sometimes an intervening event takes place after the tortfeasor’s negligent act. This intervening
act may also contribute to that negligence in causing additional damages to the injured party and
therefore limit a tortfeasor’s liability. These acts, called superseding causes (i.e., they supersede
the tortfeasor’s liability), are also defined by foreseeability.

5. Actual Damages
• In order to recover in a negligence case, the tortfeasor must have caused another
party’s actual damages (meaning some type of physical harm must have been
caused, and not just mental/emotional harm alone).
• Punitive damages may be awarded, but they are rare because they can only be
awarded when the tortfeasor’s conduct was extremely reckless or willful and
wanton.
• Many states also allow a spouse or children of an injured or deceased party to
recover damages related to the negligence. This includes loss of companionship or
marital relations (known as loss of consortium).

VI.DEFENSES TO NEGLIGENCE CLAIMS [p. 838-840]

Points to emphasize:
• Once the elements of negligence are met, the analysis then shifts to potential defenses
available to the tortfeasor.
• The two primary defenses to claims of negligence are comparative negligence and
assumption of the risk.

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 A. Comparative Negligence [p. 838]
In cases in which the injured party’s own conduct has played a factor in the harm suffered, most
states permit the tortfeasor may assert the defense of comparative negligence (allowing the jury
to divide up the proportion of negligence committed by the parties in terms of percentage (see
Figure 41.1). In states which use the alternate common law doctrine of contributory negligence, if
the plaintiff is even 1 percent at fault, it is a complete bar to recovery.

B. Assumption of the Risk [p. 839]

• When an injured party knows that a substantial and apparent risk is associated with certain
conduct, and the party goes ahead with the dangerous activity anyway, the tortfeasor may
assert the defense of assumption of the risk so long as (1) the injured party/plaintiff knew
or should have known (by virtue of the circumstances or warning signs, etc.) that a risk of
harm was inherent in the activity and (2) the injured party/plaintiff voluntarily participated
in the activity.
• Certain activities are considered to be “inherently dangerous” (such as bungee jumping or
parachuting), and companies that provide these activities may have limited protection from
liability if they acted reasonably in minimizing the dangers and made full disclosures of
the risks to participants.

CASE 41.6 Zeidman v. Fisher, 980 A.2d 637 (Pa. Super. Ct. 2009)

Facts: Zeidman and Fisher were participants in a golf foursome at a charity tournament. On one
hole where the view of the fairway was partially blocked, the foursome became concerned that
they might inadvertently hit any players that might be hidden by the blind spots on the fairway
ahead of them. The group agreed that Zeidman would take a golf cart and ride ahead to see if the
course was clear for the group to hit. Zeidman made his observation and returned to his foursome
in the cart. Because he intended to return to his foursome to report that the group ahead was out of
harm’s way and because he never signaled to his group that it was safe to hit, Zeidman never
entertained the possibility that one of his group would hit a shot. Before Zeidman returned, Fisher,
becoming impatient, hit his shot while Zeidman was driving his cart back to the foursome. Fisher’s
shot was errant, and the ball struck Zeidman in the face, causing serious and permanent injuries.
The trial court dismissed Zeidman’s negligence lawsuit against Fisher on summary judgment,

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15
ruling that Zeidman had assumed the risk of participating in the golf match, which barred any
recovery. Zeidman appealed.

Issue: Did Zeidman willingly assume the risk of injury?

Ruling: The Pennsylvania Superior Court reversed the trial court’s decision and ruled in favor of
Zeidman. The court reasoned that the assumption of the risk doctrine requires that the evidence
show that the injured party (1) fully understood the specific risk, (2) voluntarily chose to encounter
it, and (3) manifested a willingness to accept the known risk. Because he drove ahead with
everyone in the foursome knowing that he was checking for danger, he expected the party to wait
for his return prior to hitting a shot. Therefore, Zeidman did not manifest a willingness to accept a
known risk.

Case Questions:
1. If Zeidman had signaled to his partners that all was clear from the fairway and was then hit
while returning in the cart, would Fisher be entitled to a summary judgment based on assumption
of the risk?
• It would depend on the facts, but it would seem that Zeidman manifested the assumption
of risk if he signaled the party to go ahead and hit the ball.

2. What duty did Fisher owe Zeidman in the first place? Was it a special relationship duty?
• Fisher had a duty not to create an unreasonable risk of harm, such as hitting a golf ball in
the direction of where one of his or her foursomes was driving a golf cart.

3. Focus on Critical Thinking: What other leisure sports or activities might be covered under the
assumption of the risk doctrine? Is it good public policy to shield negligent parties with the
doctrine?
• These questions are meant to solicit a discussion of how risks should be apportioned in
purely voluntary recreational activities.

VII.STRICT LIABILITY TORTS [p. 840]

Points to emphasize:
• The tort known as strict liability requires neither intent nor negligence need be proved and
is primarily used for abnormally dangerous activities and defective products.
• Strict liability is rooted in the notion that the general public benefits when liability is
imposed on those who engage in certain activities that result in harm to another party, even
if the activities are undertaken in the most careful manner possible (without negligence).

A. Abnormally Dangerous Activities [p. 840]

The Restatements set out a six-factor test to determine whether abnormally dangerous activities
trigger strict liability for any harm caused by the activity.
1. Does the activity involve a high degree of risk of some harm?

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16
2. Is there a likelihood that the harm that results will be great?
3. Is it possible to eliminate the risk by exercising reasonable care?
4. Is the activity relatively common?
5. Is the location of the activity appropriate to the risk?
6. Is there any community value that outweighs the dangerous attributes?

VIII.PRODUCTS LIABILITY [p. 841-846]

Points to emphasize:
• Products liability refers to the liability of any seller (including the manufacturer, retailer,
and any intermediary seller such as a wholesaler) of a product that, because of a defect,
causes harm to a consumer.
• In a products liability case, the injured party may pursue a legal remedy against the seller
under one of three theories: (1) negligence, (2) warranty, or (3) strict liability.

A. Negligence [p. 841]

• Although historically negligence was severely limited as a remedy because the law
protected only the actual purchaser, a revised rule announced in the landmark case
of MacPherson v. Buick has been adopted in every state.
• Under the MacPherson rule, one who negligently manufacturers a product is liable
for any injuries to persons (and, in some limited cases, property) proximately
caused by the negligence.
• Courts have found that manufacturers have the duty of care regarding proper
design, manufacturing, testing, inspection, and shipping.
• Retailers do not have as comprehensive a duty as the manufacturer, but they still
have a duty to warn consumers of any product they know or suspect to be
unreasonably dangerous.

B. Warranty [p. 841]

Warranty laws can impose liability even in the absence of negligence. When the seller makes a
representation of fact about a product, this is known as an express warranty. If the seller has not
made a specific representation about the product, the buyer still may be protected by a Uniform
Commercial Code–imposed implied warranty.

C. Strict Liability [p. 841-842]

With strict liability cases, the injured party need not prove the elements of negligence.
Additionally, the case may be brought against not only the product’s manufacturer, but also all the
parties through the chain of commerce, including the retailer.
Restatement § 402A, which has been adopted by the majority of states, imposes strict liability on
the seller so long as the injured party can show that the product was in a defective condition and
that the defect rendered the product unreasonably dangerous.
• Section 402A liability is triggered only when:

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17
 o the seller is engaged in the business of selling such a product; and
o the product is expected to and does reach the user or consumer without a
substantial change in the condition in which it is sold.

• Section 402A’s strict liability is imposed on the seller even though:

o the seller has exercised all possible care in the preparation and sale of the product;
and
o the user or consumer has not bought the product from or entered into any
contractual relationship with the seller.

1. Defining “Defect”
In order to recover for an injury, the product must have been defective and must have created a
danger that is outside the reasonable consumer’s expectations. Courts have recognized several
theories of unreasonably dangerous defects.

a) Design or Manufacturing Defect

A product may become dangerous if it is designed improperly in that foreseeable risks of harm
posed by the product could have been reduced or avoided by some alternative design. Even
products that are designed properly may still be rendered dangerously defective by some mistake
made during the manufacturing process.

b) Inadequate Warning
Most courts have held that the manufacturer of a product has a duty to warn unless the danger is
“open and obvious.” Failure to warn may render the product unreasonably dangerous even absent
any manufacturing or design defect. One common category of inadequate warning cases involves
prescription drugs, but the theory of unreasonable danger applies to all products that carry some
danger in use (such as a lawn mower or snow thrower).

CASE 41.7 Bunch v. Hoffinger Industries, 20 Cal. Rptr. 3d 780 (Cal. App. 2004)

Facts: Bunch, an 11-year-old girl, dove into an above-ground pool that was only four feet deep.
As a result, Bunch suffered a severe injury to her spine that rendered her a quadriplegic. Bunch
filed suit against Hoffinger as the manufacturer of the pool liner alleging, among other theories,
that Hoffinger was liable for failing to provide adequate warnings that could have prevented the
tragedy. At trial, Bunch testified that she saw only a sticker that depicted a man doing a “pike”
dive with the word “caution” and she thought that the caution referred only to pike diving. Bunch
also called expert witnesses to testify that warnings to children between the ages of 7 and 12 must
be concrete and spell out any consequences of diving into shallow water. Another of Bunch’s
experts testified that the risk of spinal paraplegia was not readily apparent to an 11-year-old and
that it was difficult for someone in that age group to judge the depth of a pool. Hoffinger countered
that (1) warning labels on pools were not feasible before it left the factory because the label would
become distorted by the stretching of the liner and (2) Bunch had assumed the risk because she
had swum at that same pool prior to that occasion and ignored an adult present at the pool who

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18
warned against diving. The jury returned a verdict in Bunch’s favor and awarded her $16,112,306.
Hoffinger appealed.

Issue: Is a sign board alongside the pool a sufficient warning especially for a product used by
children?

Ruling: The California Court of Appeals affirmed the judgment and verdict in favor of Bunch.
The court rejected Hoffinger’s contention that it owed no duty to warn. Although the court
acknowledged that some previous cases have held that no recovery was available for those who
made a shallow dive into an aboveground pool because the danger was obvious, they distinguished
those cases from the facts in this case because Bunch was only 11 years old. Age was one of the
important factors in determining an awareness of open or obvious danger. It also rejected
Hoffinger’s assumption of the risk argument and ruled that any assumed risk by an injured party
does not insulate equipment suppliers from liability for injury from providing defective equipment.
With respect to the failure-to-warn issue, the court held that the jury’s conclusions were sound and
in accord with expert testimony that pool industry standards require manufacturers to prominently
display permanent warnings on their pools and that Hoffinger’s sticker was below industry
standards. Thus, the court concluded that the record supported the jury’s determination that
Hoffinger’s warnings were inadequate.

Case Questions:
1. Why is the injured party’s age one of the most important factors in considering a failure-to-
warn claim?
• Assumption of risk assumes that the party had the mental capacity to understand the
risk. An 11-year-old has fewer life experiences than a 31 year-old and may not be able
to appreciate the risks that a 31-year-old would.

2. Do you agree with Hoffinger’s contention that the injured party assumed the risk? Why or
why not?
• The sign showed a specific type of dive which was interpreted literally by the 11-year-
old. She avoided doing the type of dive specified, but in her mind did not see the sticker
as a warning for diving in general, and therefore did not assume the risk.

3. Focus on Critical Thinking: What other products can you think of that may require a more
effective warning given the age of the average user? Should bicycles, skateboards, and
snowboards fall into the same category? Why or why not?
• These questions are designed to elicit a conversion on age and the appropriateness of
warnings regarding recreational items marketed to children.

c) Improper Packaging
A product can be rendered unreasonably dangerous by a defect in the packaging such as with toxic
products that require safety-proof containers as well as food or beverage packages that should
show whether the product has been tampered with (such as a seal on a bottle of juice).

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 d) Unavoidably Unsafe
Some products, even if designed and manufactured correctly and adequate warning have been
given, are still dangerous (such drugs, cigarettes, and guns). Courts struggle to define liability in
these cases.

D. Causation and Damages [p. 846]

Once it has been established that the product is unreasonably dangerous, the injured party need
now prove only that the defective product was the cause of the injuries and that the product caused
an actual injury that resulted in damages.

E. Seller’s Defenses [p. 846]

Although strict liability imposes a relatively onerous burden on the seller, the law recognizes
several defenses for a seller even if the injured party has established all the required elements for
liability.

1. Substantial Change
If a product leaves the manufacturing plant in a reasonable condition (not dangerous) and then is
contaminated or damaged in the next stage of the commercial chain of delivery, any resulting harm
is outside the strict liability model. Depending on the circumstances, of course, the manufacturer
may still be liable for negligence, but not under strict liability.

2. Assumption of the Risk

An injured party has assumed the risk if the party knew or should have known about the risk and
disregarded this risk by continuing with the activity at issue for her own benefit.

3. Misuse of Product
When the injured party did not use the product in the way an ordinarily prudent person would, then
the seller may use product misuse as a defense. Courts have been reluctant to allow this defense
unless that particular use of the product was so far from its ordinary use that it was not reasonably
foreseeable by the seller.

IX.END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 847-848]

Chapter Review Questions [p. 805-806] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [p. 847]
1. Have you ever signed a liability waiver? Was it related to amateur sports, such as skiing, golf,
racquetball, or the like? Did you understand what you were waiving?
• This question helps to start a discussion on how common waivers really are. Ask
students to be on the lookout for waivers in their daily life. This includes waivers of

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20
 liability for using software or their smart phone. Students can benefit from comparing
the language from waiver to waiver because it illustrates that not all waivers are the
same (e.g., limited liability language versus no liability language). It is also
instructive to examine the font of the waiver and compare it section by section and
explain why certain provisions are in bold or italics or caps.
2. Is it ethical for a business to ask for a waiver? Isn’t the idea behind the tort system to spread
risk among parties? In theory, a waiver eliminates all the risk on one side and allocates it to the
other side. Is that fair?
• Some states prohibit certain kinds of waivers if the terms are too oppressive. This
question allows students to apply a legal strategy (prevention) and then to view the
strategy through an ethical lens. Use the framework set out in Chapter 2 to generate a
discussion on ethical decision-making regimes (principles-based, consequences-
based, and contract based) as well as implications for corporate social responsibility
versus liability.
3. Should minors be able to sign a waiver without parental consent? Why or why not?
• This question allows students to understand that fundamentally waivers are a form of
contract. The same public policy reasons that apply for minors as not having capacity
to contract apply to waivers.

Case Summary Questions and Answers [p. 848-850]

CASE SUMMARY 41.1 Mattison v. Johnston, 730 P.2d 286 (Ariz. App. 1986)
1. Who prevails and why? Are there conflicting public policy concerns in this case?
• Mattison prevailed. The court held that the purpose of the contractual provision was
for competition purposes (i.e., to prevent the competition from taking talent) and
rejected Johnston’s theory that it was Drowne’s choice. That may be true, but the fact
remains that Johnston was aware of the restriction and still offer an inducement to
break the agreement.

2. Why would Mattison sue Johnston for interference rather than suing Drowne for breach?
• It is speculation of course, but Mattison may be seeking a deeper pocket (Johnston
rather than Drowne) and/or that ultimately Mattison wanted Drowne to return to
Mattison’s Salon and a breach of contract lawsuit would typically preclude any return
by Drowne.

CASE SUMMARY 41.2 Maher v. Best Western Inn, 717 So. 2d 97 (Fla. App. 5th Dist. 1998)
1. What duty did Best Western owe Maher?
• Best Western owed her a special duty (heightened) which was triggered by their
special innkeeper-guest relationship. Therefore, Best Western had a duty to warn and
assist any business visitors or patrons of potential danger or harm.

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2. Was it reasonable for Best Western to do more to prevent the attack?
• The court held that since Best Western solicited guests with pets, including dogs that
the innkeeper created a foreseeable zone of risk, “which placed upon it a duty to
either lessen the risk or see that sufficient precautions are taken to protect others from
the harm the risk poses.”
3. Would a bystander have had a duty to prevent the attack had it occurred on the street?
• No. Absent a special relationship, there is no general duty to act (legally) to prevent
harm. A bystander with no special relationship has no liability for nonfeasance.

CASE SUMMARY 41.3 Wurtzel v. Starbucks Coffee Co., 257 F. Supp. 2d 520 (E.D.N.Y.
2003)
1. Was Starbucks clearly negligent without any need for witnesses?
• The court held that the doctrine of res ipsa loquitor is inapplicable because Wurtzel
did not have exclusive control at the time of the accident. The court pointed out that it
is entirely possible that the force exerted by the turning of the car alone caused the
coffee cup to spill and injure Wurtzel. Notably, no coffee spilled before the car
turned.
2. Who else may have been negligent?
• The manufacturer of the cup/lid as a matter of products liability under 402a.

CASE SUMMARY 41.4 Coker v. Wal-Mart Stores, Inc., 642 So. 2d 774 (Fla. App. 1st Dist.
1994)
1. Is Walmart liable?
• Although the trial court dismissed the case against Wal-Mart on summary judgment,
the appellate court held that there was enough evidence for a trier of fact to find
liability. Under Florida law, to state a cause of action for negligence, Coker was
required to allege that: (1) Wal-Mart owed a legal duty that included within its ambit
her husband, Billy Wayne Coker; (2) Wal-Mart breached that duty; (3) the breach
was a legal or proximate cause of her husband's death; and (4) Coker suffered
damages as a result.

2. What if it was reasonable to assume that the two men were over 21?
• It’s not necessarily a reasonableness issue. The court held that Wal-Mart’s failure to
abide by a federal statute that prohibits the sale of ammunition was a breach of duty
to Coker. If the men had been over 21, that would change the “duty” dimension of the
case.
3. Could Walmart have foreseen the robbery any more than the train conductor could have
foreseen the package full of fireworks in Palsgraf?
• While it is true that Wal-Mart could not have foreseen the specific harm to Coker, the
court concluded that the complaint sufficiently alleged a causal relationship between

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 Coker's decedent's death and Wal-Mart's negligence in selling the ammunition to
Bonifay and Fordham in violation of the statute.

CASE SUMMARY 41.5 Burton v. MDC PGA Plaza Corp., 78 So. 3d 732 (Fla. App. 4th Dist.
2012)
1. Can a property owner be liable for injuries when a dangerous condition is open and obvious?
Does the owner have a duty to warn when the dangerous condition is open and obvious?
• The court ruled in favor of MDC. They held that the pothole was such an open and
obvious condition that they could not have anticipated that anyone would be harmed
by it. They cite several cases finding that some conditions are so obvious that neither
a warning nor correction of the condition is required by the owner.
2. Can a property owner be liable for injuries when a dangerous condition is open and obvious
and the injured party was well aware of the dangerous condition?
• The court held that “some injury-causing conditions are so open and obvious that they
can be held as a matter of law not to give rise to liability as dangerous conditions.”
3. Does Burton’s knowledge of the dangerous condition merely raise an issue of fact as to her
own comparative negligence?
• No. The danger was so open and obvious that it cannot constitute a breach of duty in
the first place. Comparative negligence is a defense and only asserted if the elements
of negligence are made out.

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 Chapter 42
Administrative Law

CHAPTER OVERVIEW
This chapter provides a guide to administrative law and its processes as an important aspect of
business regulation.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain how administrative agencies derive authority from statutes to Application
regulate business.
Describe the sources of administrative law. Knowledge
Categorize the functions of administrative agencies. Critical
Thinking
Distinguish how the types of limits on administrative agency authority. Application
Demonstrate how state and federal administrative laws relate to one Critical
another. Thinking

Teaching Tip:
Because administrative law can be a complex topic for students, it is important to introduce the
topic so that students can understand this topic. Provide the students with examples of
administrative agencies at the federal, state, and local level and discuss what these agencies
provide for businesses.

I. ADMINISTRATIVE LAW IN A BUSINESS CONTEXT (p. 854)

Points to emphasize:
• Business regulation has generally increased and as a result administrative law’s reach
over business has greatly expanded and increased in complexity.
• This is due to many competing stakeholders have demanded that the government regulate
business activities to protect society’s diverse interests.
• Every time the legislature enacts legislation, an existing administrative agency must
oversee the new law or a new administrative agency must be created to oversee it.
• The statutes that create an agency or give the agency explicit authority to implement a
statute are called enabling statutes.
• Department, non-department, and independent agencies are collectively referred to as
administrative agencies.

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 II. SOURCES OF ADMINISTRATIVE LAW (p. 857)
Administrative law integrates four distinct sources of law that operates in conjunction: (1) US
Constitution; (2) enabling statutes; (3) Administrative Procedures Act; and (4) common law.

A. The U.S. Constitution (p. 857)

Points to emphasize:
• The U.S. Constitution creates a national government of three branches, Congress, the
president, and the courts.
• The constitutional authority of administrative agencies fits within the president’s Article
II power to implement, or carry out, legislation.
• Due to their extensive regulatory oversight, administrative agencies are said to make up a
fourth branch of government.
• The Constitution places limits on the types of powers that agencies may exercise and how
agencies go about executing their functions (limiting unreasonable searches and seizures,
due process rights, judicial review, separation of powers (nondelegation doctrine).
• Nondelegation doctrine=Congress may not give an agency so much rulemaking
discretion that Congress abdicates its responsibility to exercise its powers granted in the
Constitution.

B. Enabling Statutes (p. 857)

Points to emphasize:
• These are the sources of an agency’s authority and establish the agency’s scope and
jurisdiction over matters.

C. The Administrative Procedure Act (APA) (p. 858)

Points to emphasize:
• Created in 1946, the APA imposes procedural requirements on administrative agencies.
• The APA provides for judicial review of agency actions and determinations.

D. Common Law (p. 858)

Points to emphasize:
• Courts sometimes refer to common law when they apply or interpret the APA.

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 III. PRIMARY FUNCTIONS OF ADMINISTRATIVE AGENCIES (p. 859)

A. Rulemaking (p. 859)

Points to emphasize:
• Rulemaking is the agency process for making rules, which can have a similar effect as
legislation.
• Agency rules that have legal effect and impact the rights of parties are known as
legislative rules. This must be authorized by statute.
• Rules issued by federal administrative agencies are published in the Code of Federal
Regulations (CFR).
• Other rules are called non-legislative rules express an agency’s interpretation of a statute
or describe the agency’s policy views and are not legally binding on parties.
• Formal rulemaking is used only when Congress has specifically indicated in the
enabling statute that the agency rules must be made “on the record after a hearing.”
• Informal rulemaking occurs when these steps are followed: (1) the agency conducts a
study and research; (2) the agency gives public notice and publication of the proposed
rule in the Federal Register; (3) the agency solicits public comments; and (4) the agency
revises and publishes the final rule.

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Case 42.1 Association of Private Sector Colleges and Universities v. Duncan [p. 862]

Facts: Congress passed the Higher Education Act (HEA) providing for new federal aid to
postsecondary students and their families that attend public, private and for-profit institutions.
The US Department of Education is charged with the administration and oversight for this
statute. An investigation of for-profit institutions found that students were misled and potential
fraud. New proposed rules were promulgated to prevent fraud and improve accountability. After
a notice and comment period the new rules were published with an additional rule with
requirements for distance learning programs. This was challenged by the APSCU.

Issue: Did the Dept. of Education violate the APA when it added a rule that had not gone
through the notice and comment process?

Ruling: The trial court agreed with the APSCU regarding the distance learning rule. On appeal
the court ruled that the addition of the distance learning rule was not an extension or outgrowth
of the existing rules. Proper notice with an opportunity to comment on the distance learning rules
was not provided to the interested parties.

Answers to case questions:

1. By including an announcement in its notice of proposed rulemaking that specifically

mentioned distance learning and education.

2. That the APA informal rulemaking process is not followed if rules are introduced that are not
reasonably expected by the regulated party as a logical outgrowth of existing regulations.

3. This question is intended to elicit critical thinking responses from the students.

B. Licensing (p. 863)

Points to emphasize:
• Administrative agencies regulate and administer laws through licensing.
• Powers are delegated to issue, renew, suspend, or revoke licenses
• Agencies can fine and restrict licenses to those businesses issued licenses.

C. Investigation and Enforcement (p. 863)

Points to emphasize:
• Inspections are used to monitor compliance with regulations.
• Agencies must not conduct an unreasonable search and seizure.
• Prosecutorial discretion occurs when an agency has a broad discretion as to when or
whom to regulate.
• Agencies can require businesses to (1) keep certain records for inspection, (2) turn over
relevant documents that may be useful to determine compliance with a particular rule,
and (3) request statements or other information from the business’s principals and
managers.

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Case 42.2 Trinity Marine Products v. Secretary of Labor Elaine Chao (p. 864)

Facts: OSHA inspectors were turned away from Trinity so the inspectors obtained an
administrative warrant and returned with federal marshals. Trinity allowed the inspection under
protest.

Issue: Was the warrant issued based upon probable cause? Should a contested warrant be subject
to a hearing?

Ruling: The appellate court ruled in favor of OSHA because the standards for probable cause for
administrative warrants is lower than those for criminal warrants. There was sufficient
information to justify an inspection and when Trinity refused, the use of marshals to gain entry
was appropriate.

Answers to case questions:

1. Likely not since the standards for establishing probable cause under an administrative warrant
are fairly low.

2. When there is no specific evidence of a violation or when there are no reasonable legislative
or administrative standards for conducting an investigation.

3. This question is intended to elicit critical thinking responses from the students.

D. Adjudications (p. 865)

Points to emphasize:
• Agencies may be given authority to adjudicate matters under their jurisdiction with the
use of administrative law judges (ALJ).

