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Learning Objectives
By the end of this section, you will be able to:
• Understand in what circumstances a principal will be vicariously liable for torts committed by employees.
• Recognize the difference between agents whose tort and criminal liability may be imputed to the employer and those whose liability will not be so imputed.
• Know when the principal will be vicariously liable for intentional torts committed by the agent.
• Explain what is meant by “the scope of employment,” within which the agent’s actions may be attributed to the principal and without which they will not.
• Name special cases of vicarious liability.
• Describe the principal’s liability for crimes committed by the agent.
Principal’s Tort Liability
The Distinction between Direct and Vicarious Liability
When is the principal liable for injuries that the agent causes another to suffer?
Direct Liability
There is a distinction between torts prompted by the principal himself and torts of which the principal was innocent. If the principal directed the agent to commit a tort or knew that the consequences of the agent’s carrying out his instructions would bring harm to someone, the principal is liable. This is an application of the general common-law principle that one cannot escape liability by delegating an unlawful act to another. The syndicate that hires a hitman is as culpable of murder as the man who pulls the trigger. Similarly, a principal who is negligent in his use of agents will be held liable for their negligence. This rule comes into play when the principal fails to supervise employees adequately, gives faulty directions, or hires incompetent or unsuitable people for a particular job. Imposing liability on the principal in these cases is readily justifiable since it is the principal’s own conduct that is the underlying fault; the principal here is directly liable.
Vicarious Liability
But the principle of liability for one’s agent is much broader, extending to acts of which the principal had no knowledge, that he had no intention to commit nor involvement in, and that he may in fact have expressly prohibited the agent from engaging in. This is the principle of respondeat superior (“let the master answer”) or the master-servant doctrine, which imposes on the principal vicarious liability (vicarious means “indirectly, as, by, or through a substitute”) under which the principal is responsible for acts committed by the agent within the scope of the employment (see Figure 15.2).
The modern basis for vicarious liability is sometimes termed the “deep pocket” theory: the principal (usually a corporation) has deeper pockets than the agent, meaning that it has the wherewithal to pay for the injuries traceable one way or another to events it set in motion. A million-dollar industrial accident is within the means of a company or its insurer; it is usually not within the means of the agent—employee—who caused it.
The “deep pocket” of the defendant-company is not always very deep, however. For many small businesses, in fact, the principle of respondeat superior is one of life or death. One example was the closing in San Francisco of the much-beloved Larraburu Brothers Bakery—at the time, the world’s second largest sourdough bread maker. The bakery was held liable for \$2 million in damages after one of its delivery trucks injured a six-year-old boy. The bakery’s insurance policy had a limit of \$1.25 million, and the bakery could not absorb the excess. The Larraburus had no choice but to cease operations. (See http://www.outsidelands.org/larraburu.php.)
Respondeat superior raises three difficult questions: (1) What type of agents can create tort liability for the principal? (2) Is the principal liable for the agent’s intentional torts? (3) Was the agent acting within the scope of his employment? We will consider these questions in turn.
Agents for Whom Principals Are Vicariously Liable
In general, the broadest liability is imposed on the master in the case of tortious physical conduct by a servant, as discussed in Chapter 14. If the servant acted within the scope of his employment—that is, if the servant’s wrongful conduct occurred while performing his job—the master will be liable to the victim for damages unless, as we have seen, the victim was another employee, in which event the workers’ compensation system will be invoked. Vicarious tort liability is primarily a function of the employment relationship and not agency status.
Ordinarily, an individual or a company is not vicariously liable for the tortious acts of independent contractors. The plumber who rushes to a client’s house to repair a leak and causes a traffic accident does not subject the homeowner to liability. But there are exceptions to the rule. Generally, these exceptions fall into a category of duties that the law deems nondelegable. In some situations, one person is obligated to provide protection to or care for another. The failure to do so results in liability whether or not the harm befell the other because of an independent contractor’s wrongdoing. Thus a homeowner has a duty to ensure that physical conditions in and around the home are not unreasonably dangerous. If the owner hires an independent contracting firm to dig a sewer line and the contractor negligently fails to guard passersby against the danger of falling into an open trench, the homeowner is liable because the duty of care in this instance cannot be delegated. (The contractor is, of course, liable to the homeowner for any damages paid to an injured passerby.)
Liability for Agent’s Intentional Torts
In the nineteenth century, a principal was rarely held liable for intentional wrongdoing by the agent if the principal did not command the act complained of. The thought was that one could never infer authority to commit a willfully wrongful act. Today, liability for intentional torts is imputed to the principal if the agent is acting to further the principal’s business. See the very disturbing Lyon v. Carey in Section 15.4.2 “Employer’s Liability for Employee’s Intentional Torts: Scope of Employment”.
Deviations from Employment
The general rule is that a principal is liable for torts only if the servant committed them “in the scope of employment.” But determining what this means is not easy.
The “Scope of Employment” Problem
It may be clear that the person causing an injury is the agent of another. But a principal cannot be responsible for every act of an agent. If an employee is following the letter of his instructions, it will be easy to determine liability. But suppose an agent deviates in some way from his job. The classic test of liability was set forth in an 1833 English case, Joel v. Morrison.Joel v. Morrison, 6 Carrington & Payne 501. The plaintiff was run over on a highway by a speeding cart and horse. The driver was the employee of another, and inside was a fellow employee. There was no question that the driver had acted carelessly, but what he and his fellow employee were doing on the road where the plaintiff was injured was disputed. For weeks before and after the accident, the cart had never been driven in the vicinity in which the plaintiff was walking, nor did it have any business there. The suggestion was that the employees might have gone out of their way for their own purposes. As the great English jurist Baron Parke put it, “If the servants, being on their master’s business, took a detour to call upon a friend, the master will be responsible.…But if he was going on a frolic of his own, without being at all on his master’s business, the master will not be liable.” In applying this test, the court held the employer liable.
The test is thus one of degree, and it is not always easy to decide when a detour has become so great as to be transformed into a frolic. For a time, a rather mechanical rule was invoked to aid in making the decision. The courts looked to the servant’s purposes in “detouring.” If the servant’s mind was fixed on accomplishing his own purposes, then the detour was held to be outside the scope of employment; hence the tort was not imputed to the master. But if the servant also intended to accomplish his master’s purposes during his departure from the letter of his assignment, or if he committed the wrong while returning to his master’s task after the completion of his frolic, then the tort was held to be within the scope of employment.
This test is not always easy to apply. If a hungry deliveryman stops at a restaurant outside the normal lunch hour, intending to continue to his next delivery after eating, he is within the scope of employment. But suppose he decides to take the truck home that evening, in violation of rules, in order to get an early start the next morning. Suppose he decides to stop by the beach, which is far away from his route. Does it make a difference if the employer knows that his deliverymen do this?
The Zone of Risk Test
Court decisions in the last forty years have moved toward a different standard, one that looks to the foreseeability of the agent’s conduct. By this standard, an employer may be held liable for his employee’s conduct even when devoted entirely to the employee’s own purposes, as long as it was foreseeable that the agent might act as he did. This is the “zone of risk” test. The employer will be within the zone of risk for vicarious liability if the employee is where she is supposed to be, doing—more or less—what she is supposed to be doing, and the incident arose from the employee’s pursuit of the employer’s interest (again, more or less). That is, the employer is within the zone of risk if the servant is in the place within which, if the master were to send out a search party to find a missing employee, it would be reasonable to look. See Section 4, Cockrell v. Pearl River Valley Water Supply Dist.
Special Cases of Vicarious Liability
Vicarious liability is not limited to harm caused in the course of an agency relationship. It may also be imposed in other areas, including torts of family members, and other torts governed by statute or regulation. We will examine each in turn.
Use of Automobiles
A problem commonly arises when an automobile owner lends his vehicle to a personal friend, someone who is not an agent, and the borrower injures a third person. Is the owner liable? In many states, the owner is not liable; in other states, however, two approaches impose liability on the owner.
The first approach is legislative: owner’s consent statutes make the owner liable when the automobile is being driven with his consent or knowledge. The second approach to placing liability on the owner is judicial and known as the family purpose doctrine. Under this doctrine, a family member who negligently injures someone with the car subjects the owner to liability if the family member was furthering family purposes. These are loosely defined to include virtually every use to which a child, for example, might put a car. In a Georgia case, Dixon v. Phillips, the father allowed his minor son to drive the car but expressly forbade him from letting anyone else do so.Dixon v. Phillips, 217 S.E.2d 331 (Ga. 1975). Nevertheless, the son gave the wheel to a friend and a collision occurred while both were in the car. The court held the father liable because he made the car available for the pleasure and convenience of his son and other family members.
Torts of Family Members
At common law, the husband was liable for the torts of his wife, not because she was considered an agent but because she was considered to be an extension of him. “Husband and wife were only one person in law,”O.W. Holmes, Agency, 4 Harvard Law Rev. 353 (1890–91). says Holmes, and any act of the wife was supposed to have been done at the husband’s direction (to which Mr. Dickens’s Mr. Bumble responded, in the memorable line, “If the law supposes that, the law is a ass—a idiot”Charles Dickens, Oliver Twist, (London: 1838), chap 51.). This ancient view has been abrogated by statute or by court ruling in all the states, so that now a wife is solely responsible for her own torts unless she in fact serves as her husband’s agent.
Unlike wives, children are not presumed at common law to be agents or extensions of the father so that normally parents are not vicariously liable for their children’s torts. However, they can be held liable for failing to control children known to be dangerous.
Most states have statutorily changed the common-law rule, making parents responsible for willful or malicious tortious acts of their children whether or not they are known to be mischief-makers. Thus the Illinois Parental Responsibility Law provides the following: “The parent or legal guardian of an unemancipated minor who resides with such parent or legal guardian is liable for actual damages for the willful or malicious acts of such minor which cause injury to a person or property.”Ill. Rev. Stat. (2005), chapter 70, paragraph 51. http://law.justia.com/illinois/codes/2005/chapter57/2045.html. Several other states impose a monetary limit on such liability.
Other Torts Governed by Statute or Regulation
There are certain types of conduct that statutes or regulation attempt to control by placing the burden of liability on those presumably in a position to prevent the unwanted conduct. An example is the “Dramshop Act,” which in many states subjects the owner of a bar to liability if the bar continues to serve an intoxicated patron who later is involved in an accident while intoxicated. Another example involves the sale of adulterated or short-weight foodstuffs: the employer of one who sells such may be liable, even if the employer did not know of the sales.
Principal’s Criminal Liability
As a general proposition, a principal will not be held liable for an agent’s unauthorized criminal acts if the crimes are those requiring specific intent. Thus a department store proprietor who tells his chief buyer to get the “best deal possible” on next fall’s fashions is not liable if the buyer steals clothes from the manufacturer. A principal will, however, be liable if the principal directed, approved, or participated in the crime. Cases here involve, for example, a corporate principal’s liability for agents’ activity in antitrust violations—price-fixing is one such violation.
There is a narrow exception to the broad policy of immunity. Courts have ruled that under certain regulatory statutes and regulations, an agent’s criminality may be imputed to the principal, just as civil liability is imputed under Dramshop Acts. These include pure food and drug acts, speeding ordinances, building regulations, child labor rules, and minimum wage and maximum hour legislation. Misdemeanor criminal liability may be imposed upon corporations and individual employees for the sale or shipment of adulterated food in interstate commerce, notwithstanding the fact that the defendant may have had no actual knowledge that the food was adulterated at the time the sale or shipment was made.
Key Takeaway
The principal will be liable for the employee’s torts in two circumstances: first, if the principal was directly responsible, as in hiring a person the principal knew or should have known was incompetent or dangerous; second, if the employee committed the tort in the scope of business for the principal. This is the master-servant doctrine or respondeat superior. It imposes vicarious liability on the employer: the master (employer) will be liable if the employee was in the zone of activity creating a risk for the employer (“zone of risk” test), that is—generally—if the employee was where he was supposed to be, when he was supposed to be there, and the incident arose out of the employee’s interest (however perverted) in promoting the employer’s business.
Special cases of vicarious liability arise in several circumstances. For example, the owner of an automobile may be liable for torts committed by one who borrows it, or if it is—even if indirectly—used for family purposes. Parents are, by statute in many states, liable for their children’s torts. Similarly by statute, the sellers and employers of sellers of alcohol or adulterated or short-weight foodstuffs may be liable. The employer of one who commits a crime is not usually liable unless the employer put the employee up to the crime or knew that a crime was being committed. But some prophylactic statutes impose liability on the employer for the employee’s crime—even if the employee had no intention to commit it—as a means to force the employer to prevent such actions.
Exercises
1. What is the difference between direct and vicarious employer tort liability?
2. What is meant by the “zone of risk” test?
3. Under what circumstances will an employer be liable for intentional torts of the employee?
4. When will the employer be liable for an employee’s criminal acts? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/15%3A_Liability_of_Principal_and_Agent_Termination_of_Agency/15.02%3A_Principals_Tort_and_Criminal_Liability.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the agent’s personal liability for tort.
• Understand the agent’s personal liability for contract.
• Recognize the ways the agency relationship is terminated.
Agent’s Personal Liability for Torts and Contracts
Tort Liability
That a principal is held vicariously liable and must pay damages to an injured third person does not excuse the agent who actually committed the tortious acts. A person is always liable for his or her own torts (unless the person is insane, involuntarily intoxicated, or acting under extreme duress). The agent is personally liable for his wrongful acts and must reimburse the principal for any damages the principal was forced to pay, as long as the principal did not authorize the wrongful conduct. The agent directed to commit a tort remains liable for his own conduct but is not obliged to repay the principal. Liability as an agent can be burdensome, sometimes perhaps more burdensome than as a principal. The latter normally purchases insurance to cover against wrongful acts of agents, but liability insurance policies frequently do not cover the employee’s personal liability if the employee is named in a lawsuit individually. Thus doctors’ and hospitals’ malpractice policies protect a doctor from both her own mistakes and those of nurses and others that the doctor would be responsible for; nurses, however, might need their own coverage. In the absence of insurance, an agent is at serious risk in this lawsuit-conscious age. The risk is not total. The agent is not liable for torts of other agents unless he is personally at fault—for example, by negligently supervising a junior or by giving faulty instructions. For example, an agent, the general manager for a principal, hires Brown as a subordinate. Brown is competent to do the job but by failing to exercise proper control over a machine negligently injures Ted, a visitor to the premises. The principal and Brown are liable to Ted, but the agent is not.
Contract Liability
It makes sense that an agent should be liable for her own torts; it would be a bad social policy indeed if a person could escape tort liability based on her own fault merely because she acted in an agency capacity. It also makes sense that—as is the general rule—an agent is not liable on contracts she makes on the principal’s behalf; the agent is not a party to a contract made by the agent on behalf of the principal. No public policy would be served by imposing liability, and in many cases it would not make sense. Suppose an agent contracts to buy \$25 million of rolled aluminum for a principal, an airplane manufacturer. The agent personally could not reasonably perform such contract, and it is not intended by the parties that she should be liable. (Although the rule is different in England, where an agent residing outside the country is liable even if it is clear that he is signing in an agency capacity.) But there are three exceptions to this rule: (1) if the agent is undisclosed or partially disclosed, (2) if the agent lacks authority or exceeds it, or (3) if the agent entered into the contract in a personal capacity. We consider each situation.
Agent for Undisclosed or Partially Disclosed Principal
An agent need not, and frequently will not, inform the person with whom he is negotiating that he is acting on behalf of a principal. The secret principal is usually called an “undisclosed principal.” Or the agent may tell the other person that he is acting as an agent but not disclose the principal’s name, in which event the principal is “partially disclosed.” To understand the difficulties that may occur, consider the following hypothetical but common example. A real estate developer known for building amusement parks wants to acquire several parcels of land to construct a new park. He wants to keep his identity secret to hold down the land cost. If the landowners realized that a major building project was about to be launched, their asking price would be quite high. So the developer obtains two options to purchase land by using two secret agents—Betty and Clem.
Betty does not mention to sellers that she is an agent; therefore, to those sellers the developer is an undisclosed principal. Clem tells those with whom he is dealing that he is an agent but refuses to divulge the developer’s name or his business interest in the land. Thus the developer is, to the latter sellers, a partially disclosed principal. Suppose the sellers get wind of the impending construction and want to back out of the deal. Who may enforce the contracts against them?
The developer and the agents may sue to compel transfer of title. The undisclosed or partially disclosed principal may act to enforce his rights unless the contract specifically prohibits it or there is a representation that the signatories are not signing for an undisclosed principal. The agents may also bring suit to enforce the principal’s contract rights because, as agents for an undisclosed or partially disclosed principal, they are considered parties to their contracts.
Now suppose the developer attempts to call off the deal. Whom may the sellers sue? Both the developer and the agents are liable. That the sellers had no knowledge of the developer’s identity—or even that there was a developer—does not invalidate the contract. If the sellers first sue agent Betty (or Clem), they may still recover the purchase price from the developer as long as they had no knowledge of his identity prior to winning the first lawsuit. The developer is discharged from liability if, knowing his identity, the plaintiffs persist in a suit against the agents and recover a judgment against them anyway. Similarly, if the seller sues the principal and recovers a judgment, the agents are relieved of liability. The seller thus has a “right of election” to sue either the agent or the undisclosed principal, a right that in many states may be exercised any time before the seller collects on the judgment.
Lack of Authority in Agent
An agent who purports to make a contract on behalf of a principal, but who in fact has no authority to do so, is liable to the other party. The theory is that the agent has warranted to the third party that he has the requisite authority. The principal is not liable in the absence of apparent authority or ratification. But the agent does not warrant that the principal has capacity. Thus an agent for a minor is not liable on a contract that the minor later disavows unless the agent expressly warranted that the principal had attained his majority. In short, the implied warranty is that the agent has authority to make a deal, not that the principal will necessarily comply with the contract once the deal is made.
Agent Acting on Own Account
An agent will be liable on contracts made in a personal capacity—for instance, when the agent personally guarantees repayment of a debt. The agent’s intention to be personally liable is often difficult to determine on the basis of his signature on a contract. Generally, a person signing a contract can avoid personal liability only by showing that he was in fact signing as an agent. If the contract is signed “Jones, Agent,” Jones can introduce evidence to show that there was never an intention to hold him personally liable. But if he signed “Jones” and neither his agency nor the principal’s name is included, he will be personally liable. This can be troublesome to agents who routinely indorse checks and notes. There are special rules governing these situations.
Termination of Agency
The agency relationship is not permanent. Either by action of the parties or by law, the relationship will eventually terminate.
By Act of the Parties
Certainly the parties to an agency contract can terminate the agreement. As with the creation of the relationship, the agreement may be terminated either expressly or implicitly.
Express Termination
Many agreements contain specified circumstances whose occurrence signals the end of the agency. The most obvious of these circumstances is the expiration of a fixed period of time (“agency to terminate at the end of three months” or “on midnight, December 31”). An agreement may also terminate on the accomplishment of a specified act (“on the sale of the house”) or following a specific event (“at the conclusion of the last horse race”).
Mutual consent between the parties will end the agency. Moreover, the principal may revoke the agency or the agent may renounce it; such a revocation or renunciation of agency would be an express termination. Even a contract that states the agreement is irrevocable will not be binding, although it can be the basis for a damage suit against the one who breached the agreement by revoking or renouncing it. As with any contract, a person has the power to breach, even in absence of the right to do so. If the agency is coupled with an interest, however, so that the authority to act is given to secure an interest that the agent has in the subject matter of the agency, then the principal lacks the power to revoke the agreement.
Implied Termination
There are a number of other circumstances that will spell the end of the relationship by implication. Unspecified events or changes in business conditions or the value of the subject matter of the agency might lead to a reasonable inference that the agency should be terminated or suspended; for example, the principal desires the agent to buy silver but the silver market unexpectedly rises and silver doubles in price overnight. Other circumstances that end the agency include disloyalty of the agent (e.g., he accepts an appointment that is adverse to his first principal or embezzles from the principal), bankruptcy of the agent or of the principal, the outbreak of war (if it is reasonable to infer that the principal, knowing of the war, would not want the agent to continue to exercise authority), and a change in the law that makes a continued carrying out of the task illegal or seriously interferes with it.
By Operation of Law
Aside from the express termination (by agreement of both or upon the insistence of one), or the necessary or reasonable inferences that can be drawn from their agreements, the law voids agencies under certain circumstances. The most frequent termination by operation of law is the death of a principal or an agent. The death of an agent also terminates the authority of subagents he has appointed, unless the principal has expressly consented to the continuing validity of their appointment. Similarly, if the agent or principal loses capacity to enter into an agency relationship, it is suspended or terminated. The agency terminates if its purpose becomes illegal.
Even though authority has terminated, whether by action of the parties or operation of law, the principal may still be subject to liability. Apparent authority in many instances will still exist; this is called lingering authority. It is imperative for a principal on termination of authority to notify all those who may still be in a position to deal with the agent. The only exceptions to this requirement are when termination is effected by death, loss of the principal’s capacity, or an event that would make it impossible to carry out the object of the agency.
Key Takeaway
A person is always liable for her own torts, so an agent who commits a tort is liable; if the tort was in the scope of employment the principal is liable too. Unless the principal put the agent up to committing the tort, the agent will have to reimburse the principal. An agent is not generally liable for contracts made; the principal is liable. But the agent will be liable if he is undisclosed or partially disclosed, if the agent lacks authority or exceeds it, or, of course, if the agent entered into the contract in a personal capacity.
Agencies terminate expressly or impliedly or by operation of law. An agency terminates expressly by the terms of the agreement or mutual consent, or by the principal’s revocation or the agent’s renunciation. An agency terminates impliedly by any number of circumstances in which it is reasonable to assume one or both of the parties would not want the relationship to continue. An agency will terminate by operation of law when one or the other party dies or becomes incompetent, or if the object of the agency becomes illegal. However, an agent may have apparent lingering authority, so the principal, upon termination of the agency, should notify those who might deal with the agent that the relationship is severed.
Exercises
1. Pauline, the owner of a large bakery business, wishes to expand her facilities by purchasing the adjacent property. She engages Alice as an agent to negotiate the deal with the property owner but instructs her not to tell the property owner that she—Alice—is acting as an agent because Pauline is concerned that the property owner would demand a high price. A reasonable contract is made. When the economy sours, Pauline decides not to expand and cancels the plan. Who is liable for the breach?
2. Peter, the principal, instructs his agent, Alice, to tour England and purchase antique dining room furniture for Peter’s store. Alice buys an antique bed set. Who is liable, Peter or Alice? Suppose the seller did not know of the limit on Alice’s authority and sells the bed set to Alice in good faith. What happens when Peter discovers he owes the seller for the set?
3. Under what circumstances will the agency terminate expressly?
4. Agent is hired by Principal to sell a new drug, Phobbot. Six months later, as it becomes apparent that Phobbot has nasty side effects (including death), the Food and Drug Administration orders the drug pulled from the shelves. Agent’s agency is terminated; what terminology is appropriate to describe how?
5. Principal engages Agent to buy lumber, and in that capacity Agent deals with several large timber owners. Agent’s contract ends on July 31; on August 1, Agent buys \$150,000 worth of lumber from a seller with whom he had dealt previously on Principal’s behalf. Who is liable and why? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/15%3A_Liability_of_Principal_and_Agent_Termination_of_Agency/15.03%3A_Agents_Personal_Liability_for_Torts_and_Contracts_Termination_of_Agency.txt |
Implied Authority
Kanavos v. Hancock Bank & Trust Company
439 N.E.2d 311 (Mass. 1982)
KASS, J.
At the close of the plaintiff’s evidence, the defendant moved for a directed verdict, which the trial judge allowed. The judge’s reason for so doing was that the plaintiff, in his contract action, failed to introduce sufficient evidence tending to prove that the bank officer who made the agreement with which the plaintiff sought to charge the bank had any authority to make it. Upon review of the record we are of opinion that there was evidence which, if believed, warranted a finding that the bank officer had the requisite authority or that the bank officer had apparent authority to make the agreement in controversy. We therefore reverse the judgment.
For approximately ten years prior to 1975, Harold Kanavos and his brother borrowed money on at least twenty occasions from the Hancock Bank & Trust Company (the Bank), and, during that period, the loan officer with whom Kanavos always dealt was James M. Brown. The aggregate loans made by the Bank to Kanavos at any given time went as high as \$800,000.
Over that same decade, Brown’s responsibilities at the Bank grew, and he had become executive vice-president. Brown was also the chief loan officer for the Bank, which had fourteen or fifteen branches in addition to its head office. Physically, Brown’s office was at the head office, toward the rear of the main banking floor, opposite the office of the president—whose name was Kelley. Often Brown would tell Kanavos that he had to check an aspect of a loan transaction with Kelley, but Kelley always backed Brown up on those occasions.…
[The plaintiff, Harold Kanavos, entered into an agreement with the defendant Bank whereby stock owned by the Kanavos brothers was sold to the Bank and the plaintiff was given an option to repurchase the stock. Kanavos’ suit against the Bank was based on an amendment to the agreement offered by Brown.]
Kanavos was never permitted to introduce in evidence the terms of the offer Brown made. That offer was contained in a writing, dated July 16, 1976, on bank letterhead, which read as follows: “This letter is to confirm our conversation regarding your option to re-purchase the subject property. In lieu of your not exercising your option, we agree to pay you \$40,000 representing a commission upon our sale of the subject property, and in addition, will give you the option to match the price of sale of said property to extend for a 60 day period from the time our offer is received.” Brown signed the letter as executive vice-president. The basis of exclusion was that the plaintiff had not established the authority of Brown to make with Kanavos the arrangement memorialized in the July 16, 1976, letter.
Whether Brown’s job description impliedly authorized the right of last refusal or cash payment modification is a question of how, in the circumstances, a person in Brown’s position could reasonably interpret his authority. Whether Brown had apparent authority to make the July 16, 1976, modification is a question of how, in the circumstances, a third person, e.g., a customer of the Bank such as Kanavos, would reasonably interpret Brown’s authority in light of the manifestations of his principal, the Bank.
Titles of office generally do not establish apparent authority. Brown’s status as executive vice-president was not, therefore, a badge of apparent authority to modify agreements to which the Bank was a party.
Trappings of office, e.g., office and furnishing, private secretary, while they may have some tendency to suggest executive responsibility, do not without other evidence provide a basis for finding apparent authority. Apparent authority is drawn from a variety of circumstances. Thus in Federal Nat. Bank v. O’Connell…(1940), it was held apparent authority could be found because an officer who was a director, vice-president and treasurer took an active part in directing the affairs of the bank in question and was seen by third parties talking with customers and negotiating with them. In Costonis v. Medford Housing Authy.…(1961), the executive director of a public housing authority was held to have apparent authority to vary specifications on the basis of the cumulative effect of what he had done and what the authority appeared to permit him to do.
In the instant case there was evidence of the following variety of circumstances: Brown’s title of executive vice-president; the location of his office opposite the president; his frequent communications with the president; the long course of dealing and negotiations; the encouragement of Kanavos by the president to deal with Brown; the earlier amendment of the agreement by Brown on behalf of the Bank on material points, namely the price to be paid by the Bank for the shares and the repurchase price; the size of the Bank (fourteen or fifteen branches in addition to the main office); the secondary, rather than fundamental, nature of the change in the terms of the agreement now repudiated by the Bank, measured against the context of the overall transaction; and Brown’s broad operating authority…all these added together would support a finding of apparent authority. When a corporate officer, as here, is allowed to exercise general executive responsibilities, the “public expectation is that the corporation should be bound to engagements made on its behalf by those who presume to have, and convincingly appear to have, the power to agree.” [Citation] This principle does not apply, of course, where in the business context, the requirement of specific authority is presumed, e.g., the sale of a major asset by a corporation or a transaction which by its nature commits the corporation to an obligation outside the scope of its usual activity. The modification agreement signed by Brown and dated July 16, 1976, should have been admitted in evidence, and a verdict should not have been directed.
Judgment reversed.
Case Questions
1. Why are “titles of office” insufficient to establish apparent authority?
2. Why are “trappings of office” insufficient to establish apparent authority?
3. What is the relationship between apparent authority and estoppel? Who is estopped to do what, and why?
Employer’s Liability for Employee’s Intentional Torts: Scope of Employment
Lyon v. Carey
533 F.2d 649 (Cir. Ct. App. DC 1976)
McMillan, J.:
Corene Antoinette Lyon, plaintiff, recovered a \$33,000.00 verdict [about \$142,000 in 2010 dollars] in the United States District Court for the District of Columbia before Judge Barrington T. Parker and a jury, against the corporate defendants, George’s Radio and Television Company, Inc., and Pep Line Trucking Company, Inc. The suit for damages arose out of an assault, including rape, committed with a knife and other weapons upon the plaintiff on May 9, 1972, by Michael Carey, a nineteen-year-old deliveryman for Pep Line Trucking Company, Inc. Three months after the trial, Judge Parker set aside the verdict and rendered judgment for both defendants notwithstanding the verdict. Plaintiff appealed.…
Although the assault was perhaps at the outer bounds of respondeat superior, the case was properly one for the jury. Whether the assault in this case was the outgrowth of a job-related controversy or simply a personal adventure of the deliveryman, was a question for the jury. This was the import of the trial judge’s instructions. The verdict as to Pep Line should not have been disturbed.
Irene Lyon bought a mattress and springs for her bed from the defendant George’s Radio and Television Company, Inc. The merchandise was to be delivered on May 9, 1972. Irene Lyon had to be at work and the plaintiff [Irene’s sister] Corene Lyon, had agreed to wait in her sister’s apartment to receive the delivery.
A C.O.D. balance of \$13.24 was due on the merchandise, and Irene Lyon had left a check for \$13.24 to cover that balance. Plaintiff had been requested by her sister to “wait until the mattress and the springs came and to check and make sure they were okay.”
Plaintiff, fully clothed, answered the door. Her description of what happened is sufficiently brief and unqualified that it will bear repeating in full. She testified, without objection, as follows:
I went to the door, and I looked in the peephole, and I asked who was there. The young man told me he was a delivery man from George’s. He showed me a receipt, and it said, ‘George’s.’ He said he [needed cash on delivery—COD], so I let him in, and I told him to bring the mattress upstairs and he said, ‘No,’ that he wasn’t going to lug them upstairs, and he wanted the COD first, and I told him I wanted to see the mattress and box springs to make sure they were okay, and he said no, he wasn’t going to lug them upstairs [until he got the check].
So this went back and forwards and so he was getting angry, and I told him to wait right here while I go get the COD. I went to the bedroom to get the check, and I picked it up, and I turned around and he was right there.
And then I was giving him the check and then he told me that his boss told him not to accept a check, that he wanted cash money, and that if I didn’t give him cash money, he was going to take it on my ass, and he told me that he was no delivery man, he was a rapist and then he threw me on the bed.
[The Court] Talk louder, young lady, the jury can’t hear you.
[The witness] And then he threw me on the bed, and he had a knife to my throat.
[Plaintiff’s attorney] Then what happened?
And then he raped me.
Plaintiff’s pre-trial deposition was a part of the record on appeal, and it shows that Carey raped plaintiff at knife point; that then he chased her all over the apartment with a knife and scissors and cut plaintiff in numerous places on her face and body, beat and otherwise attacked her. All of the physical injury other than the rape occurred after rather than before the rape had been accomplished.…
[Carey was convicted of rape and sent to prison. The court determined that George’s was properly dismissed because Pep Line, Carey’s employer, was an independent contractor over which George’s had no control.]
The principal question, therefore, is whether the evidence discloses any other basis upon which a jury could reasonably find Pep Line, the employer of Carey, liable for the assault.
Michael Carey was in the employment of the defendant Pep Line as a deliveryman. He was authorized to make the delivery of the mattress and springs plaintiff’s sister had bought. He gained access to the apartment only upon a showing of the delivery receipt for the merchandise. His employment contemplated that he visit and enter that particular apartment. Though the apartment was not owned by nor in the control of his employer, it was nevertheless a place he was expected by his employer to enter.
After Carey entered, under the credentials of his employment and the delivery receipt, a dispute arose naturally and immediately between him and the plaintiff about two items of great significance in connection with his job. These items were the request of the plaintiff, the customer’s agent, to inspect the mattress and springs before payment (which would require their being brought upstairs before the payment was made), and Carey’s insistence on getting cash rather than a check.
The dispute arose out of the very transaction which had brought Carey to the premises, and, according to the plaintiff’s evidence, out of the employer’s instructions to get cash only before delivery.
On the face of things, Pep Line Trucking Company, Inc. is liable, under two previous decisions of the Court of Appeals for the District of Columbia Circuit. [Citation (1953)] held a taxi owner liable for damages (including a broken leg) sustained by a customer who had been run over by the taxi in pursuit of a dispute between the driver and the customer about a fare. [Citation (1939)], held a restaurant owner liable to a restaurant patron who was beaten with a stick by a restaurant employee, after a disagreement over the service. The theory was that:
It is well established that an employer may be held responsible in tort for assaults committed by an employee while he is acting within the scope of his employment, even though he may act wantonly and contrary to his employer’s instructions. [Citations] “…having placed [the employee] in charge and committed the management of the business to his care, defendants may not escape liability either on the ground of his infirmity of temperament or because, under the influence of passion aroused by plaintiff’s threat to report the circumstances, he went beyond the ordinary line of duty and inflicted the injury shown in this case. [Citations]”
Munick v. City of Durham ([Citation], Supreme Court of North Carolina, 1921), though not a binding precedent, is informative and does show that the theory of liability advanced by the plaintiff is by no means recent in origin. The plaintiff, Munick, a Russian born Jew, testified that he went to the Durham, North Carolina city water company office on April 17, 1919, and offered to pay his bill with “three paper dollars, one silver dollar, and fifty cents in pennies.” The pennies were in a roll “like the bank fixes them.” The clerk gave a receipt and the plaintiff prepared to leave the office. The office manager came into the room, saw the clerk counting the pennies, became enraged at the situation, shoved the pennies onto the floor and ordered Munick to pick them up. Bolton, the manager, “locked the front door and took me by the jacket and called me ‘God damned Jew,’ and said, ‘I want only bills.’ I did not say anything and he hit me in the face. I did not resist, and the door was locked and I could not get out.…” With the door locked, Bolton then repeatedly choked and beat the plaintiff, finally extracted a bill in place of the pennies, and ordered him off the premises with injuries including finger marks on his neck that could be seen for eight or ten days. Bolton was convicted of unlawful assault [but the case against the water company was dismissed].
The North Carolina Supreme Court (Clark, C. J.) reversed the trial court’s dismissal and held that the case should have gone to the jury. The court…said [Citation]:
“‘It is now fully established that corporations may be held liable for negligent and malicious torts, and that responsibility will be imputed whenever such wrongs are committed by their employees and agents in the course of their employment and within its scope * * * in many of the cases, and in reliable textbooks * * * ‘course of employment’ is stated and considered as sufficiently inclusive; but, whether the one or the other descriptive term is used, they have the same significance in importing liability on the part of the principal when the agent is engaged in the work that its principal has employed or directed him to do and * * * in the effort to accomplish it. When such conduct comes within the description that constitutes an actionable wrong, the corporation principal, as in other cases of principal and agent, is liable not only for ‘the act itself, but for the ways and means employed in the performance thereof.’
“In 1 Thompson, Negligence, s 554, it is pointed out that, unless the above principle is maintained:
“‘It will always be more safe and profitable for a man to conduct his business vicariously than in his own person. He would escape liability for the consequences of many acts connected with his business, springing from the imperfections of human nature, because done by another, for which he would be responsible if done by himself. Meanwhile, the public, obliged to deal or come in contact with his agent, for injuries done by them must be left wholly without redress. He might delegate to persons pecuniarily irresponsible the care of large factories, of extensive mines, of ships at sea, or of railroad trains on land, and these persons, by the use of the extensive power thus committed to them, might inflict wanton and malicious injuries on third persons, without other restraint than that which springs from the imperfect execution of the criminal laws. A doctrine so fruitful of mischief could not long stand unshaken in an enlightened jurisprudence.’ This court has often held the master liable, even if the agent was willful, provided it was committed in the course of his employment. [Citation]”
“The act of a servant done to effect some independent purpose of his own and not with reference to the service in which he is employed, or while he is acting as his own master for the time being, is not within the scope of his employment so as to render the master liable therefor. In these circumstances the servant alone is liable for the injury inflicted.” [Citation].…”The general idea is that the employee at the time of doing the wrongful act, in order to fix liability on the employer, must have been acting in behalf of the latter and not on his own account [Citation].”
The principal physical (as opposed to psychic) damage to the plaintiff is a number of disfiguring knife wounds on her head, face, arms, breasts and body. If the instrumentalities of assault had not included rape, the case would provoke no particular curiosity nor interest because it comes within all the classic requirements for recovery against the master. The verdict is not attacked as excessive, and could not be excessive in light of the physical injuries inflicted.
It may be suggested that [some of the cases discussed] are distinguishable because in each of those cases the plaintiff was a business visitor on the defendant’s “premises.”…Home delivery customers are usually in their homes, sometimes alone; and deliveries of merchandise may expose householders to one-on-one confrontations with deliverymen. It would be a strange rule indeed which, while allowing recovery for assaults committed in “the store,” would deny a master’s liability for an assault committed on a lone woman in her own home, by a deliveryman required by his job to enter the home.…
If, as in [one case discussed], the assault was not motivated or triggered off by anything in the employment activity but was the result of only propinquity and lust, there should be no liability. However, if the assault, sexual or otherwise, was triggered off or motivated or occasioned by a dispute over the conduct then and there of the employer’s business, then the employer should be liable.
It is, then, a question of fact for the trier of fact, rather than a question of law for the court, whether the assault stemmed from purely and solely personal sources or arose out of the conduct of the employer’s business; and the trial judge so instructed the jury.
It follows that, under existing decisions of the District of Columbia Circuit, plaintiff has made out a case for the jury against Pep Line Trucking, Inc. unless the sexual character of one phase of the assault bars her from recovery for damages from all phases of the assault.
We face, then, this question: Should the entire case be taken from the jury because, instead of a rod of wood (as in [one case]), in addition to weapons of steel (as in [one case, a knife]); and in addition to his hands (as in [the third case, regarding the dispute about the pennies]), Carey also employed a sexual weapon, a rod of flesh and blood in the pursuit of a job-related controversy?
The answer is, No. It is a jury’s job to decide how much of plaintiff’s story to believe, and how much if any of the damages were caused by actions, including sexual assault, which stemmed from job-related sources rather than from purely personal origins.…
The judgment is affirmed as to the defendant George’s and reversed as to the defendant Pep Line Trucking Company, Inc.
Case Questions
1. What triggered the dispute here?
2. The court observes, “On the face of things, Pep Line Trucking Company, Inc. is liable.” But there are two issues that give the court cause for more explanation. (1) Why does the court discuss the point that the assault did not occur on the employer’s premises? (2) Why does the court mention that the knife assault happened after the rape?
3. It is difficult to imagine that a sexual assault could be anything other than some “purely and solely personal” gratification, unrelated to the employer’s business. How did the court address this?
4. What is the controlling rule of law as to the employer’s liability for intentional torts here?
5. What does the court mean when it says, “the assault was perhaps at the outer bounds of respondeat superior”?
6. Would the jury think about who had the “deep pocket” here? Who did have it?
Employer’s Liability for Employee’s Intentional Torts: Scope of Employment
Cockrell v. Pearl River Valley Water Supply Dist.
865 So.2d 357 (Miss. 2004)
The Pearl River Valley Water Supply District (“District”) was granted summary judgment pursuant to the Mississippi Tort Claims Act (MTCA) dismissing with prejudice all claims asserted against it by Sandra Cockrell. Cockrell appeals the ruling of the circuit court citing numerous errors. Finding the motion for summary judgment was properly granted in favor of the District, this Court affirms the final judgment entered by the Circuit Court of Rankin County.
Facts and Proceedings in the Trial Court
On June 28, 1998, Sandra Cockrell was arrested for suspicion of driving under the influence of alcohol by Officer Joey James who was employed as a security patrol officer with the Reservoir Patrol of the Pearl River Valley Water Supply District. Officer James then transported Cockrell to the Reservoir Patrol office and administered an intoxilyzer test. The results of the test are not before us; however, we do know that after the test was administered, Officer James apologized to Cockrell for arresting her, and he assured her that he would prepare her paperwork so that she would not have to spend much time in jail. As they were leaving the Reservoir Patrol office, Officer James began asking Cockrell personal questions such as where she lived, whether she was dating anyone and if she had a boyfriend. Officer James then asked Cockrell for her cell phone number so that he could call and check on her. As they were approaching his patrol car for the trip to the Rankin County jail, Officer James informed Cockrell that she should be wearing handcuffs; however, he did not handcuff Cockrell, and he allowed her to ride in the front seat of the patrol car with him. In route to the jail, Cockrell became emotional and started crying. As she was fixing her makeup using the mirror on the sun visor, Officer James pulled his patrol car into a church parking lot and parked the car. He then pulled Cockrell towards him in an embrace and began stroking her back and hair telling her that things would be fine. Cockrell told Officer James to release her, but he continued to embrace her for approximately five minutes before continuing on to the jail.
On June 30, 1998, Cockrell returned to the Reservoir Patrol office to retrieve her driver’s license. Officer James called Cockrell into his office and discussed her DUI charge with her. As she was leaving, Officer James grabbed her from behind, turned her around, pinned both of her arms behind her and pulled her to his chest. When Officer James bent down to kiss her, she ducked her head, thus causing Officer James to instead kiss her forehead. When Officer James finally released Cockrell, she ran out of the door and drove away. [Subsequently, Cockrell’s attorney threatened civil suit against Patrol; James was fired in October 1998.]
On September 22, 1999, Cockrell filed a complaint for damages against the District alleging that on the nights of June 28 and June 30, 1998, Officer James was acting within the course and scope of his employment with the District and that he acted with reckless disregard for her emotional well-being and safety.…On April 2, 2002, the District filed its motion for summary judgment alleging that there was no genuine issue of material fact regarding Cockrell’s claim of liability. The motion alleged that the conduct described by Cockrell was outside the course and scope of Officer James’s public employment as he was intending to satisfy his lustful urges. Cockrell responded to the motion arguing that the misconduct did occur in the course and scope of Officer James’s employment with the District and also that the misconduct did not reach the level of a criminal offense such that the District could be found not liable under the MTCA.
The trial court entered a final judgment granting the District’s motion for summary judgment and dismissing the complaint with prejudice. The trial court found that the District could not be held liable under the MTCA for the conduct of Officer James which was both criminal and outside the course and scope of his employment. Cockrell…appeal[ed].
Discussion
Summary judgment is granted in cases where there is “no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law.”…
Cockrell contends there is a genuine issue of material of fact regarding whether Officer James was acting in the course and scope of his employment with the District during the incidents which occurred on the nights of June 28 and June 30, 1998. Cockrell argues Officer James’s conduct, although inappropriate, did not rise to the level of criminal conduct. Cockrell contends Officer James’s action of hugging Cockrell was similar to an officer consoling a victim of a crime. Cockrell does admit that Officer James’s action of kissing her is more difficult to view as within the course and scope of his employment…
The District argues that although Officer James acted within the course and scope of his duties when he arrested Cockrell, his later conduct, which was intended to satisfy his lustful desires, was outside the scope of his employment with it.…
“Mississippi law provides that an activity must be in furtherance of the employer’s business to be within the scope and course of employment.” [Citation] To be within the course and scope of employment, an activity must carry out the employer’s purpose of the employment or be in furtherance of the employer’s business. [Citations] Therefore, if an employee steps outside his employer’s business for some reason which is not related to his employment, the relationship between the employee and the employer “is temporarily suspended and this is so ‘no matter how short the time and the [employer] is not liable for [the employee’s] acts during such time.’” “An employee’s personal unsanctioned recreational endeavors are beyond the course and scope of his employment.” [Citation]
[In one case cited,] Officer Kerry Collins, a Jackson Police officer, was on duty when he came upon the parked car of L.T., a minor, and her boyfriend, who were about to engage in sexual activity. [Citation] Officer Collins instructed L.T. to take her boyfriend home, and he would follow her to make sure she followed his orders. After L.T. dropped off her boyfriend, Officer Collins continued to follow her until he pulled L.T. over. Officer Collins then instructed L.T. to follow him to his apartment or else he would inform L.T.’s parents of her activities. L.T. followed Officer Collins to his apartment where they engaged in sexual activity. Upon returning home, L.T. told her parents everything that had happened. L.T. and her parents filed suit against Officer Collins, the City of Jackson and the Westwood Apartments, where Officer Collins lived rent free in return for his services as a security guard.…The district court granted summary judgment in favor of the City finding that Officer Collins acted outside the course and scope of his employment with the Jackson Police Department. [Citation]
In [Citation] the plaintiff sued the Archdiocese of New Orleans for damages that allegedly resulted from his sexual molestation by a Catholic priest. The Fifth Circuit found that the priest was not acting within the course and scope of his employment. The Fifth Circuit held that “smoking marijuana and engaging in sexual acts with minor boys” in no way furthered the interests of his employer.
The Southern District of Mississippi and the Fifth Circuit, applying Mississippi law, have held that sexual misconduct falls outside the course and scope of employment. There is no question that Officer James was within the course and scope of his employment when he first stopped Cockrell for suspicion of driving under the influence of alcohol. However, when Officer James diverted from his employment for personal reasons, he was no longer acting in the furtherance of his employer’s interests…Therefore, the District cannot be held liable…for the misconduct of Officer James which occurred outside the course and scope of his employment.
Affirmed.
Case Questions
1. How can this case and Lyon v. Carey (Section 15.4.2 “Employer’s Liability for Employee’s Intentional Torts: Scope of Employment”) be reconciled? Both involve an agent’s unacceptable behavior—assault—but in Lyon the agent’s actions were imputed to the principal, and in Cockrell the agent’s actions were not imputed to the principal.
2. What is the controlling rule of law governing the principal’s liability for the agent’s actions?
3. The law governing the liability of principals for acts of their agents is well settled. Thus the cases turn on the facts. Who decides what the facts are in a lawsuit? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/15%3A_Liability_of_Principal_and_Agent_Termination_of_Agency/15.04%3A_Cases.txt |
Summary
A contract made by an agent on behalf of the principal legally binds the principal. Three types of authority may bind the principal: (1) express authority—that which is actually given and spelled out, (2) implied authority—that which may fairly be inferred from the parties’ relationship and which is incidental to the agent’s express authority, and (3) apparent authority—that which reasonably appears to a third party under the circumstances to have been given by the principal. Even in the absence of authority, a principal may ratify the agent’s acts.
The principal may be liable for tortious acts of the agent but except under certain regulatory statutes may not be held criminally liable for criminal acts of agents not prompted by the principal. Under the doctrine of respondeat superior, a principal is generally liable for acts by a servant within the scope of employment. A principal usually will not be held liable for acts of nonservant agents that cause physical damage, although he will be held liable for nonphysical torts, such as misrepresentation. The principal will not be held liable for tortious acts of independent contractors, although the principal may be liable for injuries resulting from his failure to act in situations in which he was not legally permitted to delegate a duty to act. Whenever an agent is acting to further the principal’s business interests, the principal will be held vicariously liable for the agent’s intentional torts. What constitutes scope of employment is not easy to determine; the modern trend is to hold a principal liable for the conduct of an agent if it was foreseeable that the agent might act as he did.
Most states have special rules of vicarious liability for special situations; for example, liability of an automobile owner for use by another. Spouses are not vicariously liable for each other, nor are parents for children, except for failing to control children known to be dangerous.
In general, an agent is not personally liable on contracts he has signed on behalf of a principal. This general rule has several exceptions recognized in most states: (1) when the agent is serving an undisclosed or partially disclosed principal, (2) when the agent lacks authority or exceeds his authority, and (3) if the agent entered into the contract in a personal capacity.
The agency relationship may be terminated by mutual consent, by express agreement of the parties that the agency will end at a certain time or on the occurrence of a certain event, or by an implied agreement arising out of the circumstances in each case. The agency may also be unilaterally revoked by the principal—unless the agency is coupled with an interest—or renounced by the agent. Finally, the agency will terminate by operation of law under certain circumstances, such as death of the principal or agent.
Exercises
1. Parke-Bernet Galleries, acting as agent for an undisclosed principal, sold a painting to Weisz. Weisz later discovered that the painting was a forgery and sued Parke-Bernet for breach of contract. In defense, Parke-Bernet argued that as a general rule, agents are not liable on contracts made for principals. Is this a good defense? Explain.
2. Lynch was the loan officer at First Bank. Patterson applied to borrow \$25,000. Bank policy required that Lynch obtain a loan guaranty from Patterson’s employer, a milk company. The manager of the milk company visited the bank and signed a guaranty on behalf of the company. The last paragraph of the guaranty stated, “This guaranty is signed by an officer having legal right to bind the company through authorization of the Board of Directors.” Should Lynch be satisfied with this guaranty? Would he be satisfied if the president of the milk company, who was also a director, affirmed that the manager had authority to sign the guaranty? Explain.
3. Ralph owned a retail meat market. Ralph’s agent Sam, without authority but purporting to act on Ralph’s behalf, borrowed \$7,500 from Ted. Although he never received the money, Ralph repaid \$700 of the alleged loan and promised to repay the rest. If Sam had no authority to make the loan, is Ralph liable? Why?
4. A guest arrived early one morning at the Hotel Ohio. Clemens, a person in the hotel office who appeared to be in charge, walked behind the counter, registered the guest, gave him a key, and took him to his room. The guest also checked valuables (a diamond pin and money) with Clemens, who signed a receipt on behalf of the hotel. Clemens in fact was a roomer at the hotel, not an employee, and had no authority to act on behalf of the hotel. When Clemens absconded with the valuables, the guest sued the hotel. Is the hotel liable? Why?
5. A professional basketball player punched an opposing player in the face during the course of a game. The opponent, who was seriously injured, sued the owner of the team for damages. A jury awarded the player \$222,000 [about \$800,000 in 2010 dollars] for medical expenses, \$200,000 [\$700,000] for physical pain, \$275,000 [\$963,000] for mental anguish, \$1,000,000 [\$3.5 million] for lost earnings, and \$1,500,000 [\$5.2 million] in punitive damages (which was \$500,000 more than requested by the player). The jury also awarded \$50,000 [\$150,000] to the player’s wife for loss of companionship. If we assume that the player who threw the punch acted out of personal anger and had no intention to further the business, how could the damage award against his principal be legally justified?
6. A doctor in a University of Chicago hospital seriously assaulted a patient in an examining room. The patient sued the hospital on the theory that the doctor was an agent or employee of the hospital and the assault occurred within the hospital. Is the hospital liable for the acts of its agent? Why?
7. Hector was employed by a machine shop. One day he made a delivery for his employer and proceeded back to the shop. When he was four miles from the shop and on the road where it was located, he turned left onto another road to visit a friend. The friend lived five miles off the turnoff. On the way to the friend’s house, Hector caused an accident. The injured person sued Hector’s employer. Is the employer liable? Discuss.
8. A fourteen-year-old boy, who had no driver’s license, took his parents’ car without permission and caused an automobile accident. A person injured in the accident sued the boy’s parents under the relevant state’s Parental Responsibility Law (mentioned in Section 15.2.1 “Principal’s Tort Liability”). Are the parents liable? Discuss.
9. In the past decades the Catholic Church has paid out hundreds of millions of dollars in damage awards to people—mostly men—who claimed that when they were boys and teenagers they were sexually abused by their local parish priests, often on Church premises. That is, the men claimed they had been victims of child rape. Obviously, such behavior is antithetical to any reasonable standard of clergy behavior: the priests could not have been in the scope of employment. How is the Church liable?
SELF CHECK QUESTIONS
1. Authority that legally may bind the principal includes
1. implied authority
2. express authority
3. apparent authority
4. all of the above
2. As a general rule, a principal is not
1. liable for tortious acts of an agent, even when the principal is negligent
2. liable for acts of a servant within the scope of employment
3. criminally liable for acts of the agent
4. liable for nondelegable duties performed by independent contractors
3. An agent may be held personally liable on contracts signed on behalf of a principal when
1. the agent is serving an undisclosed or partially disclosed principal
2. the agent exceeds his authority
3. the agent entered into the contract in a personal capacity
4. all of the above are true
4. An agency relationship may be terminated by
1. an implied agreement arising out of the circumstances
2. mutual consent of parties
3. death of the principal or agent
4. all of the above
5. The principal’s liability for the agent’s acts of which the principal had no knowledge or intention to commit is called
1. contract liability
2. implied liability
3. respondeat superior
4. all of the above
1. d
2. c
3. d
4. c
5. b | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/15%3A_Liability_of_Principal_and_Agent_Termination_of_Agency/15.05%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• How common-law employment at will is modified by common-law doctrine, federal statutes, and state statutes
• Various kinds of prohibited discrimination under Title VII and examples of each kind
• The various other protections for employees imposed by federal statute, including the Age Discrimination in Employment Act (ADEA) and the Americans with Disabilities Act (ADA)
In this chapter, we will examine the laws that govern the relationship between the employer and the employee who belongs, or wants to belong, to a union. Although federal labor law is confined to that relationship, laws dealing with the employment relationship—both state and federal—are far broader than that.
16: Employment Law
Because most employees do not belong to unions, a host of laws dealing with the many faces of discrimination shapes employers’ power over and duties to their employees. Beyond the issue of discrimination, the law also governs a number of other issues, such as the extent to which an employer may terminate the relationship itself. We examine these issues later in this chapter.
Even before statutes governing collective bargaining and various state and federal discrimination laws, the common law set the boundaries for employer-employee relationships. The basic rule that evolved prior to the twentieth century was “employment at will.” We will look at employment at will toward the end of this chapter. But as we go through the key statutes on employment law and employment discrimination, bear in mind that these statutes stand as an important set of exceptions to the basic common-law rule of employment at will. That rule holds that in the absence of a contractual agreement otherwise, an employee is free to leave employment at any time and for any reason; similarly, an employer is free to fire employees at any time and for any reason.
16.02: Federal Employment Discrimination Laws
Learning Objectives
By the end of this section, you will be able to:
• Know the various federal discrimination laws and how they are applied in various cases.
• Distinguish between disparate impact and disparate treatment cases.
• Understand the concept of affirmative action and its limits in employment law.
As we look at federal employment discrimination laws, bear in mind that most states also have laws that prohibit various kinds of discriminatory practices in employment. Until the 1960s, Congress had intruded but little in the affairs of employers except in union relationships. A company could refuse to hire members of racial minorities, exclude women from promotions, or pay men more than women for the same work. But with the rise of the civil rights movement in the early 1960s, Congress (and many states) began to legislate away the employer’s frequently exercised power to discriminate. The most important statutes are Title VII of the Civil Rights Act of 1964, the Equal Pay Act of 1963, the Age Discrimination in Employment Act of 1967, and the Americans with Disabilities Act of 1990.
Title VII of the Civil Rights Act of 1964
The most basic antidiscrimination law in employment is in Title VII of the federal Civil Rights Act of 1964. The key prohibited discrimination is that based on race, but Congress also included sex, religion, national origin, and color as prohibited bases for hiring, promotion, layoff, and discharge decisions. To put the Civil Rights Act in its proper context, a short history of racial discrimination in the United States follows.
The passage of the Civil Rights Act of 1964 was the culmination of a long history that dated back to slavery, the founding of the US legal system, the Civil War, and many historical and political developments over the ninety-nine years from the end of the Civil War to the passage of the act. The years prior to 1964 had seen a remarkable rise of civil disobedience, led by many in the civil rights movement but most prominently by Dr. Martin Luther King Jr. Peaceful civil disobedience was sometimes met with violence, and television cameras were there to record most of it.
While the Civil War had addressed slavery and the secession of Southern states, the Thirteenth, Fourteenth, and Fifteenth Amendments, ratified just after the war, provided for equal protection under the law, guaranteed citizenship, and protected the right to vote for African Americans. The amendments also allowed Congress to enforce these provisions by enacting appropriate, specific legislation.
But during the Reconstruction Era, many of the Southern states resisted the laws that were passed in Washington, DC, to bolster civil rights. To a significant extent, decisions rendered by the US Supreme Court in this era—such as Plessy v. Ferguson, condoning “separate but equal” facilities for different races—restricted the utility of these new federal laws. The states effectively controlled the public treatment of African Americans, and a period of neglect set in that lasted until after World War II. The state laws essentially mandated segregated facilities (restaurants, hotels, schools, water fountains, public bathrooms) that were usually inferior for blacks.
Along with these Jim Crow laws in the South, the Ku Klux Klan was very strong, and lynchings (hangings without any sort of public due process) by the Klan and others were designed to limit the civil and economic rights of the former slaves. The hatred of blacks from that era by many whites in America has only gradually softened since 1964. Even as the civil rights bill was being debated in Congress in 1964, some Young Americans for Freedom in the right wing of the GOP would clandestinely chant “Be a man, join the Klan” and sing “We will hang Earl Warren from a sour apple tree,” to the tune of “Battle Hymn of the Republic,” in anger over the Chief Justice’s presiding over Brown v. Board of Education, which reversed Plessy v. Ferguson.
But just a few years earlier, the public service and heroism of many black military units and individuals in World War II had created a perceptual shift in US society; men of many races who had served together in the war against the Axis powers (fascism in Europe and the Japanese emperor’s rule in the Pacific) began to understand their common humanity. Major migrations of blacks from the South to industrial cities of the North also gave impetus to the civil rights movement.
Bills introduced in Congress regarding employment policy brought the issue of civil rights to the attention of representatives and senators. In 1945, 1947, and 1949, the House of Representatives voted to abolish the poll tax. The poll tax was a method used in many states to confine voting rights to those who could pay a tax, and often, blacks could not. The Senate did not go along, but these bills signaled a growing interest in protecting civil rights through federal action. The executive branch of government, by presidential order, likewise became active by ending discrimination in the nation’s military forces and in federal employment and work done under government contract.
The Supreme Court gave impetus to the civil rights movement in its reversal of the “separate but equal” doctrine in the Brown v. Board of Education decision. In its 1954 decision, the Court said, “To separate black children from others of similar age and qualifications solely because of their race generates a feeling of inferiority as to their status in the community that may affect their hearts and minds in a way never to be undone.…We conclude that in the field of public education the doctrine of separate but equal has no place. Separate educational facilities are inherently unequal.”
This decision meant that white and black children could not be forced to attend separate public schools. By itself, however, this decision did not create immediate gains, either in public school desegregation or in the desegregation of other public facilities. There were memorable standoffs between federal agents and state officials in Little Rock, Arkansas, for example; the Democratic governor of Arkansas personally blocked young black students from entering Little Rock’s Central High School, and it was only President Eisenhower’s order to have federal marshals accompany the students that forced integration. The year was 1957.
But resistance to public school integration was widespread, and other public facilities were not governed by the Brown ruling. Restaurants, hotels, and other public facilities were still largely segregated. Segregation kept blacks from using public city buses, park facilities, and restrooms on an equal basis with whites. Along with inferior schools, workplace practices throughout the South and also in many Northern cities sharply limited African Americans’ ability to advance economically. Civil disobedience began to grow.
The bus protests in Montgomery, Alabama, were particularly effective. Planned by civil rights leaders, Rosa Parks’s refusal to give up her seat to a white person and sit at the back of the public bus led to a boycott of the Montgomery bus system by blacks and, later, a boycott of white businesses in Montgomery. There were months of confrontation and some violence; finally, the city agreed to end its long-standing rules on segregated seating on buses.
There were also protests at lunch counters and other protests on public buses, where groups of Northern protesters—Freedom Riders—sometimes met with violence. In 1962, James Meredith’s attempt to enroll as the first African American at the University of Mississippi generated extreme hostility; two people were killed and 375 were injured as the state resisted Meredith’s admission. The murders of civil rights workers Medgar Evers and William L. Moore added to the inflamed sentiments, and whites in Birmingham, Alabama, killed four young black girls who were attending Sunday school when their church was bombed.
These events were all covered by the nation’s news media, whose photos showed beatings of protesters and the use of fire hoses on peaceful protesters. Social tensions were reaching a postwar high by 1964. According to the government, there were nearly one thousand civil rights demonstrations in 209 cities in a three-month period beginning May 1963. Representatives and senators could not ignore the impact of social protest. But the complicated political history of the Civil Rights Act of 1964 also tells us that the legislative result was anything but a foregone conclusion.See CongressLink, “Major Features of the Civil Rights Act of 1964,” at http://www.congresslink.org/print_basics_histmats_civilrights64text.htm.
In Title VII of the Civil Rights Act of 1964, Congress for the first time outlawed discrimination in employment based on race, religion, sex, or national origin:. Title VII declares: “It shall be an unlawful employment practice for an employer to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against any individual with respect to his compensation, terms, conditions, or privileges of employment, because of such individual’s race, color, religion, sex, or national origin.” Title VII applies to (1) employers with fifteen or more employees whose business affects interstate commerce, (2) all employment agencies, (3) labor unions with fifteen or more members, (4) state and local governments and their agencies, and (5) most federal government employment.
In 1984, the Supreme Court said that Title VII applies to partnerships as well as corporations when ruling that it is illegal to discriminatorily refuse to promote a female lawyer to partnership status in a law firm. This applies, by implication, to other fields, such as accounting.Hishon v. King & Spalding, 467 U.S. 69 (1984). The remedy for unlawful discrimination is back pay and hiring, reinstatement, or promotion.
Title VII established the Equal Employment Opportunity Commission (EEOC) to investigate violations of the act. A victim of discrimination who wishes to file suit must first file a complaint with the EEOC to permit that agency to attempt conciliation of the dispute. The EEOC has filed a number of lawsuits to prove statistically that a company has systematically discriminated on one of the forbidden bases. The EEOC has received perennial criticism for its extreme slowness in filing suits and for failure to handle the huge backlog of complaints with which it has had to wrestle.
The courts have come to recognize two major types of Title VII cases:
1. Cases of disparate treatment
• In this type of lawsuit, the plaintiff asserts that because of race, sex, religion, or national origin, he or she has been treated less favorably than others within the organization. To prevail in a disparate treatment suit, the plaintiff must show that the company intended to discriminate because of one of the factors the law forbids to be considered. Thus in McDonnell Douglas Corp. v. Green, the Supreme Court held that the plaintiff had shown that the company intended to discriminate by refusing to rehire him because of his race.McDonnell Douglas Corp. v. Green, 411 U.S. 792 (1973). In general, there are two types of disparate treatment cases: (1) pattern-and-practice cases, in which the employee asserts that the employer systematically discriminates on the grounds of race, religion, sex, or national origin; and (2) reprisal or retaliation cases, in which the employee must show that the employer discriminated against him or her because that employee asserted his or her Title VII rights.
2. Cases of disparate impact
• In this second type of Title VII case, the employee need not show that the employer intended to discriminate but only that the effect, or impact, of the employer’s action was discriminatory. Usually, this impact will be upon an entire class of employees. The plaintiff must demonstrate that the reason for the employer’s conduct (such as refusal to promote) was not job related. Disparate impact cases often arise out of practices that appear to be neutral or nondiscriminatory on the surface, such as educational requirements and tests administered to help the employer choose the most qualified candidate. In the seminal case of Griggs v. Duke Power Co., the Supreme Court held that under Title VII, an employer is not free to use any test it pleases; the test must bear a genuine relationship to job performance.Griggs v. Duke Power Co., 401 U.S. 424 (1971).Griggs stands for the proposition that Title VII “prohibits employment practices that have discriminatory effects as well as those that are intended to discriminate.”
Discrimination Based on Religion
An employer who systematically refuses to hire Catholics, Jews, Buddhists, or members of any other religious group engages in unlawful disparate treatment under Title VII. But refusal to deal with someone because of his or her religion is not the only type of violation under the law. Title VII defines religion as including religious observances and practices as well as belief and requires the employer to “reasonably accommodate to an employee’s or prospective employee’s religious observance or practice” unless the employer can demonstrate that a reasonable accommodation would work an “undue hardship on the conduct of the employer’s business.” Thus a company that refused even to consider permitting a devout Sikh to wear his religiously prescribed turban on the job would violate Title VII.
But the company need not make an accommodation that would impose more than a minimal cost. For example, an employee in an airline maintenance department, open twenty-four hours a day, wished to avoid working on his Sabbath. The employee belonged to a union, and under the collective bargaining agreement, a rotation system determined by seniority would have put the worker into a work shift that fell on his Sabbath. The Supreme Court held that the employer was not required to pay premium wages to someone whom the seniority system would not require to work on that day and could discharge the employee if he refused the assignment.Trans World Airlines v. Hardison, 432 U.S. 63 (1977).
Title VII permits religious organizations to give preference in employment to individuals of the same religion. Obviously, a synagogue looking for a spiritual leader would hire a rabbi and not a priest.
Sex Discrimination
A refusal to hire or promote a woman simply because she is female is a clear violation of Title VII. Under the Pregnancy Act of 1978, Congress declared that discrimination because of pregnancy is a form of sex discrimination. Equal pay for equal or comparable work has also been an issue in sex (or gender) discrimination. Barbano v. Madison County (see Section 16.4.1 “Disparate Treatment: Burdens of Proof”), presents a straightforward case of sex discrimination. In that case, notice how the plaintiff has the initial burden of proving discriminatory intent and how the burden then shifts to the defendant to show a plausible, nondiscriminatory reason for its hiring decision.
The late 1970s brought another problem of sex discrimination to the fore: sexual harassment. There is much fear and ignorance about sexual harassment among both employers and employees. Many men think they cannot compliment a woman on her appearance without risking at least a warning by the human resources department. Many employers have spent significant time and money trying to train employees about sexual harassment, so as to avoid lawsuits. Put simply, sexual harassment involves unwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of a sexual nature.
There are two major categories of sexual harassment: (1) quid pro quo and (2) hostile work environment.
Quid pro quo comes from the Latin phrase “one thing in return for another.” If any part of a job is made conditional on sexual activity, there is quid pro quo sexual harassment. Here, one person’s power over another is essential; a coworker, for example, is not usually in a position to make sexual demands on someone at his same level, unless he has special influence with a supervisor who has power to hire, fire, promote, or change work assignments. A supervisor, on the other hand, typically has those powers or the power to influence those kinds of changes. For example, when the male foreman says to the female line worker, “I can get you off of the night shift if you’ll sleep with me,” there is quid pro quo sexual harassment.
In Harris v. Forklift Systems, Inc.Harris v. Forklift Systems, Inc., 510 U.S. 17 (1993). and in Meritor v. Vinson,Meritor v. Vinson, 477 U.S. 57 (1986). we see examples of hostile work environment. Hostile work environment claims are more frequent than quid pro quo claims and so are more worrisome to management. An employee has a valid claim of sexual harassment if sexual talk, imagery, or behavior becomes so pervasive that it interferes with the employee’s ability to work to her best capacity. On occasion, courts have found that offensive jokes, if sufficiently frequent and pervasive in the workplace, can create a hostile work environment. Likewise, comments about body parts or public displays of pornographic pictures can also create a hostile work environment. In short, the plaintiff can be detrimentally offended and hindered in the workplace even if there are no measurable psychological injuries.
In the landmark hostile work environment case of Meritor v. Vinson, the Supreme Court held that Title VII’s ban on sexual harassment encompasses more than the trading of sexual favors for employment benefits. Unlawful sexual harassment also includes the creation of a hostile or offensive working environment, subjecting both the offending employee and the company to damage suits even if the victim was in no danger of being fired or of losing a promotion or raise.
In recalling Harris v. Forklift Systems (Chapter 1, Section 1.6), we see that the “reasonable person” standard is declared by the court as follows: “So long as the environment would reasonably be perceived, and is perceived, as hostile or abusive there is no need for it also to be psychologically injurious.” In Duncan v. General Motors Corporation (see Section 16.4.2 “Title VII and Hostile Work Environment”), Harris is used as a precedent to deny relief to a woman who was sexually harassed, because the court believed the conditions were not severe or pervasive enough to unreasonably interfere with her work.
Sex discrimination in terms of wages and benefits is common enough that a number of sizeable class action lawsuits have been brought. A class action lawsuit is generally initiated by one or more people who believe that they, along with a group of other people, have been wronged in similar ways. Class actions for sexual harassment have been successful in the past. On June 11, 1998, the EEOC reached a \$34 million settlement with Mitsubishi over allegations of widespread sexual harassment at the Normal, Illinois, auto plant. The settlement involved about five hundred women who split the \$34 million, although only seven received the maximum \$300,000 allowed by law. The others received amounts ranging from \$8,000 to \$225,000.
Class action lawsuits involve specific plaintiffs (called class plaintiffs or class representatives) who are named in the class action lawsuit to assert the claims of the unnamed or absent members of the class; thus all those with a common complaint need not file their own separate lawsuit. From the point of view of plaintiffs who may have lost only a few thousand dollars annually as a result of the discrimination, a class action is advantageous: almost no lawyer would take a complicated civil case that had a potential gain of only a few thousand dollars. But if there are thousands of plaintiffs with very similar claims, the judgment could be well into the millions. Defendants can win the procedural battle by convincing a court that the proposed class of plaintiffs does not present common questions of law or of fact.
In the Wal-Mart class action case decided by the Supreme Court in 2011, three named plaintiffs (Dukes, Arana, and Kwapnoski) represented a proposed class of 1.5 million current or former Wal-Mart employees. The plaintiffs’ attorneys asked the trial court in 2001 to certify as a class all women employed at any Wal-Mart domestic retail store at any time since December of 1998. As the case progressed through the judicial system, the class grew in size. If the class was certified, and discrimination proven, Wal-Mart could have been liable for over \$1 billion in back pay. So Wal-Mart argued that as plaintiffs, the cases of the 1.5 million women did not present common questions of law or of fact—that is, that the claims were different enough that the Court should not allow a single class action lawsuit to present such differing kinds of claims. Initially, a federal judge disagreed, finding the class sufficiently coherent for purposes of federal civil procedure. The US Court of Appeals for the Ninth Circuit upheld the trial judge on two occasions.
But the US Supreme Court agreed with Wal-Mart. In the majority opinion, Justice Scalia discussed the commonality condition for class actions.
Quite obviously, the mere claim by employees of the same company that they have suffered a Title VII injury, or even a disparate impact Title VII injury, gives no cause to believe that all their claims can productively be litigated at once. Their claims must depend upon a common contention—for example, the assertion of discriminatory bias on the part of the same supervisor. That common contention, moreover, must be of such a nature that it is capable of classwide resolution—which means that determination of its truth or falsity will resolve an issue that is central to the validity of each one of the claims in one stroke.564 U.S. ___ (2011).
Finding that there was no common contention, the Supreme Court reversed the lower courts. Many commentators, and four dissenting Justices, believed that the majority opinion has created an unnecessarily high hurdle for class action plaintiffs in Title VII cases.
Discrimination Based on Race, Color, and National Origin
Title VII was primarily enacted to prohibit employment discrimination based on race, color, and national origin. Race refers to broad categories such as black, Caucasian, Asian, and Native American. Color simply refers to the color of a person’s skin, and national origin refers to the country of the person’s ancestry.
Exceptions to Title VII
Merit
Employers are allowed to select on merit and promote on merit without offending title VII’s requirements. Merit decisions are usually based on work, educational experience, and ability tests. All requirements, however, must be job related. For example, the ability to lift heavy cartons of sixty pounds or more is appropriate for certain warehouse jobs but is not appropriate for all office workers. The ability to do routine maintenance (electrical, plumbing, construction) is an appropriate requirement for maintenance work but not for a teaching position. Requiring someone to have a high school degree, as in Griggs vs. Duke Power Co., is not appropriate as a qualification for common labor.
Seniority
Employers may also maintain seniority systems that reward workers who have been with the company for a long time. Higher wages, benefits, and choice of working hours or vacation schedules are examples of rewards that provide employees with an incentive to stay with the company. If they are not the result of intentional discrimination, they are lawful. Where an employer is dealing with a union, it is typical to see seniority systems in place.
Bona Fide Occupational Qualification (BFOQ)
For certain kinds of jobs, employers may impose bona fide occupational qualifications (BFOQs). Under the express terms of Title VII, however, a bona fide (good faith) occupational qualification of race or color is never allowed. In the area of religion, as noted earlier, a group of a certain religious faith that is searching for a new spiritual leader can certainly limit its search to those of the same religion. With regard to sex (gender), allowing women to be locker-room attendants only in a women’s gym is a valid BFOQ. One important test that the courts employ in evaluating an employer’s BFOQ claims is the “essence of the business” test.
In Diaz v. Pan American World Airways, Inc., the airline maintained a policy of exclusively hiring females for its flight attendant positions.Diaz v. Pan American World Airways, Inc., 442 F.2d 385 (5th Cir. 1971). The essence of the business test was established with the court’s finding that “discrimination based on sex is valid only when the essence of the business operation would be undermined by not hiring members of one sex exclusively.” Although the court acknowledged that females might be better suited to fulfill the required duties of the position, this was not enough to fulfill the essence of the business test:
The primary function of an airline is to transport passengers safely from one point to another. While a pleasant environment, enhanced by the obvious cosmetic effect that female stewardesses provide as well as…their apparent ability to perform the non-mechanical functions of the job in a more effective manner than most men, may all be important, they are tangential to the essence of the business involved. No one has suggested that having male stewards will so seriously affect the operation of an airline as to jeopardize or even minimize its ability to provide safe transportation from one place to another.Diaz v. Pan American World Airways, Inc., 442 F.2d 385 (5th Cir. 1971).