E. Administering Public Benefits (p. 865)

Points to emphasize:
• When Congress confers a benefit to citizens at large, administrative agencies distribute
those benefits.
• Use of the application process

IV. LIMITS ON ADMINISTRATIVE AGENCIES (p. 866)

Points to emphasize:
• The three branches of government have tools to limit the power and authority of
agencies.
• Public oversight ensures a degree of transparency and accountability.

A. Legislative Oversight (p. 866)

Points to emphasize:
• Congress can limit agency power by less budgetary funding, enact legislation restricting
agency authority, APA, removal of agency heads, and legislative hearings.

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 B. Executive Control (p. 866)
Points to emphasize:
• Agencies are extensions of the executive branch’s authority to carry out legislative
mandates.
• The executive branch can exert authority through appointments, removal from office, and
executive actions (executive orders).

C. Judicial Review (p. 866)

Points to emphasize:
• Courts look first to the language of the statute.
• Under the Chevron test, courts apply the arbitrary and capricious standard to determine
whether an agency’s actions were lawful.

Case 42.3 Alabama Assn. Of Realtors v. Dept. Of Health and Human Services, 594 U.S. ___
(2021)

Facts: The Director of the Centers for Disease Control and Prevention (CDC) imposed a
nationwide moratorium on evictions of any tenants living in a county experiencing
substantial or high levels of COVID-19 and who demonstrate financial need. The Alabama
Association of Realtors obtained a judgment at the US District Court vacating the CDC’s
moratorium.

Issue: Did the CDC exceed its authority by imposing a nationwide moratorium?

Ruling: The Supreme Court ended the stay and upheld the lower court’s decision to end or
vacate the CDC’s eviction moratorium. The Court held that the CDC exceeded its statutory
authority and only Congress possessed the authority enact a nationwide moratorium on evictions.

Answers to case questions:

1. This question is intended to elicit critical thinking responses from students.

2. Because the CDC exceeded its statutory authority.

3. This question in intended to elicit critical thinking responses from students.

D. Public Accountability (p. 869)

Points to emphasize:
• Public accountability is accomplished through statutorily authorized citizen suits as well
as mandatory-disclosure laws.
• Citizen suits are authorized by many statutes where a member of the public at large who
is directly affected by a particular agency action/inaction can bring a lawsuit against
violators of a particular agency regulation and/or the administrative agency itself for
failing to fulfill a statutory duty.
• Agencies must be transparent by allowing public access to informational records.

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 • The Freedom of Information Act (FOIA) gives the public the right to examine many
government documents.
o Many exemptions: (1) sensitive national defense or foreign policy information,
(2) agency personnel matters, and (3) trade secrets and privileged commercial
information.
• The Government in Sunshine Act requires certain agency meetings to be open to the
public.

CASE 42.4 Consumer Federation of America v. Department of Agriculture [p. 870]

Facts: CFA suspected that a proposed rule from the USDA was weaker than originally proposed
due to industry pressure. CFA filed a FOIA request wanting access to the public calendars of 6
USDA officials/admin. Assistant. USDA failed to timely respond. It ultimately said that the
calendars were not agency records.

Issue: Should the USDA be compelled to disclose the calendars pursuant to the FOIA request?

Ruling: The appellate court ruled in favor of the CFA, overturning the trial court’s decision in
favor of USDA because the calendars were agency records. The calendars were used to conduct
agency business and relied upon by the authors and colleagues to facilitate the day-to-day
operations of the department’s work. However, the administrative assistant’s calendar was not an
agency record.

Answers to case questions:

1. That top USDA officials met with industry representatives who might have lobbied against
the regulation.

2. The calendars has official business; they were distributed widely within the agency and were
relied upon others to make appointments.

3. This question is intended to generate critical thinking responses from the students.

V. STATE ADMINISTRATIVE LAW (p. 872)

Points to emphasize:
• In addition to federal agencies, business owners and managers should expect to encounter
various state administrative agencies.
• State agencies have broad executive, legislative, and adjudication discretion in matters of
state government.
• State administrative law often mirrors the federal system in terms of how regulations are
developed, implemented, and enforced.

Thinking Strategically Questions and Answers [p. 873]

1. Does the Fair Mayo packaging misbrand the product and violate the statute and the FDA
regulation? Why or why not?

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 The key issue here is whether mayo is equivalent to mayonnaise. The real case this
exercise is based on (Just Mayo) settled with the FDA since the legal argument was that
mayo is not mayonnaise, and that if the FDA intended to regulate mayo it would have
used that terminology in the regulations.

2. Should Sarah challenge the FDA warning letter? How can she go about doing this?

See the answer above. In the real case an attorney from the high-profile law firm Boies
Schiller was hired and the core of his response was as indicated above. The attorney
represented the firm and signaled they would be willing to litigate this issue in the courts.

3. What else can Sarah do to reach a compromise with the FDA and ensure compliance?
Should Sarah change her labeling? How?

Sarah could agree to issue more disclaimers in the packaging to indicate the mayo is egg-
free to avoid confusion.

4. How would you respond to the FDA’s letter? Would you seek professional legal advice?
Why or why not?

These questions are intended to elicit critical thinking responses from the students.

Key Terms [p. 875]

Chapter Review Questions [pp. 877-878]

Case Summary Questions and Answers [pp. 875-877]

CASE SUMMARY 42.1 American Medical Association v. United States Internal Revenue
Service, 887 F.2d 760 (7th Cir. 1989)

1. Is the new test a logical outgrowth of the original test? Why or why not?

• Yes, the three factors are a logical outgrowth of the prior seven factors.

2. How could the IRS have avoided a successful challenge to this new rule?

• They could have issued a notice of their change of the final rule from seven
factors to only three factors.

CASE SUMMARY 42.2 Federal Express Corporation v. Holowecki, 128 S. Ct. 1147 (2008)

1. Who prevails and why?

• The EEOC prevails since it did not define a charge and this questionnaire can
be reasonably related to pursuing an agency action as defined by the statute.

2. Will the court defer to the EEOC’s interpretation? Why or why not?

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 • Yes, since the questionnaire fulfils the agency’s requirement to obtain notice
of complaints under the statute.

CASE SUMMARY 42.3 Ranchers Cattlemen Action Legal Fund United Stockgrowers of
America v. U.S. Department of Agriculture, 499 F.3d 1108 (9th Cir. 2007)

1. Is the decision arbitrary and capricious? Why or why not?

• Not as long as there was a fact-based assessment by the agency within its area
of scientific expertise.

2. Does the fact that the agency held several comment periods impact your analysis?
Why or why not?

• Yes, several comment periods indicate that the APA rulemaking process was
upheld and that the agency considered information from several interested
parties.

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 Chapter 43
Consumer Protection

CHAPTER OVERVIEW
This chapters surveys (1) the scope and role of state lemon laws in protecting consumers who
purchase new and used vehicles; (2) the role of the Federal Trade Commission in protecting
consumers against unfair advertising practices; (3) the role of the Food and Drug Administration
in protecting consumers with respect to food and drugs; (4) the role of the U.S. Department of
Transportation with respect to automobile safety and odometer settings; and (5) the role of the
Consumer Financial Protection Bureau with respect to consumer loans, credit transactions, and
the collection of consumer debt.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Summarize the role played by state lemon laws in business transactions with Knowledge
consumers.
Articulate the standards used by the U.S. Federal Trade Commission to define Knowledge
false advertising and other deceptive practices.
Explain the role of the U.S. Food and Drug Administration in protecting Knowledge
consumers with respect to food and drugs.
Summarize the role of the U.S. Department of Transportation with respect to Knowledge
automobile safety and odometer settings.
Explain the role of the Consumer Financial Protection Bureau with respect to Knowledge
consumer loans, credit transactions, and the collection of consumer debt.

Teaching Tip: Lemon Laws

While lemon laws are only a small part of consumer law, it is useful to start the chapter with
them because many students can relate to lemon laws as many have bought or will soon being
buying their first new or used car.

I. STATE LEMON LAWS [p. 880]

Points to emphasize:

• In general, a lemon refers to a new or used vehicle that turns out to have serious
manufacturing defects affecting its safety, value, or utility.
• Most new-vehicle lemon laws require that an auto manufacturer repurchase a vehicle
with a significant defect that the manufacturer is unable to repair within a reasonable
amount of time.
• Lemon laws generally consider the nature of the problem with the vehicle, the number of
days that the vehicle is unavailable to the consumer for service of the same mechanical
issue, and the number of repair attempts made.

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 • If repairs cannot be completed within the total number of days described in the state
statute, the manufacturer becomes obligated to buy back the defective vehicle.

II. DECEPTIVE TRADE PRACTICES [pp. 881-883]

Points to emphasize:
• The Federal Trade Commission (FTC) is an independent agency of the United States
government.
• The main mission of the FTC is to protect consumers against anticompetitive, deceptive,
and unfair business practices.

A. False Advertising [p. 881]

Points to emphasize:

• The Federal Trade Commission Act (FTCA) is federal law enacted to protect consumers.
• The FTCA established the FTC and charged the FTC with the broad mandate of
preventing unfair and deceptive acts or trade practices in commercial transactions.
• A deceptive practice is one that results in some sort of detriment to the consumer.
• Making expressly false statements in an advertisement about a product’s quality,
ingredients, or effectiveness is prohibitive deceptive advertising.
• Fake testimonials or fake endorsements are also prohibited.
• The FTC also investigates bait-and-switch schemes in which a seller advertises an item
sale at a particularly good price or on favorable terms, but the seller has not intention of
actually selling that product at that price or on those terms. The seller discourages the
purchase of the advertised item and instead tries to convince the buyer to purchase a
different item for a higher price or on less favorable terms.
• Common forms of deceptive advertising via pricing include (1) misrepresenting the
prices of a competitor; (2) artificial inflation of retail price to make the sale price seem
better; and (3) using “clearance priced” or “marked down for sale” when the item does
not have a reduced price.

B. Telemarketing and Do Not Call Registry [pp. 881-882]

Points to emphasize:

• The Telephone Consumer Protection Act and the Telemarketing and Consumer
Fraud and Abuse Act combined (1) allow consumers to opt out of receiving unwanted
calls from telemarketers, (2) ban the use of unsolicited recorded calls and faxes, (3)
regulate 900-number calls to prevent consumers from unknowingly generating charges,
(4) prohibit telemarketers from making false representations, and (5) require disclosure of
all material terms of a proposed transaction.
• Consumers can sign up on the Do Not Call Registry to be on a list that protects them
from certain unsolicited calls by telemarketers.

C. Spam [p. 882]

Points to emphasize:

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 • The Controlling the Assault of Non-Solicited Pornography and Marketing Act of
2003 (CAN-SPAM Act) outlawed most of the dubious methods used by spammers
offering unsolicited e-mails advertising products or services and imposed criminal
sanctions in severe cases.
• The CAN-SPAM Act also prohibits spammers (online marketing providers) from
falsifying the “from” name and information in the subject line designed to fool
consumers into opening an unsolicited e-mail message. It also imposed an affirmative
obligation on the sender to notify the recipient of procedures to opt out of receiving any
future e-mail for the sender.
• The CAN-SPAM Act also allows e-mail recipients, in some cases, the right to bring a
private lawsuit directly against the spammer.

D. Consumer Review Fairness Act of 2016 [p. 883]

Points to emphasize:

• The Consumer Review Fairness Act (CRFA) protects people’s ability to share their
honest opinions about a business’s products, services, or conduct in any forum, including
social media.
• The law specifies that a violation of the CRFA will be treated the same as violating the
FTC rule defining an unfair and deceptive act or practice.

III. FOOD AND DRUG SAFETY [pp. 883-884]

Points to emphasize:
• The Food and Drug Administration (FDA) is a federal agency of the Untied States
Department of Health and Human Services.
• The FDA is empowered to enforce the Food, Drug, and Cosmetic Act (FDCA) to
regulate the testing, manufacture, and distribution of foods, medications, medical devices,
and cosmetics.
• The FDCA requires that certain food ingredients, additives, drugs or medical devices
obtain formal FDA approval prior to selling the product to the general public.
• FDA regulations also govern the labeling of food packages and define specific food
safety processes, procedures, and standards.
• The FDA investigates any public outbreaks of illness related to food contamination. Its
powers include seizure of contaminated products, mandatory recalls, civil enforcement
lawsuits, fines, and criminal prosecution for egregious cases.
• The FDA is led by the Commissioner of Food and Drugs, who is appointed by the
president with the advice and consent of the Senate. The Commissioner reports to the
Secretary of Health and Human Services.

IV. AUTOMOBILES [p. 885]

Points to emphasize:

• The United States Department of Transportation (DOT) is concerned with transportation

and public safety.

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 • The Highway Safety Act of 1970 created the National Highway Traffic Safety
Administration (NHTSA). The NHTSA is charged with writing and enforcing motor
vehicle safety standards as well as regulations for motor vehicle theft resistance and fuel
economy under its Corporate Average Fuel Economy (CAFE) System.
• The NHTSA also licenses vehicle manufacturers and importers, allows or blocks the
import of vehicles and safety-regulated vehicle parts, administers the vehicle ID number
(VIN) system, develops the dummies used ins safety testing, and provides automobile
insurance cost information.
• NHTSA also created and maintains the data files by the National Center for Statistics and
Analysis. The Fatality Analysis Reporting System (FARS) has become a resource for
traffic safety research.
• The Federal Odometer Act makes it a crime to change vehicle odometers and requires
that any faulty odometer be plainly disclosed in writing to potential buyers. This law (1)
defines and prohibits odometer tampering, (2) prohibits buying or installing devices used
for tampering, (3) prescribes procedures for odometer repair, (4) requires disclosures
about the actual mileage of a vehicle when it is sold, (5) gives jurisdiction to the
Secretary of Transportation to enforce the statute, and (6) imposes recordkeeping
requirements on dealers and distributors of vehicles.

V. CONSUMER DEBT [pp. 885-890]

Points to emphasize:

• The Consumer Financial Protection Bureau (CFPB) is empowered to monitor and

regulate consumer financial markets, including consumer loans and credit cards.
• The main mission of the CFBP is provide consumer protection by offering education
programs and information, by performing research and providing data to lawmakers and
the public, and by creating policy and enforcing rules to protect consumers from fraud
and unfair practices.

A. Credit Transactions [p. 886]

Points to emphasize:

• A consumer credit transaction takes place between a creditor and a borrower.

• Under the Fair and Accurate Credit Transactions Act (FACTA), consumers
(borrowers) are entitled to request a free copy of their credit reports once every 12
months.
• The Consumer Credit Protection Act (CCPA) regulates credit transactions between a
creditor and a borrower.
• The Truth in Lending Act (TILA) is part of the CCPA and requires lenders to disclose
to borrower applicants certain information about the loan or terms of credit.
• In Case 43.1, a court considers a consumer’s claim that she was entitled to cancel a loan
contract because the required cancellation notice was inadequate.

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Case 43.1 Palmer v. Champion Mortgage, 465 F.3d 24 (1st Cir. 2006)

Facts: In March 2003, Palmer obtained a debt-consolidation loan from Champion that was
secured by a second mortgage on her home. On the day of the closing, Palmer signed several
loan documents as well as the required TILA disclosures. Several days later, Palmer received
copies of these documents by mail along with the “notice of her right to cancel” disclosure
required by the TILA. In August 2003, she filed for cancelation which was not within the allotted
time (three business days) described in the notice. Palmer claimed that the right to cancel should
be extended and that Champion failed to make the TILA disclosures because the time frames in
the cancelation notice were too confusing.

Opinion: The U.S. Court of Appeals for the First Circuit affirmed the trial court’s decision and
dismissed Palmer’s claim. The court held that the notice complied with the TILA disclosure
requirements and that an objectively reasonable consumer would not find the notice confusing.

Case Questions

1. Given the language of the time frame notice, do you agree with the court’s statements that it
was clear and that objectively reasonable consumers would not be confused by it? Why or why
not?

• According to the court, the language in the notice was clear and concise. Not only did it
say “three days”, it noted the latest postmark date that would be accepted.

2. The court says that any “reasonable alert” person is the average consumer. Do you agree that
the average consumer is reasonably alert? What standard should be used to judge the “average
consumer”?

• The court used an objectively reasonable person standard. The average customer is
reasonable.

3. Focus on Critical Thinking. Examine Figure 44.4. This is a notice that is similar to the notice
Palmer received. Does it affect your analysis?

• The students should review the figure and share their opinions.

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 B. Debt Collection [pp. 888-890]

Points to emphasize:

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 • Consumer credit transactions are heavily regulated in an effort to protect consumers and
to level the playing field between creditors and consumer debtors.
• The Fair Debt Collection Act (FDCPA) applies to agents involved in debt collection for
consumer debts. It applies only to agents of the debtor. A creditor attempting to collect
her own debt is not subject to the act.
• The FDCPA requires that the collection agency make known certain rights of the debtor
in a validation disclosure when making the initial inquiry about the debt.
• Under the FDCPA, the collection agency must investigate any disputed debt and obtain
written verification of the debt from the original creditor.
• The FDCPA limits the contact that a debt collector may have with third parties and
makes certain methods of collection unlawful (e.g., harassing).
• In Case 43.2, the CFPB investigates the unlawful collection practices of a law firm.

Case 43.2 U.S. Consumer Financial Protection Bureau v. Pressler & Pressler LLP, Consent
Order, 2016-CFPB-0009 (2016)

Facts: The Consumer Financial Protection Bureau (CFPB) investigated Pressler & Pressler, LLP
(Pressler), a law firm, due to the numerous complaints from consumers concerning violations of
the Fair Debt Collection Practices Act (FDCPA). The investigation revealed multiple instances
of debt-collection efforts in which Pressler employees violated the “False or Unsubstantiated
Representations about Owing a Debt” section of the Fair Credit Reporting Act (FRCP). In
addition, the firm filed more than 500,000 lawsuits against consumers for payments due to
various creditors. This massive litigation mill was powered by an automated claim-preparation
system and by non-attorney support staff, who determined which consumers to sue. Actual
attorneys spent less than a few minutes reviewing each case before initiating a lawsuit.

Opinion: The CFPB announced that it had entered into a Consent Order with the Pressler law
firm whereby Pressler and its two principal partners agreed to a civil fine of $1 million. Pressler
agreed to halt the practice that caused the filing of inaccurate mass-produced lawsuits targeting
consumers in debt in violation of both the FDCPA and the Dodd-Frank Wall Street Reform and
Consumer Protection Act. In sum, Pressler failed to obtain documentation from creditors
verifying the validity and the accuracy of the debt owed.

Case Questions

1. Although this is an enforcement action against Pressler by the CFPB, do individual who have
been victimized by Pressler have any legal recourse?

• The FDCPA also provides individual consumers with a statutory cause of action so that a
debtor may sue a collection agent directly for any damages suffered, plus attorney fees
incurred in bringing suit.

2. Why is it relevant that actual attorneys generally spent less than a few minutes, sometimes
less than 30 seconds, reviewing each case before initiating a lawsuit?

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 • Not enough time was spent by the experts verifying the accuracy and the validity of the
debt owed by consumers to the law firm’s clients. Some of the lawsuits were frivolous
and could have been avoided if an attorney had reviewed the material more carefully.

3. Focus on Critical Thinking. Have you, a family member, or a friend ever been contacted by a
debt collector? Did the collection agent use intimidations tactics? In your opinion, did he or she
violate the FDCPA? Did the debt collector act ethically? Explain.

• This question can be used to start a discussion in the class; however, some students may
be reluctant to share this information.

VI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [pp. 891-892]

Chapter Review Questions [pp. 894-895] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [pp. 890-891]

Checkout section 10 of AirBnB’s Terms of Service here: http://www.airbnb.com/terms#sec10

(“Ratings and Reviews”). In your opinion, does Section 10 of AirBnB’s user agreement comply
with the Consumer Review Fairness Act? Why or why not?

• This question is designed to generate discussion about statutory interpretation and

statutory compliance. The Consumer Review Fairness Act protects the right of consumers
to leave honest reviews about a business, while Section 10 AirBnB’s user agreement
allows both guests and hosts to leave reviews about each other!

Case Summary Questions and Answers [pp. 892-894]

CASE SUMMARY 43.1 Phoenix of Broward, Inc. v. McDonald’s Corp., 489 F.3d 1156 (11th
Cir. 2007)

1. In addition to the FBI, which consumer protection agency of the federal government would
also have legal authority to investigate this matter?

• The FTC because it has the legal mandate under the Federal Trade Commission Act to
prevent unfair and deceptive acts or trade practices in commercial transactions.

2. What legal actions could the consumer protection agency identified in Question 1 take
against McDonald’s?

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 • The FTC could issue new regulations regarding promotional games, update its existing
regulations, and/or bring an enforcement action against McDonald’s for unfair and
deceptive acts or trade practices.

CASE SUMMARY 43.2 Barrer v. Chase Bank USA, 566 F.3d 883 (9th Cir. 2009)

1. Do Chase’s actions comply with the TILA? Why or why not?

• This question is designed to generate discussion about applied statutory interpretation—

in this case, whether the “Change in Terms” in the credit card agreement were
sufficiently clear and conspicuous.

2. Why shouldn’t the Barrers be liable for failing to reject the new terms?

• Because TILA requires that the new terms be clear and conspicuous; specifically, if a
court agrees with the plaintiffs (the Barrers) that the new terms were not sufficiently clear
and conspicuous, then it does not matter under TILA that they failed to state their
objection to the new terms.

CASE SUMMARY 43.3 Myers v. LHR, Inc., 543 F. Supp. 2d 1215 (S.D. Cal. 2008)

1. Were LHR’s actions lawful under the FDCPA? Why or why not?

• This question is designed to generate discussion about statutory interpretation. The

FDCPA limits the contact that a debt collector may have with third parties and makes
certain methods of collection unlawful (e.g., harassment) but it does not specify whether
the conduct described above falls within its ambit.

2. If LHR’s actions were not lawful, what could it have done to comply with the act?

• This question is designed to generate discussion about statutory compliance. One could
argue that LHR should have rejected the $3000 settlement if LHR was going to report
Ms. Meyers to credit agencies.

CASE SUMMARY 43.4 U.S. v. Facebook, Inc., Case No. 19-cv-2184 (D.D.C. 2019)

1. Should Facebook users whose data was harvested by Cambridge Analytica without their
consent receive compensation from the $5 billion penalty Facebook agreed to pay to the
FTC?

• This question is designed to generate discussion about the difference between private and
public legal remedies. When a private party brings a private action (such as a lawsuit for
tort) against a defendant, the plaintiff may often be entitled to recover monetary damages
directly from the defendant, but when an administrative agency (like the FTC in this
case) brings a public enforcement action, any monetary recovery usually goes to the
government.

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2. Assume Facebook was unaware of what Cambridge Analytica was doing with its users’ data.
Why should Facebook have to answer for the misdeeds of Cambridge Analytica?

• This question is designed to generate discussion about the general legal of principle of
vicarious liability. On the one hand, one could argue that A should not be legally
responsible for the actions of B, but in this case, Facebook had entered into a consent
order with the FTC in which Facebook voluntarily agreed to do a better job protecting
user privacy. Given this consent decree, one could argue that Facebook had a legal duty
to monitor the behavior of firms like Cambridge Analytica.

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 Chapter 44
Criminal Law and Procedure

CHAPTER OVERVIEW
This chapter discusses how criminal law, criminal procedure, and the criminal justice system
impact the legal environment of business.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Distinguish between criminal law and criminal procedure. Application
Compare and contrast criminal law with civil law. Application
Articulate the requirements for criminal liability. Knowledge
Identify circumstances in which business managers and owners may be liable Application
for criminal violations by a corporation.
Provide specific examples of white-collar crime laws that may impact a Application
business entity and/or its owners and managers.
Differentiate between the investigative phase and the adjudication phase in Application
the criminal justice system.
Explain various constitutional procedural protections afforded to those Knowledge
accused of a crime.
Articulate the exclusionary rule and how it applies in a business context. Application

I. CRIMINAL LAW VERSUS CRIMINAL PROCEDURE [p. 897]

Points to emphasize:

• Whereas criminal law defines the boundaries of behavior and prescribes sanctions for
violating those boundaries, criminal procedure refers to the legal process and safeguards
afforded to individuals (and in some cases business entities) during criminal
investigations, arrests, trials, and sentencing.
• Criminal law consists of a body of law that, for the purposes of preventing harm to
society, defines what conduct is criminal and prescribes the punishment to be imposed for
such conduct.
• Criminal procedure sets limits on the government’s authority in applying criminal law.

II. CRIMINAL LAW AND CIVIL LAW [p. 897]

Points to emphasize:

● Civil laws are designed to compensate parties (including businesses) for damages as a
result of another’s conduct. Criminal statutes are designed to protect society, and the
violation of a criminal law results in a penalty to the violator, such as a fine or
imprisonment, based on the wrongdoer’s level of culpability.

● Nearly two-thirds of the states have enacted criminal codes based on the Model Penal
Code (MPC) adopted by the American Law Institute (ALI) in 1962.

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 A. Burden of Proof [p. 897]
One significant difference between a criminal case and a civil case is the burden of proof. In a
civil case, the plaintiff needs to prove only by a preponderance of the evidence that the
defendant committed a civil wrong (the fact finder need be convinced only that the defendant’s
liability was more likely than not to be true for the plaintiff to meet her burden of proof). In a
criminal case, the government must prove its case beyond a reasonable doubt (the fact finder
must be convinced that the defendant’s criminal liability is not in doubt to a reasonable person).

III. CRIMINAL LIABILITY [p. 898-900]

Points to emphasize:
● From a legal perspective, a crime has two parts: (1) a physical part, in which the
defendant committed an act or omission, and (2) a mental part, which involves the
defendant’s subjective state of mind.