The reason that airlines now use the gender-neutral term flight attendant is a direct result of Title VII. In the 1990s, Hooters had some difficulty convincing the EEOC and certain male plaintiffs that only women could be hired as waitstaff in its restaurants. With regard to national origin, directors of movies and theatrical productions would be within their Title VII BFOQ rights to restrict the roles of fictional Asians to those actors whose national origin was Asian, but could also permissibly hire Caucasian actors made up in “yellow face.”
Defenses in Sexual Harassment Cases
In the 1977 term, the US Supreme Court issued two decisions that provide an affirmative defense in some sexual harassment cases. In Faragher v. City of Boca RatonFaragher v. City of Boca Raton, 524 U.S. 775 (1998). and in Burlington Industries, Inc. v. Ellerth,Burlington Industries v. Ellerth, 524 U.S. 742 (1988). female employees sued for sexual harassment. In each case, they proved that their supervisors had engaged in unconsented-to touching as well as verbal sexual harassment. In both cases, the plaintiff quit her job and, after going through the EEOC process, got a right-to-sue letter and in fact sued for sexual harassment. In Faragher, the employer had never disseminated the policy against sexual harassment to its employees. But in the second case, Burlington Industries, the employer had a policy that was made known to employees. Moreover, a complaints system had been established that was not used by the female employee.
Both opinions rejected the notion of strict or automatic liability for employers when agents (employees) engage in sexual harassment. But the employer can have a valid defense to liability if it can prove (1) that it exercised reasonable care to prevent and correct any sexual harassment behaviors and (2) that the plaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer or to otherwise avoid harm. As with all affirmative defenses, the employer has the burden of proving this defense.
Affirmative Action
Affirmative action is mentioned in the statutory language of Title VII, as courts have the power to order affirmative action as a remedy for the effects of past discriminatory actions. In addition to court-ordered affirmative action, employers may voluntarily use an affirmative action plan to remedy the effects of past practices or to achieve diversity within the workforce to reflect the diversity in their community. In Johnson v. Santa Clara County Transportation Agency,Johnson v. Santa Clara County Transportation Agency, 480 U.S. 616 (1987). the agency had an affirmative action plan. A woman was promoted from within to the position of dispatcher, even though a male candidate had a slightly higher score on a test that was designed to measure aptitude for the job. The man brought a lawsuit alleging sex discrimination. The Court found that voluntary affirmative action was not reverse discrimination in this case, but employers should be careful in hiring and firing and layoff decisions versus promotion decisions. It is in the area of promotions that affirmative action is more likely to be upheld.
In government contracts, President Lyndon Johnson’s Executive Order 11246 prohibits private discrimination by federal contractors. This is important, because one-third of all US workers are employed by companies that do business with the federal government. Because of this executive order, many companies that do business with the government have adopted voluntary affirmative action programs. In 1995, the Supreme Court limited the extent to which the government could require contractors to establish affirmative action programs. The Court said that such programs are permissible only if they serve a “compelling national interest” and are “narrowly tailored” so that they minimize the harm to white males. To make a requirement for contractors, the government must show that the programs are needed to remedy past discrimination, that the programs have time limits, and that nondiscriminatory alternatives are not available.Adarand Constructors, Inc. v. Pena, 515 U.S. 200 (1995).
The Age Discrimination in Employment Act
The Age Discrimination in Employment Act (ADEA) of 1967 (amended in 1978 and again in 1986) prohibits discrimination based on age, and recourse to this law has been growing at a faster rate than any other federal antibias employment law. In particular, the act protects workers over forty years of age and prohibits forced retirement in most jobs because of age. Until 1987, federal law had permitted mandatory retirement at age seventy, but the 1986 amendments that took effect January 1, 1987, abolished the age ceiling except for a few jobs, such as firefighters, police officers, tenured university professors, and executives with annual pensions exceeding \$44,000. Like Title VII, the law has a BFOQ exception—for example, employers may set reasonable age limitations on certain high-stress jobs requiring peak physical condition.
There are important differences between the ADEA and Title VII, as Gross v. FBL Financial Services, Inc. (Section 16.4.3 “Age Discrimination: Burden of Persuasion”) makes clear. It is now more difficult to prove an age discrimination claim than a claim under Title VII.
Disabilities: Discrimination against the Handicapped
The 1990 Americans with Disabilities Act (ADA) prohibits employers from discriminating on the basis of disability. A disabled person is someone with a physical or mental impairment that substantially limits a major life activity or someone who is regarded as having such an impairment. This definition includes people with mental illness, epilepsy, visual impairment, dyslexia, and AIDS. It also covers anyone who has recovered from alcoholism or drug addiction. It specifically does not cover people with sexual disorders, pyromania, kleptomania, exhibitionism, or compulsive gambling.
Employers cannot disqualify an employee or job applicant because of disability as long as he or she can perform the essential functions of the job, with reasonable accommodation. Reasonable accommodation might include installing ramps for a wheelchair, establishing more flexible working hours, creating or modifying job assignments, and the like.
Reasonable accommodation means that there is no undue hardship for the employer. The law does not offer uniform standards for identifying what may be an undue hardship other than the imposition on the employer of a “significant difficulty or expense.” Cases will differ: the resources and situation of each particular employer relative to the cost or difficulty of providing the accommodation will be considered; relative cost, rather than some definite dollar amount, will be the issue.
As with other areas of employment discrimination, job interviewers cannot ask questions about an applicant’s disabilities before making a job offer; the interviewer may only ask whether the applicant can perform the work. Requirements for a medical exam are a violation of the ADA unless the exam is job related and required of all applicants for similar jobs. Employers may, however, use drug testing, although public employers are to some extent limited by the Fourth Amendment requirements of reasonableness.
The ADA’s definition of disability is very broad. However, the Supreme Court has issued several important decisions that narrow the definition of what constitutes a disability under the act.
Two kinds of narrowing decisions stand out: one deals with “correctable conditions,” and the other deals with repetitive stress injuries. In 1999, the Supreme Court reviewed a case that raised an issue of whether severe nearsightedness (which can be corrected with lenses) qualifies as a disability under the ADA.Sutton v. United Airlines, Inc., 527 U.S. 471 (1999). The Supreme Court ruled that disability under the ADA will be measured according to how a person functions with corrective drugs or devices and not how the person functions without them. In Orr v. Wal-Mart Stores, Inc., a federal appellate court held that a pharmacist who suffered from diabetes did not have a cause of action against Wal-Mart under the ADA as long as the condition could be corrected by insulin.Orr v. Wal-Mart Stores, Inc., 297 F.3d 720 (8th Cir. 2002).
The other narrowing decision deals with repetitive stress injuries. For example, carpal tunnel syndrome—or any other repetitive stress injury—could constitute a disability under the ADA. By compressing a nerve in the wrist through repetitive use, carpal tunnel syndrome causes pain and weakness in the hand. In 2002, the Supreme Court determined that while an employee with carpal tunnel syndrome could not perform all the manual tasks assigned to her, her condition did not constitute a disability under the ADA because it did not “extensively limit” her major life activities. (See Section 16.4.4 “Disability Discrimination”.)
Equal Pay Act
The Equal Pay Act of 1963 protects both men and women from pay discrimination based on sex. The act covers all levels of private sector employees and state and local government employees but not federal workers. The act prohibits disparity in pay for jobs that require equal skill and equal effort. Equal skill means equal experience, and equal effort means comparable mental and/or physical exertion. The act prohibits disparity in pay for jobs that require equal responsibility, such as equal supervision and accountability, or similar working conditions.
In making their determinations, courts will look at the stated requirements of a job as well as the actual requirements of the job. If two jobs are judged to be equal and similar, the employer cannot pay disparate wages to members of different sexes. Along with the EEOC enforcement, employees can also bring private causes of action against an employer for violating this act. There are four criteria that can be used as defenses in justifying differentials in wages: seniority, merit, quantity or quality of product, and any factor other than sex. The employer will bear the burden of proving any of these defenses.
A defense based on merit will require that there is some clearly measurable standard that justifies the differential. In terms of quantity or quality of product, there may be a commission structure, piecework structure, or quality-control-based payment system that will be permitted. Factors “other than sex” do not include so-called market forces. In Glenn v. General Motors Corp., the US Court of Appeals for the Eleventh Circuit rejected General Motor’s argument that it was justified in paying three women less than their male counterparts on the basis of “the market force theory” that women will work for less than a man.Glenn v. General Motors Corp., 841 F.2d 1567 (1988).
Key Takeaway
Starting with employment at will as a common-law doctrine, we see many modifications by statute, particularly after 1960. Title VII of the Civil Rights Act of 1964 is the most significant, for it prohibits employers engaged in interstate commerce from discriminating on the basis of race, color, sex, religion, or national origin.
Sex discrimination, especially sexual harassment, has been a particularly fertile source of litigation. There are many defenses to Title VII claims: the employer may have a merit system or a seniority system in place, or there may be bona fide occupational qualifications in religion, gender, or national origin. In addition to Title VII, federal statutes limiting employment discrimination are the ADEA, the ADA, and the Equal Pay Act.
Exercises
1. Go to the EEOC website. Describe the process by which an employee or ex-employee who wants to make a Title VII claim obtains a right-to-sue letter from the EEOC.
2. Again, looking at the EEOC website, find the statistical analysis of Title VII claims brought to the EEOC. What kind of discrimination is most frequent?
3. According to the EEOC website, what is “retaliation”? How frequent are retaliation claims relative to other kinds of claims?
4. Greg Connolly is a member of the Church of God and believes that premarital sex and abortion are sinful. He works as a pharmacist for Wal-Mart, and at many times during the week, he is the only pharmacist available to fill prescriptions. One product sold at his Wal-Mart is the morning-after pill (RU 468). Based on his religious beliefs, he tells his employer that he will refuse to fill prescriptions for the morning-after pill. Must Wal-Mart make a reasonable accommodation to his religious beliefs? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/16%3A_Employment_Law/16.01%3A_Introduction_to_Employment_Law.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand what is meant by employment at will under common law.
• Explain the kinds of common-law (judicially created) exceptions to the employment-at-will doctrine, and provide examples.
At common law, an employee without a contract guaranteeing a job for a specific period was an employee at will and could be fired at any time and for any reason, or even for no reason at all. The various federal statutes we have just examined have made inroads on the at-will doctrine. Another federal statute, the Occupational Safety and Health Act, prohibits employers from discharging employees who exercise their rights under that law.
The courts and legislatures in more than forty states have made revolutionary changes in the at-will doctrine. They have done so under three theories: tort, contract, and duty of good faith and fair dealing. We will first consider the tort of wrongful discharge.
Courts have created a major exception to the employment-at-will rule by allowing the tort of wrongful discharge. Wrongful discharge means firing a worker for a bad reason. What is a bad reason? A bad reason can be:
1. discharging an employee for refusing to violate a law,
2. discharging an employee for exercising a legal right,
3. discharging an employee for performing a legal duty, and
4. discharging an employee in a way that violates public policy.
Discharging an Employee for Refusing to Violate a Law
Some employers will not want employees to testify truthfully at trial. In one case, a nurse refused a doctor’s order to administer a certain anesthetic when she believed it was wrong for that particular patient; the doctor, angry at the nurse for refusing to obey him, then administered the anesthetic himself. The patient soon stopped breathing. The doctor and others could not resuscitate him soon enough, and he suffered permanent brain damage. When the patient’s family sued the hospital, the hospital told the nurse she would be in trouble if she testified. She did testify according to her oath in the court of law (i.e., truthfully), and after several months of harassment, was finally fired on a pretext. The hospital was held liable for the tort of wrongful discharge. As a general rule, you should not fire an employee for refusing to break the law.
Discharging an Employee for Exercising a Legal Right
Suppose Bob Berkowitz files a claim for workers’ compensation for an accident at Pacific Gas & Electric, where he works and where the accident that injured him took place. He is fired for doing so, because the employer does not want to have its workers’ comp premiums increased. In this case, the right exercised by Berkowitz is supported by public policy: he has a legal right to file the claim, and if he can establish that his discharge was caused by his filing the claim, he will prove the tort of wrongful discharge.
Discharging an Employee for Performing a Legal Duty
Courts have long held that an employee may not be fired for serving on a jury. This is so even though courts do recognize that many employers have difficulty replacing employees called for jury duty. Jury duty is an important civic obligation, and employers are not permitted to undermine it.
Discharging an Employee in a Way That Violates Public Policy
This is probably the most controversial basis for a tort of wrongful discharge. There is an inherent vagueness in the phrase “basic social rights, duties, or responsibilities.” This is similar to the exception in contract law: the courts will not enforce contract provisions that violate public policy. (For the most part, public policy is found in statutes and in cases.) But what constitutes public policy is an important decision for state courts. In Wagenseller v. Scottsdale Memorial Hospital,Wagenseller v. Scottsdale Memorial Hospital, 147 Ariz. 370; 710 P.2d 1025 (1085). for example, a nurse who refused to “play along” with her coworkers on a rafting trip was discharged. The group of coworkers had socialized at night, drinking alcohol; when the partying was near its peak, the plaintiff refused to be part of a group that bared their buttocks to the tune of “Moon River” (a composition by Henry Mancini that was popular in the 1970s). The court, at great length, considered that “mooning” was a misdemeanor under Arizona law and that therefore her employer could not discharge her for refusing to violate a state law.
Other courts have gone so far as to include professional oaths and codes as part of public policy. In Rocky Mountain Hospital and Medical Services v. Diane Mariani, the Colorado Supreme Court reviewed a trial court decision to refuse relief to a certified public accountant who was discharged when she refused to violate her professional code.Rocky Mountain Hospital and Medical Services v. Diane Mariani, 916 P.2d 519 (Colo. 1996). (Her employer had repeatedly required her to come up with numbers and results that did not reflect the true situation, using processes that were not in accord with her training and the code.) The court of appeals had reversed the trial court, and the Supreme Court had to decide if the professional code of Colorado accountants could be considered to be part of public policy. Given that accountants were licensed by the state on behalf of the public, and that the Board of Accountancy had published a code for accounting professionals and required an oath before licensing, the court noted the following:
The Colorado State Board of Accountancy is established pursuant to section 12-2-103, 5A C.R.S. (1991). The Board has responsibility for making appropriate rules of professional conduct, in order to establish and maintain a high standard of integrity in the profession of public accounting. § 12-2-104, 5A C.R.S. (1991). These rules of professional conduct govern every person practicing as a certified public accountant. Id. Failure to abide by these rules may result in professional discipline. § 12-2-123, 5A C.R.S. (1991). The rules of professional conduct for accountants have an important public purpose. They ensure the accurate reporting of financial information to the public. They allow the public and the business community to rely with confidence on financial reporting. Rule 7.1, 3 C.C.R. 705-1 (1991). In addition, they ensure that financial information will be reported consistently across many businesses. The legislature has endorsed these goals in section 12-2-101, 5A C.R.S.
The court went on to note that the stated purpose of the licensing and registration of certified public accountants was to “provide for the maintenance of high standards of professional conduct by those so licensed and registered as certified public accountants.” Further, the specific purpose of Rule 7.1 provided a clear mandate to support an action for wrongful discharge. Rule 7.1 is entitled “Integrity and Objectivity” and states, “A certificate holder shall not in the performance of professional services knowingly misrepresent facts, nor subordinate his judgment to others.” The fact that Mariani’s employer asked her to knowingly misrepresent facts was a sufficient basis in public policy to make her discharge wrongful.
Contract Modification of Employment at Will
Contract law can modify employment at will. Oral promises made in the hiring process may be enforceable even though the promises are not approved by top management. Employee handbooks may create implied contracts that specify personnel processes and statements that the employees can be fired only for a “just cause” or only after various warnings, notice, hearing, or other procedures.
Good Faith and Fair Dealing Standard
A few states, among them Massachusetts and California, have modified the at-will doctrine in a far-reaching way by holding that every employer has entered into an implied covenant of good faith and fair dealing with its employees. That means, the courts in these states say, that it is “bad faith” and therefore unlawful to discharge employees to avoid paying commissions or pensions due them. Under this implied covenant of fair dealing, any discharge without good cause—such as incompetence, corruption, or habitual tardiness—is actionable. This is not the majority view, as the case in Section 16.4.4 “Disability Discrimination” makes clear.
Key Takeaway
Although employment at will is still the law, numerous exceptions have been established by judicial decision. Employers can be liable for the tort of wrongful discharge if they discharge an employee for refusing to violate a law, for exercising a legal right or performing a legal duty, or in a way that violates basic public policy.
Exercises
1. Richard Mudd, an employee of Compuserve, is called for jury duty in Wayne County, Michigan. His immediate supervisor, Harvey Lorie, lets him know that he “must” avoid jury duty at all costs. Mudd tells the judge of his circumstances and his need to be at work, but the judge refuses to let Mudd avoid jury duty. Mudd spends the next two weeks at trial. He sends regular e-mails and texts to Lorie during this time, but on the fourth day gets a text message from Lorie that says, “Don’t bother to come back.” When he does return, Lorie tells him he is fired. Does Mudd have a cause of action for the tort of wrongful discharge?
2. Olga Monge was a schoolteacher in her native Costa Rica. She moved to New Hampshire and attended college in the evenings to earn US teaching credentials. At night, she worked at the Beebe Rubber Company after caring for her husband and three children during the day. When she applied for a better job at the plant, the foreman offered to promote her if she would be “nice” and go out on a date with him. She refused, and he assigned her to a lower-wage job, took away her overtime, made her clean the washrooms, and generally ridiculed her. She finally collapsed at work, and he fired her. Does Monge have any cause of action? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/16%3A_Employment_Law/16.03%3A_Employment_at_Will.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the various federal and state statutes that affect employers in the areas of plant closings, pensions, workers’ compensation, use of polygraphs, and worker safety.
The Federal Plant-Closing Act
A prime source of new jobs across the United States is the opening of new industrial plants—which accounted for millions of jobs a year during the 1970s and 1980s. But for every 110 jobs thus created, nearly 100 were lost annually in plant closings during that period. In the mid-1980s alone, 2.2 million plant jobs were lost each year. As serious as those losses were for the national economy, they were no less serious for the individuals who were let go. Surveys in the 1980s showed that large numbers of companies provided little or no notice to employees that their factories were to be shut down and their jobs eliminated. Nearly a quarter of businesses with more than 100 employees provided no specific notice to their employees that their particular work site would be closed or that they would suffer mass layoffs. More than half provided two weeks’ notice or less.
Because programs to support dislocated workers depend heavily on the giving of advance notice, a national debate on the issue in the late 1980s culminated in 1988 in Congress’s enactment of the Worker Adjustment and Retraining Notification (WARN) Act, the formal name of the federal plant-closing act. Under this law, businesses with 100 or more employees must give employees or their local bargaining unit, along with the local city or county government, at least sixty days’ notice whenever (1) at least 50 employees in a single plant or office facility would lose their jobs or face long-term layoffs or a reduction of more than half their working hours as the result of a shutdown and (2) a shutdown would require long-term layoffs of 500 employees or at least a third of the workforce. An employer who violates the act is liable to employees for back pay that they would have received during the notice period and may be liable to other fines and penalties.
An employer is exempted from having to give notice if the closing is caused by business circumstances that were not reasonably foreseeable as of the time the notice would have been required. An employer is also exempted if the business is actively seeking capital or business that if obtained, would avoid or postpone the shutdown and the employer, in good faith, believes that giving notice would preclude the business from obtaining the needed capital or business.
The Employee Polygraph Protection Act
Studies calling into question the reliability of various forms of lie detectors have led at least half the states and, in 1988, Congress to legislate against their use by private businesses. The Employee Polygraph Protection Act forbids private employers from using lie detectors (including such devices as voice stress analyzers) for any reason. Neither employees nor applicants for jobs may be required or even asked to submit to them. (The act has some exceptions for public employers, defense and intelligence businesses, private companies in the security business, and manufacturers of controlled substances.)
Use of polygraphs, machines that record changes in the subject’s blood pressure, pulse, and other physiological phenomena, is strictly limited. They may be used in conjunction with an investigation into such crimes as theft, embezzlement, and industrial espionage, but in order to require the employee to submit to polygraph testing, the employer must have “reasonable suspicion” that the employee is involved in the crime, and there must be supporting evidence for the employer to discipline or discharge the employee either on the basis of the polygraph results or on the employee’s refusal to submit to testing. The federal polygraph law does not preempt state laws, so if a state law absolutely bars an employer from using one, the federal law’s limited authorization will be unavailable.
Occupational Safety and Health Act
In a heavily industrialized society, workplace safety is a major concern. Hundreds of studies for more than a century have documented the gruesome toll taken by hazardous working conditions in mines, on railroads, and in factories from tools, machines, treacherous surroundings, and toxic chemicals and other substances. Studies in the late 1960s showed that more than 14,000 workers were killed and 2.2 million were disabled annually—at a cost of more than \$8 billion and a loss of more than 250 million worker days. Congress responded in 1970 with the Occupational Safety and Health Act, the primary aim of which is “to assure so far as possible every working man and woman in the Nation safe and healthful working conditions.”
The act imposes on each employer a general duty to furnish a place of employment free from recognized hazards likely to cause death or serious physical harm to employees. It also gives the secretary of labor the power to establish national health and safety standards. The standard-making power has been delegated to the Occupational Safety and Health Administration (OSHA), an agency within the US Department of Labor. The agency has the authority to inspect workplaces covered by the act whenever it receives complaints from employees or reports about fatal or multiple injuries. The agency may assess penalties and proceed administratively to enforce its standards. Criminal provisions of the act are enforced by the Justice Department.
During its first two decades, OSHA was criticized for not issuing standards very quickly: fewer than thirty national workplace safety standards were issued by 1990. But not all safety enforcement is in the hands of the federal government: although OSHA standards preempt similar state standards, under the act the secretary may permit the states to come up with standards equal to or better than federal standards and may make grants to the states to cover half the costs of enforcement of the state safety standards.
Employee Retirement Income Security Act
More than half the US workforce is covered by private pension plans for retirement. One 1988 estimate put the total held in pension funds at more than \$1 trillion, costing the federal Treasury nearly \$60 billion annually in tax write-offs. As the size of the private pension funds increased dramatically in the 1960s, Congress began to hear shocking stories of employees defrauded out of pension benefits, deprived of a lifetime’s savings through various ruses (e.g., by long vesting provisions and by discharges just before retirement). To put an end to such abuses, Congress, in 1974, enacted the Employee Retirement Income Security Act (ERISA).
In general, ERISA governs the vesting of employees’ pension rights and the funding of pension plans. Within five years of beginning employment, employees are entitled to vested interests in retirement benefits contributed on their behalf by individual employers. Multiemployer pension plans must vest their employees’ interests within ten years. A variety of pension plans must be insured through a federal agency, the Pension Benefit Guaranty Corporation, to which employers must pay annual premiums. The corporation may assume financial control of underfunded plans and may sue to require employers to make up deficiencies. The act also requires pension funds to disclose financial information to beneficiaries, permits employees to sue for benefits, governs the standards of conduct of fund administrators, and forbids employers from denying employees their rights to pensions. The act largely preempts state law governing employee benefits.
Fair Labor Standards Act
In the midst of the Depression, Congress enacted at President Roosevelt’s urging a national minimum wage law, the Fair Labor Standards Act of 1938 (FLSA). The act prohibits most forms of child labor and established a scale of minimum wages for the regular workweek and a higher scale for overtime. (The original hourly minimum was twenty-five cents, although the administrator of the Wage and Hour Division of the US Department of Labor, a position created by the act, could raise the minimum rate industry by industry.) The act originally was limited to certain types of work: that which was performed in transporting goods in interstate commerce or in producing goods for shipment in interstate commerce.
Employers quickly learned that they could limit the minimum wage by, for example, separating the interstate and intrastate components of their production. Within the next quarter century, the scope of the FLSA was considerably broadened, so that it now covers all workers in businesses that do a particular dollar-volume of goods that move in interstate commerce, regardless of whether a particular employee actually works in the interstate component of the business. It now covers between 80 and 90 percent of all persons privately employed outside of agriculture, and a lesser but substantial percentage of agricultural workers and state and local government employees. Violations of the act are investigated by the administrator of the Wage and Hour Division, who has authority to negotiate back pay on the employee’s behalf. If no settlement is reached, the Labor Department may sue on the employee’s behalf, or the employee, armed with a notice of the administrator’s calculations of back wages due, may sue in federal or state court for back pay. Under the FLSA, a successful employee will receive double the amount of back wages due.
Workers’ Compensation Laws
Since the beginning of the twentieth century, work-related injuries or illnesses have been covered under state workers’ compensation laws that provide a set amount of weekly compensation for disabilities caused by accidents and illnesses suffered on the job. The compensation plans also pay hospital and medical expenses necessary to treat workers who are injured by, or become ill from, their work. In assuring workers of compensation, the plans eliminate the hazards and uncertainties of lawsuits by eliminating the need to prove fault. Employers fund the compensation plans by paying into statewide plans or purchasing insurance.
Other State Laws
Although it may appear that most employment law is federal, employment discrimination is largely governed by state law because Congress has so declared it. The Civil Rights Act of 1964 tells federal courts to defer to state agencies to enforce antidiscrimination provisions of parallel state statutes with remedies similar to those of the federal law. Moreover, many states have gone beyond federal law in banning certain forms of discrimination. Thus well before enactment of the Americans with Disabilities Act, more than forty states prohibited such discrimination in private employment. More than a dozen states ban employment discrimination based on marital status, a category not covered by federal law. Two states have laws that protect those that may be considered “overweight.” Two states and more than seventy counties or municipalities ban employment discrimination on the basis of sexual orientation; most large companies have offices or plants in at least one of these jurisdictions. By contrast, federal law has no statutory law dealing with sexual orientation.
Key Takeaway
There are a number of important federal employment laws collective bargaining or discrimination. These include the federal plant-closing act, the Employee Polygraph Protection Act, the Occupational Safety and Health Act, the Employee Retirement Income Security Act, and the Fair Labor Standards Act. At the state level, workers’ compensation laws preempt common-law claims against employers for work-related injuries, and state equal opportunity employment laws provide remedies for certain kinds of workplace discrimination that have no parallel at the federal level.
Exercises
1. United Artists is a corporation doing business in Texas. United Pension Fund is a defined-contribution employee pension benefit plan sponsored by United Artists for employees. Each employee has his or her own individual pension account, but plan assets are pooled for investment purposes. The plan is administered by the board of trustees. From 1977 to 1986, seven of the trustees made a series of loans to themselves from the plan. These trustees did not (1) require the borrowers to submit a written application for the loans, (2) assess the prospective borrower’s ability to repay loans, (3) specify a period in which the loans were to be repaid, or (4) call the loans when they remained unpaid. The trustees also charged less than fair-market-value interest for the loans. The secretary of labor sued the trustees, alleging that they had breached their fiduciary duty in violation of ERISA. Who won?Mc Laughlin v. Rowley, 69 F.Supp. 1333 (N.D. Tex. 1988).
2. Arrow Automotive Industries remanufactures and distributes automobile and truck parts. Its operating plants produce identical product lines. The company is planning to open a new facility in Santa Maria, California. The employees at the Arrow plant in Hudson, Massachusetts, are represented by a union, the United Automobile, Aerospace, and Agricultural Implement Workers of America. The Hudson plant has a history of unprofitable operations. The union called a strike when the existing collective bargaining agreement expired and a new agreement could not be reached. After several months, the board of directors of the company voted to close the striking plant. The closing would give Arrow a 24 percent increase in gross profits and free capital and equipment for the new Santa Maria plant. In addition, the existing customers of the Hudson plant could be serviced by the Spartanburg, South Carolina, plant, which is currently being underutilized. What would have to be done if the plant-closing act applied to the situation?Arrow Automotive Industries, Inc. v. NLRB, 853 F.2d 233 (4th Cir. 1989). | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/16%3A_Employment_Law/16.04%3A_Other_Employment-Related_Laws.txt |
Disparate Treatment: Burdens of Proof
Barbano v. Madison County
922 F.2d 139 (2d Cir. 1990)
Factual Background
At the Madison County (New York State) Veterans Service Agency, the position of director became vacant. The County Board of Supervisors created a committee of five men to hold interviews for the position. The committee interviewed Maureen E. Barbano and four others. When she entered the interview room, she heard someone say, “Oh, another woman.” At the beginning of the interview, Donald Greene said he would not consider “some woman” for the position. Greene also asked Barbano some personal questions about her family plans and whether her husband would mind if she transported male veterans. Ms. Barbano answered that the questions were irrelevant and discriminatory. However, Greene replied that the questions were relevant because he did not want to hire a woman who would get pregnant and quit. Another committee member, Newbold, agreed that the questions were relevant, and no committee member said the questions were not relevant.
None of the interviewers rebuked Greene or objected to the questions, and none of them told Barbano that she need not answer them. Barbano did state that if she decided to have a family she would take no more time off than medically necessary. Greene once again asked whether Barbano’s husband would object to her “running around the country with men” and said he would not want his wife to do it. Barbano said she was not his wife. The interview concluded after Barbano asked some questions about insurance.
After interviewing several other candidates, the board hired a man. Barbano sued the county for sex discrimination in violation of Title VII, and the district court held in her favor. She was awarded \$55,000 in back pay, prejudgment interest, and attorney’s fees. Madison County appealed the judgment of Federal District Judge McAvoy; Barbano cross-appealed, asking for additional damages.
The court then found that Barbano had established a prima facie case of discrimination under Title VII, thus bringing into issue the appellants’ purported reasons for not hiring her. The appellants provided four reasons why they chose Wagner over Barbano, which the district court rejected either as unsupported by the record or as a pretext for discrimination in light of Barbano’s interview. The district court then found that because of Barbano’s education and experience in social services, the appellants had failed to prove that absent the discrimination, they still would not have hired Barbano. Accordingly, the court awarded Barbano back pay, prejudgment interest, and attorney’s fees. Subsequently, the court denied Barbano’s request for front pay and a mandatory injunction ordering her appointment as director upon the next vacancy. This appeal and cross-appeal followed.
From the Opinion of FEINBERG, CIRCUIT JUDGE
Appellants argue that the district court erred in finding that Greene’s statements during the interview showed that the Board discriminated in making the hiring decision, and that there was no direct evidence of discrimination by the Board, making it improper to require that appellants prove that they would not have hired Barbano absent the discrimination. Barbano in turn challenges the adequacy of the relief awarded to her by the district court.
A. Discrimination
At the outset, we note that Judge McAvoy’s opinion predated Price Waterhouse v. Hopkins, 490 U.S. 228, 109 S. Ct. 1775, 104 L. Ed. 2d 268 (1990), in which the Supreme Court made clear that a “pretext” case should be analyzed differently from a “mixed motives” case. Id. 109 S. Ct. at 1788-89. Judge McAvoy, not having the benefit of the Court’s opinion in Price Waterhouse, did not clearly distinguish between the two types of cases in analyzing the alleged discrimination. For purposes of this appeal, we do not think it is crucial how the district court categorized the case. Rather, we need only concern ourselves with whether the district court’s findings of fact are supported by the record and whether the district court applied the proper legal standards in light of its factual findings.
Whether the case is one of pretext or mixed motives, the plaintiff bears the burden of persuasion on the issue of whether gender played a part in the employment decision. Price Waterhouse v. Hopkins, at 1788. Appellants contend that Barbano did not sustain her burden of proving discrimination because the only evidence of discrimination involved Greene’s statements during the interview, and Greene was an elected official over whom the other members of the Board exercised no control. Thus, appellants maintain, since the hiring decision was made by the 19-member board, evidence of discrimination by one member does not establish that the Board discriminated in making the hiring decision.
We agree that discrimination by one individual does not necessarily imply that a collective decision-making body of which the individual is a member also discriminated. However, the record before us supports the district court’s finding that the Board discriminated in making the hiring decision.
First, there is little doubt that Greene’s statements during the interview were discriminatory. He said he would not consider “some woman” for the position. His questioning Barbano about whether she would get pregnant and quit was also discriminatory, since it was unrelated to a bona fide occupational qualification. King v. Trans World Airlines, 738 F.2d 255, 258 n.2 (8th Cir. 1984). Similarly, Greene’s questions about whether Barbano’s husband would mind if she had to “run around the country with men,” and that he would not want his wife to do it, were discriminatory, since once again the questions were unrelated to bona fide occupational qualifications. Hopkins, at 1786.
Moreover, the import of Greene’s discriminatory questions was substantial, since apart from one question about her qualifications, none of the interviewers asked Barbano about other areas that allegedly formed the basis for selecting a candidate. Thus, Greene’s questioning constituted virtually the entire interview, and so the district court properly found that the interview itself was discriminatory.
Next, given the discriminatory tenor of the interview, and the acquiescence of the other Committee members to Greene’s line of questioning, it follows that the judge could find that those present at the interview, and not merely Greene, discriminated against Barbano. Judge McAvoy pointed out that the Chairman of the Committee, Newbold, thought Greene’s discriminatory questions were relevant. Significantly, Barbano protested that Greene’s questions were discriminatory, but no one agreed with her or told her that she need not answer. Indeed, no one even attempted to steer the interview in another direction. This knowing and informed toleration of discriminatory statements by those participating in the interview constitutes evidence of discrimination by all those present. That each member was independently elected to the Board does not mean that the Committee itself was unable to control the course of the interview. The Committee had a choice of how to conduct the interview, and the court could find that the Committee exercised that choice in a plainly discriminatory fashion.
This discrimination directly affected the hiring decision. At the end of the interviewing process, the interviewers evaluated the candidates, and on that basis submitted a recommendation as to which candidate to hire for the position. “Evaluation does not occur in a vacuum. By definition, when evaluating a candidate to fill a vacant position, one compares that candidate against other eligible candidates.” Berl v. County of Westchester, 849 F.2d 712, 715 (2d Cir. 1988). Appellants stipulated that Barbano was qualified for the position. Again, because Judge McAvoy could find that the evaluation of Barbano was biased by gender discrimination, the judge could also find that the Committee’s recommendation to hire Wagner, which was the result of a weighing of the relative merits of Barbano, Wagner and the other eligible candidates, was necessarily tainted by discrimination.
The Board in turn unanimously accepted the Committee’s recommendation to hire Wagner, and so the Board’s hiring decision was made in reliance upon a discriminatory recommendation. The Supreme Court in Hopkins v. Price Waterhouse found that a collective decision-making body can discriminate by relying upon discriminatory recommendations, and we are persuaded that the reasoning in that case applies here as well.
In Hopkins’ case against Price Waterhouse, Ann Hopkins, a candidate for partnership at the accounting firm of Price Waterhouse, alleged that she was refused admission as a partner because of sex discrimination. Hopkins’s evidence of discrimination consisted largely of evaluations made by various partners. Price Waterhouse argued that such evidence did not prove that its internal Policy Board, which was the effective decision-maker as to partnership in that case, had discriminated. The Court rejected that argument and found the evidence did establish discrimination:
Hopkins showed that the partnership solicited evaluations from all of the firm’s partners; that it generally relied very heavily on such evaluations in making its decision; that some of the partners’ comments were the product of [discrimination]; and that the firm in no way disclaimed reliance on those particular comments, either in Hopkins’ case or in the past. Certainly, a plausible—and, one might say, inevitable—conclusion to draw from this set of circumstances is that the Policy Board in making its decision did in fact take into account all of the partners’ comments, including the comments that were motivated by [discrimination].
Hopkins, at 1794.
In a very significant sense, Barbano presents an even stronger case of discrimination because the only recommendation the Board relied upon here was discriminatory, whereas in Price Waterhouse, not all of the evaluations used in the decision-making process were discriminatory. On the other hand, it is true that the discriminatory content of some of the evaluations in Price Waterhouse was apparent from reading them, whereas here, the recommendation was embodied in a resolution to the Board and a reading of the resolution would not reveal that it was tainted by discrimination. Nonetheless, the facts in this case show that the Board was put on notice before making the appointment that the Committee’s recommendation was biased by discrimination.
Barbano was a member of the public in attendance at the Board meeting in March 1980 when the Board voted to appoint Wagner. Before the Board adopted the resolution appointing Wagner, Barbano objected and asked the Board if male applicants were asked the questions she was asked during the interview. At this point, the entire Board membership was alerted to the possibility that the Committee had discriminated against Barbano during her interview. The Committee members did not answer the question, except for Newbold, who evaded the issue by stating that he did not ask such questions. The Board’s ability to claim ignorance at this point was even further undermined by the fact that the Chairman of the Board, Callahan, was present at many of the interviews, including Barbano’s, in his role as Chairman of the Board. Callahan did not refute Barbano’s allegations, implying that they were worthy of credence, and none of the Board members even questioned Callahan on the matter.
It is clear that those present understood Barbano was alleging that she had been subjected to discrimination during her interview. John Patane, a member of the Board who had not interviewed Barbano, asked Barbano whether she was implying that Madison County was not an equal opportunity employer. Barbano said yes. Patane said the County already had their “token woman.” Callahan apologized to Barbano for “any improper remarks that may have been made,” but an apology for discrimination does not constitute an attempt to eliminate the discrimination from the hiring decision. Even though the Board was aware of possible improprieties, it made no investigation whatsoever into the allegations and did not disclaim any reliance upon the discrimination. In short, the circumstances show the Board was willing to rely on the Committee’s recommendation even if Barbano had been discriminated against during her interview. On these facts, it was not clearly erroneous for the district court to conclude that Barbano sustained her burden of proving discrimination by the Board.
B. The Employer’s Burden
Having found that Barbano carried her burden of proving discrimination, the district court then placed the burden on appellants to prove by a preponderance of the evidence that, absent the discrimination, they would not have hired Barbano for the position. Appellants argue that this burden is only placed on an employer if the plaintiff proves discrimination by direct evidence, and since Barbano’s evidence of discrimination was merely circumstantial, the district court erred by placing the burden of proof on them. Appellants, however, misapprehend the nature of Barbano’s proof and thus the governing legal standard.
The burden is properly placed on the defendant “once the plaintiff establishes by direct evidence that an illegitimate factor played a motivating or substantial role in an employment decision.” Grant v. Hazelett Strip-Casting Corp., 880 F.2d 1564, 1568 (2d Cir. 1989). Thus, the key inquiry on this aspect of the case is whether the evidence is direct, that is, whether it shows that the impermissible criterion played some part in the decision-making process. See Hopkins, at 1791; Grant, 880 F.2d at 1569. If plaintiff provides such evidence, the fact-finder must then determine whether the evidence shows that the impermissible criterion played a motivating or substantial part in the hiring decision. Grant, 880 F.2d at 1569.
As we found above, the evidence shows that Barbano’s gender was clearly a factor in the hiring decision. That the discrimination played a substantial role in that decision is shown by the importance of the recommendation to the Board. As Rafte testified, the Board utilizes a committee system, and so the Board “usually accepts” a committee’s recommendation, as it did here when it unanimously voted to appoint Wagner. Had the Board distanced itself from Barbano’s allegations of discrimination and attempted to ensure that it was not relying upon illegitimate criteria in adopting the Committee’s recommendation, the evidence that discrimination played a substantial role in the Board’s decision would be significantly weakened. The Board showed no inclination to take such actions, however, and in adopting the discriminatory recommendation allowed illegitimate criteria to play a substantial role in the hiring decision.
The district court thus properly required appellants to show that the Board would not have hired Barbano in the absence of discrimination. “The employer has not yet been shown to be a violator, but neither is it entitled to the…presumption of good faith concerning its employment decisions. At this point the employer may be required to convince the fact-finder that, despite the smoke, there is no fire.” Hopkins, at 1798-99 (O’Connor, J., concurring).
Judge McAvoy noted in his opinion that appellants claimed they chose Wagner over Barbano because he was better qualified in the following areas: (1) interest in veterans’ affairs; (2) experience in the military; (3) tactfulness; and (4) experience supervising an office. The judge found that the evidence before him supported only appellants’ first and second reasons for refusing to hire Barbano, but acknowledged that the Committee members “were enamored with Wagner’s military record and involvement with veterans’ organizations.” However, neither of these is listed as a job requirement in the job description, although the district court found that membership in a veterans’ organization may indicate an interest in veterans’ affairs. Nonetheless, the district court found that given Barbano’s “education and experience in social services,” appellants failed to carry their burden of proving by a preponderance of the evidence that, absent discrimination, they would not have hired Barbano.
The district court properly held appellants to a preponderance of the evidence standard. Hopkins, 109 S. Ct. at 1795.…
At the time of the hiring decision in 1980, Barbano had been a Social Welfare Examiner for Madison County for the three previous years. In this position, she determined the eligibility of individuals for public assistance, medicaid or food stamps, and would then issue or deny the individual’s application based on all federal, state and local regulations pertaining to the program from which the individual was seeking assistance. Barbano was thus familiar with the operation of public assistance programs, knew how to fill out forms relating to benefits and had become familiar with a number of welfare agencies that could be of use to veterans. Barbano was also working towards an Associate Degree in Human Services at the time. Rafte testified that Barbano’s resume was “very impressive.” Moreover, Barbano, unlike Wagner, was a resident of Madison County, and according to Rafte, a candidate’s residency in the county was considered to be an advantage. Finally, Barbano had also enlisted in the United States Marine Corps in 1976, but during recruit training had been given a vaccine that affected her vision. She had received an honorable discharge shortly thereafter.
Wagner had nine years experience as an Air Force Personnel Supervisor, maintaining personnel records, had received a high school equivalency diploma and took several extension classes in management. He had been honorably discharged from the Air Force in 1965 with the rank of Staff Sergeant. Wagner was a member of the American Legion, and his application for the position included recommendations from two American Legion members. However, for the six years prior to his appointment as Director, Wagner’s sole paid employment was as a school bus driver and part-time bartender at the American Legion. Wagner admitted that before he was hired he had no knowledge of federal, state and local laws, rules and regulations pertaining to veterans’ benefits and services, or knowledge of the forms, methods and procedures used to process veteran benefits claims. Wagner also had not maintained liaison with welfare agencies and was unfamiliar with the various welfare agencies that existed in the county.
To be sure, both candidates were qualified for the Director’s position, and it is not our job—nor was it the district court’s—to decide which one was preferable. However, there is nothing to indicate that Judge McAvoy misconceived his function in this phase of the case, which was to decide whether appellants failed to prove by a preponderance of the evidence that they would not have hired Barbano even if they had not discriminated against her. The judge found that defendants had not met that burden. We must decide whether that finding was clearly erroneous, and we cannot say that it was.
Case Questions
1. Madison County contended that Barbano needed to provide “direct evidence” of discrimination that had played a motivating or substantial part in the decision. What would such evidence look like? Is it likely that most plaintiffs who are discriminated against because of their gender would be able to get “direct evidence” that gender was a motivating or substantial factor?
2. The “clearly erroneous” standard is applied here, as it is in many cases where appellate courts review trial court determinations. State the test, and say why the appellate court believed that the trial judge’s ruling was not “clearly erroneous.”
Title VII and Hostile Work Environment
Duncan v. General Motors Corporation
300 F.3d 928 (8th Cir. 2002)
OPINION BY HANSEN, Circuit Judge.
The Junior College District of St. Louis (the College) arranged for Diana Duncan to provide in-house technical training at General Motors Corporation’s (GMC) manufacturing facility in Wentzville, Missouri. Throughout her tenure at GMC, Duncan was subjected to unwelcome attention by a GMC employee, James Booth, which culminated in Duncan’s resignation. Duncan subsequently filed this suit under Title VII of the Civil Rights Act and the Missouri Human Rights Act, see 42 U.S.C. §§ 2000e-2000e-17; Mo. Rev. Stat. §§ 213.010-213.137,2 alleging that she was sexually harassed and constructively discharged. A jury found in favor of Duncan and awarded her \$4600 in back pay, \$700,000 in emotional distress damages on her sexual harassment claim, and \$300,000 in emotional distress damages on her constructive discharge claim. GMC appeals from the district court’s denial of its post trial motion for judgment as a matter of law, and the district court’s award of attorneys’ fees attendant to the post trial motion. We reverse.
I
Diana Duncan worked as a technical training clerk in the high-tech area at GMC as part of the College’s Center for Business, Industry, and Labor program from August 1994 until May 1997. Duncan provided in-house training support to GMC employees.
Duncan first learned about the College’s position at GMC from Booth, a United Auto Workers Union technology training coordinator for GMC. Booth frequented the country club where Duncan worked as a waitress and a bartender. Booth asked Duncan if she knew anyone who had computer and typing skills and who might be interested in a position at GMC. Duncan expressed interest in the job. Booth brought the pre-employment forms to Duncan at the country club, and he forwarded her completed forms to Jerry Reese, the manager of operations, manufacturing, and training for the College. Reese arranged to interview Duncan at GMC. Reese, Booth, and Ed Ish, who was Booth’s management counterpart in the high-tech area of the GMC plant, participated in the interview. Duncan began work at GMC in August 1994.
Two weeks after Duncan began working at GMC, Booth requested an off-site meeting with her at a local restaurant. Booth explained to Duncan that he was in love with a married coworker and that his own marriage was troubled. Booth then propositioned Duncan by asking her if she would have a relationship with him. Duncan rebuffed his advance and left the restaurant. The next day Duncan mentioned the incident to the paint department supervisor Joe Rolen, who had no authority over Booth. Duncan did not report Booth’s conduct to either Reese (her supervisor) at the College or Ish (Booth’s management counterpart) at GMC. However, she did confront Booth, and he apologized for his behavior. He made no further such “propositions.” Duncan stated that Booth’s manner toward her after she declined his advance became hostile, and he became more critical of her work. For example, whenever she made a typographical error, he told her that she was incompetent and that he should hire a “Kelly Services” person to replace her. Duncan admitted that Booth’s criticisms were often directed at other employees as well, including male coworkers.
Duncan testified to numerous incidents of Booth’s inappropriate behavior. Booth directed Duncan to create a training document for him on his computer because it was the only computer with the necessary software. The screen saver that Booth had selected to use on his computer was a picture of a naked woman. Duncan testified to four or five occasions when Booth would unnecessarily touch her hand when she handed him the telephone. In addition, Booth had a planter in his office that was shaped like a slouched man wearing a sombrero. The planter had a hole in the front of the man’s pants that allowed for a cactus to protrude. The planter was in plain view to anyone entering Booth’s office. Booth also kept a child’s pacifier that was shaped like a penis in his office that he occasionally showed to his coworkers and specifically to Duncan on two occasions.
In 1995, Duncan requested a pay increase and told Booth that she would like to be considered for an illustrator’s position. Booth said that she would have to prove her artistic ability by drawing his planter. Duncan objected, particularly because previous applicants for the position were required to draw automotive parts and not his planter. Ultimately, Duncan learned that she was not qualified for the position because she did not possess a college degree.
Additionally in 1995, Booth and a College employee created a “recruitment” poster that was posted on a bulletin board in the high-tech area. The poster portrayed Duncan as the president and CEO of the Man Hater’s Club of America. It listed the club’s membership qualifications as: “Must always be in control of: (1) Checking, Savings, all loose change, etc.; (2) (Ugh) Sex; (3) Raising children our way!; (4) Men must always do household chores; (5) Consider T.V. Dinners a gourmet meal.”…
On May 5, 1997, Booth asked Duncan to type a draft of the beliefs of the “He-Men Women Hater’s Club.” The beliefs included the following:
—Constitutional Amendment, the 19th, giving women [the] right to vote should be repealed. Real He-Men indulge in a lifestyle of cursing, using tools, handling guns, driving trucks, hunting and of course, drinking beer.
—Women really do have coodies [sic] and they can spread.
—Women [are] the cause of 99.9 per cent of stress in men.
—Sperm has a right to live.
—All great chiefs of the world are men.
—Prostitution should be legalized.
Duncan refused to type the beliefs and resigned two days later.
Duncan testified that she complained to anyone who would listen to her about Booth’s behavior, beginning with paint department supervisor Joe Rolen after Booth propositioned her in 1994. Duncan testified that between 1994 and 1997 she complained several times to Reese at the College about Booth’s behavior, which would improve at least in the short term after she spoke with Reese.…
Duncan filed a charge of sex discrimination with the Equal Employment Opportunity Commission (EEOC) on October 30, 1997. The EEOC issued Duncan a right to sue notice on April 17, 1998. Alleging sexual harassment and constructive discharge, Duncan filed suit against the College and GMC under both Title VII of the Civil Rights Act and the Missouri Human Rights Act. Duncan settled with the College prior to trial. After the jury found in Duncan’s favor on both counts against GMC, GMC filed a post-trial motion for judgment as a matter of law or, alternatively, for a new trial. The district court denied the motion. The district court also awarded Duncan attorneys’ fees in conjunction with GMC’s post-trial motion. GMC appeals.
II
A. Hostile Work Environment
GMC argues that it was entitled to judgment as a matter of law on Duncan’s hostile work environment claim because she failed to prove a prima facie case. We agree.…
It is undisputed that Duncan satisfies the first two elements of her prima facie case: she is a member of a protected group and Booth’s attention was unwelcome. We also conclude that the harassment was based on sex.…Although there is some evidence in the record that indicates some of Booth’s behavior, and the resulting offensive and disagreeable atmosphere, was directed at both male and female employees, GMC points to ten incidents when Booth’s behavior was directed at Duncan alone. GMC concedes that five of these ten incidents could arguably be based on sex: (1) Booth’s proposition for a “relationship”; (2) Booth’s touching of Duncan’s hand; (3) Booth’s request that Duncan sketch his planter; (4) the Man Hater’s Club poster; and (5) Booth’s request that Duncan type the He-Men Women Haters beliefs. “A plaintiff in this kind of case need not show…that only women were subjected to harassment, so long as she shows that women were the primary target of such harassment.” We conclude that a jury could reasonably find that Duncan and her gender were the overriding themes of these incidents. The evidence is sufficient to support the jury finding that the harassment was based on sex.
We agree, however, with GMC’s assertion that the alleged harassment was not so severe or pervasive as to alter a term, condition, or privilege of Duncan’s employment.…To clear the high threshold of actionable harm, Duncan has to show that “the workplace is permeated with discriminatory intimidation, ridicule, and insult.” Harris v. Forklift Systems, Inc., 510 U.S. 17, 21, 126 L. Ed. 2d 295, 114 S. Ct. 367 (1993) (internal quotations omitted). “Conduct that is not severe or pervasive enough to create an objectively hostile or abusive work environment—an environment that a reasonable person would find hostile or abusive—is beyond Title VII’s purview.” Oncale, 523 U.S. at 81 (internal quotation omitted). Thus, the fourth part of a hostile environment claim includes both objective and subjective components: an environment that a reasonable person would find hostile and one that the victim actually perceived as abusive. Harris, 510 U.S. at 21-22. In determining whether the conduct is sufficiently severe or pervasive, we look to the totality of the circumstances, including the “frequency of the discriminatory conduct; its severity; whether it is physically threatening or humiliating, or a mere offensive utterance; and whether it unreasonably interferes with an employee’s work performance.”…These standards are designed to “filter out complaints attacking the ordinary tribulations of the workplace, such as the sporadic use of abusive language, gender-related jokes, and occasional teasing.” Faragher v. City of Boca Raton, 524 U.S. 775, 788, 141 L. Ed. 2d 662, 118 S. Ct. 2275 (1998) (internal quotations omitted).
The evidence presented at trial illustrates that Duncan was upset and embarrassed by the posting of the derogatory poster and was disturbed by Booth’s advances and his boorish behavior; but, as a matter of law, she has failed to show that these occurrences in the aggregate were so severe and extreme that a reasonable person would find that the terms or conditions of Duncan’s employment had been altered.…Numerous cases have rejected hostile work environment claims premised upon facts equally or more egregious than the conduct at issue here. See, e.g., Shepherd v. Comptroller of Pub. Accounts, 168 F.3d 871, 872, 874 (5th Cir.) (holding that several incidents over a two-year period, including the comment “your elbows are the same color as your nipples,” another comment that plaintiff had big thighs, repeated touching of plaintiff’s arm, and attempts to look down the plaintiff’s dress, were insufficient to support hostile work environment claim), cert. denied, 528 U.S. 963, 145 L. Ed. 2d 308, 120 S. Ct. 395 (1999); Adusumilli v. City of Chicago, 164 F.3d 353, 357, 361-62 (7th Cir. 1998) (holding conduct insufficient to support hostile environment claim when employee teased plaintiff, made sexual jokes aimed at her, told her not to wave at police officers “because people would think she was a prostitute,” commented about low-necked tops, leered at her breasts, and touched her arm, fingers, or buttocks on four occasions), cert. denied, 528 U.S. 988, 145 L. Ed. 2d 367, 120 S. Ct. 450 (1999); Black v. Zaring Homes,, Inc., 104 F.3d 822, 823-24, 826 (6th Cir.) (reversing jury verdict and holding behavior merely offensive and insufficient to support hostile environment claim when employee reached across plaintiff, stating “nothing I like more in the morning than sticky buns” while staring at her suggestively; suggested to plaintiff that parcel of land be named “Hootersville,” “Titsville,” or “Twin Peaks”; and asked “weren’t you there Saturday night dancing on the tables?” while discussing property near a biker bar), cert. denied, 522 U.S. 865, 139 L. Ed. 2d 114, 118 S. Ct. 172 (1997); Weiss v. Coca-Cola Bottling Co., 990 F.2d 333, 337 (7th Cir. 1993) (holding no sexual harassment when plaintiff’s supervisor asked plaintiff for dates, asked about her personal life, called her a “dumb blond,” put his hand on her shoulder several times, placed “I love you” signs at her work station, and attempted to kiss her twice at work and once in a bar).
Booth’s actions were boorish, chauvinistic, and decidedly immature, but we cannot say they created an objectively hostile work environment permeated with sexual harassment. Construing the evidence in the light most favorable to Duncan, she presented evidence of four categories of harassing conduct based on her sex: a single request for a relationship, which was not repeated when she rebuffed it, four or five isolated incidents of Booth briefly touching her hand, a request to draw a planter, and teasing in the form of a poster and beliefs for an imaginary club. It is apparent that these incidents made Duncan uncomfortable, but they do not meet the standard necessary for actionable sexual harassment. It is worth noting that Duncan fails to even address this component of her prima facie case in her brief. We conclude as a matter of law that she did not show a sexually harassing hostile environment sufficiently severe or pervasive so as to alter the conditions of her employment, a failure that dooms Duncan’s hostile work environment claim. See Meritor Sav. Bank, FSB v. Vinson, 477 U.S. 57, 67, 91 L. Ed. 2d 49, 106 S. Ct. 2399 (1986).
For the foregoing reasons, we reverse the district court’s denial of judgment as a matter of law. Because GMC should have prevailed on its post-trial motion, the award of attorneys’ fees is likewise vacated.
RICHARD S. ARNOLD, Circuit Judge, dissenting.
The Court concludes that the harassment suffered by Ms. Duncan was not so severe or pervasive as to alter a term, condition, or privilege of her employment, and that, therefore, GMC is entitled to judgment as a matter of law on her hostile-work environment and constructive-discharge claims. I respectfully disagree.
Ms. Duncan was subjected to a long series of incidents of sexual harassment in her workplace, going far beyond “gender-related jokes and occasional teasing.” Faragher v. City of Boca Raton, 524 U.S. 775, 788 (1988). When the evidence is considered in the light most favorable to her, and she is given the benefit of all reasonable inferences, there is “substantial evidence to sustain the cause of action.” Stockmen’s Livestock Market, Inc. v. Norwest Bank of Sioux City, 135 F.3d 1236, 1240 (8th Cir. 1998) In Ms. Duncan’s case, a jury reached the conclusion that Mr. Booth’s offensive behavior created a hostile work environment. I believe this determination was reasonable and supported by ample evidence.
Ms. Duncan was subjected to a sexual advance by her supervisor within days of beginning her job. This proposition occurred during work hours and was a direct request for a sexual relationship. The Court characterizes this incident as a “single request,” (but) [t]his description minimizes the effect of the sexual advance on Ms. Duncan’s working conditions. During the months immediately following this incident, Mr. Booth became hostile to Ms. Duncan, increased his criticism of her work, and degraded her professional capabilities in front of her peers. Significantly, there is no suggestion that this hostile behavior occurred before Ms. Duncan refused his request for sex. From this evidence, a jury could easily draw the inference that Mr. Booth changed his attitude about Ms. Duncan’s work because she rejected his sexual advance.
Further, this sexual overture was not an isolated incident. It was only the beginning of a string of degrading actions that Mr. Booth directed toward Ms. Duncan based on her sex. This inappropriate behavior took many forms, from physical touching to social humiliation to emotional intimidation. For example, Mr. Booth repeatedly touched Ms. Duncan inappropriately on her hand. He publicly singled her out before her colleagues as a “Man Hater” who “must always be in control of” sex. He required her to choose between drawing a vulgar planter displayed in his office or not being considered for a promotion, an unfair choice that would likely intimidate a reasonable person from seeking further career advancement.
The Court cites cases in which our sister Circuits have rejected hostile-work environment claims premised upon facts that the Court determines to be “equally or more egregious” than the conduct at issue here. I do not agree that Ms. Duncan experienced less severe harassment than those plaintiffs. For example, in Weiss v. Coca-Cola Bottling Co., 990 F.2d 333 (7th Cir. 1993), the plaintiff did not allege that her work duties or evaluations were different because of her sex. This is not the situation Ms. Duncan faced. She was given specific tasks of a sexually charged nature, such as typing up the minutes of the “He-Man Women Hater’s Club.” Performing this “function” was presented to her as a required duty of her job.
Also Ms. Duncan was subjected to allegations that she was professionally “incompetent because of her sex.”…She adduced evidence of this factor when she testified that after she rejected his sexual advance, Mr. Booth became more critical of her work. With the request for her to draw the planter for a promotion, Ms. Duncan also faced “conduct that would prevent her from succeeding in the workplace,” a fact that Ms. Shepherd could not point to in her case. Additionally, Ms. Duncan was “propositioned” to sleep with her employer…a claim not made by Ms. Shepherd.
Finally, we note that in Ms. Duncan’s case the harassing acts were directed specifically at her. The Court in Black v. Zaring Homes, 104 F.3d 822, 826 (6th Cir.), cert. denied, 522 U.S. 865, 139 L. Ed. 2d 114, 118 S. Ct. 172 (1997), stated that the lack of specific comments to the plaintiff supported the conclusion that the defendant’s conduct was not severe enough to create actionable harm. By contrast, in the present case, a jury could reasonably conclude that Ms. Duncan felt particularly humiliated and degraded by Mr. Booth’s behavior because she alone was singled out for this harassment.
Our own Court’s Title VII jurisprudence suggests that Ms. Duncan experienced enough offensive conduct to constitute sexual harassment. For example, in Breeding v. Arthur J. Gallagher and Co. we reversed a grant of summary judgment to an employer, stating that a supervisor who “fondled his genitals [**25] in front of” a female employee and “used lewd and sexually inappropriate language” could create an environment severe enough to be actionable under Title VII. 164 F.3d 1151, 1159 (8th Cir. 1999). In Rorie v. United Parcel Service, we concluded that a work environment in which “a supervisor pats a female employee on the back, brushes up against her, and tells her she smells good” could be found by a jury to be a hostile work environment. 151 F.3d 757, 762 (8th Cir. 1998). Is it clear that the women in these cases suffered harassment greater than Ms. Duncan? I think not.
We have acknowledged that “there is no bright line between sexual harassment and merely unpleasant conduct, so a jury’s decision must generally stand unless there is trial error.” Hathaway v. Runyon, 132 F.3d 1214, 1221 (8th Cir. 1998). We have also ruled that “once there is evidence of improper conduct and subjective offense, the determination of whether the conduct rose to the level of abuse is largely in the hands of the jury.” Howard v. Burns Bros., Inc., 149 F.3d 835, 840 (8th Cir. 1998). The Court admits that Ms. Duncan took subjective offense to Mr. Booth’s behavior and characterizes Mr. Booth’s behavior as “boorish, chauvinistic, and decidedly immature.” Thus, the Court appears to agree that Mr. Booth’s behavior was “improper conduct.” I believe the Court errs in deciding as a matter of law that the jury did not act reasonably in concluding that Ms. Duncan faced severe or pervasive harassment that created a hostile work environment.
Therefore, I dissent from the Court’s conclusion that Ms. Duncan did not present sufficient evidence to survive judgment as a matter of law on her hostile work-environment and constructive-discharge claims.
Case Questions
1. Which opinion is more persuasive to you—the majority opinion or the dissenting opinion?
2. “Numerous cases have rejected hostile work environment claims premised upon facts equally or more egregious than the conduct at issue here.” By what standard or criteria does the majority opinion conclude that Duncan’s experiences were no worse than those mentioned in the other cases?
3. Should the majority on the appeals court substitute its judgment for that of the jury?
Age Discrimination: Burden of Persuasion
Gross v. FBL Financial Services, Inc.
557 U.S. ___ (2009)
JUSTICE CLARENCE THOMAS delivered the opinion of the court.
I
Petitioner Jack Gross began working for respondent FBL Financial Group, Inc. (FBL), in 1971. As of 2001, Gross held the position of claims administration director. But in 2003, when he was 54 years old, Gross was reassigned to the position of claims project coordinator. At that same time, FBL transferred many of Gross’ job responsibilities to a newly created position—claims administration manager. That position was given to Lisa Kneeskern, who had previously been supervised by Gross and who was then in her early forties. Although Gross (in his new position) and Kneeskern received the same compensation, Gross considered the reassignment a demotion because of FBL’s reallocation of his former job responsibilities to Kneeskern.
In April 2004, Gross filed suit in District Court, alleging that his reassignment to the position of claims project coordinator violated the ADEA, which makes it unlawful for an employer to take adverse action against an employee “because of such individual’s age.” 29 U. S. C. §623(a). The case proceeded to trial, where Gross introduced evidence suggesting that his reassignment was based at least in part on his age. FBL defended its decision on the grounds that Gross’ reassignment was part of a corporate restructuring and that Gross’ new position was better suited to his skills.
At the close of trial, and over FBL’s objections, the District Court instructed the jury that it must return a verdict for Gross if he proved, by a preponderance of the evidence, that FBL “demoted [him] to claims projec[t] coordinator” and that his “age was a motivating factor” in FBL’s decision to demote him. The jury was further instructed that Gross’ age would qualify as a “‘motivating factor,’ if [it] played a part or a role in [FBL]’s decision to demote [him].” The jury was also instructed regarding FBL’s burden of proof. According to the District Court, the “verdict must be for [FBL]…if it has been proved by the preponderance of the evidence that [FBL] would have demoted [Gross] regardless of his age.” Ibid. The jury returned a verdict for Gross, awarding him \$46,945 in lost compensation. FBL challenged the jury instructions on appeal. The United States Court of Appeals for the Eighth Circuit reversed and remanded for a new trial, holding that the jury had been incorrectly instructed under the standard established in Price Waterhouse v. Hopkins, 490 U. S. 228 (1989). In Price Waterhouse, this Court addressed the proper allocation of the burden of persuasion in cases brought under Title VII of the Civil Rights Act of 1964, when an employee alleges that he suffered an adverse employment action because of both permissible and impermissible considerations—i.e., a “mixed-motives” case. 490 U. S., at 232, 244–247 (plurality opinion). The Price Waterhouse decision was splintered. Four Justices joined a plurality opinion, and three Justices dissented. Six Justices ultimately agreed that if a Title VII plaintiff shows that discrimination was a “motivating” or a “ ‘substantial’ “ factor in the employer’s action, the burden of persuasion should shift to the employer to show that it would have taken the same action regardless of that impermissible consideration. Justice O’Connor further found that to shift the burden of persuasion to the employer, the employee must present “direct evidence that an illegitimate criterion was a substantial factor in the [employment] decision.”…
Because Gross conceded that he had not presented direct evidence of discrimination, the Court of Appeals held that the District Court should not have given the mixed-motives instruction. Ibid. Rather, Gross should have been held to the burden of persuasion applicable to typical, non-mixed-motives claims; the jury thus should have been instructed only to determine whether Gross had carried his burden of “prov[ing] that age was the determining factor in FBL’s employment action.”
We granted certiorari, 555 U.S. ___ (2008), and now vacate the decision of the Court of Appeals.
II
The parties have asked us to decide whether a plaintiff must “present direct evidence of discrimination in order to obtain a mixed-motive instruction in a non-Title VII discrimination case.” Before reaching this question, however, we must first determine whether the burden of persuasion ever shifts to the party defending an alleged mixed-motives discrimination claim brought under the ADEA. We hold that it does not.
A
Petitioner relies on this Court’s decisions construing Title VII for his interpretation of the ADEA. Because Title VII is materially different with respect to the relevant burden of persuasion, however, these decisions do not control our construction of the ADEA.
In Price Waterhouse, a plurality of the Court and two Justices concurring in the judgment determined that once a “plaintiff in a Title VII case proves that [the plaintiff’s membership in a protected class] played a motivating part in an employment decision, the defendant may avoid a finding of liability only by proving by a preponderance of the evidence that it would have made the same decision even if it had not taken [that factor] into account.” 490 U. S., at 258; see also id., at 259–260 (opinion of White, J.); id., at 276 (opinion of O’Connor, J.). But as we explained in Desert Palace, Inc. v. Costa, 539 U. S. 90, 94–95 (2003), Congress has since amended Title VII by explicitly authorizing discrimination claims in which an improper consideration was “a motivating factor” for an adverse employment decision. See 42 U. S. C. §2000e–2(m) (providing that “an unlawful employment practice is established when the complaining party demonstrates that race, color, religion, sex, or national origin was a motivating factor for any employment practice, even though other factors also motivated the practice” (emphasis added))…
This Court has never held that this burden-shifting framework applies to ADEA claims. And, we decline to do so now. When conducting statutory interpretation, we “must be careful not to apply rules applicable under one statute to a different statute without careful and critical examination.” Unlike Title VII, the ADEA’s text does not provide that a plaintiff may establish discrimination by showing that age was simply a motivating factor. Moreover, Congress neglected to add such a provision to the ADEA when it amended Title VII to add §§2000e–2(m) and 2000e–5(g)(2)(B), even though it contemporaneously amended the ADEA in several ways.…
We cannot ignore Congress’ decision to amend Title VII’s relevant provisions but not make similar changes to the ADEA. When Congress amends one statutory provision but not another, it is presumed to have acted intentionally.…As a result, the Court’s interpretation of the ADEA is not governed by Title VII decisions such as Desert Palace and Price Waterhouse.
B
Our inquiry therefore must focus on the text of the ADEA to decide whether it authorizes a mixed-motives age discrimination claim. It does not. “Statutory construction must begin with the language employed by Congress and the assumption that the ordinary meaning of that language accurately expresses the legislative purpose.”…The ADEA provides, in relevant part, that “[i]t shall be unlawful for an employer…to fail or refuse to hire or to discharge any individual or otherwise discriminate against any individual with respect to his compensation, terms, conditions, or privileges of employment, because of such individual’s age.” 29 U. S. C. §623(a)(1) (emphasis added).
The words “because of” mean “by reason of: on account of.” Webster’s Third New International Dictionary 194 (1966); see also Oxford English Dictionary 746 (1933) (defining “because of” to mean “By reason of, on account of” (italics in original)); The Random House Dictionary of the English Language 132 (1966) (defining “because” to mean “by reason; on account”). Thus, the ordinary meaning of the ADEA’s requirement that an employer took adverse action “because of” age is that age was the “reason” that the employer decided to act.…To establish a disparate-treatment claim under the plain language of the ADEA, therefore, a plaintiff must prove that age was the “but-for” cause of the employer’s adverse decision.…
It follows, then, that under §623(a)(1), the plaintiff retains the burden of persuasion to establish that age was the “but-for” cause of the employer’s adverse action. Indeed, we have previously held that the burden is allocated in this manner in ADEA cases. See Kentucky Retirement Systems v. EEOC, 554 U. S. ____. And nothing in the statute’s text indicates that Congress has carved out an exception to that rule for a subset of ADEA cases. Where the statutory text is “silent on the allocation of the burden of persuasion,” we “begin with the ordinary default rule that plaintiffs bear the risk of failing to prove their claims.” Schaffer v. Weast, 546 U. S. 49, 56 (2005)…
Hence, the burden of persuasion necessary to establish employer liability is the same in alleged mixed-motives cases as in any other ADEA disparate-treatment action. A plaintiff must prove by a preponderance of the evidence (which may be direct or circumstantial), that age was the “but-for” cause of the challenged employer decision.
III
Finally, we reject petitioner’s contention that our interpretation of the ADEA is controlled by Price Waterhouse, which initially established that the burden of persuasion shifted in alleged mixed-motives Title VII claims. In any event, it is far from clear that the Court would have the same approach were it to consider the question today in the first instance.
Whatever the deficiencies of Price Waterhouse in retrospect, it has become evident in the years since that case was decided that its burden-shifting framework is difficult to apply. For example, in cases tried to a jury, courts have found it particularly difficult to craft an instruction to explain its burden-shifting framework.…Thus, even if Price Waterhouse was doctrinally sound, the problems associated with its application have eliminated any perceivable benefit to extending its framework to ADEA claims.
IV
We hold that a plaintiff bringing a disparate-treatment claim pursuant to the ADEA must prove, by a preponderance of the evidence, that age was the “but-for” cause of the challenged adverse employment action. The burden of persuasion does not shift to the employer to show that it would have taken the action regardless of age, even when a plaintiff has produced some evidence that age was one motivating factor in that decision. Accordingly, we vacate the judgment of the Court of Appeals and remand the case for further proceedings consistent with this opinion.
It is so ordered.
Case Questions
1. What is the practical effect of this decision? Will plaintiffs with age-discrimination cases find it harder to win after Gross?
2. As Justice Thomas writes about it, does “but-for” cause here mean the “sole cause”? Must plaintiffs now eliminate any other possible cause in order to prevail in an ADEA lawsuit?
3. Based on this opinion, if the employer provides a nondiscriminatory reason for the change in the employee’s status (such as “corporate restructuring” or “better alignment of skills”), does the employer bear any burden of showing that those are not just words but that, for example, the restructuring really does make sense or that the “skills” really do line up better in the new arrangement?
4. If the plaintiff was retained at the same salary as before, how could he have a “discrimination” complaint, since he still made the same amount of money?
5. The case was decided by a 5-4 majority. A dissent was filed by Justice Stevens, and a separate dissent by Justice Breyer, joined by Justices Ginsburg and Souter. You can access those at http://www.law.cornell.edu/supct/pdf/08-441P.ZD1.
Disability Discrimination
Toyota v. Williams
534 U.S. 184 (2000)
Factual Background
Ella Williams’s job at the Toyota manufacturing plant involved using pneumatic tools. When her hands and arms began to hurt, she consulted a physician and was diagnosed with carpal tunnel syndrome. The doctor advised her not to work with any pneumatic tools or lift more than twenty pounds. Toyota shifted her to a different position in the quality control inspection operations (QCIO) department, where employees typically performed four different tasks. Initially, Williams was given two tasks, but Toyota changed its policy to require all QCIO employees to rotate through all four tasks. When she performed the “shell body audit,” she had to hold her hands and arms up around shoulder height for several hours at a time.
She soon began to experience pain in her neck and shoulders. When she asked permission to do only the two tasks that she could perform without difficulty, she was refused. According to Toyota, Williams then began missing work regularly.
In 1997, Toyota Motor Manufacturing, Kentucky, Inc. terminated Ella Williams, citing her poor attendance record. Subsequently, claiming to be disabled from performing her automobile assembly line job by carpal tunnel syndrome and related impairments, Williams sued Toyota for failing to provide her with a reasonable accommodation as required by the Americans with Disabilities Act (ADA) of 1990.
Granting Toyota summary judgment, the district court held that Williams’s impairment did not qualify as a disability under the ADA because it had not substantially limited any major life activity and that there was no evidence that Williams had had a record of a substantially limiting impairment. In reversing, the court of appeals found that the impairments substantially limited Williams in the major life activity of performing manual tasks. Because her ailments prevented her from doing the tasks associated with certain types of manual jobs that require the gripping of tools and repetitive work with hands and arms extended at or above shoulder levels for extended periods of time, the appellate court concluded that Williams demonstrated that her manual disability involved a class of manual activities affecting the ability to perform tasks at work.
JUSTICE SANDRA DAY O’CONNOR delivered the unanimous opinion of the court.
When it enacted the ADA in 1990, Congress found that some 43 million Americans have one or more physical or mental disabilities. If Congress intended everyone with a physical impairment that precluded the performance of some isolated, unimportant, or particularly difficult manual task to qualify as disabled, the number of disabled Americans would surely have been much higher. We therefore hold that to be substantially limited in performing manual tasks, an individual must have an impairment that prevents or severely restricts the individual from doing activities that are of central importance to most people’s daily lives. The impairments impact must also be permanent or long-term.
When addressing the major life activity of performing manual tasks, the central inquiry must be whether the claimant is unable to perform the variety of tasks central to most people’s daily lives, not whether the claimant is unable to perform the tasks associated with her specific job. In this case, repetitive work with hands and arms extended at or above shoulder levels for extended periods of time is not an important part of most people’s daily lives. The court, therefore, should not have considered respondent’s inability to do such manual work in or specialized assembly line job as sufficient proof that she was substantially limited in performing manual tasks.
At the same time, the Court of Appeals appears to have disregarded the very type of evidence that it should have focused upon. It treated as irrelevant “[t]he fact that [respondent] can…ten[d] to her personal hygiene [and] carr[y]out personal or household chores.” Yet household chores, bathing, and brushing one’s teeth are among the types of manual tasks of central importance to people’s daily lives, and should have been part of the assessment of whether respondent was substantially limited in performing manual tasks.
The District Court noted that at the time respondent sought an accommodation from petitioner, she admitted that she was able to do the manual tasks required by her original two jobs in QCIO. In addition, according to respondent’s deposition testimony, even after her condition worsened, she could still brush her teeth, wash her face, bathe, tend her flower garden, fix breakfast, do laundry, and pick up around the house. The record also indicates that her medical conditions caused her to avoid sweeping, to quit dancing, to occasionally seek help dressing, and to reduce how often she plays with her children, gardens, and drives long distances. But these changes in her life did not amount to such severe restrictions in the activities that are of central importance to most people’s daily lives that they establish a manual task disability as a matter of law. On this record, it was therefore inappropriate for the Court of Appeals to grant partial summary judgment to respondent on the issue of whether she was substantially limited in performing manual tasks, and its decision to do so must be reversed.
Accordingly, we reverse the Court of Appeals’ judgment granting partial summary judgment to respondent and remand the case for further proceedings consistent with this opinion.
Case Questions
1. What is the court’s most important “finding of fact” relative to hands and arms? How does this relate to the statutory language that Congress created in the ADA?
2. The case is remanded to the lower courts “for further proceedings consistent with this opinion.” In practical terms, what does that mean for this case? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/16%3A_Employment_Law/16.05%3A_Cases.txt |
Summary
For the past forty-eight years, Title VII of the Civil Rights Act of 1964 has prohibited employment discrimination based on race, religion, sex, or national origin. Any employment decision, including hiring, promotion, and discharge, based on one of these factors is unlawful and subjects the employer to an award of back pay, promotion, or reinstatement. The Equal Employment Opportunity Commission (EEOC) may file suits, as may the employee—after the commission screens the complaint.
Two major types of discrimination suits are those for disparate treatment (in which the employer intended to discriminate) and disparate impact (in which, regardless of intent, the impact of a particular non-job-related practice has a discriminatory effect). In matters of religion, the employer is bound not only to refrain from discrimination based on an employee’s religious beliefs or preferences but also to accommodate the employee’s religious practices to the extent that the accommodation does not impose an undue hardship on the business.
Sex discrimination, besides refusal to hire a person solely on the basis of sex, includes discrimination based on pregnancy. Sexual harassment is a form of sex discrimination, and it includes the creation of a hostile or offensive working environment. A separate statute, the Equal Pay Act, mandates equal pay for men and women assigned to the same job.
One major exception to Title VII permits hiring people of a particular religion, sex, or nationality if that feature is a bona fide occupational qualification. There is no bona fide occupational qualification (BFOQ) exception for race, nor is a public stereotype a legitimate basis for a BFOQ.
Affirmative action plans, permitting or requiring employers to hire on the basis of race to make up for past discrimination or to bring up the level of minority workers, have been approved, even though the plans may seem to conflict with Title VII. But affirmative action plans have not been permitted to overcome bona fide seniority or merit systems.
The Age Discrimination in Employment Act protects workers over forty from discharge solely on the basis of age. Amendments to the law have abolished the age ceiling for retirement, so that most people working for employers covered by the law cannot be forced to retire.
The Americans with Disabilities Act of 1990 prohibits discrimination based on disability and applies to most jobs in the private sector.
At common law, an employer was free to fire an employee for any reason or for no reason at all. In recent years, the employment-at-will doctrine has been seriously eroded. Many state courts have found against employers on the basis of implied contracts, tortious violation of public policy, or violations of an implied covenant of good faith and fair dealing.
Beyond antidiscrimination law, several other statutes have an impact on the employment relationship. These include the plant-closing law, the Employee Polygraph Protection Act, the Occupational Safety and Health Act, the Employee Retirement Income Security Act, and the Fair Labor Standards Act.
Exercises
1. Rainbow Airlines, a new air carrier headquartered in Chicago with routes from Rome to Canberra, extensively studied the psychology of passengers and determined that more than 93 percent of its passengers felt most comfortable with female flight attendants between the ages of twenty-one and thirty-four. To increase its profitability, the company issued a policy of hiring only such people for jobs in the air but opened all ground jobs to anyone who could otherwise qualify. The policy made no racial distinction, and, in fact, nearly 30 percent of the flight attendants hired were black. What violations of federal law has Rainbow committed, if any?
2. Tex Olafson worked for five years as a messenger for Pressure Sell Advertising Agency, a company without a unionized workforce. On his fifth anniversary with the company, Tex was called in to the president’s office, was given a 10 percent raise, and was complimented on his diligence. The following week, a new head of the messenger department was hired. He wanted to appoint his nephew to a messenger job but discovered that a company-wide hiring freeze prevented him from adding another employee to the messenger ranks. So he fired Tex and hired his nephew. What remedy, if any, does Tex have? What additional facts might change the result?
3. Ernest lost both his legs in combat in Vietnam. He has applied for a job with Excelsior Products in the company’s quality control lab. The job requires inspectors to randomly check products coming off the assembly line for defects. Historically, all inspectors have stood two-hour shifts. Ernest proposes to sit in his wheelchair. The company refuses to hire him because it says he will be less efficient. Ernest’s previous employment record shows him to be a diligent, serious worker. Does Ernest have a legal right to be hired? What additional facts might you want to know in deciding?
4. Marlene works for Frenzied Traders, a stockbrokerage with a seat on the New York Stock Exchange. For several years, Marlene has been a floor trader, spending all day in the hurly-burly of stock trading, yelling herself hoarse. Each year, she has received a large bonus from the company. She has just told the company that she is pregnant. Citing a company policy, she is told she can no longer engage in trading because it is too tiring for pregnant women. Instead, she may take a backroom job, though the company cannot guarantee that the floor job will be open after she delivers. Marlene also wants to take six months off after her child is born. The company says it cannot afford to give her that time. It has a policy of granting paid leave to anyone recuperating from a stay in the hospital and unpaid leave for four months thereafter. What legal rights does Marlene have, and what remedies is she entitled to?
5. Charlie Goodfellow works for Yum-burger and has always commanded respect at the local franchise for being the fastest server. One day, he undergoes a profound religious experience, converts to Sikhism, and changes his name to Sanjay Singh. The tenets of his religion require him to wear a beard and a turban. He lets his beard grow, puts on a turban, and his fellow workers tease him. When a regional vice president sees that Sanjay is not wearing the prescribed Yum-Burger uniform, he fires him. What rights of Sanjay, if any, has Yum-burger violated? What remedies are available to him?
SELF CHECK QUESTIONS
1. Affirmative action in employment
1. is a requirement of Title VII of the Civil Rights Act of 1964
2. is prohibited by Title VII of the Civil Rights Act of 1964
3. is a federal statute enacted by Congress
4. depends on the circumstances of each case for validity
2. The Age Discrimination in Employment Act protects
1. all workers of any age
2. all workers up to age seventy
3. most workers over forty
4. no workers over seventy
3. Federal laws barring discrimination against the handicapped and disabled
1. apply to all disabilities
2. apply to most disabilities in private employment
3. apply to all disabilities in public employment
4. apply to most disabilities in public employment
4. Under Title VII, a bona fide occupational qualification exception may never apply to cases involving
1. racial discrimination
2. religious discrimination
3. sex discrimination
4. age discrimination
5. The employment-at-will doctrine derives from
1. Title VII of the Civil Rights Act of 1964
2. employment contracts
3. the common law
4. liberty of contract under the Constitution
1. d
2. c
3. b
4. a
5. c | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/16%3A_Employment_Law/16.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• How collective bargaining was resisted for many years in the United States, and how political and economic changes resulted in legalization of labor unions
• The four major federal labor laws in the United States
• The process by which bargaining units are recognized by the National Labor Relations Board
• The various kinds of unfair labor practices that employers might engage in, and those that unions and their members might engage in
Over half a century, the federal law of labor relations has developed out of four basic statutes into an immense body of cases and precedent regulating the formation and governance of labor unions and the relationships among employers, unions, and union members. Like antitrust law, labor law is a complex subject that has spawned a large class of specialized practitioners. Though specialized, it is a subject that no employer of any size can ignore, for labor law has a pervasive influence on how business is conducted throughout the United States. In this chapter, we examine the basic statutory framework and the activities that it regulates.
17: Labor-Management Relations
It is important to note at the outset that legal rights for laborers in the United States came about through physical and political struggles. The right of collective bargaining and the right to strike (and corresponding rights for employers, such as the lockout) were hard-won and incremental. The legislation described in this chapter began only after many years of labor-management strife, including judicial opposition to unions and violent and deadly confrontations between prounion workers and management.
In 1806, the union of Philadelphia Journeymen Cordwainers was convicted of and bankrupted by charges of criminal conspiracy after a strike for higher wages, setting a precedent by which the US government would combat unions for years to come. Andrew Jackson became a strikebreaker in 1834 when he sent troops to the construction sites of the Chesapeake and Ohio Canal. In 1877, a general strike halted the movement of US railroads. In the following days, strike riots spread across the United States. The next week, federal troops were called out to force an end to the nationwide strike. At the Battle of the Viaduct in Chicago, federal troops (recently returned from an Indian massacre) killed thirty workers and wounded over one hundred. Numerous other violent confrontations marked the post–Civil War period in America, including the violent rail strikes of 1877, when President Rutherford B. Hayes sent troops to prevent obstruction of the mails. President Grover Cleveland used soldiers to break the Pullman strike of 1894. Not until the anthracite coal strikes in Pennsylvania in 1902 did the US government become a mediator between labor and management rather than an enforcer for industry.
Many US labor historians see the first phase of the labor movement in terms of the struggles in the private sector that led to the labor legislation of the New Deal, described in Section 17.1. The second phase of the movement, post–World War II, saw less violent confrontation and more peaceful resolution of labor issues in collective bargaining. Yet right-to-work states in the southern part of the United States and globalization weakened the attractiveness of unions in the private sector. Right-to-work states provided a haven for certain kinds of manufacturing operations that wanted no part of bargaining with unions. Globalization meant that companies could (realistically) threaten to relocate outside the United States entirely. Unions in the public sector of the United States began to grow stronger relative to unions in the private sector: governments could not relocate as companies could, and over the last half century, there has been a gradual decline in private sector unionism and growth in public sector unionism. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/17%3A_Labor-Management_Relations/17.01%3A_Introduction_to_Labor-Management_Relations.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand and explain the rise of labor unions in the United States.
• Explain what common-law principles were used by employers and courts to resist legalized collective bargaining.
• Be able to put US labor law in its historical context.
Labor and the Common Law in the Nineteenth Century
Labor unions appeared in modern form in the United States in the 1790s in Boston, New York, and Philadelphia. Early in the nineteenth century, employers began to seek injunctions against union organizing and other activities. Two doctrines were employed: (1) common-law conspiracy and (2) common-law restraint of trade. The first doctrine held that workers who joined together were acting criminally as conspirators, regardless of the means chosen or the objectives sought.
The second doctrine—common-law restraint of trade—was also a favorite theory used by the courts to enjoin unionizing and other joint employee activities. Workers who banded together to seek better wages or working conditions were, according to this theory, engaged in concerted activity that restrained trade in their labor. This theory made sense in a day in which conventional wisdom held that an employer was entitled to buy labor as cheaply as possible—the price would obviously rise if workers were allowed to bargain jointly rather than if they were required to offer their services individually on the open market.
Labor under the Antitrust Laws
The Sherman Act did nothing to change this basic judicial attitude. A number of cases decided early in the act’s history condemned labor activities as violations of the antitrust law. In particular, in the Danbury Hatters’ case (Loewe v. Lawlor) the Supreme Court held that a “secondary boycott” against a nonunionized company violated the Sherman Act. The hatters instigated a boycott of retail stores that sold hats manufactured by a company whose workers had struck. The union was held liable for treble damages.Loewe v. Lawlor, 208 U.S. 274 (1908).
By 1912, labor had organized widely, and it played a pivotal role in electing Woodrow Wilson and giving him a Democratic Congress, which responded in 1914 with the Clayton Act’s “labor exemption.” Section 6 of the Clayton Act says that labor unions are not “illegal combinations or conspiracies in restraint of trade, under the antitrust laws.” Section 20 forbids courts from issuing injunctions in cases involving strikes, boycotts, and other concerted union activities (which were declared to be lawful) as long as they arose out of disputes between employer and employees over the terms of employment.
But even the Clayton Act proved of little lasting value to the unions. In 1921, the Supreme Court again struck out against a secondary boycott that crippled the significance of the Clayton Act provisions. In the case, a machinists’ union staged a boycott against an employer (by whom the members were not employed) in order to pressure the employer into permitting one of its factories to be unionized. The Court ruled that the Clayton Act exemptions applied only in cases involving an employer and its own employees.Duplex Printing Press Co. v. Deering, 254 U.S. 443 (1921). Without the ability to boycott under those circumstances, and with the threat of antitrust prosecutions or treble-damage actions, labor would be hard-pressed to unionize many companies. More antiunion decisions followed.
Moves toward Modern Labor Legislation
Collective bargaining appeared on the national scene for the first time in 1918 with the creation of the War Labor Conference Board. The National War Labor Board was empowered to mediate or reconcile labor disputes that affected industries essential to the war, but after the war, the board was abolished.
In 1926, Congress enacted the Railway Labor Act. This statute imposed a duty on railroads to bargain in good faith with their employees’ elected representatives. The act also established the National Mediation Board to mediate disputes that were not resolved in contract negotiations. The stage was set for more comprehensive national labor laws. These would come with the Great Depression.
The Norris–La Guardia Act
The first labor law of the Great Depression was the Norris–La Guardia Act of 1932. It dealt with the propensity of federal courts to issue preliminary injunctions, often ex parte (i.e., after hearing only the plaintiff’s argument), against union activities. Even though the permanent injunction might later have been denied, the effect of the vaguely worded preliminary injunction would have been sufficient to destroy the attempt to unionize. The Norris–La Guardia Act forbids federal courts from temporarily or permanently enjoining certain union activities, such as peaceful picketing and strikes. The act is applicable is any “labor dispute,” defined as embracing “any controversy concerning terms or conditions of employment, or concerning the association or representation of persons in negotiating, fixing, maintaining, changing, or seeking to arrange terms or conditions of employment, regardless of whether or not the disputants stand in the proximate relation of employer and employee.” This language thus permitted the secondary boycott that had been held a violation of the antitrust laws in Duplex Printing Press v. Deering. The act also bars the courts from enforcing so-called yellow-dog contracts—agreements that employees made with their employer not to join unions.
The National Labor Relations Act (the Wagner Act)
In 1935, Congress finally enacted a comprehensive labor statute. The National Labor Relations Act (NLRA), often called the Wagner Act after its sponsor, Senator Robert F. Wagner, declared in Section 7 that workers in interstate commerce “have the right to self-organization, to form, join or assist labor organizations, to bargain collectively through representatives of their own choosing, and to engage in concerted activities for the purpose of collective bargaining or other mutual aid or protection.” Section 8 sets out five key unfair labor practices:
1. Interference with the rights guaranteed by Section 7
2. Interference with the organization of unions, or dominance by the employer of union administration (this section thus outlaws “company unions”)
3. Discrimination against employees who belong to unions
4. Discharging or otherwise discriminating against employees who seek relief under the act
5. Refusing to bargain collectively with union representatives
The procedures for forming a union to represent employees in an appropriate “bargaining unit” are set out in Section 9. Finally, the Wagner Act established the National Labor Relations Board (NLRB) as an independent federal administrative agency, with power to investigate and remedy unfair labor practices.
The Supreme Court upheld the constitutionality of the act in 1937 in a series of five cases. In the first, NLRB v. Jones & Laughlin Steel Corp., the Court ruled that congressional power under the Commerce Clause extends to activities that might affect the flow of interstate commerce, as labor relations certainly did.NLRB v. Jones & Laughlin Steel Corp., 301 U.S. 1 (1937). Through its elaborate mechanisms for establishing collective bargaining as a basic national policy, the Wagner Act has had a profound effect on interstate commerce during the last half-century.
The Taft-Hartley Act (Labor-Management Relations Act)
The Wagner Act did not attempt to restrict union activities in any way. For a dozen years, opponents of unions sought some means of curtailing the breadth of opportunity opened up to unions by the Wagner Act. After failing to obtain relief in the Supreme Court, they took their case to Congress and finally succeeded after World War II when, in 1947, Congress, for the first time since 1930, had Republican majorities in both houses. Congress responded to critics of “big labor” with the Taft-Hartley Act, passed over President Truman’s veto. Taft-Hartley—known formally as the Labor-Management Relations Act—did not repeal the protections given employees and unions under the NLRA. Instead, it balanced union power with a declaration of rights of employers. In particular, Taft-Hartley lists six unfair labor practices of unions, including secondary boycotts, strikes aimed at coercing an employer to fire an employee who refuses to join a union, and so-called jurisdictional strikes over which union should be entitled to do specified jobs at the work site.
In addition to these provisions, Taft-Hartley contains several others that balance the rights of unions and employers. For example, the act guarantees both employers and unions the right to present their views on unionization and collective bargaining. Like employers, unions became obligated to bargain in good faith. The act outlaws the closed shop (a firm in which a worker must belong to a union), gives federal courts the power to enforce collective bargaining agreements, and permits private parties to sue for damages arising out of a secondary boycott. The act also created the Federal Mediation and Conciliation Service to cope with strikes that create national emergencies, and it declared strikes by federal employees to be unlawful. It was this provision that President Reagan invoked in 1981 to fire air traffic controllers who walked off the job for higher pay.
The Landrum-Griffin Act
Congressional hearings in the 1950s brought to light union corruption and abuses and led in 1959 to the last of the major federal labor statutes, the Landrum-Griffin Act (Labor-Management Reporting and Disclosure Act). It established a series of controls on internal union procedures, including the method of electing union officers and the financial controls necessary to avoid the problems of corruption that had been encountered. Landrum-Griffin also restricted union picketing under various circumstances, narrowed the loopholes in Taft-Hartley’s prohibitions against secondary boycotts, and banned “hot cargo” agreements (see Section 17.3.6 “Hot Cargo Agreement”).
Key Takeaway
Common-law doctrines were used in the early history of the labor movement to enjoin unionizing and other joint employee activities. These were deemed to be restraints of trade that violated antitrust laws. In addition, common-law conspiracy charges provided criminal enforcement against joint employee actions and agreements. Politically, the labor movement gained some traction in 1912 and got an antitrust-law exemption in the Clayton Act. But it was not until the Great Depression and the New Deal that the right of collective bargaining was recognized by federal statute in the National Labor Relations Act. Subsequent legislation (Taft-Hartley and Landrum-Griffin) added limits to union activities and controls over unions in their internal functions.
Exercises
1. Use the Internet to find stories of government-sponsored violence against union activities in the late 1900s and early part of the twentieth century. What were some of the most violent confrontations, and what caused them? Discuss why business and government were so opposed to collective bargaining.
2. Use the Internet to find out which countries in the world have legal systems that support collective bargaining. What do these countries have in common with the United States? Does the People’s Republic of China support collective bargaining? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/17%3A_Labor-Management_Relations/17.02%3A_A_Brief_History_of_Labor_Legislation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the process that leads to recognition of bargaining units by the National Labor Relations Board.
The National Labor Relations Board (NLRB) consists of five board members, appointed by the president and confirmed by the Senate, who serve for five-year, staggered terms. The president designates one of the members as chairman. The president also appoints the general counsel, who is in charge of the board’s investigatory and prosecutorial functions and who represents the NLRB when it goes (or is taken) to court. The general counsel also oversees the thirty-three regional offices scattered throughout the country, each of which is headed by a regional director.
The NLRB serves two primary functions: (1) it investigates allegations of unfair labor practices and provides remedies in appropriate cases, and (2) it decides in contested cases which union should serve as the exclusive bargaining agent for a particular group of employees.
Unfair Labor Practice Cases
Unfair labor practice cases are fairly common; some twenty-two thousand unfair labor practice claims were filed in 2008. Volume was considerably higher thirty years ago; about forty thousand a year was typical in the early 1980s. A charge of an unfair labor practice must be presented to the board, which has no authority to initiate cases on its own. Charges are investigated at the regional level and may result in a complaint by the regional office. A regional director’s failure to issue a complaint may be appealed to the general counsel, whose word is final (there is no possible appeal).
A substantial number of charges are dismissed or withdrawn each year—sometimes as many as 70 percent. Once issued, the complaint is handled by an attorney from the regional office. Most cases, usually around 80 percent, are settled at this level. If not settled, the case will be tried before an administrative law judge, who will take evidence and recommend a decision and an order. If no one objects, the decision and order become final as the board’s opinion and order. Any party may appeal the decision to the board in Washington. The board acts on written briefs, rarely on oral argument. The board’s order may be appealed to the US court of appeals, although its findings of fact are not reviewable “if supported by substantial evidence on the record considered as a whole.” The board may also go to the court of appeals to seek enforcement of its orders.
Representation Cases
The NLRB is empowered to oversee representative elections—that is, elections by employees to determine whether or not to be represented by a union. The board becomes involved if at least 30 percent of the members of a potential bargaining unit petition it to do so or if an employer petitions on being faced with a claim by a union that it exclusively represents the employees. The board determines which bargaining unit is appropriate and which employees are eligible to vote. A representative of the regional office will conduct the election itself, which is by secret ballot. The regional director may hear challenges to the election procedure to determine whether the election was valid.
Key Takeaway
The NLRB has two primary functions: (1) it investigates allegations of unfair labor practices and provides remedies in appropriate cases, and (2) it decides in contested cases which union should serve as the exclusive bargaining agent for a particular group of employees.
Exercises
1. Go to the website for the NLRB. Find out how many unfair labor practice charges are filed each year. Also find out how many “have merit” according to the NLRB.
2. How many of these unfair labor practice charges that “have merit” are settled through the auspices of the NLRB? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/17%3A_Labor-Management_Relations/17.03%3A_The_National_Labor_Relations_Board-_Organization_and_Functions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe and explain the process for the National Labor Relations Board to choose a particular union as the exclusive bargaining representative.
• Describe and explain the various duties that employers have in bargaining.
• Indicate the ways in which employers may commit unfair labor practice by interfering with union activity.
• Explain the union’s right to strike and the difference between an economic strike and a strike over an unfair labor practice.
• Explain secondary boycotts and hot cargo agreements and why they are controversial.
Choosing the Union as the Exclusive Bargaining Representative
Determining the Appropriate Union
As long as a union has a valid contract with the employer, no rival union may seek an election to oust it except within sixty to ninety days before the contract expires. Nor may an election be held if an election has already been held in the bargaining unit during the preceding twelve months.
Whom does the union represent? In companies of even moderate size, employees work at different tasks and have different interests. Must the secretaries, punch press operators, drivers, and clerical help all belong to the same union in a small factory? The National Labor Relations Board (NLRB) has the authority to determine which group of employees will constitute the appropriate bargaining unit. To make its determination, the board must look at the history of collective bargaining among similar workers in the industry; the employees’ duties, wages, skills, and working conditions; the relationship between the proposed unit and the structure of the employer’s organization; and the desires of the employees themselves.
Two groups must be excluded from any bargaining unit—supervisory employees and independent contractors. Determining whether or not a particular employee is a supervisor is left to the discretion of the board.
Interfering with Employee Communication
To conduct an organizing drive, a union must be able to communicate with the employees. But the employer has valid interests in seeing that employees and organizers do not interfere with company operations. Several different problems arise from the need to balance these interests.
One problem is the protection of the employer’s property rights. May nonemployee union organizers come onto the employer’s property to distribute union literature—for example, by standing in the company’s parking lots to hand out leaflets when employees go to and from work? May organizers, whether employees or not, picket or hand out literature in private shopping centers in order to reach the public—for example, to protest a company’s policies toward its nonunion employees? The interests of both employees and employers under the NLRB are twofold: (1) the right of the employees (a) to communicate with each other or the public and (b) to hear what union organizers have to say, and (2) the employers’ (a) property rights and (b) their interest in managing the business efficiently and profitably.
The rules that govern in these situations are complex, but in general they appear to provide these answers: (1) If the persons doing the soliciting are not employees, the employer may bar them from entering its private property, even if they are attempting to reach employees—assuming that the employer does not discriminate and applies a rule against use of its property equally to everyone.NLRB v. Babcock Wilcox Co., 351 U.S. 105 (1956). (2) If the solicitors are not employees and they are trying to reach the public, they have no right to enter the employer’s private property. (3) If the solicitors are employees who are seeking to reach the public, they have the right to distribute on the employer’s property—in a common case, in a shopping center—unless they have a convenient way to reach their audience on public property off the employer’s premises.Hudgens v. NLRB, 424 U.S. 507 (1976). (4) If the solicitors are employees seeking to reach employees, the employer is permitted to limit the distribution of literature or other solicitations to avoid litter or the interruption of work, but it cannot prohibit solicitation on company property altogether.
In the leading case of Republic Aviation Corp. v. NLRB, the employer, a nonunion plant, had a standing rule against any kind of solicitation on the premises.Republic Aviation Corp. v. NLRB, 324 U.S. 793 (1945). Thereafter, certain employees attempted to organize the plant. The employer fired one employee for soliciting on behalf of the union and three others for wearing union buttons. The Supreme Court upheld the board’s determination that the discharges constituted an unfair labor practice under Section 8(a) of the NLRA. It does not matter, the Court said, whether the employees had other means of communicating with each other or that the employer’s rule against solicitation may have no effect on the union’s attempt to organize the workers. In other words, the employer’s intent or motive is irrelevant. The only question is whether the employer’s actions might tend to interfere with the employees’ exercise of their rights under the NLRB.
Regulating Campaign Statements
A union election drive is not like a polite conversation over coffee; it is, like political campaigns, full of charges and countercharges. Employers who do not want their employees unionized may warn darkly of the effect of the union on profitability; organizers may exaggerate the company’s financial position. In a 1982 NLRB case, NLRB v. Midland National Life Ins. Co., the board said it would not set aside an election if the parties misrepresented the issues or facts but that it would do so if the statements were made in a deceptive manner—for example, through forged documents.Midland National Life Ins. Co., 263 N.L.R.B. 130 (1982). The board also watches for threats and promises of rewards; for example, the employer might threaten to close the plant if the union succeeds. In NLRB v. Gissel Packing Co., the employer stated his worries throughout the campaign that a union would prompt a strike and force the plant to close.NLRB v. Gissel Packing Co., 395 U.S. 575 (1969). The board ruled that the employer’s statements were an impermissible threat. To the employer’s claim that he was simply exercising his First Amendment rights, the Supreme Court held that although employers do enjoy freedom of speech, it is an unfair labor practice to threaten consequences that are not rooted in economic realities.
A union campaign has become an intricate legal duel, heavily dependent on strategic considerations of law and public relations. Neither management nor labor can afford to wage a union campaign without specialized advisers who can guide the thrust and parry of the antagonists. Labor usually has such advisers because very few organizational drives are begun without outside organizers who have access to union lawyers. A business person who attempts to fight a union, like a labor organizer or an employee who attempts to organize one, takes a sizeable risk when acting alone, without competent advice. For example, an employer’s simple statement like “We will get the heating fixed” in response to a seemingly innocent question about the “drafty old building” at a meeting with employees can lead to an NLRB decision to set aside an election if the union loses, because the answer can easily be construed as a promise, and under Section 8(c) of the National Labor Relations Act (NLRA), a promise of reward or benefit during an organization campaign is an unfair labor practice by management. Few union election campaigns occur without questions, meetings, and pamphleteering carefully worked out in advance.
The results of all the electioneering are worth noting. In the 1980s, some 20 percent of the total US workforce was unionized. As of 2009, the union membership rate was 12.3 percent, and more union members were public employees than private sector employees. Fairly or unfairly, public employee unions were under attack as of 2010, as their wages generally exceeded the average wages of other categories of workers.
Exclusivity
Once selected as the bargaining representative for an appropriate group of employees, the union has the exclusive right to bargain. Thereafter, individual employees may not enter into separate contracts with the employer, even if they voted against the particular union or against having a union at all. The principle of exclusivity is fundamental to the collective bargaining process. Just how basic it is can be seen in Emporium Capwell Co. v. Western Addition Community Organization (Section 17.4.1 “Exclusivity”), in which one group of employees protested what they thought were racially discriminatory work assignments, barred under the collective bargaining agreement (the contract between the union and the employer). Certain of the employees filed grievances with the union, which looked into the problem more slowly than the employees thought necessary. They urged that the union permit them to picket, but the union refused. They picketed anyway, calling for a consumer boycott. The employer warned them to desist, but they continued and were fired. The question was whether they were discharged for engaging in concerted activity protected under Section 7 of the NLRA.
The Duty to Bargain
The Duty to Bargain in Good Faith
The NLRA holds both employer and union to a duty to “bargain in good faith.” What these words mean has long been the subject of controversy. Suppose Mr. Mardian, a company’s chief negotiator, announces to Mr. Ulasewicz, the company’s chief union negotiator, “I will sit down and talk with you, but be damned if I will agree to a penny more an hour than the people are getting now.” That is not a refusal to bargain: it is a statement of the company’s position, and only Mardian’s actual conduct during the negotiations will determine whether he was bargaining in good faith. Of course, if he refused to talk to Ulasewicz, he would have been guilty of a failure to bargain in good faith.
Suppose Mardian has steadily insisted during the bargaining sessions that the company must have complete control over every aspect of the labor relationship, including the right to hire and fire exactly as it saw fit, the right to raise or lower wages whenever it wanted, and the right to determine which employee was to do which job. The Supreme Court has said that an employer is not obligated to accept any particular term in a proposed collective bargaining agreement and that the NLRB may not second-guess any agreement eventually reached.NLRB v. American National Insurance Co., 343 U.S. 395 (1962). However, the employer must actually engage in bargaining, and a stubborn insistence on leaving everything entirely to the discretion of management has been construed as a failure to bargain.NLRB v. Reed St Prince Manufacturing Co., 205 F.2d 131 (1st Cir. 1953).
Suppose Mardian had responded to Ulasewicz’s request for a ten-cent-an-hour raise: “If we do that, we’ll go broke.” Suppose further that Ulasewicz then demanded, on behalf of the union, that Mardian prove his contention but that Mardian refused. Under these circumstances, the Supreme Court has ruled, the NLRB is entitled to hold that management has failed to bargain in good faith, for once having raised the issue, the employer must in good faith demonstrate veracity.NLRB v. Truitt Manufacturer Co., 351 U.S. 149 (1956).
Mandatory Subjects of Bargaining
The NLRB requires employers and unions to bargain over “terms and condition of employment.” Wages, hours, and working conditions—whether workers must wear uniforms, when the lunch hour begins, the type of safety equipment on hand—are well-understood terms and conditions of employment. But the statutory phrase is vague, and the cases abound with debates over whether a term insisted on by union or management is within the statutory phrase. No simple rule can be stated for determining whether a desire of union or management is mandatory or nonmandatory. The cases do suggest that management retains the right to determine the scope and direction of the enterprise, so that, for example, the decision to invest in labor-saving machinery is a nonmandatory subject—meaning that a union could not insist that an employer bargain over it, although the employer may negotiate if it desires. Once a subject is incorporated in a collective bargaining agreement, neither side may demand that it be renegotiated during the term of the agreement.
The Board’s Power to Compel an Agreement
A mere refusal to agree, without more, is not evidence of bad-faith bargaining. That may seem a difficult conclusion to reach in view of what has just been said. Nevertheless, the law is clear that a company may refuse to accede to a union’s demand for any reason other than an unwillingness to consider the matter in the first place. If a union negotiator cannot talk management into accepting his demand, then the union may take other actions—including strikes to try to force management to bow. It follows from this conclusion that the NLRB has no power to compel agreement—even if management is guilty of negotiating in bad faith. The federal labor laws are premised on the fundamental principle that the parties are free to bargain.
Interference and Discrimination by the Employer
Union Activity on Company Property
The employer may not issue a rule flatly prohibiting solicitation or distribution of literature during “working time” or “working hours”—a valid rule against solicitation or distribution must permit these activities during employees’ free time, such as on breaks and at meals. A rule that barred solicitation on the plant floor during actual work would be presumptively valid. However, the NLRB has the power to enjoin its enforcement if the employer used the rule to stop union soliciting but permitted employees during the forbidden times to solicit for charitable and other causes.
“Runaway Shop”
A business may lawfully decide to move a factory for economic reasons, but it may not do so to discourage a union or break it apart. The removal of a plant from one location to another is known as a runaway shop. An employer’s representative who conceals from union representatives that a move is contemplated commits an unfair labor practice because the union is deprived of the opportunity to negotiate over an important part of its members’ working conditions. If a company moves a plant and it is later determined that the move was to interfere with union activity, the board may order the employer to offer affected workers employment at the new site and the cost of transportation.
Other Types of Interference
Since “interference” is not a precise term but descriptive of a purpose embodied in the law, many activities lie within its scope. These include hiring professional strikebreakers to disrupt a strike, showing favoritism toward a particular union to discourage another one, awarding or withholding benefits to encourage or discourage unionization, engaging in misrepresentations and other acts during election campaigns, spying on workers, making employment contracts with individual members of a union, blacklisting workers, attacking union activists physically or verbally, and disseminating various forms of antiunion propaganda.
Discrimination against Union Members
Under Section 8(a)(3) of the NLRA, an employer may not discriminate against employees in hiring or tenure to encourage or discourage membership in a labor organization. Thus an employer may not refuse to hire a union activist and may not fire an employee who is actively supporting the union or an organizational effort if the employee is otherwise performing adequately on the job. Nor may an employer discriminate among employees seeking reinstatement after a strike or discriminatory layoff or lockout (a closing of the job site to prevent employees from coming to work), hiring only those who were less vocal in their support of the union.
The provision against employer discrimination in hiring prohibits certain types of compulsory unionism. Four basic types of compulsory unionism are possible: the closed shop, the union shop, maintenance-of-membership agreements, and preferential hiring agreements. In addition, a fifth arrangement—the agency shop—while not strictly compulsory unionism, has characteristics similar to it. Section 8(a)(3) prohibits the closed shop and preferential hiring. But Section 14 permits states to enact more stringent standards and thus to outlaw the union shop, the agency shop, and maintenance of membership as well.
1. Closed shop. This type of agreement requires a potential employee to belong to the union before being hired and to remain a member during employment. It is unlawful, because it would require an employer to discriminate on the basis of membership in deciding whether to hire.
2. Union shop. An employer who enters into a union shop agreement with the union may hire a nonunion employee, but all employees who are hired must then become members of the union and remain members so long as they work at the job. Because the employer may hire anyone, a union or nonunion member, the union shop is lawful unless barred by state law.
3. Maintenance-of-membership agreements. These agreements require employees who are members of the union before being hired to remain as members once they are hired unless they take advantage of an “escape clause” to resign within a time fixed in the collective bargaining agreement. Workers who were not members of the union before being hired are not required to join once they are on the job. This type of agreement is lawful unless barred by state law.
4. Preferential hiring. An employer who accepts a preferential hiring clause agrees to hire only union members as long as the union can supply him with a sufficient number of qualified workers. These clauses are unlawful.
5. Agency shop. The agency shop is not true compulsory unionism, for it specifically permits an employee not to belong to the union. However, it does require the employee to pay into the union the same amount required as dues of union members. The legality of an agency shop is determined by state law. If permissible under state law, it is permissible under federal law.
The Right to Strike
Section 13 of the NLRA says that “nothing in this Act, except as specifically provided for herein, shall be construed so as either to interfere with or impede or diminish in any way the right to strike, or to affect the limitations or qualifications on that right.” The labor statutes distinguish between two types of strikes: the economic strike and the strike over an unfair labor practice. In the former, employees go on strike to try to force the employer to give in to the workers’ demands. In the latter, the strikers are protesting the employer’s committing an unfair labor practice. The importance of the distinction lies in whether the employees are entitled to regain their jobs after the strike is over. In either type of strike, an employer may hire substitute employees during the strike. When it concludes, however, a difference arises. In NLRB v. International Van Lines, the Supreme Court said that an employer may hire permanent employees to take over during an economic strike and need not discharge the substitute employees when it is done.NLRB v. International Van Lines, 409 U.S. 48 (1972). That is not true for a strike over an unfair labor practice: an employee who makes an unconditional offer to return to his job is entitled to it, even though in the meantime the employer may have replaced him.
These rules do not apply to unlawful strikes. Not every walkout by workers is permissible. Their collective bargaining agreement may contain a no-strike clause barring strikes during the life of the contract. Most public employees—that is, those who work for the government—are prohibited from striking. Sit-down strikes, in which the employees stay on the work site, precluding the employer from using the facility, are unlawful. So are wildcat strikes, when a faction within the union walks out without authorization. Also unlawful are violent strikes, jurisdictional strikes, secondary strikes and boycotts, and strikes intended to force the employer to sign “hot cargo” agreements (see Section 17.3.6 “Hot Cargo Agreement”).
To combat strikes, especially when many employers are involved with a single union trying to bargain for better conditions throughout an industry, an employer may resort to a lockout. Typically, the union will call a whipsaw strike, striking some of the employers but not all. The whipsaw strike puts pressure on the struck employers because their competitors are still in business. The employers who are not struck may lawfully respond by locking out all employees who belong to the multiemployer union. This is known as a defensive lockout. In several cases, the Supreme Court has ruled that an offensive lockout, which occurs when the employer, anticipating a strike, locks the employees out, is also permissible.
Secondary Boycotts
Section 8(b)(4), added to the NLRA by the Taft-Hartley Act, prohibits workers from engaging in secondary boycotts—strikes, refusals to handle goods, threats, coercion, restraints, and other actions aimed at forcing any person to refrain from performing services for or handling products of any producer other than the employer, or to stop doing business with any other person. Like the Robinson-Patman Act (Chapter 26), this section of the NLRA is extremely difficult to parse and has led to many convoluted interpretations. However, its essence is to prevent workers from picketing employers not involved in the primary labor dispute.
Suppose that the Amalgamated Widget Workers of America puts up a picket line around the Ace Widget Company to force the company to recognize the union as the exclusive bargaining agent for Ace’s employees. The employees themselves do not join in the picketing, but when a delivery truck shows up at the plant gates and discovers the pickets, it turns back because the driver’s policy is never to cross a picket line. This activity falls within the literal terms of Section (8)(b)(4): it seeks to prevent the employees of Ace’s suppliers from doing business with Ace. But in NLRB v. International Rice Milling Co., the Supreme Court declared that this sort of primary activity—aimed directly at the employer involved in the primary dispute—is not unlawful.NLRB v. International Rice Milling Co., 341 U.S. 665 (1951). So it is permissible to throw up a picket line to attempt to stop anyone from doing business with the employer—whether suppliers, customers, or even the employer’s other employees (e.g., those belonging to other unions). That is why a single striking union is so often successful in closing down an entire plant: when the striking union goes out, the other unions “honor the picket line” by refusing to cross it and thus stay out of work as well. The employer might have been able to replace the striking workers if they were only a small part of the plant’s labor force, but it becomes nearly impossible to replace all the workers within a dozen or more unions.
Suppose the United Sanders Union strikes the Ace Widget Company. Nonunion sanders refuse to cross the picket line. So Ace sends out its unsanded widgets to Acme Sanders, a job shop across town, to do the sanding job. When the strikers learn what Ace has done, they begin to picket Acme, at which point Acme’s sanders honor the picket line and refuse to enter the premises. Acme goes to court to enjoin the pickets—an exception to the Norris–La Guardia Act permits the federal courts to enjoin picketing in cases of unlawful secondary boycotts. Should the court grant the injunction? It might seem so, but under the so-called ally doctrine, the court will not. Since Acme is joined with Ace to help it finish the work, the courts deem the second employer an ally (or extension) of the first. The second picket line, therefore, is not secondary.
Suppose that despite the strike, Ace manages to ship its finished product to the Dime Store, which sells a variety of goods, including widgets. The union puts up a picket around the store; the picketers bear signs that urge shoppers to refrain from buying any Ace widgets at the Dime Store. Is this an unlawful secondary boycott? Again, the answer is no. A proviso to Section 8(b)(4) permits publicity aimed at truthfully advising the public that products of a primary employer with whom the union is on strike are being distributed by a secondary employer.
Now suppose that the picketers carried signs and orally urged shoppers not to enter the Dime Store at all until it stopped carrying Ace’s widgets. That would be unlawful: a union may not picket a secondary site to persuade consumers to refrain from purchasing any of the secondary employer’s products. Likewise, the union may not picket in order to cause the secondary employees (the salesclerks at the Dime Store) to refuse to go to work at the secondary employer. The latter is a classic example of inducing a secondary work stoppage, and it is barred by Section 8(b)(4). However, in DeBartolo Corp. v. Florida Gulf Coast Building and Construction Trades Council, the Supreme Court opened what may prove to be a significant loophole in the prohibition against secondary boycotts.DeBartolo Corp. v. Florida Gulf Coast Building and Construction Trades Council, 485 U.S. 568 (1988). Instead of picketing, the union distributed handbills at the entrance to a shopping mall, asking customers not to patronize any stores in the mall until the mall owner, in building new stores, promised to deal only with contractors paying “fair wages.” The Court approved the handbilling, calling it “only an attempt to persuade customers not to shop in the mall,” distinguishing it from picketing, which the Court said would constitute a secondary boycott.
Hot Cargo Agreement
A union might find it advantageous to include in a collective bargaining agreement a provision under which the employer agrees to refrain from dealing with certain people or from purchasing their products. For example, suppose the Teamsters Union negotiates a contract with its employers that permits truckers to refuse to carry goods to an employer being struck by the Teamsters or any other union. The struck employer is the primary employer; the employer who has agreed to the clause—known as a hot cargo clause—is the secondary employer. The Supreme Court upheld these clauses in United Brotherhood of Carpenters and Joiners, Local 1976 v. NLRB, but the following year, Congress outlawed them in Section 8(e), with a partial exemption for the construction industry and a full exemption for garment and apparel workers.United Brotherhood of Carpenters and Joiners, Local 1976 v. NLRB, 357 U.S. 93 (1958).
Discrimination by Unions
A union certified as the exclusive bargaining representative in the appropriate bargaining unit is obligated to represent employees within that unit, even those who are not members of the union. Various provisions of the labor statutes prohibit unions from entering into agreements with employers to discriminate against nonmembers. The laws also prohibit unions from treating employees unfairly on the basis of race, creed, color, or national origin.
Jurisdictional Disputes
Ace Widget, a peaceful employer, has a distinguished labor history. It did not resist the first union, which came calling in 1936, just after the NLRA was enacted; by 1987, it had twenty-three different unions representing 7,200 workers at forty-eight sites throughout the United States. Then, because of increasingly more powerful and efficient machinery, United Widget Workers realized that it was losing jobs throughout the industry. It decided to attempt to bring within its purview jobs currently performed by members of other unions. United Widget Workers asked Ace to assign all sanding work to its members. Since sanding work was already being done by members of the United Sanders, Ace management refused. United Widget Workers decided to go on strike over the issue. Is the strike lawful? Under Section 8(b)(4)(D), regulating jurisdictional disputes, it is not. It is an unfair labor practice for a union to strike or engage in other concerted actions to pressure an employer to assign or reassign work to one union rather than another.
Bankruptcy and the Collective Bargaining Agreement
An employer is bound by a collective bargaining agreement to pay the wages of unionized workers specified in the agreement. But obviously, no paper agreement can guarantee wages when an insolvent company goes out of business. Suppose a company files for reorganization under the bankruptcy laws (see Chapter 13). May it then ignore its contractual obligation to pay wages previously bargained for? In the early 1980s, several major companies—for example, Continental Airlines and Oklahoma-based Wilson Foods Corporation—sought the protection of federal bankruptcy law in part to cut union wages. Alarmed, Congress, in 1984, amended the bankruptcy code to require companies to attempt to negotiate a modification of their contracts in good faith. In Bankruptcy Code Section 1113, Congress set forth several requirements for a debtor to extinguish its obligations under a collective bargaining agreement (CBA). Among other requirements, the debtor must make a proposal to the union modifying the CBA based on accurate and complete information, and meet with union leaders and confer in good faith after making the proposal and before the bankruptcy judge would rule.
If negotiations fail, a bankruptcy judge may approve the modification if it is necessary to allow the debtor to reorganize, and if all creditors, the debtor, and affected parties are treated fairly and equitably. If the union rejects the proposal without good cause, and the debtor has met its obligations of fairness and consultation from section 1113, the bankruptcy judge can accept the proposed modification to the CBA. In 1986, the US court of appeals in Philadelphia ruled that Wheeling-Pittsburgh Steel Corporation could not modify its contract with the United Steelworkers simply because it was financially distressed. The court pointed to the company’s failure to provide a “snap-back” clause in its new agreement. Such a clause would restore wages to the higher levels of the original contract if the company made a comeback faster than anticipated.Wheeling-Pittsburgh Steel Corp. v. United Steelworkers of America, 791 F.2d 1071 (3d Cir. 1986). But in the 2006 case involving Northwest Airlines Chapter 11 reorganization,In re Northwest Airlines Corp., 2006 Bankr. LEXIS 1159 (So. District N.Y.). the court found that Northwest had to reduce labor costs if it were going to successfully reorganize, that it had made an equitable proposal and consulted in good faith with the union, but that the union had rejected the proposed modification without good cause. Section 1113 was satisfied, and Northwest was allowed to modify its CBA with the union.
Key Takeaway
The NLRB determines the appropriate bargaining unit and also supervises union organizing drives. It must balance protecting the employer’s rights, including property rights and the right to manage the business efficiently, with the right of employees to communicate with each other. The NLRB will select a union and give it the exclusive right to bargain, and the result will usually be a collective bargaining unit. The employer should not interfere with the unionizing process or interfere once the union is in place. The union has the right to strike, subject to certain very important restrictions.
Exercises
1. Suppose that employees of the Shop Rite chain elect the Allied Food Workers Union as their exclusive bargaining agent. Negotiations for an initial collective bargaining agreement begin, but after six months, no agreement has been reached. The company finds excess damage to merchandise in its warehouse and believes that this was intentional sabotage by dissident employees. The company notifies the union representative that any employees doing such acts will be terminated, and the union, in turn, notifies the employees. Soon thereafter, a Shop Rite manager notices an employee in the flour section—where he has no right to be—making quick motions with his hands. The manager then finds several bags of flour that have been cut. The employee is fired, whereupon a fellow employee and union member leads more than two dozen employees in an immediate walkout. The company discharges these employees and refuses to rehire them. The employees file a grievance with the NLRB. Are they entitled to get their jobs back?NLRB v. Shop Rite Foods, 430 F.2d 786 (5th Cir. 1970).
2. American Shipbuilding Company has a shipyard in Chicago, Illinois. During winter months, it repairs ships operating on the Great Lakes, and the workers at the shipyard are represented by several different unions. In 1961, the unions notified the company of their intention to seek a modification of the current collective bargaining agreement. On five previous occasions, agreements had been preceded by strikes (including illegal strikes) that were called just after ships arrived in the shipyard for repairs. In this way, the unions had greatly increased their leverage in bargaining with the company. Because of this history, the company was anxious about the unions’ strike plans. In August 1961, after extended negotiations, the company and the unions reached an impasse. The company then decided to lay off most of the workers and sent the following notice: “Because of the labor dispute which has been unresolved since August of 1961, you are laid off until further notice.” The unions filed unfair labor practice charges with the NLRB. Did the company engage in an unfair labor practice?American Shipbuilding Company v. NLRB, 380 U.S. 300 (1965). | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/17%3A_Labor-Management_Relations/17.04%3A_Labor_and_Management_Rights_under_the_Federal_Labor_Laws.txt |
Exclusivity
Emporium Capwell Co. v. Western Addition Community Organization
420 U.S. 50 (1975)
The Emporium Capwell Company (Company) operates a department store in San Francisco. At all times relevant to this litigation it was a party to the collective-bargaining agreement negotiated by the San Francisco Retailer’s Council, of which it was a member, and the Department Store Employees Union (Union), which represented all stock and marketing area employees of the Company. The agreement, in which the Union was recognized as the sole collective-bargaining agency for all covered employees, prohibited employment discrimination by reason of race, color, creed, national origin, age, or sex, as well as union activity. It had a no-strike or lockout clause, and it established grievance and arbitration machinery for processing any claimed violation of the contract, including a violation of the anti-discrimination clause.
On April 3, 1968, a group of Company employees covered by the agreement met with the secretary-treasurer of the Union, Walter Johnson, to present a list of grievances including a claim that the Company was discriminating on the basis of race in making assignments and promotions. The Union official agreed to certain of the grievances and to investigate the charge of racial discrimination. He appointed an investigating committee and prepared a report on the employees’ grievances, which he submitted to the Retailer’s Council and which the Council in turn referred to the Company. The report described “the possibility of racial discrimination” as perhaps the most important issue raised by the employees and termed the situation at the Company as potentially explosive if corrective action were not taken. It offers as an example of the problem the Company’s failure to promote a Negro stock employee regarded by other employees as an outstanding candidate but a victim of racial discrimination.
Shortly after receiving the report, the Company’s labor relations director met representatives and agreed to “look into the matter” of discrimination, and see what needed to be done. Apparently unsatisfied with these representations, the Union held a meeting in September attended by Union officials, Company employees, and representatives of the California Fair Employment Practices Committee (FEPC) and the local anti-poverty agency. The secretary-treasurer of the Union announced that the Union had concluded that the Company was discriminating, and that it would process every such grievance through to arbitration if necessary. Testimony about the Company’s practices was taken and transcribed by a court reporter, and the next day the Union notified the Company of its formal charge and demanded that the union-management Adjustment Board be convened “to hear the entire case.”
At the September meeting some of the Company’s employees had expressed their view that the contract procedures were inadequate to handle a systemic grievance of this sort; they suggested that the Union instead begin picketing the store in protest. Johnson explained that the collective agreement bound the Union to its processes and expressed his view that successful grievants would be helping not only themselves but all others who might be the victims of invidious discrimination as well. The FEPC and anti-poverty agency representatives offered the same advice. Nonetheless, when the Adjustment Board meeting convened on October 16, James Joseph Hollins, Torn Hawkins, and two other employees whose testimony the Union had intended to elicit refused to participate in the grievance procedure. Instead, Hollins read a statement objecting to reliance on correction of individual inequities as an approach to the problem of discrimination at the store and demanding that the president of the Company meet with the four protestants to work out a broader agreement for dealing with the issue as they saw it. The four employees then walked out of the hearing.
…On Saturday, November 2, Hollins, Hawkins, and at least two other employees picketed the store throughout the day and distributed at the entrance handbills urging consumers not to patronize the store. Johnson encountered the picketing employees, again urged them to rely on the grievance process, and warned that they might be fired for their activities. The pickets, however, were not dissuaded, and they continued to press their demand to deal directly with the Company president.
On November 7, Hollins and Hawkins were given written warnings that a repetition of the picketing or public statements about the Company could lead to their discharge. When the conduct was repeated the following Saturday, the two employees were fired.
[T]he NLRB Trial Examiner found that the discharged employees had believed in good faith that the Company was discriminating against minority employees, and that they had resorted to concerted activity on the basis of that belief. He concluded, however, that their activity was not protected by § 7 of the Act and that their discharges did not, therefore, violate S 8(a)(1).
The Board, after oral argument, adopted the findings and conclusions of its Trial Examiner and dismissed the complaint. Among the findings adopted by the Board was that the discharged employees’ course of conduct was no mere presentation of a grievance but nothing short of a demand that the [Company] bargain with the picketing employees for the entire group of minority employees.
The Board concluded that protection of such an attempt to bargain would undermine the statutory system of bargaining through an exclusive, elected representative, impede elected unions’ efforts at bettering the working conditions of minority employees, “and place on the Employer an unreasonable burden of attempting to placate self-designated representatives of minority groups while abiding by the terms of a valid bargaining agreement and attempting in good faith to meet whatever demands the bargaining representative put forth under that agreement.”
On respondent’s petition for review the Court of Appeals reversed and remanded. The court was of the view that concerted activity directed against racial discrimination enjoys a “unique status” by virtue of the national labor policy against discrimination.…The issue, then, is whether such attempts to engage in separate bargaining are protected by 7 of the Act or proscribed by § 9(a).
Central to the policy of fostering collective bargaining, where the employees elect that course, is the principle of majority rule. If the majority of a unit chooses union representation, the NLRB permits it to bargain with its employer to make union membership a condition of employment, thus, imposing its choice upon the minority.
In vesting the representatives of the majority with this broad power, Congress did not, of course, authorize a tyranny of the majority over minority interests. First, it confined the exercise of these powers to the context of a “unit appropriate” for the purposes of collective bargaining, i.e., a group of employees with a sufficient commonality of circumstances to ensure against the submergence of a minority with distinctively different interests in the terms and conditions of their employment. Second, it undertook in the 1959 Landrum-Griffin amendments to assure that minority voices are heard as they are in the functioning of a democratic institution. Third, we have held, by the very nature of the exclusive bargaining representative’s status as representative of all unit employees, Congress implicitly imposed upon it a duty fairly and in good faith to represent the interests of minorities within the unit. And the Board has taken the position that a union’s refusal to process grievances against racial discrimination in violation of that duty is an unfair labor practice.…
* * *
The decision by a handful of employees to bypass a grievance procedure in favor of attempting to bargain with their employer…may or may not be predicated upon the actual existence of discrimination. An employer confronted with bargaining demands from each of several minority groups who would not necessarily, or even probably, be able to agree to remain real steps satisfactory to all at once. Competing claims on the employer’s ability to accommodate each group’s demands, e.g., for reassignments and promotions to a limited number of positions, could only set one group against the other even if it is not the employer’s intention to divide and overcome them.…In this instance we do not know precisely what form the demands advanced by Hollins, Hawkins, et al, would take, but the nature of the grievance that motivated them indicates that the demands would have included the transfer of some minority employees to sales areas in which higher commissions were paid. Yet the collective-bargaining agreement provided that no employee would be transferred from a higher-paying to a lower-paying classification except by consent or in the course of a layoff or reduction in force. The potential for conflict between the minority and other employees in this situation is manifest. With each group able to enforce its conflicting demands—the incumbent employees by resort to contractual processes and minority employees by economic coercion—the probability of strife and deadlock is high; the making headway against discriminatory practices would be minimal.
* * *
Accordingly, we think neither aspect of respondent’s contention in support of a right to short-circuit orderly, established processes eliminating discrimination in employment is well-founded. The policy of industrial self-determination as expressed in § 7 does not require fragmentation of the bargaining unit along racial or other lines in order to consist with the national labor policy against discrimination. And in the face of such fragmentation, whatever its effect on discriminatory practices, the bargaining process that the principle of exclusive representation is meant to lubricate could not endure unhampered.
* * *
Reversed.
Case Questions
1. Why did the picketers think that the union’s response had been inadequate?
2. In becoming members of the union, which had a contract that included an antidiscrimination clause along with a no-strike clause and a no-lockout clause, did the protesting employees waive all right to pursue discrimination claims in court? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/17%3A_Labor-Management_Relations/17.05%3A_Case.txt |
Summary
Federal labor law is grounded in the National Labor Relations Act, which permits unions to organize and prohibits employers from engaging in unfair labor practices. Amendments to the National Labor Relations Act (NLRA), such as the Taft-Hartley Act and the Landrum-Griffin Act, declare certain acts of unions and employees also to be unfair labor practices.
The National Labor Relations Board supervises union elections and decides in contested cases which union should serve as the exclusive bargaining unit, and it also investigates allegations of unfair labor practices and provides remedies in appropriate cases.
Once elected or certified, the union is the exclusive bargaining unit for the employees it represents. Because the employer is barred from interfering with employee communications when the union is organizing for an election, he may not prohibit employees from soliciting fellow employees on company property but may limit the hours or spaces in which this may be done. The election campaign itself is an intricate legal duel; rewards, threats, and misrepresentations that affect the election are unfair labor practices.
The basic policy of the labor laws is to foster good-faith collective bargaining over wages, hours, and working conditions. The National Labor Relations Board (NLRB) may not compel agreement: it may not order the employer or the union to adopt particular provisions, but it may compel a recalcitrant company or union to bargain in the first place.
Among the unfair labor practices committed by employers are these:
1. Discrimination against workers or prospective workers for belonging to or joining unions. Under federal law, the closed shop and preferential hiring are unlawful. Some states outlaw the union shop, the agency shop, and maintenance-of-membership agreements.
2. Interference with strikes. Employers may hire replacement workers during a strike, but in a strike over an unfair labor practice, as opposed to an economic strike, the replacement workers may be temporary only; workers are entitled to their jobs back at the strike’s end.
Among the unfair labor practices committed by unions are these:
1. Secondary boycotts. Workers may not picket employers not involved in the primary labor dispute.
2. Hot cargo agreements. An employer’s agreement, under union pressure, to refrain from dealing with certain people or purchasing their products is unlawful.
Exercises
1. After years of working without a union, employees of Argenta Associates began organizing for a representation election. Management did not try to prevent the employees from passing out leaflets or making speeches on company property, but the company president did send out a notice to all employees stating that in his opinion, they would be better off without a union. A week before the election, he sent another notice, stating that effective immediately, each employee would be entitled to a twenty-five-cents-an-hour raise. The employees voted the union down. The following day, several employees began agitating for another election. This time management threatened to fire anyone who continued talking about an election on the ground that the union had lost and the employees would have to wait a year. The employees’ organizing committee filed an unfair labor practice complaint with the NLRB. What was the result?
2. Palooka Industries sat down with Local 308, which represented its telephone operators, to discuss renewal of the collective bargaining agreement. Palooka pressed its case for a no-strike clause in the next contract, but Local 308 refused to discuss it at all. Exasperated, Palooka finally filed an unfair labor practice claim with the NLRB. What was the result?
3. Union organizers sought to organize the punch press operators at Dan’s Machine Shop. The shop was located on a lot surrounded by heavily forested land from which access to employees was impossible. The only practical method of reaching employees on the site was in the company parking lot. When the organizers arrived to distribute handbills, the shop foreman, under instructions from Dan, ordered them to leave. At a hearing before the NLRB, the company said that it was not antiunion but that its policy, which it had always strictly adhered to, forbade nonemployees from being on the property if not on company business. Moreover, company policy barred any activities that would lead to littering. The company noted that the organizers could reach the employees in many other ways—meeting the employees personally in town after hours, calling them at home, writing them letters, or advertising a public meeting. The organizers responded that these methods were far less effective means of reaching the employees. What was the result? Why?
SELF CHECK QUESTIONS
1. Which of the following is not a subject of mandatory bargaining?
1. rate of pay per hour
2. length of the workweek
3. safety equipment
4. new products to manufacture
2. Under a union shop agreement,
1. an employer may not hire a nonunion member
2. an employer must hire a nonunion member
3. an employee must join the union after being hired
4. an employee must belong to the union before being hired
3. Which of the following is always unlawful under federal law?
1. union shop
2. agency shop
3. closed shop
4. runaway shop
4. An employer’s agreement with its union to refrain from dealing with companies being struck by other unions is a
1. secondary boycott agreement
2. hot cargo agreement
3. lockout agreement
4. maintenance-of-membership agreement
5. Striking employees are entitled to their jobs back when they are engaged in
1. economic strikes
2. jurisdictional strikes
3. both economic and jurisdictional strikes
4. neither economic nor jurisdictional strikes
1. d
2. c
3. c
4. b
5. a | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/17%3A_Labor-Management_Relations/17.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The importance of partnership and the present status of partnership law
• The extent to which a partnership is an entity
• The tests that determine whether a partnership exists
• Partnership by estoppel
• Partnership formation
18: PartnershipsGeneral Characteristics and Formation
Learning Objectives
By the end of this section, you will be able to:
• Describe the importance of partnership.
• Understand partnership history.
• Identify the entity characteristics of partnerships.
Importance of Partnership Law
It would be difficult to conceive of a complex society that did not operate its businesses through organizations. In this chapter we study partnerships, limited partnerships, and limited liability companies, and we touch on joint ventures and business trusts.
When two or more people form their own business or professional practice, they usually consider becoming partners. Partnership law defines a partnership as “the association of two or more persons to carry on as co-owners a business for profit…whether or not the persons intend to form a partnership.”Revised Uniform Partnership Act, Section 202(a). In 2011, there were more than three million business firms in the United States as partnerships (see Table 18.1, showing data to 2006), and partnerships are a common form of organization among accountants, lawyers, doctors, and other professionals. When we use the word partnership, we are referring to the general business partnership. There are also limited partnerships and limited liability partnerships, which are discussed in Chapter 20.
Table \(1\): Selected Data: Number of US Partnerships, Limited Partnerships, and Limited Liability Companies
2003 2004 2005 2006
Total number of active partnerships 2,375,375 2,546,877 2,763,625 2,947,116
Number of partners 14,108,458 15,556,553 16,211,908 16,727,803
Number of limited partnerships 378,921 402,238 413,712 432,550
Number of partners 6,262,103 7,023,921 6,946,986 6,738,737
Number of limited liability companies 1,091,502 1,270,236 1,465,223 1,630,161
Number of partners 4,226,099 4,949,808 5,640,146 6,361,958
Partnerships are also popular as investment vehicles. Partnership law and tax law permit an investor to put capital into a limited partnership and realize tax benefits without liability for the acts of the general partners.
Even if you do not plan to work within a partnership, it can be important to understand the law that governs it. Why? Because it is possible to become someone’s partner without intending to or even realizing that a partnership has been created. Knowledge of the law can help you avoid partnership liability.
History of Partnership Law
Through the Twentieth Century
Partnership is an ancient form of business enterprise, and special laws governing partnerships date as far back as 2300 BC, when the Code of Hammurabi explicitly regulated the relations between partners. Partnership was an important part of Roman law, and it played a significant role in the law merchant, the international commercial law of the Middle Ages.
In the nineteenth century, in both England and the United States, partnership was a popular vehicle for business enterprise. But the law governing it was jumbled. Common-law principles were mixed with equitable standards, and the result was considerable confusion. Parliament moved to reduce the uncertainty by adopting the Partnership Act of 1890, but codification took longer in the United States. The Commissioners on Uniform State Laws undertook the task at the turn of the twentieth century. The Uniform Partnership Act (UPA), completed in 1914, and the Uniform Limited Partnership Act (ULPA), completed in 1916, were the basis of partnership law for many decades. UPA and ULPA were adopted by all states except Louisiana.
The Current State of Partnership Law
Despite its name, UPA was not enacted uniformly among the states; moreover, it had some shortcomings. So the states tinkered with it, and by the 1980s, the National Conference of Commissioners on Uniform Laws (NCCUL) determined that a revised version was in order. An amended UPA appeared in 1992, and further amendments were promulgated in 1993, 1994, 1996, and 1997. The NCCUL reports that thirty-nine states have adopted some version of the revised act. This chapter will discuss the Revised Uniform Partnership Act (RUPA) as promulgated in 1997, but because not all jurisdictions have not adopted it, where RUPA makes significant changes, the original 1914 UPA will also be considered.NCCUSL, Uniform Law Commission, “Acts: Partnership Act,” www.nccusl.org/Act.aspx?title=Partnership%20Act. The following states have adopted the RUPA: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Delaware, District of Columbia, Florida, Hawaii, Idaho, Illinois, Iowa, Kansas, Kentucky, Maine, Maryland, Minnesota, Mississippi, Montana, Nebraska, Nevada, New Jersey, New Mexico, North Dakota, Oklahoma, Oregon, Puerto Rico, South Dakota (substantially similar), Tennessee, Texas (substantially similar), US Virgin Islands, Vermont, Virginia, and Washington. Connecticut, West Virginia, and Wyoming adopted the 1992 or 1994 version. Here are the states that have not adopted RUPA (Louisiana never adopted UPA at all): Georgia, Indiana, Massachusetts, Michigan, Mississippi, New Hampshire, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, and Wisconsin. The NCCUL observes in its “prefatory note” to the 1997 act: “The Revised Act is largely a series of ‘default rules’ that govern the relations among partners in situations they have not addressed in a partnership agreement. The primary focus of RUPA is the small, often informal, partnership. Larger partnerships generally have a partnership agreement addressing, and often modifying, many of the provisions of the partnership act.”University of Pennsylvania Law School, Biddle Law Library, “Uniform Partnership Act (1997),” NCCUSL Archives, www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/upa97fa.pdf.
Entity Theory
Meaning of “Legal Entity”
A significant difference between a partnership and most other kinds of business organization relates to whether, and the extent to which, the business is a legal entity. A legal entity is a person or group that the law recognizes as having legal rights, such as the right to own and dispose of property, to sue and be sued, and to enter into contracts; the entity theory is the concept of a business firm as a legal person, with existence and accountability separate from its owners. When individuals carry out a common enterprise as partners, a threshold legal question is whether the partnership is a legal entity. The common law said no. In other words, under the common-law theory, a partnership was but a convenient name for an aggregate of individuals, and the rights and duties recognized and imposed by law are those of the individual partners. By contrast, the mercantile theory of the law merchant held that a partnership is a legal entity that can have rights and duties independent of those of its members.
During the drafting of the 1914 UPA, a debate raged over which theory to adopt. The drafters resolved the debate through a compromise. In Section 6(1), UPA provides a neutral definition of partnership (“an association of two or more persons to carry on as co-owners a business for profit”) and retained the common-law theory that a partnership is an aggregation of individuals—the aggregate theory.
RUPA moved more toward making partnerships entities. According to the NCCUL, “The Revised Act enhances the entity treatment of partnerships to achieve simplicity for state law purposes, particularly in matters concerning title to partnership property. RUPA does not, however, relentlessly apply the entity approach. The aggregate approach is retained for some purposes, such as partners’ joint and several liability.”University of Pennsylvania Law School, Biddle Law Library, “Uniform Partnership Act (1997),” NCCUSL Archives, www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/upa97fa.pdf. Section 201(a) provides, “A partnership is an entity distinct from its partners.”RUPA, Section 201(a).
Entity Characteristics of a Partnership
Under RUPA, then, a partnership has entity characteristics, but the partners remain guarantors of partnership obligations, as always—that is the partners’ joint and several liability noted in the previous paragraph (and discussed further in Chapter 19). This is a very important point and a primary weakness of the partnership form: all partners are, and each one of them is, ultimately personally liable for the obligations of the partnership, without limit, which includes personal and unlimited liability. This personal liability is very distasteful, and it has been abolished, subject to some exceptions, with limited partnerships and limited liability companies, as discussed in Chapter 20. And, of course, the owners of corporations are also not generally liable for the corporation’s obligations, which is a major reason for the corporate form’s popularity.
For Accounting Purposes
Under both versions of the law, the partnership may keep business records as if it were a separate entity, and its accountants may treat it as such for purposes of preparing income statements and balance sheets.
For Purposes of Taxation
Under both versions of the law, partnerships are not taxable entities, so they do not pay income taxes. Instead, each partner’s distributive share, which includes income or other gain, loss, deductions, and credits, must be included in the partner’s personal income tax return, whether or not the share is actually distributed.
For Purposes of Litigation
In litigation, the aggregate theory causes some inconvenience in naming and serving partnership defendants: under UPA, lawsuits to enforce a partnership contract or some other right must be filed in the name of all the partners. Similarly, to sue a partnership, the plaintiff must name and sue each of the partners. This cumbersome procedure was modified in many states, which enacted special statutes expressly permitting suits by and against partnerships in the firm name. In suits on a claim in federal court, a partnership may sue and be sued in its common name. The move by RUPA to make partnerships entities changed very little. Certainly it provides that “a partnership may sue and be sued in the name of the partnership”—that’s handy where the plaintiff hopes for a judgment against the partnership, without recourse to the individual partners’ personal assets.RUPA, Section 307(a). But a plaintiff must still name the partnership and the partners individually to have access to both estates, the partnership and the individuals’: “A judgment against a partnership is not by itself a judgment against a partner. A judgment against a partnership may not be satisfied from a partner’s assets unless there is also a judgment against the partner.”RUPA, Section 307(c).
For Purposes of Owning Real Estate
Aggregate theory concepts bedeviled property co-ownership issues, so UPA finessed the issue by stating that partnership property, real or personal, could be held in the name of the partners as “tenants in partnership”—a type of co-ownership—or it could be held in the name of the partnership.Uniform Partnership Act, Section 25(1); UPA, Section 8(3). Under RUPA, “property acquired by the partnership is property of the partnership and not of the partners.”RUPA, Section 203. But RUPA is no different from UPA in practical effect. The latter provides that “property originally brought into the partnership stock or subsequently acquired by purchase…on account of the partnership, is partnership property.”UPA, Section 8(1). Under either law, a partner may bring onto the partnership premises her own property, not acquired in the name of the partnership or with its credit, and it remains her separate property. Under neither law can a partner unilaterally dispose of partnership property, however labeled, for the obvious reason that one cannot dispose of another’s property or property rights without permission.UPA, Sections 9(3)(a) and 25; RUPA, Section 302. And keep in mind that partnership law is the default: partners are free to make up partnership agreements as they like, subject to some limitations. They are free to set up property ownership rules as they like.
For Purposes of Bankruptcy
Under federal bankruptcy law—state partnership law is preempted—a partnership is an entity that may voluntarily seek the haven of a bankruptcy court or that may involuntarily be thrust into a bankruptcy proceeding by its creditors. The partnership cannot discharge its debts in a liquidation proceeding under Chapter 7 of the bankruptcy law, but it can be rehabilitated under Chapter 11 (see Chapter 13).
Key Takeaway
Partnership law is very important because it is the way most small businesses are organized and because it is possible for a person to become a partner without intending to. Partnership law goes back a long way, but in the United States, most states—but not all—have adopted the Revised Uniform Partnership Act (RUPA, 1997) over the previous Uniform Partnership Act, originally promulgated in 1914. One salient change made by RUPA is to directly announce that a partnership is an entity: it is like a person for purposes of accounting, litigation, bankruptcy, and owning real estate. Partnerships do not pay taxes; the individual partners do. But in practical terms, what RUPA does is codify already-existing state law on these matters, and partners are free to organize their relationship as they like in the partnership agreement.
Exercises
1. When was UPA set out for states to adopt? When was RUPA promulgated for state adoption?
2. What does it mean to say that the partnership act is the “default position”? For what types of partnership is UPA (or RUPA) likely to be of most importance?
3. What is the aggregate theory of partnership? The entity theory? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/18%3A_PartnershipsGeneral_Characteristics_and_Formation/18.01%3A_Introduction_to_Partnerships_and_Entity_Theory.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe the creation of an express partnership.
• Describe the creation of an implied partnership.
• Identify tests of partnership existence.
• Understand partnership by estoppel.
Creation of an Express Partnership
Creation in General
The most common way of forming a partnership is expressly—that is, in words, orally or in writing. Such a partnership is called an express partnership. If parties have an express partnership with no partnership agreement, the relevant law—the Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act (RUPA)—applies the governing rules.
Assume that three persons have decided to form a partnership to run a car dealership. Able contributes \$250,000. Baker contributes the building and space in which the business will operate. Carr contributes his services; he will manage the dealership.
The first question is whether Able, Baker, and Carr must have a partnership agreement. As should be clear from the foregoing discussion, no agreement is necessary as long as the tests of partnership are met. However, they ought to have an agreement in order to spell out their rights and duties among themselves.
The agreement itself is a contract and should follow the principles and rules spelled out in Chapter 8 of this book. Because it is intended to govern the relations of the partners toward themselves and their business, every partnership contract should set forth clearly the following terms: (1) the name under which the partners will do business; (2) the names of the partners; (3) the nature, scope, and location of the business; (4) the capital contributions of each partner; (5) how profits and losses are to be divided; (6) how salaries, if any, are to be determined; (7) the responsibilities of each partner for managing the business; (8) limitations on the power of each partner to bind the firm; (9) the method by which a given partner may withdraw from the partnership; (10) continuation of the firm in the event of a partner’s death and the formula for paying a partnership interest to his heirs; and (11) method of dissolution.
Specific Issues of Concern
In forming a partnership, three of these items merit special attention. And note again that if the parties do not provide for these in their agreement, RUPA will do it for them as the default.