A. Act Requirement [p. 898]

The act requirement, also called by its Latin name, actus reus, requires the government to prove
that a defendant’s actions (overt conduct) objectively satisfied the elements of a particular
offense. An act by omission occurs when a crime is defined in terms of failure to act.

B. Mental Requirement [p. 898-899]

The mental element, also called by its Latin name, mens rea, which translates literally as “guilty
mind,” requires that the defendant have a requisite degree of culpability with regard to each
element of a given crime. The words contained in a criminal statute to express the guilty mind
requirement include intentionally, knowingly, maliciously, willfully, and wantonly. Some statutes
permit culpability with a showing of reckless or negligent conduct.

C. Defenses [p. 899]

● Even when the requisite mental state and criminal act standards are proved, the law
provides for certain defenses.
● Self-defense is an example of a defense to a criminal charge of homicide in which the
law recognizes that certain cases necessitate the use of deadly force to repel an attack
when the defendant reasonably fears that death or substantial harm is about to occur
either to the defendant or to a third party.

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 ● Mental incapacity is a defense when the defendant’s actions to be related to some type
of mental disease or defect.
● Duress can be a defense when the defendant has committed a crime in response to
another person’s threat to inflict personal injury (threats to property or reputation are
insufficient).
● Intoxication, which standard varies on whether the intoxication was voluntary or
involuntary, can also be a defense the defendant unable to understand that his conduct
constituted a crime.

D. Types of Crime [p. 899-900]

Crimes may be classified in several different ways. Felonies are crimes that generally carry one
year or more of incarceration as the penalty. Misdemeanors are crimes that carry up to one year
of incarceration as the penalty. Many states also have a classification of crimes known as
summary offenses or infraction offenses, which are minor crimes that carry no threat of a jail
sentence for first-time offenders.

IV. CRIMINAL LAW AND BUSINESS ENTITIES [p. 900-901]

Points to emphasize:

● The modern trend in criminal law is to expand the scope of criminal statutes to include
criminal culpability for corporations and their principals.
● The Model Penal Code (MPC) provides for criminal liability for business entities if any
one of the following applies: (1) The criminal act by the business’s agent is within the
scope of his employment and the statute imposes liability on the business for such an act,
(2) The criminal omission is the failure to perform a specific duty imposed by law, or (3)
The crime is authorized by one of the corporation’s top-level managers.

A. Individual Liability for Business Crimes [p. 900]

Congress and state legislatures have also expanded criminal culpability for individual officers
and directors (and sometimes majority owners) for corporate crimes committed within the scope
of their employment. Because of the inherent difficulties in terms of proof, most statutes do not
require the specific mental intent (guilty mind) that is required for other crimes.

B. Responsible Corporate Officers: The Park Doctrine [p. 901]

The responsible corporate officer doctrine, commonly referred to as the Park doctrine, permits
the government to prosecute employees for corporate misconduct when they are in a position of
authority and fail to prevent or correct a violation of the Food, Drug, and Cosmetic Act (FDCA).

CASE 44.1 United States v. DeCoster, 828 F.3d 626 (8th Cir. 2016)

Facts: Jack DeCoster owned Quality Egg, LLC, an Iowa egg production company. Jack’s son
Peter DeCoster served as the company’s chief operating officer. In one of the facilities in Maine,
salmonella was detected and remedied. Even though salmonella was suspected at the facility in
Iowa, Quality Egg continued to sell eggs from this facility. In 2010, 56,000 people became ill
due to eggs from Iowa. An FDA inspection revealed dangerous conditions that led to the

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contamination. The government began a criminal investigation of the company’s food safety
practices and ultimately filed criminal charges for failing to prevent or correct a violation of the
Food, Drug, and Cosmetic Act (FDCA). The DeCosters both pled guilty, as responsible
corporate officers of Quality Egg, LLC, for introducing eggs that had been adulterated with
salmonella into interstate commerce. The trial court sentenced Jack and Peter to three months’
imprisonment. The DeCosters appealed, arguing that their prison sentences were unreasonable
and disproportionate because they had no specific knowledge of the eggs the company
distributed had salmonella.

Issue: In order to find corporate officers criminally liable, must they be aware of the actual
violation?

Ruling: No, the appellate court affirmed the criminal sentence stating that under the FDCA,
responsible corporate officers who by reason of their position in the corporation have the
responsibility and authority to take necessary measures to prevent or remedy violations of the
FDCA and fail to do so, may be held criminally liable as responsible corporate agents, regardless
of whether they were actually aware of or intended to cause the violation. The DeCosters knew
or should have known about the contamination based on their previous experiences.

Case Questions

1. Why is it important in this case that the DeCosters’s conduct violated the FDCA? Because the
Park doctrine only applies to violations of the FDCA.
2. What was the DeCosters’s theory of the case on appeal? Because they were not specifically
aware of the salmonella contamination in the Iowa plant, they lacked the mental intent necessary
to be held criminally liable.
3. Focus on Critical Thinking: Given what we know about the impact of the salmonella outbreak
in 2010, would there be any tort claims against Quality Egg? Against the DeCosters? Explain.
This question is meant to elicit a discussion on potential tort cases arising from criminal
conduct.

V. WHITE COLLAR CRIME [p. 903-909]

Points to emphasize:
● White-collar crimes usually signify criminal violations by corporations or individuals,
including fraud, bribery, theft, and conspiracy committed in the course of the offender’s
occupational duties.

A. Fraud [p. 903-904]

Fraud is the most common white-collar crime and is used to describe a transaction in which one
party makes false representations of a matter of fact (either by words or conduct) that are
intended to deceive another. The basic elements of criminal fraud are (1) a false representation
(or concealment) concerning a material fact (one that is essential to the agreement or one that
affects the value of the transaction) and (2) another party that relies on the false
misrepresentation of the fact and suffers damages as a result. In 1990, Congress passed the Mail

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Fraud Act with the intent of giving federal prosecutors significant leverage in prosecuting
white-collar criminals. The statute criminalizes any fraud in which the defrauding party uses the
mail or any wire, radio, or television in perpetrating the fraud. Another form of fraud is
embezzlement. Embezzlement involves fraudulent concealment of financial records to perpetrate
theft by someone in a position of trust.

B. Ponzi Schemes [p. 904-905]

A Ponzi scheme is a fraudulent investment operation that pays returns to investors from their
own money or money paid by subsequent investors rather than from any actual profit earned.
The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-
increasing flow of money from investors in order to keep the scheme going. The largest Ponzi
scheme ever operated by a single person, was perpetrated by investment manager, Bernard
Madoff, who cost his investors billions of dollars. Madoff pleaded guilty to 11 felonies,
including fraud and perjury and was sentenced to 150 years in prison.

C. Conspiracy [p. 905]

Conspiracy is an agreement by two or more persons to commit a criminal act. Because the crime
is complete upon agreement, there is a very low threshold for satisfying the criminal act
requirement. Conspiracy requires a specific intent to achieve the object of the conspiracy but
does not require that the act actually be carried out.

D. Obstruction of Justice [p. 905]

Prosecutors have been increasingly willing to prosecute white-collar criminals under federal laws
prohibiting the obstruction of justice for any conduct related to attempting to cover up evidence
of wrongdoing. Cover-ups take many forms, including (1) lying to investigators, (2) altering
documents, (3) shredding or concealing documents or any media such as videotape, and (4)
inducing other witnesses to lie or influencing witnesses to refrain from cooperating with
authorities.

E. Racketeer Influenced and Corrupt Organizations Act [p. 905-906]

The federal Racketeer Influenced and Corrupt Organizations Act (RICO) was enacted in
1970 to provide the government with a powerful tool to fight the rising tide of organized crime.
Because RICO laws define racketeering in such broad terms, including crimes such as wire
fraud, mail fraud, and securities fraud, prosecutors have been increasingly willing to bring RICO
cases in white-collar crime and political corruption cases. Although the penalties under RICO are
stiff, the real teeth of the law are found in its forfeiture provisions (permitting the government to
seize the defendant’s personal assets if the government can prove they were obtained through
criminal activity.

F. Securities Crimes [p. 906]

In the wake of the financial crisis that began in 2008, the government has become increasingly
aggressive about the enforcement of insider trading laws, which are federal securities statutes
directed at corporate insiders who have access to certain information that is not available to the
general investment public.

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 G. Foreign Corrupt Practices Act [p. 906-907]
The Foreign Corrupt Practices Act (FCPA) of 1977 is a criminal statute that was enacted
principally to prevent corporate bribery of foreign officials in business transactions. The law
prohibits a company and its officers, employees, and agents from giving, offering, or promising
anything of value to any foreign (non-U.S.) official with the intent to obtain or retain business or
any other advantage. This prohibition is interpreted broadly in that companies may be held liable
for violating the antibribery provisions of the FCPA regardless of whether they take any action in
the United States

CASE 44.2 United States v. Esquenazi, 752 F.3d 912 (11th Cir. 2014)

Facts: Esquenazi was a co-owner/ president of Terra which purchased phone time from foreign
vendors and resold the minutes to customers in the United States. Terra contracted to buy
minutes from Teleco, a foreign corporation, directly. In October 2001, Terra contacted Teleco
about $400,000 in past-due accounts. According to testimony at trial, Antoine (Terra’s Director
of International Relations) agreed to reduce Terra’s future bills to Teleco in exchange for
receiving from Terra 50 percent of what the company saved. Esquenazi was fully aware of the
arrangement and shared details of the deal in a meeting with executive management. The
following month, Terra began funneling personal payments to Antoine using the subterfuge of
sham consulting agreements. As part of an IRS investigation, Esquenazi admitted he had bribed
Teleco officials. The government charged Esquenazi and other Terra officials with several
counts of violating the Foreign Corrupt Practices Act (FCPA). Esquenazi pleaded not guilty,
proceeded to trial, and was found guilty on all counts. On appeal, Esquenazi argued that his
conviction should be reversed because the FCPA did not apply to the Terra-Teleco payments
because they were paid directly to Teleco, a corporation, and not to “foreign officials” as
required by the FCPA.

Issue: Can a corporation be an “instrumentality” of a foreign government meeting the

requirement of the FCPA?

Ruling: Yes, the appellate court affirmed the criminal conviction of Esquenazi holding that
Teleco was an “instrumentality” of the Haitian government due to the government’s involvement
in the day-to-day decisions of the company (97% of ownership in Teleco was held by the Haitian
government).

Case Questions

1. Why is it important to the court’s analysis that Antoine set up a sham company and consulting
agreements? This conduct demonstrates both the requisite acts and mental state required for a
criminal conviction.
2. If Esquenazi had not known about the bribes, would he still be guilty under the FCPA? It
would depend on the circumstances but generally the FCPA requires that the defendant knew or
had reason to know that it will likely be given to a government official.

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6
3. Focus on Critical Thinking: This case was controversial because it was the first time that an
appellate court had interpreted the term “foreign official” in the FCPA so broadly. Critics
contend that the court inserted its own broad definition instead of using the narrower definition
intended by Congress. Did the court go too far? If Congress had meant to include public/private
partnerships in the definition of a foreign official, wouldn’t they have added it into the statute? Is
this good public policy? These questions are meant to encourage a discussion on how far courts
should go in interpreting language in a statute.

H. Computer Fraud and Abuse Act [p. 908]

There are three major classes of criminal activity through use of a computer: (1) engaging in
unauthorized use of a computer, (2) creating or releasing a malicious computer program, and (3)
harassing and stalking in cyberspace. In a 1983 incident that received substantial media attention,
a group of hackers managed to access the computer system at Sloan-Kettering and alter patient
files. The incident led to passage of the Computer Fraud and Abuse Act (CFAA), which was
amended in 2001 by the USA PATRIOT Act. The law prohibits unauthorized use of computers
to commit seven different crimes: (1) espionage, (2) accessing unauthorized information, (3)
accessing a nonpublic government computer, (4) fraud by computer, (5) damage to computer, (6)
trafficking in passwords, and (7) extortionate threats to damage a computer.

VI. THE CRIMINAL JUSTICE SYSTEM [p. 909-910]

Points to emphasize:
● The criminal justice system operates in two phases: investigation and adjudication.
● Procedural safeguards that are afforded to those suspected or accused of crimes constitute
criminal procedure and are discussed in the next section of this chapter.

A. Investigation [p. 909]

● During the investigation phase, the authorities become aware of an alleged criminal act
and begin an investigation by gathering physical evidence and interviewing witnesses and
potential suspects.
● A warrant may be issued based only on probable cause.
● Once the authorities believe that sufficient evidence creates enough probable cause to
indicate the culpability of a suspect, they will, either obtain an arrest warrant or, more
commonly, arrest the suspect by taking him into physical custody. The suspect, now
charged, is referred to as the defendant and is formally read the charges by a magistrate.
● The magistrate then sets bail (if appropriate) and, if necessary, appoints an attorney to
represent the defendant.
● The prosecutor decides whether to (1) proceed with prosecuting the defendant on the
original charge, (2) amend the charges as necessary, or (3) drop the charges altogether
due to lack of evidence.

B. Adjudication [p. 910]

● If the prosecutor elects to proceed with the charges, the defendant is entitled to a
preliminary adjudication. The prosecutor presents evidence of the defendant’s guilt, and
the decision maker (either the grand jurors or the magistrate) determines whether
probable cause exists to hold the defendant over for trial or dismiss the charges.

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7
 ● The defendant is notified that he is held over for trial through either an indictment (in the
case of a grand jury) or formal filing of an information (in the case of a magistrate).
● The defendant is then entitled to an arraignment in a state trial court, at which he is
informed of the final charges and is asked to enter a plea of guilty, not guilty, or no
contest.
● If a plea agreement cannot be reached, the case proceeds to trial.
● In a trial, the finder of fact (usually a jury in a criminal trial) weighs the evidence and
determines whether the prosecutor has proved the charges against the defendant beyond a
reasonable doubt. If the jury finds the defendant guilty, this results in a conviction. If the
jury finds the defendant not guilty, this results in an acquittal and the defendant cannot be
prosecuted for the same charges again. If the jury is deadlocked (unable to reach a
consensus decision), this results in a mistrial and the prosecutor decides whether or not to
file charges against the defendant a second time.
● If the defendant is convicted, he may file an appeal setting out the basis for having the
conviction reversed.

VII. CRIMINAL PROCEDURE [p. 911-913]

Points to emphasize:
● While criminal law defines the boundaries of behavior and prescribes sanctions for
violating those boundaries, criminal procedure refers to legal safeguards to protect the
rights of individuals (and in some cases business entities) during investigation by the
government, arrest, trial, and sentencing.
● The protections are primarily provided by the U.S. Constitution’s Bill of Rights.

A. Searches and Arrests [p. 911-912]

The Fourth Amendment to the U.S. Constitution protects individuals (and sometimes businesses)
from unreasonable search and seizure by government agents and permits warrants to be issued
only if probable cause exists. A warrant is usually required before a search takes place (with
certain exceptions). A warrant for arrest is generally not required to take a suspect into custody.
Regardless of whether a search or arrest warrant exists, the action taken by authorities must
always be reasonable and consistent with constitutional protections. The authorities may conduct
limited, warrantless searches in certain cases.

B. Expectation of Privacy [p. 912]

A fundamental part of the protections provided by the Fourth Amendment is that its protections
are based on whether an individual’s reasonable expectation of privacy has been violated by
government authorities. While individuals have a high level of expectation of privacy in their
homes, it is diminished when they appear in public.

C. Plain View Doctrine [p. 912-913]

Courts have held that authorities generally do not commit a Fourth Amendment violation under
the plain view doctrine which is when a government agent obtains evidence by virtue of seeing
an object that is in his plain view and the agent has the right to be in the position to have that
view. Courts have limited authorities’ ability to obtain information by means of special high-tech
devices that are not available to the general public. In holding that the use of a thermal imager to
peer into a home constituted an illegal search, the Court reasoned that because the data could not

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8
be obtained through use of the naked eye or basic equipment available to the general public, the
action constituted a search even though government authorities had not physically entered the
house. The courts have adopted a similar position regarding aerial observations made by
authorities.

D. Search Incident to Arrest [p. 913]

The search incident to arrest exception allows a law enforcement officer who has lawfully
arrested a defendant to search the defendant’s person without obtaining a warrant. The primary
reasons that justify this exception are (1) protection of the officer/agent and others involved in
the booking process and (2) prevention of the destruction of evidence by the defendant.

1. Electronic Devices [p. 913]

One increasingly important issue faced by law enforcement is the extent to which electronic
devices, such as cell phones, fit into current law of unlawful search and seizure as defined by the
Fourth Amendment.

Teaching Tip: Cell phone privacy

In addition to the Riley v. California case, you could make the students aware of Carpenter v.
U.S. which held that the government needs a warrant to track your cell phone location data
https://www.supremecourt.gov/opinions/17pdf/16-402_h315.pdf.

CASE 44.3 Riley v. California, 144 S. Ct. 2473 (2014)

Facts: Riley was arrested for concealed possession of two loaded handguns found under the seat
of his car during a traffic stop. When examining Riley’s phone at the police station, a detective
found videos and photographs that connected Riley with a gang-related shooting. Prosecutors
argued that the search of the cell phone was proper because it was incident to a lawful arrest
within the guidelines of previous case law. The trial court denied Riley’s motion to suppress the
evidence based on the Fourth Amendment, and Riley was convicted at trial. Riley appealed to
the U.S. Supreme Court, arguing that the evidence obtained from his cell phone was a
warrantless search that did not fall into any category of exception.

Issue: Can the government search the contents of a cell phone collected incident to arrest
without a warrant?

Ruling: No, the Supreme Court held that the digital era required a rule that individuals have a
high level of expectation of privacy in their cell phones because they are capable of storing and
accessing a quantity of information, some highly personal, that no person would ever have had
on his person in hardcopy form. The Court also reasoned that the search incident to arrest
exception to the warrant requirement had two primary purposes: officer safety and prevention of
the destruction of evidence (neither of which applied to the instant facts).

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Case Questions

1. The Court has held previously that a search incident to arrest may include the defendant’s
wallet/ purse. Is there really a difference between a wallet and a cell phone? What if Riley’s
wallet had contained incriminating photographs of him? Would the police be required to get
a warrant?
• Items in a wallet can be used to harm an officer or be easily destroyed. While what is in a
phone is not either, it also contains highly personal items that would most likely never be
found on a person in hard copy.

2. Why does the Court point out that the warrant requirement is “not merely an inconvenience to
be somehow ‘weighed’ against the claims of police efficiency”? How is that related to
Riley’s circumstances?
• A warrant is constitutionally required to protect citizens from government overreach.

3. Focus on Critical Thinking: In what way does this case illustrate the clash between
technology and case precedent? What role does stare decisis (“let the decision stand”) play in
this case?
• These questions are meant to create a discussion on how the law must keep up with
changes in technology and how that plays into precedent.

E. Search of Business Premises [p. 914-915]

Courts have been very reluctant to extend reasonable-expectation-of-privacy rights to the
workplace. Certain businesses are classified as pervasively regulated and, therefore, are not
entitled to full Fourth Amendment protections. Even in cases where courts have held that
administrative agencies are required to obtain an administrative warrant to conduct an inspection
of a business, the Court has held that agencies are held to a lower standard of probable cause to
obtain the warrant than would be required if the government were obtaining a criminal warrant.

F. Self-Incrimination [p. 915-916]

● The Fifth Amendment provides that no person “shall be compelled in any criminal case
to be a witness against himself.” This means that individuals have the right not to offer
any information or statements that may be used against them in a criminal prosecution.
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 Note that the right against self-incrimination also protects those called as witnesses in
other types of matters.
● Although most case law surrounding this right deals with police interrogations of a
suspect, business owners and managers should realize that agents of regulatory agencies,
such as the Internal Revenue Service, are bound by the same guidelines as agents of
police agencies are when interviewing suspects during a criminal investigation. An
important element of this protection is that it is limited to custodial interrogations, in
which the interviewee has been taken into custody or deprived of his freedom in some
significant way.

G. Production of Business Records [p. 916]

Business records such as letters, memorandums, e-mail exchanges, inventory accounts, financial
documents, and the like are often at the heart of cases where government authorities are
investigating potential criminal activity in the business environment. Although the U.S. Supreme
Court has held that certain business records may be classified as private papers and are protected
by the Fifth Amendment, this protection has been severely narrowed over the past several
decades.

LANDMARK CASE 44.4 Braswell v. United States, 487 U.S. 99 (1988)

Facts: Braswell was the sole shareholder and officer in two companies. When the government
subpoenaed the corporation’s records in connection with an investigation, Braswell asserted his
Fifth Amendment right against self-incrimination.

Issue: Can a corporation with only one shareholder be required to turn over its records or can the
sole shareholder assert a right against self-incrimination?

Ruling: The U.S. Supreme Court ruled against Braswell and compelled him to hand over the
books and records because a corporation can act only through its officers and employees. When
an officer or employee acts as a records custodian for that company, then he is not entitled to
Fifth Amendment protection because he is no longer acting as a private individual but as part of
a corporation. The Fifth Amendment protects only private individuals.

Case Questions

1. What was Braswell’s legal theory for his refusal to hand over the documents to the
government?
• His corporation was his alter ego; thus, he could assert a right against self-incrimination
on behalf of the corporation.

2. What if Braswell’s company was a sole proprietorship rather than a corporation? What if he
ran it alone out of his apartment? When should the Fifth Amendment start or stop protecting
him?

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 • A sole proprietor cannot assert the Fifth Amendment to avoid producing the records of a
collective entity, even if those records might incriminate him personally.

3. Focus on Critical Thinking: If a corporation has been recognized as a legal “person” for First
Amendment purposes, shouldn’t the Fifth Amendment protect it too?
• This question is designed to elicit a discussion of under what circumstances the right
against self-incrimination should apply.

VIII. EXCLUSIONARY RULE [p. 917-919]

Points to emphasize:
● Trial courts are required to exclude presentation of any evidence that is obtained as a
result of a constitutional violation.

A. Good Faith Exception [p. 918]

The exclusionary rule itself is controversial because it tends to benefit guilty parties by excluding
key evidence that would help convict them. The Supreme Court has fashioned several exceptions
to the exclusionary rule such as when the government can show that authorities were acting in
good faith in obtaining evidence based on a search warrant issued by an authorized judge that
was later found to be unsupported by an appropriate level of probable cause.

IX. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 920]

Chapter Review Questions [p. 922-923] Note: Answers and explanations are provided at
the very end of the chapter.
Thinking Strategically Questions and Answers [p. 919]

1. Critics of the Park doctrine contend that the notion of holding someone strictly liable for a
crime where they had no participation or knowledge is unfair and raises public policy concerns.
Do you agree? Why or why not?
• This question is intended as a point of departure for a discussion on criminal liability for
corporate executives that were not directly involved in criminal acts. It may be useful for
students to re-read United States v. DeCoster, (case 45.1) before discussing the Park
doctrine. Potential issues to raise include fairness of strict liability; government functions
to protect public health; the appropriateness of the narrow application (violations related
to food contamination); impact of the Park doctrine as a deterrent.

2. Use your favorite search engine to look up corporate compliance codes for companies that
sell products or services that you use. How well does their corporate compliance align with the
DOJ guidelines? What changes would you suggest? Why?
• Students have favorite national restaurant chains that they typically look up to, but it can
also be valuable to investigate businesses that compromise your local business
communities. Students benefit from comparing businesses compliance codes and trying
to figure out how even small business owners may benefit from corporate compliance

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 codes. This question may also serve as a practical application of an organization’s
commitment to corporate social responsibility.

Case Summary Questions and Answers [p. 920-922]

CASE SUMMARY 44.1 Bear Stearns & Co. v. Wyler,182 F. Supp. 2d 679 (N.D. Ill. 2002)

1. Will the court force Wyler to disclose the documents? Are they business records?
• The court ordered Wyler to turn the documents over. They rejected his claim that the
documents would incriminate him because 1) he failed to explain how his production of
the documents at issue would have an incriminating aspect; and 2) a witness is not
exonerated from answering “merely because he declares that in so doing, he would
incriminate himself; his assertion does not of itself establish the hazard of incrimination.”

2. Does the Fifth Amendment apply in civil suits?

• Yes. But there must be a specific reason why the production of the documents at issue
would be incriminating before asserting a Fifth Amendment claim. The court does not
require a showing that there is a pending criminal investigation, “but there must be some
explanation, some set of facts, that would lead the court to the conclusion.”

CASE SUMMARY 44.2 Lamb v. Philip Morris, Inc., 915 F.2d 1024 (6th Cir. 1990)

1. What criminal law did Philip Morris possibly violate? Why?

• The offer of $12.5 MM for charity in exchange for the government’s is a violation of the
Foreign Corrupt Practices Act. The donation was a quid pro quo if Philip Morris knew
that all or a portion of the money was for purposes of influencing any act or decision of a
foreign official.

2. Should the criminal law object to providing money to poor Venezuelan children and offering
work for poor Venezuelan farmers?
• This is a public policy question and students should also apply their knowledge of ethical
decision-making (Chapter 2) to answer this question.

CASE SUMMARY 44.3 United States v. Osborn, No. 3:12-cr-00047-M (N.D. Tex. 2012)

1. What is the government’s theory of the case as to why Osborn was charged?
• The government charged Osborn under the Park doctrine. The government alleged that
Osborn was a responsible corporate officer of Apothécure. It also alleged that he had the
responsibility and authority to prevent the FDCA violations.

2. Who prevails and why? Explain your answer.

• The government prevailed. Osborn by reason of his position at the company, had the
responsibility to prevent the FDCA violations. It was also alleged that Osborn instructed
employees as to how to perform their duties, including ensuring that pharmacists and
pharmacy technicians were properly trained and supervised.

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CASE SUMMARY 44.4 State v. Yenzer, 195 P.3d 271 (Kan. Ct. App. 2008)

1. Is Yenzer’s dental appointment time protected by the Fourth Amendment? Why or why not?
• The court held Yenzer has not made a constitutional claim warranting suppression. Nor
was there any legal authority to support her assertion that suppression is a proper remedy
for a HIPAA violation.

2. Did the police go too far in this case by requesting confidential information from the dentist’s
receptionist? Isn’t the exclusionary rule intended to deter unlawful conduct by authorities?
• The addressed the propriety of the conduct by the police: “While we do not condone the
disclosure of information that occurred here, we must conclude that even if Yenzer could
show a HIPAA violation, the district court did not err in denying Yenzer's motion to
suppress.” Still, the court held that HIPPA violations do not result in a such an extreme
remedy as suppression of evidence.

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 Chapter 45
Insurance Law

CHAPTER OVERVIEW
This chapter will provide an overview of the various insurance laws that apply to the relationship
between the parties to an insurance contract.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Summarize the basic aspects of the insurance business. Knowledge
Identify the insurance policies most applicable to business. Application
Describe the fundamental aspects of an insurance contract. Knowledge
Demonstrate the factors that influence insurance pricing. Critical
Thinking
Describe the essential aspects of insurance regulation Knowledge

I. THE INSURANCE BUSINESS (pp. 924-926)

Points to emphasize:
• Two factors that influence a business’s decision to pay for insurance are the magnitude of
the loss and the probability of the event’s occurrence.
• Expected loss = (probability x magnitude of loss)
• Insurance is a contractual relationship where the insured transfers a specified risk to a
third-party insurer that aggregates similar risks into a common pool.
• Premium = price the insured pays to the third party to transfer the risk of loss
• In the event of a loss, the insurer agrees to indemnify (pay) the insured for the value
stated in the insurance policy.
• The required uncertainty of the risk of loss = fortuitous (accidental) event
• Moral Hazard = when an insured party engages in riskier behavior because of the
reliance on insurance to cover the liability or loss
• Insurers reduce the chance of a moral hazard by including a deductible on a policy and
refusing to insure intentional torts and criminal activity.

II. TYPES OF INSURANCE POLICIES (pp. 926-927)

Points to emphasize:
• The three main types of risks are personal, property, and liability.
• Personal insurance are policies related to life, health, accident, and disability.
• Property insurance includes homeowners, renters, automobile, and boat insurance.
Businesses get property insurance to protect assets in the event of loss, damage, or theft.
• Liability insurance includes negligence that injures others, property-related torts, and
mistakes made by officers or board members. A commercial general liability policy
(CGL) covers risks like bodily injury and property damage due to mon-professional
negligence of employees.

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 • Professional malpractice insurance indemnifies the insured for up to the specified
policy limit for negligent acts performed by professional employees that injure clients.
• Errors and omissions (E&O) liability insurance indemnifies the directors and
executive officers of a corporation if they breach any of their fiduciary duties.

III. INSURANCE CONTRACTS (pp. 928-930)

Points to emphasize:
• Insurance contracts require that the insured demonstrate they have an insurable interest.
• An insurable interest is an interest by the insured in the value of what is being insure
that arises from a financial or legal relationship.
• Insurable interests arise from property, contracts, and legal liability.
• Property based insurable interests can arise from property or equipment ownership, a
lease, an easement, or mineral rights.
• Contract-based insurable interests relate to the rights one has to property owned by
someone else.
• Many business activities have the potential to create liability and thus an insurable
interest to limit those losses.
• The requirement that an insured demonstrate an insurable interest has two policy
justifications: to prevent parties from engaging in pure speculative gambling with
respects to others’ assets or liabilities and to reduce moral hazard.
• The insurer has both a contractual right and a duty to defend any lawsuit alleging claims
against the insured that might trigger liability under the policy.
• Legal defense is an important aspect of liability insurance because the costs of defending
a lawsuit can be substantial.
• Once a loss is paid to the insured, the right of subrogation gives the insurer the right to
pursue a legal claim against the party who caused the loss to the insured.

Case 45.1 Administrative Committee of the Wal-Mart Stores, Inc. Associates’ Health and
Welfare Plan v. James A. Shank et. al

Facts: Deborah Shank was a Wal-Mart employee and member of it’s Plan. Shank was in a car
accident and declared incompetent. The Plan paid for Shank’s medical expenses Shank filed a
lawsuit against the parties responsible for her injuries and settled the case for $700,000.
$417,477 was placed in a trust for Shank. The plan had a subrogation and reimbursement clause.
The Committee for the Plan sued to enforce these clauses. The district court granted summary
judgement to the Committee. Shanks appealed.

Issue: Did the Plan have right to reimbursement?

Ruling: The appellate court affirmed the trial court decision because the language of the Plan
was clear. Reimbursement and subrogation are crucial to the financial viability of self-funded
health plans.

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Case Questions and Answers:

1. The court relied on the fact that Walmart’s health insurance plan was self-funded, which
means Walmart was the insurer. Why did this factor matter?

• A self-insured company must set aside company reserves of cash to fund liabilities
under the plan. This means the company is liable for any risks and assumes those
risks.

2. After the media reported this story, Walmart dropped its lawsuit against the Shanks and the
company changed its subrogation policy. What does this tell you about the ethics of subrogation
in health insurance cases?

• These clauses may be an example of a financial legal strategy in the insurance filed,
yet, they may be so one-sided that they are viewed as unethical and oppressive.

3. Focus on Critical Thinking: Do you agree with the court’s decision? Explain.

• This question is designed to elicit critical thinking from the students as well as an
ethical perspective.

Teaching Tip:

The following news clip video of the Wal-Mart case can be a useful too to share with the
students online or in class:

https://www.youtube.com/watch?v=tewQvODCcGY

This video provides a human and compelling although heartbreaking aspect to this story. It is
worth mentioning to the students that after this news segment was produced Wal-Mart decided to
drop its claim against the Shanks, however, it did not change its company reimbursement policy
based on subrogation.

IV. INSURANCE PRICING (pp. 930-932)

Points to emphasize:
• The goal of the indemnity principle is to reimburse the insured for the losses sustained
and no more.
• Insurers value risk with access to historical data to allow for the determination of the
probability of an event occurring utilizing actuaries that are trained in mathematics and
use statistical models to calculate the probabilities and loss exposure of particular risks.
• General formula: Premium=Losses + LAE + UW expenses + UW profit
• The insured may take several steps as a part of a risk management program to
minimize the probabilities of a loss, or the loss amount should the event occur.

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V. INSURANCE REGULATION (pp. 933-934)

Points to emphasize:
• State laws and regulations, when Congress passed the McCarran-Ferguson Act
relinquishing control to the states.
• To the extent that state statutes overlap, insurance commissioners are empowered to (1)
ensure that the customers are charged fair and reasonable prices for insurance products;
(2) protect the solvency of insurers; (3) prevent unfair insurer practices; and (4) guarantee
the availability of coverage to the public.

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 • In some cases, insurance regulators require that insurers contribute toward a residual
market plan, which provides coverage for those unable to obtain insurance through
regular markets.
• An important aspect of insurance regulation is the imposition on insurers of a duty of
good faith toward the insured. This means to behave reasonably and honestly.

Case 45.2 Cotton States Mutual Insurance Co. v. Brightman (p. 939)

Facts: Brightman was in a car accident when a van owned by Martin and driven by Cumbo
struck his car. Martin had a $300,000 insurance policy with Cotton States Insurance and Cumbo
had a $100,000 policy with State Farm. Brightman offered to settle with Cotton for policy
maximums if accepted within 10 days. Cotton refused to settle and opted for litigation. A jury
awarded Brightman $1,800,000. Cotton paid $300,000 but the remainder was to be paid by
defendants.

Issue: Did Cotton States fail to reasonably settle the claim?

Ruling: The Georgia Supreme Court held that Cotton States had unreasonably refused to settle
the case and was liable to the insured for the excess jury award judgment.

Answers to case questions:

1. Why would an insurance company refuse to settle a claim that is near, or at, the policy
limit?
• The insurance company may strategically decide to take the chance that jury verdict
will be in favor the insured party (defendant) or that the jury may award less than the
policy limit amount.

2. Why does an insurer have complete control over the decision to settle a case?
• Under the terms of the insurance contract, an insured party delegates or transfers the
authority to settle a case to the insurance company.

3. Focus on Critical Thinking; Was this case correctly decided? Did the insurer exhibit good
faith? Explain.
• These questions are intended to elicit critical thinking responses from the students.

VI. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES (p. 934)

Thinking Strategically Questions and Answers [p. 9934]

1. Would Walton’s Supermarkets prefer to settle or litigate the case? Explain.

• Given that the expected value of the verdict is somewhere between $1,000,000 to
$1,500,000, this means Walton’s faces a potential out-of-pocket expense of
$500,000 to $1,000,000. Given this scenario Walton’s would prefer to settle the
claim to eliminate this risk.

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 2. Does First Indemnity have valid reasons to proceed with litigation? Invalid reasons?

• Given the unpredictable outcome of the case, First Indemnity is facing a difficult
decision since the standard is reasonable behavior and they have a duty to protect
their client’s interests. To avoid potential liability from their client they may wish
to settle the case.

3. Does Melissa have to accept the settlement offer? Why or why not?

• Melissa does not have to accept the settlement offer, since the insurance company
is the final decider of whether to settle (or not) under the terms of the insurance
contract.

4. What are the potential legal and financial repercussions if Melissa decides to reject the
settlement offer?

• First Indemnity may face liability and a lawsuit from Walstons if a jury finds in
favor of the plaintiff for an amount that is much higher than $500,000. This may
also damage the business relationship between First Indemnity and Walstons.

5. How would you respond to the letter?

• This question is designed to elicit individualized critical thinking responses from

students.

Key Terms [p. 941]

Chapter Review Questions [pp. 943-944]

Case Summary Questions and Answers [pp. 942-943]

CASE SUMMARY 46.1 Balentine v. New Jersey Insurance Underwriting Association 966 A.2d
1098 (N.J. Super. Ct. App. Div. 2009)

1. Why would the insurer deny Balentine’s claim?

The insurer may have rejected the argument that Balentine had a legal claim to the
property because of Balentine’s bankuptcy and lack of a contract such as a lease. Or, the
insurer may have engaged in bad faith.

2. On what ground would the court find that Balentine had an insurable interest?
If the property was transferred to Gianeta it may be that Balentine was given a lease
contract, management contract or simply a transfer of authority to manage the property
and any of these were relied on by the court to create a legal interest sufficient to create
an insurable interest.

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CASE SUMMARY 46.2 Eyeblaster, Inc. v. Federal Insurance Co., 613 F.3d 797 (8th Cir. 2010)

1. Why does the CGL only protect tangible property as opposed to intangible property like
software?
• The litigation risks concerning intangible property have risen dramatically in the
knowledge economy. These risks including patent, trademark, and trade secret
infringement can be covered under supplemental insurance policies and are also
more related to professional risks.

2. Do you agree with the court’s decision? Explain.

• This question is designed to elicit a critical thinking response from the students.

CASE SUMMARY 46.3 Papudesu v. Medical Malpractice Joint Underwriting Association of

Rhode Island, 18 A.3d 495 (R.I. 2011)

1. Was the language in the insurance policy vague?

• No, the language is fairly clear in that it delegates the authority and responsibility
of investigating a claim against the insured and gives the insurance company full
authority with regard to the question whether to settle or litigate.

2. Should insurance companies take the insured party’s settlement preferences into account?
Explain your answer.
• Yes, although this may be limited to cases involving the insurer’s duty of good
faith to settle a claim that is near the policy limit to avoid unreasonable losses for
the insured party.

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 Chapter 46
Environmental Law

CHAPTER OVERVIEW
This chapters discusses the origins, sources, and enforcement mechanisms used in environmental
law as well as the primary environmental statutes that apply to business operations.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Explain the impact of environmental regulation on business. Knowledge
Identify the origins and sources of environmental law. Knowledge
Describe the role of the Environmental Protection Agency and state agencies Knowledge
in the implementation and enforcement of environmental laws.
Explain the role of citizen suits in enforcing environmental regulations. Knowledge
Describe the primary objectives and provisions of major federal statutes that Knowledge
protect the environment.
Provide examples of various industries regulated by air and water pollution Application
laws related to the disposal of waste and hazardous materials.
Articulate the potential liability of various parties under the federal Knowledge
environmental cleanup statutes.

I. IMPACT OF ENVIRONMENTAL LAW ON BUSINESS [p. 941]

Points to emphasize:
• Business owners and managers should think of environmental regulation as broad-based
and relevant to large and small businesses alike.
• Liability for environmental cleanup is a concern for business owners and managers if
their business operations involve the ownership of land.

II. ORIGINS AND SOURCES OF ENVIRONMENTAL LAW [p. 941]

Points to emphasize:
• The origins of environmental protections are primarily based on the common law
doctrine of nuisance.
• Federal and state statutes that impact businesses are primarily designed to (1) ensure that
government agency decisions have the least possible impact on the environment, (2)
promote clean air and water through regulations and permits, (3) regulate the use and
disposal of solid and hazardous waste, (4) clean up property or waterways that are
contaminated with hazardous waste, and (5) protect wildlife and endangered species.

III. GOVERNMENT ENFORCEMENT [p. 942]

Points to emphasize:

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 • The U.S. Environmental Protection Agency (EPA) is the primary agency for
administering, implementing, and enforcing federal environmental laws.
• States have their own environmental regulation agencies to enforce state environmental
laws and local governments often pass environmental ordinances to prevent local hazards
(e.g., illegal dumping).

IV. CITIZEN SUIT PROVISIONS AND WATCHDOG GROUPS [p. 942-943]

Points to emphasize:
• Citizen interest organizations (watchdog groups) have contributed to the enforcement of
environmental statutes and policy.
• Citizen suit provision in statutes give watchdog groups and individual citizens
authorization to file suit against either a polluter who is in violation of environmental
statutes or regulations or a government agency or unit that is not taking legally mandated
steps to carry out environmental law enforcement.
• In Case 47.1, a court analyzes the procedure used in a citizen suit under the Clean Water
Act.

Case 46.1 Friends of the Earth v. Gaston Cooper Recycling Corp., 29 F.3d 387 (4th Cir.
2011)

Facts: Gaston Cooper Recycling (Gaston) owned a metals smelting facility in South Carolina
and operated it until 1995. After 1995, Gaston continued to treat contaminated storm water at
the facility and to release this treated water into a lake on Gaston's property. However, the
lake’s water overflow discharged into other waterways and spread pollutants that resulted
from the contact of rainwater with scrap metal stored by Gaston on its property. Friends of
the Earth (Friends) is an environmental citizen action group whose members include owners
of property affected by the Gaston pollutants. Friends sent Gaston the statutorily required
notice letter that alleged violations of the Clean Water Act. Friends brought a citizen suit and
the trial court imposed a $2.3 million fine on Gaston. Gaston appealed arguing that the
imposition of the citizen suit fine was not authorized by the statute because much of the
penalty was related to pollutants that were not identified in the original notice letter.
Opinion: The Fourth Circuit Court of Appeals reversed the civil fines imposed by the trial
court except the ones that were articulated in Friend’s citizen suit notice. The court held that
the notice letter provision in the statute has the legislative objective of citizen suit provisions
bringing a polluter into regulatory compliance. That objective would be frustrated if courts
were to impose civil fines on a polluter based on violations that were unknown to the violator
at the time of the letter notice. However, the court upheld several fines that were related to
the allegations contained in the notice letter from Friends.

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 Case Questions

1. Did Gaston escape a substantial civil fine based on a statutory technicality?

• Arguably yes, but Friends should have included sufficient information in the notice to
allow Gaston to correct the violation and avert the citizen suit.

2. What could Friends have included in the notice letter that might help it prevail in a future
case in which the true extent of the violation is known?

• The notice letter must include all the sufficient information to permit the violator to
know was standards he has violated and enough information to correct the violation.

3. Focus on Critical Thinking. Are citizen suit provisions an effective way to achieve
environmental objectives? Do citizens have the expertise necessary to make legal or
scientific determinations that are inherent in environmental regulation? Should enforcement
be left to the government? Why or why not?

• The intent of this question is to spark a discussion on the effectiveness of public

interest groups and whether the government has the necessary means to enforce all
violations.

V. NATIONAL ENVIRONMENTAL POLICY ACT [p. 944-945]

Points to emphasize:
• The National Environmental Policy Act (NEPA) focuses on planning and prevention
rather than of achieving a certain result.
• The NEPA established a process that must be followed by federal agencies in making
decisions that have the potential to significantly impact the environment.
• The NEPA created the Council on Environmental Quality to oversee the NEPA
procedures and make periodic progress reports to Congress and the president.

A. NEPA Coverage and Procedures [p. 944-945]

Points to emphasize:
• NEPA procedures are triggered when a federal agency takes any action that reasonably
may be considered as having an impact on the environment.
• NEPA is also activated with Congress passes a law that requires federal funding (e.g.,
federal highway).

B. Procedural Steps [p. 945]

Points to emphasize:

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 • Federal agencies are required to incorporate NEPA procedural steps into their decision-
making process by identifying the purpose of and need for a promised project, possible
alternative, and any environmental impact.
• Once the agency has incorporated NEPA procedural steps, the agency must categorize
the action into one of three classifications based on its level of environmental impact: (1)
categorical exclusion (little or no impact), (2) environmental assessment (unknown
impact), or (3) environmental impact statement (potentially significant impact). Table
46.1 provides summary of these three categories.

VI. THE CLEAN AIR ACT [p. 946-949]

Points to emphasize:

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 • Enacted in 1963, the Clean Air Act (CAA) is aimed at improving outdoor air quality in
the United States.
• The CAA was expanded in 1997 and now provides a system of market-based incentives
and enforcement options intended to encourage voluntary compliance with clean air
standards.
• The CAA authorized the EPA to establish the National Ambient Air Quality Standards
(NAAQS), which set permissible levels of certain air pollutants.
• The basic structure of the CAA focuses on pollution form either stationary sources
(manufacturing plants) or mobile sources (motor vehicles).

A. Stationary Sources of Air Pollution [p. 946-947]

Points to emphasize:

• Each state is required to develop a collection of regulations, State Implementation Plan

(SIP), that will help it achieve a reduction in each pollutant to below the maximum level
set in the NAAQS. The SIP must be submitted to the EPA
• SIPS feature a program for issuing (1) operating permits to existing stationary sources
that emit pollutants at special levels; (2) preoperating permits for any new source of
pollutants being planned; and (3) new source permits for substantial modifications to an
existing source.

B. Market-Based Approaches [p. 947]

Points to emphasize:
• Market-based approach of the CAA is accomplished through (1) emissions trading via
the permitting process and (2) a cap-and-trade plan intended to achieve lower levels of
pollutants that contribute to acid rain.
• A business may be allowed to expand its pollution output in one area if it is able to offset
the increase by reducing another pollutant in greater measure that the one being
expanded.

C. Economic Incentive Theory [p. 947]

Points to emphasize:

• Under the economic incentive theory, overall pollution reduction will result if businesses
have an economic and competitive incentive, rather than a mandate to invest in modern
equipment and plants.
• Figure 46.1 provides a summary of arguments for and against market-based approaches
in a point-counterpoint format.

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5
 D. Mobile Sources [p. 948]
Points to emphasize:
• The internal combustion engine remains a significant source of hazardous pollutants.
• The Transport and Air Quality (TAQ) program regulates (1) tailpipe emissions, (2) fuel
economy, (3) performance standards, and (4) the composition and distribution of fuels
used in motor vehicles.

1. Tailpipe Emissions [p. 948]

Points to emphasize:
• States may use the federal or the California tailpipe emission standards.
• Both standards require an inspection and maintenance program to ensure car
manufacturers limit the exhaust emissions of five major pollutants that emit from
tailpipes, including hydrocarbons and carbon dioxide.

2. Fuel Economy Standards [p. 948]

Points to emphasize:
• The Corporate Average Fuel Economy (CAFE) standards set average mpg requirements
for motor vehicles and are determined by the year of the motor vehicle’s production and
its classification.
• The CAFE standards were overhauled in 2007 by the Energy Independence and Security
Act, which increased the mandated average for cars from 27.5 to 35.5 mpg by 2020.

3. Performance Standards [p. 948-949]

Points to emphasize:

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 • The TAQ program requires that motor vehicles manufacturers obtain a Certificate of
Conformity from the EPA that certifies that a vehicle’s useful life is at least 10 years or
100,000 miles for passenger cars and up to 365,000 miles for heavy trucks.
• Performance standards also include requirements for certain in-vehicle diagnostic
systems that allow a mechanic to detect otherwise hidden defects in emission control
systems.

4. Fuel Composition and Distribution [p. 949]

Points to emphasize:
• The EPA uses a registration system to ensure that any fuel product is tested and certified
as safe for public health and used in compliance with CAA regulations.
• The CAA bans the use of lead-based gasoline and includes a requirement that gasoline
components contain certain detergents to reduce emissions.

VII. WATER POLLUTION CONTROL [p. 949-952]

A. The Clean Water Act [p. 949]
Points to emphasize:

• The Clean Water Act (CWA) sets and regulates water quality standards.
• The CWA is a federal statute implemented and enforced by the EPA in tandem with the
U.S. Army Corps of Engineers and state agencies.
• Any pollution discharge that violates the CWA triggers enhanced penalties if it was a
result of gross negligence or willful conduct.

B. Water Quality Regulation [p. 950]

Points to emphasize:
• Each state sets water quality standards, subject to EPA review, for the tangible waterways
within the state’s borders.
• Pollution emission into the waterways from sources such as industrial plants is regulated
through the EPA’s National Pollution Discharge Elimination System. The system
establishes permitting procedures for businesses and individuals that require discharge of
some material into a water source in order to operate their facilities.

C. Oil Spills [p. 951]

Points to emphasize:

• The Oil Pollution Act (OPA) increased the EPA’s authority to prevent and respond to
disastrous oil spills in public water sources.
• The law also imposed a tax on oil freighters in order to fund the national Oil Spill
Liability Trust Fund.

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7
• Energy companies are required to file environmental impact plans with the U.S.
Department of the Interior.

Case 46.2 In re Oil Spill by the Oil Rig “Deepwater Horizon” in the Gulf of Mexico,
MDL 2179, U.S. District Court, E.D. Louisiana (September 9, 2014)

Facts: The Deepwater Horizon was a nine-year-old semi-submersible, mobile, floating,

dynamically positioned drilling rig that could operate in waters up to 10,000 feet deep. The
rig was owned by Transocean, Inc., and was chartered and operated by BP from March 2008
to September 2013. It was drilling a deep exploratory well roughly 41 miles off the Louisiana
coast when high-pressure methane gas from the well expanded into the drilling riser and rose
into the drilling rig, where it ignited and exploded, engulfing the platform with 126 crew
members on board. Eleven people were killed, and 17 others were injured. The Deepwater
Horizon sank two days after the explosion.
Subsequent investigations revealed that BP managers misread pressure data, failed to
administer appropriate tests for integrity of the well, and gave their approval for rig workers
to replace drilling fluid in the well with seawater. However, the seawater was not heavy
enough to prevent gas that had been leaking into the well from firing up the pipe to the rig
and causing the explosion. While acknowledging responsibility for the accident, BP argued
that the blame should be fully shared with Trans- Ocean, the owner of the Deepwater
Horizon oil rig, and Halliburton, a contractor that oversaw a critical step in closing up the
well. Transocean and Halliburton denied any liability. The government charged BP,
Transocean, and Halliburton with, among other charges, a violation of the Clean Water Act
(CWA) and Oil Pollution Act (OPA). It also asked the court to impose enhanced penalties
based on the “recklessness” and “willful conduct” provisions of the CWA and OPA. The
impact of such a finding would result in BP being liable for four times the maximum
penalties.

Opinion: The court ruled that BP was liable for willful and reckless conduct. It determined
that the BP crew took risks that led to environmental disaster. The court found that several
crucial conversations between BP employees indicated a willful course of conduct that fit
squarely into the statutory definitions of “reckless” or “willful” in the CWA and OPA. The
court also found that Transocean’s and Halliburton’s conduct was negligent but not reckless.

Case Questions

1. Why did the court find BP liable for enhanced penalties under the CWA and OPA?

• The court pointed to the actions of BP employees at the time of the incident and
found that they took risks that led to the environmental disaster. In particular, the

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8
 court ruled that the evidence indicated that the results of a pressure test should have
prompted quick action to prevent an impending blowout.

2. At the time of the court’s decision, BP had already paid $28 billion in cleanup costs and
economic claims. Should there be no cap on BP’s liability, even if it forces the company into
bankruptcy?

• This question is intended to spark discussion among the students on whether it is in

the public’s interest to drive BP into bankruptcy.

3. Focus on Critical Thinking. Consider the enhanced penalty provision in the CWA and
OPA. Enhanced penalties are common in criminal statutes to punish conduct and deter
behavior that the public considers particularly egregious (e.g., hate crimes). Do violations of
environmental laws rise to that standard of egregiousness? Does the public actually benefit
from enhanced penalties, or in regard to events such as the Deepwater Horizon explosion, is
this more of a political reaction to media coverage?

• Students should discuss the relationship between enhanced penalties in different

contexts as a comparative exercise. Are environmental crimes as egregious as hate
crimes?

D. Drinking Water [p. 953]

Points to emphasize:

• The Safe Drinking Water Act (SDWA) is a federal statute that sets minimum quality
and safety standards for every public water system and every source of drinking water in
the United States.
• The statute requires the EPA to balance both costs and health benefits in setting the
standards.