Who Can Be a Partner?
As discussed earlier in this chapter, a partnership is not limited to a direct association between human beings but may also include an association between other entities, such as corporations or even partnerships themselves.A joint venture—sometimes known as a joint adventure, coadventure, joint enterprise, joint undertaking, syndicate, group, or pool—is an association of persons to carry on a particular task until completed. In essence, a joint venture is a “temporary partnership.” In the United States, the use of joint ventures began with the railroads in the late 1800s. Throughout the middle part of the twentieth century joint ventures were common in the manufacturing sector. By the late 1980s, they increasingly appeared in both manufacturing and service industries as businesses looked for new, competitive strategies. They are aggressively promoted on the Internet: “Joint Ventures are in, and if you’re not utilizing this strategic weapon, chances are your competition is, or will soon be, using this to their advantage.…possibly against you!” (Scott Allen, “Joint Venturing 101,” About.com Entrepreneurs, http://entrepreneurs.about.com/od/beyondstartup/a/jointventures.htm).As a risk-avoiding device, the joint venture allows two or more firms to pool their differing expertise so that neither needs to “learn the ropes” from the beginning; neither needs the entire capital to start the enterprise.Partnership rules generally apply, although the relationship of the joint venturers is closer to that of special than general agency as discussed in Chapter 14. Joint venturers are fiduciaries toward one another. Although no formality is necessary, the associates will usually sign an agreement. The joint venture need have no group name, though it may have one. Property may be owned jointly. Profits and losses will be shared, as in a partnership, and each associate has the right to participate in management. Liability is unlimited.Sometimes two or more businesses will form a joint venture to carry out a specific task—prospecting for oil, building a nuclear reactor, doing basic scientific research—and will incorporate the joint venture. In that case, the resulting business—known as a “joint venture corporation”—is governed by corporation law, not the law of partnership, and is not a joint venture in the sense described here. Increasingly, companies are forming joint ventures to do business abroad; foreign investors or governments own significant interests in these joint ventures. For example, in 1984 General Motors entered into a joint venture with Toyota to revive GM’s shuttered Fremont, California, assembly plant to create New United Motor Manufacturing, Inc. (NUMMI). For GM the joint venture was an opportunity to learn about lean manufacturing from the Japanese company, while Toyota gained its first manufacturing base in North America and a chance to test its production system in an American labor environment. Until May 2010, when the copartnership ended and the plant closed, NUMMI built an average of six thousand vehicles a week, or nearly eight million cars and trucks. These vehicles were the Chevrolet Nova (1984–88), the Geo Prizm (1989–97), the Chevrolet Prizm (1998–2002), and the Hilux (1991–95, predecessor of the Tacoma), as well as the Toyota Voltz, the Japanese right-hand-drive version of the Pontiac Vibe. The latter two were based on the Toyota Matrix. Paul Stenquist, “GM and Toyota’s Joint Venture Ends in California,” New York Times, April 2, 2010, wheels.blogs.nytimes.com/2010/04/02/g-m-and-toyotas-joint-venture-ends-in-california. Family members can be partners, and partnerships between parents and minor children are lawful, although a partner who is a minor may disaffirm the agreement.
Written versus Oral Agreements
If the business cannot be performed within one year from the time that the agreement is entered into, the partnership agreement should be in writing to avoid invalidation under the Statute of Frauds. Most partnerships have no fixed term, however, and are partnerships “at will” and therefore not covered by the Statute of Frauds.
Validity of the Partnership Name
Able, Baker, and Carr decide that it makes good business sense to choose an imposing, catchy, and well-known name for their dealership—General Motors Corporation. There are two reasons why they cannot do so. First, their business is a partnership, not a corporation, and should not be described as one. Second, the name is deceptive because it is the name of an existing business. Furthermore, if not registered, the name would violate the assumed or fictitious name statutes of most states. These require that anyone doing business under a name other than his real name register the name, together with the names and addresses of the proprietors, in some public office. (Often, the statutes require the proprietors to publish this information in the newspapers when the business is started.) As Loomis v. Whitehead in Section 18.3.2 “Creation of a Partnership: Registering the Name” shows, if a business fails to comply with the statute, it could find that it will be unable to file suit to enforce its contracts.
Creation of Implied Partnership
An implied partnership exists when in fact there are two or more persons carrying on a business as co-owners for profit. For example, Carlos decides to paint houses during his summer break. He gathers some materials and gets several jobs. He hires Wally as a helper. Wally is very good, and pretty soon both of them are deciding what jobs to do and how much to charge, and they are splitting the profits. They have an implied partnership, without intending to create a partnership at all.
Tests of Partnership Existence
But how do we know whether an implied partnership has been created? Obviously, we know if there is an express agreement. But partnerships can come into existence quite informally, indeed, without any formality—they can be created accidentally. In contrast to the corporation, which is the creature of statute, partnership is a catchall term for a large variety of working relationships, and frequently, uncertainties arise about whether or not a particular relationship is that of partnership. The law can reduce the uncertainty in advance only at the price of severely restricting the flexibility of people to associate. As the chief drafter of the Uniform Partnership Act (UPA, 1914) explained,
All other business associations are statutory in origin. They are formed by the happening of an event designated in a statute as necessary to their formation. In corporations this act may be the issuing of a charter by the proper officer of the state; in limited partnerships, the filing by the associates of a specified document in a public office. On the other hand, an infinite number of combinations of circumstances may result in co-ownership of a business. Partnership is the residuum, including all forms of co-ownership, of a business except those business associations organized under a specific statute.W. D. Lewis, “The Uniform Partnership Act,” Yale Law Journal 24 (1915): 617, 622.
Because it is frequently important to know whether a partnership exists (as when a creditor has dealt with only one party but wishes to also hold others liable by claiming they were partners, see Section 18.3.1 “Tests of Partnership Existence”, Chaiken v. Employment Security Commission), a number of tests have been established that are clues to the existence of a partnership (see Figure 18.1). We return to the definition of a partnership: “the association of two or more persons to carry on as co-owners a business for profit[.]” The three elements are (1) the association of persons, (2) as co-owners, (3) for profit.
Association of Persons
This element is pretty obvious. A partnership is a contractual agreement among persons, so the persons involved need to have capacity to contract. But RUPA does not provide that only natural persons can be partners; it defines person as follows: “‘Person’ means an individual, corporation, business trust, estate, trust, partnership, association, joint venture, government, governmental subdivision, agency, or instrumentality, or any other legal or commercial entity.”RUPA, Section 101(10). Thus unless state law precludes it, a corporation can be a partner in a partnership. The same is true under UPA.
Co-owners of a Business
If what two or more people own is clearly a business—including capital assets, contracts with employees or agents, an income stream, and debts incurred on behalf of the operation—a partnership exists. A tougher question arises when two or more persons co-own property. Do they automatically become partners? The answer can be important: if one of the owners while doing business pertinent to the property injures a stranger, the latter could sue the other owners if there is a partnership.
Co-ownership comes in many guises. The four most common are joint tenancy, tenancy in common, tenancy by the entireties, and community property. In joint tenancy, the owners hold the property under a single instrument, such as a deed, and if one dies, the others automatically become owners of the deceased’s share, which does not descend to his heirs. Tenancy in common has the reverse rule: the survivor tenants do not take the deceased’s share. Each tenant in common has a distinct estate in the property. The tenancy by the entirety and community property (in community-property states) forms of ownership are limited to spouses, and their effects are similar to that of joint tenancy. These concepts are discussed in more detail in relation to real property in Chapter 31.
Suppose a husband and wife who own their home as tenants by the entirety (or community property) decide to spend the summer at the seashore and rent their home for three months. Is their co-ownership sufficient to establish that they are partners? The answer is no. By UPA Section 7(2) and RUPA Section 202(b)(1), the various forms of joint ownership by themselves do not establish partnership, whether or not the co-owners share profits made by the use of the property. To establish a partnership, the ownership must be of a business, not merely of property.
Sharing of Profits
There are two aspects to consider with regard to profits: first, whether the business is for-profit, and second, whether there is a sharing of the profit.
Business for Profit
Unincorporated nonprofit organizations (UNAs) cannot be partnerships. The paucity of coherent law governing these organizations gave rise in 2005 to the National Conference of Commissioners of Uniform Laws’ promulgation of the Revised Uniform Unincorporated Nonprofit Association Act (RUUNAA). The prefatory note to this act says, “RUUNAA was drafted with small informal associations in mind. These informal organizations are likely to have no legal advice and so fail to consider legal and organizational questions, including whether to incorporate. The act provides better answers than the common law for a limited number of legal problems…There are probably hundreds of thousands of UNAs in the United States including unincorporated nonprofit philanthropic, educational, scientific and literary clubs, sporting organizations, unions, trade associations, political organizations, churches, hospitals, and condominium and neighborhood associations.”Revised Uniform Unincorporated Nonprofit Associations Act, www.abanet.org/intlaw/leadership/policy/RUUNAA_Final_08.pdf. At least twelve states have adopted RUUNAA or its predecessor.
Sharing the Profit
While co-ownership does not establish a partnership unless there is a business, a business by itself is not a partnership unless co-ownership is present. Of the tests used by courts to determine co-ownership, perhaps the most important is sharing of profits. Section 202(c) of RUPA provides that “a person who receives a share of the profits of a business is presumed to be a partner in the business,” but this presumption can be rebutted by showing that the share of the profits paid out was (1) to repay a debt; (2) wages or compensation to an independent contractor; (3) rent; (4) an annuity, retirement, or health benefit to a representative of a deceased or retired partner; (5) interest on a loan, or rights to income, proceeds, or increase in value from collateral; or (5) for the sale of the goodwill of a business or other property. Section 7(4) of UPA is to the same effect.
Other Factors
Courts are not limited to the profit-sharing test; they also look at these factors, among others: the right to participate in decision making, the duty to share liabilities, and the manner in which the business is operated. Section 18.3.1 “Tests of Partnership Existence”, Chaiken v. Employment Security Commission, illustrates how these factors are weighed in court.
Creation of Partnership by Estoppel
Ordinarily, if two people are not legally partners, then third parties cannot so regard them. For example, Mr. Tot and Mr. Tut own equal shares of a house that they rent but do not regard it as a business and are not in fact partners. They do have a loose “understanding” that since Mr. Tot is mechanically adept, he will make necessary repairs whenever the tenants call. On his way to the house one day to fix its boiler, Mr. Tot injures a pedestrian, who sues both Mr. Tot and Mr. Tut. Since they are not partners, the pedestrian cannot sue them as if they were; hence Mr. Tut has no partnership liability.
Suppose that Mr. Tot and Mr. Tut happened to go to a lumberyard together to purchase materials that Mr. Tot intended to use to add a room to the house. Short of cash, Mr. Tot looks around and espies Mr. Tat, who greets his two friends heartily by saying within earshot of the salesman who is debating whether to extend credit, “Well, how are my two partners this morning?” Messrs. Tot and Tut say nothing but smile faintly at the salesman, who mistakenly but reasonably believes that the two are acknowledging the partnership. The salesman knows Mr. Tat well and assumes that since Mr. Tat is rich, extending credit to the “partnership” is a “sure thing.” Messrs. Tot and Tut fail to pay. The lumberyard is entitled to collect from Mr. Tat, even though he may have forgotten completely about the incident by the time suit is filed. Under Uniform Partnership Act Section 16(1), Mr. Tat would be liable for the debt as being part of a partnership by estoppel. The Revised Uniform Partnership Act is to the same effect:
Section 308. Liability of Purported Partner.
(a) If a person, by words or conduct, purports to be a partner, or consents to being represented by another as a partner, in a partnership or with one or more persons not partners, the purported partner is liable to a person to whom the representation is made, if that person, relying on the representation, enters into a transaction with the actual or purported partnership.
Partnership by estoppel has two elements: (1) a representation to a third party that there is in fact a partnership and (2) reliance by the third party on the representation. See Section 18.3.3 “Partnership by Estoppel”, Chavers v. Epsco, Inc., for an example of partnership by estoppel.
Key Takeaway
A partnership is any two or more persons—including corporate persons—carrying on a business as co-owners for profit. A primary test of whether a partnership exists is whether there is a sharing of profits, though other factors such as sharing decision making, sharing liabilities, and how the business is operated are also examined.
Most partnerships are expressly created. Several factors become important in the partnership agreement, whether written or oral. These include the name of the business, the capital contributions of each partner, profit sharing, and decision making. But a partnership can also arise by implication or by estoppel, where one has held herself as a partner and another has relied on that representation.
Exercises
1. Why is it necessary—or at least useful—to have tests to determine whether a partnership exists?
2. What elements of the business organization are examined to make this determination?
3. Jacob rents farmland from Davis and pays Davis a part of the profits from the crop in rent. Is Davis a partner? What if Davis offers suggestions on what to plant and when? Now is he a partner?
4. What elements should be included in a written partnership agreement?
5. What is an implied partnership?
6. What is a partnership by estoppel, and why are its “partners” estopped to deny its existence? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/18%3A_PartnershipsGeneral_Characteristics_and_Formation/18.02%3A_Partnership_Formation.txt |
Tests of Partnership Existence
Chaiken v. Employment Security Commission
274 A.2d 707 (Del. 1971)
STOREY, J.
The Employment Security Commission, hereinafter referred to as the Commission, levied an involuntary assessment against Richard K. Chaiken, complainant, hereinafter referred to as Chaiken, for not filing his unemployment security assessment report. Pursuant to the same statutory section, a hearing was held and a determination made by the Commission that Chaiken was the employer of two barbers in his barber shop and that he should be assessed as an employer for his share of unemployment compensation contributions. Chaiken appealed the Commission’s decision.…
Both in the administrative hearing and in his appeal brief Chaiken argues that he had entered into partnership agreements with each of his barbers and, therefore, was and is not subject to unemployment compensation assessment. The burden is upon the individual assessed to show that he is outside the ambit of the statutory sections requiring assessment. If Chaiken’s partnership argument fails he has no secondary position and he fails to meet his burden.
Chaiken contends that he and his “partners”:
1. properly registered the partnership name and names of partners in the prothonotary’s office, in accordance with [the relevant statute],The word prothonotary means first notary of the court. The prothonotary is the keeper of the civil records for the court system. The office is responsible for the creation, maintenance, and certification of matters pending or determined by the court. The office is also responsible for certain reporting and collection duties to state agencies.
2. properly filed federal partnership information returns and paid federal taxes quarterly on an estimated basis, and
3. duly executed partnership agreements.
Of the three factors, the last is most important. Agreements of “partnership” were executed between Chaiken and Mr. Strazella, a barber in the shop, and between Chaiken and Mr. Spitzer, similarly situated. The agreements were nearly identical. The first paragraph declared the creation of a partnership and the location of business. The second provided that Chaiken would provide barber chair, supplies, and licenses, while the other partner would provide tools of the trade. The paragraph also declared that upon dissolution of the partnership, ownership of items would revert to the party providing them. The third paragraph declared that the income of the partnership would be divided 30% for Chaiken, 70% for Strazella; 20% for Chaiken and 80% for Spitzer. The fourth paragraph declared that all partnership policy would be decided by Chaiken, whose decision was final. The fifth paragraph forbade assignment of the agreement without permission of Chaiken. The sixth paragraph required Chaiken to hold and distribute all receipts. The final paragraph stated hours of work for Strazella and Spitzer and holidays.
The mere existence of an agreement labeled “partnership” agreement and the characterization of signatories as “partners” docs not conclusively prove the existence of a partnership. Rather, the intention of the parties, as explained by the wording of the agreement, is paramount.
A partnership is defined as an association of two or more persons to carry on as co-owners a business for profit. As co-owners of a business, partners have an equal right in the decision making process. But this right may be abrogated by agreement of the parties without destroying the partnership concept, provided other partnership elements are present.
Thus, while paragraph four reserves for Chaiken all right to determine partnership policy, it is not standing alone, fatal to the partnership concept. Co-owners should also contribute valuable consideration for the creation of the business. Under paragraph two, however, Chaiken provides the barber chair (and implicitly the barber shop itself), mirror, licenses and linen, while the other partners merely provide their tools and labor—nothing more than any barber-employee would furnish. Standing alone, however, mere contribution of work and skill can be valuable consideration for a partnership agreement.
Partnership interests may be assignable, although it is not a violation of partnership law to prohibit assignment in a partnership agreement. Therefore, paragraph five on assignment of partnership interests does not violate the partnership concept. On the other hand, distribution of partnership assets to the partners upon dissolution is only allowed after all partnership liabilities are satisfied. But paragraph two of the agreement, in stating the ground rules for dissolution, makes no declaration that the partnership assets will be utilized to pay partnership expenses before reversion to their original owners. This deficiency militates against a finding in favor of partnership intent since it is assumed Chaiken would have inserted such provision had he thought his lesser partners would accept such liability. Partners do accept such liability, employees do not.
Most importantly, co-owners carry on “a business for profit.” The phrase has been interpreted to mean that partners share in the profits and the losses of the business. The intent to divide the profits is an indispensable requisite of partnership. Paragraph three of the agreement declares that each partner shall share in the income of the business. There is no sharing of the profits, and as the agreement is drafted, there are no profits. Merely sharing the gross returns does not establish a partnership. Nor is the sharing of profits prima facie evidence of a partnership where the profits received are in payment of wages.
The failure to share profits, therefore, is fatal to the partnership concept here.
Evaluating Chaiken’s agreement in light of the elements implicit in a partnership, no partnership intent can be found. The absence of the important right of decision making or the important duty to share liabilities upon dissolution individually may not be fatal to a partnership. But when both are absent, coupled with the absence of profit sharing, they become strong factors in discrediting the partnership argument. Such weighing of the elements against a partnership finding compares favorably with Fenwick v. Unemployment Compensation Commission, which decided against the partnership theory on similar facts, including the filing of partnership income tax forms.
In addition, the total circumstances of the case taken together indicate the employer-employee relationship between Chaiken and his barbers. The agreement set forth the hours of work and days off—unusual subjects for partnership agreements. The barbers brought into the relationship only the equipment required of all barber shop operators. And each barber had his own individual “partnership” with Chaiken. Furthermore, Chaiken conducted all transactions with suppliers, and purchased licenses, insurance, and the lease for the business property in his own name. Finally, the name “Richard’s Barber Shop” continued to be used after the execution of the so-called partnership agreements. [The Commission’s decision is affirmed.]
Case Questions
1. Why did the unemployment board sue Chaiken?
2. Why did Chaiken set up this “partnership”?
3. What factors did the court examine to determine whether there was a partnership here? Which one was the most important?
4. Why would it be unusual in a partnership agreement to set forth the hours of work and days off?
Creation of a Partnership: Registering the Name
Loomis v. Whitehead
183 P.3d 890 (Nev. 2008)
Per Curiam.
In this appeal, we address whether [Nevada Revised Statute] NRS 602.070 bars the partners of an unregistered fictitious name partnership from bringing an action arising out of a business agreement that was not made under the fictitious name. [The statute] prohibits persons who fail to file an assumed or fictitious name certificate from suing on any contract or agreement made under the assumed or fictitious name. We conclude that it does not bar the partners from bringing the action so long as the partners did not conduct the business or enter into an agreement under the fictitious name or otherwise mislead the other party into thinking that he was doing business with some entity other than the partners themselves.
Background Facts
Appellants Leroy Loomis and David R. Shanahan raised and sold cattle in Elko County, Nevada. Each of the appellants had certain responsibilities relating to the cattle business. Loomis supplied the livestock and paid expenses, while Shanahan managed the day-to-day care of the cattle. Once the cattle were readied for market and sold, Loomis and Shanahan would share the profits equally. While Loomis and Shanahan often called themselves the 52 Cattle Company, they had no formal partnership agreement and did not file an assumed or fictitious name certificate in that name. Loomis and Shanahan bring this appeal after an agreement entered into with respondent Jerry Carr Whitehead failed.
In the fall of 2003, Shanahan entered into a verbal agreement with Whitehead, a rancher, through Whitehead’s ranch foreman to have their cattle wintered at Whitehead’s ranch. Neither Loomis nor Whitehead was present when the ranch foreman made the deal with Shanahan, but the parties agree that there was no mention of the 52 Cattle Company at the time they entered into the agreement or anytime during the course of business thereafter. Shanahan and Loomis subsequently alleged that their cattle were malnourished and that a number of their cattle died from starvation that winter at Whitehead’s ranch. Whitehead denied these allegations.
Suit against Whitehead
The following summer, Shanahan and Loomis sued Whitehead, claiming negligence and breach of contract. Later, well into discovery, Whitehead was made aware of the existence of the 52 Cattle Company when Shanahan stated in his deposition that he did not actually own any of the cattle on Whitehead’s ranch. In his deposition, he described the partnership arrangement. At about the same time, Whitehead learned that the name “52 Cattle Company” was not registered with the Elko County Clerk.
Whitehead then filed a motion for partial summary judgment, asserting that, pursuant to NRS 602.070, Loomis and Shanahan’s failure to register their fictitiously named partnership with the county clerk barred them from bringing a legal action. The district court agreed with Whitehead, granted the motion, and dismissed Loomis and Shanahan’s claims. Loomis and Shanahan timely appealed.
Discussion
The district court found that Loomis and Shanahan conducted business under a fictitious name without filing a fictitious name certificate with the Elko County Clerk as required by NRS 602.010.NRS 602.010(1): “Every person doing business in this state under an assumed or fictitious name that is in any way different from the legal name of each person who owns an interest in the business must file with the county clerk of each county in which the business is being conducted a certificate containing the information required by NRS 602.020.” The district court therefore concluded that, pursuant to NRS 602.070, they were barred from bringing an action against Whitehead because they did not file a fictitious name certificate for the 52 Cattle Company.NRS 602.070: “No action may be commenced or maintained by any person…upon or on account of any contract made or transaction had under the assumed or fictitious name, or upon or on account of any cause of action arising or growing out of the business conducted under that name, unless before the commencement of the action the certificate required by NRS 602.010 has been filed.”
Loomis and Shanahan contend that the district court erred in granting partial summary judgment because they did not enter into a contract with Whitehead under the name of the 52 Cattle Company, and they did not conduct business with Whitehead under that name. Loomis and Shanahan argue that NRS 602.070 is not applicable to their action against Whitehead because they did not mislead Whitehead into thinking that he was doing business with anyone other than them. We agree.…
When looking at a statute’s language, this court is bound to follow the statute’s plain meaning, unless the plain meaning was clearly not intended. Here, in using the phrase “under the assumed or fictitious name,” the statute clearly bars bringing an action when the claims arise from a contract, transaction, or business conducted beneath the banner of an unregistered fictitious name. However, NRS 602.070 does not apply to individual partners whose transactions or business with another party were not performed under the fictitious name.
Here, Whitehead knew that Shanahan entered into the oral contract under his own name. He initially thought that Shanahan owned the cattle and Loomis had “some type of interest.” Shanahan did not enter into the contract under the fictitious “52 Cattle Company” name. Moreover, Whitehead does not allege that he was misled by either Loomis or Shanahan in any way that would cause him to think he was doing business with the 52 Cattle Company. In fact, Whitehead did not know of the 52 Cattle Company until Shanahan mentioned it in his deposition. Under these circumstances, when there simply was no indication that Loomis and Shanahan represented that they were conducting business as the 52 Cattle Company and no reliance by Whitehead that he was doing business with the 52 Cattle Company, NRS 602.070 does not bar the suit against Whitehead.
We therefore reverse the district court’s partial summary judgment in this instance and remand for trial because, while the lawsuit between Loomis and Whitehead involved partnership business, the transaction at issue was not conducted and the subsequent suit was not maintained under the aegis of the fictitiously named partnership.
Case Questions
1. The purpose of the fictitious name statute might well be, as the court here describes it, “to prevent fraud and to give the public information about those entities with which they conduct business.” But that’s not what the statute says; it says nobody can sue on a cause of action arising out of business conducted under a fictitious name if the name is not registered. The legislature determined the consequence of failure to register. Should the court disregard the statute’s plain, unambiguous meaning?
2. That was one of two arguments by the dissent in this case. The second one was based on this problem: Shanahan and Loomis agreed that the cattle at issue were partnership cattle bearing the “52” brand. That is, the cows were not Shanahan’s; they were the partnership’s. When Whitehead moved to dismiss Shanahan’s claim—again, because the cows weren’t Shanahan’s—Shanahan conceded that but for the existence of the partnership he would have no claim against Whitehead. If there is no claim against the defendant except insofar as he harmed the partnership business (the cattle), how could the majority assert that claims against Whitehead did not arise out of “the business” conducted under 52 Cattle Company? Who has the better argument, the majority or the dissent?
3. Here is another problem along the same lines but with a different set of facts and a Uniform Partnership Act (UPA) jurisdiction (i.e., pre–Revised Uniform Partnership Act [RUPA]). Suppose the plaintiffs had a partnership (as they did here), but the claim by one was that the other partner had stolen several head of cattle, and UPA was in effect so that the partnership property was owned as “tenant in partnership”—the cattle would be owned by the partners as a whole. A person who steals his own property cannot be criminally liable; therefore, a partner cannot be guilty of stealing (or misappropriating) firm property. Thus under UPA there arise anomalous cases, for example, in People v. Zinke, 555 N.E.2d 263 (N.Y. 1990), which is a criminal case, Zinke embezzled over a million dollars from his own investment firm but the prosecutor’s case against him was dismissed because, the New York court said, “partners cannot be prosecuted for stealing firm property.” If the partnership is a legal entity, as under RUPA, how is this result changed?
Partnership by Estoppel
Chavers v. Epsco, Inc.
98 S.W.3d 421 (Ark. 2003)
Hannah, J.
Appellants Reggie Chavers and Mark Chavers appeal a judgment entered against them by the Craighead County Circuit Court. Reggie and Mark argue that the trial court erred in holding them liable for a company debt based upon partnership by estoppel because the proof was vague and insufficient and there was no detrimental reliance on the part of a creditor. We hold that the trial court was not clearly erroneous in finding liability based upon partnership by estoppel. Accordingly, we affirm.
Facts
Gary Chavers operated Chavers Welding and Construction (“CWC”), a construction and welding business, in Jonesboro. Gary’s sons Reggie Chavers and Mark Chavers joined their father in the business after graduating from high school. Gary, Mark, and Reggie maintain that CWC was a sole proprietorship owned by Gary, and that Reggie and Mark served only as CWC employees, not as CWC partners.
In February 1999, CWC entered into an agreement with Epsco, Inc. (“Epsco”), a staffing service, to provide payroll and employee services for CWC. Initially, Epsco collected payments for its services on a weekly basis, but later, Epsco extended credit to CWC. Melton Clegg, President of Epsco, stated that his decision to extend credit to CWC was based, in part, on his belief that CWC was a partnership.
CWC’s account with Epsco became delinquent, and Epsco filed a complaint against Gary, Reggie, and Mark, individually, and doing business as CWC, to recover payment for the past due account. Gary discharged a portion of his obligation to Epsco due to his filing for bankruptcy. Epsco sought to recover CWC’s remaining debt from Reggie and Mark. After a hearing on March 7, 2002, the trial court issued a letter opinion, finding that Reggie and Mark “represented themselves to [Epsco] as partners in an existing partnership and operated in such a fashion to give creditors in general, and Epsco in particular, the impression that such creditors/potential creditors were doing business with a partnership.…” On May 21, 2002, the trial court entered an order stating that Reggie and Mark were partners by estoppel as relates to Epsco. The trial court found that Reggie and Mark were jointly and severally liable for the debt of CWC in the amount of \$80,360.92. In addition, the trial court awarded Epsco pre-judgment interest at the rate of six percent, post-judgment interest at the rate of ten percent, and attorney’s fees in the amount of \$8,036.92.
[The relevant Arkansas statute provides]:
(1) When a person, by words spoken or written or by conduct, represents himself, or consents to another representing him to any one, as a partner in an existing partnership or with one (1) or more persons not actual partners, he is liable to any person to whom such representation has been made, who has, on the faith of such representation, given credit to the actual or apparent partnership, and if he has made such representation or consented to its being made in a public manner, he is liable to that person, whether the representation has or has not been made or communicated to that person so giving credit by or with the knowledge of the apparent partner making the representation or consenting to it being made.
(a) When a partnership liability results, he is liable as though he were an actual member of the partnership.
We have long recognized the doctrine of partnership by estoppel. [Citation, 1840], the court stated that
they who hold themselves out to the world as partners in business or trade, are to be so regarded as to creditors and third persons; and the partnership may be established by any evidence showing that they so hold themselves out to the public, and were so regarded by the trading community.
Further, we have stated that “[p]artnerships may be proved by circumstantial evidence; and evidence will sometimes fix a joint liability, where persons are charged as partners, in a suit by a third person, when they are not, in fact, partners as between themselves.” [Citation, 1843.]
In [Citation, 1906], the court noted that
[a] person who holds himself out as a partner of a firm is estopped to deny such representation, not only as to those as to whom the representation was directly made, but as to all others who had knowledge of such holding out and in reliance thereon sold goods to the firm.…
In addition, “if the party himself puts out the report that he is a partner, he will be liable to all those selling goods to the firm on the faith and credit of such report.” [Citation] When a person holds himself out as a member of partnership, any one dealing with the firm on the faith of such representation is entitled to assume the relation continues until notice of some kind is given of its discontinuance. [Citations]
In [Citation, 1944], the court wrote:
It is a thoroughly well-settled rule that persons who are not as between themselves partners, or as between whom there is in fact no legal partnership, may nevertheless become subject to the liabilities of partners, either by holding themselves out as partners to the public and the world generally or to particular individuals, or by knowingly or negligently permitting another person to do so. All persons who hold themselves out, or knowingly permit others to hold them out, to the public as partners, although they are not in partnership, become bound as partners to all who deal with them in their apparent relation.
The liability as a partner of a person who holds himself out as a partner, or permits others to do so, is predicated on the doctrine of estoppel and on the policy of the law seeking to prevent frauds on those who lend their money on the apparent credit of those who are held out as partners. One holding himself out as a partner or knowingly permitting himself to be so held out is estopped from denying liability as a partner to one who has extended credit in reliance thereon, although no partnership has in fact existed.
In the present case, the trial court cited specific examples of representations made by Reggie and Mark indicating that they were partners of CWC, including correspondence to Epsco, checks written to Epsco, business cards distributed to the public, and credit applications. We will discuss each in turn.
The Fax Cover Sheet
At trial, Epsco introduced Plaintiff’s Exhibit # 2, a fax cover sheet from “Chavers Construction” to Epsco. The fax cover sheet was dated July 19, 2000. The fax cover sheet contained the address, telephone number, and fax number of the business. Listed under this information was “Gary, Reggie, or Mark Chavers.” Epsco argues that Gary, Reggie, and Mark are all listed on the fax cover sheet, and that this indicates that they were holding themselves out to the public as partners of the business. The trial court’s finding that the fax cover sheet indicated that Reggie and Mark were holding themselves out as partners of CWC is not clearly erroneous.
The Epsco Personnel Credit Application
Epsco introduced Plaintiff’s Exhibit # 9, a personnel credit application, which was received from CWC. Adams testified that the exhibit represented a completed credit application that she received from CWC. The type of business checked on the credit application is “partnership.” Adams testified that the application showed the company to be a partnership, and that this information was relied upon in extending credit. Clegg testified that he viewed the credit application which indicated that CWC was a partnership, and that his decision to extend credit to CWC was based, in part, on his belief that CWC was a partnership. Gary denied filling out the credit application form.
It was within the trial court’s discretion to find Adams’s and Clegg’s testimony more credible than Gary’s testimony and to determine that Epsco relied on the statement of partnership on the credit application before extending credit to CWC. The trial court’s finding concerning the credit application is not clearly erroneous.
The Checks to Epsco
Epsco argues that Plaintiff’s Exhibit # 3 and Plaintiff’s Exhibit # 11, checks written to Epsco showing the CWC account to be in the name of “Gary A. or Reggie J. Chavers,” indicates that Reggie was holding himself out to be a partner of CWC. Plaintiff’s Exhibit # 3 was signed by Gary, and Plaintiff’s Exhibit # 11 was signed by Reggie. The checks are evidence that Reggie was holding himself out to the public as a partner of CWC, and Epsco could have detrimentally relied on the checks before extending credit to CWC. The trial court was not clearly erroneous in finding that the checks supported a finding of partnership by estoppel.
The Business Card
Epsco introduced Plaintiff’s Exhibit # 4, a business card that states “Chavers Welding, Construction & Crane Service.” Listed on the card as “owners” are Gary Chavers and Reggie Chavers. Gary testified that the business cards were printed incorrectly, and that Reggie’s name should not have been included as an owner. He also testified that some of the cards might have been handed out, and that it was possible that he might have given one of the cards to a business listed as one of CWC’s credit references on Plaintiff’s Exhibit # 1.
The business card listing Reggie as an owner indicates that Reggie was holding himself out as a partner. As we stated in [Citation] when a person holds himself out as a member of partnership, any one dealing with the firm on the faith of such representation is entitled to assume the relation continues until notice of some kind is given of its discontinuance. There is no indication that Reggie ever informed any person who received a business card that the business relationship listed on the card was incorrect or had been discontinued. The trial court’s finding concerning the business card is not clearly erroneous.
The Dealership Application
Epsco introduced Plaintiff’s Exhibit # 5, an application form from “Chavers Welding,” signed by Reggie, seeking a dealership from Sukup Manufacturing. The application, dated January 23, 1997, lists “Gary & Reggie Chavers” as owners of “Chavers Welding.” The application is signed by Reggie. Reggie admits that he signed the dealership application and represented that he was an owner of “Chavers Welding,” but he dismisses his statement of ownership as mere “puffery” on his part. Epsco argues that instead, the application shows that Reggie was holding himself out to the public as being a partner. The trial court’s determination that Reggie’s dealership application supports a finding of partnership by estoppel is not clearly erroneous.
In sum, the trial court was not clearly erroneous in finding that Reggie and Mark held themselves out as partners of CWC and that Epsco detrimentally relied on the existence of the partnership before extending credit to CWC. The appellants argue that even if we find Reggie liable based upon partnership by estoppel, there was scant proof of Mark being liable based upon partnership by estoppel. We disagree. We are aware that some examples of holding out cited in the trial court’s order pertain only to Reggie. However, the representations attributed to both Reggie and Mark are sufficient proof to support the trial court’s finding that both Reggie and Mark are estopped from denying liability to Epsco.
Affirmed.
Case Questions
1. What is the rationale for the doctrine of partnership by estoppel?
2. Gary and Reggie claimed the evidence brought forth to show the existence of a partnership was unconvincing. How credible were their claims? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/18%3A_PartnershipsGeneral_Characteristics_and_Formation/18.03%3A_Cases.txt |
Summary
The basic law of partnership is found in the Uniform Partnership Act and Revised Uniform Partnership Act. The latter has been adopted by thirty-five states. At common law, a partnership was not a legal entity and could not sue or be sued in the partnership name. Partnership law defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit.” The Uniform Partnership Act (UPA) assumes that a partnership is an aggregation of individuals, but it also applies a number of rules characteristic of the legal entity theory. The Revised Uniform Partnership Act (RUPA) assumes a partnership is an entity, but it applies one crucial rule characteristic of the aggregate theory: the partners are ultimately liable for the partnership’s obligations. Thus a partnership may keep business records as if it were a legal entity, may hold real estate in the partnership name, and may sue and be sued in federal court and in many state courts in the partnership name.
Partnerships may be created informally. Among the clues to the existence of a partnership are (1) co-ownership of a business, (2) sharing of profits, (3) right to participate in decision making, (4) duty to share liabilities, and (5) manner in which the business is operated. A partnership may also be formed by implication; it may be formed by estoppel when a third party reasonably relies on a representation that a partnership in fact exists.
No special rules govern the partnership agreement. As a practical matter, it should sufficiently spell out who the partners are, under what name they will conduct their business, the nature and scope of the business, capital contributions of each partner, how profits are to be divided, and similar pertinent provisions. An oral agreement to form a partnership is valid unless the business cannot be performed wholly within one year from the time that the agreement is made. However, most partnerships have no fixed terms and hence are “at-will” partnerships not subject to the Statute of Frauds.
Exercises
1. Able, Baker, and Carr own, as partners, a warehouse. The income from the warehouse during the current year is \$300,000, two-thirds of which goes to Able. Who must file a tax return listing this as income, the partnership or Able? Who pays the tax, the partnership or Able?
2. The Havana Club operated in Salt Lake City under a lease running to defendant Dale Bowen, who owned the equipment, furnishings, and inventory. He did not himself work in operating the club. He made an oral agreement with Frances Cutler, who had been working for him as a bartender, that she take over the management of the club. She was to have the authority and the responsibility for the entire active management and operation: to purchase the supplies, pay the bills, keep the books, hire and fire employees, and do whatever else was necessary to run the business. As compensation, the arrangement was for a down-the-middle split; each was to receive \$300 per week plus one half of the net profits. This went on for four years until the city took over the building for a redevelopment project. The city offered Bowen \$30,000 as compensation for loss of business while a new location was found for the club. Failing to find a suitable location, the parties decided to terminate the business. Bowen then contended he was entitled to the entire \$30,000 as the owner, Cutler being an employee only. She sued to recover half as a partner. What was the result? Decide and discuss.
3. Raul, a business student, decided to lease and operate an ice cream stand during his summer vacation. Because he could not afford rent payments, his lessor agreed to take 30 percent of the profits as rent and provide the stand and the parcel of real estate on which it stood. Are the two partners?
4. Able, Baker, and Carr formed the ABC Partnership in 2001. In 2002 Able gave her three sons, Duncan, Eldon, and Frederick, a gift of her 41 percent interest in the partnership to provide money to pay for their college expenses. The sons reported income from the partnership on their individual tax returns, and the partnership reported the payment to them on its information return. The sons were listed as partners on unaudited balance sheets in 2003, and the 2004 income statement listed them as partners. The sons never requested information about the management of the firm, never attended any meetings or voted, and never attempted to withdraw the firm’s money or even speak with the other partners about the firm. Two of the sons didn’t know where the firm was located, but they all once received “management fees” totaling \$3,000, without any showing of what the “fees” were for. In 2005, the partnership incurred liability for pension-fund contributions to an employee, and a trustee for the fund asserted that Able’s sons were personally liable under federal law for the money owing because they were partners. The sons moved for summary judgment denying liability. How should the court rule?
5. The Volkmans wanted to build a house and contacted David McNamee for construction advice. He told them that he was doing business with Phillip Carroll. Later the Volkmans got a letter from McNamee on stationery that read “DP Associates,” which they assumed was derived from the first names of David and Phillip. At the DP Associates office McNamee introduced Mr. Volkman to Carroll, who said to Volkman, “I hope we’ll be working together.” At one point during the signing process a question arose and McNamee said, “I will ask Phil.” He returned with the answer to the question. After the contract was signed but before construction began, Mr. Volkman visited the DP Associates office where the two men chatted; Carroll said to him, “I am happy that we will be working with you.” The Volkmans never saw Carroll on the construction site and knew of no other construction supervised by Carroll. They understood they were purchasing Carroll’s services and construction expertise through DP Associates. During construction, Mr. Volkman visited the DP offices several times and saw Carroll there. During one visit, Mr. Volkman expressed concerns about delays and expressed the same to Carroll, who replied, “Don’t worry. David will take care of it.” But David did not, and the Volkmans sued DP Associates, McNamee, and Carroll. Carroll asserted he could not be liable because he and McNamee were not partners. The trial court dismissed Carroll on summary judgment; the Volkmans appealed. How should the court rule on appeal?
6. Wilson and VanBeek want to form a partnership. Wilson is seventeen and VanBeek is twenty-two. May they form a partnership? Explain.
7. Diane and Rachel operate a restaurant at the county fair every year to raise money for the local 4-H Club. They decide together what to serve, what hours to operate, and generally how to run the business. Do they have a partnership?
SELF CHECK QUESTIONS
1. The basic law of partnership is currently found in
1. common law
2. constitutional law
3. statutory law
4. none of the above
2. Existence of a partnership may be established by
1. co-ownership of a business for profit
2. estoppel
3. a formal agreement
4. all of the above
3. Which is false?
1. An oral agreement to form a partnership is valid.
2. Most partnerships have no fixed terms and are thus not subject to the Statute of Frauds.
3. Strict statutory rules govern partnership agreements.
4. A partnership may be formed by estoppel.
4. Partnerships
1. are not taxable entities
2. may buy, sell, or hold real property in the partnership name
3. may file for bankruptcy
4. have all of the above characteristics
5. Partnerships
1. are free to select any name not used by another partnership
2. must include the partners’ names in the partnership name
3. can be formed by two corporations
4. cannot be formed by two partnerships
1. c
2. d
3. c
4. d
5. c | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/18%3A_PartnershipsGeneral_Characteristics_and_Formation/18.04%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The operation of a partnership, including the relations among partners and relations between partners and third parties
• The dissolution and winding up of a partnership
19: Partnership Operation and Termination
Learning Objectives
By the end of this section, you will be able to:
• Recognize the duties partners owe each other: duties of service, loyalty, care, obedience, information, and accounting.
• Identify the rights that partners have, including the rights to distributions of money, to management, to choice of copartners, to property of the partnership, to assign partnership interest, and to enforce duties and rights.
Most of the rules discussed in this section apply unless otherwise agreed, and they are really intended for the small firm.“The basic mission of RUPA is to serve the small firm. Large partnerships can fend for themselves by drafting partnership agreements that suit their special needs.” Donald J. Weidner, “RUPA and Fiduciary Duty: The Texture of Relationship,” Law and Contemporary Problems 58, no. 2 (1995): 81, 83. The Uniform Partnership Act (UPA) and the Revised Uniform Partnership Act (RUPA) do not dictate what the relations among partners must be; the acts supply rules in the event that the partners have not done so for themselves. In this area, it is especially important for the partners to elaborate their agreement in writing. If the partners should happen to continue their business beyond the term fixed for it in their agreement, the terms of the agreement continue to apply.
Duties Partners Owe Each Other
Among the duties partners owe each other, six may be called out here: (1) the duty to serve, (2) the duty of loyalty, (3) the duty of care, (4) the duty of obedience, (5) the duty to inform copartners, and (6) the duty to account to the partnership. These are all very similar to the duty owed by an agent to the principal, as partnership law is based on agency concepts.Revised Uniform Partnership Act, Section 404, Comment 3: “Indeed, the law of partnership reflects the broader law of principal and agent, under which every agent is a fiduciary.”
Duty to Serve
Unless otherwise agreed, expressly or impliedly, a partner is expected to work for the firm. The partnership, after all, is a profit-making co-venture, and it would not do for one to loaf about and still expect to get paid. For example, suppose Joan takes her two-week vacation from the horse-stable partnership she operates with Sarah and Sandra. Then she does not return for four months because she has gone horseback riding in the Southwest. She might end up having to pay if the partnership hired a substitute to do her work.
Duty of Loyalty
In general, this requires partners to put the firm’s interests ahead of their own. Partners are fiduciaries as to each other and as to the partnership, and as such, they owe a fiduciary duty to each other and the partnership. Judge Benjamin Cardozo, in an often-quoted phrase, called the fiduciary duty “something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928). Breach of the fiduciary duty gives rise to a claim for compensatory, consequential, and incidental damages; recoupment of compensation; and—rarely—punitive damages. See Section 19.4.1 “Breach of Partnership Fiduciary Duty”, Gilroy v. Conway, for an example of breach of fiduciary duty.
Application of the Fiduciary Standard to Partnership Law
Under UPA, all partners are fiduciaries of each other—they are all principals and agents of each other—though the word fiduciary was not used except in the heading to Section 21. The section reads, “Every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.”
Section 404 of RUPA specifically provides that a partner has a fiduciary duty to the partnership and other partners. It imposes the fiduciary standard on the duty of loyalty in three circumstances:
1. to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity;
2. to refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership; and
3. to refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership.
Limits on the Reach of the Fiduciary Duty
This sets out a fairly limited scope for application of the fiduciary standard, which is reasonable because partners do not delegate open-ended control to their copartners. Further, there are some specific limits on how far the fiduciary duty reaches (which means parties are held to the lower standard of “good faith”). Here are two examples. First, RUPA—unlike UPA—does not extend to the formation of the partnership; Comment 2 to RUPA Section 404 says that would be inappropriate because then the parties are “really dealing at arm’s length.” Second, fiduciary duty doesn’t apply to a dissociated partner (one who leaves the firm—discussed in Section 19) who can immediately begin competing without the others’ consent; and it doesn’t apply if a partner violates the standard “merely because the partner’s conduct furthers the partner’s own interest.”RUPA, Section 503(b)(2); RUPA, Section 404 (e). Moreover, the partnership agreement may eliminate the duty of loyalty so long as that is not “manifestly unreasonable.”RUPA, Section 103(2)(c).
Activities Affected by the Duty of Loyalty
The duty of loyalty means, again, that partners must put the firm’s interest above their own. Thus it is held that a partner
• may not compete with the partnership,
• may not make a secret profit while doing partnership business,
• must maintain the confidentiality of partnership information.
This is certainly not a comprehensive list, and courts will determine on a case-by-case basis whether the duty of loyalty has been breached.
Duty of Care
Stemming from its roots in agency law, partnership law also imposes a duty of care on partners. Partners are to faithfully serve to the best of their ability. Section 404 of RUPA imposes the fiduciary standard on the duty of care, but rather confusingly: how does the “punctilio of an honor the most sensitive”—as Judge Cardozo described that standard—apply when under RUPA Section 404(c) the “the duty of care…is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law”? Recognize that a person can attend to business both loyally and negligently. For example, Alice Able, a partner in a law firm who is not very familiar with the firm’s computerized bookkeeping system, attempts to trace a missing check and in so doing erases a month’s worth of records. She has not breached her duty of care: maybe she was negligent, but not grossly negligent under RUPA Section 404(c). The partnership agreement may reduce the duty of care so long as it is not “unreasonably reduce[d]”; it may increase the standard too.RUPA, Section 103(2)(d); RUPA, Section 103.
Duty of Obedience
The partnership is a contractual relationship among the partners; they are all agents and principals of each other. Expressly or impliedly that means no partner can disobey the partnership agreement or fail to follow any properly made partnership decision. This includes the duty to act within the authority expressly or impliedly given in the partnership agreement, and a partner is responsible to the other partners for damages or losses arising from unauthorized activities.
Duty to Inform Copartners
As in the agency relationship, a partner is expected to inform copartners of notices and matters coming to her attention that would be of interest to the partnership.
Duty to Account
The partnership—and necessarily the partners—have a duty to allow copartners and their agents access to the partnership’s books and records and to provide “any information concerning the partnership’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties under the partnership agreement [or this Act].”UPA, Sections 19 and 20; RUPA, Section 403. The fiduciary standard is imposed upon the duty to account for “it any property, profit, or benefit derived by [a] partner,” as noted in RUPA Section 404.RUPA, Section 404(1).
The Rights That Partners Have in a Partnership
Necessarily, for every duty owed there is a correlative right. So, for example, if a partner has a duty to account, the other partners and the partnership have a right to an accounting. Beyond that, partners have recognized rights affecting the operation of the partnership.
Here we may call out the following salient rights: (1) to distributions of money, (2) to management, (3) to choose copartners, (4) to property of the partnership, (5) to assign partnership interest, and (6) to enforce duties and rights.
Rights to Distributions
The purpose of a partnership is ultimately to distribute “money or other property from a partnership to a partner in the partner’s capacity.”RUPA, Section 101(3). There are, however, various types of money distributions, including profits (and losses), indemnification, capital, and compensation.
Right to Profits (and Losses)
Profits and losses may be shared according to any formula on which the partners agree. For example, the partnership agreement may provide that two senior partners are entitled to 35 percent each of the profit from the year and the two junior partners are entitled to 15 percent each. The next year the percentages will be adjusted based on such things as number of new clients garnered, number of billable hours, or amount of income generated. Eventually, the senior partners might retire and each be entitled to 2 percent of the firm’s income, and the previous junior partners become senior, with new junior partners admitted.
If no provision is stated, then under RUPA Section 401(b), “each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner’s share of the profits.” Section 18(a) of the Uniform Partnership Act is to the same effect. The right to share in the profits is the reason people want to “make partner”: a partner will reap the benefits of other partners’ successes (and pay for their failures too). A person working for the firm who is not a partner is an associate and usually only gets only a salary.
Right to Indemnification
A partner who incurs liabilities in the normal course of business or to preserve its business or property is entitled to indemnification (UPA Section 18(b), RUPA Section 401(c)). The liability is a loan owing to the partner by the firm.
Right to Return of Capital Contribution
When a partner joins a partnership, she is expected to make a capital contribution to the firm; this may be deducted from her share of the distributed profit and banked by the firm in its capital account. The law provides that “the partnership must reimburse a partner for an advance of funds beyond the amount of the partner’s agreed capital contribution, thereby treating the advance as a loan.”UPA, Section 18(c); RUPA, Section 401(d). A partner may get a return of capital under UPA after creditors are paid off if the business is wound down and terminated.UPA, Section 40(b); RUPA, Section 807(b).
Right to Compensation
Section 401(d) of RUPA provides that “a partner is not entitled to remuneration for services performed for the partnership, except for reasonable compensation for services rendered in winding up the business of the partnership”; UPA Section 18(f) is to the same effect. A partner gets his money from the firm by sharing the profits, not by a salary or wages.
Rights to Management
Under UPA, all partners are fiduciaries of each other—they are all principals and agents of each other—though the word <em class=”im_emphasis”>fiduciary</em> was not used except in the <em class=”im_emphasis”>heading</em> to Section 21. The section reads, “Every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.”
Right to Choose Partners
A business partnership is often analogized to a marriage partnership. In both there is a relationship of trust and confidence between (or among) the parties; in both the poor judgment, negligence, or dishonesty of one can create liabilities on the other(s). In a good marriage or good partnership, the partners are friends, whatever else the legal relationship imposes. Thus no one is compelled to accept a partner against his or her will. Section 401(i) of RUPA provides, “A person may become a partner only with the consent of all of the partners.” UPA Section 18(g) is to the same effect; the doctrine is called delectus personae. The freedom to select new partners, however, is not absolute. In 1984, the Supreme Court held that Title VII of the Civil Rights Act of 1964—which prohibits discrimination in employment based on race, religion, national origin, or sex—applies to partnerships.Hishon v. King & Spalding, 467 U.S. 69 (1984).
Right to Property of the Partnership
Partners are the owners of the partnership, which might not include any physical property; that is, one partner could contribute the building, furnishings, and equipment and rent those to the partnership (or those could count as her partnership capital contribution and become the partnership’s). But partnership property consists of all property originally advanced or contributed to the partnership or subsequently acquired by purchase or contribution. Unless a contrary intention can be shown, property acquired with partnership funds is partnership property, not an individual partner’s: “Property acquired by a partnership is property of the partnership and not of the partners individually.”RUPA, Section 203; UPA, Sections 8(1) and 25.
Rights in Specific Partnership Property: UPA Approach
Suppose that Able, who contributed the building and grounds on which the partnership business is conducted, suddenly dies. Who is entitled to her share of the specific property, such as inventory, the building, and the money in the cash register—her husband and children, or the other partners, Baker and Carr? Section 25(1) of UPA declares that the partners hold the partnership property as tenants in partnership. As spelled out in Section 25(2), the specific property interest of a tenant in partnership vests in the surviving partners, not in the heirs. But the heirs are entitled to the deceased partner’s interest in the partnership itself, so that while Baker and Carr may use the partnership property for the benefit of the partnership without consulting Able’s heirs, they must account to her heirs for her proper share of the partnership’s profits.
Rights in Specific Property: RUPA Approach
Section 501 of RUPA provides, “A partner is not a co-owner of partnership property and has no interest in partnership property which can be transferred, either voluntarily or involuntarily.” Partnership property is owned by the entity; UPA’s concept of tenants in partnership is abolished in favor of adoption of the entity theory. The result, however, is not different.
Right to Assign Partnership Interest
One of the hallmarks of the capitalistic system is that people should be able to dispose of their property interests more or less as they see fit. Partnership interests may be assigned to some extent.
Voluntary Assignment
At common law, assignment of a partner’s interest in the business—for example, as a mortgage in return for a loan—would result in a legal dissolution of the partnership. Thus in the absence of UPA, which changed the law, Baker’s decision to mortgage his interest in the car dealership in return for a \$20,000 loan from his bank would mean that the three—Able, Baker, and Carr—were no longer partners. Section 27 of UPA declares that assignment of an interest in the partnership neither dissolves the partnership nor entitles the assignee “to interfere in the management or administration of the partnership business or affairs, or to require any information or account of partnership transactions, or to inspect the partnership books.” The assignment merely entitles the assignee to receive whatever profits the assignor would have received—this is the assignor’s transferable interest.UPA, Section 26. Under UPA, this interest is assignable.UPA, Section 27.
Under RUPA, the same distinction is made between a partner’s interest in the partnership and a partner’s transferable interest. The Official Comment to Section 101 reads as follows: “‘Partnership interest’ or ‘partner’s interest in the partnership’ is defined to mean all of a partner’s interests in the partnership, including the partner’s transferable interest and all management and other rights. A partner’s ‘transferable interest’ is a more limited concept and means only his share of the profits and losses and right to receive distributions, that is, the partner’s economic interests.”RUPA, Official Comment to Section 101.
This transferable interest is assignable under RUPA 503 (unless the partners agree to restrict transfers, Section 103(a)). It does not, by itself, cause the dissolution of the partnership; it does not entitle the transferee to access to firm information, to participate in running the firm, or to inspect or copy the books. The transferee is entitled to whatever distributions the transferor partner would have been entitled to, including, upon dissolution of the firm, the net amounts the transferor would have received had there been no assignment.
RUPA Section 101(b)(3) confers standing on a transferee to seek a judicial dissolution and winding up of the partnership business as provided in Section 801(6), thus continuing the rule of UPA Section 32(2). But under RUPA 601(4)(ii), the other partners may by unanimous vote expel a partner who has made “a transfer of all or substantially all of that partner’s transferable interest in the partnership, other than a transfer for security purposes [as for a loan].” Upon a creditor foreclosure of the security interest, though, the partner may be expelled.
Involuntary Assignment
It may be a misnomer to describe an involuntary assignment as a “right”; it might better be thought of as a consequence of the right to own property. In any event, if a partner is sued in his personal capacity and a judgment is rendered against him, the question arises: may the judgment creditor seize partnership property? Section 28 of UPA and RUPA Section 504 permit a judgment creditor to obtain a charging order, which charges the partner’s interest in the partnership with obligation to satisfy the judgment. The court may appoint a receiver to ensure that partnership proceeds are paid to the judgment creditor. But the creditor is not entitled to specific partnership property. The partner may always pay off the debt and redeem his interest in the partnership. If the partner does not pay off the debt, the holder of the charging order may acquire legal ownership of the partner’s interest. That confers upon the judgment creditor an important power: he may, if the partnership is one at will, dissolve the partnership and claim the partner’s share of the assets. For that reason, the copartners might wish to redeem the interest—pay off the creditor—in order to preserve the partnership. As with the voluntary assignment, the assignee of an involuntary assignment does not become a partner. See Figure 19.1.
Right to Enforce Partnership Rights
The rights and duties imposed by partnership law are, of course, valueless unless they can be enforced. Partners and partnerships have mechanisms under the law to enforce them.
Right to Information and Inspection of Books
We noted in Section 19.1.1 “Duties Partners Owe Each Other” of this chapter that partners have a duty to account; the corollary right is the right to access books and records, which is usually very important in determining partnership rights. Section 403(b) of RUPA provides, “A partnership shall provide partners and their agents and attorneys access to its books and records. It shall provide former partners and their agents and attorneys access to books and records pertaining to the period during which they were partners. The right of access provides the opportunity to inspect and copy books and records during ordinary business hours. A partnership may impose a reasonable charge, covering the costs of labor and material, for copies of documents furnished.”RUPA Section 403(b).
Section 19 of UPA is basically in accord. This means that without demand—and for any purpose—the partnership must provide any information concerning its business and affairs reasonably required for the proper exercise of the partner’s rights and duties under the partnership agreement or the act; and on demand, it must provide any other information concerning the partnership’s business and affairs, unless the demand is unreasonable or improper.RUPA, Section 403(c)(1); RUPA, Section 403(c)(2). Generally, the partnership agreement cannot deny the right to inspection.
The duty to account mentioned in Section 19.1.1 “Duties Partners Owe Each Other” of this chapter normally means that the partners and the partnership should keep reasonable records so everyone can tell what is going on. A formal accounting under UPA is different.
Under UPA Section 22, any partner is entitled to a formal account (or accounting) of the partnership affairs under the following conditions:
1. If he is wrongfully excluded from the partnership business or possession of its property by his copartners;
2. If the right exists under the terms of any agreement;
3. If a partner profits in violation of his fiduciary duty (as per UPA 22); and
4. Whenever it is otherwise just and reasonable.
At common law, partners could not obtain an accounting except in the event of dissolution. But from an early date, equity courts would appoint a referee, auditor, or special master to investigate the books of a business when one of the partners had grounds to complain, and UPA broadened considerably the right to an accounting. The court has plenary power to investigate all facets of the business, evaluate claims, declare legal rights among the parties, and order money judgments against any partner in the wrong.
Under RUPA Section 405, this “accounting” business is somewhat modified. Reflecting the entity theory, the partnership can sue a partner for wrongdoing, which is not allowed under UPA. Moreover, to quote from the Official Comment, RUPA “provides that, during the term of the partnership, partners may maintain a variety of legal or equitable actions, including an action for an accounting, as well as a final action for an accounting upon dissolution and winding up. It reflects a new policy choice that partners should have access to the courts during the term of the partnership to resolve claims against the partnership and the other partners, leaving broad judicial discretion to fashion appropriate remedies[, and] an accounting is not a prerequisite to the availability of the other remedies a partner may have against the partnership or the other partners.”RUPA Official Comment 2, Section 405(b).
Key Takeaway
Partners have important duties in a partnership, including (1) the duty to serve—that is, to devote herself to the work of the partnership; (2) the duty of loyalty, which is informed by the fiduciary standard: the obligation to act always in the best interest of the partnership and not in one’s own best interest; (3) the duty of care—that is, to act as a reasonably prudent partner would; (4) the duty of obedience not to breach any aspect of the agreement or act without authority; (5) the duty to inform copartners; and (6) the duty to account to the partnership.
Partners also have rights. These include the rights (1) to distributions of money, including profits (and losses), indemnification, and return of capital contribution (but not a right to compensation); (2) to management; (3) to choose copartners; (4) to property of the partnership, and no partner has any rights to specific property; (5) to assign (voluntarily or involuntarily) the partnership interest; and (6) to enforce duties and rights by suits in law or equity. (Under RUPA, a formal accounting is not first required.)
Exercises
1. At the US Senate website, read about the history of treaties in the United States. What is an “executive agreement,” and why has the use of executive agreements grown so fast since World War II?
2. Is NAFTA a treaty or an executive agreement? What practical difference does it make if it is one rather than the other? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/19%3A_Partnership_Operation_and_Termination/19.02%3A_Operation-_Relations_among_Partners.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the partners’ and partnership’s contract liability.
• Understand the partners’ and partnership’s tort and criminal liability.
• Describe the partners’ and partnership’s tax liability.
By express terms, the law of agency applies to partnership law. Every partner is an agent of the partnership for the purpose of its business. Consequently, the following discussion will be a review of agency law, covered in Chapter 18 as it applies to partnerships. The Revised Uniform Partnership Act (RUPA) adds a few new wrinkles to the liability issue.
Contract Liability
Liability of the Partnership
Recall that an agent can make contracts on behalf of a principal under three types of authority: express, implied, and apparent. Express authority is that explicitly delegated to the agent, implied authority is that necessary to the carrying out of the express authority, and apparent authority is that which a third party is led to believe has been conferred by the principal on the agent, even though in fact it was not or it was revoked. When a partner has authority, the partnership is bound by contracts the partner makes on its behalf. Section 19.4.2 “Partnership Authority, Express or Apparent”, Hodge v. Garrett, discusses all three types of authority.
The General Rule
Section 305 of RUPA restates agency law: “A partnership is liable for loss or injury, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course”RUPA Section 305. of partnership business or with its authority. The ability of a partner to bind the partnership to contract liability is problematic, especially where the authority is apparent: the firm denies liability, lawsuits ensue, and unhappiness generally follows.
But the firm is not liable for an act not apparently in the ordinary course of business, unless the act was authorized by the others.RUPA, Section 301(2); UPA, Section 9(2). Section 401(j) of RUPA requires the unanimous consent of the partners for a grant of authority outside the ordinary course of business, unless the partnership agreement provides otherwise.
Under the Uniform Partnership Act (UPA) Section 9(3), the firm is not liable for five actions that no single partner has implied or apparent authority to do, because they are not “in the ordinary course of partnership.” These actions are: (1) assignment of partnership property for the benefit of creditors, (2) disposing of the firm’s goodwill (selling the right to do business with the firm’s clients to another business), (3) actions that make it impossible to carry on the business, (4) confessing a judgment against the partnership, and (5) submitting a partnership claim or liability. RUPA omits that section, leaving it to the courts to decide the outer limits of the agency power of a partner. In any event, unauthorized actions by a partner may be ratified by the partnership.
Partnership “Statements”
New under RUPA is the ability of partnerships, partners, or even nonpartners to issue and file “statements” that announce to the world the establishment or denial of authority. The goal here is to control the reach of apparent authority. There are several kinds of statements authorized.
A statement of partnership authority is allowed by RUPA Section 303. It specifies the names of the partners authorized, or not authorized, to enter into transactions on behalf of the partnership and any other matters. The most important goal of the statement of authority is to facilitate the transfer of real property held in the name of the partnership. A statement must specify the names of the partners authorized to execute an instrument transferring that property.
A statement of denial, RUPA Section 304, operates to allow partners (and persons named as partners) an opportunity to deny any fact asserted in a statement of partnership authority.
A statement of dissociation, RUPA Section 704, may be filed by a partnership or a dissociated partner, informing the world that the person is no longer a partner. This tells the world that the named person is no longer in the partnership.
There are three other statements authorized: a statement of qualification establishes that the partnership has satisfied all conditions precedent to the qualification of the partnership as a limited liability partnership; a statement of foreign qualification means a limited liability partnership is qualified and registered to do business in a state other than that in which it is originally registered; and a statement of amendment or cancellation of any of the foregoing.RUPA, Section 1001(d); RUPA, Section 1102. Limited liability partnerships are taken up in Chapter 20.
Generally, RUPA Section 105 allows partnerships to file these statements with the state secretary of state’s office; those affecting real estate need to be filed with (or also with) the local county land recorder’s office. The notices bind those who know about them right away, and they are constructive notice to the world after ninety days as to authority to transfer real property in the partnership’s name, as to dissociation, and as to dissolution. However, as to other grants or limitations of authority, “only a third party who knows or has received a notification of a partner’s lack of authority in an ordinary course transaction is bound.”RUPA, Section 303, Comment 3.
Since RUPA is mostly intended to provide the rules for the small, unsophisticated partnership, it is questionable whether these arcane “statements” are very often employed.
Personal Liability of Partners, in General
It is clear that the partnership is liable for contracts by authorized partners, as discussed in the preceding paragraphs. The bad thing about the partnership as a form of business organization is that it imposes liability on the partners personally and without limit. Section 306 of RUPA provides that “all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.”RUPA, Section 306. Section 13 of UPA is in accord.
Liability of Existing Partners
Contract liability is joint and several: that is, all partners are liable (“joint”) and each is “several.” (We usually do not use several in modern English to mean “each”; it’s an archaic usage.) But—and here’s the intrusion of entity theory—generally RUPA requires the judgment creditor to exhaust the partnership’s assets before going after the separate assets of a partner. Thus under RUPA the partners are guarantors of the partnership’s liabilities.RUPA Section 306.
Under UPA, contract liability is joint only, not also several. This means the partners must be sued in a joint action brought against them all. A partner who is not named cannot later be sued by a creditor in a separate proceeding, though the ones who were named could see a proportionate contribution from the ones who were not.
Liability of Incoming Partners
Under RUPA Section 306(b), a new partner has no personal liability to existing creditors of the partnership, and only her capital investment in the firm is at risk for the satisfaction of existing partnership debts. Sections 17 and 41(7) of UPA are in accord. But, again, under either statute a new partner’s personal assets are at risk with respect to partnership liabilities incurred after her admission as a partner. This is a daunting prospect, and it is the reason for the invention of hybrid forms of business organization: limited partnerships, limited liability companies, and limited liability partnerships. The corporate form, of course, also (usually) obviates the owners’ personal liability.
Tort and Criminal Liability
Partnership Liability for Torts
The rules affecting partners’ tort liability (discussed in Section 19.2.1 “Contract Liability”) and those affecting contract liability are the same. Section 13 of UPA says the partnership is liable for “any wrongful act or omission of any partner acting in the ordinary course of the business of the partnership or with the authority of his co-partners.”UPA, Section 13.A civil “wrongful act” is necessarily either a tort or a breach of contract, so no distinction is made between them. (Section 305 of RUPA changed the phraseology slightly by adding after any wrongful act or omission the words or other actionable conduct; this makes the partnership liable for its partner’s no-fault torts.) That the principal should be liable for its agents’ wrongdoings is of course basic agency law. RUPA does expand liability by allowing a partner to sue during the term of the partnership without first having to get out of it, as is required under UPA.
For tortious acts, the partners are said to be jointly and severally liable under both UPA and RUPA, and the plaintiff may separately sue one or more partners. Even after winning a judgment, the plaintiff may sue other partners unnamed in the original action. Each and every partner is separately liable for the entire amount of the debt, although the plaintiff is not entitled to recover more than the total of his damages. The practical effect of the rules making partners personally liable for partnership contracts and torts can be huge. In his classic textbook Economics, Professor Paul Samuelson observed that unlimited liability “reveals why partnerships tend to be confined to small, personal enterprises.…When it becomes a question of placing their personal fortunes in jeopardy, people are reluctant to put their capital into complex ventures over which they can exercise little control.…In the field of investment banking, concerns like JPMorgan Chase used to advertise proudly ‘not incorporated’ so that their creditors could have extra assurance. But even these concerns have converted themselves into corporate entities.”Paul A. Samuelson, Economics (New York: McGraw-Hill, 1973), 106.
Partners’ Personal Liability for Torts
Of course, a person is always liable for his own torts. All partners are also liable for any partner’s tort committed in the scope of partnership business under agency law, and this liability is—again—personal and unlimited, subject to RUPA’s requirement that the judgment creditor exhaust the partnership’s assets before going after the separate assets of the partners. The partner who commits a tort or breach of trust must indemnify the partnership for losses paid to the third party.RUPA, Section 405(a).
Liability for Crimes
Criminal liability is generally personal to the miscreant. Nonparticipating copartners are ordinarily not liable for crimes if guilty intent is an element. When guilty intent is not an element, as in certain regulatory offenses, all partners may be guilty of an act committed by a partner in the course of the business.
Liability for Taxes
Corporate income gets taxed twice under federal law: once to the corporation and again to the shareholders who receive income as dividends. However, the partnership’s income “passes through” the partnership and is distributed to the partners under the conduit theory. When partners get income from the firm they have to pay tax on it, but the partnership pays no tax (it files an information return). This is perceived to be a significant advantage of the partnership form.
Key Takeaway
The partnership is generally liable for any contract made by a partner with authority express, implied, or apparent. Under RUPA the firm, partners, or even nonpartners may to some extent limit their liability by filing “statements” with the appropriate state registrar; such statements only affect those who know of them, except that a notice affecting the right of a partner to sell real estate or regarding dissociation or dissolution is effective against the world after ninety days.
All partners are liable for contracts entered into and torts committed by any partner acting in or apparently in the normal course of business. This liability is personal and unlimited, joint and several (although under UPA contract liability it is only joint). Incoming partners are not liable, in contract or in tort, for activities predating their arrival, but their capital contribution is at risk. Criminal liability is generally personal unless the crime requires no intention.
Exercises
1. What is the partnership’s liability for contracts entered into by its partners?
2. What is the personal liability of partners for breach of a contract made by one of the partnership’s members?
3. Why would people feel more comfortable knowing that JPMorgan Bank—Morgan was at one time the richest man in the United States—was a partnership and not a corporation?
4. What is the point of RUPA’s “statements”? How can they be of use to a partner who has, for example, retired and is no longer involved in the firm?
5. Under what circumstances is the partnership liable for crimes committed by its partners?
6. How is a partnership taxed more favorably than a corporation? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/19%3A_Partnership_Operation_and_Termination/19.03%3A_Operation-_The_Partnership_and_Third_Parties.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the dissolution of general partnerships under the Uniform Partnership Act (UPA).
• Understand the dissociation and dissolution of general partnerships under the Revised Uniform Partnership Act (RUPA).
• Explain the winding up of partnerships under UPA and RUPA.
It is said that a partnership is like a marriage, and that extends to its ending too. It’s easier to get into a partnership than it is to get out of it because legal entanglements continue after a person is no longer a partner. The rules governing “getting out” of a partnership are different under the Revised Uniform Partnership Act (RUPA) than under the Uniform Partnership Act (UPA). We take up UPA first.
Dissolution of Partnerships under UPA
Dissolution, in the most general sense, means a separation into component parts.
Meaning of Dissolution under UPA
People in business are sometimes confused about the meaning of dissolution. It does not mean the termination of a business. It has a precise legal definition, given in UPA Section 29: The partnership is not necessarily terminated on dissolution; rather, it continues until the winding up of partnership affairs is completed, and the remaining partners may choose to continue on as a new partnership if they want.UPA, Section 30. But, again, under UPA the partnership dissolves upon the withdrawal of any partner.
Causes of Dissolution
Partnerships can dissolve for a number of reasons.UPA, Section 31.
In Accordance with the Agreement
The term of the partnership agreement may have expired or the partnership may be at will and one of the partners desires to leave it. All the partners may decide that it is preferable to dissolve rather than to continue. One of the partners may have been expelled in accordance with a provision in the agreement. In none of these circumstances is the agreement violated, though its spirit surely might have been. Professor Samuelson calls to mind the example of William Dean Howells’s Silas Lapham, who forces his partner to sell out by offering him an ultimatum: “You may buy me out or I’ll buy you out.” The ultimatum was given at a time when the partner could not afford to buy Lapham out, so the partner had no choice.
In Violation of the Agreement
Dissolution may also result from violation of the agreement, as when the partners decide to discharge a partner though no provision permits them to do so, or as when a partner decides to quit in violation of a term agreement. In the former case, the remaining partners are liable for damages for wrongful dissolution, and in the latter case, the withdrawing partner is liable to the remaining partners the same way.
By Operation of Law
A third reason for dissolution is the occurrence of some event, such as enactment of a statute, that makes it unlawful to continue the business. Or a partner may die or one or more partners or the entire partnership may become bankrupt. Dissolution under these circumstances is said to be by operation of law.UPA, Section 31.
By Court Order
Finally, dissolution may be by court order. Courts are empowered to dissolve partnerships when “on application by or for a partner” a partner is shown to be a lunatic, of unsound mind, incapable of performing his part of the agreement, “guilty of such conduct as tends to affect prejudicially the carrying on of the business,” or otherwise behaves in such a way that “it is not reasonably practicable to carry on the business in partnership with him.” A court may also order dissolution if the business can only be carried on at a loss or whenever equitable. In some circumstances, a court will order dissolution upon the application of a purchaser of a partner’s interest.UPA, Section 32.
Effect of Dissolution on Authority
For the most part, dissolution terminates the authority of the partners to act for the partnership. The only significant exceptions are for acts necessary to wind up partnership affairs or to complete transactions begun but not finished at the time of dissolution.UPA, Section 33. Notwithstanding the latter exception, no partner can bind the partnership if it has dissolved because it has become unlawful to carry on the business or if the partner seeking to exercise authority has become bankrupt.
After Dissolution
After a partnership has dissolved, it can follow one of two paths. It can carry on business as a new partnership, or it can wind up the business and cease operating (see Figure 19.2).
Forming a New Partnership
In order to carry on the business as a new partnership, there must be an agreement—preferably as part of the original partnership agreement but maybe only after dissolution (and maybe oral)—that upon dissolution (e.g., if a partner dies, retires, or quits) the others will regroup and carry on.
Under UPA the remaining partners have the right to carry on when (1) the dissolution was in contravention of the agreement, (2) a partner was expelled according to the partnership agreement, or (3) all partners agree to carry on.UPA, Sections 37 and 38.
Whether the former partner dies or otherwise quits the firm, the noncontinuing one or his, her, or its legal representative is entitled to an accounting and to be paid the value of the partnership interest, less damages for wrongful dissolution.UPA, Section 38. The firm may need to borrow money to pay the former partner or her estate; or, in the case of a deceased partner, the money to pay the former partner is obtained through a life insurance buyout policy.