VIII. REGULATION OF SOLID WASTE AND HAZARDOUS MATERIALS DISPOSAL

[p. 954-955]
Points to emphasize:
• Solid waste generally refers to garbage, refuse, sludge from a waste treatment plant, and
sewage.
• Hazardous materials include chemical compounds and other inherently toxic substances
used primarily in industry, agriculture, and research facilities.

A. Resource Conservation and Recovery Act [p. 954-955]

Points to emphasize:

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 • The Resource Conservation and Recovery Act (RCRA) is intended to regulate active
and future facilities that produce solid waste and/or hazardous material.
• The RCRA crates a “cradle-to-grave” procedure for handling waste from its origins to its
transportation, treatment, storage, and disposal.
• The RCRA establishes reporting requirements and procedures and provides for civil
penalties and citizen suits. It also includes criminal provisions for intentional violations.
• The RCRA bans open dumping of solid waste and authorizes the EPA to set standards for
municipal waste landfill facilities.
• The RCRA regulates waste that is or becomes hazardous. It regulates both those who
generate the pollution (generator) and those who transport the waste (transporter).

B. Toxic Substances Control Act [p. 955]

Points to emphasize:
• The Toxic Substance Control Act (TSCA) is a federal statute that gives the EPA
jurisdiction to control risks that may be posed by the manufacture, processing, use, and
disposal of chemical compounds.
• The statute provides for (1) an EPA-maintained inventory of every chemical substance
that may be legally manufactured in, processed in, or imported into the United States; (2)
EPA authority to require companies to conduct specific screening tests that may reveal
risks to public welfare; (3) EPA regulation on the use, labeling, and control measures of
the substance; (4) record-keeping requirements; and (5) an obligation to report any
potential adverse impact that the manufacturer, processor, or importer may become aware
of in the course of operations.

IX. COMPREHENSIVE ENVIRONMENTAL RESPONSE, COMPENSATION, AND

LIABILITY ACT [p. 955-958]
Congress passed the Comprehensive Environmental Response, Compensation, and Liability
Act (CERCLA) in 1980.

A. Superfund [p. 956]

Points to emphasize:

• The CERCLA is commonly referred to as the Superfund because its main provisions
center on the notion that cleanup operations for abandoned toxic waste sites are to be
funded by a self-sustaining quasi-escrow fund administered by the federal government.
• In 1986, the CERCLA was amended by the Superfund Amendments and
Reauthorization Act (SARA). SARA requires the states to establish emergency
response commission to draft emergency procedures for a hazardous chemical accident
and to implement them in the event of such an accident.

B. Removal and Remedies Responses [p. 956]

Points to emphasize:

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 • The Superfund law established a two-front approach to handling hazardous substance
cleanup: (1) removal, whereby authorization is given for actions to address releases or
imminent releases of hazardous materials; and (2) remedial, whereby the EPA identifies
the most hazardous waste sites and establishes a National Priorities List (NPL) for
cleanup.
• Figure 46.2 provides a map of the Superfund sites on the NPL.

C. Liability of Principally Responsible Parties (PRPs) [p. 956-957]

Points to emphasize:

• The Superfund law (1) is retroactive and, therefore, applies to any disposal made prior to
its enactment in 1980, and (2) imposes broad strict liability standards for cleanup costs on
certain businesses and individuals that fit the statute’s definition of a principally
responsible party (PRP).
• The three classes of PRPs are: (1) current owners of the site; (2) any owner or operator of
the site at the time with the hazardous substances were disposed at the site; and (3) any
business that accepts hazardous substances for transport to the site and selected the site.
• The Superfund imposes joint-and-several liability on the PRPs.

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 D. Consent Decrees [p. 957]
Points to emphasize:
• If a settlement regarding the cleanup process is reached before cleanup efforts are
commenced or are complete, the EPA and the PRP enter into a binding agreement, called
a consent decree.
• A consent decree lays out how the cleanup plan will be implemented and who will bear
which costs.

E. Allocation of Liability [p. 958]

Once a PRP has entered into a consent decree, the PRP has the right to sue third parties such as
transporters, other polluters, and municipalities to recover a portion of the cleanup costs related
to the polluter’s action.

Case 46.3 Goodrich Corp. v. Town of Middlebury, 311 F.3d 154 (2d Cir. 2002)

Facts: For decades, two public landfills accepted industrial waste, including municipal solid
waste from various municipalities. The EPA declared the landfills to be Superfund sites
because they were leaking chemicals and threatening the local water supply. The EPA
identified the PRSs and it entered into consent decrees with them. The PRPs, which were all
corporations, sued several municipalities for contribution for the cleanup. A court-
appointed special master came to certain conclusion about which parties contributed how
much waste, but the trial court did not follow those conclusions. The trial court allocated
much of the liability to the municipalities. The municipalities appealed.

Opinion: The U.S. Court of Appeals for the Second Circuit affirmed the district court’s
ruling. The allocation of costs in such complicated proceedings may produce varying
results; the court chose a method of allocation that was proper based on the evidence. For
the court to abuse its discretion, it would have to have committed an error of law or be
clearly wrong in its finding of facts.

Case Questions

1. Suppose the coalition sues the companies that transported the waste. Are they liable for
PRPs? Why or why not?
• Companies that transported waste can be held liable as a PRP under the Superfund
law and can be held jointly and severally liable as a PRP.

2. Why do you believe that the court rejected the special master’s report? Do you agree with
the court’s decision?
• While some deference should be given to the special master’s conclusions, the court
has the expertise and perhaps is in a better position to balance liability of the parties.

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 3. Focus on Critical Thinking. Should courts have broad discretion when engaging in a
Superfund allocation analysis? Is the public interest best served by a court deciding the
allocation? Why or why not?
• Courts are usually in the best position to weigh interests and should be given broad
authority but perhaps not absolute.

F. Defenses to Liability [p. 959]

1. Secured Creditors
Lenders-owners may avoid liability so long as the lender was (1) an owner by virtue of the
contaminated property being used as collateral for a loan and (2) not participating in the
management of the facility prior to foreclosure.

2. Innocent Landowners [p. 959]

Points to emphasize:
• A current landowner of a site that is listed on the NPL may avoid liability for cleanup
costs so long as the owner establishes that she purchased the property without knowledge
of the contamination.
• The owner must comply with land-use restrictions, take reasonable steps to limit the
impact of the hazardous substances on the general public, and cooperate with the
government agencies.

3. Prospective Purchasers [p. 959]

Points to emphasize:

• The Small Business Liability Relief Act provides a defense to a Superfund liability for a
party that purchased the property with knowledge of the contamination.
• The statute provides for limited liability so long as the owner agrees to take responsible
steps to limit the impact of the contamination, prevent further contamination, and notify
authorities of any imminent or actual pollutant release.

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X. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [p. 962-963]

Chapter Review Questions [p. 965-966] Note: Answers and explanations are provided at
the very end of the chapter.
Law, Ethics, and Society [p. 950-951]

1. Is greenwashing protected commercial speech under the First Amendment to the U.S.
Constitution, or is it an unfair trade practice like fraud? Explain.

• This question allows students to explore constitutional dimensions of environmental

policy. Where is the line to be drawn between misleading consumers and constitutional
rights of businesses to engage in commercial speech? If the course content covered
commercial speech in Chapter 3 (Business and the Constitution), ask students to use the
Central Hudson Gas (p. 57-58) test to any potential attempt to regulate greenwashing.

2. Should there be a specific law against greenwashing as a matter of public policy? Explain
your answer.

• This question encourages students to think about environmental law in the context of
public policy. Argument for: Greenwashing is misleading and should be regulated just as
any consumer protection matter would be. Against: It is virtually impossible to regulate
specific instances of greenwashing and, arguably, it is already unlawful to mislead
consumers.

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14
3. Who is in the best position to enforce a greenwashing law? The Environmental Protection
Agency (EPA)? Consumers? Rival companies? Explain.

• Perhaps all of the above. EPA is primarily concerned with promulgation and
administration of federal laws that directly impact environmental quality, a right to sue
statute would empower consumers to enforce the regulation without the need for
government oversight.

Thinking Strategically Questions and Answers [p. 961-962]

1. What role should the government have in transaction screenings? Although the EPA has
established standards for “qualified” environmental firms, how enforceable are those standards
as a practical matter? Should environmental firms be required to obtain a permit prior to offering
screening services, or should that be left to the consumer?

• This question examines what has been a very hot topic in environmental law: how much
oversight should the government have over firms? The issue of whether oversight is best
left to the states includes questions of resources and whether state regulation leads to
environmental forum shopping.

2. Use your preferred search engine to locate an environmental screening firm near you. What
kind of information do they provide about qualifications, pricing, processes, and experience?

• Students may benefit from being assigned to put together a grid to compare different
aspects of each company. The services provided can vary greatly, but due diligence
typically involves visual or records searches for possible asbestos, lead paint, radon,
biological issues, contamination, mold etc. The grid might help show pricing and
processes differences between firms.

Case Summary Questions and Answers [p. 963-964]

CASE SUMMARY 46.1 Sierra Club v. El Paso Gold Mines, Inc., 421 F.3d 1133 (10th Cir.
2005)

1. Does the Sierra Club have an actionable claim under the Clean Water Act? Why or why not?

• The court ruled that the Sierra Club did have an actionable claim under the CWA. They
held that “point source owners such as El Paso can be liable for the discharge of
pollutants occurring on their land, whether or not they acted in some way to cause the
discharge… This is a case where if you own the leaky ‘faucet,’ you are responsible for its
‘drips.’"

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15
2. If El Paso wanted to use the land for mining activity, would the company be required to obtain
a permit? If so, what would need to be done in order to obtain the permit?

• Yes. They would be required to obtain a permit through EPA’s National Pollution
Discharge Elimination System. In order to obtain the permit, El Paso must show that they
have installed the best practical solution technology (See p. 906).

CASE SUMMARY 46.2 United States v. Southeastern Pennsylvania Transportation Authority,

235 F.3d 817 (3d Cir. 2000)

1. Do any of the prior owners of the rail yard have PRP liability?

• The court held that prior owners did have PRP liability. PCBs were used at the rail yard
for at least twenty years. Amtrak owned the yard for ten years while PCBs were used.
During that ten-year period, first Conrail and then SEPTA operated the yard.

2. Could SEPTA or Amtrak have taken action to avoid liability? Explain

• The court doesn’t address this question, but it does help illustrate the point of
environmental screenings as helping to avoid liability as either an innocent landowner or
(after 2002) Small Business Liability Relief Act.

CASE SUMMARY 46.3 William Paxton v. Wal-Mart Stores, Inc., 176 Ohio App. 3d 364
(2008)

1. What federal statute(s) could apply to this case? Explain.

• The Resource Conversation and Recovery Act (RCRA) could have applied if appropriate
because it is the federal law that regulates active and future facilities that produce solid
waste. However, note that RCRA has a “universal waste” exemption for the type of solid
waste at issue in this case.

3. Citing the RCRA “cradle-to-grave” procedure, do you think Wal-Mart was contributory in
violation of the statute? Why or why not?

• The court does not address this (although they held that Wal-Mart had no liability under
state law), but the point of RCRA is to be sure that a polluter has liability all the way
through proper disposal. Here, Wal-Mart did not ensure that the pollutants were properly
disposed of aside from contracting with a recycle facility.

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16
CASE SUMMARY 46.4 Beverly E. Black and James A. Black v. George Weston &
Stroehmann Bakeries, Inc., U.S. Dist. Ct. (W.D.N.Y. 2008)

1. What standard was used to determine whether or not the discharges constituted a violation of
the Clean Air Act?

• The standards are called the "National primary ambient air quality standards" and
commonly referred to as the "NAAQS." After the EPA Administrator establishes the
NAAQS, the individual states must then submit a plan for the implementation,
maintenance, and enforcement of such primary standard(s).

2. What common law doctrine could Black possibly have pursued in an attempt to compel
Stroehmann to cease polluting?

• Common law nuisance. A private nuisance threatens one person or a relatively few, an
essential feature being an interference with use or enjoyment of land. According to the
court, a person is liable for private nuisance "if his conduct is a legal cause of the
invasion of the interest in the private use and enjoyment of land and such invasion is
intentional and unreasonable, negligent or reckless.”

CASE SUMMARY 46.5 No Spray Coalition, Inc. V. City of New York, 2000 WL 1401458
(S.D.N.Y. 2000)

1. What would No Spray have to prove in order to have an actionable claim under the CWA?

• No Spray has to show: the City is in violation of the CWA; that the government is not
already prosecuting the City for the same violation.

2. Explain the significance of citizen suit provisions and watchdog groups in the context of this
case.

• Citizen suits are significant because they contribute to the enforcement of environmental
statutes and policy.

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17
 Chapter 47
Antitrust and Regulation of Competition

CHAPTER OVERVIEW
This chapter discusses government regulation of competition and antitrust law. Students are first
introduced to the historical context and origins of competition regulation. The chapter then
provides a broad-based overview of the statutory scheme in federal antitrust law and examines
how antitrust laws are applied to various anti-competitive practices.

KEY LEARNING OUTCOMES

Outcome Accreditation
Categories
Articulate the fundamental purpose and source of law for antitrust regulation. Knowledge
Identify the main federal statutes in antitrust law. Application
Distinguish and explain the differences between the per se standard and the Application
rule of reason standard.
List and articulate the primary ways that businesses use horizontal and Knowledge
vertical restraints of trade.
Recognize when a business has achieved a monopoly and explain the Application
restrictions on a monopoly business under antitrust law.
Explain why the United States v. Microsoft case is an important part of Knowledge
antitrust law.
Articulate the role of more modern antitrust statutes in regulating Knowledge
competition.

Teaching Tip: Making Connections

Instructors are always looking for ways to connect the material in the course to the wider
institutional curriculum (both business and general education or core courses). I will typically
take time to point out the title page from Wealth of Nations reproduced on p. 973 of the text and
say a word or two about Smith’s influence on the development of public policy and law. If time
permits, it is also a useful exercise to run a search on a legal database to see how frequently
Smith’s work is still cited by modern courts.

I. BACKGROUND, PURPOSE, AND SOURCES OF ANTITRUST LAW [p. 968]

Points to emphasize:
• The purposes of antitrust law are to prevent, punish, and deter certain anticompetitive
conduct and unfair business practices that existed at the beginning of the industrial
revolution era.
• Both civil penalties and criminal sanctions apply to violators of antitrust laws.

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 • Modern day antitrust enforcement is concerned with protecting the competitive process
rather than protecting individual competitor companies, ultimately benefiting the
consumers.

II. FEDERAL STATUTES AND ENFORCEMENT [p. 968-969]

Points to emphasize:
• Antitrust laws are exclusively federal statutes enforced by the Department of Justice and
the Federal Trade Commission (FTC), with The Sherman Act as the primary governing
statute.
• The Clayton Act significantly amended the Robinson-Patman Act in 1936, and the
Celler-Kefauver Antimerger Act in 1950.
• The Federal Trade Commission Act of 1914, administered solely by the FTC, is a
catchall enactment that has been construed to include all the prohibitions of other
antitrust laws.
• Antitrust laws also permit an aggrieved party to file a private enforcement action against
an alleged antitrust violator, sometimes for triple damages, intended to provide a financial
deterrent to antitrust infraction and to compensate parties injured through anticompetitive
behavior.

III. SHERMAN ANTITRUST ACT [p. 969-977]

Points to emphasize:
• The Sherman Act is divided into two parts prohibiting (1) contracts, combinations, and
conspiracies in restraint of trade, and (2) monopolization.
• Only a monopoly that has been acquired or maintained through prohibited conduct is
illegal.

A. PER SE STANDARD VERSUS RULE OF REASON STANDARD [p. 970]

• Two standards used by federal courts in deciding whether or not a certain transaction or
action violates the Sherman Act in an unreasonable manner.
o The per se standard occurs when concerted activities are blatantly
anticompetitive as articulated in the body of case law, and the violator has no
defense.
o Rule of Reason: An alternative standard used by federal courts that contemplates
a scale in which the court weighs any anticompetitive harm suffered against
market wide benefits of their actions.

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B. RULE OF REASON [p. 971]

• The Court developed the rule of reason which requires that a judge/jury embark on an
examination into market complexities and industry practices in order to determine
whether or not the parties’ actions violate the Sherman Act.
• Businesses are allowed to offer evidence that its actions were reasonable because they
were justified and necessitated by economic conditions.
• The rule of reason contemplates a scale in which the court weighs any anticompetive
harm suffered against the market wide benefits of the action. The court looks to see if the
rationale given is a pretext.

1. Two-Sided Markets [p. 971]

• A two-sided market is at work when an organization creates value primarily
be enabling direct interactions between two (or more) distinct types of
affiliated customers through the use of technology (ex. credit cards).

Case 47.1 Ohio v. American Express Co., 138 S.Ct. 2274 (2018)
Facts: In order to increase its share of the consumer credit market, Discover developed a low-
transaction fee that provided incentives for merchants to steer consumers towards using Discover
over other credit cards. Other credit card companies responded with a low-transaction-fee model
with “antisteering” provisions in their agreements with merchants. The DOJ and several states
brought a civil lawsuit against Amex, Visa and Mastercard. Visa and Mastercard settled. The
trial court ruled in favor of the DOJ; the appellate court reversed and the states appealed to the
U.S. Supreme Court.
Issue: What is the scope of the two sided credit-card market?
Ruling: The U.S. Supreme Court ruled in favor of Amex. The Court determined that the increase
in merchant fees did not create an anticompetitive effect. The government’s argument focused on
only one side of the two-sided credit card platform. A price increase on one side cannot by itself
demonstrate an anticompetitive exercise of market power.
Case Questions:
1. Why are credit card transactions considered a “two-sided market”?
• Because there are two sides to the transaction, the merchant side and the
customer card-holder side.
2. According to the Court, what evidence would be needed to establish that antisteering
provisions violated antitrust laws?
• Proof that antisteering provisions increased the cost of credit-card transactions
above a competitive level, reduced the number of credit-card transactions, or
otherwise stifled competition in the credit card market.

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3. Focus on Critical Thinking: What other types of business transactions could be considered
two-sided? Are purchases from online retailers or ride-sharing companies two-sided? What is
the impact of this decision on new economy companies that use technology platforms that
may be considered two-sided?
• These questions should lead to discussions regarding two-sided business
transactions.

C. PER SE SHERMAN ACT VIOLATIONS: RESTRAINTS [p. 972-973]

• The US Supreme Court has established a body of law establishing that certain per se
violations are through the use of horizontal restraints (agreements between
competitors), and through the use of vertical restraints (agreements between
noncompetitors acting in concert with another party along the chain of commercial
supply).

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D. HORIZONTAL RESTRAINTS [p. 973-977]

• The most common types of prohibited horizontal restraints are horizontal price fixing,
allocation of markets or customers, and boycotts.
o Meeting of the Minds: A crucial component of a horizontal restraint is some
meeting of the minds among the parties, satisfied through circumstantial evidence
regarding the timing of any communications between the parties and their
subsequent restraining actions.
o Frequent meetings and conversations by competitors, followed by restraining
actions are circumstantial evidence of anticompetitive collusion.
o Price-Fixing: Agreement between competitors to fix actual prices and
agreements that affect prices are generally illegal per se.
§ Although price-leading may appear to be price-fixing, the element of
agreement is usually not satisfied, because the competitors are not taking
these actions in concert.
§ In the past decade, the Supreme Court has narrowed the use of the per se
standard and expanded the use of the rule of reason analysis in certain
cases of horizontal price fixing.
o Market Allocation: Agreement between competitors to divide up markets or
geographic regions is illegal per se.
o Boycotts: Concerted refusal to sell or buy from an individual, firm, or group—
may be illegal per se or by use of the rule of reason, depending on specific facts.

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Case 47.2 Texaco, Inc. v. Dagher, et al., 547 U.S. 1 (2006)

Facts: Texaco and Shell formed a joint venture, Equilon, to consolidate their operations in the
western U.S., whereby they agreed to share expenses and profits from the jointly controlled new
entity. Although Equilon engaged in the refinement of crude oil into gasoline, the actual end
product was sold to retailers under the brand names of Texaco and Shell at a mutually agreed
upon price. The retailers of Texaco and Shell products brought a class action lawsuit against
Texaco and Shell, alleging that creating the joint venture was a per se violation of the Sherman
Act because it amounted to a horizontal price-fixing scheme.
Issue: Was the joint venture agreement a per se violation of the Sherman Act?
Ruling: No. Per se liability applies only to agreements that are so plainly anticompetitive that no
study of the industry is needed to establish their illegality. Applying the rule of reason standard,
the joint venture agreement was not horizontal price-fixing because the challenged pricing policy
was simply price-setting by a single entity, Equilon, and not a pricing agreement between
competing entities with respect to their competing products.
Answers to case questions:
1. Does this case mean that competitors may simply create a joint venture to avoid any liability
for price-fixing?

• This case does not mean that competitors may simply create a joint venture to avoid any
liability for price-fixing because even if a transaction is not considered a per se violation,
the actions or transaction in question must also meet the rule of reason standard. If
competitors create a joint venture with the sole purpose of price-fixing, the
anticompetitive harm would outweigh the market wide benefit of their action, thus a court
would find the competitors actions in violation of the Sherman Act.
2. Why did the retailers allege that forming this joint venture was anticompetitive?

• The retailers alleged that forming this joint venture was anticompetitive behavior because
Texaco and Shell mutually agreed upon a price, thus ending any price competition between
the two companies. The retailers believed that Equilon essentially resulted in one company
being able to manipulate prices, resulting in limited choices.
3. Critical Thinking: Is this decision consistent with protecting consumers from price-fixing?

• The Equilon partnership did not avoid liability for price-fixing by taking on the form of a
joint venture, rather it was not liable for price-fixing because antitrust plaintiffs failed to
demonstrate that the joint venture was in fact unreasonable and anticompetitive.
Additionally, the Sherman Act prohibits business entities from gaining monopoly power
by merging their company with a competitor where the action will substantially lessen
competition or tend to create a monopoly.

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E. VERTICAL RESTRAINTS [p. 976]
• The pivotal element to establish a per se vertical price fixing violation is an agreement to
a specific retail price of a product at a lower level in the supply chain.
o Nonprice Restraints: Relationships between the buyer and seller related to an
exclusive franchise and/or a specified territory is governed by the rule of reason
and the Clayton Act.
o Tying Agreements: Sellers that tie a second product to the first product are acting
illegally per se if the seller possesses sufficient market power as to render the tie-
in as coercive.
§ Courts apply a soft per se analysis in determining the legality of a tying
arrangement.
o Criminal Liability: The Antitrust Criminal Penalty Enhancement and Reform Act
of 2004 enhanced penalties for violations of antitrust laws. The maximum fine for
individuals was set at $1 million, and the maximum fine for corporations was
raised to $100 million.

Concept Summary: Restraints of Trade

IV. ANTITRUST LAW AND SPORTS [p. 978-981]

Points to emphasize:
• The debate: whether collegiate and professional sports leagues are unfairly restraining
trade through league rules and policies. Most recently, collegiate student-athletes have
challenged the NCAA that prohibit being paid for the use of their names, images, and
likenesses.
• Major League Baseball: Exempted from Sherman Act since 1922. SCOTUS re-
examined the exemption in Flood v. Kuhn.

Case 47.3 O’Bannon v. National Collegiate Athletic Association, 802 F.3d 1049 (9th Cir.
2015)

Facts: The National Collegiate Athletic Association (NCAA) rules prohibit student-athletes from
being paid for the use of their names, images, and likenesses (NILs). Until 2014, these rules also
capped the total amount of scholarship money that student-athletes could receive. In 2008,
O’Bannon, a former All-American basketball player at UCLA, learned he was depicted in a
college basketball video game produced by Electronic Arts (EA), a software company that
produced video games based on college football and men’s basketball from the late 1990s until
around 2013. O’Bannon saw an avatar of himself—a virtual player who visually resembled
O’Bannon, played for UCLA, and wore O’Bannon’s jersey number. O’Bannon had never
consented to the use of his likeness in the video game, and he had not been compensated for it.
O’Bannon sued the NCAA and the Collegiate Licensing Company (CLC), the entity which
licenses the trademarks of the NCAA and a number of its member schools for commercial use, in
federal court. O’Bannon argued that the NCAA’s amateurism rules, insofar as they prevented

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student-athletes from being compensated for the use of their NILs, were an illegal restraint of
trade under the Sherman Act. The trial courts sided with O’Bannon but, the NCAA appealed on
the basis that (1) the NCAA rules are not subject to antitrust laws, and (2) even if they were
subject to antitrust laws, their amateurism rules do not constitute unlawful restraint of trade.

Issue: Are the NCAA Rules subject to antitrust laws and if so, does their amateurism rule
constitute unlawful restraint of trade?

Ruling: Although the court acknowledged that many of the NCAA’s amateurism rules are likely
to be procompetitive, they held that those rules are not exempt from antitrust scrutiny. However,
the rule of reason should be used. In this case, the scholarship money used was an appropriate
alternative to cash compensation.

Case Questions:

1. What is the court’s reasoning for ruling that the NCAA rules have an anticompetitive effect?
• The rules prohibit athletes from accepting compensation and that is sufficient
evidence of a potential unlawful restraint of trade.

2. Why does the court use a rule of reason analysis rather than a per se rule?
• There is no per se violation here because the NCAA has a viable alternative.

3. Critical Thinking: In 2021, the NCAA changed their policy on names, images, and likeness
(NIL) use by college athletes. Athletes may now benefit financially from their name, image
and likeness without violating NCAA rules., Is this enough? Should the NCAA have
resources to help college athletes negotiate among competitors?
• This question is intended to spur a discussion on whether or not college athletes
should be paid for their efforts rather than given a scholarship.