Partnerships routinely insure the lives of the partners, who have no ownership interests in the insurance policies. The policies should bear a face amount equal to each partner’s interest in the partnership and should be adjusted as the fortunes of the partnership change. Proceeds of the insurance policy are used on death to pay the purchase price of the interest inherited by the deceased’s estate. If the insurance policy pays out more than the interest at stake, the partnership retains the difference. If the policy pays out less, the partnership agrees to pay the difference in installments.
Another set of issues arises when the partnership changes because an old partner departs and a new one joins. Suppose that Baker leaves the car dealership business and his interest is purchased by Alice, who is then admitted to the partnership. Assume that when Baker left, the business owed Mogul Parts Company \$5,000 and Laid Back Upholsterers \$4,000. After Baker left and Alice joined, Mogul sells another \$5,000 worth of parts to the firm on credit, and Sizzling Radiator Repair, a new creditor, advances \$3,000 worth of radiator repair parts. These circumstances pose four questions.
First, do creditors of the old partnership remain creditors of the new partnership? Yes.UPA, Section 41(1).
Second, does Baker, the old partner, remain liable to the creditors of the old partnership? Yes.UPA, Section 36(1). That could pose uncomfortable problems for Baker, who may have left the business because he lost interest in it and wished to put his money elsewhere. The last thing he wants is the threat of liability hanging over his head when he can no longer profit from the firm’s operations. That is all the more true if he had a falling out with his partners and does not trust them. The solution is given in UPA Section 36(2), which says that an old partner is discharged from liability if the creditors and the new partnership agree to discharge him.
Third, is Alice, the new partner, liable to creditors of the old partnership? Yes, but only to the extent of her capital contribution.UPA, Section 17.
Fourth, is Baker, the old partner, liable for debts incurred after his withdrawal from the partnership? Surprisingly, yes, unless Baker takes certain action toward old and new creditors. He must provide actual notice that he has withdrawn to anyone who has extended credit in the past. Once he has done so, he has no liability to these creditors for credit extended to the partnership thereafter. Of course, it would be difficult to provide notice to future creditors, since at the time of withdrawal they would not have had a relationship with the partnership. To avoid liability to new creditors who knew of the partnership, the solution required under UPA Section 35(l)(b)(II) is to advertise Baker’s departure in a general circulation newspaper in the place where the partnership business was regularly carried on.
Winding Up and Termination
Because the differences between UPA’s and RUPA’s provisions for winding up and termination are not as significant as those between their provisions for dissolution, the discussion for winding up and termination will cover both acts at once, following the discussion of dissociation and dissolution under RUPA.
Dissociation and Dissolution of Partnerships under RUPA
Comment 1 to RUPA Section 601 is a good lead-in to this section. According to the comment, RUPA dramatically changes the law governing partnership breakups and dissolution. An entirely new concept, “dissociation,” is used in lieu of UPA term “dissolution” to denote the change in the relationship caused by a partner’s ceasing to be associated in the carrying on of the business. “Dissolution” is retained but with a different meaning. The entity theory of partnership provides a conceptual basis for continuing the firm itself despite a partner’s withdrawal from the firm.
Under UPA, the partnership is an aggregate, a collection of individuals; upon the withdrawal of any member from the collection, the aggregate dissolves. But because RUPA conforms the partnership as an entity, there is no conceptual reason for it to dissolve upon a member’s withdrawal. “Dissociation” occurs when any partner ceases to be involved in the business of the firm, and “dissolution” happens when RUPA requires the partnership to wind up and terminate; dissociation does not necessarily cause dissolution.
Dissociation
Dissociation, as noted in the previous paragraph, is the change in relations caused by a partner’s withdrawal from the firm’s business.
Causes of Dissociation
Dissociation is caused in ten possible ways: (1) a partner says she wants out; (2) an event triggers dissociation as per the partnership agreement; (3) a partner is expelled as per the agreement; (4) a partner is expelled by unanimous vote of the others because it is unlawful to carry on with that partner, because that partner has transferred to a transferee all interest in the partnership (except for security purposes), or because a corporate partner’s or partnership partner’s existence is effectively terminated; (5) by a court order upon request by the partnership or another partner because the one expelled has been determined to have misbehaved (engaged in serious wrongful conduct, persists in abusing the agreement, acts in ways making continuing the business impracticable); (6) the partner has declared bankruptcy; (7) the partner has died or had a guardian appointed, or has been adjudicated as incompetent; (8) the partner is a trust whose assets are exhausted; (9) the partner is an estate and the estate’s interest in the partnership has been entirely transferred; (10) the partner dies or, if the partner is another partnership or a corporation trust or estate, that entity’s existence is terminated.RUPA, Section 601.
Effect of Dissociation
After a partner dissociates, the partner’s right to participate in management terminates. (However, if the dissociation goes on to dissolution and winding up, partners who have not wrongfully caused the dissociation may participate in winding-up activities.)RUPA. Sections 603(b) and 804(a). The dissociated partner’s duty of loyalty and care terminates; the former partner may compete with the firm, except for matters arising before the dissociation.RUPA, Section 603(b)(3).
When partners come and go, as they do, problems may arise. What power does the dissociated partner have to bind the partnership? What power does the partnership have to impose liability on the dissociated one? RUPA provides that the dissociated partner loses any actual authority upon dissociation, and his or her apparent authority lingers for not longer than two years if the dissociated one acts in a way that would have bound the partnership before dissociation, provided the other party (1) reasonably believed the dissociated one was a partner, (2) did not have notice of the dissociation, and (3) is not deemed to have constructive notice from a filed “statement of dissociation.”RUPA, Section 603(b)(1). The dissociated partner, of course, is liable for damages to the partnership if third parties had cause to think she was still a partner and the partnership became liable because of that; she is liable to the firm as an unauthorized agent.RUPA, Section 702.
A partner’s dissociation does nothing to change that partner’s liability for predissociation obligations.RUPA, Section 703(a). For postdissociation liability, exposure is for two years if at the time of entering into the transaction the other party (1) reasonably believed the dissociated one was a partner, (2) didn’t have notice of the dissociation, and (3) is not deemed to have constructive notice from a filed “statement of dissociation.” For example, Baker withdraws from the firm of Able, Baker, and Carr. Able contracts with HydroLift for a new hydraulic car lift that costs \$25,000 installed. HydroLift is not aware at the time of contracting that Baker is disassociated and believes she is still a partner. A year later, the firm not having been paid, HydroLift sues Able, Baker, and Carr and the partnership. Baker has potential liability. Baker could have protected herself by filing a “statement of dissociation,” or—better—the partnership agreement should provide that the firm would file such statements upon the dissociation of any partner (and if it does not, it would be liable to her for the consequences).
Dissolution
Dissociation does not necessarily cause dissolution (see the discussion later in this section of how the firm continues after a dissociation); dissolution and winding up happen only for the causes stated in RUPA Section 801, discussed in the following paragraphs.
Causes of Dissolution
There are three causes of dissolution: (1) by act of the partners—some dissociations do trigger dissolution; (2) by operation of law; or (3) by court order. The partnership agreement may change or eliminate the dissolution trigger as to (1); dissolution by the latter two means cannot be tinkered with.RUPA, Section 103.
(1) Dissolution by act of the partners may occur as follows:
• Any member of an at-will partnership can dissociate at any time, triggering dissolution and liquidation. The partners who wish to continue the business of a term partnership, though, cannot be forced to liquidate the business by a partner who withdraws prematurely in violation of the partnership agreement. In any event, common agreement formats for dissolution will provide for built-in dispute resolution, and enlightened partners often agree to such mechanisms in advance to avoid the kinds of problems listed here.
• Any partnership will dissolve upon the happening of an event the partners specified would cause dissolution in their agreement. They may change their minds, of course, agree to continue, and amend the partnership agreement accordingly.
• A term partnership may be dissolved before its term expires in three ways. First, if a partner dissociated by death, declaring bankruptcy, becoming incapacitated, or wrongfully dissociates, the partnership will dissolve if within ninety days of that triggering dissociation at least half the remaining partners express their will to wind it up. Second, the partnership may be dissolved if the term expires. Third, it may be dissolved if all the partners agree to amend the partnership agreement by expressly agreeing to dissolve.
(2) Dissolution will happen in some cases by operation of law if it becomes illegal to continue the business, or substantially all of it. For example, if the firm’s business was the manufacture and distribution of trans fats and it became illegal to do that, the firm would dissolve.Trans fats are hydrogenated vegetable oils; the process of hydrogenation essentially turns the oils into semisolids, giving them a higher melting point and extending their shelf life but, unfortunately, also clogging consumers’ arteries and causing heart disease. California banned their sale effective January 1, 2010; other jurisdictions have followed suit. This cause of dissolution is not subject to partnership agreement.
(3) Dissolution by court order can occur on application by a partner. A court may declare that it is, for various reasons specified in RUPA Section 801(5), no longer reasonably practicable to continue operation. Also, a court may order dissolution upon application by a transferee of a partner’s transferable interest or by a purchaser at a foreclosure of a charging order if the court determines it is equitable. For example, if Creditor gets a charging order against Paul Partner and the obligation cannot reasonably be paid by the firm, a court could order dissolution so Creditor would get paid from the liquidated assets of the firm.
Effect of Dissolution
A partnership continues after dissolution only for the purpose of winding up its business. The partnership is terminated when the winding up of its business is completed.RUPA, Section 802. However, before winding up is completed, the partners—except any wrongfully dissociating—may agree to carry on the partnership, in which case it resumes business as if dissolution never happened.RUPA, Section 802(b).
Continuing after Dissociation
Dissociation, again, does not necessarily cause dissolution. In an at-will partnership, the death (including termination of an entity partner), bankruptcy, incapacity, or expulsion of a partner will not cause dissolution.RUPA, Sections 601 and 801. In a term partnership, the firm continues if, within ninety days of an event triggering dissociation, fewer than half the partners express their will to wind up. The partnership agreement may provide that RUPA’s dissolution-triggering events, including dissociation, will not trigger dissolution. However, the agreement cannot change the rules that dissolution is caused by the business becoming illegal or by court order. Creditors of the partnership remain as before, and the dissociated partner is liable for partnership obligations arising before dissociation.
Section 701 of RUPA provides that if the firm continues in business after a partner dissociates, without winding up, then the partnership must purchase the dissociated partner’s interest; RUPA Section 701(b) explains how to determine the buyout price. It is the amount that would have been distributed to the dissociated partner if, on the date of dissociation, the firm’s assets were sold “at a price equal to the greater of the liquidation value or the value based on a sale of the entire business as a going concern,” minus damages for wrongful dissociation. A wrongful dissociater may have to wait a while to get paid in full, unless a court determines that immediate payment “will not cause an undue hardship to the partnership,” but the longest nonwrongful dissociaters need to wait is 120 days.RUPA, Section 701(e). A dissociated partner can sue the firm to determine the buyout price and the court may assess attorney’s, appraiser’s, and expert’s fees against a party the court finds “acted arbitrarily, vexatiously, or in bad faith.”RUPA, Section 701(h)(4)(i).
Winding Up the Partnership under UPA and RUPA
If the partners decide not to continue the business upon dissolution, they are obliged to wind up the business. The partnership continues after dissolution only for the purpose of winding up its business, after which it is terminated.UPA, Section 30; RUPA, Section 802(a).Winding up entails concluding all unfinished business pending at the date of dissolution and payment of all debts. The partners must then settle accounts among themselves in order to distribute the remaining assets. At any time after dissolution and before winding up is completed, the partners (except a wrongfully dissociated one) can stop the process and carry on the business.
UPA and RUPA are not significantly different as to winding up, so they will be discussed together. Two issues are discussed here: who can participate in winding up and how the assets of the firm are distributed on liquidation.
Who Can Participate in Winding Up
The partners who have not wrongfully dissociated may participate in winding up the partnership business. On application of any partner, a court may for good cause judicially supervise the winding up.UPA, Section 37; RUPA, Section 803(a).
Settlement of Accounts among Partners
Determining the priority of liabilities can be problematic. For instance, debts might be incurred to both outside creditors and partners, who might have lent money to pay off certain accounts or for working capital.
An agreement can spell out the order in which liabilities are to be paid, but if it does not, UPA Section 40(a) and RUPA Section 807(1) rank them in this order: (1) to creditors other than partners, (2) to partners for liabilities other than for capital and profits, (3) to partners for capital contributions, and finally (4) to partners for their share of profits (see Figure 19.3). However, RUPA eliminates the distinction between capital and profits when the firm pays partners what is owed to them; RUPA Section 807(b) speaks simply of the right of a partner to a liquidating distribution.
Partners are entitled to share equally in the profits and surplus remaining after all liabilities, including those owed to partners, are paid off, although the partnership agreement can state a different share—for example, in proportion to capital contribution. If after winding up there is a net loss, whether capital or otherwise, each partner must contribute toward it in accordance with his share in the profits, had there been any, unless the agreement states otherwise. If any of the partners is insolvent or refuses to contribute and cannot be sued, the others must contribute their own share to pay off the liabilities and in addition must contribute, in proportion to their share of the profits, the additional amount necessary to pay the liabilities of their defaulting partners.
In the event of insolvency, a court may take possession of both partnership property and individual assets of the partners; this again is a big disadvantage to the partnership form.
The estate of a deceased partner is credited or liable as that partner would have been if she were living at the time of the distribution.
Key Takeaway
Under UPA, the withdrawal of any partner from the partnership causes dissolution; the withdrawal may be caused in accordance with the agreement, in violation of the agreement, by operation of law, or by court order. Dissolution terminates the partners’ authority to act for the partnership, except for winding up, but remaining partners may decide to carry on as a new partnership or may decide to terminate the firm. If they continue, the old creditors remain as creditors of the new firm, the former partner remains liable for obligations incurred while she was a partner (she may be liable for debts arising after she left, unless proper notice is given to creditors), and the former partner or her estate is entitled to an accounting and payment for the partnership interest. If the partners move to terminate the firm, winding up begins.
Under RUPA, a partner who ceases to be involved in the business is dissociated, but dissociation does not necessarily cause dissolution. Dissociation happens when a partner quits, voluntarily or involuntarily; when a partner dies or becomes incompetent; or on request by the firm or a partner upon court order for a partner’s wrongful conduct, among other reasons. The dissociated partner loses actual authority to bind the firm but remains liable for predissociation obligations and may have lingering authority or lingering liability for two years provided the other party thought the dissociated one was still a partner; a notice of dissociation will, after ninety days, be good against the world as to dissociation and dissolution. If the firm proceeds to termination (though partners can stop the process before its end), the next step is dissolution, which occurs by acts of partners, by operation of law, or by court order upon application by a partner if continuing the business has become untenable. After dissolution, the only business undertaken is to wind up affairs. However, the firm may continue after dissociation; it must buy out the dissociated one’s interest, minus damages if the dissociation was wrongful.
If the firm is to be terminated, winding up entails finishing the business at hand, paying off creditors, and splitting the remaining surplus or liabilities according the parties’ agreement or, absent any, according to the relevant act (UPA or RUPA).
Exercises
1. Under UPA, what is the effect on the partnership of a partner’s ceasing to be involved in the business?
2. Can a person no longer a partner be held liable for partnership obligations after her withdrawal? Can such a person incur liability to the partnership?
3. What obligation does a partnership or its partners owe to a partner who wrongfully terminates the partnership agreement?
4. What bearing does RUPA’s use of the term dissociate have on the entity theory that informs the revised act?
5. When a partnership is wound up, who gets paid first from its assets? If the firm winds up toward termination and has inadequate assets to pay its creditors, what recourse, if any, do the creditors have? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/19%3A_Partnership_Operation_and_Termination/19.04%3A_Dissolution_and_Winding_Up.txt |
Breach of Partnership Fiduciary Duty
Gilroy v. Conway
391 N.W. 2d 419 (Mich. App. 1986)
PETERSON, J.
Defendant cheated his partner and appeals from the trial court’s judgment granting that partner a remedy.
Plaintiff was an established commercial photographer in Kalamazoo who also had a partnership interest in another photography business, Colonial Studios, in Coldwater. In 1974, defendant became plaintiff’s partner in Colonial Studios, the name of which was changed to Skylight Studios. Under the partnership agreement, defendant was to be the operating manager of the partnership, in return for which he would have a guaranteed draw. Except for the guaranteed draw, the partnership was equal in ownership and the sharing of profits.
Prior to defendant’s becoming a partner, the business had acquired a small contractual clientele of schools for which the business provided student portrait photographs. The partners agreed to concentrate on this type of business, and both partners solicited schools with success. Gross sales, which were \$40,000 in 1974, increased every year and amounted to \$209,085 in 1980 [about \$537,000 in 2011 dollars].
In the spring of 1981, defendant offered to buy out plaintiff and some negotiations followed. On June 25, 1981, however, plaintiff was notified by the defendant that the partnership was dissolved as of July 1, 1981. Plaintiff discovered that defendant: had closed up the partnership’s place of business and opened up his own business; had purchased equipment and supplies in preparation for commencing his own business and charged them to the partnership; and had taken with him the partnership employees and most of its equipment.
Defendant had also stolen the partnership’s business. He had personally taken over the business of some customers by telling them that the partnership was being dissolved; in other cases he simply took over partnership contracts without telling the customers that he was then operating on his own. Plaintiff also learned that defendant’s deceit had included the withdrawal, without plaintiff’s knowledge, of partnership funds for defendant’s personal use in 1978 in an amount exceeding \$11,000 [about \$36,000 in 2011 dollars].
The trial judge characterized the case as a “classic study of greed” and found that defendant had in effect appropriated the business enterprise, holding that defendant had “knowingly and willfully violated his fiduciary relationship as a partner by converting partnership assets to his use and, in doing so, literally destroying the partnership.” He also found that the partnership could have been sold as a going business on June 30, 1981, and that after a full accounting, it had a value on that date of \$94,596 less accounts payable of \$17,378.85, or a net value of \$77,217.15. The division thereof after adjustments for plaintiff’s positive equity or capital resulted in an award to plaintiff for his interest in the business of \$53,779.46 [about \$126,000 in 2011 dollars].…
Plaintiff also sought exemplary [punitive] damages. Count II of the complaint alleged that defendant’s conduct constituted a breach of defendant’s fiduciary duty to his partner under §§ 19-22 of the Uniform Partnership Act, and Count III alleged conversion of partnership property. Each count contained allegations that defendant’s conduct was willful, wanton and in reckless disregard of plaintiff’s rights and that such conduct had caused injury to plaintiff’s feelings, including humiliation, indignity and a sense of moral outrage. The prayer for relief sought exemplary damages therefore.
Plaintiff’s testimony on the point was brief. He said:
The effect of really the whole situation, and I think it was most apparent when I walked into the empty building, was extreme disappointment and really total outrage at the fact that something that I had given the utmost of my talent and creativity, energy, and whatever time was necessary to build, was totally destroyed and there was just nothing of any value that was left.…My business had been stolen and there wasn’t a thing that I could do about it. And to me, that was very humiliating that one day I had something that I had worked 10 years on, and the next day I had absolutely nothing of any value.
As noted above, the trial judge found that defendant had literally destroyed the partnership by knowingly and willfully converting partnership assets in violation of his fiduciary duty as a partner. He also found that plaintiff had suffered a sense of outrage, indignity and humiliation and awarded him \$10,000 [\$23,000 in 2011 dollars] as exemplary damages.
Defendant appeals from that award, asserting that plaintiff’s cause of action arises from a breach of the partnership contract and that exemplary damages may not be awarded for breach of that contract.…
If it were to be assumed that a partner’s breach of his fiduciary duty or appropriation of partnership equipment and business contract to his own use and profit are torts, it is clear that the duty breached arises from the partnership contract. One acquires the property interest of a co-tenant in partnership only by the contractual creation of a partnership; one becomes a fiduciary in partnership only by the contractual undertaking to become a partner. There is no tortious conduct here existing independent of the breach of the partnership contract.
Neither do we see anything in the Uniform Partnership Act to suggest that an aggrieved partner is entitled to any remedy other than to be made whole economically. The act defines identically the partnership fiduciary duty and the remedy for its breach, i.e., to account:
Sec. 21. (1) Every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.
So, the cases involving a partner’s breach of the fiduciary duty to their partners have been concerned solely with placing the wronged partners in the economic position that they would have enjoyed but for the breach.
[Judgment for plaintiff affirmed, as modified with regard to damages.]
Case Questions
1. For what did the court award the plaintiff \$53,000?
2. The court characterizes the defendant as having “cheated his partner”—that is, Conway committed fraud. (Gilroy said his business had been “stolen.”) Fraud is a tort. Punitive damages may be awarded against a tortfeasor, even in a jurisdiction that generally disallows punitive damages in contract. In fact, punitive damages are sometimes awarded for breach of the partnership fiduciary duty. In Cadwalader, Wickersham & Taft v. Beasley, 728 So.2d 253 (Florida Ct. App., 1998), a New York law firm was found to have wrongfully expelled a partner lawyer, Beasley, from membership in its Palm Beach, Florida, offices. New York law controlled. The trial court awarded Beasley \$500,000 in punitive damages. The appeals court, construing the same UPA as the court construed in Gilroy, said:Under New York law, the nature of the conduct which justifies an award of punitive damages is conduct having a high degree of moral culpability, or, in other words, conduct which shows a “conscious disregard of the rights of others or conduct so reckless as to amount to such disregard.”…[S]ince the purpose of punitive damages is to both punish the wrongdoer and deter others from such wrongful behavior, as a matter of policy, courts have the discretion to award punitive damages[.]…[The defendant] was participating in a clandestine plan to wrongfully expel some partners for the financial gain of other partners. Such activity cannot be said to be honorable, much less to comport with the “punctilio of an honor.” Because these findings establish that [the defendant] consciously disregarded the rights of Beasley, we affirm the award of punitive damages. As a matter of social policy, which is the better ruling, the Michigan court’s in Gilroy or the Florida court’s in Cadwalader?
Partnership Authority, Express or Apparent
Hodge v Garrett
614 P.2d 420 (Idaho 1980)
Bistline, J.
[Plaintiff] Hodge and defendant-appellant Rex E. Voeller, the managing partner of the Pay-Ont Drive-In Theatre, signed a contract for the sale of a small parcel of land belonging to the partnership. That parcel, although adjacent to the theater, was not used in theater operations except insofar as the east 20 feet were necessary for the operation of the theater’s driveway. The agreement for the sale of land stated that it was between Hodge and the Pay-Ont Drive-In Theatre, a partnership. Voeller signed the agreement for the partnership, and written changes as to the footage and price were initialed by Voeller. (The trial court found that Hodge and Voeller had orally agreed that this 20 foot strip would be encumbered by an easement for ingress and egress to the partnership lands.)
Voeller testified that he had told Hodge prior to signing that Hodge would have to present him with a plat plan which would have to be approved by the partners before the property could be sold. Hodge denied that a plat plan had ever been mentioned to him, and he testified that Voeller did not tell him that the approval of the other partners was needed until after the contract was signed. Hodge also testified that he offered to pay Voeller the full purchase price when he signed the contract, but Voeller told him that that was not necessary.
The trial court found that Voeller had actual and apparent authority to execute the contract on behalf of the partnership, and that the contract should be specifically enforced. The partners of the Pay-Ont Drive-In Theatre appeal, arguing that Voeller did not have authority to sell the property and that Hodge knew that he did not have that authority.
At common law one partner could not, “without the concurrence of his copartners, convey away the real estate of the partnership, bind his partners by a deed, or transfer the title and interest of his copartners in the firm real estate.” [Citation] This rule was changed by the adoption of the Uniform Partnership Act.…[citing the statute].
The meaning of these provisions was stated in one text as follows:
“If record title is in the partnership and a partner conveys in the partnership name, legal title passes. But the partnership may recover the property (except from a bona fide purchaser from the grantee) if it can show (A) that the conveying partner was not apparently carrying on business in the usual way or (B) that he had in fact no authority and the grantee had knowledge of that fact. The burden of proof with respect to authority is thus on the partnership.” [Citation]
Thus this contract is enforceable if Voeller had the actual authority to sell the property, or, even if Voeller did not have such authority, the contract is still enforceable if the sale was in the usual way of carrying on the business and Hodge did not know that Voeller did not have this authority.
As to the question of actual authority, such authority must affirmatively appear, “for the authority of one partner to make and acknowledge a deed for the firm will not be presumed.…” [Citation] Although such authority may be implied from the nature of the business, or from similar past transactions [Citation], nothing in the record in this case indicates that Voeller had express or implied authority to sell real property belonging to the partnership. There is no evidence that Voeller had sold property belonging to the partnership in the past, and obviously the partnership was not engaged in the business of buying and selling real estate.
The next question, since actual authority has not been shown, is whether Voeller was conducting the partnership business in the usual way in selling this parcel of land such that the contract is binding under [the relevant section of the statute] i.e., whether Voeller had apparent authority. Here the evidence showed, and the trial court found:
1. “That the defendant, Rex E. Voeller, was one of the original partners of the Pay-Ont Drive In Theatre; that the other defendants obtained their partnership interest by inheritance upon the death of other original partners; that upon the death of a partner the partnership affairs were not wound up, but instead, the partnership merely continued as before, with the heirs of the deceased partner owning their proportionate share of the partnership interest.
2. “That at the inception of the partnership, and at all times thereafter, Rex E. Voeller was the exclusive, managing partner of the partnership and had the full authority to make all decisions pertaining to the partnership affairs, including paying the bills, preparing profit and loss statements, income tax returns and the ordering of any goods or services necessary to the operation of the business.”
The court made no finding that it was customary for Voeller to sell real property, or even personal property, belonging to the partnership. Nor was there any evidence to this effect. Nor did the court discuss whether it was in the usual course of business for the managing partner of a theater to sell real property. Yet the trial court found that Voeller had apparent authority to sell the property. From this it must be inferred that the trial court believed it to be in the usual course of business for a partner who has exclusive control of the partnership business to sell real property belonging to the partnership, where that property is not being used in the partnership business. We cannot agree with this conclusion. For a theater, “carrying on in the usual way the business of the partnership,” [Citation to relevant section of the statute] means running the operations of the theater; it does not mean selling a parcel of property adjacent to the theater. Here the contract of sale stated that the land belonged to the partnership, and, even if Hodge believed that Voeller as the exclusive manager had authority to transact all business for the firm, Voeller still could not bind the partnership through a unilateral act which was not in the usual business of the partnership. We therefore hold that the trial court erred in holding that this contract was binding on the partnership.
Judgment reversed. Costs to appellant.
Case Questions
1. What was the argument that Voeller had actual authority? What did the court on appeal say about that argument?
2. What was the argument that Voeller had apparent authority? What did the court on appeal say about that argument? To rephrase the question, what facts would have been necessary to confer on Voeller apparent authority?
Partnership Bound by Contracts Made by a Partner on Its Behalf; Partners’ Duties to Each Other; Winding Up
Long v. Lopez
115 S.W.3d 221 (Texas App. 2003)
Holman, J.
Wayne A. Long [plaintiff at the trial court] sued Appellee Sergio Lopez to recover from him, jointly and severally, his portion of a partnership debt that Long had paid. After a bench trial, the trial court ruled that Long take nothing from Appellee. We reverse and render, and remand for calculation of attorney’s fees in this suit and pre- and post-judgment interest.
Long testified that in September 1996, Long, Lopez, and Don Bannister entered into an oral partnership agreement in which they agreed to be partners in Wood Relo (“the partnership”), a trucking business located in Gainesville, Texas. Wood Relo located loads for and dispatched approximately twenty trucks it leased from owner-operators.…
The trial court found that Long, Lopez, and Bannister formed a partnership, Wood Relo, without a written partnership agreement. Lopez does not contest these findings.
Long testified that to properly conduct the partnership’s business, he entered into an office equipment lease with IKON Capital Corporation (“IKON”) on behalf of the partnership. The lease was a thirty-month contract under which the partnership leased a telephone system, fax machine, and photocopier at a rate of \$577.91 per month. The lease agreement was between IKON and Wood Relo; the “authorized signer” was listed as Wayne Long, who also signed as personal guarantor.
Long stated that all three partners were authorized to buy equipment for use by the partnership. He testified that the partners had agreed that it was necessary for the partnership to lease the equipment and that on the day the equipment was delivered to Wood Relo’s office, Long was the only partner at the office; therefore, Long was the only one available to sign the lease and personal guaranty that IKON required. [The partnership disintegrated when Bannister left and he later filed for bankruptcy.]…Long testified that when Bannister left Wood Relo, the partnership still had “quite a few” debts to pay, including the IKON lease.…
Eventually, IKON did repossess all the leased equipment. Long testified that he received a demand letter from IKON, requesting payment by Wood Relo of overdue lease payments and accelerating payment of the remaining balance of the lease. IKON sought recovery of past due payments in the amount of \$2,889.55 and accelerated future lease payments in the amount of \$11,558.20, for a total of \$14,447.75, plus interest, costs, and attorney’s fees, with the total exceeding \$16,000. Long testified that he advised Lopez that he had received the demand letter from IKON.
Ultimately, IKON filed a lawsuit against Long individually and d/b/a Wood Relo, but did not name Lopez or Bannister as parties to the suit. Through his counsel, Long negotiated a settlement with IKON for a total of \$9,000. An agreed judgment was entered in conjunction with the settlement agreement providing that if Long did not pay the settlement, Wood Relo and Long would owe IKON \$12,000.
After settling the IKON lawsuit, Long’s counsel sent a letter to Lopez and Bannister regarding the settlement agreement, advising them that they were jointly and severally liable for the \$9,000 that extinguished the partnership’s debt to IKON, plus attorney’s fees.…
The trial court determined that Long was not entitled to reimbursement from Lopez because Long was not acting for the partnership when he settled IKON’s claim against the partnership. The court based its conclusion on the fact that Long had no “apparent authority with respect to lawsuits” and had not notified Lopez of the IKON lawsuit.
Analysis
To the extent that a partnership agreement does not otherwise specify, the provisions of the Texas Revised Partnership Act govern the relations of the partners and between the partners and the partnership. [Citations] Under the Act, each partner has equal rights in the management and conduct of the business of a partnership. With certain inapplicable exceptions, all partners are liable jointly and severally for all debts and obligations of the partnership unless otherwise agreed by the claimant or provided by law. A partnership may be sued and may defend itself in its partnership name. Each partner is an agent of the partnership for the purpose of its business; unless the partner does not have authority to act for the partnership in a particular matter and the person with whom the partner is dealing knows that the partner lacks authority, an act of a partner, including the execution of an instrument in the partnership name, binds the partnership if “the act is for apparently carrying on in the ordinary course: (1) the partnership business.” [Citation] If the act of a partner is not apparently for carrying on the partnership business, an act of a partner binds the partnership only if authorized by the other partners. [Citation]
The extent of authority of a partner is determined essentially by the same principles as those measuring the scope of the authority of an agent. [Citation] As a general rule, each partner is an agent of the partnership and is empowered to bind the partnership in the normal conduct of its business. [Citation] Generally, an agent’s authority is presumed to be coextensive with the business entrusted to his care. [Citations] An agent is limited in his authority to such contracts and acts as are incident to the management of the particular business with which he is entrusted. [Citation]
Winding Up the Partnership
A partner’s duty of care to the partnership and the other partners is to act in the conduct and winding up of the partnership business with the care an ordinarily prudent person would exercise in similar circumstances. [Citation] During the winding up of a partnership’s business, a partner’s fiduciary duty to the other partners and the partnership is limited to matters relating to the winding up of the partnership’s affairs. [Citation]
Long testified that he entered into the settlement agreement with IKON to save the partnership a substantial amount of money. IKON’s petition sought over \$16,000 from the partnership, and the settlement agreement was for \$9,000; therefore, Long settled IKON’s claim for 43% less than the amount for which IKON sued the partnership.
Both Long and Lopez testified that the partnership “fell apart,” “virtually was dead,” and had to move elsewhere.…The inability of the partnership to continue its trucking business was an event requiring the partners to wind up the affairs of the partnership. See [Citation]…
The Act provides that a partner winding up a partnership’s business is authorized, to the extent appropriate for winding up, to perform the following in the name of and for and on behalf of the partnership:
1. prosecute and defend civil, criminal, or administrative suits;
2. settle and close the partnership’s business;
3. dispose of and convey the partnership’s property;
4. satisfy or provide for the satisfaction of the partnership’s liabilities;
5. distribute to the partners any remaining property of the partnership; and
6. perform any other necessary act. [Citation]
Long accrued the IKON debt on behalf of the partnership when he secured the office equipment for partnership operations, and he testified that he entered into the settlement with IKON when the partnership was in its final stages and the partners were going their separate ways. Accordingly, Long was authorized by the Act to settle the IKON lawsuit on behalf of the partnership.…
Lopez’s Liability for the IKON Debt
If a partner reasonably incurs a liability in excess of the amount he agreed to contribute in properly conducting the business of the partnership or for preserving the partnership’s business or property, he is entitled to be repaid by the partnership for that excess amount. [Citation] A partner may sue another partner for reimbursement if the partner has made such an excessive payment. [Citation]
With two exceptions not applicable to the facts of this case, all partners are liable jointly and severally for all debts and obligations of the partnership unless otherwise agreed by the claimant or provided by law. Because Wood Relo was sued for a partnership debt made in the proper conduct of the partnership business, and Long settled this claim in the course of winding up the partnership, he could maintain an action against Lopez for reimbursement of Long’s disproportionate payment. [Citations]
Attorneys’ Fees
Long sought to recover the attorney’s fees expended in defending the IKON claim, and attorney’s fees expended in the instant suit against Lopez. Testimony established that it was necessary for Long to employ an attorney to defend the action brought against the partnership by IKON; therefore, the attorney’s fees related to defending the IKON lawsuit on behalf of Wood Relo are a partnership debt for which Lopez is jointly and severally liable. As such, Long is entitled to recover from Lopez one-half of the attorney’s fees attributable to the IKON lawsuit. The evidence established that reasonable and necessary attorney’s fees to defend the IKON lawsuit were \$1725. Therefore, Long is entitled to recover from Lopez \$862.50.
Long also seeks to recover the attorney’s fees expended pursuing the instant lawsuit. See [Texas statute citation] (authorizing recovery of attorney’s fees in successful suit under an oral contract); see also [Citation] (holding attorney’s fees are recoverable by partner under because action against other partner was founded on partnership agreement, which was a contract). We agree that Long is entitled to recover reasonable and necessary attorney’s fees incurred in bringing the instant lawsuit. Because we are remanding this case so the trial court can determine the amount of pre- and post-judgment interest to be awarded to Long, we also remand to the trial court the issue of the amount of attorney’s fees due to Long in pursuing this lawsuit against Lopez for collection of the amount paid to IKON on behalf of the partnership.
Conclusion
We hold the trial court erred in determining that Long did not have authority to act for Wood Relo in defending, settling, and paying the partnership debt owed by Wood Relo to IKON. Lopez is jointly and severally liable to IKON for \$9,000, which represents the amount Long paid IKON to defend and extinguish the partnership debt. We hold that Lopez is jointly and severally liable to Long for \$1725, which represents the amount of attorney’s fees Long paid to defend against the IKON claim. We further hold that Long is entitled to recover from Lopez reasonable and necessary attorney’s fees in pursuing the instant lawsuit.
We reverse the judgment of the trial court. We render judgment that Lopez owes Long \$5362.50 (one-half of the partnership debt to IKON plus one-half of the corresponding attorney’s fees). We remand the case to the trial court for calculation of the amount of attorney’s fees owed by Lopez to Long in the instant lawsuit, and calculation of pre- and post-judgment interest.
Case Questions
1. Why did the trial court determine that Lopez owed Long nothing?
2. Absent a written partnership agreement, what rules control the operation and winding up of the partnership?
3. Why did the appeals court determine that Long did have authority to settle the lawsuit with IKON?
4. Lopez was not named by IKON when it sued Long and the partnership. Why did the court determine that did not matter, that Lopez was still liable for one-half the costs of settling that case?
5. Why was Long awarded compensation for the attorneys’ fees expended in dealing with the IKON matter and in bringing this case?
Dissolution under RUPA
Horizon/CMS Healthcare Corp. v. Southern Oaks Health Care, Inc.
732 So.2d 1156 (Fla. App. 1999)
Goshorn, J.
Horizon is a large, publicly traded provider of both nursing home facilities and management for nursing home facilities. It wanted to expand into Osceola County in 1993. Southern Oaks was already operating in Osceola County[.]…Horizon and Southern Oaks decided to form a partnership to own the proposed [new] facility, which was ultimately named Royal Oaks, and agreed that Horizon would manage both the Southern Oaks facility and the new Royal Oaks facility. To that end, Southern Oaks and Horizon entered into several partnership and management contracts in 1993.
In 1996, Southern Oaks filed suit alleging numerous defaults and breaches of the twenty-year agreements.…[T]he trial court found largely in favor of Southern Oaks, concluding that Horizon breached its obligations under two different partnership agreements [and that] Horizon had breached several management contracts. Thereafter, the court ordered that the partnerships be dissolved, finding that “the parties to the various agreements which are the subject of this lawsuit are now incapable of continuing to operate in business together” and that because it was dissolving the partnerships, “there is no entitlement to future damages.…” In its cross appeal, Southern Oaks asserts that because Horizon unilaterally and wrongfully sought dissolution of the partnerships, Southern Oaks should receive a damage award for the loss of the partnerships’ seventeen remaining years’ worth of future profits. We reject its argument.
Southern Oaks argues Horizon wrongfully caused the dissolution because the basis for dissolution cited by the court is not one of the grounds for which the parties contracted. The pertinent contracts provided in section 7.3 “Causes of Dissolution”: “In addition to the causes for dissolution set forth in Section 7.2(c), the Partnership shall be dissolved in the event that:…(d) upon thirty (30) days prior written notice to the other Partner, either Partner elects to dissolve the Partnership on account of an Irreconcilable Difference which arises and cannot, after good faith efforts, be resolved.…”
Southern Oaks argues that what Horizon relied on at trial as showing irreconcilable differences—the decisions of how profits were to be determined and divided—were not “good faith differences of opinion,” nor did they have “a material and adverse impact on the conduct of the Partnerships’ Business.” Horizon’s refusal to pay Southern Oaks according to the terms of the contracts was not an “irreconcilable difference” as defined by the contract, Southern Oaks asserts, pointing out that Horizon’s acts were held to be breaches of the contracts. Because there was no contract basis for dissolution, Horizon’s assertion of dissolution was wrongful, Southern Oaks concludes.
Southern Oaks contends further that not only were there no contractual grounds for dissolution, dissolution was also wrongful under the Florida Statutes. Southern Oaks argues that pursuant to section [of that statute] Horizon had the power to dissociate from the partnership, but, in the absence of contract grounds for the dissociation, Horizon wrongfully dissociated. It asserts that it is entitled to lost future profits under Florida’s partnership law.…
We find Southern Oaks’ argument without merit. First, the trial court’s finding that the parties are incapable of continuing to operate in business together is a finding of “irreconcilable differences,” a permissible reason for dissolving the partnerships under the express terms of the partnership agreements. Thus, dissolution was not “wrongful,” assuming there can be “wrongful” dissolutions, and Southern Oaks was not entitled to damages for lost future profits. Additionally, the partnership contracts also permit dissolution by “judicial decree.” Although neither party cites this provision, it appears that pursuant thereto, the parties agreed that dissolution would be proper if done by a trial court for whatever reason the court found sufficient to warrant dissolution.
Second, even assuming the partnership was dissolved for a reason not provided for in the partnership agreements, damages were properly denied. Under RUPA, it is clear that wrongful dissociation triggers liability for lost future profits. See [RUPA:] “A partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation. The liability is in addition to any other obligation of the partner to the partnership or to the other partners.” However, RUPA does not contain a similar provision for dissolution; RUPA does not refer to the dissolutions as rightful or wrongful. [RUPA sets out] “Events causing dissolution and winding up of partnership business,” [and] outlines the events causing dissolution without any provision for liability for damages.…[RUPA] recognizes judicial dissolution:
A partnership is dissolved, and its business must be wound up, only upon the occurrence of any of the following events:…
(5) On application by a partner, a judicial determination that:
(a) The economic purpose of the partnership is likely to be unreasonably frustrated;
(b) Another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with such partner; or
(c) It is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement[.]…
Paragraph (5)(c) provides the basis for the trial court’s dissolution in this case. While “reasonably practicable” is not defined in RUPA, the term is broad enough to encompass the inability of partners to continue working together, which is what the court found.
Certainly the law predating RUPA allowed for recovery of lost profits upon the wrongful dissolution of a partnership. See e.g., [Citation]: “A partner who assumes to dissolve the partnership before the end of the term agreed on in the partnership articles is liable, in an action at law against him by his co-partner for the breach of the agreement, to respond in damages for the value of the profits which the plaintiff would otherwise have received.”
However, RUPA brought significant changes to partnership law, among which was the adoption of the term “dissociation.” Although the term is undefined in RUPA, dissociation appears to have taken the place of “dissolution” as that word was used pre-RUPA. “Dissolution” under RUPA has a different meaning, although the term is undefined in RUPA. It follows that the pre-RUPA cases providing for future damages upon wrongful dissolution are no longer applicable to a partnership dissolution. In other words a “wrongful dissolution” referred to in the pre-RUPA case law is now, under RUPA, known as “wrongful dissociation.” Simply stated, under [RUPA], only when a partner dissociates and the dissociation is wrongful can the remaining partners sue for damages. When a partnership is dissolved, RUPA…provides the parameters of liability of the partners upon dissolution.…
[Citation]: “Dissociation is not a condition precedent to dissolution.…Most dissolution events are dissociations. On the other hand, it is not necessary to have a dissociation to cause a dissolution and winding up.”
Southern Oaks’ attempt to bring the instant dissolution under the statute applicable to dissociation is rejected. The trial court ordered dissolution of the partnership, not the dissociation of Horizon for wrongful conduct. There no longer appears to be “wrongful” dissolution—either dissolution is provided for by contract or statute or the dissolution was improper and the dissolution order should be reversed. In the instant case, because the dissolution either came within the terms of the partnership agreements or [RUPA] (judicial dissolution where it is not reasonably practicable to carry on the partnership business), Southern Oaks’ claim for lost future profits is without merit. Affirmed.
Case Questions
1. Under RUPA, what is a dissociation? What is a dissolution?
2. Why did Southern Oaks claim there was no contractual basis for dissolution, notwithstanding the determination that Horizon had breached the partnership agreement and the management contract?
3. Given those findings, what did Southern Oaks not get at the lower-court trial that it wanted on this appeal?
4. Why didn’t Southern Oaks get what it wanted on this appeal? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/19%3A_Partnership_Operation_and_Termination/19.05%3A_Cases.txt |
Summary
Most of the Uniform Partnership Act (UPA) and Revised Uniform Partnership Act (RUPA) rules apply only in the absence of agreement among the partners. Under both, unless the agreement states otherwise, partners have certain duties: (1) the duty to serve—that is, to devote themselves to the work of the partnership; (2) the duty of loyalty, which is informed by the fiduciary standard: the obligation to act always in the best interest of the partnership and not in one’s own best interest; (3) the duty of care—that is, to act as a reasonably prudent partner would; (4) the duty of obedience not to breach any aspect of the agreement or act without authority; (5) the duty to inform copartners; and (6) the duty to account to the partnership. Ordinarily, partners operate through majority vote, but no act that contravenes the partnership agreement itself can be undertaken without unanimous consent.
Partners’ rights include rights (1) to distributions of money, including profits (and losses) as per the agreement or equally, indemnification, and return of capital contribution (but not a right to compensation); (2) to management as per the agreement or equally; (3) to choose copartners; (4) to property of the partnership, but no partner has any rights to specific property (under UPA the partners own property as tenants in partnership; under RUPA the partnership as entity owns property, but it will be distributed upon liquidation); (5) to assign (voluntarily or involuntarily) the partnership interest; the assignee does not become a partner or have any management rights, but a judgment creditor may obtain a charging order against the partnership; and (6) to enforce duties and rights by suits in law or equity (under RUPA a formal accounting is not required).
Under UPA, a change in the relation of the partners dissolves the partnership but does not necessarily wind up the business. Dissolution may be voluntary, by violation of the agreement, by operation of law, or by court order. Dissolution terminates the authority of the partners to act for the partnership. After dissolution, a new partnership may be formed.
Under RUPA, a change in the relation of the partners is a dissociation, leaving the remaining partners with two options: continue on; or wind up, dissolve, and terminate. In most cases, a partnership may buy out the interest of a partner who leaves without dissolving the partnership. A term partnership also will not dissolve so long as at least one-half of the partners choose to remain. When a partner’s dissociation triggers dissolution, partners are allowed to vote subsequently to continue the partnership.
When a dissolved partnership is carried on as a new one, creditors of the old partnership remain creditors of the new one. A former partner remains liable to the creditors of the former partnership. A new partner is liable to the creditors of the former partnership, bur only to the extent of the new partner’s capital contribution. A former partner remains liable for debts incurred after his withdrawal unless he gives proper notice of his withdrawal; his actual authority terminates upon dissociation and apparent authority after two years.
If the firm is to be terminated, it is wound up. The assets of the partnership include all required contributions of partners, and from the assets liabilities are paid off (1) to creditors and (2) to partners on their accounts. Under RUPA, nonpartnership creditors share equally with unsatisfied partnership creditors in the personal assets of their debtor-partners.
Exercises
1. Anne and Barbara form a partnership. Their agreement specifies that Anne will receive two-thirds of the profit and Barbara will get one-third. The firm suffers a loss of \$3,000 the first year. How are the losses divided?
2. Two lawyers, Glenwood and Higgins, formed a partnership. Glenwood failed to file Client’s paperwork on time in a case, with adverse financial consequences to Client. Is Higgins liable for Glenwood’s malpractice?
3. When Client in Exercise 2 visited the firm’s offices to demand compensation from Glenwood, the two got into an argument. Glenwood became very agitated; in an apparent state of rage, he threw a law book at Client, breaking her nose. Is Higgins liable?
4. Assume Glenwood from Exercise 2 entered into a contract on behalf of the firm to buy five computer games. Is Higgins liable?
5. Grosberg and Goldman operated the Chatham Fox Hills Shopping Center as partners. They agreed that Goldman would deposit the tenants’ rental checks in an account in Grosberg’s name at First Bank. Without Grosberg’s knowledge or permission, Goldman opened an account in both their names at Second Bank, into which Goldman deposited checks payable to the firm or the partners. He indorsed each check by signing the name of the partnership or the partners. Subsequently, Goldman embezzled over \$100,000 of the funds. Second Bank did not know Grosberg and Goldman were partners. Grosberg then sued Second Bank for converting the funds by accepting checks on which Grosberg’s or the partnership’s indorsement was forged. Is Second Bank liable? Discuss.
6. Pearson Collings, a partner in a criminal defense consulting firm, used the firm’s phones and computers to operate a side business cleaning carpets. The partnership received no compensation for the use of its equipment. What claim would the other partners have against Collings?
7. Follis, Graham, and Hawthorne have a general partnership, each agreeing to split losses 20 percent, 20 percent, and 60 percent, respectively. While on partnership business, Follis negligently crashes into a victim, causing \$100,000 in damages. Follis declares bankruptcy, and the firm’s assets are inadequate to pay the damages. Graham says she is liable for only \$20,000 of the obligation, as per the agreement. Is she correct?
8. Ingersoll and Jackson are partners; Kelly, after much negotiation, agreed to join the firm effective February 1. But on January 15, Kelly changed his mind. Meanwhile, however, the other two had already arranged for the local newspaper to run a notice that Kelly was joining the firm. The notice ran on February 1. Kelly did nothing in response. On February 2, Creditor, having seen the newspaper notice, extended credit to the firm. When the firm did not pay, Creditor sought to have Kelly held liable as a partner. Is Kelly liable?
SELF CHECK QUESTIONS
1. Under UPA, a partner is generally entitled to a formal accounting of partnership affairs
1. whenever it is just and reasonable
2. if a partner is wrongfully excluded from the business by copartners
3. if the right exists in the partnership agreement
4. all of the above
2. Donners, Inc., a partner in CDE Partnership, applies to Bank to secure a loan and assigns to Bank its partnership interest. After the assignment, which is true?
1. Bank steps into Donners’s shoes as a partner.
2. Bank does not become a partner but has the right to participate in the management of the firm to protect its security interest until the loan is paid.
3. Bank is entitled to Donners’s share of the firm’s profits.
4. Bank is liable for Donners’s share of the firm’s losses.
5. None of these is true.
3. Which of these requires unanimous consent of the partners in a general partnership?
1. the assignment of a partnership interest
2. the acquisition of a partnership debt
3. agreement to be responsible for the tort of one copartner
4. admission of a new partner
5. agreement that the partnership should stand as a surety for a third party’s obligation
4. Paul Partner (1) bought a computer and charged it to the partnership’s account; (2) cashed a firm check and used the money to buy a computer in his own name; (3) brought from home a computer and used it at the office. In which scenario does the computer become partnership property?
1. 1 only
2. 1 and 2
3. 1, 2, and 3
5. That partnerships are entities under RUPA means they have to pay federal income tax in their own name.
1. true
2. false
6. That partnerships are entities under RUPA means the partners are not personally liable for the firm’s debts beyond their capital contributions.
1. true
2. false
1. d
2. c
3. d
4. b
5. a
6. b | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/19%3A_Partnership_Operation_and_Termination/19.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The limited partnership
• The limited liability company
• Other hybrid business forms: the sub-S corporation, limited liability partnerships, and limited liability limited partnerships
This chapter provides a bridge between the partnership and the corporate form. It explores several types of associations that are hybrid forms—that is, they share some aspects of partnerships and some of corporations. Corporations afford the inestimable benefit of limited liability, partnerships the inestimable benefit of limited taxation. Businesspeople always seek to limit their risk and their taxation.
20: Hybrid Business Forms
At base, whether to allow businesspeople and investors to grasp the holy grail of limited liability is a political issue. When we say a person is “irresponsible,” it means he (or she, or it) does not take responsibility for his harmful actions; the loss is borne by others. Politically speaking, there is an incentive to allow businesspeople insulation from liability: it encourages them to take risks and invest, thus stimulating economic activity and forestalling unemployment. So the political trade-off with allowing various inventive forms of business organization is between providing business actors with the security that they will lose only their calculable investment, thus stimulating the economy, versus the “moral hazard” of allowing them to emerge mostly unscathed from their own harmful or foolish activities, thus externalizing resulting losses upon others. Some people feel that during the run-up to the “Great Recession” of 2007–09, the economic system allowed too much risk taking. When the risky investments collapsed, though, instead of forcing the risk takers to suffer loss, the government intervened—it “bailed them out,” as they say, putting the consequences of the failed risks on the taxpayer.
The risk-averseness and inventiveness of businesspeople is seemingly unlimited, as is investors’ urge to make profits through others’ efforts with as little risk as possible. The rationale for the invention of these hybrid business forms, then, is (1) risk reduction and (2) tax reduction. Here we take up the most common hybrid types first: limited partnerships and limited liability companies. Then we cover them in the approximate chronological order of their invention: sub-S corporations, limited liability partnerships, and limited liability limited partnerships. All these forms are entities.
20.02: Limited Partnerships
Learning Objectives
By the end of this section, you will be able to:
• Governing law and definition
• Creation and capitalization
• Control and compensation
• Liabilities
• Taxation
• Termination
Governing Law and Definition
The limited partnership is attractive because of its treatment of taxation and its imposition of limited liability on its limited partners.
Governing Law
The original source of limited partnership law is the Uniform Limited Partnership Act (ULPA), which was drafted in 1916. A revised version, the Revised Uniform Limited Partnership Act (RULPA), was adopted by the National Conference of Commissioners on Uniform Laws in 1976 and further amended in 1985 and in 2001.
The 2001 act was drafted for a world in which limited liability partnerships and limited liability companies can meet many of the needs formerly met by limited partnerships. This Act therefore targets two types of enterprises that seem largely beyond the scope of LLPs and LLCs: (i) sophisticated, manager-entrenched commercial deals whose participants commit for the long term, and (ii) estate planning arrangements (family limited partnerships). The Act accordingly assumes that, more often than not, people utilizing it will want (1) strong centralized management, strongly entrenched, and (2) passive investors with little control over or right to exit the entity. The Act’s rules, and particularly its default rules, have been designed to reflect these assumptions.“Uniform Limited Partnership Act (2001), Prefatory Note,” NCCUSL Archives, www.law.upenn.edu/bll/archives/ulc/ulpa/final2001.pdf.
All states except Louisiana adopted the 1976 or 1985 act—most opting for the 1985 version—and sixteen states have adopted the 2001 version. The acts may be properly referred to with a hyphen: “ULPA-1985,” or “ULPA-2001”; the word revised has been dropped. Here, we mainly discuss ULPA-1985. The Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act (RUPA) also applies to limited partnerships except where it is inconsistent with the limited partnership statutes. The ULPA-2001 is not so much related to UPA or RUPA as previous versions were.
Definition
A limited partnership (LP) is defined as “a partnership formed by two or more persons under the laws of a State and having one or more general partners and one or more limited partners.”ULPA, Section 102(11). The form tends to be attractive in business situations that focus on a single or limited-term project, such as making a movie or developing real estate; it is also widely used by private equity firms.
Creation and Capitalization
Unlike a general partnership, a limited partnership is created in accordance with the state statute authorizing it. There are two categories of partners: limited and general. The limited partners capitalize the business and the general partners run it.
Creation
The act requires that the firm’s promoters file a certificate of limited partnership with the secretary of state; if they do not, or if the certificate is substantially defective, a general partnership is created. The certificate must be signed by all general partners. It must include the name of the limited partnership (which must include the words limited partnership so the world knows there are owners of the firm who are not liable beyond their contribution) and the names and business addresses of the general partners. If there are any changes in the general partners, the certificate must be amended. The general partner may be, and often is, a corporation. Having a general partner be a corporation achieves the goal of limited liability for everyone, but it is somewhat of a “clunky” arrangement. That problem is obviated in the limited liability company, discussed in Section 20.2. Here is an example of a limited partnership operating agreement: http://www.wyopa.com/Articles%20of%20limited%20partnership.htm.
Any natural person, partnership, limited partnership (domestic or foreign), trust, estate, association, or corporation may become a partner of a limited partnership.
Capitalization
The money to capitalize the business typically comes mostly from the limited partners, who may themselves be partnerships or corporations. That is, the limited partners use the business as an investment device: they hope the managers of the firm (the general partners) will take their contributions and give them a positive return on it. The contributions may be money, services, or property, or promises to make such contributions in the future.
Control and Compensation
Control
Control is not generally shared by both classes of partners.
General Partners
The control of the limited partnership is in the hands of the general partners, which may—as noted—be partnerships or corporations.
Limited Partners
Under ULPA-1985 and its predecessors, a limited partner who exercised any significant control would incur liability like a general partner as to third parties who believed she was one (the “control rule”). However, among the things a limited partner could do that would not risk the loss of insulation from personal liability were these “safe harbors”:
• Acting as an agent, employee, or contractor for the firm; or being an officer, director, or shareholder of a corporate general partner
• Consulting with the general partner of the firm
• Requesting or attending a meeting of partners
• Being a surety for the firm
• Voting on amendments to the agreement, on dissolution or winding up the partnership, on loans to the partnership, on a change in its nature of business, on removing or admitting a general or limited partner
However, see Section 20.3.3 “Limited Liability Limited Partnerships” for how this “control rule” has been abolished under ULPA-2001.
General partners owe fiduciary duties to other general partners, the firm, and the limited partners; limited partners who do not exercise control do not owe fiduciary duties. See Figure 20.1.
The partnership agreement may specify which general or limited partners have the right to vote on any matter, but if the agreement grants limited partners voting rights beyond the “safe harbor,” a court may abolish that partner’s limited liability.
Assignment of Partnership Rights
Limited partnership interests may be assigned in whole or in part; if in whole, the assignor ceases to be a partner unless otherwise agreed. An assignment is usually made as security for a loan. The assignee becomes a new limited partner only if all the others consent or if provided for in the certificate; the assignment does not cause dissolution. The happy ease with which a limited partner can divest himself of the partnership interest makes the investment in the firm here more like that in a corporation than in a general partnership.
Inspection of Books
Limited partners have the right to inspect the firm’s books and records, they may own competing interests, they may be creditors of the firm, and they may bring derivative suits on the firm’s behalf. They may not withdraw their capital contribution if that would impair creditors’ rights.
Addition of New Partners
Unless the partnership agreement provides otherwise (it usually does), the admission of additional limited partners requires the written consent of all. A general partner may withdraw at any time with written notice; if withdrawal is a violation of the agreement, the limited partnership has a right to claim of damages. A limited partner can withdraw any time after six months’ notice to each general partner, and the withdrawing partner is entitled to any distribution as per the agreement or, if none, to the fair value of the interest based on the right to share in distributions.
Compensation
We noted in discussing partnerships that the partners are not entitled to “compensation,” that is, payment for their work; they are entitled to a share of the profits. For limited partnerships, the rule is a bit different.
General Partners
Often, general partners are paid for their management work on a sliding scale, receiving a greater share of each dollar of cash flow as the limited partners’ cash distributions rise, thus giving the general partner an incentive to increase limited-partner distributions.
Limited Partners
Profits or losses are shared as agreed in the certificate or, if there is no agreement, in accordance with the percentages of capital contributions made.
Liabilities
Liability is not shared.
General Partners
The general partners are liable as in a general partnership, and they have the same fiduciary duty and duty of care as partners in a general partnership. However, see the discussion in Section 20.3.3 “Limited Liability Limited Partnerships” of the newest type of LP, the limited liability limited partnership (triple LP), where the general partner is also afforded limited liability under ULPA-2001.
Limited Partners
The limited partners are only liable up to the amount of their capital contribution, provided the surname of the limited partner does not appear in the partnership name (unless his name is coincidentally the same as that of one of the general partners whose name does appear) and provided the limited partner does not participate in control of the firm. See Section 20.4.1 “Limited Partnerships: Limited Partners’ Liability for Managing Limited Partnership” for a case that highlights liability issues for partners.
We have been discussing ULPA-1985 here. But in a world of limited liability companies, limited liability partnerships, and limited liability limited partnerships, “the control rule has become an anachronism”; ULPA-2001 “provides a full, status-based liability shield for each limited partner, ‘even if the limited partner participates in the management and control of the limited partnership.’ULPA-2001, Section 303. The section thus eliminates the so-called control rule with respect to personal liability for entity obligations and brings limited partners into parity with LLC members, LLP partners and corporate shareholders.”Official Comment to Uniform Limited Partnership Act 2001, Section 303. And as will be noted in Section 20.3.3 “Limited Liability Limited Partnerships” under ULPA-2001 the general partner is also shielded from liability.
Taxation
Assuming the limited partnership meets a minimum number of criteria related to limited liability, centralized management, duration, and transferability of ownership, it can enjoy the benefits of pass-through taxation; otherwise it will be taxed as a corporation. Pass-through (“conduit”) taxation is usually very important to partners.
Termination
The limited partnership’s termination involves the same three steps as in a general partnership: (1) dissolution, (2) winding up, and (3) termination.
Dissolution
Dissolution of a limited partnership is the first step toward termination (but termination does not necessarily follow dissolution). The limited partners have no power to dissolve the firm except on court order, and the death or bankruptcy of a limited partner does not dissolve the firm. The following events may cause dissolution: (1) termination of the partnership as per the certificate’s provisions; (2) termination upon an event specified in the partnership agreement; (3) the unanimous written consent of the partners; (4) the withdrawal of a general partner, unless at least one remains and the agreement says one is enough, or if within ninety days all partners agree to continue; (5) an event that causes the business to be illegal; and (6) judicial decree of dissolution when it is not reasonable to carry on. If the agreement has no term, its dissolution is not triggered by some agreed-to event, and none of the other things listed cause dissolution.
Dissolution requires the filing of a certificate of cancellation with the state if winding up commences.
Winding Up
General partners who have not wrongfully dissolved the partnership may wind it up, and so may the limited partners if all the general partners have wrongfully dissolved the firm. Any partner or that person’s legal representative can petition a court for winding up, with cause.
Upon winding up, the assets are distributed (1) to creditors, including creditor-partners, not including liabilities for distributions of profit; (2) to partners and ex-partners to pay off unpaid distributions; (3) to partners as return of capital contributions, unless otherwise agreed; and (4) to partners for partnership interests in proportion as they share in distributions, unless otherwise agreed. No distinction is made between general and limited partners—they share equally, unless otherwise agreed. When winding up is completed, the firm is terminated.
It is worth reiterating the part about “unless otherwise agreed”: people who form any kind of a business organization—partnership, a hybrid form, or corporations—can to a large extent choose to structure their relationship as they see fit. Any aspect of the company’s formation, operation, or ending that is not included in an agreement flops into the default provisions of the relevant law.
Key Takeaway
A limited partnership is a creature of statute: it requires filing a certificate with the state because it confers on some of its members the marvel of limited liability. It is an investment device composed of one or more general partners and one or more limited partners; limited partners may leave with six months’ notice and are entitled to an appropriate payout. The general partner is liable as a partner is a general partnership; the limited partners’ liability is limited to the loss of their investment, unless they exercise so much control of the firm as to become general partners. The general partner is paid, and the general and limited partners split profit as per the agreement or, if none, in the proportion as they made capital contributions. The firm is usually taxed like a general partnership: it is a conduit for the partners’ income. The firm is dissolved upon the end of its term, upon an event specified in the agreement, or in several other circumstances, but it may have indefinite existence.
Exercises
1. Why does the fact that the limited liability company provides limited liability for some of its members mean that a state certificate must be filed?
2. What liability has the general partner? The limited partner?
3. How easy is it for the limited partner to dispose of (sell) her partnership interest? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/20%3A_Hybrid_Business_Forms/20.01%3A_Introduction_to_Hybrid_Business_Forms.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the history and law governing limited liability companies (LLCs).
• Identify the creation and capitalization of an LLC.
• Understand control and compensation of a firm.
• Recognize liabilities in the LLC form.
• Explain the taxation of an LLC.
• Identify how LLCs are terminated.
History and Law Governing Limited Liability Companies
History of the Limited Liability Company
The limited liability company (LLC) gained sweeping popularity in the late twentieth century because it combines the best aspects of partnership and the best aspects of corporations: it allows all its owners (members) insulation from personal liability and pass-through (conduit) taxation. The first efforts to form LLCs were thwarted by IRS rulings that the business form was too much like a corporation to escape corporate tax complications. Tinkering by promoters of the LLC concept and flexibility by the IRS solved those problems in interesting and creative ways.
Corporations have six characteristics: (1) associates, (2) an objective to carry on a business and divide the gains, (3) continuity of life, (4) centralized management, (5) limited liability, and (6) free transferability of interests. Partnerships also, necessarily, have the first two corporate characteristics; under IRS rulings, if the LLC is not to be considered a corporation for tax purposes, it must lack at least one-half of the remaining four characteristics of a corporation: the LLC, then, must lack two of these corporate characteristics (otherwise it will be considered a corporation): (1) limited liability, (2) centralized management, (3) continuity of life, or (4) free transferability of interests. But limited liability is essential and centralized management is necessary for passive investors who don’t want to be involved in decision making, so pass-through taxation usually hinges on whether an LLC has continuity of life and free transferability of accounts. Thus it is extremely important that the LLC promoters avoid the corporate characteristics of continuity of life and free transferability of interests.
We will see how the LLC can finesse these issues.
Governing Law
All states have statutes allowing the creation of LLCs, and while a Uniform Limited Liability Company Act has been promulgated, only eight states have adopted it as of January 2011. That said, the LLC has become the entity of choice for many businesses.
Creation and Capitalization
Creation of the LLC
An LLC is created according to the statute of the state in which it is formed. It is required that the LLC members file a “certificate of organization” with the secretary of state, and the name must indicate that it is a limited liability company. Partnerships and limited partnerships may convert to LLCs; the partners’ previous liability under the other organizational forms is not affected, but going forward, limited liability is provided. The members’ operating agreement spells out how the business will be run; it is subordinate to state and federal law. Unless otherwise agreed, the operating agreement can be amended only by unanimous vote. The LLC is an entity. Foreign LLCs must register with the secretary of state before doing business in a “foreign” state, or they cannot sue in state courts.
As compared with corporations, the LLC is not a good form if the owners expect to have multiple investors or to raise money from the public. The typical LLC has relatively few members (six or seven at most), all of whom usually are engaged in running the firm.
Most early LLC statutes, at least, prohibited their use by professionals. That is, practitioners who need professional licenses, such as certified public accountants, lawyers, doctors, architects, chiropractors, and the like, could not use this form because of concern about what would happen to the standards of practice if such people could avoid legitimate malpractice claims. For that reason, the limited liability partnership was invented.
Capitalization
Capitalization is like a partnership: members contribute capital to the firm according to their agreement. As in a partnership, the LLC property is not specific to any member, but each has a personal property interest in general. Contributions may be in the form of cash, property or services rendered, or a promise to render them in the future.
Control and Compensation
Control
The LLC operating agreement may provide for either a member-managed LLC or a manager-managed (centralized) LLC. If the former, all members have actual and apparent authority to bind the LLC to contracts on its behalf, as in a partnership, and all members’ votes have equal weight unless otherwise agreed. Member-managers have duty of care and a fiduciary duty, though the parameters of those duties vary from state to state. If the firm is manager managed, only managers have authority to bind the firm; the managers have the duty of care and fiduciary duty, but the nonmanager members usually do not. Some states’ statutes provide that voting is based on the financial interests of the members. Most statutes provide that any extraordinary firm decisions be voted on by all members (e.g., amend the agreement, admit new members, sell all the assets prior to dissolution, merge with another entity). Members can make their own rules without the structural requirements (e.g., voting rights, notice, quorum, approval of major decisions) imposed under state corporate law.
If the firm has a centralized manager system, it gets a check in its “corporate-like” box, so it will need to make sure there are enough noncorporate-like attributes to make up for this one. If it looks too much like a corporation, it will be taxed like one.
One of the real benefits of the LLC as compared with the corporation is that no annual meetings are required, and no minutes need to be kept. Often, owners of small corporations ignore these formalities to their peril, but with the LLC there are no worries about such record keeping.
Compensation
Distributions are allocated among members of an LLC according to the operating agreement; managing partners may be paid for their services. Absent an agreement, distributions are allocated among members in proportion to the values of contributions made by them or required to be made by them. Upon a member’s dissociation that does not cause dissolution, a dissociating member has the right to distribution as provided in the agreement, or—if no agreement—the right to receive the fair value of the member’s interest within a reasonable time after dissociation. No distributions are allowed if making them would cause the LLC to become insolvent.
Liability
The great accomplishment of the LLC is, again, to achieve limited liability for all its members: no general partner hangs out with liability exposure.
Liability to Outsiders
Members are not liable to third parties for contracts made by the firm or for torts committed in the scope of business (but of course a person is always liable for her own torts), regardless of the owner’s level of participation—unlike a limited partnership, where the general partner is liable. Third parties’ only recourse is as against the firm’s property. See Puleo v. Topel, (see Section 20.4.2 “Liability Issues in LLCs”), for an analysis of owner liability in an LLC.
Internal Liabilities
Unless the operating agreement provides otherwise, members and managers of the LLC are generally not liable to the firm or its members except for acts or omissions constituting gross negligence, intentional misconduct, or knowing violations of the law. Members and managers, though, must account to the firm for any personal profit or benefit derived from activities not consented to by a majority of disinterested members or managers from the conduct of the firm’s business or member’s or managers use of firm property—which is the same as in partnership law.
Taxation
Assuming the LLC is properly formed so that it is not too much like a corporation, it will—upon its members’ election—be treated like a partnership for tax purposes.
Termination
Termination, loosely speaking, refers either to how the entity’s life as a business ends (continuity of life) or to how a member’s interest in the firm ends—that is, how freely the interest is transferable.
Continuity of Life
The first step in the termination of the LLC is dissolution, though dissolution is not necessarily followed by termination.
Dissolution and Winding Up
The IRS has determined that continuity of life does not exist “if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will cause a dissolution of the organization,”Treasury Regulation, § 301.7701-2(b)(1). and that if one of these events occurs, the entity may continue only with the members’ unanimous consent. Dissolution may occur even if the business is continued by the remaining members.
The typical LLC statute provides that an LLC will dissolve upon (1) expiration of the LLC’s term as per its agreement; (2) events specified in the agreement; (3) written consent of all members; (4) an “event of dissociation” of a member, unless within ninety days of the event all remaining members agree to continue, or the right to continue is stated in the LLC; (5) the entry of a judicial decree of dissolution; (6) a change in membership that results in there being fewer than two members; or (7) the expiration of two years after the effective date of administrative dissolution.
And an “event of dissociation” is typically defined as (1) a member’s voluntary withdrawal, (2) her assignment of the entire LLC interest, (3) her expulsion, (4) her bankruptcy, (5) her becoming incompetent, (6) dissolution of an entity member (as an LLC, limited partnership, or corporation), or (7) any other event specified in the agreement.
Thus under most statutes’ default position, if a member dies, becomes insane or bankrupt, retires, resigns, or is expelled, the LLC will dissolve unless within ninety days the rest of the members unanimously agree to continue. And by this means the firm does not have continuity of life. Some states provide opportunities for even more flexibility regarding the “unanimous” part. In the mid-1990s, the IRS issued revenue rulings (as opposed to regulations) that it would be enough if a “majority in interest” of remaining partners agreed to continue the business, and the “flexible” statute states adopted this possibility (the ones that did not are called “bulletproof” statutes). “Majority in interests” means a majority of profits and capital.
If the firm does dissolve, some states require public filings to that effect. If dissolution leads to winding up, things progress as in a general partnership: the business at hand is finished, accounts are rendered, bills paid, assets liquidated, and remaining assets are distributed to creditors (including member and manager creditors, but not for their shares in profits); to members and past members for unpaid distributions; to members for capital contributions; and to members as agreed or in proportion to contributions made. Upon dissolution, actual authority of members or managers terminates except as needed to wind up; members may have apparent authority, though, unless the third party had notice of the dissolution.
Free Transferability of Interest
Again, the problem here is that if a member’s interest in the LLC is as freely transferable as a shareholder’s interest in a corporation (an owner can transfer all attributes of his interest without the others’ consent), the LLC will probably be said to have a check mark in the “corporate-like” box: too many of those and the firm will not be allowed pass-through taxation. Thus the trick for the LLC promoters is to limit free transferability enough to pass the test of not being a corporation, but not limit so much as to make it really difficult to divest oneself of the interest (then it’s not a very liquid or desirable investment).
Some states’ LLC statutes have as the default rule that the remaining members must unanimously consent to allow an assignee or a transferee of a membership interest to participate in managing the LLC. Since this prevents a member from transferring all attributes of the interest (the right to participate in management isn’t transferred or assigned), the LLC formed under the default provision will not have “free transferability of interest.” But if the LLC agreement allows majority consent for the transfer of all attributes, that also would satisfy the requirement that there not be free transferability of interests. Then we get into the question of how to define “majority”: by number of members or by value of their membership? And what if only the managing partners need to consent? Or if there are two classes of membership and the transfer of interests in one class requires the consent of the other? The point is that people keep pushing the boundaries to see how close their LLC can come to corporation-like status without being called a corporation.
Statutes for LLCs allow other business entities to convert to this form upon application.
Key Takeaway
The limited liability company has become the entity of choice for many businesspeople. It is created by state authority that, upon application, issues the “certificate of organization.” It is controlled either by managers or by members, it affords its members limited liability, and it is taxed like a partnership. But these happy results are obtained only if the firm lacks enough corporate attributes to escape being labeled as a corporation. To avoid too much “corporateness,” the firm’s certificate usually limits its continuity of life and the free transferability of interest. The ongoing game is to finesse these limits: to make them as nonconstraining as possible, to get right up to the line to preserve continuity, and to make the interest as freely transferable as possible.
Exercises
1. What are the six attributes of a corporation? Which are automatically relevant to the LLC? Which two corporate attributes are usually dropped in an LLC?
2. Why does the LLC not want to be treated like a corporation?
3. Why does the name of the LLC have to include an indication that it is an LLC?
4. How did LLCs finesse the requirement that they not allow too-free transferability of the interest? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/20%3A_Hybrid_Business_Forms/20.03%3A_Limited_Liability_Companies.txt |
Learning Objectives
By the end of this section, you will be able to:
• Recognize other business forms: sub-S corporations, limited liability partnerships, and limited liability limited partnerships.
Sub-S Corporation
History
The sub-S corporation or the S corporation gets its name from the IRS Code, Chapter 1, Subchapter S. It was authorized by Congress in 1958 to help small corporations and to stem the economic and cultural influence of the relatively few, but increasingly powerful, huge multinational corporations. According to the website of an S corporation champion, “a half century later, S corporations are the most popular corporate structure in America. The IRS estimates that there were 4.5 million S corporation owners in the United States in 2007—about twice the number of C [standard] corporations.”“The History and Challenges of America’s Dominant Business Structure,” S Corp: Defending America’s Small and Family-Owned Businesses, http://www.s-corp.org/our-history.
Creation and Capitalization
The S corporation is a regular corporation created upon application to the appropriate secretary of state’s office and operated according to its bylaws and shareholders’ agreements. There are, however, some limits on how the business is set up, among them the following:
• It must be incorporated in the United States.
• It cannot have more than one hundred shareholders (a married couple counts as one shareholder).
• The only shareholders are individuals, estates, certain exempt organizations, or certain trusts.
• Only US citizens and resident aliens may be shareholders.
• The corporation has only one class of stock.
• With some exceptions, it cannot be a bank, thrift institution, or insurance company.
• All shareholders must consent to the S corporation election.
• It is capitalized as is a regular corporation.
Liability
The owners of the S corporation have limited liability.
Taxation
Taxation is the crux of the matter. The S corporation pays no corporate income tax (unless it has a lot of passive income). The S corporation’s shareholders include on their personal income statements, and pay tax on, their share of the corporation’s separately stated items of income, deduction, and loss. That is, the S corporation avoids the dreaded double taxation of corporate income.
Transferability of Ownership
S corporations’ shares can be bought or sold via share purchase agreements, and all changes in the ownership are reflected in the share ledger in the corporate minute book.
Limited Liability Partnerships
Background
In 1991, Texas enacted the first limited liability partnership (LLP) statute, largely in response to the liability that had been imposed on partners in partnerships sued by government agencies in relation to massive savings and loan failures in the 1980s.Christine M. Przybysz, “Shielded Beyond State Limits: Examining Conflict-Of-Law Issues In Limited Liability Partnerships,” Case Western Reserve Law Review 54, no. 2 (2003): 605. (Here we see an example of the legislature allowing business owners to externalize the risks of business operation.) More broadly, the success of the limited liability company attracted the attention of professionals like accountants, lawyers, and doctors who sought insulation from personal liability for the mistakes or malpractice of their partners. Their wish was granted with the adoption in all states of statutes authorizing the creation of the limited liability partnership in the early 1990s. Most partnership law under the Revised Uniform Partnership Act applies to LLPs.
Creation
Members of a partnership (only a majority is required) who want to form an LLP must file with the secretary of state; the name of the firm must include “limited liability partnership” or “LLP” to notify the public that its members will not stand personally for the firm’s liabilities.
Liability
As noted, the purpose of the LLP form of business is to afford insulation from liability for its members. A typical statute provides as follows: “Any obligation of a partnership incurred while the partnership is a limited liability partnership, whether arising in contract, tort or otherwise, is solely the obligation of the partnership. A partner is not personally liable, directly or indirectly, by way of indemnification, contribution, assessment or otherwise, for such an obligation solely by reason of being or so acting as a partner.”Revised Code of Washington (RCW), Section 25.05.130.
However, the statutes vary. The early ones only allowed limited liability for negligent acts and retained unlimited liability for other acts, such as malpractice, misconduct, or wrongful acts by partners, employees, or agents. The second wave eliminated all these as grounds for unlimited liability, leaving only breaches of ordinary contract obligation. These two types of legislation are called partial shield statutes. The third wave of LLP legislation offered full shield protection—no unlimited liability at all. Needless to say, the full-shield type has been most popular and most widely adopted. Still, however, many statutes require specified amounts of professional malpractice insurance, and partners remain fully liable for their own negligence or for wrongful acts of those in the LLP whom they supervise.
In other respects, the LLP is like a partnership.
Limited Liability Limited Partnerships
The progress toward achieving limited liability continues. A limited liability limited partnership (LLLP, or triple LP) is the latest invention. It is a limited partnership that has invoked the LLLP provisions of its state partnership law by filing with a specified public official the appropriate documentation to become an LLLP. This form completely eliminates the automatic personal liability of the general partner for partnership obligations and, under most statutes, also eliminates the “control rule” liability exposure for all limited partners. It is noteworthy that California law does not allow for an LLLP to be formed in California; however, it does recognize LLLPs formed in other states. A “foreign” LLLP doing business in California must register with the secretary of state. As of February 2011, twenty-one states allow the formation of LLLPs.
The 2001 revision of the Uniform Limited Partnership Act (ULPA) provides this definition of an LLLP: “‘Limited liability limited partnership’…means a limited partnership whose certificate of limited partnership states that the limited partnership is a limited liability limited partnership.” “Uniform Limited Partnership Act (2001),” NCCUSL Archives, www.law.upenn.edu/bll/archives/ulc/ulpa/final2001.htm; ULPA Section, 102(9). Section 404(c) gets to the point: “An obligation of a limited partnership incurred while the limited partnership is a limited liability limited partnership, whether arising in contract, tort, or otherwise, is solely the obligation of the limited partnership. A general partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or acting as a general partner. This subsection applies despite anything inconsistent in the partnership agreement that existed immediately before the consent required to become a limited liability limited partnership[.]”ULPA Section, 404(c).
In the discussion of limited partnerships, we noted that ULPA-2001 eliminates the “control rule” so that limited partners who exercise day-to-day control are not thereby liable as general partners. Now, in the section quoted in the previous paragraph, the general partner’s liability for partnership obligations is vaporized too. (Of course, the general partner is liable for its, his, or her own torts.) The preface to ULPA-2001 explains, “In a limited liability limited partnership (‘LLLP’), no partner—whether general or limited—is liable on account of partner status for the limited partnership’s obligations. Both general and limited partners benefit from a full, status-based liability shield that is equivalent to the shield enjoyed by corporate shareholders, LLC members, and partners in an LLP.”
Presumably, most existing limited partnerships will switch over to LLLPs. The ULPA-2001 provides that “the Act makes LLLP status available through a simple statement in the certificate of limited partnership.”
Ethical Concerns
There was a reason that partnership law imposed personal liability on the partners: people tend to be more careful when they are personally liable for their own mistakes and bad judgment. Many government programs reflect peoples’ interest in adverting risk: federal deposit insurance, Social Security, and bankruptcy, to name three. And of course corporate limited liability has existed for two hundred years.See, for example, David A. Moss, “Risk, Responsibility, and the Role of Government,” Drake Law Review 56, no. 2 (2008): 541. Whether the movement to allow almost anybody the right to a business organization that affords limited liability will encourage entrepreneurship and business activity or whether it will usher in a new era of moral hazard—people being allowed to escape the consequences of their own irresponsibility—is yet to be seen.
Key Takeaway
Businesspeople always prefer to reduce their risks. The partnership form imposes serious potential risk: unlimited personal liability. The corporate form eliminates that risk but imposes some onerous formalities and double taxation. Early on, then, the limited partnership form was born, but it still imposed unlimited liability on the general partner and on the limited partner if she became too actively involved. Congress was induced in the mid-1950s to allow certain small US corporations the right to single taxation, but the sub-S corporation still suffered from various limitations on its structure. In the 1980s, the limited liability company was invented; it has become the entity of choice for many businesspeople, but its availability for professionals was limited. In the late 1980s, the limited liability partnership form gained favor, and in the early 2000s, the limited liability limited partnership finished off unlimited liability for limited partnerships.
Exercises
1. The principal disadvantage of the general partnership is that it imposes unlimited personal liability on the partners. What is the disadvantage of the corporate form?
2. Why isn’t the limited partnership an entirely satisfactory solution to the liability problem of the partnership?
3. Explain the issue of “moral hazard” and the business organization form. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/20%3A_Hybrid_Business_Forms/20.04%3A_Other_Forms.txt |
Limited Partnerships: Limited Partners’ Liability for Managing Limited Partnership
Frigidaire Sales Corp. v. Union Properties, Inc.
562 P.2d 244 (Wash. 1977)
Plaintiff [Frigidaire] entered into a contract with Commercial Investors (Commercial), a limited partnership. Defendants, Leonard Mannon and Raleigh Baxter, were limited partners of Commercial. Defendants were also officers, directors, and shareholders of Union Properties, Inc., the only general partner of Commercial. Defendants controlled Union Properties, and through their control of Union Properties they exercised the day-to-day control and management of Commercial. Commercial breached the contract, and Plaintiff brought suit against Union Properties and Defendants. The trial court concluded that Defendants did not incur general liability for Commercial’s obligations by reason of their control of Commercial, and the Court of Appeals affirmed.
[Plaintiff] does not contend that Defendants acted improperly by setting up the limited partnership with a corporation as the sole general partner. Limited partnerships are a statutory form of business organization, and parties creating a limited partnership must follow the statutory requirements. In Washington, parties may form a limited partnership with a corporation as the sole general partner. [Citations]
Plaintiff’s sole contention is that Defendants should incur general liability for the limited partnership’s obligations under RCW 25.08.070, because they exercised the day-to-day control and management of Commercial. Defendants, on the other hand, argue that Commercial was controlled by Union Properties, a separate legal entity, and not by Defendants in their individual capacities. [RCW 25.08.070 then read: “A limited partner shall not become liable as a general partner unless, in addition to the exercise of his rights and powers as limited partner, he takes part in the control of the business.”]
…The pattern of operation of Union Properties was to investigate and conceive of real estate investment opportunities and, when it found such opportunities, to cause the creation of limited partnerships with Union Properties acting as the general partner. Commercial was only one of several limited partnerships so conceived and created. Defendants did not form Union Properties for the sole purpose of operating Commercial. Hence, their acts on behalf of Union Properties were not performed merely for the benefit of Commercial.…
[P]etitioner was never led to believe that Defendants were acting in any capacity other than in their corporate capacities. The parties stipulated at the trial that Defendants never acted in any direct, personal capacity. When the shareholders of a corporation, who are also the corporation’s officers and directors, conscientiously keep the affairs of the corporation separate from their personal affairs, and no fraud or manifest injustice is perpetrated upon third persons who deal with the corporation, the corporation’s separate entity should be respected. [Citations]
For us to find that Defendants incurred general liability for the limited partnership’s obligations under RCW 25.08.070 would require us to apply a literal interpretation of the statute and totally ignore the corporate entity of Union Properties, when Plaintiff knew it was dealing with that corporate entity. There can be no doubt that Defendants, in fact, controlled the corporation. However, they did so only in their capacities as agents for their principal, the corporate general partner. Although the corporation was a separate entity, it could act only through its board of directors, officers, and agents. [Citations] Plaintiff entered into the contract with Commercial. Defendants signed the contract in their capacities as president and secretary-treasurer of Union Properties, the general partner of Commercial. In the eyes of the law it was Union Properties, as a separate corporate entity, which entered into the contract with Plaintiff and controlled the limited partnership.
Further, because Defendants scrupulously separated their actions on behalf of the corporation from their personal actions, Plaintiff never mistakenly assumed that Defendants were general partners with general liability. [Citations] Plaintiff knew Union Properties was the sole general partner and did not rely on Defendants’ control by assuming that they were also general partners. If Plaintiff had not wished to rely on the solvency of Union Properties as the only general partner, it could have insisted that Defendants personally guarantee contractual performance. Because Plaintiff entered into the contract knowing that Union Properties was the only party with general liability, and because in the eyes of the law it was Union Properties, a separate entity, which controlled the limited partnership, there is no reason for us to find that Defendants incurred general liability for their acts done as officers of the corporate general partner.
The decision of the Court of Appeals is affirmed.
Case Questions
1. Frigidaire entered into a contract with Commercial Investors, a limited partnership. The general partner in the limited partnership was Union Properties, Inc., a corporation. Who were the limited partners in the limited partnership? Who were the controlling principals of the corporate general partner?
2. Why is it common for the general partner in a limited partnership to be a corporation?
3. Why does the court reiterate that the plaintiff knew it was dealing with a limited partnership that had a corporate general partner?
4. What could the plaintiff have done in this case to protect itself?
5. The court ruled in favor of the defendants, but is this setup kind of a scam? What is the “moral hazard” problem lurking in this case?
Liability Issues in LLCs
Puleo v. Topel
856 N.E.2d 1152 (Ill. App. 2006)
Plaintiffs Philip Puleo [and others]…appeal the order of the circuit court dismissing their claims against defendant Michael Topel.
The record shows that effective May 30, 2002, Thinktank, a limited liability company (LLC) primarily involved in web design and web marketing, was involuntarily dissolved by the Illinois Secretary of State…due to Thinktank’s failure to file its 2001 annual report as required by the Illinois Limited Liability Company Act (the Act) [Citation].
[In December 2002], plaintiffs, independent contractors hired by Topel, filed a complaint against Topel and Thinktank in which they alleged breach of contract, unjust enrichment, and claims under the account stated theory. Those claims stemmed from plaintiffs’ contention that Topel, who plaintiffs alleged was the sole manager and owner of Thinktank, knew or should have known of Thinktank’s involuntary dissolution, but nonetheless continued to conduct business as Thinktank from May 30, 2002, through the end of August 2002. They further contended that on or about August 30, 2002, Topel informed Thinktank employees and independent contractors, including plaintiffs, that the company was ceasing operations and that their services were no longer needed. Thinktank then failed to pay plaintiffs for work they had performed.…
On September 2, 2003, the circuit granted plaintiffs’ motion for judgment on the pleadings against Thinktank. Thereafter, on October 16, 2003, plaintiffs filed a separate motion for summary judgment against Topel [personally]. Relying on [Citation], plaintiffs contended that Topel, as a principal of Thinktank, an LLC, had a legal status similar to a shareholder or director of a corporation, who courts have found liable for a dissolved corporation’s debts. Thus, plaintiffs argued that Topel was personally liable for Thinktank’s debts.…
…The circuit court denied plaintiffs’ motion for summary judgment against Topel.…In doing so, the circuit court acknowledged that Topel continued to do business as Thinktank after its dissolution and that the contractual obligations at issue were incurred after the dissolution.
However…the court entered a final order dismissing all of plaintiffs’ claims against Topel with prejudice.…The court stated in pertinent part:
Based upon the Court’s…finding that the Illinois Legislature did not intend to hold a member of a Limited Liability Company liable for debts incurred after the Limited Liability Company had been involuntarily dissolved, the Court finds that all of Plaintiffs’ claims against Defendant Topel within the Complaint fail as a matter of law, as they are premised upon Defendant Topel’s alleged personal liability for obligations incurred in the name of Thinktank LLC after it had been involuntarily dissolved by the Illinois Secretary of State.
Plaintiffs now appeal that order…[contending] that…the circuit court erred in dismissing their claims against Topel. In making that argument, plaintiffs acknowledge that the issue as to whether a member or manager of an LLC may be held personally liable for obligations incurred by an involuntarily dissolved LLC appears to be one of first impression under the Act. That said, plaintiffs assert that it has long been the law in Illinois that an officer or director of a dissolved corporation has no authority to exercise corporate powers and thus is personally liable for any debts he incurs on behalf of the corporation after its dissolution. [Citations] Plaintiffs reason that Topel, as managing member of Thinktank, similarly should be held liable for debts the company incurred after its dissolution.
We first look to the provisions of the Act as they provided the trial court its basis for its ruling.…
(a) Except as otherwise provided in subsection (d) of this Section, the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.…
(c) The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.
(d) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:
(1) a provision to that effect is contained in the articles of organization; and
(2) a member so liable has consented in writing to the adoption of the provision or to be bound by the provision.
[Another relevant section provides]:
(a) A limited liability company is bound by a member or manager’s act after dissolution that:
(1) is appropriate for winding up the company’s business; or
(2) would have bound the company before dissolution, if the other party to the transaction did not have notice of the dissolution.
(b) A member or manager who, with knowledge of the dissolution, subjects a limited liability company to liability by an act that is not appropriate for winding up the company’s business is liable to the company for any damage caused to the company arising from the liability.
[The statute] clearly indicates that a member or manager of an LLC is not personally liable for debts the company incurs unless each of the provisions in subsection (d) is met. In this case, plaintiffs cannot establish either of the provisions in subsection (d). They have not provided this court with Thinktank’s articles of organization, much less a provision establishing Topel’s personal liability, nor have they provided this court with Topel’s written adoption of such a provision. As such, under the express language of the Act, plaintiffs cannot establish Topel’s personal liability for debts that Thinktank incurred after its dissolution.…
In 1998…the legislature amended [the LLC statute]…and in doing so removed…language which explicitly provided that a member or manager of an LLC could be held personally liable for his or her own actions or for the actions of the LLC to the same extent as a shareholder or director of a corporation could be held personally liable [which would include post-dissolution acts undertaken without authority]. As we have not found any legislative commentary regarding that amendment, we presume that by removing the noted statutory language, the legislature meant to shield a member or manager of an LLC from personal liability. [Citation] “When a statute is amended, it is presumed that the legislature intended to change the law as it formerly existed.”
Nonetheless, plaintiffs ask this court to disregard the 1998 amendment and to imply a provision into the Act similar to…the Business Corporation Act. We cannot do so.…When the legislature amended section [the relevant section] it clearly removed the provision that allowed a member or manager of an LLC to be held personally liable in the same manner as provided in section 3.20 of the Business Corporation Act. Thus, the Act does not provide for a member or manager’s personal liability to a third party for an LLC’s debts and liabilities, and no rule of construction authorizes this court to declare that the legislature did not mean what the plain language of the statute imports.
We, therefore, find that the circuit court did not err in concluding that the Act did not permit it to find Topel personally liable to plaintiffs for Thinktank’s debts and liabilities. We agree with plaintiff that the circuit court’s ruling does not provide an equitable result. However, the circuit court, like this court, was bound by the statutory language.
Accordingly, we affirm the judgment of the circuit court of Cook County.
Case Questions
1. Is it possible the defendant did not know his LLC had been involuntarily dissolved because it failed to file its required annual report? Should he have known it was dissolved?
2. If Topel’s business had been a corporation, he would not have had insulation from liability for postdissolution contracts—he would have been liable. Is the result here equitable? Is it fraud?
3. Seven months after the LLC’s existence was terminated by the state, the defendant hired a number of employees, did not pay them, and then avoided liability under the LLC shield. How else could the court have ruled here? It is possible that the legislature’s intent was simply to eliminate compulsory piercing (see Chapter 21 under corporate law principles and leave the question of LLC piercing to the courts. If so was the court’s decision was correct? The current LLC act language is similar to the Model Business Corporation Act, which surely permits piercing (see Chapter 21).
More Liability Issues in LLCs
Campbell v. Lichtenfels
2007 WL 447919 (Conn. Super. 2007)
This case concerns the aftermath of the dissolution of the parties’ law practice. Following a hearing on January 2 and 3, 2007, this court issued a memorandum of decision on January 5, 2007 granting the plaintiff a prejudgment remedy in the amount of \$15,782.01. The plaintiff has now moved for reargument, contending that the court improperly considered as a setoff one-half of a malpractice settlement paid personally by the defendant, which sum the court found to be a debt of a partnership. [The defendant was sued for malpractice by a third party; he paid the entire claim personally and when the law firm dissolved, the plaintiff’s share from the liquidated assets was reduced by one-half to account for the amount the defendant had paid.]
In support of his motion to reargue, the plaintiff relies on General Statutes Sec. 34-427(c) and, in that motion, italicizes those portions which he believes apply to his request for reargument. That section states (with emphasis as supplied in the plaintiff’s motion) that:
a partner in a registered limited liability partnership is not liable directly or indirectly, including by way of indemnification, contribution or otherwise, for any debts, obligations and liabilities of or chargeable to the partnership or another partner or partners, whether arising in contract, tort, or otherwise, arising in the course of the partnership business while the partnership is a registered limited liability partnership. (emphasis in original)
While italicizing the phases that appear to suit his purposes, the plaintiff completely ignores the most important phrase: “a partner in a registered limited liability partnership.” At the hearing, neither party presented any evidence at the hearing that tended to prove that the nature of the business relationship between the parties was that of a “registered limited liability partnership.” To the contrary, the testimony presented at the hearing revealed that the parties had a general partnership in which they had orally agreed to share profits and losses equally and that they never signed a partnership agreement. There was certainly no testimony or tangible evidence to the effect that the partnership had filed “a certificate of limited liability partnership with the Secretary of the State, stating the name of the partnership, which shall conform to the requirements of [the statute]; the address of its principal office;…a brief statement of the business in which the partnership engages; any other matters the partnership may determine to include; and that the partnership therefore applies for status as a registered limited liability partnership.” [Citation]
It is true that certain of the exhibits, such as copies of checks and letters written on the law firm letterhead, refer to the firm as “Campbell and Lichtenfels, LLP.” These exhibits, however, were not offered for the purpose of establishing the partnership’s character, and merely putting the initials “LLP” on checks and letterhead is not, in and of itself, proof of having met the statutory requirements for registration as a limited liability partnership. The key to establishing entitlement to the protections offered by [the limited liability partnership statute] is proof that the partnership has filed “a certificate of limited liability partnership with the Secretary of the State,” and the plaintiff presented no such evidence to the court.
Because the evidence presented at the hearing does not support a claim that the nature of the relationship between the parties to this case was that of partners in a registered limited liability partnership, the provisions of [the limited liability partnership statute] do not apply. Rather, this partnership is governed by the provisions of [the Uniform Partnership Act] which states: “Except as otherwise provided…all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.” Because there has been no evidence that this partnership falls within [any exceptions] the court finds Campbell and Lichtenfels to have been a general partnership in which the plaintiff shares the liability for the malpractice claim, even if he was not the partner responsible for the alleged negligence that led to that claim.
The plaintiff correctly points out that reargument is appropriate when the court has “overlooked” a “…principle of law which would have a controlling effect…” on the outcome of the case at hand. [Citation] The principle of law now raised by the plaintiff was “overlooked” by the court at the time of the hearing for two good reasons. First, it was not brought to the court’s attention at the time of the hearing. Second, and more importantly, the plaintiff presented no evidence that would have supported the claim that the principle of law in question, namely the provisions of [the limited liability partnership] was applicable to the facts of this case. Because the provisions of [that statute] are inapplicable, they are quite obviously not “controlling.” The principle of law which does control this issue is found in [general partnership law] and that principle makes the plaintiff liable for his share of the malpractice settlement, as the court has previously found. The motion for reargument is therefore denied.
Case Questions
1. If the parties had been operating as a limited liability partnership, how would that have changed the result?
2. Why did the court find that there was no limited liability partnership?
3. How does general partnership law treat a debt by one partner incurred in the course of partnership business?
4. Here, as in the case in Section 20.4.2 “Liability Issues in LLCs”, there really is no inequitable result. Why is this true? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/20%3A_Hybrid_Business_Forms/20.05%3A_Cases.txt |
Summary
Between partnerships and corporations lie a variety of hybrid business forms: limited partnerships, sub-S corporations, limited liability companies, limited liability partnerships, and limited liability limited partnerships. These business forms were invented to achieve, as much as possible, the corporate benefits of limited liability, centralized control, and easy transfer of ownership interest with the tax treatment of a partnership.
Limited partnerships were recognized in the early twentieth century and today are governed mostly by the Uniform Limited Partnership Act (ULPA-1985 or ULPA-2001). These entities, not subject to double taxation, are composed of one or more general partners and one or more limited partners. The general partner controls the firm and is liable like a partner in a general partnership (except under ULPA-2001 liability is limited); the limited partners are investors and have little say in the daily operations of the firm. If they get too involved, they lose their status as limited partners (except this is not so under ULPA-2001). The general partner, though, can be a corporation, which finesses the liability problem. A limited partnership comes into existence only when a certificate of limited partnership is filed with the state.
In the mid-twentieth century, Congress was importuned to allow small corporations the benefit of pass-through taxation. It created the sub-S corporation (referring to a section of the IRS code). It affords the benefits of taxation like a partnership and limited liability for its members, but there are several inconvenient limitations on how sub-S corporations can be set up and operate.
The 1990s saw the limited liability company become the entity of choice for many businesspeople. It deftly combines limited liability for all owners—managers and nonmanagers—with pass-through taxation and has none of the restrictions perceived to hobble the sub-S corporate form. Careful crafting of the firm’s bylaws and operating certificate allow it to combine the best of all possible business forms. There remained, though, one fly in the ointment: most states did not allow professionals to form limited liability companies (LLCs).
This last barrier was hurtled with the development of the limited liability partnership. This form, though mostly governed by partnership law, eschews the vicarious liability of nonacting partners for another’s torts, malpractice, or partnership breaches of contract. The extent to which such exoneration from liability presents a moral hazard—allowing bad actors to escape their just liability—is a matter of concern.
Having polished off liability for all owners with the LLC and the LLP, the next logical step occurred when eyes returned to the venerable limited partnership. The invention of the limited liability limited partnership in ULPA-2001 not only abolished the “control test” that made limited partners liable if they got too involved in the firm’s operations but also eliminated the general partner’s liability.
Comparison of Business Organization Forms
Type of Business Form Formation and Ownership Rules Funding Management Liability Taxes Dissolution
Limited partnership Formal filing of articles of partnership; unlimited number of general and limited partners General and limited partners contribute capital General partner General partner personally liable; limited partners to extent of contribution Under ULPA-2001, the general partner has limited liability. Flow-through as in partnership Death or termination of general partner, unless otherwise agreed
S corporation Formal filing of articles of incorporation; up to 100 shareholders allowed but only one class of stock Equity (sell stock) or debt funding (issue bonds); members share profits and losses Board of directors, officers Owners not personally liable absent piercing corporate veil (see Chapter 21) Flow-through as in partnership Only if limited duration or shareholders vote to dissolve
Limited liability company Formal filing of articles of organization; unlimited “members” Members make capital contributions, share profits and losses Member managed or manager managed Limited liability Flow-through as in partnership. Upon death or bankruptcy, unless otherwise agreed
Limited liability partnership (LLP) Formal filing of articles of LLP Members make capital contributions, share profits and losses All partners or delegated to managing partner Varies, but liability is generally on partnership; nonacting partners have limited liability Flow-through as in partnership Upon death or bankruptcy, unless otherwise agreed
Limited liability limited partnership (LLLP) Formal filing of articles of LLP; choosing LLLP form Same as above Same as above Liability on general partner abolished: all members have limited liability Flow-through as in partnership Same as above
Exercises
1. Yolanda and Zachary decided to restructure their small bookstore as a limited partnership, called “Y to Z’s Books, LP.” Under their new arrangement, Yolanda contributed a new infusion of \$300; she was named the general partner. Zachary contributed \$300 also, and he was named the limited partner: Yolanda was to manage the store on Monday, Wednesday, and Friday, and Zachary to manage it on Tuesday, Thursday, and Saturday. Y to Z Books, LP failed to pay \$800 owing to Vendor. Moreover, within a few weeks, Y to Z’s Books became insolvent. Who is liable for the damages to Vendor?
2. What result would be obtained in Exercise 1 if Yolanda and Zachary had formed a limited liability company?
3. Suppose Yolanda and Zachary had formed a limited liability partnership. What result would be obtained then?
4. Jacobsen and Kelly agreed to form an LLC. They filled out the appropriate paperwork and mailed it with their check to the secretary of state’s office. However, they made a mistake: instead of sending it to “Boston, MA”—Boston, Massachusetts—they sent it to “Boston, WA”—Boston, Washington. There is a town in Washington State called “Little Boston” that is part of an isolated Indian reservation. The paperwork got to Little Boston but then was much delayed. After two weeks, Jacobsen and Kelly figured the secretary of state in Boston, MA, was simply slow to respond. They began to use their checks, business cards, and invoices labeled “Jacobsen and Kelly, LLC.” They made a contract to construct a wind turbine for Pablo; Kelly did the work but used guy wires that were too small to support the turbine. During a modest wind a week after the turbine’s erection, it crashed into Pablo’s house. The total damages exceeded \$35,000. Pablo discovered Jacobsen and Kelly’s LLC was defectively created and sought judgment against them personally. May Pablo proceed against them both personally?
5. Holden was the manager of and a member of Frost LLLP, an investment firm. In that capacity, he embezzled \$30,000 from one of the firm’s clients, Backus. Backus sued the firm and Holden personally, but the latter claimed he was shielded from liability by the firm. Is Holden correct?
6. Bellamy, Carlisle, and Davidson formed a limited partnership. Bellamy and Carlisle were the general partners and Davidson the limited partner. They contributed capital in the amounts of \$100,000, \$100,000, and \$200,000, respectively, but then could not agree on a profit-sharing formula. At the end of the first year, how should they divide their profits?
SELF CHECK QUESTIONS
1. Peron and Quinn formed P and Q Limited Partnership. Peron made a capital contribution of \$20,000 and became a general partner. Quinn made a capital contribution of \$10,000 and became a limited partner. At the end of the first year of operation, a third party sued the partnership and both partners in a tort action. What is the potential liability of Peron and Quinn, respectively?
1. \$20,000 and \$10,000
2. \$20,000 and \$0
3. unlimited and \$0
4. unlimited and \$10,000
5. unlimited and unlimited
2. A limited partnership
1. comes into existence when a certificate of partnership is filed
2. always provides limited liability to an investor
3. gives limited partners a say in the daily operation of the firm
4. is not likely to be the business form of choice if a limited liability limited partnership option is available
5. two of these (specify)
3. Puentes is a limited partner of ABC, LP. He paid \$30,000 for his interest and he also loaned the firm \$20,000. The firm failed. Upon dissolution and liquidation,
1. Puentes will get his loan repaid pro rata along with other creditors.
2. Puentes will get repaid, along with other limited partners, in respect to his capital and loan after all other creditors have been paid.
3. if any assets remain, the last to be distributed will be the general partners’ profits.
4. if Puentes holds partnership property as collateral, he can resort to it to satisfy his claim if partnership assets are insufficient to meet creditors’ claims.
4. Reference to “moral hazard” in conjunction with hybrid business forms gets to what concern?
1. that general partners in a limited partnership will run the firm for their benefit, not the limited partners’ benefit
2. that the members of a limited liability company or limited liability partnership will engage in activities that expose themselves to potential liability
3. that the trend toward limited liability gives bad actors little incentive to behave ethically because the losses caused by their behavior are mostly not borne by them
4. that too few modern professional partnerships will see any need for malpractice insurance
5. One of the advantages to the LLC form over the sub-S form is
1. in the sub-S form, corporate profits are effectively taxed twice.
2. the sub-S form does not provide “full-shield” insulation of liability for its members.
3. the LLC cannot have a “manager-manager” form of control, whereas that is common for sub-S corporations.
4. the LLC form requires fewer formalities in its operation (minutes, annual meetings, etc.).
AnswerS
1. d
2. e (that is, a and d)
3. d (Choice a is wrong because as a secured creditor Puentes can realize on the collateral without regard to other creditors’ payment.)
4. c
5. d | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/20%3A_Hybrid_Business_Forms/20.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The historical background of the corporation
• How partnerships compare with corporations
• What the corporation is as a legal entity, and how corporate owners can lose limited liability by certain actions
• How corporations are classified
The corporation is the dominant form of the business enterprise in the modern world. As a legal entity, it is bound by much of the law discussed in the preceding chapters. However, as a significant institutional actor in the business world, the corporation has a host of relationships that have called forth a separate body of law.
21: CorporationGeneral Characteristics and Formation
Learning Objectives
By the end of this section, you will be able to:
• Comprehend the historical significance of corporate formation.
• Learn about key court decisions and their effect on interstate commerce and corporate formation.
• Become acquainted with how states formed their corporate laws.
A Fixture of Every Major Legal System
Like partnership, the corporation is an ancient concept, recognized in the Code of Hammurabi, and to some degree a fixture in every other major legal system since then. The first corporations were not business enterprises; instead, they were associations for religious and governmental ends in which perpetual existence was a practical requirement. Thus until relatively late in legal history, kings, popes, and jurists assumed that corporations could be created only by political or ecclesiastical authority and that corporations were creatures of the state or church. By the seventeenth century, with feudalism on the wane and business enterprise becoming a growing force, kings extracted higher taxes and intervened more directly in the affairs of businesses by refusing to permit them to operate in corporate form except by royal grant. This came to be known as the concession theory, because incorporation was a concession from the sovereign.
The most important concessions, or charters, were those given to the giant foreign trading companies, including the Russia Company (1554), the British East India Company (1600), Hudson’s Bay Company (1670, and still operating in Canada under the name “the Bay”), and the South Sea Company (1711). These were joint-stock companies—that is, individuals contributed capital to the enterprise, which traded on behalf of all the stockholders. Originally, trading companies were formed for single voyages, but the advantages of a continuing fund of capital soon became apparent. Also apparent was the legal characteristic that above all led shareholders to subscribe to the stock: limited liability. They risked only the cash they put in, not their personal fortunes.
Some companies were wildly successful. The British East India Company paid its original investors a fourfold return between 1683 and 1692. But perhaps nothing excited the imagination of the British more than the discovery of gold bullion aboard a Spanish shipwreck; 150 companies were quickly formed to salvage the sunken Spanish treasure. Though most of these companies were outright frauds, they ignited the search for easy wealth by a public unwary of the risks. In particular, the South Sea Company promised the sun and the moon: in return for a monopoly over the slave trade to the West Indies, it told an enthusiastic public that it would retire the public debt and make every person rich.
In 1720, a fervor gripped London that sent stock prices soaring. Beggars and earls alike speculated from January to August; and then the bubble burst. Without considering the ramifications, Parliament had enacted the highly restrictive Bubble Act, which was supposed to do away with unchartered joint-stock companies. When the government prosecuted four companies under the act for having fraudulently obtained charters, the public panicked and stock prices came tumbling down, resulting in history’s first modern financial crisis.
As a consequence, corporate development was severely retarded in England. Distrustful of the chartered company, Parliament issued few corporate charters, and then only for public or quasi-public undertakings, such as transportation, insurance, and banking enterprises. Corporation law languished: William Blackstone devoted less than 1 percent of his immensely influential Commentaries on the Law of England (1765) to corporations and omitted altogether any discussion of limited liability. In The Wealth of Nations (1776), Adam Smith doubted that the use of corporations would spread. England did not repeal the Bubble Act until 1825, and then only because the value of true incorporation had become apparent from the experience of its former colonies.
US Corporation Formation
The United States remained largely unaffected by the Bubble Act. Incorporation was granted only by special acts of state legislatures, even well into the nineteenth century, but many such acts were passed. Before the Revolution, perhaps fewer than a dozen business corporations existed throughout the thirteen colonies. During the 1790s, two hundred businesses were incorporated, and their numbers swelled thereafter. The theory that incorporation should not be accomplished except through special legislation began to give way. As industrial development accelerated in the mid-1800s, it was possible in many states to incorporate by adhering to the requirements of a general statute. Indeed, by the late nineteenth century, all but three states constitutionally forbade their legislatures from chartering companies through special enactments.
The US Supreme Court contributed importantly to the development of corporate law. In Gibbons v. Ogden,Gibbons v. Ogden, 22 U.S. 1 (1824). a groundbreaking case, the Court held that the Commerce Clause of the US Constitution (Article I, Section 8, Clause 3) granted Congress the power to regulate interstate commerce. However, in Paul v. Virginia,Paul v. Virginia, 75 U.S. 168 (1868). the Court said that a state could prevent corporations not chartered there—that is, out-of-state orforeign corporations—from engaging in what it considered the local, and not interstate, business of issuing insurance policies. The inference made by many was that states could not bar foreign corporations engaged in interstate business from their borders.
This decision brought about a competition in corporation laws. The early general laws had imposed numerous restrictions. The breadth of corporate enterprise was limited, ceilings were placed on total capital and indebtedness, incorporators were required to have residence in the state, the duration of the company often was not perpetual but was limited to a term of years or until a particular undertaking was completed, and the powers of management were circumscribed. These restrictions and limitations were thought to be necessary to protect the citizenry of the chartering legislature’s own state. But once it became clear that companies chartered in one state could operate in others, states began in effect to “sell” incorporation for tax revenues.
New Jersey led the way in 1875 with a general incorporation statute that greatly liberalized the powers of management and lifted many of the former restrictions. The Garden State was ultimately eclipsed by Delaware, which in 1899 enacted the most liberal corporation statute in the country, so that to the present day there are thousands of “Delaware corporations” that maintain no presence in the state other than an address on file with the secretary of state in Dover.
During the 1920s, the National Conference of Commissioners on Uniform State Laws drafted a Uniform Business Corporation Act, the final version of which was released in 1928. It was not widely adopted, but it did provide the basis during the 1930s for revisions of some state laws, including those in California, Illinois, Michigan, Minnesota, and Pennsylvania. By that time, in the midst of the Great Depression, the federal government for the first time intruded into corporate law in a major way by creating federal agencies, most notably the Securities and Exchange Commission in 1934, with power to regulate the interstate issuance of corporate stock.
Corporate Law Today
Following World War II, most states revised their general corporation laws. A significant development for states was the preparation of the Model Business Corporation Act by the American Bar Association’s Committee on Corporate Laws. About half of the states have adopted all or major portions of the act. The 2005 version of this act, the Revised Model Business Corporation Act (RMBCA), will be referred to throughout our discussion of corporation law.
Key Takeaway
Corporations have their roots in political and religious authority. The concept of limited liability and visions of financial rewards fueled the popularity of joint-stock companies, particularly trading companies, in late-seventeenth- and early eighteenth-century England. The English Parliament successfully enacted the Bubble Act in 1720 to curb the formation of these companies; the restrictions weren’t loosened until over one hundred years later, after England viewed the success of corporations in its former colonies. Although early corporate laws in the United States were fairly restrictive, once states began to “sell” incorporation for tax revenues, the popularity of liberal and corporate-friendly laws caught on, especially in Delaware beginning in 1899. A corporation remains a creature of the state—that is, the state in which it is incorporated. Delaware remains the state of choice because more corporations are registered there than in any other state.
Exercises
1. If the English Parliament had not enacted the Bubble Act in 1720, would the “bubble” have burst? If so, what would have been the consequences to corporate development?
2. What were some of the key components of early US corporate laws? What was the rationale behind these laws?
3. In your opinion, what are some of the liberal laws that attract corporations to Delaware? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.01%3A_Historical_Background.txt |
Learning Objectives
By the end of this section, you will be able to:
• Distinguish basic aspects of partnership formation from those of corporate formation.
• Explain ownership and control in partnerships and in publicly held and closely held corporations.
• Know how partnerships and corporations are taxed.
Let us assume that three people have already formed a partnership to run a bookstore business. Bob has contributed \$80,000. Carol has contributed a house in which the business can lawfully operate. Ted has contributed his services; he has been managing the bookstore, and the business is showing a slight profit. A friend has been telling them that they ought to incorporate. What are the major factors they should consider in reaching a decision?
Ease of Formation
Partnerships are easy to form. If the business is simple enough and the partners are few, the agreement need not even be written down. Creating a corporation is more complicated because formal documents must be placed on file with public authorities.
Ownership and Control
All general partners have equal rights in the management and conduct of the business. By contrast, ownership and control of corporations are, in theory, separated. In the publicly held corporation, which has many shareholders, the separation is real. Ownership is widely dispersed because millions of shares are outstanding and it is rare that any single shareholder will own more than a tiny percentage of stock. It is difficult under the best of circumstances for shareholders to exert any form of control over corporate operations. However, in the closely held corporation, which has few shareholders, the officers or senior managers are usually also the shareholders, so the separation of ownership and control may be less pronounced or even nonexistent.
Transferability of Interests
Transferability of an interest in a partnership is a problem because a transferee cannot become a member unless all partners consent. The problem can be addressed and overcome in the partnership agreement. Transfer of interest in a corporation, through a sale of stock, is much easier; but for the stock of a small corporation, there might not be a market or there might be contractual restrictions on transfer.
Financing
Partners have considerable flexibility in financing. They can lure potential investors by offering interests in profits and, in the case of general partnerships, control. Corporations can finance by selling freely transferable stock to the public or by incurring debt. Different approaches to the financing of corporations are discussed in “Legal Aspects of Corporate Finance”.
Taxation
The partnership is a conduit for income and is not taxed as a separate entity. Individual partners are taxed, and although limited by the 1986 Tax Reform Act, they can deduct partnership losses. Corporate earnings, on the other hand, are subject to double taxation. The corporation is first taxed on its own earnings as an entity. Then, when profits are distributed to shareholders in the form of dividends, the shareholders are taxed again. (A small corporation, with no more than one hundred shareholders, can elect S corporation status. Because S corporations are taxed as partnerships, they avoid double taxation.) However, incorporating brings several tax benefits. For example, the corporation can take deductions for life, medical, and disability insurance coverage for its employees, whereas partners or sole proprietors cannot.
Key Takeaway
Partnerships are easier to form than corporations, especially since no documents are required. General partners share both ownership and control, but in publicly held corporations, these functions are separated. Additional benefits for a partnership include flexibility in financing, single taxation, and the ability to deduct losses. Transfer of interest in a partnership can be difficult if not addressed in the initial agreement, since all partners must consent to the transfer.
Exercises
1. Provide an example of when it would be best to form a partnership, and cite the advantages and disadvantages of doing so.
2. Provide an example of when it would be best to form a corporation, and cite the advantages and disadvantages of doing so. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.02%3A_Partnerships_versus_Corporations.txt |
Learning Objectives
By the end of this section, you will be able to:
• Know what rights a corporate “person” and a natural person have in common.
• Recognize when a corporate “veil” is pierced and shareholder liability is imposed.
• Identify other instances when a shareholder will be held personally liable.
In comparing partnerships and corporations, there is one additional factor that ordinarily tips the balance in favor of incorporating: the corporation is a legal entity in its own right, one that can provide a “veil” that protects its shareholders from personal liability.
This crucial factor accounts for the development of much of corporate law. Unlike the individual actor in the legal system, the corporation is difficult to deal with in conventional legal terms. The business of the sole proprietor and the sole proprietor herself are one and the same. When a sole proprietor makes a decision, she risks her own capital. When the managers of a corporation take a corporate action, they are risking the capital of others—the shareholders. Thus accountability is a major theme in the system of law constructed to cope with legal entities other than natural persons.
The Basic Rights of the Corporate “Person”
To say that a corporation is a “person” does not automatically describe what its rights are, for the courts have not accorded the corporation every right guaranteed a natural person. Yet the Supreme Court recently affirmed in Citizens United v. Federal Election Commission (2010) that the government may not suppress the First Amendment right of political speech because the speaker is a corporation rather than a natural person. According to the Court, “No sufficient governmental interest justifies limits on the political speech of nonprofit or for-profit corporations.”Citizens United v. Federal Election Commission, 558 U.S. ___ (2010).
The courts have also concluded that corporations are entitled to the essential constitutional protections of due process and equal protection. They are also entitled to Fourth Amendment protection against unreasonable search and seizure; in other words, the police must have a search warrant to enter corporate premises and look through files. Warrants, however, are not required for highly regulated industries, such as those involving liquor or guns. The Double Jeopardy Clause applies to criminal prosecutions of corporations: an acquittal cannot be appealed nor can the case be retried. For purposes of the federal courts’ diversity jurisdiction, a corporation is deemed to be a citizen of both the state in which it is incorporated and the state in which it has its principal place of business (often, the corporate “headquarters”).
Until relatively recently, few cases had tested the power of the state to limit the right of corporations to spend their own funds to speak the “corporate mind.” Most cases involving corporate free speech address advertising, and few states have enacted laws that directly impinge on the freedom of companies to advertise. But those states that have done so have usually sought to limit the ability of corporations to sway voters in public referenda. In 1978, the Supreme Court finally confronted the issue head on in First National Bank of Boston v. Bellotti (Section 21.7.1 “Limiting a Corporation’s First Amendment Rights”). The ruling in Bellotti was reaffirmed by the Supreme Court in Citizens United v. Federal Election Commission. In Citizens United, the Court struck down the part of the McCain-Feingold ActThe Bipartisan Campaign Reform Act of 2002 (BCRA, McCain–Feingold Act, Pub.L. 107-155, 116 Stat. 81, enacted March 27, 2002, H.R. 2356). that prohibited all corporations, both for-profit and not-for-profit, and unions from broadcasting “electioneering communications.”
Absence of Rights
Corporations lack certain rights that natural persons possess. For example, corporations do not have the privilege against self-incrimination guaranteed for natural persons by the Fifth and Fourteenth Amendments. In any legal proceeding, the courts may force a corporation to turn over incriminating documents, even if they also incriminate officers or employees of the corporation. As we explore in Chapter 25, corporations are not citizens under the Privileges and Immunities Clause of the Constitution, so that the states can discriminate between domestic and foreign corporations. And the corporation is not entitled to federal review of state criminal convictions, as are many individuals.
Piercing the Corporate Veil
Given the importance of the corporate entity as a veil that limits shareholder liability, it is important to note that in certain circumstances, the courts may reach beyond the wall of protection that divides a corporation from the people or entities that exist behind it. This is known as piercing the corporate veil, and it will occur in two instances: (1) when the corporation is used to commit a fraud or an injustice and (2) when the corporation does not act as if it were one.
Fraud
The Felsenthal Company burned to the ground. Its president, one of the company’s largest creditors and also virtually its sole owner, instigated the fire. The corporation sued the insurance company to recover the amount for which it was insured. According to the court in the Felsenthal case, “The general rule of law is that the willful burning of property by a stockholder in a corporation is not a defense against the collection of the insurance by the corporation, and…the corporation cannot be prevented from collecting the insurance because its agents willfully set fire to the property without the participation or authority of the corporation or of all of the stockholders of the corporation.”D. I. Felsenthal Co. v. Northern Assurance Co., Ltd., 284 Ill. 343, 120 N.E. 268 (1918). But because the fire was caused by the beneficial owner of “practically all” the stock, who also “has the absolute management of [the corporation’s] affairs and its property, and is its president,” the court refused to allow the company to recover the insurance money; allowing the company to recover would reward fraud.Felsenthal Co. v. Northern Assurance Co., Ltd., 120 N.E. 268 (Ill. 1918).
Failure to Act as a Corporation
In other limited circumstances, individual stockholders may also be found personally liable. Failure to follow corporate formalities, for example, may subject stockholders to personal liability. This is a special risk that small, especially one-person, corporations run. Particular factors that bring this rule into play include inadequate capitalization, omission of regular meetings, failure to record minutes of meetings, failure to file annual reports, and commingling of corporate and personal assets. Where these factors exist, the courts may look through the corporate veil and pluck out the individual stockholder or stockholders to answer for a tort, contract breach, or the like. The classic case is the taxicab operator who incorporates several of his cabs separately and services them through still another corporation. If one of the cabs causes an accident, the corporation is usually “judgment proof” because the corporation will have few assets (practically worthless cab, minimum insurance). The courts frequently permit plaintiffs to proceed against the common owner on the grounds that the particular corporation was inadequately financed.
When a corporation owns a subsidiary corporation, the question frequently arises whether the subsidiary is acting as an independent entity (see Figure 21.2). The Supreme Court addressed this question of derivative versus direct liability of the corporate parent vis-à-vis its subsidiary in United States v. Bestfoods, (see Section 21.7.2 “Piercing the Corporate Veil”).
Other Types of Personal Liability
Even when a corporation is formed for a proper purpose and is operated as a corporation, there are instances in which individual shareholders will be personally liable. For example, if a shareholder involved in company management commits a tort or enters into a contract in a personal capacity, he will remain personally liable for the consequences of his actions. In some states, statutes give employees special rights against shareholders. For example, a New York statute permits employees to recover wages, salaries, and debts owed them by the company from the ten largest shareholders of the corporation. (Shareholders of public companies whose stock is traded on a national exchange or over the counter are exempt.) Likewise, federal law permits the IRS to recover from the “responsible persons” any withholding taxes collected by a corporation but not actually paid over to the US Treasury.
Key Takeaway
Corporations have some of the legal rights of a natural person. They are entitled to the constitutional protections of due process and equal protection, Fourth Amendment protection against unreasonable search and seizure, and First Amendment protection of free speech and expression. For purposes of the federal courts’ diversity jurisdiction, a corporation is deemed to be a citizen of both the state in which it is incorporated and the state in which it has its principal place of business. However, corporations do not have the privilege against self-incrimination guaranteed for natural persons by the Fifth and Fourteenth Amendments. Further, corporations are not free from liability. Courts will pierce the corporate veil and hold a corporation liable when the corporation is used to perpetrate fraud or when it fails to act as a corporation.
Exercises
1. Do you think that corporations should have rights similar to those of natural persons? Should any of these rights be curtailed?
2. What is an example of speaking the “corporate mind”?
3. If Corporation BCD’s president and majority stockholder secretly sells all of his stock before resigning a few days later, and the corporation’s unexpected change in majority ownership causes the share price to plummet, do corporate stockholders have a cause of action? If so, under what theory? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.03%3A_The_Corporate_Veil-_The_Corporation_as_a_Legal_Entity.txt |
Learning Objectives
By the end of this section, you will be able to:
• Distinguish the “public,” or municipal, corporation from the publicly held corporation.
• Explain how the tax structure for professional corporations evolved.
• Define the two types of business corporations.
Nonprofit Corporations
One of the four major classifications of corporations is the nonprofit corporation (also called not-for-profit corporation). It is defined in the American Bar Association’s Model Non-Profit Corporation Act as “a corporation no part of the income of which is distributable to its members, directors or officers.” Nonprofit corporations may be formed under this law for charitable, educational, civil, religious, social, and cultural purposes, among others.
Public Corporations
The true public corporation is a governmental entity. It is often called a municipal corporation, to distinguish it from the publicly held corporation, which is sometimes also referred to as a “public” corporation, although it is in fact private (i.e., it is not governmental). Major cities and counties, and many towns, villages, and special governmental units, such as sewer, transportation, and public utility authorities, are incorporated. These corporations are not organized for profit, do not have shareholders, and operate under different statutes than do business corporations.
Professional Corporations
Until the 1960s, lawyers, doctors, accountants, and other professionals could not practice their professions in corporate form. This inability, based on a fear of professionals’ being subject to the direction of the corporate owners, was financially disadvantageous. Under the federal income tax laws then in effect, corporations could establish far better pension plans than could the self-employed. During the 1960s, the states began to let professionals incorporate, but the IRS balked, denying them many tax benefits. In 1969, the IRS finally conceded that it would tax a professional corporation just as it would any other corporation, so that professionals could, from that time on, place a much higher proportion of tax-deductible income into a tax-deferred pension. That decision led to a burgeoning number of professional corporations.
Business Corporations
The Two Types
It is the business corporation proper that we focus on in this unit. There are two broad types of business corporations: publicly held (or public) and closely held (or close or private) corporations. Again, both types are private in the sense that they are not governmental.
The publicly held corporation is one in which stock is widely held or available for wide public distribution through such means as trading on a national or regional stock exchange. Its managers, if they are also owners of stock, usually constitute a small percentage of the total number of shareholders and hold a small amount of stock relative to the total shares outstanding. Few, if any, shareholders of public corporations know their fellow shareholders.
By contrast, the shareholders of the closely held corporation are fewer in number. Shares in a closely held corporation could be held by one person, and usually by no more than thirty. Shareholders of the closely held corporation often share family ties or have some other association that permits each to know the others.
Though most closely held corporations are small, no economic or legal reason prevents them from being large. Some are huge, having annual sales of several billion dollars each. Roughly 90 percent of US corporations are closely held.
The giant publicly held companies with more than \$1 billion in assets and sales, with initials such as IBM and GE, constitute an exclusive group. Publicly held corporations outside this elite class fall into two broad (nonlegal) categories: those that are quoted on stock exchanges and those whose stock is too widely dispersed to be called closely held but is not traded on exchanges.
Key Takeaway
There are four major classifications of corporations: (1) nonprofit, (2) municipal, (3) professional, and (4) business. Business corporations are divided into two types, publicly held and closely held corporations.
Exercises
1. Why did professionals, such as doctors, lawyers, and accountants, wait so long to incorporate?
2. Distinguish a publicly held corporation from a closely held one.
3. Are most corporations in the US publicly or closely held? Are closely held corporations subject to different provisions than publicly held ones? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.04%3A_Classifications_of_Corporations.txt |
Learning Objectives
By the end of this section, you will be able to:
• Recognize the steps to issue a corporate charter.
• Know the states’ rights in modifying a corporate charter.
• Discuss factors to consider in selecting a state in which to incorporate.
• Explain the functions and liability of a promoter.
• Understand the business and legal requirements in executing and filing the articles of incorporation.
As discussed in Section 21.4, corporate status offers companies many protections. If the owners of a business decide to incorporate after weighing the pros and cons of incorporation, they need to take the steps explained in this section.
The Corporate Charter
Function of the Charter
The ultimate goal of the incorporation process is issuance of a corporate charter. The term used for the document varies from state to state. Most states call the basic document filed in the appropriate public office the “articles of incorporation” or “certificate of incorporation,” but there are other variations. There is no legal significance to these differences in terminology.
Chartering is basically a state prerogative. Congress has chartered several enterprises, including national banks (under the National Banking Act), federal savings and loan associations, national farm loan associations, and the like, but virtually all business corporations are chartered at the state level.
Originally a legislative function, chartering is now an administrative function in every state. The secretary of state issues the final indorsement to the articles of incorporation, thus giving them legal effect.
Charter as a Contract
The charter is a contract between the state and the corporation. Under the Contracts Clause of Article I of the Constitution, no state can pass any law “impairing the obligation of contracts.” In 1816, the question arose whether a state could revoke or amend a corporate charter once granted. The corporation in question was Dartmouth College. The New Hampshire legislature sought to turn the venerable private college, operating under an old royal charter, into a public institution by changing the membership of its board. The case wound up in the Supreme Court. Chief Justice John Marshall ruled that the legislature’s attempt was unconstitutional, because to amend a charter is to impair a contract.Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819).
This decision pleased incorporators because it implied that once a corporation had been created, the state could never modify the powers it had been granted. But, in addition, the ruling seemed to favor monopolies. The theory was that by granting a charter to, say, a railroad corporation, the state was barred from creating any further railroad corporations. Why? Because, the lawyers argued, a competitor would cut into the first company’s business, reducing the value of the charter, hence impairing the contract. Justice Joseph Story, concurring in the Dartmouth case, had already suggested the way out for the states: “If the legislature mean to claim such an authority [to alter or amend the charter], it must be reserved in the grant. The charter of Dartmouth College contains no such reservation.…” The states quickly picked up on Justice Story’s suggestion and wrote into the charter explicit language giving legislatures the authority to modify corporations’ charters at their pleasure. So the potential immutability of corporate charters had little practical chance to develop.
Selection of a State
Where to Charter
Choosing the particular venue in which to incorporate is the first critical decision to be made after deciding to incorporate. Some corporations, though headquartered in the United States, choose to incorporate offshore to take advantage of lenient taxation laws. Advantages of an offshore corporation include not only lenient tax laws but also a great deal of privacy as well as certain legal protections. For example, the names of the officers and directors can be excluded from documents filed. In the United States, over half of the Fortune 500 companies hold Delaware charters for reasons related to Delaware’s having a lower tax structure, a favorable business climate, and a legal system—both its statutes and its courts—seen as being up to date, flexible, and often probusiness. Delaware’s success has led other states to compete, and the political realities have caused the Revised Model Business Corporation Act (RMBCA), which was intentionally drafted to balance the interests of all significant groups (management, shareholders, and the public), to be revised from time to time so that it is more permissive from the perspective of management.
Why Choose Delaware?
Delaware remains the most popular state in which to incorporate for several reasons, including the following: (1) low incorporation fees; (2) only one person is needed to serve the incorporator of the corporation; the RMBC requires three incorporators; (3) no minimum capital requirement; (4) favorable tax climate, including no sales tax; (5) no taxation of shares held by nonresidents; and (5) no corporate income tax for companies doing business outside of Delaware. In addition, Delaware’s Court of Chancery, a court of equity, is renowned as a premier business court with a well-established body of corporate law, thereby affording a business a certain degree of predictability in judicial decision making.
The Promoter
Functions
Once the state of incorporation has been selected, it is time for promoters, the midwives of the enterprise, to go to work. Promoters are the individuals who take the steps necessary to form the corporation, and they often will receive stock in exchange for their efforts. They have four principal functions: (1) to seek out or discover business opportunities, (2) to raise capital by persuading investors to sign stock subscriptions, (3) to enter into contracts on behalf of the corporation to be formed, (4) and to prepare the articles of incorporation.
Promoters have acquired an unsavory reputation as fast talkers who cajole investors out of their money. Though some promoters fit this image, it is vastly overstated. Promotion is difficult work often carried out by the same individuals who will manage the business.
Contract Liability
Promoters face two major legal problems. First, they face possible liability on contracts made on behalf of the business before it is incorporated. For example, suppose Bob is acting as promoter of the proposed BCT Bookstore, Inc. On September 15, he enters into a contract with Computogram Products to purchase computer equipment for the corporation to be formed. If the incorporation never takes place, or if the corporation is formed but the corporation refuses to accept the contract, Bob remains liable.
Now assume that the corporation is formed on October 15, and on October 18 it formally accepts all the contracts that Bob signed prior to October 15. Does Bob remain liable? In most states, he does. The ratification theory of agency law will not help in many states that adhere strictly to agency rules, because there was no principal (the corporation) in existence when the contract was made and hence the promoter must remain liable. To avoid this result, Bob should seek an express novation, although in some states, a novation will be implied. The intention of the parties should be stated as precisely as possible in the contract, as the promoters learned in RKO-Stanley Warner Theatres, Inc. v. Graziano, (see Section 21.7.3 “Corporate Promoter”).
The promoters’ other major legal concern is the duty owed to the corporation. The law is clear that promoters owe a fiduciary duty. For example, a promoter who transfers real estate worth \$250,000 to the corporation in exchange for \$750,000 worth of stock would be liable for \$500,000 for breach of fiduciary duty.
Preincorporation Stock Subscriptions
One of the promoter’s jobs is to obtain preincorporation stock subscriptions to line up offers by would-be investors to purchase stock in the corporation to be formed. These stock subscriptions are agreements to purchase, at a specified price, a certain number of shares of stock of a corporation, which is to be formed at some point in the future. The contract, however, actually comes into existence after formation, once the corporation itself accepts the offer to subscribe. Alice agrees with Bob to invest \$10,000 in the BCT Bookstore, Inc. for one thousand shares. The agreement is treated as an offer to purchase. The offer is deemed accepted at the moment the bookstore is incorporated.
The major problem for the corporation is an attempt by subscribers to revoke their offers. A basic rule of contract law is that offers are revocable before acceptance. Under RMBCA, Section 6.20, however, a subscription for shares is irrevocable for six months unless the subscription agreement itself provides otherwise or unless all the subscribers consent to revocation. In many states that have not adopted the model act, the contract rule applies and the offer is always revocable. Other states use various common-law devices to prevent revocation. For example, the subscription by one investor is held as consideration for the subscription of another, so that a binding contract has been formed.
Execution and Filing of the Articles of Incorporation
Once the business details are settled, the promoters, now known as incorporators, must sign and deliver the articles of incorporation to the secretary of state. The articles of incorporation typically include the following: the corporate name; the address of the corporation’s initial registered office; the period of the corporation’s duration (usually perpetual); the company’s purposes; the total number of shares, the classes into which they are divided, and the par value of each; the limitations and rights of each class of shareholders; the authority of the directors to establish preferred or special classes of stock; provisions for preemptive rights; provisions for the regulation of the internal affairs of the corporation, including any provision restricting the transfer of shares; the number of directors constituting the initial board of directors and the names and addresses of initial members; and the name and address of each incorporator. Although compliance with these requirements is largely a matter of filling in the blanks, two points deserve mention.
First, the choice of a name is often critical to the business. Under RMBCA, Section 4.01, the name must include one of the following words (or abbreviations): corporation, company, incorporated, or limited (Corp., Co., Inc., or Ltd.). The name is not allowed to deceive the public about the corporation’s purposes, nor may it be the same as that of any other company incorporated or authorized to do business in the state.
These legal requirements are obvious; the business requirements are much harder. If the name is not descriptive of the business or does not anticipate changes in the business, it may have to be changed, and the change can be expensive. For example, when Standard Oil Company of New Jersey changed its name to Exxon in 1972, the estimated cost was over \$100 million. (And even with this expenditure, some shareholders grumbled that the new name sounded like a laxative.)
The second point to bear in mind about the articles of incorporation is that drafting the clause stating corporate purposes requires special care, because the corporation will be limited to the purposes set forth. In one famous case, the charter of Cornell University placed a limit on the amount of contributions it could receive from any one benefactor. When Jennie McGraw died in 1881, leaving to Cornell the carillon that still plays on the Ithaca, New York, campus to this day, she also bequeathed to the university her residuary estate valued at more than \$1 million. This sum was greater than the ceiling placed in Cornell’s charter. After lengthy litigation, the university lost in the US Supreme Court, and the money went to her family.Cornell University v. Fiske, 136 U.S. 152 (1890). The dilemma is how to draft a clause general enough to allow the corporation to expand, yet specific enough to prevent it from engaging in undesirable activities.
Some states require the purpose clauses to be specific, but the usual approach is to permit a broad statement of purposes. Section 3.01 of the RMBCA goes one step further in providing that a corporation automatically “has the purpose of engaging in any lawful business” unless the articles specify a more limited purpose. Once completed, the articles of incorporation are delivered to the secretary of state for filing. The existence of a corporation begins once the articles have been filed.
Organizational Meeting of Directors
The first order of business, once the certificate of incorporation is issued, is a meeting of the board of directors named in the articles of incorporation. They must adopt bylaws, elect officers, and transact any other business that may come before the meeting (RMBCA, Section 2.05). Other business would include accepting (ratifying) promoters’ contracts, calling for the payment of stock subscriptions, and adopting bank resolution forms, giving authority to various officers to sign checks drawn on the corporation.
Section 10.20 of the RMBCA vests in the directors the power to alter, amend, or repeal the bylaws adopted at the initial meeting, subject to repeal or change by the shareholders. The articles of incorporation may reserve the power to modify or repeal exclusively to the shareholders. The bylaws may contain any provisions that do not conflict with the articles of incorporation or the law of the state.
Typical provisions in the bylaws include fixing the place and time at which annual stockholders’ meetings will be held, fixing a quorum, setting the method of voting, establishing the method of choosing directors, creating committees of directors, setting down the method by which board meetings may be called and the voting procedures to be followed, determining the offices to be filled by the directors and the powers with which each officer shall be vested, fixing the method of declaring dividends, establishing a fiscal year, setting out rules governing issuance and transfer of stock, and establishing the method of amending the bylaws.
Section 2.07 of the RMBCA provides that the directors may adopt bylaws that will operate during an emergency. An emergency is a situation in which “a quorum of the corporation’s directors cannot readily be assembled because of some catastrophic event.”
Key Takeaway
Articles of incorporation represent a corporate charter—that is, a contract between the corporation and the state. Filing these articles, or “chartering,” is accomplished at the state level. The secretary of state’s final approval gives these articles legal effect. A state cannot change a charter unless it reserves the right when granting the charter.
In selecting a state in which to incorporate, a corporation looks for a favorable corporate climate. Delaware remains the state of choice for incorporation, particularly for publicly held companies. Most closely held companies choose to incorporate in their home states.
Following the state selection, the promoter commences his or her functions, which include entering into contracts on behalf of the corporation to be formed (for which he or she can be held liable) and preparing the articles of incorporation.
The articles of incorporation must include the corporation’s name and its corporate purpose, which can be broad. Finally, once the certificate of incorporation is issued, the corporation’s board of directors must hold an organizational meeting.
Exercises
1. Does the Contracts Clause of the Constitution, which forbids a state from impeding a contract, apply to corporations?
2. What are some of the advantages of selecting Delaware as the state of incorporation?
3. What are some of the risks that a promoter faces for his or her actions on behalf of the corporation? Can he or she limit these risks?
4. What are the dangers of limiting a corporation’s purpose?
5. What is the order of business at the first board of directors’ meeting? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.05%3A_Corporate_Organization.txt |
Learning Objectives
By the end of this section, you will be able to:
• Distinguish between a de jure and a de facto corporation.
• Define the doctrine of corporation by estoppel.
De Jure and De Facto Corporations
If promoters meet the requirements of corporate formation, a de jure corporation, considered a legal entity, is formed. Because the various steps are complex, the formal prerequisites are not always met. Suppose that a company, thinking its incorporation has taken place when in fact it hasn’t met all requirements, starts up its business. What then? Is everything it does null and void? If three conditions exist, a court might decide that a de facto corporation has been formed; that is, the business will be recognized as a corporation. The state then has the power to force the de facto corporation to correct the defect(s) so that a de jure corporation will be created.
The three traditional conditions are the following: (1) a statute must exist under which the corporation could have been validly incorporated, (2) the promoters must have made a bona fide attempt to comply with the statute, and (3) corporate powers must have been used or exercised.
A frequent cause of defective incorporation is the promoters’ failure to file the articles of incorporation in the appropriate public office. The states are split on whether a de facto corporation results if every other legal requirement is met.
Corporation by Estoppel
Even if the incorporators omit important steps, it is still possible for a court, under estoppel principles, to treat the business as a corporation. Assume that Bob, Carol, and Ted have sought to incorporate the BCT Bookstore, Inc., but have failed to file the articles of incorporation. At the initial directors’ meeting, Carol turns over to the corporation a deed to her property. A month later, Bob discovers the omission and hurriedly submits the articles of incorporation to the appropriate public office. Carol decides she wants her land back. It is clear that the corporation was not de jure at the time she surrendered her deed, and it was probably not de facto either. Can she recover the land? Under equitable principles, the answer is no. She is estopped from denying the existence of the corporation, because it would be inequitable to permit one who has conducted herself as though there were a corporation to deny its existence in order to defeat a contract into which she willingly entered. As Cranson v. International Business Machines Corp. indicates (Section 21.7.4 “De Jure and De Facto Corporations”), the doctrine of corporation by estoppel can also be used by the corporation against one of its creditors.
Key Takeaway
A court will find that a corporation might exist under fact (de facto), and not under law (de jure) if the following conditions are met: (1) a statute exists under which the corporation could have been validly incorporated, (2) the promoters must have made a bona fide attempt to comply with the statute, and (3) corporate powers must have been used or exercised. A de facto corporation may also be found when a promoter fails to file the articles of incorporation. In the alternative, the court may look to estoppel principles to find a corporation.
Exercises
1. What are some of the formal prerequisites to forming a de jure corporation?
2. Are states in agreement over what represents a de facto corporation if a promoter fails to file the articles of incorporation?
3. What is the rationale for corporation by estoppel? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.06%3A_Effect_of_Organization.txt |
Limiting a Corporation’s First Amendment Rights
First National Bank of Boston v. Bellotti
435 U.S. 765 (1978)
MR. JUSTICE POWELL delivered the opinion of the Court.
In sustaining a state criminal statute that forbids certain expenditures by banks and business corporations for the purpose of influencing the vote on referendum proposals, the Massachusetts Supreme Judicial Court held that the First Amendment rights of a corporation are limited to issues that materially affect its business, property, or assets. The court rejected appellants’ claim that the statute abridges freedom of speech in violation of the First and Fourteenth Amendments. The issue presented in this context is one of first impression in this Court. We postponed the question of jurisdiction to our consideration of the merits. We now reverse.
The statute at issue, Mass. Gen. Laws Ann., Ch. 55, § 8 (West Supp. 1977), prohibits appellants, two national banking associations and three business corporations, from making contributions or expenditures “for the purpose of…influencing or affecting the vote on any question submitted to the voters, other than one materially affecting any of the property, business or assets of the corporation.” The statute further specifies that “[no] question submitted to the voters solely concerning the taxation of the income, property or transactions of individuals shall be deemed materially to affect the property, business or assets of the corporation.” A corporation that violates § 8 may receive a maximum fine of \$50,000; a corporate officer, director, or agent who violates the section may receive a maximum fine of \$10,000 or imprisonment for up to one year, or both. Appellants wanted to spend money to publicize their views on a proposed constitutional amendment that was to be submitted to the voters as a ballot question at a general election on November 2, 1976. The amendment would have permitted the legislature to impose a graduated tax on the income of individuals. After appellee, the Attorney General of Massachusetts, informed appellants that he intended to enforce § 8 against them, they brought this action seeking to have the statute declared unconstitutional.
The court below framed the principal question in this case as whether and to what extent corporations have First Amendment rights. We believe that the court posed the wrong question. The Constitution often protects interests broader than those of the party seeking their vindication. The First Amendment, in particular, serves significant societal interests. The proper question therefore is not whether corporations “have” First Amendment rights and, if so, whether they are coextensive with those of natural persons. Instead, the question must be whether § 8 abridges expression that the First Amendment was meant to protect. We hold that it does. The speech proposed by appellants is at the heart of the First Amendment’s protection.
The freedom of speech and of the press guaranteed by the Constitution embraces at the least the liberty to discuss publicly and truthfully all matters of public concern without previous restraint or fear of subsequent punishment. Freedom of discussion, if it would fulfill its historic function in this nation, must embrace all issues about which information is needed or appropriate to enable the members of society to cope with the exigencies of their period. Thornhill v. Alabama, 310 U.S. 88, 101-102 (1940).
The referendum issue that appellants wish to address falls squarely within this description. In appellants’ view, the enactment of a graduated personal income tax, as proposed to be authorized by constitutional amendment, would have a seriously adverse effect on the economy of the State. The importance of the referendum issue to the people and government of Massachusetts is not disputed. Its merits, however, are the subject of sharp disagreement.
We thus find no support in the First or Fourteenth Amendment, or in the decisions of this Court, for the proposition that speech that otherwise would be within the protection of the First Amendment loses that protection simply because its source is a corporation that cannot prove, to the satisfaction of a court, a material effect on its business or property. The “materially affecting” requirement is not an identification of the boundaries of corporate speech etched by the Constitution itself. Rather, it amounts to an impermissible legislative prohibition of speech based on the identity of the interests that spokesmen may represent in public debate over controversial issues and a requirement that the speaker have a sufficiently great interest in the subject to justify communication.
Section 8 permits a corporation to communicate to the public its views on certain referendum subjects—those materially affecting its business—but not others. It also singles out one kind of ballot question—individual taxation as a subject about which corporations may never make their ideas public. The legislature has drawn the line between permissible and impermissible speech according to whether there is a sufficient nexus, as defined by the legislature, between the issue presented to the voters and the business interests of the speaker.
In the realm of protected speech, the legislature is constitutionally disqualified from dictating the subjects about which persons may speak and the speakers who may address a public issue. If a legislature may direct business corporations to “stick to business,” it also may limit other corporations—religious, charitable, or civic—to their respective “business” when addressing the public. Such power in government to channel the expression of views is unacceptable under the First Amendment. Especially where, as here, the legislature’s suppression of speech suggests an attempt to give one side of a debatable public question an advantage in expressing its views to the people, the First Amendment is plainly offended.
Because that portion of § 8 challenged by appellants prohibits protected speech in a manner unjustified by a compelling state interest, it must be invalidated. The judgment of the Supreme Judicial Court is reversed.
Case Questions
1. According to the court, does § 8 abridge a freedom that the First Amendment is intended to protect? If so, which freedom(s)?
2. Must a corporation prove a material effect on its business or property to maintain protection under the First Amendment?
3. Can a state legislature dictate the subjects on which a corporation may “speak”?
Piercing the Corporate Veil
United States v. Bestfoods
113 F.3d 572 (1998)
SOUTER, JUSTICE
The United States brought this action under §107(a)(2) of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) against, among others, respondent CPC International, Inc., the parent corporation of the defunct Ott Chemical Co. (Ott II), for the costs of cleaning up industrial waste generated by Ott II’s chemical plant. Section 107(a)(2) authorizes suits against, among others, “any person who at the time of disposal of any hazardous substance owned or operated any facility.” The trial focused on whether CPC, as a parent corporation, had “owned or operated” Ott II’s plant within the meaning of §107(a)(2). The District Court said that operator liability may attach to a parent corporation both indirectly, when the corporate veil can be pierced under state law, and directly, when the parent has exerted power or influence over its subsidiary by actively participating in, and exercising control over, the subsidiary’s business during a period of hazardous waste disposal. Applying that test, the court held CPC liable because CPC had selected Ott II’s board of directors and populated its executive ranks with CPC officials, and another CPC official had played a significant role in shaping Ott II’s environmental compliance policy.
The Sixth Circuit reversed. Although recognizing that a parent company might be held directly liable under §107(a)(2) if it actually operated its subsidiary’s facility in the stead of the subsidiary, or alongside of it as a joint venturer, that court refused to go further. Rejecting the District Court’s analysis, the Sixth Circuit explained that a parent corporation’s liability for operating a facility ostensibly operated by its subsidiary depends on whether the degree to which the parent controls the subsidiary and the extent and manner of its involvement with the facility amount to the abuse of the corporate form that will warrant piercing the corporate veil and disregarding the separate corporate entities of the parent and subsidiary. Applying Michigan veil-piercing law, the court decided that CPC was not liable for controlling Ott II’s actions, since the two corporations maintained separate personalities and CPC did not utilize the subsidiary form to perpetrate fraud or subvert justice.