Case 47.4: Flood v. Kuhn, 407 U.S. 258 (1972)

Facts: Flood was a professional baseball player who was traded by the St. Louis Cardinals to the
Philadelphia Phillies. For a variety of reasons, Flood was unhappy with the trade and refused to
report to his new team while forfeiting a significant salary. Flood sent a letter to the
Commissioner of Major League Baseball (Kuhn) demanding free agency. Kuhn declined to grant
Flood free agency on the basis of the “reserve clause” in Flood’s contract. As a practical matter,
the clause allowed a team to retain the rights of a player indefinitely. Therefore, the clause
prevented Flood from negotiating with another team and gave St. Louis the right to trade him to
a new team or renew his contract.

Issue: Are the reserve clauses in the contracts illegal under the Sherman Act?

Ruling: No. The U.S. Supreme Court held for Kuhn and upheld the exemption primarily based
on the doctrine of stare decisis. Although the Court acknowledged that it is reasonable to
conclude that baseball is now engaged interstate commerce, they did not reverse their earlier

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decisions because of what the Court concluded was Congress’s “positive inaction” to their earlier
decisions exempting Major League Baseball from the antitrust laws.

Case Questions

1. Should stare decisis be such a powerful doctrine that it trumps modern societal realities (such
as baseball’s growing use of interstate commerce via radio, television, and streaming?)
• This question is intended to spur discussion on the topic of the limits of stare
decisis. It allows students to connect the concept of antitrust with a topic covered in
earlier chapters.

2. Why were the reserve clauses important to Flood’s argument?

• The reserve clause allowed an owner to keep a player indefinitely and prevent
negotiation with another team.

3. Critical Thinking: Do you agree that, as a public policy matter, Major League Baseball
should have an exemption from antitrust laws? Why or why not?
• Congress did act in response to this case by limiting the anti-trust exemption through
passage of the Curt Flood Act, but it took 26 years. On one hand, the dynamics of
major league baseball as a business operation are different. On the other hand, one
could reasonably argue that the exemption is a result of powerful lobbying (and
political donations) from concerned parties such as team owners.

• The Curt Flood Act of 1998: The passage of the Curt Flood Act of 1998 added a new
provision to existing antitrust statutes that applied only to professional baseball players
and eliminated the broad antitrust exemption for baseball.

• National Football League: The Supreme Court has declined to provide the National
Football League with a baseball-type exemption since the first challenge in 1957.

• In 2010, the U.S. Supreme Court gave its latest guidance on the topic in American
Needle, Inc. v. National Football League where they rejected the NFL’s single-entity
theory for their licensing contract for merchandising, and held that they were subject to
the Sherman Act

V. MONOPOLIZATION [p. 982-983]

Points to emphasize:
• The Sherman Act does not prohibit a business entity from becoming a monopoly, but it
does outlaw affirmative action toward monopolizing or attempting to monopolize a part
of trade or commerce.
• Laws to prevent this are called structural-offense laws because the offenses generally
do not involve a behavioral aspect.

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 • In order for a business entity to violate Section 2 of the Sherman Act, they must possess
not only monopoly power, but also must have an overt intent to monopolize.

• Monopoly Power: A business entity that has the power to fix prices or to exclude
competitors in a given market is said to have monopoly power, as determined by the
entity’s share of the relevant market.

• The Microsoft Case: In U.S. v. Microsoft, the district court ordered Microsoft to
reorganize its operating system entity separate and apart from its entity responsible for its
Internet browser software when they found that Microsoft employed illegal
anticompetitive means to maintain and further their monopoly of the operating systems
market.
o The appellate court affirmed the finding by the trial court but vacated the order
that required the company to break apart and reversed and remanded on the
findings that Microsoft illegally attempted to monopolize the browser market,
ruling that the appropriate standard was the rule of reason analysis.
o The Consent Order: Before the new trial, the Department of Justice and many of
the states settled the case by entering into a consent order requiring Microsoft to
provide competitors with information to making competing products work
seamlessly with its Windows operating system.
• In 2002, the settlement was approved as the court ruled that the consent order
was in the public interest, ending the legal battle.

• Intent to Monopolize: This analysis requires a court to examine whether or not the
alleged monopolizer has engaged in a course of conduct that would reasonably lead one
to conclude that the entity has purposefully furthered or attempted to maintain
monopoly power.

• Attempted Monopolization: The Sherman act prohibits attempts by a business to gain

monopoly power as determined by a three-part test: (1) the entity must have had a
demonstrable and specific intent to archive a monopoly; (2) the entity must have acted in
an anticompetitive manner designed to injure its actual or potential competition; and (3) a
dangerous probability that monopoly power would in fact be achieved exists.

VI. CLAYTON ACT [p. 983-984]

Points to emphasize:
• The Clayton Act (and its amendments) is a preventative statute that curbs certain
anticompetitive practices that are not specifically covered by the Sherman Act.

• Tying Arrangements and Exclusive Dealing: The Clayton Act prohibits tying
arrangements and exclusive dealing agreements involving the sale or leasing of
commodities.

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 o Only exclusive dealing agreements that may “substantially lessen the competition
or tend to create a monopoly” violate the Clayton Act.

• Mergers and Acquisitions: The Clayton Act prohibits business entities from acquiring
the stock or assets of their competitor where the action will substantially lessen
competition or tend to create a monopoly.

VII. THE FEDERAL TRADE COMMISSION ACT [p. 984-986]

• Designed as a “catch-all” device which prohibits all unfair and deceptive methods of
competition. Any anticompetitive conduct which falls outside the scope of other antitrust
laws may still violate the FTCA.
• The law also gave broad powers to the Federal Trade Commission to investigate any
complaints or instances of unfair competition.

Case 47.5 McWane, Inc. v. Federal Trade Commission

Facts: McWane manufactures pipe fittings that join together pipes and help direct the flow of
pressurized water in pipeline systems. McWane sells the fittings through distributors who in turn
sell them to end users such as a municipal water authority. In April 2006, McWane was the only
supplier who sold the fittings. In 2009, Congress passed the American Reinvestment and
Recovery Act that authorized $6 billion to fund water infrastructure projects. The law created an
increased demand for the pipe fittings and that opportunity led Star, a European-based manufac-
turer of pipe fittings, to enter the U.S. market and compete with McWane. In response to Star’s
forthcoming entry into the U.S. market, McWane implemented its “Full Support Program”
among its existing distributors. The program punished distributors who bought fittings from
other companies (such as Star) by threatening to halt their rebate program and cutting off the
distributor from purchasing McWane’s fittings for up to three months. Other distributors testified
to abiding by the Full Support Program in order to avoid the devastating result of being cut off
from all McWane fittings. Star was excluded by some distributors even after offering a more
generous rebate than McWane. Internal documents reveal that McWane’s express purpose was to
raise Star’s costs and impede it from becoming a viable competitor.
Issue: Did McWane violate the FTCA?
Ruling: Yes. The court agreed that McWane’s Full Support Program was an unlawful exclusive
dealing arrangement that foreclosed Star’s access to distributors for domestic fittings and harmed
competition, thereby contributing significantly to the maintenance of McWane’s monopoly
power in the market.
Case Questions:

1. Why is the fact that McWane had a monopoly on pipe fittings important in the analysis of
this case?

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 • The monopoly ensured that the exclusive dealing arrangements would harm competition.
If it is used to maintain the monopoly, it violates antitrust laws.

2. In what way did the McWane plan make it “economically infeasible” for a distributor to
purchase the fittings from a competitor?

• The program punished distributors who bought pipe fittings from other companies by
threatening to cut off their rebates and refusing to sell them fittings for which McWane
had a monopoly.

3. Critical Thinking: Could McWane have avoided liability by designing the Full Support
Program in a different way? The court tells us that exclusive dealing arrangements are not
per se unlawful. How could this agreement be revised so it does not run afoul of antitrust
laws?

• This question is intended to have students think about proactive law. Could McWane
have introduced a plan that didn’t run afoul of antitrust laws, but still encouraged
customer loyalty?

• Search Bias: FTC Investigates Google. In January 2013, after a nearly two-year
investigation, Google and the FTC agreed to a settlement in which Google agreed
to provide a mechanism to assure that competitors are not being excluded or
demoted unfairly in search results.

VIII. MODERN ANTITRUST STATUTES (pp. 986-987)

A. Hart-Scott-Rodino Antitrust Improvements Act of 1976 (p. 986)

Points to emphasize:
• The Hart-Scott-Rodino Act is a preventative statute that requires business entities that
are contemplating mergers involving dollar amounts of a certain size to give advance
notice to the FTC and the Department of Justice of their intention.

B. Robinson-Patman Act (p. 986-987)

Points to emphasize:
• The Robinson-Patman Act is a federal antitrust law enacted in 1936 amending the
Clayton Act provisions to provide for a broader regulatory authority to curb price
discrimination.
o Price Discrimination: Section 2(a) of the act makes it illegal for a business
entity to discriminate price “between different purchasers of commodities of
like quality or grade,” when the discrimination results in an effect that may
substantially lessen competition or tend to create a monopoly, or injure,

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 destroy, or prevent competition with any person who either grants or
knowingly receives a benefit of such discrimination.
• To violate section 2(a), a business entity must have made two or
more sales to different purchasers at different prices.
o Defenses: There are two defenses where there are no violations of antitrust
laws (1) any time a seller has different manufacturing, shipping or operational
costs that vary from buyer to buyer, and (2) if a seller conducts a good faith
campaign to meet the lower price of a competitor and this results in price
discrimination between several buyers.

END OF CHAPTER PROBLEMS, QUESTIONS AND CASES [p. 987-993]

Theory to Practice (p. 987-988)
1. The Sherman Antitrust Act prohibits any contract, combination, or conspiracy to restrain
competition. The MDC-SurgiPro agreement would violate the Sherman Act. However, the
fact that SurgiPro agreed to consider the plan, but did not commit an overt act, is significant.
To violate the statute, the parties must agree to the plan and then to commit an overt act. No
agreement or overt act has yet occurred. [Ties to Sherman Antitrust Act].
2. The agreement proposed by MDC is a price-fixing scheme which is a form of horizontal
restraint.This is a per se violation of the Sherman Act. [Ties to Horizontal Restraints: Price
Fixing].
3. The agreement by the parties to sell and buy in certain regions of the country violates the
Sherman Act. The MDC-Surgipro agreement in this question is called market allocation and
is prohibited by the statute as anticompetitive horizontal restraint. [Ties to Horizontal
Restraints: Market Allocation].
4. A court would apply the per se standard. Market allocation is a horizontal restraint and when
competitors (such as MDC and SurgiPro) divide markets by territory, this is a blatant act of
anticompetitive behavior because the agreement eliminates competition. The MDC-SurgiPro
market allocation scheme is a per se violation of the Sherman Act. [Ties to Per Se Standard
versus Rule of Reason Standard and Horizontal Restraints].
5. SupplyCo.’s refusal to sell to MDC would be considered a boycott that would ordinarily be
prohibited under the Sherman Act. Although this arrangement could be considered a
unilateral boycott that is permitted under the Colgate doctrine, the boycott was not truly
unilateral because SurgiPro. induced SupplyCo. to boycott a SurgiPro competitor. [Ties To
Boycotts].
6. Because this merger would give MDC an 80% market share, the transaction would have to
comply with provisions of the Clayton Act (designed to prevent a monopoly strategy) and
approval of the U.S. Department of Justice under the Hart-Scott-Rodino Act (allows DOJ to
veto merger transaction). [Ties to Clayton Act and Hart-Scott-Rodino Act].
Thinking Strategically 101: Is Amazon a Illegal Monopoly?
Overview: This feature traces the strategy used by Amazon for e-books and e-readers and
dangers of certain growth strategies.

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Key Terms [p. 989]
Chapter Review Questions [p. 991-993]
Case Summary Questions and Answers [p. 990-991]

CASE SUMMARY 47.1: Covad Communications Co. v. BellSouth Corp., 299 F.3d 1272
(11th Cir. 2002)

Facts: Covad is in the business of providing DSL Internet service to consumers in the southern
region of the United States. BellSouth is the regional telephone company covering the area and
also offers DSL Internet service. Covad and BellSouth entered into an agreement whereby Covad
would lease BellSouth’s phone lines used in Covad’s DSL service. Covad alleged that, after the
contract was executed, BellSouth engaged in predatory pricing. Covad sued BellSouth for
violation of the Sherman Act, claiming that BellSouth’s efforts were an attempt to further a
monopoly and squeeze Covad out of the market.
1. Who prevails and why? Covad has a viable claim in regard to their anticompetitive “price
squeeze” complaint because BellSouth’s predatory pricing could be seen as overt intent use
market domination to eliminate a competitor.
2. What section of the Sherman Act is at issue here? Section 2 of the Sherman Act covering
monopolization is at issue here because BellSouth is allegedly using market domination to
eliminate a Covad.
3. How should the court apply the statute to this case? In applying section 2 of the Sherman Act
to this case, the court should determine first whether BellSouth holds monopoly power and
then examine whether BellSouth has engaged in a course of conduct that would reasonably
lead one to conclude that the entity has purposefully furthered or attempted to maintain
monopoly power.

CASE SUMMARY 47.2: Data General Corporation, et al., v. Grumman Systems Support
Corporation, 36 F.3d 1147 (1st Cir. 1`994)

Facts: Grumman Systems accused Data General of violating the Sherman Act based on Data
General’s tying the sale of its copyrighted software with a requirement that the buyer enter into
an agreement to purchase Data General’s support services for the software. Data General
defended on the basis that the support services were an integral part of its software and not a
separate product.
1. Is this tying arrangement a violation of antitrust laws? Explain your answer. This tying
arrangement is not a violation of antitrust laws because in applying a soft per se analysis, the
agreement involves integrated components of a larger business system.
2. Is this an example of a horizontal or vertical restraint? Data General’s tying agreement is an
example of a vertical restraint because Grumman is on a different distributional level in the
chain of commercial supply.

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CASE SUMMARY 47.3: Greyhound v. International Business Machines Corporation, 559
F.2d 488 (9th Cir. 1977)

Facts: IBM manufactures and sells computers and related equipment. It also has a leasing
division. Greyhound was a leasing company that would purchase “second-generation” computers
from IBM at up to a 75 percent discount (depending on how old the equipment was) and then
lease them to its customers at a relatively inexpensive price. In fact, because Greyhound could
buy at such a high discount, it was able to undercut IBM’s standard lease rates. Although IBM
had about 82 percent of this leasing market, IBM became concerned when its leasing market
share fell. It determined that the main reason for its loss in the leasing market was that companies
like Greyhound were able to offer better terms to consumers. IBM phased in reduced discount
rates so that the maximum discount was 12 percent. Greyhound sued IBM, alleging
monopolization in violation of the Sherman Act.
1. Who prevails and why? Explain your answer. Greyhound would likely prevail because
IBM’s change in practice was evidence that they willfully acquired and maintained
monopoly power. IBM had the specific intent to attempt to monopolize the submarket and
used anticompetitive conduct to accomplish that purpose.
2. Are there any similarities between this case and the Microsoft case? Yes this case is similar
to the Microsoft case because both Microsoft and IBM used their monopoly in their
respective niches to eliminate competition from a more popular alternative.

CASE SUMMARY 47.4: Tanka v. University of Southern California, 252 F.3d 1059 (9th
Cir. 2001)

Facts: Tanka was a student athlete attending the University of Southern California (USC). When
she decided to transfer to UCLA, the athletic director at USC invoked an NCAA rule that
allowed USC to prevent Tanka from playing sports at UCLA for one year. The NCAA rule only
applied to student-athlete transfers within a particular conference. Tanka sued USC and the
NCAA, claiming that the rule amounted to a horizontal restraint violating the Sherman Act.
1. Who prevails and why? The University of Southern California prevails because the transfer
rule did not apply to interconference transfers, thus it did not have a significant
anticompetitive effect.
2. Should the rule of reason be used in this analysis? Explain. Yes the rule of reason standard
should be applied in this analysis because intercollegiate athletic practices are too unique to
be assessed using a strict per se standard.

CASE SUMMARY 47.5: In Re: Cardizem CD Antitrust Litigation, 332 F.3d 896 (6th Cir.
2003)
Facts: HRM, a manufacturer of the prescription drug Cardizem CD, and Andrx, the
manufacturer of a generic version of the drug, were embroiled in a patent infringement dispute in
1996. Andrx counterclaimed with allegations of unfair competition. After a year of extensive
settlement negotiations, the parties entered into an agreement whereby Andrx, which had
obtained FDA approval to market its generic version, agreed that it would not market the generic

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version in the United States for a certain period of time in exchange for payments by HRM of up
to $40 million per year. Both parties agreed to drop the claims from the 1996 lawsuits against
each other. The parties fulfilled the agreement faithfully, and Andrx waited until June 1999 to
market its generic drug. After its release, the generic drug sold for a much lower price than
Cardizem CD and captured a substantial portion of the market. A group of plaintiffs filed a class
action lawsuit against HRM and Andrx, alleging that their settlement agreement was a per se
violation of the Sherman Act as it was a form of horizontal price restraint.
1. Who prevails and why? Explain your reasoning. The court held that the agreement was a per
se illegal under the Sherman Act. The agreement whereby HMR paid Andrx not to enter was an
illegal restraint that violated antitrust laws.
2. What type of illegal restraint is being alleged by the plaintiffs in this case? Horizontal market
allocation (among competitors in the same market).

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 Chapter 48
Personal Property, Real Property, and Land Use Law

CHAPTER OVERVIEW
This chapter covers the various types of property and ownership rights, responsibilities, and
restrictions as well as the specific laws governing landlords and tenants and governmental
regulation of land use.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Provide a working definition of property and categories of property. Knowledge
Explain the roles of the parties in a bailment relationship. Knowledge
Identify the rights that landowners have in real property. Knowledge
Give examples of the rights of landlords and tenants. Application
Distinguish between an assignment and a sublease and explain how each can Application
be used in business planning objectives.
Identify the laws that regulate the use of real property by its owners. Knowledge

Teaching Tip: Personal and Real Property

It may be helpful to explain all of the different ways that property can be transferred, including
by sale, gift, adverse possession, accession, devise, bequest, taking, or as part of a dissolution of
marriage. You might also cover the myriad of ways that property may be held, such as in tenant
in common, joint tenancy, tenancy by the entirety, community property, condominium and
cooperative ownership.

I. DEFINITION AND CATEGORIES OF PROPERTY [p. 996-997]

Points to emphasize:
• From a legal perspective, the term property is defined broadly as a person’s set of legal
rights over others to use the property exclusively.
• Property law recognizes two distinct categories: tangible property (such as real estate or
goods) and intellectual property (such as patents).

A. Tangible Property [p. 997]

Tangible property is property that can be touched and physically possessed. The two forms of
tangible property are personal property and real property.

1. Personal Property [p. 997]

Personal property is both tangible and movable and may be owned or leased. In a business
context, goods, vehicles, inventory, and equipment for business operations (e.g., computers) are
all examples of personal property. The legal term for ownership rights in property is title. In
some instances, the law allows a party to take title solely based on possession.

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1
 2. Found Articles [p. 997]
Under the common law, the finder’s rights depend on the category of the found property: (1)
mislaid – when the owner intentionally places the property in a certain place and later forgets
about it, (2) lost - if the owner unintentionally parts with the property through either carelessness
or neglect, (3) abandoned - if the owner has thrown away or voluntarily forsaken the property, or
(4) found – the property is considered treasure trove if it is verifiably antiquated and has been
concealed for so long as to indicate that the owners are probably dead or unknown. The finder of
lost or abandoned or found (treasure trove) property acquires the right to possess the property
against the entire world except against the actual owner, regardless of the place of the finding.
The finder of the mislaid property, however, must turn the property over to the premises owner
to safeguard the property for the true owner.

CASE 48.1 Grande, as Personal Representative of the Estate of Robert A. Spann v.

Jennings et al., 278 P.3d 1287 (Ariz. Ct. App. 2012)
Facts: The personal representative (Grande) of the deceased (Spann) sold the house of the
deceased to Jennings “as is.” Jenning’s contractor (Bueghly) found $500,000 hidden inside one
of the walls who then took possession of it. When Jennings found out that Bueghly took the
money, she reported it to the police. Jennings sued Bueghly for, among other things, a court
declaration that Bueghly had no right to the money since Jennings was the homeowner. Bueghly
filed a counterclaim for a declaration that he was entitled to the found funds as a treasure trove.
In the meantime, Grande filed suit on behalf of Spann’s estate as the true owner. The cases were
consolidated, and the trial court awarded summary judgment in favor of Spann’s estate. Jennings
appealed.
Issue: Was the money mislaid, entitling Grande to possession, or abandoned, entitling Jennings
to possession?
Ruling: Because Grande did not know about the money and did not intend to abandon the funds,
it was mislaid property. The money could not be considered abandoned because it was not
voluntarily abandoned. The judgment in favor of Spann’s estate was affirmed.

Case Questions

1. What was each party’s (i.e., Grande/Spann’s, Jennings’s, and Bueghly’s) theory of the case as
to why they should get the found cash?

• Grande/Spann – mislaid – entitling them to ownership as the actual owner regardless of

who found it, Jennings – abandoned – entitled her to ownership as the house was sold as
is therefore the money was abandoned, Bueghly – abandoned – entitling him to
ownership as the money was found by him in a location indicating that it was most likely
a treasure trove.

2. Why is it important for the court to determine whether the property has been abandoned?

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 • If the property had been abandoned, rather than mislaid, ownership remains with the
actual owner.

3. Focus on Critical Thinking: How could the facts of the case be changed to lead to a
conclusion that Jennings should prevail? How could the facts be changed to lead to a conclusion
that Bueghly should prevail?

• These questions are designed to encourage a conversation on the types of factors a court
would look at to determine if property had been lost, abandoned or found.

3. Escheat Property [p. 999]

Under common law, if a property is not claimed or is abandoned, the property will revert back to
the state under a process known as Escheat. Escheat is the right of government to take
ownership of unclaimed property.

II. BAILMENTS [p. 1000-1001]

Points to emphasize:
• In a bailment relationship, although a possessor does not gain title via possession, the
nonowner is still a rightful possessor of the goods.
• A bailment relationship is created when the bailor (owner of the property) entrusts a
bailee to temporarily hold the property, usually for the parties’ mutual benefit. If the
parties intend to create a bailment relationship, the bailee owes a duty of care and a duty
to act reasonably in protecting the property

CASE 48.2 Ziva Jewelry v. Car Wash Headquarters, 897 So. 2d 1011 (Ala. 2004)
Facts: Smith was employed by Ziva Jewelry, Inc. (Ziva) as a traveling salesman who kept
expensive jewelry in the locked trunk to sell. After Smith went to a car wash (CWH)and turned
over his keys to the attendant, who left them in the car while Smith paid for the car wash. At that
time someone drove off with $850,000 jewelry in the trunk. When the car was recovered the
jewelry was gone. Ziva sued CWH, alleging that CWH, as bailee, took possession of Smith’s car
and of the jewelry inside and that CWH failed to exercise due care to safeguard and return the
bailed car and contents to Smith. The trial court granted CWH’s motion for a summary judgment
on the grounds that no bailment of the jewelry had been created. Ziva appealed.
Issue: Did CWH become a bailee of the jewelry?
Ruling: No, the appellate court affirmed the trial court’s decision ruling that CWH was unaware
of the jewelry in the trunk and did not assume responsibility for $850,000 worth of jewelry.
Without express or implied acceptance by the purported bailee, a bailment cannot arise.

Case Questions

1. If Smith’s car had not been recovered, would CWH be liable as a bailee for the car?

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 • Yes, CWH would be a bailee for the car, however, it is likely that they disclaimed
responsibility for damages.
2. When a bailee takes a car as part of a bailment relationship, isn’t the bailee also assuming
liability for what is inside?
• Not unless the bailee had knowledge of what was inside.
3. Focus on Critical Thinking: Is Smith left completely without recourse, or could he advance a
different legal theory? If the police determined that the theft was an “inside job” involving CWH
employees, how would that impact your analysis?
• These questions are designed to elicit a discussion of how knowledge is inferred in a
bailment scenario.

A. Leased Personal Property: UCC Article 2A [p. 1001]

Businesses often choose to lease personal property, especially equipment, rather than purchase it
outright and are covered state statutory laws that are modeled after Article 2A of the Uniform
Commercial Code (UCC). In an equipment lease, the lessor (owner of the property) gives the
lessee (the party leasing the property) the exclusive right to possess and use the equipment for a
fixed period in exchange for a monthly payment to the lessor. At the end of the lease term, the
equipment is returned to the lessor.

III. REAL PROPERTY [p. 1001-1002]

Points to emphasize:
• Real property ownership is primarily governed by state statutes, although some common
law principles still exist.
• The Uniform Residential Landlord-Tenant Act (URLTA) provides a model for state
statutes governing the legal relationship between residential landlords and tenants.
• When a landlord leases real property to a business, this is known as a commercial
landlord-tenant agreement and is not governed by the URLTA.

A. Ownership Rights [p. 1002]

The ownership rights to a parcel (piece) of real property also called real estate, evidenced by a
deed, include the land and any structures built upon it as well as plant life and vegetation. The
structures are known as the property’s improvements while anything attached to the property,
such as plumbing, heating and cooling systems, are known as fixtures. There are certain rights
that attach to the land: (1) rights related to the use and enjoyment of the land, (2) subsurface
rights, (3) water rights, and (4) airspace rights.

1. Use and Enjoyment of the Land [p. 1002]

Generally, landowners have the right to use and enjoy the use of their property without
interference from others. This interference is known as nuisance and occurs when one party
creates unreasonable conditions that affect the landowner’s use or enjoyment of the property.