Held:
1. When (but only when) the corporate veil may be pierced, a parent corporation may be charged with derivative CERCLA liability for its subsidiary’s actions in operating a polluting facility. It is a general principle of corporate law that a parent corporation (so-called because of control through ownership of another corporation’s stock) is not liable for the acts of its subsidiaries. CERCLA does not purport to reject this bedrock principle, and the Government has indeed made no claim that a corporate parent is liable as an owner or an operator under §107(a)(2) simply because its subsidiary owns or operates a polluting facility. But there is an equally fundamental principle of corporate law, applicable to the parent-subsidiary relationship as well as generally, that the corporate veil may be pierced and the shareholder held liable for the corporation’s conduct when, inter alia, the corporate form would otherwise be misused to accomplish certain wrongful purposes, most notably fraud, on the shareholder’s behalf. CERCLA does not purport to rewrite this well-settled rule, either, and against this venerable common-law backdrop, the congressional silence is audible. Cf. Edmonds v. Compagnie Generale Transatlantique, 443 U.S. 256, 266-267. CERCLA’s failure to speak to a matter as fundamental as the liability implications of corporate ownership demands application of the rule that, to abrogate a common-law principle, a statute must speak directly to the question addressed by the common law. United States v. Texas, 507 U.S. 529, 534.
2. A corporate parent that actively participated in, and exercised control over, the operations of its subsidiary’s facility may be held directly liable in its own right under §107(a)(2) as an operator of the facility.
(a) Derivative liability aside, CERCLA does not bar a parent corporation from direct liability for its own actions. Under the plain language of §107(a)(2), any person who operates a polluting facility is directly liable for the costs of cleaning up the pollution, and this is so even if that person is the parent corporation of the facility’s owner. Because the statute does not define the term “operate,” however, it is difficult to define actions sufficient to constitute direct parental “operation.” In the organizational sense obviously intended by CERCLA, to “operate” a facility ordinarily means to direct the workings of, manage, or conduct the affairs of the facility. To sharpen the definition for purposes of CERCLA’s concern with environmental contamination, an operator must manage, direct, or conduct operations specifically related to the leakage or disposal of hazardous waste, or decisions about compliance with environmental regulations.
(b) The Sixth Circuit correctly rejected the direct liability analysis of the District Court, which mistakenly focused on the relationship between parent and subsidiary, and premised liability on little more than CPC’s ownership of Ott II and its majority control over Ott II’s board of directors. Because direct liability for the parent’s operation of the facility must be kept distinct from derivative liability for the subsidiary’s operation of the facility, the analysis should instead have focused on the relationship between CPC and the facility itself, i.e., on whether CPC “operated” the facility, as evidenced by its direct participation in the facility’s activities. That error was compounded by the District Court’s erroneous assumption that actions of the joint officers and directors were necessarily attributable to CPC, rather than Ott II, contrary to time-honored common-law principles. The District Court’s focus on the relationship between parent and subsidiary (rather than parent and facility), combined with its automatic attribution of the actions of dual officers and directors to CPC, erroneously, even if unintentionally, treated CERCLA as though it displaced or fundamentally altered common-law standards of limited liability. The District Court’s analysis created what is in essence a relaxed, CERCLA-specific rule of derivative liability that would banish traditional standards and expectations from the law of CERCLA liability. Such a rule does not arise from congressional silence, and CERCLA’s silence is dispositive.
(c) Nonetheless, the Sixth Circuit erred in limiting direct liability under CERCLA to a parent’s sole or joint venture operation, so as to eliminate any possible finding that CPC is liable as an operator on the facts of this case. The ordinary meaning of the word “operate” in the organizational sense is not limited to those two parental actions, but extends also to situations in which, e.g., joint officers or directors conduct the affairs of the facility on behalf of the parent, or agents of the parent with no position in the subsidiary manage or direct activities at the subsidiary’s facility. Norms of corporate behavior (undisturbed by any CERCLA provision) are crucial reference points, both for determining whether a dual officer or director has served the parent in conducting operations at the facility, and for distinguishing a parental officer’s oversight of a subsidiary from his control over the operation of the subsidiary’s facility. There is, in fact, some evidence that an agent of CPC alone engaged in activities at Ott II’s plant that were eccentric under accepted norms of parental oversight of a subsidiary’s facility: The District Court’s opinion speaks of such an agent who played a conspicuous part in dealing with the toxic risks emanating from the plant’s operation. The findings in this regard are enough to raise an issue of CPC’s operation of the facility, though this Court draws no ultimate conclusion, leaving the issue for the lower courts to reevaluate and resolve in the first instance.
113 F.3d 572, vacated and remanded.
Case Questions
1. In what ways can operator liability attach to a parent corporation? How did the Sixth Circuit Court disagree with the district court’s analysis?
2. Is direct liability for a parent company’s operation of the facility distinct from derivative liability for the subsidiary’s operation of the facility? Should the focus be on parent and subsidiary or on parent and facility?
3. What norms of corporate behavior does the court look to in determining whether an officer or a director is involved in the operation of a facility?
Corporate Promoter
RKO-Stanley Warner Theatres, Inc. v. Graziano
355 A.2d. 830 (1976)
EAGEN, JUSTICE.
On April 30, 1970, RKO-Stanley Warner Theatres, Inc. [RKO], as seller, entered into an agreement of sale with Jack Jenofsky and Ralph Graziano, as purchasers. This agreement contemplated the sale of the Kent Theatre, a parcel of improved commercial real estate located at Cumberland and Kensington Avenues in Philadelphia, for a total purchase price of \$70,000. Settlement was originally scheduled for September 30, 1970, and, at the request of Jenofsky and Graziano, continued twice, first to October 16, 1970, and then to October 21, 1970. However, Jenofsky and Graziano failed to complete settlement on the last scheduled date.
Subsequently, on November 13, 1970, RKO filed a complaint in equity seeking judicial enforcement of the agreement of sale. Although Jenofsky, in his answer to the complaint, denied personal liability for the performance of the agreement, the chancellor, after a hearing, entered a decree nisi granting the requested relief sought by RKO.…This appeal ensued.
At the time of the execution of this agreement, Jenofsky and Graziano were engaged in promoting the formation of a corporation to be known as Kent Enterprises, Inc. Reflecting these efforts, Paragraph 19 of the agreement, added by counsel for Jenofsky and Graziano, recited:
It is understood by the parties hereto that it is the intention of the Purchaser to incorporate. Upon condition that such incorporation be completed by closing, all agreements, covenants, and warranties contained herein shall be construed to have been made between Seller and the resultant corporation and all documents shall reflect same.
In fact, Jenofsky and Graziano did file Articles of Incorporation for Kent Enterprises, Inc., with the State Corporation Bureau on October 9, 1971, twelve days prior to the scheduled settlement date. Jenofsky now contends the inclusion of Paragraph 19 in the agreement and the subsequent filing of incorporation papers, released him from any personal liability resulting from the non-performance of the agreement.
The legal relationship of Jenofsky to Kent Enterprises, Inc., at the date of the execution of the agreement of sale was that of promoter. As such, he is subject to the general rule that a promoter, although he may assume to act on behalf of a projected corporation and not for himself, will be held personally liable on contracts made by him for the benefit of a corporation he intends to organize. This personal liability will continue even after the contemplated corporation is formed and has received the benefits of the contract, unless there is a novation or other agreement to release liability.
The imposition of personal liability upon a promoter where that promoter has contracted on behalf of a corporation is based upon the principle that one who assumes to act for a nonexistent principal is himself liable on the contract in the absence of an agreement to the contrary.
[T]here [are] three possible understandings that parties may have when an agreement is executed by a promoter on behalf of a proposed corporation:
When a party is acting for a proposed corporation, he cannot, of course, bind it by anything he does, at the time, but he may (1) take on its behalf an offer from the other which, being accepted after the formation of the company, becomes a contract; (2) make a contract at the time binding himself, with the stipulation or understanding, that if a company is formed it will take his place and that then he shall be relieved of responsibility; or (3) bind himself personally without more and look to the proposed company, when formed, for indemnity.
Both RKO and Jenofsky concede the applicability of alternative No. 2 to the instant case. That is, they both recognize that Jenofsky (and Graziano) was to be initially personally responsible with this personal responsibility subsequently being released. Jenofsky contends the parties, by their inclusion of Paragraph 19 in the agreement, manifested an intention to release him from personal responsibility upon the mere formation of the proposed corporation, provided the incorporation was consummated prior to the scheduled closing date. However, while Paragraph 19 does make provision for recognition of the resultant corporation as to the closing documents, it makes no mention of any release of personal liability. Indeed, the entire agreement is silent as to the effect the formation of the projected corporation would have upon the personal liability of Jenofsky and Graziano. Because the agreement fails to provide expressly for the release of personal liability, it is, therefore, subject to more than one possible construction.
In Consolidated Tile and Slate Co. v. Fox, 410 Pa. 336,339,189 A.2d 228, 229 (1963), we stated that where an agreement is ambiguous and reasonably susceptible of two interpretations, “it must be construed most strongly against those who drew it.”…Instantly, the chancellor determined that the intent of the parties to the agreement was to hold Jenofsky personally responsible until such time as a corporate entity was formed and until such time as that corporate entity adopted the agreement. We believe this construction represents the only rational and prudent interpretation of the parties’ intent.
As found by the court below, this agreement was entered into on the financial strength of Jenofsky and Graziano, alone as individuals. Therefore, it would have been illogical for RKO to have consented to the release of their personal liability upon the mere formation of a resultant corporation prior to closing. For it is a well-settled rule that a contract made by a promoter, even though made for and in the name of a proposed corporation, in the absence of a subsequent adoption (either expressly or impliedly) by the corporation, will not be binding upon the corporation. If, as Jenofsky contends, the intent was to release personal responsibility upon the mere incorporation prior to closing, the effect of the agreement would have been to create the possibility that RKO, in the event of non-performance, would be able to hold no party accountable: there being no guarantee that the resultant corporation would ratify the agreement. Without express language in the agreement indicating that such was the intention of the parties, we may not attribute this intention to them.
Therefore, we hold that the intent of the parties in entering into this agreement was to have Jenofsky and Graziano personally liable until such time as the intended corporation was formed and ratified the agreement. [And there is no evidence that Kent Enterprises ratified the agreement. The decree is affirmed.]
Case Questions
1. Does a promoter’s personal liability continue even after the corporation is formed? Can he or she look to the corporation for indemnity after the corporation is formed?
2. In what instance(s) is a contract made by a promoter not binding on a corporation?
3. In whose favor does a court construe an ambiguous agreement?
De Jure and De Facto Corporations
Cranson v. International Business Machines Corp.
234 Md. 477, 200 A.2d 33 (1964)
HORNEY, JUDGE
On the theory that the Real Estate Service Bureau was neither a de jure nor a de facto corporation and that Albion C. Cranson, Jr., was a partner in the business conducted by the Bureau and as such was personally liable for its debts, the International Business Machines Corporation brought this action against Cranson for the balance due on electric typewriters purchased by the Bureau. At the same time it moved for summary judgment and supported the motion by affidavit. In due course, Cranson filed a general issue plea and an affidavit in opposition to summary judgment in which he asserted in effect that the Bureau was a de facto corporation and that he was not personally liable for its debts.
The agreed statement of facts shows that in April 1961, Cranson was asked to invest in a new business corporation which was about to be created. Towards this purpose he met with other interested individuals and an attorney and agreed to purchase stock and become an officer and director. Thereafter, upon being advised by the attorney that the corporation had been formed under the laws of Maryland, he paid for and received a stock certificate evidencing ownership of shares in the corporation, and was shown the corporate seal and minute book. The business of the new venture was conducted as if it were a corporation, through corporate bank accounts, with auditors maintaining corporate books and records, and under a lease entered into by the corporation for the office from which it operated its business. Cranson was elected president and all transactions conducted by him for the corporation, including the dealings with I.B.M., were made as an officer of the corporation. At no time did he assume any personal obligation or pledge his individual credit to I.B.M. Due to an oversight on the part of the attorney, of which Cranson was not aware, the certificate of incorporation, which had been signed and acknowledged prior to May 1, 1961, was not filed until November 24, 1961. Between May 17 and November 8, the Bureau purchased eight typewriters from I.B.M., on account of which partial payments were made, leaving a balance due of \$4,333.40, for which this suit was brought.
Although a question is raised as to the propriety of making use of a motion for summary judgment as the means of determining the issues presented by the pleadings, we think the motion was appropriate. Since there was no genuine dispute as to the material facts, the only question was whether I.B.M. was entitled to judgment as a matter of law. The trial court found that it was, but we disagree.
The fundamental question presented by the appeal is whether an officer of a defectively incorporated association may be subjected to personal liability under the circumstances of this case. We think not.
Traditionally, two doctrines have been used by the courts to clothe an officer of a defectively incorporated association with the corporate attribute of limited liability. The first, often referred to as the doctrine of de facto corporations, has been applied in those cases where there are elements showing: (1) the existence of law authorizing incorporation; (2) an effort in good faith to incorporate under the existing law; and (3) actual use or exercise of corporate powers. The second, the doctrine of estoppel to deny the corporate existence, is generally employed where the person seeking to hold the officer personally liable has contracted or otherwise dealt with the association in such a manner as to recognize and in effect admit its existence as a corporate body.
* * *
There is, as we see it, a wide difference between creating a corporation by means of the de facto doctrine and estopping a party, due to his conduct in a particular case, from setting up the claim of no incorporation. Although some cases tend to assimilate the doctrines of incorporation de facto and by estoppel, each is a distinct theory and they are not dependent on one another in their application. Where there is a concurrence of the three elements necessary for the application of the de facto corporation doctrine, there exists an entity which is a corporation de jure against all persons but the state.
On the other hand, the estoppel theory is applied only to the facts of each particular case and may be invoked even where there is no corporation de facto. Accordingly, even though one or more of the requisites of a de facto corporation are absent, we think that this factor does not preclude the application of the estoppel doctrine in a proper case, such as the one at bar.
I.B.M. contends that the failure of the Bureau to file its certificate of incorporation debarred all corporate existence. But, in spite of the fact that the omission might have prevented the Bureau from being either a corporation de jure or de facto, Jones v. Linden Building Ass’n, we think that I.B.M. having dealt with the Bureau as if it were a corporation and relied on its credit rather than that of Cranson, is estopped to assert that the Bureau was not incorporated at the time the typewriters were purchased. In 1 Clark and Marshall, Private Corporations, § 89, it is stated:
The doctrine in relation to estoppel is based upon the ground that it would generally be inequitable to permit the corporate existence of an association to be denied by persons who have represented it to be a corporation, or held it out as a corporation, or by any persons who have recognized it as a corporation by dealing with it as such; and by the overwhelming weight of authority, therefore, a person may be estopped to deny the legal incorporation of an association which is not even a corporation de facto.
In cases similar to the one at bar, involving a failure to file articles of incorporation, the courts of other jurisdictions have held that where one has recognized the corporate existence of an association, he is estopped to assert the contrary with respect to a claim arising out of such dealings.
Since I.B.M. is estopped to deny the corporate existence of the Bureau, we hold that Cranson was not liable for the balance due on account of the typewriters.
Judgment reversed; the appellee to pay the costs.
Case Questions
1. What is the fundamental question presented by the case?
2. What are the differences between creating a corporation de facto and by estoppel? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.07%3A_Cases.txt |
Summary
The hallmark of the corporate form of business enterprise is limited liability for its owners. Other features of corporations are separation of ownership and management, perpetual existence, and easy transferability of interests. In the early years of the common law, corporations were thought to be creatures of sovereign power and could be created only by state grant. But by the late nineteenth century, corporations could be formed by complying with the requirements of general corporation statutes in virtually every state. Today the standard is the Revised Model Business Corporation Act.
The corporation, as a legal entity, has many of the usual rights accorded natural persons. The principle of limited liability is broad but not absolute: when the corporation is used to commit a fraud or an injustice or when the corporation does not act as if it were one, the courts will pierce the corporate veil and pin liability on stockholders.
Besides the usual business corporation, there are other forms, including not-for-profit corporations and professional corporations. Business corporations are classified into two types: publicly held and closely held corporations.
To form a corporation, the would-be stockholders must choose the state in which they wish to incorporate. The goal of the incorporation process is issuance of a corporate charter. The charter is a contract between the state and the corporation. Although the Constitution prohibits states from impairing the obligation of contracts, states reserve the right to modify corporate charters.
The corporation is created by the incorporators (or promoters), who raise capital, enter into contracts on behalf of the corporation to be formed, and prepare the articles of incorporation. The promoters are personally liable on the contracts they enter into before the corporation is formed. Incorporators owe a fiduciary duty to each other, to investors, and to the corporation.
The articles of incorporation typically contain a number of features, including the corporate name, corporate purposes, total number of shares and classes into which they are divided, par value, and the like. The name must include one of the following words (or abbreviations): corporation, company, incorporated, or limited (Corp., Co., Inc., or Ltd.). The articles of incorporation must be filed with the secretary of state. Once they have been filed, the board of directors named in the articles must adopt bylaws, elect officers, and conduct other necessary business. The directors are empowered to alter the bylaws, subject to repeal or change by the shareholders.
Even if the formal prerequisites to incorporation are lacking, a de facto corporation will be held to have been formed if (1) a statute exists under which the corporation could have been validly incorporated, (2) the promoters made a bona fide attempt to comply with the statute, and (3) a corporate privilege was exercised. Under appropriate circumstances, a corporation will be held to exist by estoppel.
Exercises
1. Two young business school graduates, Laverne and Shirley, form a consulting firm. In deciding between the partnership and corporation form of organization, they are especially concerned about personal liability for giving bad advice to their clients; that is, in the event they are sued, they want to prevent plaintiffs from taking their personal assets to satisfy judgments against the firm. Which form of organization would you recommend? Why?
2. Assume that Laverne and Shirley in Exercise 1 must negotiate a large loan from a local bank in order to finance their firm. A friend advises them that they should incorporate in order to avoid personal liability for the loan. Is this good advice? Why?
3. Assume that Laverne and Shirley decide to form a corporation. Before the incorporation process is complete, Laverne enters into a contract on behalf of the corporation to purchase office furniture and equipment for \$20,000. After the incorporation process has been completed, the corporation formally accepts the contract made by Laverne. Is Laverne personally liable on the contract before corporate acceptance? After corporate acceptance? Why?
4. Assume that Laverne and Shirley have incorporated their business. One afternoon, an old college friend visits Shirley at the office. Shirley and her friend decide to go out for dinner to discuss old times. Shirley, being short of cash, takes money from a petty cash box to pay for dinner. (She first obtains permission from Laverne, who has done the same thing many times in the past.) Over dinner, Shirley learns that her friend is now an IRS agent and is investigating Shirley’s corporation. What problems does Shirley face in the investigation? Why?
5. Assume that Laverne and Shirley prepare articles of incorporation but forget to send the articles to the appropriate state office. A few months after they begin to operate their consulting business as a corporation, Laverne visits a client. After her meeting, in driving out of a parking lot, Laverne inadvertently backs her car over the client, causing serious bodily harm. Is Shirley liable for the accident? Why?
6. Ralph, a resident of Oklahoma, was injured when using a consumer product manufactured by a corporation whose principal offices were in Tulsa. Since his damages exceeded \$10,000, he filed a products-liability action against the company, which was incorporated in Delaware, in federal court. Does the federal court have jurisdiction? Why?
7. Alice is the president and only shareholder of a corporation. The IRS is investigating Alice and demands that she produce her corporate records. Alice refuses, pleading the Fifth Amendment privilege against self-incrimination. May the IRS force Alice to turn over her corporate records? Why?
SELF CHECK QUESTIONS
1. In comparing partnerships with corporations, the major factor favoring the corporate form is
1. ease of formation
2. flexible financing
3. limited liability
4. control of the business by investors
2. A corporation with no part of its income distributable to its members, directors, or officers is called
1. a publicly held corporation
2. a closely held corporation
3. a professional corporation
4. a nonprofit corporation
3. A corporation in which stock is widely held or available through a national or regional stock exchange is called
1. a publicly held corporation
2. a closely held corporation
3. a public corporation
4. none of the above
4. Essential to the formation of a de facto corporation is
1. a statute under which the corporation could have been validly incorporated
2. promoters who make a bona fide attempt to comply with the corporation statute
3. the use or exercise of corporate powers
4. each of the above
5. Even when incorporators miss important steps, it is possible to create
1. a corporation by estoppel
2. a de jure corporation
3. an S corporation
4. none of the above
1. c
2. d
3. a
4. d
5. a | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/21%3A_CorporationGeneral_Characteristics_and_Formation/21.08%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The general sources of corporate funds
• The basics of corporate bonds and other debt leveraging
• What the various types of stocks are
• Initial public offerings and consideration for stock
• What dividends are
• Some of the modern trends in corporate finance
A corporation requires money for many reasons. In this chapter, we look at the methods available to a corporation for raising funds, focusing on how firms generate large amounts of funds and finance large projects, such as building a new factory.
One major method of finance is the sale of stock. A corporation sells shares of stock, often in an initial public offering. In exchange for consideration—usually cash—the purchaser acquires stock in the corporation. This stock may give the owner a share in earnings, the right to transfer the stock, and, depending on the size of the corporation and the number of shares, power to exercise control. Other methods of corporate finance include bank financing and bonds. We also discuss some more modern financing methods, such as private equity and venture capital.
22: Legal Aspects of Corporate Finance
Learning Objectives
By the end of this section, you will be able to:
• Discuss the main sources for raising corporate funds.
• Examine the reinvestment of earnings to finance growth.
• Review debt and equity as methods of raising funds.
• Consider private equity and venture capital, and compare their utility to other forms of financing.
Sources
To finance growth, any ongoing business must have a source of funds. Apart from bank and trade debt, the principal sources are plowback, debt securities, equity securities, and private equity.
Plowback
A significant source of new funds that corporations spend on capital projects is earnings. Rather than paying out earnings to shareholders, the corporation plows those earnings back into the business. Plowback is simply reinvesting earnings in the corporation. It is an attractive source of capital because it is subject to managerial control. No approval by governmental agencies is necessary for its expenditure, as it is when a company seeks to sell securities, or stocks and bonds. Furthermore, stocks and bonds have costs associated with them, such as the interest payments on bonds (discussed in Section 22.1.3 “Debt Securities”), while retaining profits avoids these costs.
Debt Securities
A second source of funds is borrowing through debt securities. A corporation may take out a debt security such as a loan, commonly evidenced by a note and providing security to the lender. This is covered in Chapter 11 and Chapter 12. A common type of corporate debt security is a bond, which is a promise to repay the face value of the bond at maturity and make periodic interest payments called the coupon rate. For example, a bond may have a face value of \$1,000 (the amount to be repaid at maturity) and a coupon rate of 7 percent paid annually; the corporation pays \$70 interest on such a bond each year. Bondholders have priority over stockholders because a bond is a debt, and in the event of bankruptcy, creditors have priority over equity holders.
Equity Securities
The third source of new capital funds is equity securities—namely, stock. Equity is an ownership interest in property or a business. Stock is the smallest source of new capital but is of critical importance to the corporation in launching the business and its initial operations. Stock gives the investor a bundle of legal rights—ownership, a share in earnings, transferability and, to some extent, the power to exercise control through voting. The usual way to acquire stock is by paying cash or its equivalent as consideration. Both stock and consideration are discussed in more detail in Section 22.3.2 “Par Value and No-Par Stock” and Section 22.4.
Other Forms of Finance
While stock, debt securities, and reinvested profits are the most common types of finance for major corporations (particularly publicly traded corporations), smaller corporations or start-ups cannot or do not want to avail themselves of these financing options. Instead, they seek to raise funds through private equity, which involves private investors providing funds to a company in exchange for an interest in the company. A private equity firm is a group of investors who pool their money together for investment purposes, usually to invest in other companies. Looking to private equity firms is an option for start-ups—companies newly formed or in the process of being formed—that cannot raise funds through the bond market or that wish to avoid debt or a public stock sale. Start-ups need money to begin operations, expand, or conduct further research and development. A private equity firm might provide venture capital financing for these start-ups. Generally, private equity firms that provide a lot of venture capital must be extremely savvy about the start-up plans of new businesses and must ask the start-up entrepreneurs numerous challenging and pertinent questions. Such private equity firms expect a higher rate of return on their investment than would be available from established companies. Today, venture capital is often used to finance entrepreneurial start-ups in biotechnology and clean technology.
Sometimes, a private equity firm will buy all the publicly traded shares of a company—a process commonly termed “going private.” Private equity may also be involved in providing financing to established firms.
Another source of private equity is angel investors, affluent individuals who operate like venture capitalists, providing capital for a business to get started in exchange for repayment with interest or an ownership interest. The main difference between an angel investor and a venture capitalist is the source of funds: an angel investor invests his or her own money, while venture capitalists use pooled funds.
Private equity firms may also use a leveraged buyout (LBO) to finance the acquisition of another firm. Discussed further in Chapter 25 on Corporate Expansion, in the realm of private equity, an LBO is a financing option using debt to acquire another firm. In an LBO, private equity investors use the assets of the target corporation as collateral for a loan to purchase that target corporation. Such investors may pursue an LBO as a debt acquisition option since they do not need to use much—or even any—of their own money in order to finance the acquisition.
A major drawback to private equity, whether through a firm or through venture capital, is the risk versus return trade-off. Private equity investors may demand a significant interest in the firm, or a high return, to compensate them for the riskiness of their investment. They may demand a say in how the firm is operated or a seat on the board of directors.
Key Takeaway
There are four main sources of corporate finance. The first is plowback, or reinvesting profits in the corporation. The second is borrowing, commonly through a bond issue. A corporation sells a bond, agreeing to periodic interest payments and repayment of the face value of the bond at maturity. The third source is equity, usually stock, whereby a corporation sells an ownership interest in the corporation. The fourth source is private equity and venture capital.
Exercises
1. What are the main sources of corporate finance?
2. What are some of the legal rights associated with stock ownership?
3. Describe private equity. What are some similarities and differences between private equity and venture capital? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.01%3A_General_Sources_of_Corporate_Funds.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss the basics of corporate bonds.
• Review the advantages and disadvantages to the corporation of issuing bonds.
Basics of Corporate Bonds
Corporations often raise money through debt. This can be done through loans or bank financing but is often accomplished through the sale of bonds. Large corporations, in particular, use the bond market. Private equity is not ideal for established firms because of the high cost to them, both monetarily and in terms of the potential loss of control.
For financing, many corporations sell corporate bonds to investors. A bond is like an IOU. When a corporation sells a bond, it owes the bond purchaser periodic interest payments as well as a lump sum at the end of the life of the bond (the maturity date). A typical bond is issued with a face value, also called the par value, of \$1,000 or some multiple of \$1,000. The face value is the amount that the corporation must pay the purchaser at the end of the life of the bond. Interest payments, also called coupon payments, are usually made on a biannual basis but could be of nearly any duration. There are even zero coupon bonds, which pay only the face value at maturity.
Advantages and Disadvantages of Bonds
One advantage of issuing bonds is that the corporation does not give away ownership interests. When a corporation sells stock, it changes the ownership interest in the firm, but bonds do not alter the ownership structure. Bonds provide flexibility for a corporation: it can issue bonds of varying durations, value, payment terms, convertibility, and so on. Bonds also expand the number of investors available to the corporation. From an investor standpoint, bonds are generally less risky than stock. Most corporate bonds are given ratings—a measurement of the risk associated with holding a particular bond. Therefore, risk-averse investors who would not purchase a corporation’s stock could seek lower-risk returns in highly rated corporate bonds. Investors are also drawn to bonds because the bond market is much larger than the stock market and bonds are highly liquid and less risky than many other types of investments.
Another advantage to the corporation is the ability to make bonds “callable”—the corporation can force the investor to sell bonds back to the corporation before the maturity date. Often, there is an additional cost to the corporation (a call premium) that must be paid to the bondholder, but the call provision provides another level of flexibility for the corporation. Bonds may also be convertible; the corporation can include a provision that permits bondholders to convert their bonds into equity shares in the firm. This would permit the corporation to decrease the cost of the bonds, because bondholders would ordinarily accept lower coupon payments in exchange for the option to convert the bonds into equity. Perhaps the most important advantage to issuing bonds is from a taxation standpoint: the interest payments made to the bondholders may be deductible from the corporation’s taxes.
A key disadvantage of bonds is that they are debt. The corporation must make its bond interest payments. If a corporation cannot make its interest payments, the bondholders can force it into bankruptcy. In bankruptcy, the bondholders have a liquidation preference over investors with ownership—that is, the shareholders. Additionally, being highly leveraged can be risky: a corporation could load itself up with too much debt and not be able to make its interest payments or face-value payments. Another major consideration is the “cost” of debt. When interest rates are high, corporations must offer higher interest rates to attract investors.
Key Takeaway
Corporations often raise capital and finance operations through debt. Bank loans are one source of debt, but large corporations often turn to bonds for financing. Bonds are an IOU, whereby the corporation sells a bond to an investor; agrees to make periodic interest payments, such as 5 percent of the face value of the bond annually; and at the maturity date, pays the face value of the bond to the investor. There are several advantages to the corporation in using bonds as a financial instrument: the corporation does not give up ownership in the firm, it attracts more investors, it increases its flexibility, and it can deduct the interest payments from corporate taxes. Bonds do have some disadvantages: they are debt and can hurt a highly leveraged company, the corporation must pay the interest and principal when they are due, and the bondholders have a preference over shareholders upon liquidation.
Exercises
1. Describe a bond.
2. What are some advantages to the corporation in issuing bonds?
3. What are some disadvantages to the corporation in using bonds? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.02%3A_Bonds.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the basic features of corporate stock.
• Be familiar with the basic terminology of corporate stock.
• Discuss preferred shares and the rights of preferred shareholders.
• Compare common stock with preferred stock.
• Describe treasury stock, and explain its function.
• Analyze whether debt or equity is a better financing option.
Stocks, or shares, represent an ownership interest in a corporation. Traditionally, stock was the original capital paid into a business by its founders. This stock was then divided into shares, or fractional ownership of the stock. In modern usage, the two terms are used interchangeably, as we will do here. Shares in closely held corporations are often identical: each share of stock in BCT Bookstore, Inc. carries with it the same right to vote, to receive dividends, and to receive a distribution of the net assets of the company upon liquidation. Many large corporations do not present so simple a picture. Large corporations may have many different types of stock: different classes of common stock, preferred stock, stock with par value and no-par stock, voting and nonvoting stock, outstanding stock, and treasury stock. To find out which types of stock a company has issued, look at the shareholders’ (or stockholders’) equity section of the company’s balance sheet.
Authorized, Issued, and Outstanding Stock
Stocks have different designations depending on who holds them. The articles of incorporation spell out how many shares of stock the corporation may issue: these are its authorized shares. The corporation is not obliged to issue all authorized shares, but it may not issue more than the total without amending the articles of incorporation. The total of stock sold to investors is the issued stock of the corporation; the issued stock in the hands of all shareholders is called outstanding stock.
Par Value and No-Par Stock
Par value is the face value of stock. Par value, though, is not the market value; it is a value placed on the stock by the corporation but has little to do with the buying and selling value of that stock on the open market.
When a value is specified on a stock certificate, it is said to be par value. Par value is established in the articles of incorporation and is the floor price of the stock; the corporation may not accept less than par value for the stock.
Companies in most states can also issue no-par shares. No-par stock may be sold for whatever price is set by the board of directors or by the market—unless the shareholders themselves are empowered to establish the price. But many states permit (and some states require) no-par stock to have a stated value. Corporations issue no-par stock to reduce their exposure to liability: if the par value is greater than the market value, the corporation may be liable for that difference.
Once the universal practice, issuance of par value common stock is now limited. However, preferred stock usually has a par value, which is useful in determining dividend and liquidation rights.
The term stated capital describes the sum of the par value of the issued par value stock and the consideration received (or stated value) for the no-par stock. The excess of net assets of a corporation over stated capital is its surplus. Surplus is divided into earned surplus (essentially the company’s retained earnings) and capital surplus (all surpluses other than earned surplus). We will return to these concepts in our discussion of dividends.
Preferred Stock
The term preferred has no set legal meaning, but shareholders of preferred stock often have different rights than shareholders of common stock. Holders of preferred stock must look to the articles of incorporation to find out what their rights are. Preferred stock has elements of both stock (equity) and bonds (debt). Thus corporations issue preferred stock to attract more conservative investors: common stock is riskier than preferred stock, so corporations can attract more investors if they have both preferred and common stock.
Preference to Dividends
A dividend is a payment made to stockholders from corporate profits. Assume that one class of preferred stock is entitled to a 7 percent dividend. The percentage applies to the par value; if par value is \$100, each share of preferred is entitled to a dividend of \$7 per year. Assuming the articles of incorporation say so, this 7 percent preferred stock has preference over other classes of shares for dividend payments.
Liquidation Preference
An additional right of preferred shareholders is the right to share in the distribution of assets in the event of liquidation, after having received assets under a liquidation preference—that is, a preference, according to a predetermined formula, to receive the assets of the company on liquidation ahead of other classes of shareholders.
Convertible Shares
With one exception, the articles of incorporation may grant the right to convert any class of stock into any other at the holder’s option according to a fixed ratio. Alternatively, the corporation may force a conversion of a shareholder’s convertible stock. Thus if permitted, a preferred shareholder may convert his or her preferred shares into common stock, or vice versa. The exception bars conversion of stock into a class with an asset liquidation preference, although some states permit even that type of so-called upstream conversion to a senior security. Convertible preferred shares can be used as a poison pill (a corporate strategy to avoid a hostile takeover): when an outsider seeks to gain control, convertible shareholders may elect to convert their preferred shares into common stock, thus increasing the number of common shares and increasing the number of shares the outsider must purchase in order to gain control.
Redeemable Shares
The articles of incorporation may provide for the redemption of shares, unless in doing so the corporation would become insolvent. Redemption may be either at an established price and time or by election of the corporation or the shareholder. Redeemed stock is called cancelled stock. Unless the articles of incorporation prohibit it, the shares are considered authorized but unissued and can be reissued as the need arises. If the articles of incorporation specifically make the cancellation permanent, then the total number of authorized shares is reduced, and new shares cannot be reissued without amending the articles of incorporation. In this case, the redeemed shares cannot be reissued and must be marked as cancelled stock.
Voting Rights
Ordinarily, the articles of incorporation provide that holders of preferred shares do not have a voting right. Or they may provide for contingent voting rights, entitling preferred shareholders to vote on the happening of a particular event—for example, the nonpayment of a certain number of dividends. The articles may allow class voting for directors, to ensure that the class of preferred stockholders has some representation on the board.
Common Stock
Common stock is different from preferred stock. Common stock represents an ownership interest in a corporation. Unless otherwise provided in the articles of incorporation, common stockholders have the following rights:
1. Voting rights. This is a key difference: preferred shareholders usually do not have the right to vote. Common shareholders express their ownership interest in the corporation by voting. Votes are cast at meetings, typically the annual meetings, and the shareholders can vote for directors and on other important corporate decisions (e.g., there has been a recent push to allow shareholders to vote on executive compensation).
2. The right to ratable participation in earnings (i.e., in proportion to the total shares) and/or the right to ratable participation in the distribution of net assets on liquidation. Bondholders and other creditors have seniority upon liquidation, but if they have been satisfied, or the corporation has no debt, the common shareholders may ratably recover from what is left over in liquidation.
3. Some shares may give holders preemptive rights to purchase additional shares. This right is often invoked in two instances. First, if a corporation is going to issue more shares, a shareholder may invoke this right so that his or her total percentage ownership is not diluted. Second, the right to purchase additional shares can be invoked to prevent a hostile takeover (a poison pill, discussed in Section 22.3.3 “Preferred Stock”).
Corporations may issue different classes of shares (including both common and preferred stock). This permits a corporation to provide different rights to shareholders. For example, one class of common stock may give holders more votes than another class of common stock. Stock is a riskier investment for its purchasers compared with bonds and preferred stock. In exchange for this increased risk and junior treatment, common stockholders have the rights noted here.
Treasury Shares
Treasury shares are those that were originally issued and then reacquired by the company (such as in a buyback, discussed next) or, alternatively, never sold to the public in the first place and simply retained by the corporation. Thus treasury shares are shares held or owned by the corporation. They are considered to be issued shares but not outstanding shares.
Buyback
Corporations often reacquire their shares, for a variety of reasons, in a process sometimes called a buyback. If the stock price has dropped so far that the shares are worth considerably less than book value, the corporation might wish to buy its shares to prevent another company from taking it over. The company might decide that investing in itself is a better strategic decision than making other potential expenditures or investments. And although it is essentially an accounting trick, buybacks improve a company’s per-share earnings because profits need to be divided into fewer outstanding shares.
Buybacks can also be used to go private. Private equity may play a role in going-private transactions, as discussed in Section 22.1.5 “Other Forms of Finance”. The corporation may not have sufficient equity to buy out all its public shareholders and thus will partner with private equity to finance the stock buyback to go private. For example, in early 2011, Playboy Enterprises, Inc., publisher of Playboy magazine, went private. Hugh Hefner, the founder of Playboy, teamed up with private equity firm Rizvi Traverse Management to buy back the public shares. Hefner said that the transaction “will give us the resources and flexibility to return Playboy to its unique position and to further expand our business around the world.”Dawn C. Chmielewski and Robert Channick, “Hugh Hefner Reaches Deal to Take Playboy Private,” Los Angeles Times, January 11, 2011. http://articles.latimes.com/2011/jan/11/business/la-fi-ct-playboy-hefner-20110111.
Corporations may go private to consolidate control, because of a belief that the shares are undervalued, to increase flexibility, or because of a tender offer or hostile takeover. Alternatively, an outside investor may think that a corporation is not being managed properly and may use a tender offer to buy all the public shares.
Stocks and Bonds and Bears, Oh My!
Suppose that BCT Bookstore, Inc. has become a large, well-established corporation after a round of private equity and bank loans (since repaid) but needs to raise capital. What is the best method? There is no one right answer. Much of the decision will depend on the financial and accounting standing of the corporation: if BCT already has a lot of debt, it might be better to issue stock rather than bring on more debt. Alternatively, BCT could wish to remain a privately held corporation, and thus a stock sale would not be considered, as it would dilute the ownership. The economy in general could impact the decision: a bear market could push BCT more toward using debt, while a bull market could push BCT more toward an initial public offering (discussed in Section 22.4.1 “Sale of stock”) or stock sale. Interest rates could be low, increasing the bang-for-the-buck factor of debt. Additionally, public stock sales can be risky for the corporation: the corporation could undervalue its stock in the initial sale, selling the stock for less than what the marketplace thinks it is worth, missing out on additional funds because of this undervaluation. Debt may also be beneficial because of the tax treatment of interest payments—the corporation can deduct the interest payments from corporate profits. Thus there are many factors a corporation must consider when deciding whether to finance through debt or equity.
Key Takeaway
Stock, or shares (equity), express an ownership interest in a corporation. Shares have different designations, depending on who holds the shares. The two main types of stock are preferred stock and common stock, each with rights that often differ from the rights of the other. Preferred stock has elements of both debt and equity. Holders of preferred shares have a dividend preference and have a right to share in the distribution of assets in liquidation. Holders of common stock have a different set of rights, namely, the right to vote on important corporate decisions such as the election of directors. A corporation may purchase some of its shares from its shareholders in a process called a buyback. Stock in the hands of the corporation is called treasury stock. There are a variety of factors that a corporation must consider in determining whether to raise capital through bonds or through stock issuance.
Exercises
1. What are some key rights of holders of preferred shares?
2. What is the major difference between preferred stock and common stock?
3. Why would a corporation buy back its own shares?
4. What are some factors a corporation must consider in deciding whether to issue stock or bonds? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.03%3A_Types_of_Stock.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand what an initial public offering is and under what circumstances one is usually done.
• Examine the various requirements of selling stock.
• Discuss what adequate and valid consideration is in exchange for stock.
Sale of stock
Rather than using debt to finance operations, a corporation may instead sell stock. This is most often accomplished through an initial public offering (IPO), or the first time a corporation offers stock for sale to the public. The sale of securities, such as stock, is governed by the Securities Act of 1933. In particular, Section 5 of the 1933 act governs the specifics of the sale of securities. To return to BCT Bookstore, Inc., suppose the company wishes to sell stock on the New York Stock Exchange (NYSE) for the first time. That would be an IPO. The company would partner with securities lawyers and investment banks to accomplish the sale. The banks underwrite the sale of the securities: in exchange for a fee, the bank will buy the shares from BCT and then sell them. The company and its team prepare a registration statement, which contains required information about the IPO and is submitted to the Securities and Exchange Commission (SEC). The SEC reviews the registration statement and makes the decision whether to permit or prohibit BCT’s IPO. Once the SEC approves the IPO, BCT’s investment banks purchase the shares in the primary market and then resell them to investors on the secondary market on the NYSE. (For a further discussion of these two markets, see Chapter 24). Stock sales are not limited to an IPO—publicly traded corporations may sell stock several times after going public. The requirements of the 1933 act remain but are loosened for well-known corporations (well-known seasoned issuers).
An IPO or stock sale has several advantages. A corporation may have too much debt and would prefer to raise funds through a sale of stock rather than increasing its debt. The total costs of selling stock are often lower than financing through debt: the IPO may be expensive, but debt costs can vastly exceed the IPO cost because of the interest payments on the debt. Also, IPOs are a popular method of increasing a firm’s exposure, bringing the corporation many more investors and increasing its public image. Issuing stock is also beneficial for the corporation because the corporation can use shares as compensation; for example, employment compensation may be in the form of stock, such as in an employee stock ownership plan. Investors also seek common stock, whether in an IPO or in the secondary market. While common stock is a riskier investment than a bond, stock ownership can have tremendous upside—after all, the sky is the limit on the price of a stock. On the other hand, there is the downside: the price of the stock can plummet, causing the shareholder significant monetary loss.
Certainly, an IPO has some disadvantages. Ownership is diluted: BCT had very few owners before its IPO but may have millions of owners after the IPO. As mentioned, an IPO can be expensive. An IPO can also be undervalued: the corporation and its investment banks may undervalue the IPO stock price, causing the corporation to lose out on the difference between its determined price and the market price. Being a public corporation also places the corporation under the purview of the SEC and requires ongoing disclosures. Timing can be problematic: the registration review process can take several weeks. The stock markets can change drastically over that waiting period. Furthermore, the offering could have insufficient purchasers to raise sufficient funds; that is, the public might not have enough interest in purchasing the company’s stock to bring in sufficient funds to the corporation. Finally, a firm that goes public releases information that is available to the public, which could be useful to competitors (trade secrets, innovations, new technology, etc.).
As mentioned, one of the main disadvantages of going public is the SEC review and disclosure requirements. The Securities Exchange Act of 1934 governs most secondary market transactions. The 1934 act places certain requirements on corporations that have sold securities. Both the 1933 and 1934 acts require corporations to disseminate information to the public and/or its investors. These requirements were strengthened after the collapse of Enron in 2001. The SEC realized that its disclosure requirements were not strong enough, as demonstrated by the accounting tricks and downfall of Enron and its accountant, Arthur Andersen.For a full discussion of Enron, see Bethany McLean and Peter Elkind, Enron: The Smartest Guys in the Room (New York: Portfolio, 2004).
As a result of Enron’s accounting scandal, as well as problems with other corporations, Congress tightened the noose by passing the Sarbanes-Oxley Act of 2002Sarbanes-Oxley Act can be viewed at University of Cincinnati, “The Sarbanes-Oxley Act of 2002,” Securities Lawyer’s Deskbook, taft.law.uc.edu/CCL/SOact/toc.html. This act increased the disclosure of financial information, increased transparency, and required the dissemination of information about what a corporation was doing. For example, Section 302 of Sarbanes-Oxley requires that a corporation’s chief executive officer and chief financial officer certify annual and quarterly reports and state that the report does not contain any material falsehoods and that the financial data accurately reflect the corporation’s condition.
Nature of the Consideration
Consideration is property or services exchanged for stock. While cash is commonly used to purchase stock, a stock purchaser may pay with something other than cash, such as property, whether tangible or intangible, or services or labor performed for the corporation. In most states, promissory notes and contracts for future services are not lawful forms of consideration. The case United Steel Industries, Inc. v. Manhart, (see Section 22.7.1 “Consideration in Exchange for Stock”), illustrates the problems that can arise when services or promises of future delivery are intended as payment for stock.
Evaluating the Consideration: Watered Stock
In United Steel Industries (Section 22.7.1 “Consideration in Exchange for Stock”), assume that Griffitts’s legal services had been thought by the corporation to be worth \$6,000 but in fact were worth \$1,000, and that he had received stock with par value of \$6,000 (i.e., 6,000 shares of \$1 par value stock) in exchange for his services. Would Griffitts be liable for the \$5,000 difference between the actual value of his services and the stock’s par value? This is the problem of watered stock: the inflated consideration is in fact less than par value. The term itself comes from the ancient fraud of farmers and ranchers who increased the weight of their cattle (also known as stock) by forcing them to ingest excess water.
The majority of states follow the good-faith rule. As noted near the end of the United Steel Industries case, in the absence of fraud, “the judgment of the board of directors ‘as to the value of consideration received for shares’ is conclusive.” In other words, if the directors or shareholders conclude in good faith that the consideration does fairly reflect par value, then the stock is not watered and the stock buyer cannot be assessed for the difference. This is in line with the business judgment rule, discussed in Chapter 23. If the directors concluded in good faith that the consideration provided by Griffitts’s services accurately reflected the value of the shares, they would not be liable. The minority approach is the true value rule: the consideration must in fact equal par value by an objective standard at the time the shares are issued, regardless of the board’s good-faith judgment.
A shareholder may commence a derivative lawsuit (a suit by a shareholder, on behalf of the corporation, often filed against the corporation; see Chapter 23). In a watered stock lawsuit, the derivative suit is filed against a shareholder who has failed to pay full consideration under either rule to recover the difference between the value received by the corporation and the par value.
Key Takeaway
Corporations may raise funds through the sale of stock. This can be accomplished through an initial public offering (IPO)—the first time a corporation sells stock—or through stock sales after an IPO. The SEC is the regulatory body that oversees the sale of stock. A sale of stock has several benefits for the corporation, such as avoiding the use of debt, which can be much more expensive than selling stock. Stock sales also increase the firm’s exposure and attract investors who prefer more risk than bonds. On the other hand, stock sales have some disadvantages, namely, the dilution of ownership of the corporation. Also, the corporation may undervalue its shares, thus missing out on additional capital because of the undervaluation. Being a publicly traded company places the corporation under the extensive requirements of the SEC and the 1933 and 1934 securities acts, such as shareholder meetings and annual financial reports. The Sarbanes-Oxley Act adds yet more requirements that a corporation may wish to avoid.
Consideration is property or services exchanged for stock. Most investors will exchange money for stock. Certain forms of consideration are not permitted. Finally, a corporation may be liable if it sells watered stock, where consideration received by the corporation is less than the stock par value.
Exercises
1. Describe the process of conducting an IPO.
2. What are some advantages of selling stock?
3. What are some disadvantages of selling stock?
4. What is consideration? What are some types of consideration that may not be acceptable? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.04%3A_Initial_Public_Offerings_and_Consideration_for_Stock.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss several types of dividends.
• Review legal limitations on distributing dividends.
• Define the duties of directors when paying dividends.
Types of Dividends
A dividend is a share of profits, a dividing up of the company’s earnings. The law does not require a corporation to give out a specific type of dividend.
Cash Dividend
If a company’s finances are such that it can declare a dividend to stockholders, a cash dividend always is permissible. It is a payment (by check, ordinarily) to the stockholders of a certain amount of money per share. Under current law, qualified dividends are taxed as a long-term capital gain (usually 15 percent, but the figure can be as low as zero percent under current law). These rules are set to expire in 2013, when dividends will be taxed as ordinary income (i.e., at the recipient’s ordinary income tax rate).
Stock Dividend
Next to cash, the most frequent type of dividend is stock itself. Normally, the corporation declares a small percentage dividend (between 1 and 10 percent), so that a holder of one hundred shares would receive four new shares on a 4 percent dividend share. Although each shareholder winds up with more stock, he realizes no personal net gain at that moment, as he would with a cash dividend, because each stockholder has the same relative proportion of shares and has not sold or otherwise transferred the shares or dividend. The total outstanding stock represents no greater amount of assets than before. The corporation may issue share dividends either from treasury stock or from authorized but unissued shares.
Property Dividend
Rarely, corporations pay dividends in property rather than in cash. Armand Hammer, the legendary financier and CEO of Occidental Petroleum Corporation, recounts how during World War II he founded a liquor business by buying shares of the American Distilling Company. American Distilling was giving out one barrel of whiskey per share as a dividend. Whiskey was in short supply during the war, so Hammer bought five thousand shares and took five thousand barrels of whiskey as a dividend.
Stock Split
A stock dividend should be distinguished from a stock split. In a stock split, one share is divided into more shares—for example, a two-for-one split means that for every one share the stockholder owned before the split, he now has two shares. In a reverse stock split, shares are absorbed into one. In a one-for-two reverse split, the stockholder will get one share in place of the two he held before the split.
The stock split has no effect on the assets of the company, nor is the interest of any shareholder diluted. No transfer from surplus into stated capital is necessary. The only necessary accounting change is the adjustment of par value and stated value. Because par value is being changed, many states require not only the board of directors but also the shareholders to approve a stock split.
Why split? The chief reason is to reduce the current market price of the stock in order to make it affordable to a much wider class of investors. For example, in 1978, IBM, whose stock was then selling for around \$284, split four for one, reducing the price to about \$70 a share. That was the lowest IBM’s stock had been since 1932. Stock need not sell at stratospheric prices to be split, however; for example, American Telnet Corporation, whose stock had been selling at \$0.4375 a share, declared a five-for-one split in 1980. Apparently the company felt that the stock would be more affordable at \$0.0875 a share. At the opposite end of the spectrum are Class A shares of Warren Buffett’s Berkshire Hathaway, which routinely trade for more than \$100,000 a share. Buffett has rebuffed efforts to split the Class A shares, but in 2010, shareholders approved a fifty-for-one split of Class B shares.BusinessWeek covers many stock splits and reverse splits in its finance section, available at www.businessweek.com/finance.
Legal Limitations on Dividends
The law imposes certain limitations on cash or property dividends a corporation may disburse. Dividends may not be paid if (1) the business is insolvent (i.e., unable to pay its debts as they become due), (2) paying dividends would make it insolvent, or (3) payment would violate a restriction in the articles of incorporation. Most states also restrict the funds available for distribution to those available in earned surplus. Under this rule, a corporation that ran a deficit in the current year could still declare a dividend as long as the total earned surplus offset the deficit.
A few states—significantly, Delaware is one of them—permit dividends to be paid out of the net of current earnings and those of the immediately preceding year, both years taken as a single period, even if the balance sheet shows a negative earned surplus. Such dividends are known as nimble dividends. See Weinberg v. Baltimore Brick Co.Weinberg v. Baltimore Brick Co., 35 Del. Ch. 225; 114 A.2d 812 (Del. 1955).
Distribution from Capital Surplus
Assets in the form of cash or property may be distributed from capital surplus if the articles of incorporation so provide or if shareholders approve the distribution. Such distributions must be identified to the shareholders as coming from capital surplus.
Record Date, Payment Date, Rights of Stockholders
Under the securities exchange rules, the board of directors cannot simply declare a dividend payable on the date of the board meeting and instruct the treasurer to hand out cash. The board must fix two dates: a record date and a payment date. By the first, the board declares a dividend for shareholders of record as of a certain future date—perhaps ten days hence. Actual payment of the dividend is postponed until the payment date, which could be a month after the record date.
The board’s action creates a debtor-creditor relationship between the corporation and its shareholders. The company may not revoke a cash dividend unless the shareholders consent. It may revoke a share dividend as long as the shares have not been issued.
Discretion of Directors to Pay Dividends
When Directors Are Too Stingy
In every state, dividends are normally payable only at the discretion of the directors. Courts will order distribution only if they are expressly mandatory or if it can be shown that the directors abused their discretion by acting fraudulently or in a manner that was manifestly unreasonable. Dodge v. Ford Motor Co., (see Section 22.7.2 “Payment of Dividends”), involves Henry Ford’s refusal in 1916 to pay dividends in order to reinvest profits; it is often celebrated in business annals because of Ford’s testimony at trial, although, as it turned out, the courts held his refusal to be an act of miserliness and an abuse of discretion. Despite this ruling, many corporations today do not pay dividends. Corporations may decide to reinvest profits in the corporation rather than pay a dividend to its shareholders, or to just sit on the cash. For example, Apple Computer, Inc., maker of many popular computers and consumer electronics, saw its share price skyrocket in the late 2000s. Apple also became one of the most valuable corporations in the world. Despite an immense cash reserve, Apple has refused to pay a dividend, choosing instead to reinvest in the business, stating that they require a large cash reserve as a security blanket for acquisitions or to develop new products. Thus despite the ruling in Dodge v. Ford Motor Co., courts will usually not intercede in a corporation’s decision not to pay dividends, following the business judgment rule and the duties of directors. (For further discussion of the duties of directors, see Chapter 23).
When Directors Are Too Generous
Directors who vote to declare and distribute dividends in excess of those allowed by law or by provisions in the articles of incorporation personally may become jointly and severally liable to the corporation (but liability may be reduced or eliminated under the business judgment rule). Shareholders who receive a dividend knowing it is unlawful must repay any directors held liable for voting the illegal dividend. The directors are said to be entitled to contribution from such shareholders. Even when directors have not been sued, some courts have held that shareholders must repay dividends received when the corporation is insolvent or when they know that the dividends are illegal.
Key Takeaway
A dividend is a payment made from the corporation to its shareholders. A corporation may pay dividends through a variety of methods, although money and additional shares are the most common. Corporations may increase or decrease the total number of shares through either a stock split or a reverse stock split. A corporation may decide to pay dividends but is not required to do so and cannot issue dividends if the corporation is insolvent. Directors may be liable to the corporation for dividend payments that violate the articles of incorporation or are illegal.
Exercises
1. What is a dividend, and what are the main types of dividends?
2. Is a corporation required to pay dividends? Under what circumstances is a corporation barred from paying dividends?
3. You have ten shares of BCT, valued at \$10 each. The company engages in a two-for-one stock split. How many shares do you now have? What is the value of each share, and what is the total value of all of your BCT shares? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.05%3A_Dividends.txt |
Learning Objectives
By the end of this section, you will be able to:
• Know the modern changes to corporate finance terminology and specific requirements imposed by states.
• Compare the application of the Uniform Commercial Code to corporate finance with the applicability of the 1933 and 1934 federal securities acts.
Changes in the Revised Model Business Corporation Act
Perhaps the most dramatic innovations incorporated into the Revised Model Business Corporation Act (RMBCA) are the financial provisions. The revisions recommend eliminating concepts such as par value stock, no-par stock, stated capital, capital surplus, earned surplus, and treasury shares. It was felt that these concepts—notably par value and stated capital—no longer serve their original purpose of protecting creditors.
A key definition under the revisions is that of distributions—that is, any transfer of money or property to the shareholders. In order to make distributions, a corporation must meet the traditional insolvency test and balance sheet tests. Under the balance sheet test, corporate assets must be greater than or equal to liabilities and liquidation preferences on senior equity. The RMBCA also provides that promissory notes and contracts for future services may be used in payment for shares.
It is important to note that the RMBCA is advisory. Not every state has abandoned par value or the other financial terms. For example, Delaware is quite liberal with its requirements:
Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any or all of which classes may be of stock with par value or stock without par value and which classes or series may have such voting powers, full or limited, or no voting powers, and such designations, preferences and relative, participating, optional or other special rights, and qualifications, limitations or restrictions thereof, as shall be stated and expressed in the certificate of incorporation or of any amendment thereto, or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors pursuant to authority expressly vested in it by the provisions of its certificate of incorporation.Del. Code Ann. tit. 8, § 151 (2011).
Therefore, although the modern trend is to move away from par value as well as some other previously discussed terms—and despite the RMBCA’s abandonment of these concepts—they still, in large measure, persist.
Introduction to Article 8 of the Uniform Commercial Code
Partial ownership of a corporation would be an awkward investment if there were no ready means of transfer. The availability of paper certificates as tangible evidence of the ownership of equity securities solves the problem of what to transfer, but since a corporation must maintain records of its owners, a set of rules is necessary to spell out how transfers are to be made. That set of rules is Article 8 of the Uniform Commercial Code (UCC). Article 8 governs certificated securities, uncertificated securities, registration requirements, transfer, purchase, and other specifics of securities. Article 8 can be viewed at http://www.law.cornell.edu/ucc/8/overview.html.
The UCC and the 1933 and 1934 Securities Acts
The Securities Act of 1933 requires the registration of securities that are sold or offered to be sold using interstate commerce. The Securities Exchange Act of 1934 governs the secondary trading of securities, such as stock market sales. The UCC also governs securities, through Articles 8 and 9. The key difference is that the 1933 and 1934 acts are federal law, while the UCC operates at the state level. The UCC was established to standardize state laws governing sales and commercial transactions. There are some substantial differences, however, between the two acts and the UCC. Without going into exhaustive detail, it is important to note a few of them. For one, the definition of security in the UCC is different from the definition in the 1933 and 1934 acts. Thus a security may be governed by the securities acts but not by the UCC. The definition of a private placement of securities also differs between the UCC and the securities acts. Other differences exist.See Lynn Soukup, “Securities Law and the UCC: When Godzilla Meets Bambi,” Uniform Commercial Code Law Journal 38, no. 1 (Summer 2005): 3–28. The UCC, as well as state-specific laws, and the federal securities laws should all be considered in financial transactions.
Key Takeaway
The RMBCA advises doing away with financial concepts such as stock par value. Despite this suggestion, these concepts persist. Corporate finance is regulated through a variety of mechanisms, most notably Articles 8 and 9 of the Uniform Commercial Code and the 1933 and 1934 securities acts.
Exercises
1. What suggested changes are made by the RMBCA?
2. What does UCC Article 8 govern? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.06%3A_The_Winds_of_Change.txt |
Consideration in Exchange for Stock
United Steel Industries, Inc. v. Manhart
405 S.W.2d 231 (Tex. 1966)
MCDONALD, CHIEF JUSTICE
This is an appeal by defendants, United Steel Industries, Inc., J. R. Hurt and W. B. Griffitts, from a judgment declaring void and cancelling 5000 shares of stock in United Steel Industries, Inc. issued to Hurt, and 4000 shares of stock in such corporation issued to Griffitts.
Plaintiffs Manhart filed this suit individually and as major stockholders against defendants United Steel Industries, Inc., Hurt, and Griffitts, alleging the corporation had issued Hurt 5000 shares of its stock in consideration of Hurt agreeing to perform CPA and bookkeeping services for the corporation for one year in the future; and had issued Griffitts 4000 shares of its stock in consideration for the promised conveyance of a 5 acre tract of land to the Corporation, which land was never conveyed to the Corporation. Plaintiffs assert the 9000 shares of stock were issued in violation of Article 2.16 Business Corporation Act, and prayed that such stock be declared void and cancelled.
Trial was before the Court without a jury which, after hearing, entered judgment declaring the 5000 shares of stock issued to Hurt, and the 4000 shares issued to Griffitts, issued without valid consideration, void, and decreeing such stock cancelled.
* * *
The trial court found (on ample evidence) that the incorporators of the Corporation made an agreement with Hurt to issue him 5000 shares in consideration of Hurt’s agreement to perform bookkeeping and accounting services for the Corporation for the first year of its operation. The Corporation minutes reflect the 5000 shares issued to Hurt “in consideration of labor done, services in the incorporation and organization of the Corporation.” The trial court found (on ample evidence) that such minutes do not reflect the true consideration agreed upon, and that Hurt performed no services for the Corporation prior to February 1, 1965. The Articles of Incorporation were filed on January 28, 1965, and the 5000 shares were issued to Hurt on May 29, 1965. There is evidence that Hurt performed some services for the Corporation between January and May 29, 1965; but Hurt himself testified the “5000 (shares) were issued to me for services rendered or to be rendered for the first year in keeping the books.…”
The situation is thus one where the stock was issued to Hurt both for services already performed and for services to be rendered in the future.
The trial court concluded the promise of future services was not a valid consideration for the issuance of stock under Article 2.16 Business Corporation Act; that the issuance was void; and that since there was no apportionment of the value of future services from the value of services already rendered, the entire 5000 shares were illegally issued and void.
Article 12, Section 6, Texas Constitution, provides: “No corporation shall issue stock…except for money paid, labor done, or property actually received.…” And Article 2.16 Texas Business Corporation Act provides: “Payment for Shares.
“A. The consideration paid for the issuance of shares shall consist of money paid, labor done, or property actually received. Shares may not be issued until the full amount of the consideration, fixed as provided by law, has been paid.…
“B. Neither promissory notes nor the promise of future services shall constitute payment or part payment for shares of a corporation.
“C. In the absence of fraud in the transaction, the judgment of the board of directors…as to the value of the consideration received for shares shall be conclusive.”
The Fifth Circuit in Champion v. CIR, 303 Fed. 2d 887 construing the foregoing constitutional provision and Article 2.16 of the Business Corporation Act, held:
Where it is provided that stock can be issued for labor done, as in Texas…the requirement is not met where the consideration for the stock is work or services to be performed in the future.…The situation is not changed by reason of the provision that the stock was to be given…for services rendered as well as to be rendered, since there was no allocation or apportionment of stock between services performed and services to be performed.”
The 5000 shares were issued before the future services were rendered. Such stock was illegally issued and void.
Griffitts was issued 10,000 shares partly in consideration for legal services to the Corporation and partly in exchange for the 5 acres of land. The stock was valued at \$1 per share and the land had an agreed value of \$4000. The trial court found (upon ample evidence) that the 4000 shares of stock issued to Griffitts was in consideration of his promise to convey the land to the Corporation; that Griffitts never conveyed the land; and the issuance of the stock was illegal and void.
The judgment of the board of directors “as to the value of consideration received for shares” is conclusive, but such does not authorize the board to issue shares contrary to the Constitution, for services to be performed in the future (as in the case of Hurt), or for property not received (as in the case of Griffitts).
The judgment is correct. Defendants’ points and contentions are overruled.
AFFIRMED.
Exercises
1. What was wrong with the consideration in the transaction between United Steel and Hurt?
2. What if Hurt had completed one year of bookkeeping prior to receiving his shares?
3. What was wrong with the consideration Griffitts provided for the 4,000 shares he received?
Payment of Dividends
Dodge v. Ford Motor Co.
204 Mich. 459, 170 N.W. 668 (Mich. 1919)
[Action by plaintiffs John F. Dodge and Horace E. Dodge against defendant Ford Motor Company and its directors. The lower court ordered the directors to declare a dividend in the amount of \$19,275,385.96. The court also enjoined proposed expansion of the company. The defendants appealed.]
[T]he case for plaintiffs must rest upon the claim, and the proof in support of it, that the proposed expansion of the business of the corporation, involving the further use of profits as capital, ought to be enjoined because it is inimical to the best interests of the company and its shareholders, and upon the further claim that in any event the withholding of the special dividend asked for by plaintiffs is arbitrary action of the directors requiring judicial interference.
The rule which will govern courts in deciding these questions is not in dispute. It is, of course, differently phrased by judges and by authors, and, as the phrasing in a particular instance may seem to lean for or against the exercise of the right of judicial interference with the actions of corporate directors, the context, or the facts before the court, must be considered.
* * *
In 1 Morawetz on Corporations (2d Ed.), § 447, it is stated:
Profits earned by a corporation may be divided among its shareholders; but it is not a violation of the charter if they are allowed to accumulate and remain invested in the company’s business. The managing agents of a corporation are impliedly invested with a discretionary power with regard to the time and manner of distributing its profits. They may apply profits in payment of floating or funded debts, or in development of the company’s business; and so long as they do not abuse their discretionary powers, or violate the company’s charter, the courts cannot interfere.
But it is clear that the agents of a corporation, and even the majority, cannot arbitrarily withhold profits earned by the company, or apply them to any use which is not authorized by the company’s charter.…
Mr. Henry Ford is the dominant force in the business of the Ford Motor Company. No plan of operations could be adopted unless he consented, and no board of directors can be elected whom he does not favor. One of the directors of the company has no stock. One share was assigned to him to qualify him for the position, but it is not claimed that he owns it. A business, one of the largest in the world, and one of the most profitable, has been built up. It employs many men, at good pay.
“My ambition,” said Mr. Ford, “is to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes. To do this we are putting the greatest share of our profits back in the business.”
“With regard to dividends, the company paid sixty per cent on its capitalization of two million dollars, or \$1,200,000, leaving \$58,000,000 to reinvest for the growth of the company. This is Mr. Ford’s policy at present, and it is understood that the other stockholders cheerfully accede to this plan.”
He had made up his mind in the summer of 1916 that no dividends other than the regular dividends should be paid, “for the present.”
“Q. For how long? Had you fixed in your mind any time in the future, when you were going to pay—
“A. No.
“Q. That was indefinite in the future?
“A. That was indefinite, yes, sir.”
The record, and especially the testimony of Mr. Ford, convinces that he has to some extent the attitude towards shareholders of one who has dispensed and distributed to them large gains and that they should be content to take what he chooses to give. His testimony creates the impression, also, that he thinks the Ford Motor Company has made too much money, has had too large profits, and that although large profits might be still earned, a sharing of them with the public, by reducing the price of the output of the company, ought to be undertaken. We have no doubt that certain sentiments, philanthropic and altruistic, creditable to Mr. Ford, had large influence in determining the policy to be pursued by the Ford Motor Company—the policy which has been herein referred to.
* * *
The difference between an incidental humanitarian expenditure of corporate funds for the benefit of the employees, like the building of a hospital for their use and the employment of agencies for the betterment of their condition, and a general purpose and plan to benefit mankind at the expense of others, is obvious. There should be no confusion (of which there is evidence) of the duties which Mr. Ford conceives that he and the stockholders owe to the general public and the duties which in law he and his codirectors owe to protesting, minority stockholders. A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end and does not extend to a change in the end itself, to the reduction of profits or to the nondistribution of profits among stockholders in order to devote them to other purposes.
* * *
We are not, however, persuaded that we should interfere with the proposed expansion of the business of the Ford Motor Company. In view of the fact that the selling price of products may be increased at any time, the ultimate results of the larger business cannot be certainly estimated. The judges are not business experts. It is recognized that plans must often be made for a long future, for expected competition, for a continuing as well as an immediately profitable venture. The experience of the Ford Motor Company is evidence of capable management of its affairs. It may be noticed, incidentally, that it took from the public the money required for the execution of its plan and that the very considerable salaries paid to Mr. Ford and to certain executive officers and employees were not diminished. We are not satisfied that the alleged motives of the directors, in so far as they are reflected in the conduct of the business, menace the interests of shareholders. It is enough to say, perhaps, that the court of equity is at all times open to complaining shareholders having a just grievance.
[The court affirmed the lower court’s order that the company declare a dividend and reversed the lower court’s decision that halted company expansion].
Case Questions
1. What basis does the court use to order the payment of dividends?
2. Does the court have a positive view of Mr. Ford?
3. How do you reconcile 1 Morawetz on Corporations (2d Ed.), § 447 (“Profits earned by a corporation may be divided among its shareholders; but it is not a violation of the charter if they are allowed to accumulate and remain invested in the company’s business”) with the court’s decision?
4. Would the business judgment rule have changed the outcome of this case? Note: The business judgment rule, generally summarized, is that the directors are presumed to act in the best interest of the corporation and its shareholders and to fulfill their fiduciary duties of good faith, loyalty, and due care. The burden is on the plaintiff to prove that a transaction was so one sided that no business person of ordinary judgment would conclude that the transaction was proper and/or fair. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.07%3A_Cases.txt |
Summary
Corporations finance through a variety of mechanisms. One method is to reinvest profits in the corporation. Another method is to use private equity. Private equity involves financing from private investors, whether individuals (angel investors) or a private equity firm. Venture capital is often used as a fundraising mechanism by businesses that are just starting operations.
A third method is to finance through debt, such as a loan or a bond. A corporation sells a bond and agrees to make interest payments over the life of the bond and to pay the face value of the bond at the bond’s maturity.
The final important method of raising capital is by the sale of stock. The articles of incorporation govern the total number of shares of stock that the corporation may issue, although it need not issue the maximum. Stock in the hands of shareholders is said to be authorized, issued, and outstanding. Stock may have a par value, which is usually the floor price of the stock. No-par shares may be sold for any price set by the directors.
Preferred stock (1) may have a dividend preference, (2) takes preference upon liquidation, and (3) may be convertible. Common stock normally has the right to (1) ratable participation in earnings, (2) ratable participation in the distribution of net assets on liquidation, and (3) ratable vote.
Ordinarily, the good-faith judgment of the directors concerning the fair value of the consideration received for stock is determinative. A minority of states adhere to a true value rule that holds to an objective standard.
A corporation that sells shares for the first time engages in an initial public offering (IPO). The Securities Act of 1933 governs most IPOs and initial stock sales. A corporation that has previously issued stock may do so many times afterward, depending on the corporation’s needs. The Securities Exchange Act of 1934 governs most secondary market stock sales. The Sarbanes-Oxley Act of 2002 adds another layer of regulation to the financial transactions discussed in this chapter.
A dividend is a share of a corporation’s profits. Dividends may be distributed as cash, property, or stock. The law imposes certain limitations on the amount that the corporation may disburse; most states restrict the cash or property available for distribution to earned surplus. However, a few states, including Delaware, permit dividends to be paid out of the net of current earnings and those of the immediately preceding year, both years taken as a single period; these are known as nimble dividends. The directors have discretion, within broad limits, to set the level of dividends; however, they will be jointly and severally liable if they approve dividends higher than allowed by law or under the articles of incorporation.
With several options available, corporations face many factors to consider in deciding how to raise funds. Each option is not available to every corporation. Additionally, each option has advantages and disadvantages. A corporation must carefully weigh the pros and cons of each before making a decision to proceed on a particular financing path.
Exercises
1. Ralph and Alice have decided to incorporate their sewer cleaning business under the name R & A, Inc. Their plans call for the authorization and issuance of 5,000 shares of par value stock. Ralph argues that par value must be set at the estimated market value of the stock, while Alice feels that par value is the equivalent of book value—that is, assets divided by the number of shares. Who is correct? Why?
2. In Exercise 1, Ralph feels that R & A should have an IPO of 1 million shares of common stock, to be sold on the New York Stock Exchange (NYSE). What are the pros and cons of conducting an IPO?
3. Assume that Ralph and Alice decide to issue preferred stock. What does this entail from R & A’s standpoint? From the standpoint of a preferred stock purchaser?
4. Alice changes her mind and wants to sell bonds in R & A. What are the pros and cons of selling bonds?
5. Assume that Ralph and Alice go on to consider options other than financing through an IPO or through the sale of bonds. They want to raise \$5 million to get their business up and running, to purchase a building, and to acquire machines to clean sewers. What are some other options Ralph and Alice should consider? What would you suggest they do? Would your suggestion be different if Ralph and Alice wanted to raise \$500 million? \$50,000?
SELF CHECK QUESTIONS
1. Corporate funds that come from earnings are called
1. equity securities
2. depletion
3. debt securities
4. plowback
2. When a value is specified on a stock certificate, it is said to be
1. par value
2. no-par
3. an authorized share
4. none of the above
3. Common stockholders normally
1. have the right to vote ratably
2. do not have the right to vote ratably
3. never have preemptive rights
4. hold all of the company’s treasury shares
4. Preferred stock may be
1. entitled to cumulative dividends
2. convertible
3. redeemable
4. all of the above
5. When a corporation issues stock to the public for the first time, the corporation engages in
1. a distribution
2. an initial public offering
3. underwriting
4. a stock split
1. d
2. a
3. a
4. d
5. b | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/22%3A_Legal_Aspects_of_Corporate_Finance/22.08%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The powers of a corporation to act
• The rights of shareholders
• The duties, powers, and liability of officers and directors
Power within a corporation is present in many areas. The corporation itself has powers, although with limitations. There is a division of power between shareholders, directors, and officers. Given this division of power, certain duties are owed amongst the parties. We focus this chapter upon these powers and upon the duties owed by shareholders, directors, and officers.
23: Corporate Powers and Management
Learning Objectives
By the end of this section, you will be able to:
• Understand the two types of corporate power.
• Consider the ramifications when a corporation acts outside its prescribed powers.
• Review legal issues surrounding corporate actions.
Two Types of Corporate Powers
A corporation generally has three parties sharing power and control: directors, officers, and shareholders. Directors are the managers of the corporation, and officers control the day-to-day decisions and work more closely with the employees. The shareholders are the owners of the corporation, but they have little decision-making authority. The corporation itself has powers; while a corporation is not the same as a person (e.g., a corporation cannot be put in prison), it is allowed to conduct certain activities and has been granted certain rights.
Express Powers
The corporation may exercise all powers expressly given it by statute and by its articles of incorporation. Section 3.02 of the Revised Model Business Corporation Act (RMBCA) sets out a number of express powers, including the following: to sue and be sued in the corporate name; to purchase, use, and sell land and dispose of assets to the same extent a natural person can; to make contracts, borrow money, issue notes and bonds, lend money, invest funds, make donations to the public welfare, and establish pension plans; and to join in partnerships, joint ventures, trusts, or other enterprises. The powers set out in this section need not be included in the articles of incorporation.