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 2. Subsurface Rights [p. 1002]
Landowners have rights to the soil and, most importantly, to any mineral, oil, or natural gas
within the soil. Subsurface rights may be severed from the real property and sold to another.

3. Water Rights [p. 1002]

Also known as riparian rights, landowners have the right to reasonable use of any streams, lakes,
and groundwater (water contained in soil) that are fully or partially part of their real property.
Reasonable use means that the landowner is entitled to only as much of the water as she can put
to beneficial use upon her land while balancing the rights of others who have riparian rights in
the same stream or lake (such as an adjacent landowner).

4. Airspace Rights [p. 1002]

The law contemplates ownership of airspace by drawing an imaginary line emanating from the
borders of the property into the sky, however, this right may not be used to exclude airplane form
one’s airspace.

LANDMARK CASE 48.3 Fontainebleau Hotel v. Eden Roc, 114 So. 2d 357 (Fla. 1959)
Facts: While the Fontainebleau Hotel was constructing a 14-floor addition, the adjoining
property owner, Eden Roc, sued to halt the construction as interfering with its sunlight and air
rights.
Issue: Do landowners have a right to the free flow of air and light from the adjoining property?
Ruling: No, the court held in favor of Fontainebleau. There is no cause of action if the structure
serves a legitimate legal purpose even if it interferes with the adjoining owner’s use of their
property.
Case Questions
1. If Eden Roc could prove that the addition was constructed completely out of spite, would this
additional fact affect the court’s decision?
• No, there is no cause of action for spiteful building.
2. Why is the historical ancient lights doctrine unworkable in modern commercial life?
• Modern commercial life includes increasing density of property and free use of one’s
own property within limits. Permitting this cause of action would bring oceanside and
downtown developments to a standstill.
3. Focus on Critical Thinking: The court also notes that individuals are free to build as high as or
in any way that they want, provided that doing so does not violate any laws, restrictions, or
regulations. If the Fontainebleau had been in violation of any code or regulation, would the
outcome of the case have been different? Why or why not?
• These questions are meant to encourage a discussion on under what circumstances
construction can be halted.

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 B. Forms of Ownership Interests in Real Property [p. 1004]
Although similar to personal property rights, the ownership interests in real property may be
limited. These include (1) fee simple, (2) life estate, (3) leasehold estate, and (4) easements.

C. Sale of Real Property [p. 1005]

• The most common way for commercial real estate to be transferred is through a sale. The
agreement usually provides for a period devoted to due diligence, specifies a tentative
settlement date (also called the closing date), and is supported by a cash deposit to be
held by an escrow agent, a neutral third party designated to hold a sum of money while
the parties fulfill conditions in a contract.
• During the due diligence period, the buyer will (1) arrange for financing through a
financial institution or a private lender (such as a relative); (2) conduct an inspection of
the property to be sure that the parties are aware of any physical defects, zoning issues,
and other items that may affect the use or price of the property; and (3) have an attorney
or title agent check to be sure that the seller has clear title to the property and will be able
to convey the property without any legal obstacles.

D. Adverse Possession [p. 1005]

In some cases, a party may gain title to real estate through the doctrine of adverse possession.
To gain title to a parcel of property through adverse possession, the acquiring party must
demonstrate (1) open and notorious and visible possession, (2) exclusive possession, and (3)
continuous possession for a period of time as set forth in the state statute.

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CASE 48.4 2 North Street Corporation v. Getty Saugerties Corporation, 68 A.D.3d 1392
(N.Y. App. Div. 2009)
Facts: 2 North and Getty were adjoining property owners. Although there was a fence between
the two properties, it lied entirely on Getty’s property, but 2 North maintain the strip of land for
23 years. Getty never objected, nor did 2 North ask permission, to mow the grass, plant
vegetation or plow snow on the strip. 2 North sued for ownership under adverse possession. The
trial court ruled in favor of 2 North and Getty appealed.
Issue: Was 2 North’s possession of the property open and notorious, exclusive, and continuous
for 10 years?
Ruling: Yes, the appellate court affirmed the trial court’s holding. The action of taking care of
the strip of land for over 10 years was open and notorious, exclusive, and continuous.
Case Questions
1. Was 2 North’s use “notorious” given the fact that it is likely that Getty didn’t realize that the
strip of land was on its property? What does one have to do to use property in a notorious
fashion?
• Notorious means that the use was not hidden from the true landowner. Because 2 North
maintained the property belonging to Getty in the open, it was notorious.
2. How did 2 North satisfy the improvement requirement?
• 2 North planted vegetation on the strip of land over time.
3. Focus on Critical Thinking: Should Getty be compensated for the strip of land taken by
adverse possession? Should there be an offset for all the money invested by 2 North in
maintenance?
• These questions are designed to elicit a discussion of the fairness of adverse possession.

IV. LANDLORD-TENANT LAW [p. 1006-1008]

Points to emphasize:
• An agreement between a landlord and a tenant for the rental of property is called a lease
and is an example of the intersection between property law and contract law.
• While statutes that cover residential leases often feature protections for tenants from
arbitrary and wrongful acts of the landlord (such as a wrongful eviction), laws that
govern the relationship between landlord-tenant agreements in a commercial lease (i.e., a
lease for property that is to be used for commercial purposes such as a retail store in a
shopping center) tend not to offer as much protection for business tenants.

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Teaching Tip: Leases

Students love to ask questions about their own experiences with leases. It may be a good idea to
have information on student legal services offered at your college or university available when
you cover this section in class. A fun exercise is to have the students bring their own lease in and
locate the security deposit and default provisions. They are often surprised at what they agreed
to.

A. Tenant Rights and Remedies [p. 1007]

Fundamentally, tenants have the rights of possession, quiet enjoyment, and habitability. The right
to possession requires the landlord must deliver the legal right to possess the property to the
tenant. Quiet enjoyment is the tenant’s right to use the premises without interference from the
landlord. The right of habitability requires that the premises be free of unreasonably poor and
unsafe conditions that would prevent a person from living there. If a landlord breaches a duty or
promise to a tenant, a variety of legal alternatives are available to compensate the tenant known
as tenant remedies.

1. Tenant Duties [p. 1007]

For the most part, in a commercial lease context, the tenant’s duties under the common law are to
pay the rent as agreed upon and to act reasonably in care and use of the property

B. Landlord Rights and Remedies [p. 1008]

If a tenant violates the duty to pay rent (whether the tenant is using or has abandoned the
premises) or the duty to act reasonably in the use of the property, the common law allows several
remedies to help the landlord recover damages. Although the landlord is typically required to
return the security deposit to the tenant after subtracting the cost of any damages and giving an
itemized list of the claimed damages to the tenant at the end of the lease term, the money may be
held to cover a tenant’s default. A landlord also may remove the tenant who has breached the
lease through eviction resulting in the removal of the tenant from the premises.

V. ASSIGNMENT AND SUBLETTING [p. 1008-1009]

Points to emphasize:
• Absent an agreement to the contrary, the parties in a lease agreement may transfer their
interest to a third party.
• A landlord may sell her property to another party (who must honor the lease agreement)
during the lease term.
• If the tenant wishes to transfer his interests (i.e., his right to possess and use the premises)
to a third party for the entire remaining length of the term, this is called an assignment, if
the transfer is for less than the lease term, it is known as a sublease.

VI. GOVERNMENTAL REGULATION OF LAND USE [p. 1009-1011]

Points to emphasize:

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 • State and local governments frequently pass statutes and ordinances that impose
regulation on how a landowner may use a parcel of real estate.
• The two types of regulations that are most crucial in business planning and
• operations are zoning ordinances and environmental regulations.

A. Zoning Ordinances [p. 1009]

Zoning is generally done at the local level in the form of local ordinances passed by the county
or municipal government. When a local government passes a zoning ordinance, it is exercising
its police powers to advance legitimate objectives of the municipality as a whole.

1. Use Regulation [p. 1010]

The municipality typically is divided into zones, in each of which only certain use of the land is
permitted. These zones include areas for industrial, retail, and residential uses.

2. Enforcement and Appeals [p. 1010]

A local administrative agent, such as a zoning officer or building inspector employed by the
municipality, typically enforces local use ordinances. A zoning board or commission is often
appointed by the local government to handle appeals from decisions of the zoning officer and to
consider applications for parties that wish to have an exception to one of the zoning laws known
as variances.

3. Limits on Regulation [p. 1010]

• Courts have ruled that the law sets limits on a local government’s right to regulate private
property usage through a variety of constitutional protections of property owners.
• First, if the zoning is so overreaching that it deprives the owner of all economic value of
her property, the zoning will be categorized as a taking and the government is required to
pay the owner the market value of the property as required in the Constitution’s Takings
Clause. This is known as the power of eminent domain.
• Second, those affected by zoning ordinances are entitled to due process in the form of a
hearing.
• Third, zoning laws may not discriminate due to the equal protection clause of the
Fourteenth Amendment.

B. Environmental Regulations [p. 1010-1011]

An increasing concern for business owners and managers is federal, state, and local regulation of
land use based on the government’s interest in advancing sound environmental policy. In
general, governments may impose environmentally based land-use regulations so long as they
advance some substantial and legitimate state interest.

VII. EMINENT DOMAIN [p. 1011]

Points to emphasize:

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 • It is important to understand the difference between a legitimate government land-use
regulation and a government taking of property that triggers a constitutional requirement
to compensate the landowner.

A. Procedure [p. 1011]

Eminent domain is traditionally invoked using a condemnation proceeding. When negotiations
between the government, that has decided that certain real estate is necessary for public use, and
the private property owners of the area(s) to be taken fail, the government will file a
condemnation action. The court will determine the fair market value to be paid to the owners and
grant title to the government.

B. Public Use [p. 1011]

Typically, public use may mean the building of public highways, schools, public hospitals, and
other traditional public government functions. However, the U.S. Supreme Court has construed
the public use language very broadly for uses outside the traditional uses so long as the
government can demonstrate that its actions are rationally related to some conceivable public
purpose.

CASE 48.5 Kelo v. City of New London, 545 U.S. 469 (2005)
Facts: As part of a redevelopment plan, the City of New London brought condemnation
proceedings against 9 property owners who would not agree to sell their homes to the City.
Although the city conceded that the condemned properties were not part of the blighted areas (in
fact some had recently been renovated), they were condemned simply because of their location
in the proposed development area. The lower courts’ decisions were mixed, and the U.S.
Supreme Court accepted the case on appeal to decide the question of whether the city’s plan
qualified as a public use within the meaning of the Takings Clause of the Fifth Amendment to
the U.S. Constitution.
Issue: Can a governmental agency condemn property for the purpose carrying out a
redevelopment plan that included some private uses (such as retail, residential and commercial
uses)?
Ruling: Yes, the Supreme Court indicated that the overall purpose of the development was for
public use and that the overall elimination of blight is a legitimate public purpose.
Case Questions
1. How does the Court define “public use”?
• Public use means public purpose: including a redevelopment plan that includes some
private uses.
2. Would the case have been decided differently if the project built only a large industrial park?
Why or why not?

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 • It depends. The broad language used in the decision seemed to indicate that any use that
would increase the taxes received by the municipality or eliminate blight would be
considered acceptable.
3. Focus on Critical Thinking: In dissenting opinions, members of the Court argued that this
decision makes all private property vulnerable to being taken and transferred to another private
owner (against established principles the Court mentioned earlier) so long as the property is
upgraded in some way. Moreover, they argued that this decision is advantageous to large
corporations or individuals with political power or connections, while those with few resources
are disadvantaged. Do you agree? Why or why not?
• These questions are meant to elicit a discussion on fairness in eminent domain
proceedings.

VIII. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES

Key Terms [P. 1014]

Chapter Review Questions [P. 1016-1018] Note: Answers and explanations are provided at
the very end of the chapter.

Thinking Strategically Questions and Answers [P. 1013]

1. Have you ever signed a lease? If so, was the lease residential or commercial? Did you
negotiate the lease, or did you just sign it? Were there any terms that surprised you?
• Students may benefit from comparing different types of leases. It is likely that some
students have signed leases for off-campus apartments or summer rentals, so having them
ring in a copy of a lease they signed and discussing the terms is a valuable way to show
the impact of law on everyday transactions. It is important to highlight the differences
between a commercial lease and a residential lease.
2. If you were negotiating a commercial lease, what terms—other than rent amount—would be
most important to your business?
• Commercia lease terms that could be useful to focus on include a) right of
renewal/extension, b) right to sublet and assign (see Thinking Strategically feature), c)
landlord obligations to repair and tenant’s remedies, and d) landlord’s confessions of
judgment, and e) penalties for late payment.
3. Use your favorite search engine to find a sample commercial lease. Do you understand each
provision? Is there any risk to using a free sample lease commonly found on the Internet? What
would you add or delete to reduce your risk as a tenant?
• This question helps to emphasize the limits of DIY legal documents. A lease is one of the
most used type of Internet generic document and many of the provisions of the document
are considered “boilerplate” even though they significant ramifications and usually favor
the landlord. It also helps students understand that commercial leases can vary

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 significantly in their terms and uses (office building versus warehouse). A DIY
commercial lease may be found at:
https://www.lawdepot.com/contracts/commercial-lease-agreement/?loc=US#.Xvzg6yhKjic

Case Summary Questions and Answers [p. 1014-1016]

CASE SUMMARY 48.1 Singer Co. v. Stott & Davis Motor Express, Inc. and Stoda Corp.,
79 A.2d 227 (N.Y. App. Div. 1981)
1. Who prevails and why?
• Although the trial court initially dismissed the case, the appellate court reversed and held
in favor of Singer. They established a bailment relationship and the appellate court ruled
that “whether due caution requires a bailee to furnish the means for extinguishing fire, or
provide an all-night watchman,” is a question for the jury and that the trial court should
not have dismissed the case before a jury trial.
2. What is the standard duty that the bailee (Stoda) owes to the bailor (Singer)?
• Quoting UCC 7-204 , the court ruled that “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."

CASE SUMMARY 48.2 Chaplin v. Sanders, 676 P.2d 431 (Wash. 1984)

1. Are all the elements for adverse possession met so that Sanders now has title to the disputed
parcel? Why or why not?
• The appellate court ruled that the elements for adverse possession had been met. They
held that during the relevant statutory period, the western parcel was cleared up to the
drainage ditch while the eastern parcel remained vacant and overgrown. The residents of
the trailer park mowed the grass in the parcel and put the parcel to various uses: guest
parking, garbage disposal, gardening and picnicking. The appellate court concluded that
the contrast between the fully developed parcel west of the drainage ditch and the
overgrown, undeveloped parcel east of the drainage ditch was sufficient to put the owners
of the eastern parcel on notice of the Sanders' claim of ownership.

2. What is the appropriate starting time from which to measure ownership to satisfy
Washington’s statutory requirement for 10 years of possession?
• The court held that the owner of the parcel became aware of the possession once the
clearing by Hibbard began.

CASE SUMMARY 48.3 Dayenian v. American National Bank and Trust Co. Of Chicago, 414
N.E.2d 1199 (Ill. App. Ct. 1980)

1. Is the transfer an assignment or sublease? Why?

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 • It is an assignment because it transferred all of Dayenian’s interests in the lease for the
entire remaining term.

2. What do the Courts examine in making this determination?

• Whether the lessee transfers all of his or her rights for the entire remaining term or less
than the remaining term.

CASE SUMMARY 48.4 Amoco Oil Co. v. Jones, 467 N.W.2d 357 (Minn. Ct. App. 1991)
1. Does Jones have an obligation to rebuild the gas station? Why or why not?
• The court ruled in favor of Jones. They held that “a lease is a contract which should be
construed according to ordinary rules of interpretation….Amoco drafted the lease, thus
the lease is construed against Amoco. Amoco did not present any evidence to suggest the
parties intended Jones to assume the risk of loss by fire. Rather, the plain language of the
lease speaks of Jones' responsibility for "necessary upkeep and repairs," including
maintenance of sidewalks and driveways. Thus, Amoco did not carry its burden to show
the parties intended Jones to rebuild the property in the event of substantial damage or
destruction.
2. Why would Amoco terminate the lease?
• It is speculation, but they may have wanted to terminate the lease before the fire and once
they had a right to terminate after the fire, they did so.

CASE SUMMARY 48.5 Automobile Supply Co. v. Scene-In-Action, 172 N.E. 35 (III. 1930)
1. Who prevails and why? Do the conditions support a constructive eviction theory?
• The court held that no constrictive eviction occurred. They ruled that “to constitute an
eviction there must be something of a grave and permanent character done by the
landlord clearly indicating the intention of the landlord to deprive the tenant of the longer
beneficial enjoyment of the premises in accordance with the terms of the lease. The
failure of a landlord to furnish heat for the demised premises in accordance with the
terms of his covenant in the lease justifies the tenant in removing from the premises, and
if he does so he is discharged from the payment of rent thereafter. These facts constitute a
constructive eviction. There can be no constructive eviction, however, without the
vacating of the premises. Where a tenant fails to surrender possession after the landlord's
commission of acts justifying the abandonment of the premises the liability for rent will
continue so long as possession of the premises is continued.”

2. Suppose that the landlord had made good faith efforts to fix the problem but was unable to
for a period of three months. How would that impact your analysis?
• The bigger problem here was that the tenant didn’t actually leave the premises. If the
landlord attempted to fix the heat, it would not necessarily fit the standard of “grave and
permanent character.”

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 Chapter 49
Wills, Trusts, and Estates

CHAPTER OVERVIEW
This chapter surveys the fundamental principle of freedom of disposition; the pros and cons of
the probate system; explores the strategic advantages of trusts; the distinction between estate
taxes and inheritance taxes; and the main sources of state and federal law that apply to wills,
trusts, and estates.

KEY LEARNING OBJECTIVES

Outcome Accreditation
Categories
Identify key terms in the law of wills, trusts, and estates. Knowledge
Articulate the principle of freedom of disposition. Critical
Thinking
Summarize how the probate process works. Knowledge
Explain the strategic advantages of trusts. Application
Distinguish between estate taxes and inheritance taxes. Application
Describe the roles of the Uniform Probate Code and Uniform Trust Code in Knowledge
the development of state law.

Teaching Tip: Providing students with copies of a will and trust may bring to life this topic.

I. KEY TERMS IN WILLS, TRUSTS, AND ESTATES (pp. 1019-1021)

Points to emphasize:
• Decedent: an individual who has died. If there is a will, he is referred to as a testator. If
there is no will, he is referred to as dying intestate.
• Estate: includes all the real and personal property of the decedent that can be transferred
at death by will or intestate law.
• Will: (also referred to as a last will and testament) legal document where the testator
expresses his wishes as to how the estate should be distributed at death and appoints an
executor that manages the estate until final distribution.
• Four main requirements for a valid will: (1) the will must have been executed with
testamentary intent; (2) testator must have had testamentary capacity; (3) the will must
have been executed free of fraud, duress, undue influence, or mistake; and (4) will must
be executed through a proper ceremony, signed by at least 2 witnesses.
• Codicil: separate testamentary document whose purpose is to amend an existing will.
• Executor: person named by the testator in his will to carry out the instructions in the
will. Duties of the executor include disbursement of property to beneficiaries, looking for
potential heirs, payment of debts, and examining creditor claims.

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 • Intestacy: when a decedent dies without a will (or without fully disposing of property
during his lifetime), leaving the estate to be distributed according to state law of
residence.

II. FREEDOM OF DISPOSITION (pp. 1021-1024)

Points to emphasize:
• Freedom of disposition is the common law principle that testators should be free to
dispose of their property at death in any way they want.
• This freedom of disposition is not absolute, as testators may impose only reasonable
conditions in their will.

Case 49.1 Shapira v. Union National Bank, 315 N.E.2d 825 (Ohio Court of Common Pleas
1974) (p. 1021)

Facts: Dr. Shapira conditioned his son’s inheritance under his will upon his son’s being married
to, or marrying within seven years of the testator’s death, a Jewish girl with two Jewish parents.

Issue: Is the condition in the will unreasonable and unconditional?

Ruling: The court determined that the provision of the will did not offend the Constitution and
was not unreasonable, since the testator’s unmistakable testamentary plan was for his
possessions to be used to encourage the preservation of the Jewish faith.

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Answers to case questions:

1. What if the testator had conditioned the inheritance upon his son NOT marrying a Christian
girl? Would the outcome of this case be different?
• Because the restriction described in this question is even less restrictive than the
restriction in the will in this case, the outcome would most likely be same.

2. What if the testator had imposed a shorter time limit, say one year (instead of seven), but had
allowed his son to marry a girl of any religious faith? Would the outcome of this case be
different?
• Consistent with the principle of freedom of disposition or testamentary freedom, such a
temporal restriction would most likely be upheld by most courts.

3. Do you agree with the court conclusion that “the right to receive property by will is a creature
of the law, and is not a natural right”? Why or why not?
• This question is asking about the source of our legal rights, and the “right answer” (pun
intended) ultimately depends on one’s preferred theory of law. On the one hand, a “legal
positivist” would argue that most if not all rights are the creatures of courts, legislation,
constitutions, or other man-made enactments of law; on the other hand, a “natural
lawyer” would argue that certain rights are “pre-political”, i.e. exist even in the absence
of a formal law recognizing those rights.

Case 49.2 Shaw Family Archives v. CMG Worldwide, 486 F. Supp. 2d 309 (S.D.N.Y. 2007) (p.
1023)

Facts: Marilyn Monroe left most of her estate to her method-acting mentor Lee Strasberg.
Strasberg died leaving his estate to his wife Anna, who then administered the Monroe estate. The
Shaw family heirs, however, claimed that they owned the copyrights of several images of
Marilyn Monroe taken by their father.

Issue: Who has the rights to the pictures?

Ruling: The district court ruled that the when Marilyn died, New York did not recognize a
transferable post-mortem right of publicity. New York estate law allows testators to devise only
the transferrable rights they possess at the time of their deaths. Thus, Monroe did not convey the
right to her image to her heirs. Thus, the Shaws could exploit the many images of Monroe taken
by their father.

Answers to case questions:

1. What if Indiana had enacted its Right of Publicity Act in 1963? Would the outcome of the
case be the same?
• Since Marilyn Monroe died in 1962, the outcome of the case would most likely be the
same.

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2. The movie “The Seven Year Itch” was distributed by the movie studio 20th Century Fox.
Could the movie studio have sued the Shaw family to stop the sales of the merchandise with
images of Marilyn Monroe in the film?
• The facts state that the photographer Sam Shaw owned the copyright to the famous
picture of Marilyn Monroe standing on the subway grate and that Shaw transferred this
right to his heirs, so the distributor of the movie in which this famous photograph was
taken would most likely not be able to prevent Shaw’s heir from selling merchandise with
the photograph.

3. Marilyn Monroe’s death was ruled a suicide. In your opinion, should death by suicide result in
the forfeiture of the right to transfer one’s estate by will? Why or why not?
• This is what scholars refer to as a “normative question,” meaning that the answer to this
question depends on one’s values. On the one hand, one could argue that reasonable
restrictions on testamentary freedom designed to deter suicide are good public policy; on
the other hand, one could argue that freedom of disposition is a fundamental right that
should not be interfered with, even in the case of suicide.

III. PROBATE (pp. 1024-1025)

Points to emphasize:
• Probate is a process that manages, settles, and distributes your property according to the
terms of your will or by operation of intestate law if no valid will exists.
• The decedent’s personal representative assembles and distributes the assets in the
decedent’s estate to the beneficiaries designed in the decedent’s will or to the decedent’s
heirs as determined by intestacy law.
• This process is supposed to protect the rights of creditors because the decedent’s personal
representative must identify and notify the decedent’s creditors of the probate
proceedings.

IV. THE STRATEGIC ADVANTAGES OF TRUSTS (pp. 1025-1027)

A. Trusts (p. 1025)

Points to emphasize:
• Parties involved:
o Trustor: the person creating the trust. Also referred to as settlor, grantor, or
creator.
o Trustee: the person or company that holds the legal title to the assets in the trust
and is generally responsible for managing and distributing the asserts in
accordance with the terms of the trust.
o Beneficiary: the person entitled to receive part or all of the property from the
trust.
• Trust: three-party fiduciary relationship where the trustor transfers a piece of property to
a trustee for the benefit of a beneficiary.

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 • Revocable trusts (or living trusts) are created during the trustor’s lifetime and can be
changed/revoked at any time while the trustor is still living. The trustor is the trustee
during his/her lifetime, but it becomes irrevocable when the trustor dies.

Irrevocable trusts are created during the trustor’s lifetime or upon his/her death under
the terms of a will or other trust and usually can’t be changed or revoked.

B. Probate Avoidance: Strategic Aspects of Trusts (p. 1027)

Points of emphasize:
• Assets in a trust are transferred outside of the probate system, saving time and court fees,
and potentially reducing estate taxes as well.
• Other strategic benefits of trusts include control, protection against spendthrifts, and
privacy and probate savings.

V. DEATH TAXES (pp. 1027-1029)

Points to emphasize:
• Estate tax: tax on the transfer of the estate of a deceased person via a will or under the
laws of intestacy.
• Under the federal Tax Cuts and Jobs Act of 2017, estate tax kicks in after $11.58 million
have been exempted. The tax begins at 18% but climbs to 40% for all assets over $1
million or beyond the exemption. After 2025, the cutoff reverts to $5.49 million.
• Estate tax is part of the gift and estate tax system in the U.S.
• Gift tax applies to transfers of property during a person’s life.
• Estate taxes are paid by the decedent’s estate before money is distributed to heirs or
beneficiaries; by contrast, inheritance taxes are paid by the person who inherits the
money or assets from the decedent.

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VI. THE UNIFORM CODES AND THE RESTATEMENTS (pp. 1029-1030)

Points to emphasize:
• Uniform Probate Code (UPC): comprehensive model act drafted by the National
Conference of Commissioners on Uniform State Laws, which governs inheritance and
decedents’ estates in the U.S. Not adopted in all 50 states.
• UPC purposes: streamline the probate process and to standardize and modernize the
various state laws governing wills, trusts, and intestacy.
• The Uniform Trust Code (UTC) is a comprehensive model act governing the creation
of trusts.
• The Restatement of Property and the Restatement of Trusts provide guidance to courts.

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Case 49.3 Payne v. Stalley, 672 So. 2d 822 (Fla. Dist. Ct. App. 1995) (pp. 1029-1030)

Facts: Richard Wood died in Florida. Priscilla Paynes was a pre-death judgment creditor of Mr.
Wood which was obtained in Michigan. The Michigan lawyer for Paynes missed a deadline in
the Florida court, relying on the Uniform Probate Code.

Issue: Should the claim against the estate be allowed?

Ruling: The appellate court agreed with the disallowance of the Paynes’s claim as the Florida
probate law, not the text of the Uniform Probate Code, applied to the case.

Answers to case questions:

1. Why should the Paynes be penalized for a mistake made by their lawyer?
• Although the result in this case no doubt seems unfair, to be able to answer this question,
we must revisit the basics of agency law. The lawyer is the agent of his client, and the
client is the principal, so when the lawyer acts on behalf of his client (and makes a
mistake when so acting), both the action and the mistake are imputed to the client.

2. Should Congress adopt a national probate law for the entire United States? Why or why not?
• This answer poses a policy question, one with constitutional implications, since the
United States is a “federal system” and since matters like probate have traditionally been
left to the states.

3. In reality, Florida had adopted the original 1969 version of the UPC but had not adopted
some of the subsequent amendments to the UPC. Given this fact, was the mistake made by the
Paynes’ lawyer a reasonable one? Explain.
• This issue would be relevant in any eventual malpractice lawsuit against the lawyer by
the Paynes. Because lawyers have special training and are considered experts in the law,
they are held to a higher standard of conduct than the public.

Thinking Strategically Question and Answer [p. 1031]

During his life, Prince was highly litigious, waging a career-long crusade with his record label,
YouTube, bootleggers, and streaming services such as Spotify and Pandora for sovereignty over
his seismic body of work, which included 39 studio albums. (See, for example, this report in
Billboard: https://www.billboard.com/articles/news/cover-story/7348551/prince-battle-to-
control-artist-rights. Also, try searching for “Prince” on YouTube, and you will be surprised by
how little of his work is available there.) Given this well-documented obsession with control
over his work, why did Prince fail to leave a will or use a trust before his death? Specifically,
would Prince have wanted to open his Paisley Park home and studio to public as a museum?

Answers: It is worth noting that Prince was not yet 58 years old when he died, so this
strategic blunder (the lack of a will or trust) may simply be the result of Prince’s untimely
death. Had he lived longer, one would presume that he would have made sure to leave a

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 will or trust with detailed instructions about the fate of his music as well as the future
disposition of his Paisley Park home.

Key Terms [p. 1032]

Chapter Review Questions [pp. 1033-1035]

Case Summary Questions and Answers [pp. 1032-10333]

CASE SUMMARY 49.1 Eyerman v. Mercantile Trust Co., 524 S.W.2d 210 (Mo. Ct. App.
1975)

1. How would you have decided this case?

• The court ruled for the neighbors, but a dissenting judge would have ruled for the estate
based on the principle of testamentary freedom. In truth, this is a difficult case to decide,
since we must balance the principle of freedom of disposition with the interest of
protecting cultural or historical landmarks that benefit the wider population.

2. What if Mrs. Johnston were a novelist and had requested that her executor burn all her
unpublished manuscripts. May an executor refuse to honor such a request?
• Again, this is a very difficult question to answer. On the one hand, we have the principle
of freedom of disposition, which arguably includes the right to destroy what one owns,
but on the other hand, certain third parties might be harmed by the destruction of such
works.

CASE SUMMARY 49.2 Estate of Garrett, 94 A.2d 357 (Penn. 1953)

1. Should the law permit intestate succession by remote or distant heirs? Where should the law
draw the line?
• This is actually a very difficult question to answer, since it calls us to make a policy
decision about which heirs to recognize in the case of intestacy (i.e. when the decedent
did not leave a will or trust).

2. If no heirs had been found in this case, who would have inherited Henrietta’s estate: the
Commonwealth of Pennsylvania or the United States?
• Recall that the United States is a “federal system” and that matters like intestacy have
traditionally been left to the states. Given this legal background, it is the Commonwealth
of Pennsylvania that would be entitled to Henrietta’s estate in the event no heirs were
located.

CASE SUMMARY 49.3 Riggs v. Palmer, 115 N.Y. 506 (N.Y. Court of Appeals 1889)

1. How should the court decide this case?

• This case was made famous in legal circles by the legal philosopher Ronald Dworkin.
The majority ruled that the murdering heir should not be able to profit from his misdeeds,

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 but a dissenting justice thought that the court was bound to respect the wishes of the
testator and allow the murdering heir to receive his share of the estate.

2. What if Elmer had not been convicted of murder but of manslaughter instead?
• It is possible the court would have ruled the same way even in the case of manslaughter,
and it is also possible that the dissenting justice would have prevailed. The point of this
case (and of the hypothetical posed in this question) is to illustrate what Ronald Dworkin
himself famously referred to as “hard cases.”

CASE SUMMARY 49.4 North Carolina Department of Revenue v. The Kimberley Rice
Kaestner 1992 Family Trust, 588 U.S. ___ (2019)

1. Is the portion of the trust created for the benefit of the trustor’s daughter Kimberly subject to
taxation in North Carolina?
• In a unanimous decision, the Supreme Court of the United States answered this question
in the negative based on due process concerns. Specifically, SCOTUS held that presence
of in-state beneficiaries, standing alone, does not empower a state to tax trust income that
has not been distributed to the beneficiaries where the beneficiaries have no right to
demand that income and are uncertain to receive it. The Court also concluded that the
residence of the beneficiaries in North Carolina, by itself, does not supply the minimum
connection necessary to sustain the state tax.

2. Does it matter whether it is a federal judge or a state court judge who gets to decide this
issue?
• A “legal realist” would argue that it absolutely matters whether a federal or local court
decides this case because a federal forum is less likely to be swayed by or partial to the
state interests being asserted in this case. Indeed, this possibility is one of the reasons
federal courts have diversity jurisdiction to decide cases involving citizens of different
states.

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 Chapter 50
Intellectual Property

CHAPTER OVERVIEW
This chapter surveys the intellectual property systems, which include trade secrets, patents,
copyrights, and trademarks. It also looks at how managers can secure and derive value from
these knowledge-based rights.

Key Learning Outcomes

Outcome Accreditation
Categories
Demonstrate how intellectual capital results in intellectual property. Application
Explain the requirements for protecting information as a trade secret. Application
Discuss the requirements for obtaining a patent. Critical
Thinking
Distinguish among the various theories of copyright infringement. Application
Identify the strength of a trademark based on its classification. Knowledge

Teaching Tip: A good start to this material in order for students to fully understand intellectual
property would be to show some examples of each of the categories to the students.

I. THE RELATIONSHIP BETWEEN INTELLECTUAL CAPITAL AND

INTELLECTUAL PROPERTY (p. 1037)

Points to emphasize:
• Intellectual property is an umbrella term for the legal property rights related to trade
secrets, patents, copyrights, and trademarks.
• Intellectual property is the result of a knowledge flow within an intellectual capital
management program, made up of knowledge, skills, education, training, know-how, and
creativity of individuals.
• The knowledge that resides within employees is tacit knowledge.
• Explicit knowledge is knowledge that is recorded and available for the company’s
interpretation, application, and reproduction. It is an intellectual asset that may achieve
the status of intellectual property when the knowledge is fully secured within an
intellectual property regime.
• Licensing agreements, a contract, involving an intellectual property owner (the licensor)
who grants the property user (the licensee) permission to use the property in exchange for
a fee (royalty).

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 II. PROTECTING TRADE SECRETS (p. 1038)

Points to emphasize:
• Trade secrets such as processes, formulas, methods, procedures, and lists can be
valuable assets that allow companies to obtain a competitive advantage.
• Trade secrets can include information that is broader than what can be protected with
patents or copyrights.

A. Trade Secret Requirements (p. 1038)

Points to emphasize:
• Courts look at many common law factors to determine whether information constitutes a
trade secret:
o The extent to which the information is known outside the owner’s business.
o Measures taken by the owner to guard the confidentiality of the information.
o The value of the information to competitors.
o The amount invested in terms of time and money to develop the information.
o The efforts to maintain trade secret confidentiality among employees and third-
party vendors.
• A trade secret can be maintained as long as it remains secret.
• Non-disclosure confidentiality agreements are important tools to protect trade secrets.

B. Infringement through Misappropriation (p. 1039)

Points to emphasize:

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 • Misappropriation: (1) the acquisition of a trade secret of another by a person who
knows or has reason to know that the trade secret was acquired by improper means or (2)
any disclosure or use of a trade secret of another without expressed or implied consent
that was knowingly obtained by improper means.
• Improper means: theft, bribery, misrepresentation, breach or inducement of a breach of a
duty to maintain secrecy, or espionage through electronic or other means

C. Criminal Sanctions (p. 1039)

Points to emphasize:
• Some states make trade secret misappropriation a criminal offense.
• The Economic Espionage Act is a federal statute that provides criminal penalties at the
federal level for the domestic and foreign theft of trade secrets.

D. Exclusive Rights for Unlimited Duration (p. 1039)

Points to emphasize:
• Protection does not expire after a fixed period of time.
• Owner of a trade secret has the right to keep others from misappropriating and using
the trade secret for the duration of the firm’s existence.
• Owner must take reasonable steps to keep the information secret.
• Trade secrets may be independently discovered or reverse engineered without
liability.

CASE 50.1 Starwood Hotels & Resorts Worldwide, Inc. v. Hilton Hotels Corporation, Ross
Klein, and Amar Lalvani (p. 1016)

Facts: Starwood Hotels sued defendants alleging trade secret theft. Klein and Lalvani were
former Starwood senior executives that had access to confidential information. Hilton wanted to
create a model of hotels similar to Starwood’s and recruited Klein and Lalvani to accomplish
this. Items taken from digitally stored files included lists of property owners, developers, and
designers, current and prospective financial and marketing information, site-specific project data,
marketing and demographic studies, and training and operation materials for launching a hotel.
Starwood had Klein and Lalvani sign detailed confidentiality agreements and password-protected
secure servers were used.

Issue: Were trade secrets misappropriated?

Ruling: The court issued a preliminary injunction against Hilton to prevent it from using any
trade secret-protected information.

Answers to case questions:

1. Yes, Starwood hired individuals with the training and creativity to launch an innovative brand
within the hospitality industry. This tacit knowledge was then expressed in plans, strategies,
financial information, and contracts as explicit knowledge. This explicit knowledge was then
protected as trade secrets.

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2. This preliminary injunction was a very favorable outcome for Starwood for a few reasons.
First, it halted the development of a competitor until the litigation was finalized. This also
created a bad public relations scenario for Hilton and the individuals involved. Lastly, when a
preliminary injunction is awarded it signals that the plaintiff has a very strong case and is likely
to win the case on the merits.
3. This question is designed to elicit critical thinking responses from the students. Note:
Starwood obtained a very favorable settlement that included a permanent injunction against
using the stolen data, the individuals were fired by Hilton, and Hilton offered Starwood
$75,000,000 as a settlement. This article described the issue in greater detail:

https://www.latimes.com/archives/la-xpm-2010-dec-24-la-fi-1224-hilton-starwood-20101224-
story.html

III. PATENTS (p. 1041)

Points to emphasize:
• A patent is a statutorily created right that allows an inventor the exclusive right to make,
use, license, and sell her invention for a limited amount of time.
• Patent rights are important to all businesses, but particularly vital to manufacturing,
technology, and pharmaceutical sectors.
• Patent application procedure is expensive and attorney must be involved, and
enforcement is also expensive.

A. Patent Prosecution (p. 1042)

Points to emphasize:
• Prosecuting a patent=application process
• Patent prosecution has three stages: (1) Prior art: database search to see if a similar
invention is not protected by an existing patent or technical disclosure; (2) inventor files a
provisional patent application with the U.S. Patent and Trademark Office; and (3) once
the parties are satisfied that the invention is patentable, a nonprovisional application is
filed with the USPTO.

B. Types of Patents (p. 1043)

Points to emphasize:
• Utility patents: any new and useful process, machine, article of manufacture, or
composition of matter or any new and useful improvement; last for 20 years from the
date of application.
• Design patents: new ornamental design on articles of manufacture; how a product looks;
lasts for 14 years from the date of application.
• Plant patents: invention or discovery of asexually or sexually reproducible plants; last for
20 years from the date of application.

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 C. Patent Eligibility Standards (p. 1044)
Points to emphasize:
• Invention must be novel and nonobvious and be a proper subject matter for protection
under the patent law.
• Novelty standard: (1) public use test, (2) first-inventor-to-file rule, and (3)
determination by the USPTO that the applicant filed the patent application within a
reasonable time of the invention.
• Nonobviousness standard: invention must be something more than that which would be
obvious, in light of publicly available knowledge, to one who is skilled in the relevant
field.
• Patentable subject matter standard: prevents laws of nature, natural phenomena, and
abstract ideas from being patentable.

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 D. Requirements for Design Patents (p. 1044)
Points to emphasize:
• Protect inventors of any new, original, and ornamental design for an article of
manufacture.
• Subject to the same requirements of novelty and nonobvious, and the design must be
primarily ornamental (not primarily functional).
• Protect the appearance of an article.

E. Business Method Patents (p. 1045)

Points to emphasize:
• Recognized in 1996
• Protection to a process developed by a business in the name of efficiency or some
competitive advantage.
• Must be in a novel or nonobvious way.

CASE 50.2 Alice Corporation Pty, Ltd. V. CLS Bank International et al., (p. 1021)

Facts: Alice held patents to disclose plans to manage certain forms of financial risk, “enables the
management of risk relating to specified, yet unknown, future events, related to a computerized
scheme. These are designed to facilitate the exchange of financial obligations between two
parties using a computer system as a third-party intermediary. CLS operates a global network
that facilitates currency transactions. CLS filed suit against Alice seeking a declaratory judgment
that the patents were invalid.

Issue: Are the processes directed to an abstract idea and thus ineligible for patent?

Ruling: The U.S. Supreme Court ruled in favor of CLS because the patents were directed to an
abstract idea and thus invalid because implementing those claims on a computer was insufficient

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to transform the idea into a patentable invention. The court applied a two-part test, does the claim
cover an abstract idea and do claims contain an inventive concept sufficient to transform the idea
into a patent-eligible application of the idea.

Answers to case questions:

1. The Court did not believe abstract claims performed solely on a computer are eligible patent
subject matter.
2. The Court is stating that the claims of Alice’s patent were simply abstract instructions to be
performed on any computer. This level of generic application and abstraction does not merit
patent protection.
3. This question is designed to elicit critical thinking responses from the students.

F. Trade Secret versus Patent (p. 1046)

Points to emphasize:
• Relevant questions (1) ease of reverse engineering the invention, (2) cost, and (3) patent
applications are published and open to public inspection 18 months after the application
date.

G. Infringement (p. 1047)

Points to emphasize:
• Anyone who makes, uses, or sells a patented invention during the term of the patent
without authorization engages in patent infringement.
• Intent is not required.
• Willful patent infringement: intentional infringement that merits higher damages.
• Literal patent infringement: three rules (1) rule of exactness, (2) rule of addition, and
(3) rule of omission
• Doctrine of equivalence: Courts can find infringement if the invention performs
substantially the same function in substantially the same way to achieve the same result.

H. Notice, Enforcement, and Remedies (p. 1047)

Points to emphasize:
• Patent owners must put patent number, “patent”, or “pat” on an article to collect damages
from infringers.
• Courts can issue injunction to cease infringing the patent and/or allow damages (actual,
prejudgment interest, attorney fees, and trebled damages)

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 IV. COPYRIGHTS (p. 1049)

Copyrights: creators can obtain a copyright by having an “original work of authorship fixed in
any tangible medium of expression,” and includes literary works, musical works, dramatic
works, choreographic works, motion pictures, sound recordings, and pictorial or graphical works.
A. Required Elements of a Work (p. 1049)
Points to emphasize:
• A work must meet the test of (1) originality, (2) some degree of creativity, and (3) fixed
in a durable medium.

B. Rights Granted (p. 1049)

Points to emphasize:
• Owner will have the exclusive right to (1) reproduce the work in whole/part, (2) adapt the
work or prepare derivatives, (3) distribute copies, and (4) perform and display the work.
• Open source license agreement can allow others to use and modify copyright-protected
software.
• Creative commons license: licensing of photos, videos, or songs through online
publishing

C. Registration and Notice (p. 1050)

Points to emphasize:
• Registration not required for the creator to own the rights.
• Registration allows the creator to bring an infringement action in federal court and to
collect damages.
• Copyright notice symbol

D. Copyright Infringement (p. 1050)

Points to emphasize:
• Three theories to pursue an infringer (1) direct infringement (copied without
permission), (2) indirect infringement (facilitator liable for damages), and (3) vicarious
infringement (agency law where infringing party is acting on behalf of principal)
• No Electronic Theft Act: criminal penalties for violation of Copyright Act, retail value
over $1,000 can be maximum fines of $250,000 and potential jail time.

E. Defenses to Infringement Claims (p. 1051)

Points to emphasize:
• Fair Use: look at the purpose and nature of the use, nature of the work itself, the amount
and substantiality of the material used, and market effect of the use.

CASE 50.3 Metro-Goldwyn-Mayer Studios v. Grokster, Ltd. (p. 1028)

Facts: Grokster created a P2P file-sharing whereby it would be impossible for Grokster to know
if files being shared were an infringing use, it was entitled to fair use exception because it was
capable of substantial non-infringing uses.

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Issue: Was Grokster’s scheme a valid use of the fair use exception to infringement?

Ruling: The U.S. Supreme Court ruled that Grokster could be liable for inducing copyright
infringement and reversed the court of appeals decision. Grokster distributed a device with the
intent to promote its use to infringe copyrights are liable for the resulting acts by third parties.

Answers to case questions:

1. Because it demonstrates the intent to operate a service very similar to Napster that targets
former Napster users.
2. Because of the evidence showing the intent to promote copyright infringement by others
(contributory infringement)
3. This question is intended to elicit critical thinking responses from students.

• A work that is in the public domain is not protectable under copyright laws.
• The first sale doctrine allows the owner of a copyrighted work to resell or gift the work to
another without permission of the copyright owner.

V. TRADEMARKS (p. 1054)

Points to emphasize:
• Trademark: a nonfunctional, distinctive word, name, shape, symbol, phrase, or
combination of words and symbols that helps consumers to distinguish one product or
service from another.
• Landham Act: federal statute that protects an owner’s registered trademark from use
without the owner’s permission.
• Service marks: used to identify business services

A. Trade Dress (p. 1055)

Points to emphasize:
• Trade dress: a product’s shape or the color combination of its packaging.

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 B. Classifications of Trademarks (p. 1055)
Points to emphasize:
• Arbitrary and fanciful: a mark that has no direct connection to the product
• Suggestive: suggests the product/service without literally describing it
• Descriptive: makes specific reference to features, qualities, or characteristics of a
product/service and is not inherently distinctive (may have a secondary meaning)
• Generic: cannot be registered as a trademark

Case No. 50.4 In re Hershey Chocolate and Confectionery Corp. (p. 1032)
Facts: Hershey filed an application with the USPTO for a trademark to protect the product
design of its chocolate bar. Registration was refused.

Issue: Was the proposed trademark a functional configuration of the bar and was in a
nondistinctive configuration of the bar that doesn’t function as a mark?

Ruling: On appeal, the Trademark Trial and Appeal Board ruled in favor of Hershey because the
prominent decorative recessed rectangle and raised border design was a unique branding design
and a secondary meaning was created.

Answers to case questions:

1. Significant sales and advertising figures, length of exclusive use of the mark, and a survey that
connected an association with the product design to the source of the goods (Hershey).
2. Product design elements are often labeled descriptive marks and must meet the secondary
meaning requirements.
3. These questions are designed to elicit critical thinking responses from the students.

C. Acquiring Rights (p. 1057)

Points to emphasize:
• Holders acquire rights to trademark protection either through (1) use in commerce or (2)
federal registration with the USPTO.

D. Applications and the USPTO (p. 1059)

Points to emphasize:
• Registration of the mark is not automatic.
• The approval process will examine the mark for distinctiveness, checks for any similar
marks already registered, and ensures compliance with the trademark registration
standards.
• Lanham Act allows for rejection of a mark if it is “immoral, deceptive, or scandalous
matter” or may be disparaging to “people, institutions, beliefs, or national symbols”

E. First Amendment Concerns (p. 1059)

Points to emphasize:
• In re Tam (2015), reversed a rejection of the name “The Slants” and held that section 2a
of the Lanham Act was unconstitutional.

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 F. Maintaining the Mark (p. 1060)
Points to emphasize:
• 10-year registration period, must be renewed unlimited times to keep the trademark

G. Policing the Mark (p. 1060)

Points to emphasize:
• Holders have an obligation to protect their rights by policing the mark.
• Cease and desist letter: letter to alleged infringer asking them to stop using the mark or
face legal action
• Prevent the use of the mark as a noun or verb to prevent it from losing its distinctiveness
and becoming generic.
H. Trademark Infringement (p. 1060)
Points to emphasize:
• Infringement occurs when a party uses a protected mark without consent.
• BOP on holder to show that the infringement would likely cause confusion among
reasonable consumers under the likelihood of confusion standard (balancing test)
• Factors: strength of the mark, similarity between marks, proximity of the products and
their competitiveness with each other, evidence that the mark holder may be preparing to
launch a product for sale in the market of the alleged infringer’s product, evidence of
actual consumer confusion, evidence of bad faith, quality of the products; and
sophistication of consumers in the relevant markets.

I. Trademark Dilution (p. 1061)

Points to emphasize:
• Federal Trademark Dilution Act: holders may enforce their rights based on a dilution
claim.
• Claims of blurring or tarnishment

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 VI. END OF CHAPTER PROBLEMS, QUESIONS AND CASES (p. 1063)

Thinking Strategically Questions and Answers [p. 1063]

Teaching Tip:

Below is the actual cease-and-desist letter that was sent by Chik-fil-A’s attorney to Eat More
Kale. Showing the students the list of companies that had agreed to cease-and-desist on page 5 of
the letter usually generates significant classroom discussion.

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1. Does Bo’s trademark create likelihood of confusion? Apply the Polaroid test to explain
your answer.
• This is a grey area since different juries may arrive at a different conclusion. The
Polaroid factors applied to Eat More Kale may generate a good in class
discussion with some of the factors, e.g. strength of the mark and the lack of
sophistication among consumers helping Chik-fil-A. Whereas other factors such
as the proximity of the products and lack of evidence of bad faith or actual
confusion leaning more toward Eat More Kale.

2. Does Bo’s trademark dilute the EAT MORE CHIKIN mark? Why or why not?
• This hinges on whether Eat Mor Chikin is legally classified as a famous mark. If
not, there is no dilution. If the mark is famous then a blurring claim may succeed
if Eat More Kale blurs the distinctiveness of Eat Mor Chikin even absent any
confusion.

3. Why did so many other companies agree to Chick-fil-A’s demands?

• Because they lacked the financial resources to legally challenge Chik-fil-A. It
boiled down to a cost-benefit decision.

4. Would you advise Bo to share the cease and desist letter on Facebook? Why or why not?
• It apparently worked very well for Bo. His sharing of the letter generated intense
debate and scrutiny. This led to media coverage, including a New York Times
article on trademark bullying. Then Governor Bernie Sanders from Vermont also
provided support. The case was circulated among a list-serve of law professors
and Bo obtained pro bono legal representation from the University of New

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 Hampshire IP clinic and they helped defend Bo against the Trademark Office
proceedings and appeal the denial of his trademark. He eventually obtained a
federal trademark three years later due to all of these efforts and sold many t-
shirts in the process.

5. How would you handle this issue?

• This question is designed to elicit individualized and critical thinking responses.

Key Terms [pp. 1039-1040]

Chapter Review Questions [pp. 141-142]

Case Summary Questions and Answers [pp. 140-141]

CASE SUMMARY 50.1 Harvey Barnett v. Shidler, 338 F.3d 1125 (10th Cir. 2003)

1. Does the swim-float-swim technique qualify as a trade secret? Why or Why not?
• Yes, it is information that is valuable and not generally well-known and
reasonable efforts were undertaken (such as NDAs) to keep secrecy.

2. What factors would the court use to assess whether the technique is a trade secret?
Discuss.
• The factors cited above.

CASE SUMMARY 50.2 In re Reed Elsevier, Inc. 2007 WL 1086403 (Fed. Cir. 2007)

1. Is the lawyers.com mark too generic for protection? Why or why not?
• Yes, since it uses a generic or commonly used word that is in common usage to
stand for the product or service being advertised.

2. If the court determines the mark is primarily descriptive, what further obstacle must Reed
overcome to obtain protection for the mark?
• Reed will have to demonstrate secondary meaning to obtain the trademark.

CASE SUMMARY 50.3 KSR International v. Teleflex, 550 U.S. 398 (2007)

1. What do you think Teleflex’s specific theory of infringement was?

• They probably argued it violated the doctrine of equivalents.

2. Which element of patentability does KSR claim Teleflex is missing in the combined
device?
• Obviousness since it would be obvious to add the electronic throttle.

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