Implied Powers
Corporate powers beyond those explicitly established are implied powers. For example, suppose BCT Bookstore, Inc.’s statement of purpose reads simply, “to operate a bookstore.” The company may lawfully conduct all acts that are necessary or appropriate to running a bookstore—hiring employees, advertising special sales, leasing trucks, and so forth. Could Ted, its vice president and general manager, authorize the expenditure of funds to pay for a Sunday afternoon lecture on the perils of nuclear war or the adventures of a professional football player? Yes—if the lectures are relevant to current books on sale or serve to bring people into the store, they comply with the corporation’s purpose.
The Ultra Vires Doctrine
The law places limitations upon what acts a corporation may undertake. Corporations cannot do anything they wish, but rather, must act within the prescribed rules as laid out in statute, case law, their articles of incorporation, and their bylaws. Sometimes, though, a corporation will step outside its permitted power (literally “beyond the powers). The ultra vires doctrine holds that certain legal consequences attach to an attempt by a corporation to carry out acts that are outside its lawful powers. Ultra vires (literally “beyond the powers”) is not limited to illegal acts, although it encompasses actions barred by statute as well as by the corporate charter. Under the traditional approach, either the corporation or the other party could assert ultra vires as a defense when refusing to abide by a wholly executory contract. The ultra vires doctrine loses much of its significance when corporate powers are broadly stated in a corporation’s articles. Furthermore, RMBCA Section 3.04 states that “the validity of corporate action may not be challenged on the ground that the corporation lacks or lacked power to act.”
Nonetheless, ultra vires acts are still challenged in courts today. For example, particularly in the area of environmental law, plaintiffs are challenging corporate environmental actions as ultra vires. Delaware corporation law states that the attorney general shall revoke the charter of a corporation for illegal acts. Additionally, the Court of Chancery of Delaware has jurisdiction to forfeit or revoke a corporate charter for abuse of corporate powers.Del. Code Ann., Title 8, Section 284 (2011). See Adam Sulkowski’s “Ultra Vires Statutes: Alive, Kicking, and a Means of Circumventing the Scalia Standing Gauntlet.”Adam Sulkowski, “Ultra Vires Statutes: Alive, Kicking, and a Means of Circumventing the Scalia Standing Gauntlet,” Journal of Environmental Law and Litigation 14, no. 1 (2009): 75.
In essence, ultra vires retains force in three circumstances:
1. Shareholders may bring suits against the corporation to enjoin it from acting beyond its powers.
2. The corporation itself, through receivers, trustees, or shareholders, may sue incumbent or former officers or directors for causing the corporation to act ultra vires.
3. The state attorney general may assert the doctrine in a proceeding to dissolve the corporation or to enjoin it from transacting unauthorized business (see Figure 23.1).
Suppose an incorporated luncheon club refuses to admit women as club members or guests. What happens if this action is ultra vires? Cross v. The Midtown Club, Inc. (see Section 23.5.1 “Ultra Vires Acts”), focuses on this issue. An ultra vires act is not necessarily criminal or tortious. However, every crime and tort is in some sense ultra vires because a corporation never has legal authority to commit crimes or torts. They raise special problems, to which we now turn.
Criminal, Tortious, and Other Illegal Acts
The early common law held that a corporation could not commit a crime because it did not have a mind and could not therefore have the requisite intent. An additional dilemma was that society could not literally imprison a corporation. Modern law is not so constricting. Illegal acts of its agents may be imputed to the corporation. Thus if the board of directors specifically authorizes the company to carry out a criminal scheme, or the president instructs his employees to break a regulatory law for the benefit of the company, the corporation itself may be convicted. Of course, it is rare for people in a corporate setting to avow their criminal intentions, so in most cases courts determine the corporation’s liability by deciding whether an employee’s crime was part of a job-related activity. The individuals within the corporation are much more likely to be held legally liable, but the corporation may be as well. For example, in extreme cases, a court could order the dissolution of the corporation; revoke some or all of its ability to operate, such as by revoking a license the corporation may hold; or prevent the corporation from engaging in a critical aspect of its business, such as acting as a trustee or engaging in securities transactions. But these cases are extremely rare.
That a corporation is found guilty of a violation of the law does not excuse company officials who authorized or carried out the illegal act. They, too, can be prosecuted and sent to jail. Legal punishments are being routinely added to the newer regulatory statutes, such as the Occupational Safety and Health Act, and the Toxic Substances Control Act—although prosecution depends mainly on whether and where a particular administration wishes to spend its enforcement dollars. Additionally, state prosecuting attorneys have become more active in filing criminal charges against management when employees are injured or die on the job. For instance, a trial court judge in Chicago sentenced a company president, plant manager, and foreman to twenty-five years in prison after they were convicted of murder following the death of a worker as a result of unsafe working conditions at a plant;People v. O’Neil, 550 N.E.2d 1090 (Ill. App. 1990). the punishments were later overturned, but the three pled guilty several years later and served shorter sentences of varying duration.
More recently, prosecutors have been expanding their prosecutions of corporations and developing methodologies to evaluate whether a corporation has committed a criminal act; for example, US Deputy Attorney General Paul McNulty revised “Principles of Federal Prosecutions of Business Organizations” in 2006 to further guide prosecutors in indicting corporations. The Securities and Exchange Commission, the Department of Justice, other regulatory bodies, and legal professionals have increasingly sought legal penalties against both corporations and its employees. See Exercise 2 at the end of this section to consider the legal ramifications of a corporation and its employees for the drunk-driving death of one of its patrons.
In certain cases, the liability of an executive can be vicarious. The Supreme Court affirmed the conviction of a chief executive who had no personal knowledge of a violation by his company of regulations promulgated by the Food and Drug Administration. In this case, an officer was held strictly liable for his corporation’s violation of the regulations, regardless of his knowledge, or lack thereof, of the actions (see Chapter 6).United States v. Park, 421 U.S. 658 (1975). This stands in contrast to the general rule that an individual must know, or should know, of a violation of the law in order to be liable. Strict liability does not require knowledge. Thus a corporation’s top managers can be found criminally responsible even if they did not directly participate in the illegal activity. Employees directly responsible for violation of the law can also be held liable, of course. In short, violations of tort law, criminal law, and regulatory law can result in negative consequences for both the corporation and its employees.
Key Takeaway
A corporation has two types of powers: express powers and implied powers. When a corporation is acting outside its permissible power, it is said to be acting ultra vires. A corporation engages in ultra vires acts whenever it engages in illegal activities, such as criminal acts.
Exercises
1. What is an ultra vires act?
2. A group of undergraduate students travel from their university to a club. The club provides dinner and an open bar. One student becomes highly intoxicated and dies as the result of an automobile collision caused by the student. Can the club be held liable for the student’s death? See Commonwealth v. Penn Valley Resorts.Commonwealth v. Penn Valley Resorts, 494 A.2d 1139 (Pa. Super. 1985). | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/23%3A_Corporate_Powers_and_Management/23.01%3A_Powers_of_a_Corporation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the various parts of the corporate management structure and how they relate to one another.
• Describe the processes and practices of typical corporate meetings, including annual meetings.
• Explain the standard voting process in most US corporations and what the respective roles of management and shareholders are.
• Understand what corporate records can be reviewed by a shareholder and under what circumstances.
General Management Functions
In the modern publicly held corporation, ownership and control are separated. The shareholders “own” the company through their ownership of its stock, but power to manage is vested in the directors. In a large publicly traded corporation, most of the ownership of the corporation is diluted across its numerous shareholders, many of whom have no involvement with the corporation other than through their stock ownership. On the other hand, the issue of separation and control is generally irrelevant to the closely held corporation, since in many instances the shareholders are the same people who manage and work for the corporation.
Shareholders do retain some degree of control. For example, they elect the directors, although only a small fraction of shareholders control the outcome of most elections because of the diffusion of ownership and modern proxy rules; proxy fights are extremely difficult for insurgents to win. Shareholders also may adopt, amend, and repeal the corporation’s bylaws; they may adopt resolutions ratifying or refusing to ratify certain actions of the directors. And they must vote on certain extraordinary matters, such as whether to amend the articles of incorporation, merge, or liquidate.
Meetings
In most states, the corporation must hold at least one meeting of shareholders each year. The board of directors or shareholders representing at least 10 percent of the stock may call a special shareholders’ meeting at any time unless a different threshold number is stated in the articles or bylaws. Timely notice is required: not more than sixty days nor less than ten days before the meeting, under Section 7.05 of the Revised Model Business Corporation Act (RMBCA). Shareholders may take actions without a meeting if every shareholder entitled to vote consents in writing to the action to be taken. This option is obviously useful to the closely held corporation but not to the giant publicly held companies.
Right to Vote
Who Has the Right to Vote?
Through its bylaws or by resolution of the board of directors, a corporation can set a “record date.” Only the shareholders listed on the corporate records on that date receive notice of the next shareholders’ meeting and have the right to vote. Every share is entitled to one vote unless the articles of incorporation state otherwise.
The one-share, one-vote principle, commonly called regular voting or statutory voting, is not required, and many US companies have restructured their voting rights in an effort to repel corporate raiders. For instance, a company might decide to issue both voting and nonvoting shares (as we discussed in Chapter 23), with the voting shares going to insiders who thereby control the corporation. In response to these new corporate structures, the Securities and Exchange Commission (SEC) adopted a one-share, one-vote rule in 1988 that was designed to protect a shareholder’s right to vote. In 1990, however, a federal appeals court overturned the SEC rule on the grounds that voting rights are governed by state law rather than by federal law.Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990).
Quorum
When the articles of incorporation are silent, a shareholder quorum is a simple majority of the shares entitled to vote, whether represented in person or by proxy, according to RMBCA Section 7.25. Thus if there are 1 million shares, 500,001 must be represented at the shareholder meeting. A simple majority of those represented shares is sufficient to carry any motion, so 250,001 shares are enough to decide upon a matter other than the election of directors (governed by RMBCA, Section 7.28). The articles of incorporation may decree a different quorum but not less than one-third of the total shares entitled to vote.
Cumulative Voting
Cumulative voting means that a shareholder may distribute his total votes in any manner that he chooses—all for one candidate or several shares for different candidates. With cumulative voting, each shareholder has a total number of votes equal to the number of shares he owns multiplied by the number of directors to be elected. Thus if a shareholder has 1,000 shares and there are five directors to be elected, the shareholder has 5,000 votes, and he may vote those shares in a manner he desires (all for one director, or 2,500 each for two directors, etc.). Some states permit this right unless the articles of incorporation deny it. Other states deny it unless the articles of incorporation permit it. Several states have constitutional provisions requiring cumulative voting for corporate directors.
Cumulative voting is meant to provide minority shareholders with representation on the board. Assume that Bob and Carol each owns 2,000 shares, which they have decided to vote as a block, and Ted owns 6,000 shares. At their annual shareholder meeting, they are to elect five directors. Without cumulative voting, Ted’s slate of directors would win: under statutory voting, each share represents one vote available for each director position. With this method, by placing as many votes as possible for each director, Ted could cast 6,000 votes for each of his desired directors. Thus each of Ted’s directors would receive 6,000 votes, while each of Bob and Carol’s directors would receive only 4,000. Under cumulative voting, however, each shareholder has as many votes as there are directors to be elected. Hence with cumulative voting Bob and Carol could strategically distribute their 20,000 votes (4,000 votes multiplied by five directors) among the candidates to ensure representation on the board. By placing 10,000 votes each on two of their candidates, they would be guaranteed two positions on the board. (The candidates from the two slates are not matched against each other on a one-to-one basis; instead, the five candidates with the highest number of votes are elected.) Various formulas and computer programs are available to determine how votes should be allocated, but the principle underlying the calculations is this: cumulative voting is democratic in that it allows the shareholders who own 40 percent of the stock—Bob and Carol—to elect 40 percent of the board.
RMBCA Section 8.08 provides a safeguard against attempts to remove directors. Ordinarily, a director may be removed by a majority vote of the shareholders. Cumulative voting will not aid a given single director whose ouster is being sought because the majority obviously can win on a straight vote. So Section 8.08 provides, “If cumulative voting is authorized, a director may not be removed if the number of votes sufficient to elect him under cumulative voting is voted against his removal.”
Voting Arrangements to Concentrate Power
Shareholders use three types of arrangements to concentrate their power: proxies, voting agreements, and voting trusts.
Proxies
A proxy is the representative of the shareholder. A proxy may be a person who stands in for the shareholder or may be a written instrument by which the shareholder casts her votes before the shareholder meeting. Modern proxy voting allows shareholders to vote electronically through the Internet, such as at http://www.proxyvoting.com. Proxies are usually solicited by and given to management, either to vote for proposals or people named in the proxy or to vote however the proxy holder wishes. Through the proxy device, management of large companies can maintain control over the election of directors. Proxies must be signed by the shareholder and are valid for eleven months from the time they are received by the corporation unless the proxy explicitly states otherwise. Management may use reasonable corporate funds to solicit proxies if corporate policy issues are involved, but misrepresentations in the solicitation can lead a court to nullify the proxies and to deny reimbursement for the solicitation cost. Only the last proxy given by a particular shareholder can be counted.
Proxy solicitations are regulated by the SEC. For instance, SEC rules require companies subject to the Securities Exchange Act of 1934 to file proxy materials with the SEC at least ten days before proxies are mailed to shareholders. Proxy statements must disclose all material facts, and companies must use a proxy form on which shareholders can indicate whether they approve or disapprove of the proposals.
Dissident groups opposed to management’s position are entitled to solicit their own proxies at their own expense. The company must either furnish the dissidents with a list of all shareholders and addresses or mail the proxies at corporate expense. Since management usually prefers to keep the shareholder list private, dissidents can frequently count on the corporation to foot the mailing bill.
Voting Agreements
Unless they intend to commit fraud on a minority of stockholders, shareholders may agree in advance to vote in specific ways. Such a voting agreement, often called a shareholder agreement, is generally legal. Shareholders may agree in advance, for example, to vote for specific directors; they can even agree to vote for the dissolution of the corporation in the event that a predetermined contingency occurs. A voting agreement is easier to enter into than a voting trust (discussed next) and can be less expensive, since a trustee is not paid to administer a voting agreement. A voting agreement also permits shareholders to retain their shares rather than turning the shares over to a trust, as would be required in a voting trust.
Voting Trusts
To ensure that shareholder agreements will be honored, shareholders in most states can create a voting trust. By this device, voting shares are given to voting trustees, who are empowered to vote the shares in accordance with the objectives set out in the trust agreement. Section 7.30 of the RMBCA limits the duration of voting trusts to ten years. The voting trust is normally irrevocable, and the shareholders’ stock certificates are physically transferred to the voting trustees for the duration of the trust. The voting trust agreement must be on file at the corporation, open for inspection by any shareholder.
Inspection of Books and Records
Shareholders are legally entitled to inspect the records of the corporation in which they hold shares. These records include the articles of incorporation, bylaws, and corporate resolutions. As a general rule, shareholders who want certain records (such as minutes of a board of directors’ meeting or accounting records) must also have a “proper purpose,” such as to determine the propriety of the company’s dividend policy or to ascertain the company’s true financial worth. Improper purposes include uncovering trade secrets for sale to a competitor or compiling mailing lists for personal business purposes. A shareholder’s motivation is an important factor in determining whether the purpose is proper, as the courts attempt to balance the rights of both the shareholders and the corporation. For example, a Minnesota court applied Delaware law in finding that a shareholder’s request to view the corporation’s shareholder ledger to identify shareholders and communicate with them about the corporation’s involvement in the Vietnam War was improper. A desire to communicate with the other corporate shareholders was found to be insufficient to compel inspection.Pillsbury v. Honeywell, 291 Minn. 322; 191 N.W.2d 406 (Minn. 1971). Contrast that finding with a Delaware court’s finding that a shareholder had a proper purpose in requesting a corporation’s shareholder list in order to communicate with them about the economic risks of the firm’s involvement in Angola.The Conservative Caucus Research, Analysis & Education Foundation, Inc. v. Chevron, 525 A.2d 569 (Del. 1987). See Del. Code Ann., Title 8, Section 220 (2011).
Preemptive Rights
Assume that BCT Bookstore has outstanding 5,000 shares with par value of ten dollars and that Carol owns 1,000. At the annual meeting, the shareholders decide to issue an additional 1,000 shares at par and to sell them to Alice. Carol vehemently objects because her percentage of ownership will decline. She goes to court seeking an injunction against the sale or an order permitting her to purchase 200 of the shares (she currently has 20 percent of the total). How should the court rule?
The answer depends on the statutory provision dealing with preemptive rights—that is, the right of a shareholder to be protected from dilution of her percentage of ownership. In some states, shareholders have no preemptive rights unless expressly declared in the articles of incorporation, while other states give shareholders preemptive rights unless the articles of incorporation deny it. Preemptive rights were once strongly favored, but they are increasingly disappearing, especially in large publicly held companies where ownership is already highly diluted.
Derivative Actions
Suppose Carol discovers that Ted has been receiving kickbacks from publishers and has been splitting the proceeds with Bob. When at a directors’ meeting, Carol demands that the corporation file suit to recover the sums they pocketed, but Bob and Ted outvote her. Carol has another remedy. She can file a derivative action against them. A derivative lawsuit is one brought on behalf of the corporation by a shareholder when the directors refuse to act. Although the corporation is named as a defendant in the suit, the corporation itself is the so-called real party in interest—the party entitled to recover if the plaintiff wins.
While derivative actions are subject to abuse by plaintiffs’ attorneys seeking settlements that pay their fees, safeguards have been built into the law. At least ninety days before starting a derivative action, for instance, shareholders must demand in writing that the corporation take action. Shareholders may not commence derivative actions unless they were shareholders at the time of the wrongful act. Derivative actions may be dismissed if disinterested directors decide that the proceeding is not in the best interests of the corporation. (A disinterested director is a director who has no interest in the disputed transaction.) Derivative actions are discussed further in Chapter 23.
Key Takeaway
In large publicly traded corporations, shareholders own the corporation but have limited power to affect decisions. The board of directors and officers exercise much of the power. Shareholders exercise their power at meetings, typically through voting for directors. Statutes, bylaws, and the articles of incorporation determine how voting occurs—such as whether a quorum is sufficient to hold a meeting or whether voting is cumulative. Shareholders need not be present at a meeting—they may use a proxy to cast their votes or set up voting trusts or voting agreements. Shareholders may view corporate documents with proper demand and a proper purpose. Some corporations permit shareholders preemptive rights—the ability to purchase additional shares to ensure that the ownership percentage is not diluted. A shareholder may also file suit on behalf of the corporation—a legal proceeding called a derivative action.
Exercises
1. Explain cumulative voting. What is the different between cumulative voting and regular voting? Who benefits from cumulative voting?
2. A shareholder will not be at the annual meeting. May that shareholder vote? If so, how?
3. The BCT Bookstore is seeking an additional store location. Ted, a director of BCT, knows of the ideal building that would be highly profitable for BCT and finds out that it is for sale. Unbeknownst to BCT, Ted is starting a clothing retailer. He purchases the building for his clothing business, thereby usurping a corporate opportunity for BCT. Sam, a BCT shareholder, finds out about Ted’s business deal. Does Sam have any recourse? See RMBCA Section 8.70. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/23%3A_Corporate_Powers_and_Management/23.02%3A_Rights_of_Shareholders.txt |
Learning Objectives
By the end of this section, you will be able to:
• Examine the responsibility of directors and the delegation of decisions.
• Discuss the qualifications, election, and removal of directors.
• Determine what requirements are placed on directors for meetings and compensation.
General Management Responsibility of the Directors
Directors derive their power to manage the corporation from statutory law. Section 8.01 of the Revised Model Business Corporation Act (RMBCA) states that “all corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors.” A director is a fiduciary, a person to whom power is entrusted for another’s benefit, and as such, as the RMBCA puts it, must perform his duties “in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances” (Section 8.30). A director’s main responsibilities include the following: (1) to protect shareholder investments, (2) to select and remove officers, (3) to delegate operating authority to the managers or other groups, and (4) to supervise the company as a whole.
Delegation to Committees
Under RMBCA Section 8.25, the board of directors, by majority vote, may delegate its powers to various committees. This authority is limited to some degree. For example, only the full board can determine dividends, approve a merger, and amend the bylaws. The delegation of authority to a committee does not, by itself, relieve a director from the duty to exercise due care.
Delegation to Officers
The directors often delegate to officers the day-to-day authority to execute the policies established by the board and to manage the firm (see Figure 23.2). Normally, the president is the chief executive officer (CEO) to whom all other officers and employees report, but sometimes the CEO is also the chairman of the board.
Number and Election of Directors
Section 8.03 of the RMBCA provides that there must be one director, but there may be more, the precise number to be fixed in the articles of incorporation or bylaws. The initial members of the board hold office until the first annual meeting, when elections occur. (The initial board members are permitted to succeed themselves.) Directors are often chosen to serve one-year terms and must be elected or reelected by the shareholders annually, unless there are nine or more directors. In that case, if the articles of incorporation so provide, the board may be divided into two or three roughly equal classes and their terms staggered, so that the second class is elected at the second annual meeting and the third at the third annual meeting. A staggered board allows for the continuity of directors or as a defense against a hostile takeover.
Directors’ Qualifications and Characteristics
The statutes do not catalog qualifications that directors are expected to possess. In most states, directors need not be residents of the state or shareholders of the corporation unless required by the articles of incorporation or bylaws, which may also set down more precise qualifications if desired.
Until the 1970s, directors tended to be a homogeneous lot: white male businessmen or lawyers. Political change—rising consumer, environmental, and public interest consciousness—and embarrassment stemming from disclosures made in the wake of Securities and Exchange Commission (SEC) investigations growing out of Watergate prompted companies to diversify their boardrooms. Today, members of minority groups and women are being appointed in increasing numbers, although their proportion to the total is still small. Outside directors (directors who are not employees, officers, or otherwise associated with the corporation; they are also called nonexecutive directors) are becoming a potent force on corporate boards. The trend to promote the use of outside directors has continued—the Sarbanes-Oxley Act of 2002 places emphasis on the use of outside directors to provide balance to the board and protect the corporation’s investors.
Removal of Directors and Officers
In 1978, one week before he was scheduled to unveil the 1979 Mustang to trade journalists in person, Lee Iacocca, president of the Ford Motor Company, was summarily fired by unanimous vote of the board of directors, although his departure was billed as a resignation. Iacocca was reported to have asked company chairman Henry Ford II, “What did I do wrong?” To which Ford was said to have replied, “I just don’t like you.”“Friction Triggers Iacocca Ouster,” Michigan Daily, July 15, 1978. To return to our usual example: BCT Bookstore is set to announce its acquisition of Borders Group, Inc., a large book retailer that is facing bankruptcy. Alice, one of BCT’s directors, was instrumental in the acquisition. One day prior to the announcement of the acquisition, BCT’s board relieved Alice of her directorship, providing no reason for the decision. The story raises this question: May a corporate officer, or director for that matter, be fired without cause?
Yes. Many state statutes expressly permit the board to fire an officer with or without cause. However, removal does not defeat an officer’s rights under an employment contract. Shareholders may remove directors with or without cause at any meeting called for the purpose. A majority of the shares entitled to vote, not a majority of the shares represented at the meeting, are required for removal.
Meetings
Directors must meet, but the statutes themselves rarely prescribe how frequently. More often, rules prescribing time and place are set out in the bylaws, which may permit members to participate in any meeting by conference telephone. In practice, the frequency of board meetings varies.
The board or committees of the board may take action without meeting if all members of the board or committee consent in writing. A majority of the members of the board constitutes a quorum, unless the bylaws or articles of incorporation specify a larger number. Likewise, a majority present at the meeting is sufficient to carry any motion unless the articles or bylaws specify a larger number.
Compensation
In the past, directors were supposed to serve without pay, as shareholder representatives. The modern practice is to permit the board to determine its own pay unless otherwise fixed in the articles of incorporation. Directors’ compensation has risen sharply in recent years. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, however, has made significant changes to compensation, allowing shareholders a “say on pay,” or the ability to vote on compensation.
Key Takeaway
The directors exercise corporate powers. They must exercise these powers with good faith. Certain decisions may be delegated to a committee or to corporate officers. There must be at least one director, and directors may be elected at once or in staggered terms. No qualifications are required, and directors may be removed without cause. Directors, just like shareholders, must meet regularly and may be paid for their involvement on the board.
Exercises
1. What are the fiduciary duties required of a director? What measuring comparison is used to evaluate whether a director is meeting these fiduciary duties?
2. How would a staggered board prevent a hostile takeover? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/23%3A_Corporate_Powers_and_Management/23.03%3A_Duties_and_Powers_of_Directors_and_Officers.txt |
Learning Objectives
By the end of this section, you will be able to:
• Examine the fiduciary duties owed by directors and officers.
• Consider constituency statutes.
• Discuss modern trends in corporate compliance and fiduciary duties.
Nature of the Problem
Not so long ago, boards of directors of large companies were quiescent bodies, virtual rubber stamps for their friends among management who put them there. By the late 1970s, with the general increase in the climate of litigiousness, one out of every nine companies on the Fortune 500 list saw its directors or officers hit with claims for violation of their legal responsibilities.“D & O Claims Incidence Rises,” Business Insurance, November 12, 1979, 18. In a seminal case, the Delaware Supreme Court found that the directors of TransUnion were grossly negligent in accepting a buyout price of \$55 per share without sufficient inquiry or advice on the adequacy of the price, a breach of their duty of care owed to the shareholders. The directors were held liable for \$23.5 million for this breach.Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). Thus serving as a director or an officer was never free of business risks. Today, the task is fraught with legal risk as well.
Two main fiduciary duties apply to both directors and officers: one is a duty of loyalty, the other the duty of care. These duties arise from responsibilities placed upon directors and officers because of their positions within the corporation. The requirements under these duties have been refined over time. Courts and legislatures have both narrowed the duties by defining what is or is not a breach of each duty and have also expanded their scope. Courts have further refined the duties, such as laying out tests such as in the Caremark case, outlined in Section 23.4.3 “Duty of Care”. Additionally, other duties have been developed, such as the duties of good faith and candor.
Duty of Loyalty
As a fiduciary of the corporation, the director owes his primary loyalty to the corporation and its stockholders, as do the officers and majority shareholders. This responsibility is called the duty of loyalty. When there is a conflict between a director’s personal interest and the interest of the corporation, he is legally bound to put the corporation’s interest above his own. This duty was mentioned in Exercise 3 of Section 23.2 when Ted usurped a corporate opportunity and will be discussed later in this section.
Two situations commonly give rise to the director or officer’s duty of loyalty: (1) contracts with the corporation and (2) corporate opportunity (see Figure 23.3).
Contracts with the Corporation
The law does not bar a director from contracting with the corporation he serves. However, unless the contract or transaction is “fair to the corporation,” Sections 8.61, 8.62, and 8.63 of the Revised Model Business Corporation Act (RMBCA) impose on him a stringent duty of disclosure. In the absence of a fair transaction, a contract between the corporation and one of its directors is voidable. If the transaction is unfair to the corporation, it may still be permitted if the director has made full disclosure of his personal relationship or interest in the contract and if disinterested board members or shareholders approve the transaction.
Corporate Opportunity
Whenever a director or officer learns of an opportunity to engage in a variety of activities or transactions that might be beneficial to the corporation, his first obligation is to present the opportunity to the corporation. The rule encompasses the chance of acquiring another corporation, purchasing property, and licensing or marketing patents or products. This duty of disclosure was placed into legal lexicon by Judge Cardozo in 1928 when he stated that business partners owe more than a general sense of honor among one another; rather, they owe “the punctilio of honor most sensitive.”Meinhard v. Salmon, 164 N.W. 545 (N.Y. 1928). Thus when a corporate opportunity arises, business partners must disclose the opportunity, and a failure to disclose is dishonest—a breach of the duty of loyalty.
Whether a particular opportunity is a corporate opportunity can be a delicate question. For example, BCT owns a golf course and a country club. A parcel of land adjacent to their course comes on the market for sale, but BCT takes no action. Two BCT officers purchase the land personally, later informing the BCT board about the purchase and receiving board ratification of their purchase. Then BCT decides to liquidate and enters into an agreement with the two officers to sell both parcels of land. A BCT shareholder brings a derivative suit against the officers, alleging that purchasing the adjacent land stole a corporate opportunity. The shareholder would be successful in his suit. In considering Farber v. Servan Land Co., Inc.,Farber v. Servan Land Co., Inc., 662 F.2d 371 (5th Cir. 1981). a case just like the one described, the Farber court laid out four factors in considering whether a corporate opportunity has been usurped:
1. Whether there is an actual corporate opportunity that the firm is considering
2. Whether the corporation’s shareholders declined to follow through on the opportunity
3. Whether the board or its shareholders ratified the purchase and, specifically, whether there were a sufficient number of disinterested voters
4. What benefit was missed by the corporation
In considering these factors, the Farber court held that the officers had breached a duty of loyalty to the corporation by individually purchasing an asset that would have been deemed a corporate opportunity.
When a director serves on more than one board, the problem of corporate opportunity becomes even more complex, because he may be caught in a situation of conflicting loyalties. Moreover, multiple board memberships pose another serious problem. A direct interlock occurs when one person sits on the boards of two different companies; an indirect interlock happens when directors of two different companies serve jointly on the board of a third company. The Clayton Act prohibits interlocking directorates between direct competitors. Despite this prohibition, as well as public displeasure, corporate board member overlap is commonplace. According to an analysis by USA Today and The Corporate Library, eleven of the fifteen largest companies have at least two board members who also sit together on the board of another corporation. Furthermore, CEOs of one corporation often sit on the boards of other corporations. Bank board members may sit on the boards of other corporations, including the bank’s own clients. This web of connections has both pros and cons.For a further discussion of board member connectedness, see Matt Krant, “Web of Board Members Ties Together Corporation America,” at http://www.usatoday.com/money/companies/management/2002-11-24-interlock_x.htm.
Duty of Care
The second major aspect of the director’s responsibility is that of duty of care. Section 8.30 of RMBCA calls on the director to perform his duties “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” An “ordinarily prudent person” means one who directs his intelligence in a thoughtful way to the task at hand. Put another way, a director must make a reasonable effort to inform himself before making a decision, as discussed in the next paragraph. The director is not held to a higher standard required of a specialist (finance, marketing) unless he is one. A director of a small, closely held corporation will not necessarily be held to the same standard as a director who is given a staff by a large, complex, diversified company. The standard of care is that which an ordinarily prudent person would use who is in “a like position” to the director in question. Moreover, the standard is not a timeless one for all people in the same position. The standard can depend on the circumstances: a fast-moving situation calling for a snap decision will be treated differently later, if there are recriminations because it was the wrong decision, than a situation in which time was not of the essence.
What of the care itself? What kind of care would an ordinarily prudent person in any situation be required to give? Unlike the standard of care, which can differ, the care itself has certain requirements. At a minimum, the director must pay attention. He must attend meetings, receive and digest information adequate to inform him about matters requiring board action, and monitor the performance of those to whom he has delegated the task of operating the corporation. Of course, documents can be misleading, reports can be slanted, and information coming from self-interested management can be distorted. To what heights must suspicion be raised? Section 8.30 of the RMBCA forgives directors the necessity of playing detective whenever information, including financial data, is received in an apparently reliable manner from corporate officers or employees or from experts such as attorneys and public accountants. Thus the director does not need to check with another attorney once he has received financial data from one competent attorney.
A New Jersey Supreme Court decision considered the requirements of fiduciary duties, particularly the duty of care. Pritchard & Baird was a reissuance corporation owned by Pritchard and having four directors: Pritchard, his wife, and his two sons. Pritchard and his sons routinely took loans from the accounts of the firm’s clients. After Pritchard died, his sons increased their borrowing, eventually sending the business into bankruptcy. During this time, Mrs. Pritchard developed a fondness for alcohol, drinking heavily and paying little attention to her directorship responsibilities. Creditors sued Mrs. Pritchard for breaches of her fiduciary duties, essentially arguing that the bankruptcy would not have occurred had she been acting properly. After both the trial court and appellate court found for the creditors, the New Jersey Supreme Court took up the case. The court held that a director must have a basic understanding of the business of the corporation upon whose board he or she sits. This can be accomplished by attending meetings, reviewing and understanding financial documents, investigating irregularities, and generally being involved in the corporation. The court found that Mrs. Pritchard’s being on the board because she was the spouse was insufficient to excuse her behavior, and that had she been performing her duties, she could have prevented the bankruptcy.Francis v. United Jersey Bank, 87 N.J. 15, 432 A.2d 814 (N.J. 1981).
Despite the fiduciary requirements, in reality a director does not spend all his time on corporate affairs, is not omnipotent, and must be permitted to rely on the word of others. Nor can directors be infallible in making decisions. Managers work in a business environment, in which risk is a substantial factor. No decision, no matter how rigorously debated, is guaranteed. Accordingly, courts will not second-guess decisions made on the basis of good-faith judgment and due care. This is the business judgment rule, mentioned in previous chapters. The business judgment rule was coming into prominence as early as 1919 in Dodge v. Ford, discussed in Chapter 22. It has been a pillar of corporate law ever since. As described by the Delaware Supreme Court: “The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors.…It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).
Under the business judgment rule, the actions of directors who fulfill their fiduciary duties will not be second-guessed by a court. The general test is whether a director’s decision or transaction was so one sided that no businessperson of ordinary judgment would reach the same decision. The business judgment rule has been refined over time. While the business judgment rule may seem to provide blanket protection for directors (the rule was quite broad as outlined by the court in Dodge v. Ford), this is not the case. The rule does not protect every decision made by directors, and they may face lawsuits, a topic to which we now turn. For further discussions of the business judgment rule, see Cede & Co. v. Technicolor, Inc.,Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993).In re The Walt Disney Co. Derivative Litigation,In re The Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006). and Smith v. Van Gorkom.Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
If a shareholder is not pleased by a director’s decision, that shareholder may file a derivative suit. The derivative suit may be filed by a shareholder on behalf of the corporation against directors or officers of the corporation, alleging breach of their fiduciary obligations. However, a shareholder, as a prerequisite to filing a derivative action, must first demand that the board of directors take action, as the actual party in interest is the corporation, not the shareholder (meaning that if the shareholder is victorious in the lawsuit, it is actually the corporation that “wins”). If the board refuses, is its decision protected by the business judgment rule? The general rule is that the board may refuse to file a derivative suit and will be protected by the business judgment rule. And even when a derivative suit is filed, directors can be protected by the business judgment rule for decisions even the judge considers to have been poorly made. See In re The Walt Disney Co. Derivative Litigation, (see Section 23.5.2 “Business Judgment Rule”).
In a battle for control of a corporation, directors (especially “inside” directors, who are employees of the corporation, such as officers) often have an inherent self-interest in preserving their positions, which can lead them to block mergers that the shareholders desire and that may be in the firm’s best interest. As a result, Delaware courts have modified the usual business judgment presumption in this situation. In Unocal Corp. v. Mesa Petroleum,Unocal Corp. v. Mesa Petroleum, 493 A.2d 946 (Del. 1985). for instance, the court held that directors who adopt a defensive mechanism “must show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed.…[T]hey satisfy that burden ‘by showing good faith and reasonable investigation.’” The business judgment rule clearly does not protect every decision of the board. The Unocal court developed a test for the board: the directors may only work to prevent a takeover when they can demonstrate a threat to the policies of the corporation and that any defensive measures taken to prevent the takeover were reasonable and proportional given the depth of the threat. The Unocal test was modified further by requiring a finding, before a court steps in, that the actions of a board were coercive, a step back toward the business judgment rule.Unitrin v. American General Corp., 651 A.2d 1361 (Del. 1995).
In a widely publicized case, the Delaware Supreme Court held that the board of Time, Inc. met the Unocal test—that the board reasonably concluded that a tender offer by Paramount constituted a threat and acted reasonably in rejecting Paramount’s offer and in merging with Warner Communications.Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989).
The specific elements of the fiduciary duties are not spelled out in stone. For example, the Delaware courts have laid out three factors to examine when determining whether a duty of care has been breached:In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).
1. The directors knew, or should have known, that legal breaches were occurring.
2. The directors took no steps to prevent or resolve the situation.
3. This failure caused the losses about which the shareholder is complaining in a derivative suit.
Thus the court expanded the duty of oversight (which is included under the umbrella of the duty of care; these duties are often referred to as the Caremark duties). Furthermore, courts have recognized a duty of good faith—a duty to act honestly and avoid violations of corporate norms and business practices.For more information, see Melvin Eisenberg, “The Duty of Good Faith in Corporate Law,” 31 Delaware Journal of Corporate Law, 1 (2005). Therefore, the split in ownership and decision making within the corporate structure causes rifts, and courts are working toward balancing the responsibilities of the directors to their shareholders with their ability to run the corporation.
Constituency Statutes and Corporate Social Responsibility
Until the 1980s, the law in all the states imposed on corporate directors the obligation to advance shareholders’ economic interests to ensure the long-term profitability of the corporation. Other groups—employees, local communities and neighbors, customers, suppliers, and creditors—took a back seat to this primary responsibility of directors. Of course, directors could consider the welfare of these other groups if in so doing they promoted the interests of shareholders. But directors were not legally permitted to favor the interests of others over shareholders. The prevailing rule was, and often still is, that maximizing shareholder value is the primary duty of the board. Thus in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.,Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). the Delaware Supreme Court held that Revlon’s directors had breached their fiduciary duty to the company’s shareholders in response to a hostile tender offer from Pantry Pride. While the facts of the case are intricate, the general gist is that the Revlon directors thwarted the hostile tender by adopting a variation of a poison pill involving a tender offer for their own shares in exchange for debt, effectively eliminating Pantry Pride’s ability to take over the firm. Pantry Pride upped its offer price, and in response, Revlon began negotiating with a leveraged buyout by a third party, Forstmann Little. Pantry Pride publicly announced it would top any bid made by Forstmann Little. Despite this, the Revlon board negotiated a deal with Forstmann Little. The court noted an exception to the general rule that permitted directors to consider the interests of other groups as long as “there are rationally related benefits accruing to the stockholders.” But when a company is about to be taken over, the object must be to sell it to the highest bidder, Pantry Pride in this case. It is then, said the court, in situations where the corporation is to be sold, that “concern for nonstockholder interests is inappropriate,” thus giving rise to what are commonly called the Revlon duties.
Post-Revlon, in response to a wave of takeovers in the late 1980s, some states have enacted laws to give directors legal authority to take account of interests other than those of shareholders in deciding how to defend against hostile mergers and acquisitions. These laws are known as constituency statutes, because they permit directors to take account of the interests of other constituencies of corporations. These do not permit a corporation to avoid its Revlon duties (that when a corporation is up for sale, it must be sold to the highest bidder) but will allow a corporation to consider factors other than shareholder value in determining whether to make charitable donations or reinvest profits. This ability has been further expanding as the concept of corporate social responsibility has grown, as discussed later in this section.
Although the other constituency statutes are not identically worded, they are all designed to release directors from their formal legal obligation to keep paramount the interests of shareholders. The Pennsylvania and Indiana statutes make this clear; statutes in other states are worded a bit more ambiguously, but the intent of the legislatures in enacting these laws seems clear: directors may give voice to employees worried about the loss of jobs or to communities worried about the possibility that an out-of-state acquiring company may close down a local factory to the detriment of the local economy. So broadly worded are these laws that although the motive for enacting them was to give directors a weapon in fighting hostile tender offers, in some states the principle applies to any decision by a board of directors. So, for example, it is possible that a board might legally decide to give a large charitable grant to a local community—a grant so large that it would materially decrease an annual dividend, contrary to the general rule that at some point the interests of shareholders in dividends clearly outweighs the board’s power to spend corporate profits on “good works.”
Critics have attacked the constituency statutes on two major grounds: first, they substitute a clear principle of conduct for an amorphous one, because they give no guidance on how directors are supposed to weigh the interests of a corporation’s various constituencies. Second, they make it more difficult for shareholders to monitor the performance of a company’s board; measuring decisions against the single goal of profit maximization is far easier than against the subjective goal of “balancing” a host of competing interests. Constituency statutes run contrary to the concept of shareholders as owners, and of the fiduciary duties owed to them, effectively softening shareholder power. Nevertheless, since many states now have constituency statutes, it is only reasonable to expect that the traditional doctrine holding shareholder interests paramount will begin to give way, even as the shareholders challenge new decisions by directors that favor communities, employees, and others with an important stake in the welfare of the corporations with which they deal. For a more complete discussion of constituency statutes, see “Corporate Governance and the Sarbanes-Oxley Act: Corporate Constituency Statutes and Employee Governance.”Brett H. McDonnell, “Corporate Governance and the Sarbanes-Oxley Act: Corporate Constituency Statutes and Employee Governance,” William Mitchell Law Review 30 (2004): 1227.
Many modern corporations have begun to promote socially responsible behavior. While dumping toxic waste out the back door of the manufacturing facility rather than expending funds to properly dispose of the waste may result in an increase in value, the consequences of dumping the waste can be quite severe, whether from fines from regulatory authorities or from public backlash. Corporate social responsibility results from internal corporate policies that attempt to self-regulate and fulfill legal, ethical, and social obligations. Thus under corporate social responsibility, corporations may make donations to charitable organizations or build environmentally friendly or energy-efficient buildings. Socially irresponsible behavior can be quite disastrous for a corporation. Nike, for example, was hit by consumer backlash due to its use of child labor in other countries, such as India and Malaysia. British Petroleum (BP) faced public anger as well as fines and lawsuits for a massive oil spill in the Gulf of Mexico. This spill had serious consequences for BP’s shareholders—BP stopped paying dividends, its stock price plummeted, and it had to set aside significant amounts of money to compensate injured individuals and businesses.
Many businesses try to fulfill what is commonly called the triple bottom line, which is a focus on profits, people, and the planet. For example, Ben and Jerry’s, the ice cream manufacturer, had followed a triple bottom line practice for many years. Nonetheless, when Ben and Jerry’s found itself the desired acquisition of several other businesses, it feared that a takeover of the firm would remove this focus, since for some firms, there is only one bottom line—profits. Unilever offered \$43.60 per share for Ben and Jerry’s. Several Ben and Jerry’s insiders made a counteroffer at \$38 per share, arguing that a lower price was justified given the firm’s focus. Ultimately, in a case like this, the Revlon duties come into play: when a corporation is for sale, corporate social responsibility goes out the window and only one bottom line exists—maximum shareholder value. In the case of Ben and Jerry’s, the company was acquired in 2000 for \$326 million by Unilever, the Anglo-Dutch corporation that is the world’s largest consumer products company.
Sarbanes-Oxley and Other Modern Trends
The Sarbanes-Oxley Act of 2002, enacted following several accounting scandals, strengthens the duties owed by the board and other corporate officers. In particular, Title III contains corporate responsibility provisions, such as requiring senior executives to vouch for the accuracy and completeness of their corporation’s financial disclosures. While the main goal of Sarbanes-Oxley is to decrease the incidents of financial fraud and accounting tricks, its operative goal is to strengthen the fiduciary duties of loyalty and care as well as good faith.
The modern trend has been to impose more duties. Delaware has been adding to the list of fiduciary responsibilities other than loyalty and care. As mentioned previously, the Delaware judicial system consistently recognizes a duty of good faith. The courts have further added a duty of candor with shareholders when the corporation is disseminating information to its investors. Particular duties arise in the context of mergers, acquisitions, and tender offers. As mentioned previously in the Revlon case, the duty owed to shareholders in situations of competing tender offers is that of maximum value. Other duties may arise, such as when directors attempt to retain their positions on the board in the face of a hostile tender offer. Trends in fiduciary responsibilities, as well as other changes in the business legal field, are covered extensively by the American Bar Association at www.americanbar.org/groups/business_law.html.
Liability Prevention and Insurance
Alice, the director of BCT, has been charged with breaching her duty of care. Is she personally liable for a breach of the duty of care? How can a director avoid liability? Of course, she can never avoid defending a lawsuit, for in the wake of any large corporate difficulty—from a thwarted takeover bid to a bankruptcy—some group of shareholders will surely sue. But the director can immunize herself ultimately by carrying out her duties of loyalty and care. In practice, this often means that she should be prepared to document the reasonableness of her reliance on information from all sources considered. Second, if the director dissents from action that she considers mistaken or unlawful, she should ensure that her negative vote is recorded. Silence is construed as assent to any proposition before the board, and assent to a woefully mistaken action can be the basis for staggering liability.
Corporations, however, are permitted to limit or eliminate the personal liability of its directors. For example, Delaware law permits the articles of incorporation to contain a provision eliminating or limiting the personal liability of directors to the corporation, with some limitations.Del. Code Ann., Title 8, Section 102(b)(7) (2011).
Beyond preventive techniques, another measure of protection from director liability is indemnification (reimbursement). In most states, the corporation may agree under certain circumstances to indemnify directors, officers, and employees for expenses resulting from litigation when they are made party to suits involving the corporation. In third-party actions (those brought by outsiders), the corporation may reimburse the director, officer, or employee for all expenses (including attorneys’ fees), judgments, fines, and settlement amounts. In derivative actions, the corporation’s power to indemnify is more limited. For example, reimbursement for litigation expenses of directors adjudged liable for negligence or misconduct is allowed only if the court approves. In both third-party and derivative actions, the corporation must provide indemnification expenses when the defense is successful.
Whether or not they have the power to indemnify, corporations may purchase liability insurance for directors, officers, and employees (for directors and officers, the insurance is commonly referred to as D&O insurance). But insurance policies do not cover every act. Most exclude “willful negligence” and criminal conduct in which intent is a necessary element of proof. Furthermore, the cost of liability insurance has increased dramatically in recent years, causing some companies to cancel their coverage. This, in turn, jeopardizes the recent movement toward outside directors because many directors might prefer to leave or decline to serve on boards that have inadequate liability coverage. As a result, most states have enacted legislation that allows a corporation, through a charter amendment approved by shareholders, to limit the personal liability of its outside directors for failing to exercise due care. In 1990, Section 2.02 of the RMBCA was amended to provide that the articles of incorporation may include “a provision eliminating or limiting the liability of a director to the corporation or its shareholders for money damages.…” This section includes certain exceptions; for example, the articles may not limit liability for intentional violations of criminal law. Delaware Code Section 102(b)(7), as mentioned previously, was enacted after Smith v. Van Gorkom (discussed in Section 23.4.3 “Duty of Care”) and was prompted by an outcry about the court’s decision. As a result, many corporations now use similar provisions to limit director liability. For example, Delaware and California permit the limitation or abolition of liability for director’s breach of the duty of care except in instances of fraud, bad faith, or willful misconduct.
Key Takeaway
Directors and officers have two main fiduciary duties: the duty of loyalty and the duty of care. The duty of loyalty is a responsibility to act in the best interest of the corporation, even when that action may conflict with a personal interest. This duty commonly arises in contracts with the corporation and with corporate opportunities. The duty of care requires directors and officers to act with the care of an ordinarily prudent person in like circumstances. The business judgment rule may protect directors and officers, since courts give a presumption to the corporation that its personnel are informed and act in good faith. A shareholder may file a derivative lawsuit on behalf of the corporation against corporate insiders for breaches of these fiduciary obligations or other actions that harm the corporation. While directors and officers have obligations to the corporation and its shareholders, they may weigh other considerations under constituency statutes. In response to recent debacles, state and federal laws, such as Sarbanes-Oxley, have placed further requirements on officers and directors. Director and officer expenses in defending claims of wrongful acts may be covered through indemnification or insurance.
Exercises
1. What are the two major fiduciary responsibilities that directors and officers owe to the corporation and its shareholders?
2. What are some benefits of having interlocking directorates? What are some disadvantages?
3. Is there any connection between the business judgment rule and constituency statutes? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/23%3A_Corporate_Powers_and_Management/23.04%3A_Liability_of_Directors_and_Officers.txt |
Ultra Vires Acts
Cross v. The Midtown Club, Inc.
33 Conn. Supp. 150; 365 A.2d 1227 (Conn. 1976)
STAPLETON, JUDGE.
The following facts are admitted or undisputed: The plaintiff is a member in good standing of the defendant nonstock Connecticut corporation. Each of the individual defendants is a director of the corporation, and together the individual defendants constitute the entire board of directors. The certificate of incorporation sets forth that the sole purpose of the corporation is “to provide facilities for the serving of luncheon or other meals to members.” Neither the certificate of incorporation nor the bylaws of the corporation contain any qualifications for membership, nor does either contain any restrictions on the luncheon guests members may bring to the club. The plaintiff sought to bring a female to lunch with him, and both he and his guest were refused seating at the luncheon facility. The plaintiff wrote twice to the president of the corporation to protest the action, but he received no reply to either letter. On three different occasions, the plaintiff submitted applications for membership on behalf of a different female, and only on the third of those occasions did the board process the application, which it then rejected. Shortly after both of the above occurrences, the board of directors conducted two separate pollings of its members, one by mail, the other by a special meeting held to vote on four alternative proposals for amending the bylaws of corporation concerning the admission of women members and guests. None of these proposed amendments to the bylaws received the required number of votes for adoption. Following that balloting, the plaintiff again wrote to the president of the corporation and asked that the directors stop interfering with his rights as a member to bring women guests to the luncheon facility and to propose women for membership. The president’s reply was that “the existing bylaws, house rules and customs continue in effect, and therefore [the board] consider[s] the matter closed.”
* * *
In addition to seeking a declaratory judgment which will inform him of his rights vis-à-vis the corporation and its directors, the plaintiff is also seeking injunctive relief, orders directing the admission of the plaintiff’s candidate to membership and denying indemnity to the directors, money damages, and costs and expenses including reasonable attorney’s fees. It should be noted at the outset that the plaintiff is not making a claim under either the federal or state civil rights or equal accommodations statutes, but that he is solely asserting his membership rights under the certificate of incorporation, the bylaws, and the statutes governing the regulation of this nonstock corporation. As such, this is a case of first impression in Connecticut.
* * *
Connecticut has codified the common-law right of a member to proceed against his corporation or its directors in the event of an ultra vires act. In fact, it has been done specifically under the Nonstock Corporation Act.
No powers were given to the defendant corporation in its certificate of incorporation, only a purpose, and as a result the only incidental powers which the defendant would have under the common law are those which are necessary to effect its purpose, that being to serve lunch to its members. Since the club was not formed for the purpose of having an exclusively male luncheon club, it cannot be considered necessary to its stated purpose for the club to have the implied power at common law to exclude women members.
Under the Connecticut Nonstock Corporation Act, the corporation could have set forth in its certificate of incorporation that its purpose was to engage in any lawful activity permitted that corporation. That was not done. Its corporate purposes were very narrowly stated to be solely for providing “facilities for the serving of luncheon or other meals to members.” The certificate did not restrict the purpose to the serving of male members. Section 33-428 of the General Statutes provides that the corporate powers of a nonstock corporation are those set forth in the Nonstock Corporation Act, those specifically stated in the certificate of incorporation, neither of which includes the power to exclude women members, and the implied power to “exercise all legal powers necessary or convenient to effect any or all of the purposes stated in its certificate of incorporation.…”
We come, thus, to the nub of this controversy and the basic legal question raised by the facts in this case: Is it necessary or convenient to the purpose for which this corporation was organized for it to exclude women members? This court concludes that it is not. While a corporation might be organized for the narrower purpose of providing a luncheon club for men only, this one was not so organized. Its stated purpose is broader and this court cannot find that it is either necessary or convenient to that purpose for its membership to be restricted to men. It should be borne in mind that this club is one of the principal luncheon clubs for business and professional people in Stamford. It is a gathering place where a great many of the civic, business, and professional affairs of the Stamford community are discussed in an atmosphere of social intercourse. Given the scope of the entry of women today into the business and professional life of the community and the changing status of women before the law and in society, it would be anomalous indeed for this court to conclude that it is either necessary or convenient to the stated purpose for which it was organized for this club to exclude women as members or guests.
While the bylaws recognize the right of a member to bring guests to the club, the exclusion of women guests is nowhere authorized and would not appear to be any more necessary and convenient to the purpose of the club than the exclusion of women members. The bylaws at present contain no restrictions against female members or guests and even if they could be interpreted as authorizing those restrictions, they would be of no validity in light of the requirement of § 33-459 (a) of the General Statutes, that the bylaws must be “reasonable [and] germane to the purposes of the corporation.…”
The court therefore concludes that the actions and policies of the defendants in excluding women as members and guests solely on the basis of sex is ultra vires and beyond the power of the corporation and its management under its certificate of incorporation and the Nonstock Corporation Act, and in derogation of the rights of the plaintiff as a member thereof. The plaintiff is entitled to a declaratory judgment to that effect and one may enter accordingly.
Case Questions
1. What is the basis of the plaintiff’s claim?
2. Would the club have had a better defense against the plaintiff’s claim if its purpose was “to provide facilities for the serving of luncheon or other meals to male members”?
3. Had the corporation’s purpose read as it does in Question 2, would the plaintiff have had other bases for a claim?
Business Judgment Rule
In re The Walt Disney Co. Derivative Litigation
907 A.2d 693 (Del. Ch. 2005)
JACOBS, Justice:
[The Walt Disney Company hired Ovitz as its executive president and as a board member for five years after lengthy compensation negotiations. The negotiations regarding Ovitz’s compensation were conducted predominantly by Eisner and two of the members of the compensation committee (a four-member panel). The terms of Ovitz’s compensation were then presented to the full board. In a meeting lasting around one hour, where a variety of topics were discussed, the board approved Ovitz’s compensation after reviewing only a term sheet rather than the full contract. Ovitz’s time at Disney was tumultuous and short-lived.]…In December 1996, only fourteen months after he commenced employment, Ovitz was terminated without cause, resulting in a severance payout to Ovitz valued at approximately \$ 130 million. [Disney shareholders then filed derivative actions on behalf of Disney against Ovitz and the directors of Disney at the time of the events complained of (the “Disney defendants”), claiming that the \$130 million severance payout was the product of fiduciary duty and contractual breaches by Ovitz and of breaches of fiduciary duty by the Disney defendants and a waste of assets. The Chancellor found in favor of the defendants. The plaintiff appealed.]
We next turn to the claims of error that relate to the Disney defendants. Those claims are subdivisible into two groups: (A) claims arising out of the approval of the OEA [Ovitz employment agreement] and of Ovitz’s election as President; and (B) claims arising out of the NFT [nonfault termination] severance payment to Ovitz upon his termination. We address separately those two categories and the issues that they generate.…
…[The due care] argument is best understood against the backdrop of the presumptions that cloak director action being reviewed under the business judgment standard. Our law presumes that “in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.” Those presumptions can be rebutted if the plaintiff shows that the directors breached their fiduciary duty of care or of loyalty or acted in bad faith. If that is shown, the burden then shifts to the director defendants to demonstrate that the challenged act or transaction was entirely fair to the corporation and its shareholders.…
The appellants’ first claim is that the Chancellor erroneously (i) failed to make a “threshold determination” of gross negligence, and (ii) “conflated” the appellants’ burden to rebut the business judgment presumptions, with an analysis of whether the directors’ conduct fell within the 8 Del. C. § 102(b)(7) provision that precludes exculpation of directors from monetary liability “for acts or omissions not in good faith.” The argument runs as follows: Emerald Partners v. Berlin required the Chancellor first to determine whether the business judgment rule presumptions were rebutted based upon a showing that the board violated its duty of care, i.e., acted with gross negligence. If gross negligence were established, the burden would shift to the directors to establish that the OEA was entirely fair. Only if the directors failed to meet that burden could the trial court then address the directors’ Section 102(b)(7) exculpation defense, including the statutory exception for acts not in good faith.
This argument lacks merit. To make the argument the appellants must ignore the distinction between (i) a determination of bad faith for the threshold purpose of rebutting the business judgment rule presumptions, and (ii) a bad faith determination for purposes of evaluating the availability of charter-authorized exculpation from monetary damage liability after liability has been established. Our law clearly permits a judicial assessment of director good faith for that former purpose. Nothing in Emerald Partners requires the Court of Chancery to consider only evidence of lack of due care (i.e. gross negligence) in determining whether the business judgment rule presumptions have been rebutted.…
The appellants argue that the Disney directors breached their duty of care by failing to inform themselves of all material information reasonably available with respect to Ovitz’s employment agreement.…[but the] only properly reviewable action of the entire board was its decision to elect Ovitz as Disney’s President. In that context the sole issue, as the Chancellor properly held, is “whether [the remaining members of the old board] properly exercised their business judgment and acted in accordance with their fiduciary duties when they elected Ovitz to the Company’s presidency.” The Chancellor determined that in electing Ovitz, the directors were informed of all information reasonably available and, thus, were not grossly negligent. We agree.
…[The court turns to good faith.] The Court of Chancery held that the business judgment rule presumptions protected the decisions of the compensation committee and the remaining Disney directors, not only because they had acted with due care but also because they had not acted in bad faith. That latter ruling, the appellants claim, was reversible error because the Chancellor formulated and then applied an incorrect definition of bad faith.
…Their argument runs as follows: under the Chancellor’s 2003 definition of bad faith, the directors must have “consciously and intentionally disregarded their responsibilities, adopting a ‘we don’t care about the risks’ attitude concerning a material corporate decision.” Under the 2003 formulation, appellants say, “directors violate their duty of good faith if they are making material decisions without adequate information and without adequate deliberation[,]” but under the 2005 post-trial definition, bad faith requires proof of a subjective bad motive or intent. This definitional change, it is claimed, was procedurally prejudicial because appellants relied on the 2003 definition in presenting their evidence of bad faith at the trial.…
Second, the appellants claim that the Chancellor’s post-trial definition of bad faith is erroneous substantively. They argue that the 2003 formulation was (and is) the correct definition, because it is “logically tied to board decision-making under the duty of care.” The post-trial formulation, on the other hand, “wrongly incorporated substantive elements regarding the rationality of the decisions under review rather than being constrained, as in a due care analysis, to strictly procedural criteria.” We conclude that both arguments must fail.
The appellants’ first argument—that there is a real, significant difference between the Chancellor’s pre-trial and post-trial definitions of bad faith—is plainly wrong. We perceive no substantive difference between the Court of Chancery’s 2003 definition of bad faith—a “conscious and intentional disregard [of] responsibilities, adopting a we don’t care about the risks’ attitude…”—and its 2005 post-trial definition—an “intentional dereliction of duty, a conscious disregard for one’s responsibilities.” Both formulations express the same concept, although in slightly different language.
The most telling evidence that there is no substantive difference between the two formulations is that the appellants are forced to contrive a difference. Appellants assert that under the 2003 formulation, “directors violate their duty of good faith if they are making material decisions without adequate information and without adequate deliberation.” For that ipse dixit they cite no legal authority. That comes as no surprise because their verbal effort to collapse the duty to act in good faith into the duty to act with due care, is not unlike putting a rabbit into the proverbial hat and then blaming the trial judge for making the insertion.
…The precise question is whether the Chancellor’s articulated standard for bad faith corporate fiduciary conduct—intentional dereliction of duty, a conscious disregard for one’s responsibilities—is legally correct. In approaching that question, we note that the Chancellor characterized that definition as “an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith.” That observation is accurate and helpful, because as a matter of simple logic, at least three different categories of fiduciary behavior are candidates for the “bad faith” pejorative label.
The first category involves so-called “subjective bad faith,” that is, fiduciary conduct motivated by an actual intent to do harm. That such conduct constitutes classic, quintessential bad faith is a proposition so well accepted in the liturgy of fiduciary law that it borders on axiomatic.…The second category of conduct, which is at the opposite end of the spectrum, involves lack of due care—that is, fiduciary action taken solely by reason of gross negligence and without any malevolent intent. In this case, appellants assert claims of gross negligence to establish breaches not only of director due care but also of the directors’ duty to act in good faith. Although the Chancellor found, and we agree, that the appellants failed to establish gross negligence, to afford guidance we address the issue of whether gross negligence (including a failure to inform one’s self of available material facts), without more, can also constitute bad faith. The answer is clearly no.
…”issues of good faith are (to a certain degree) inseparably and necessarily intertwined with the duties of care and loyalty.…” But, in the pragmatic, conduct-regulating legal realm which calls for more precise conceptual line drawing, the answer is that grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith. The conduct that is the subject of due care may overlap with the conduct that comes within the rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must remain quite distinct.…
The Delaware General Assembly has addressed the distinction between bad faith and a failure to exercise due care (i.e., gross negligence) in two separate contexts. The first is Section 102(b)(7) of the DGCL, which authorizes Delaware corporations, by a provision in the certificate of incorporation, to exculpate their directors from monetary damage liability for a breach of the duty of care. That exculpatory provision affords significant protection to directors of Delaware corporations. The statute carves out several exceptions, however, including most relevantly, “for acts or omissions not in good faith.…” Thus, a corporation can exculpate its directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith. To adopt a definition of bad faith that would cause a violation of the duty of care automatically to become an act or omission “not in good faith,” would eviscerate the protections accorded to directors by the General Assembly’s adoption of Section 102(b)(7).
A second legislative recognition of the distinction between fiduciary conduct that is grossly negligent and conduct that is not in good faith, is Delaware’s indemnification statute, found at 8 Del. C. § 145. To oversimplify, subsections (a) and (b) of that statute permit a corporation to indemnify (inter alia) any person who is or was a director, officer, employee or agent of the corporation against expenses…where (among other things): (i) that person is, was, or is threatened to be made a party to that action, suit or proceeding, and (ii) that person “acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation.…” Thus, under Delaware statutory law a director or officer of a corporation can be indemnified for liability (and litigation expenses) incurred by reason of a violation of the duty of care, but not for a violation of the duty to act in good faith.
Section 145, like Section 102(b)(7), evidences the intent of the Delaware General Assembly to afford significant protections to directors (and, in the case of Section 145, other fiduciaries) of Delaware corporations. To adopt a definition that conflates the duty of care with the duty to act in good faith by making a violation of the former an automatic violation of the latter, would nullify those legislative protections and defeat the General Assembly’s intent. There is no basis in policy, precedent or common sense that would justify dismantling the distinction between gross negligence and bad faith.
That leaves the third category of fiduciary conduct, which falls in between the first two categories of (1) conduct motivated by subjective bad intent and (2) conduct resulting from gross negligence. This third category is what the Chancellor’s definition of bad faith—intentional dereliction of duty, a conscious disregard for one’s responsibilities—is intended to capture. The question is whether such misconduct is properly treated as a non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith. In our view it must be, for at least two reasons.
First, the universe of fiduciary misconduct is not limited to either disloyalty in the classic sense (i.e., preferring the adverse self-interest of the fiduciary or of a related person to the interest of the corporation) or gross negligence. Cases have arisen where corporate directors have no conflicting self-interest in a decision, yet engage in misconduct that is more culpable than simple inattention or failure to be informed of all facts material to the decision. To protect the interests of the corporation and its shareholders, fiduciary conduct of this kind, which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed. A vehicle is needed to address such violations doctrinally, and that doctrinal vehicle is the duty to act in good faith. The Chancellor implicitly so recognized in his Opinion, where he identified different examples of bad faith as follows:
The good faith required of a corporate fiduciary includes not simply the duties of care and loyalty, in the narrow sense that I have discussed them above, but all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders. A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.
…Second, the legislature has also recognized this intermediate category of fiduciary misconduct, which ranks between conduct involving subjective bad faith and gross negligence. Section 102(b)(7)(ii) of the DGCL expressly denies money damage exculpation for “acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” By its very terms that provision distinguishes between “intentional misconduct” and a “knowing violation of law” (both examples of subjective bad faith) on the one hand, and “acts…not in good faith,” on the other. Because the statute exculpates directors only for conduct amounting to gross negligence, the statutory denial of exculpation for “acts…not in good faith” must encompass the intermediate category of misconduct captured by the Chancellor’s definition of bad faith.
For these reasons, we uphold the Court of Chancery’s definition as a legally appropriate, although not the exclusive, definition of fiduciary bad faith. We need go no further. To engage in an effort to craft (in the Court’s words) “a definitive and categorical definition of the universe of acts that would constitute bad faith” would be unwise and is unnecessary to dispose of the issues presented on this appeal.…
For the reasons stated above, the judgment of the Court of Chancery is affirmed.
Case Questions
1. How did the court view the plaintiff’s argument that the Chancellor had developed two different types of bad faith?
2. What are the three types of bad faith that the court discusses?
3. What two statutory provisions has the Delaware General Assembly passed that address the distinction between bad faith and a failure to exercise due care (i.e., gross negligence)? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/23%3A_Corporate_Powers_and_Management/23.05%3A_Cases.txt |
Summary
A corporation may exercise two types of powers: (1) express powers, set forth by statute and in the articles of incorporation, and (2) implied powers, necessary to carry out its stated purpose. The corporation may always amend the articles of incorporation to change its purposes. Nevertheless, shareholders may enjoin their corporation from acting ultra vires, as may the state attorney general. However, an individual stockholder, director, or officer (except in rare instances under certain regulatory statutes) may not be held vicariously liable if he did not participate in the crime or tort.
Because ownership and control are separated in the modern publicly held corporation, shareholders generally do not make business decisions. Shareholders who own voting stock do retain the power to elect directors, amend the bylaws, ratify or reject certain corporate actions, and vote on certain extraordinary matters, such as whether to amend the articles of incorporation, merge, or liquidate.
In voting for directors, various voting methodologies may be used, such as cumulative voting, which provides safeguards against removal of minority-shareholder-supported directors. Shareholders may use several voting arrangements that concentrate power, including proxies, voting agreements, and voting trusts. Proxies are regulated under rules promulgated by the Securities and Exchange Commission (SEC).
Corporations may deny preemptive rights—the rights of shareholders to prevent dilution of their percentage of ownership—by so stating in the articles of incorporation. Some states say that in the absence of such a provision, shareholders do have preemptive rights; others say that there are no preemptive rights unless the articles specifically include them.
Directors have the ultimate authority to run the corporation and are fiduciaries of the firm. In large corporations, directors delegate day-to-day management to salaried officers, whom they may fire, in most states, without cause. The full board of directors may, by majority, vote to delegate its authority to committees.
Directors owe the company a duty of loyalty and of care. A contract between a director and the company is voidable unless fair to the corporation or unless all details have been disclosed and the disinterested directors or shareholders have approved. Any director or officer is obligated to inform fellow directors of any corporate opportunity that affects the company and may not act personally on it unless he has received approval. The duty of care is the obligation to act “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” Other fiduciary duties have also been recognized, and constituency statutes permit the corporation to consider factors other than shareholders in making decisions. Shareholders may file derivative suits alleging breaches of fiduciary responsibilities. The duties have been expanded. For example, when the corporation is being sold, the directors have a duty to maximize shareholder value. Duties of oversight, good faith, and candor have been applied.
The corporation may agree, although not in every situation, to indemnify officers, directors, and employees for litigation expenses when they are made party to suits involving the corporation. The corporation may purchase insurance against legal expenses of directors and officers, but the policies do not cover acts of willful negligence and criminal conduct in which intent is a necessary element of proof. Additionally, the business judgment rule may operate to protect the decisions of the board.
The general rule is to maximize shareholder value, but over time, corporations have been permitted to consider other factors in decision making. Constituency statutes, for example, allow the board to consider factors other than maximizing shareholder value. Corporate social responsibility has increased, as firms consider things such as environmental impact and consumer perception in making decisions.
Exercises
1. First Corporation, a Massachusetts company, decides to expend \$100,000 to publicize its support of a candidate in an upcoming presidential election. A Massachusetts statute forbids corporate expenditures for the purpose of influencing the vote in elections. Chauncey, a shareholder in First Corporation, feels that the company should support a different presidential candidate and files suit to stop the company’s publicizing efforts. What is the result? Why?
2. Assume in Exercise 1 that Chauncey is both an officer and a director of First Corporation. At a duly called meeting of the board, the directors decide to dismiss Chauncey as an officer and a director. If they had no cause for this action, is the dismissal valid? Why?
3. A book publisher that specializes in children’s books has decided to publish pornographic literature for adults. Amanda, a shareholder in the company, has been active for years in an antipornography campaign. When she demands access to the publisher’s books and records, the company refuses. She files suit. What arguments should Amanda raise in the litigation? Why?
4. A minority shareholder brought suit against the Chicago Cubs, a Delaware corporation, and their directors on the grounds that the directors were negligent in failing to install lights in Wrigley Field. The shareholder specifically alleged that the majority owner, Philip Wrigley, failed to exercise good faith in that he personally believed that baseball was a daytime sport and felt that night games would cause the surrounding neighborhood to deteriorate. The shareholder accused Wrigley and the other directors of not acting in the best financial interests of the corporation. What counterarguments should the directors assert? Who will win? Why?
5. The CEO of First Bank, without prior notice to the board, announced a merger proposal during a two-hour meeting of the directors. Under the proposal, the bank was to be sold to an acquirer at \$55 per share. (At the time, the stock traded at \$38 per share.) After the CEO discussed the proposal for twenty minutes, with no documentation to support the adequacy of the price, the board voted in favor of the proposal. Although senior management strongly opposed the proposal, it was eventually approved by the stockholders, with 70 percent in favor and 7 percent opposed. A group of stockholders later filed a class action, claiming that the directors were personally liable for the amount by which the fair value of the shares exceeded \$55—an amount allegedly in excess of \$100 million. Are the directors personally liable? Why or why not?
SELF CHECK QUESTIONS
1. Acts that are outside a corporation’s lawful powers are considered
1. ultra vires
2. express powers
3. implied powers
4. none of the above
2. Powers set forth by statute and in the articles of incorporation are called
1. implied powers
2. express powers
3. ultra vires
4. incorporation by estoppel
3. The principle that mistakes made by directors on the basis of good-faith judgment can be forgiven
1. is called the business judgment rule
2. depends on whether the director has exercised due care
3. involves both of the above
4. involves neither of the above
4. A director of a corporation owes
1. a duty of loyalty
2. a duty of care
3. both a duty of loyalty and a duty of care
4. none of the above
5. A corporation may purchase indemnification insurance
1. to cover acts of simple negligence
2. to cover acts of willful negligence
3. to cover acts of both simple and willful negligence
4. to cover acts of criminal conduct
1. a
2. b
3. c
4. c
5. a | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/23%3A_Corporate_Powers_and_Management/23.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The nature of securities regulation
• The Securities Act of 1933 and the Securities Exchange Act of 1934
• Liability under securities laws
• What insider trading is and why it’s unlawful
• Civil and criminal penalties for violations of securities laws
Both the registration and the trading of securities are highly regulated by the Securities and Exchange Commission (SEC). A violation of a securities law can lead to severe criminal and civil penalties. But first we examine the question, Why is there a need for securities regulation?
24: Securities Regulation
Learning Objectives
By the end of this section, you will be able to:
• Recognize that the definition of security encompasses a broad range of interests.
• Understand the functions of the Securities and Exchange Commission and the penalties for violations of the securities laws.
• Understand which companies the Securities Exchange Act of 1934 covers.
• Explore the purpose of state Blue Sky Laws.
• Know the basic provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
What we commonly refer to as “securities” are essentially worthless pieces of paper. Their inherent value lies in the interest in property or an ongoing enterprise that they represent. This disparity between the tangible property—the stock certificate, for example—and the intangible interest it represents gives rise to several reasons for regulation. First, there is need for a mechanism to inform the buyer accurately what it is he is buying. Second, laws are necessary to prevent and provide remedies for deceptive and manipulative acts designed to defraud buyers and sellers. Third, the evolution of stock trading on a massive scale has led to the development of numerous types of specialists and professionals, in dealings with whom the public can be at a severe disadvantage, and so the law undertakes to ensure that they do not take unfair advantage of their customers.
The Securities Act of 1933 and the Securities Exchange Act of 1934 are two federal statutes that are vitally important, having virtually refashioned the law governing corporations during the past half century. In fact, it is not too much to say that although they deal with securities, they have become the general federal law of corporations. This body of federal law has assumed special importance in recent years as the states have engaged in a race to the bottom in attempting to compete with Delaware’s permissive corporation law (see Chapter 21).
What Is a Security?
Securities law questions are technical and complex and usually require professional counsel. For the nonlawyer, the critical question on which all else turns is whether the particular investment or document is a security. If it is, anyone attempting any transaction beyond the routine purchase or sale through a broker should consult legal counsel to avoid the various civil and criminal minefields that the law has strewn about.
The definition of security, which is set forth in the Securities Act of 1933, is comprehensive, but it does not on its face answer all questions that financiers in a dynamic market can raise. Under Section 2(1) of the act, “security” includes “any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
Under this definition, an investment may not be a security even though it is so labeled, and it may actually be a security even though it is called something else. For example, does a service contract that obligates someone who has sold individual rows in an orange orchard to cultivate, harvest, and market an orange crop involve a security subject to regulation under federal law? Yes, said the Supreme Court in Securities & Exchange Commission v. W. J. Howey Co.Securities & Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). The Court said the test is whether “the person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Under this test, courts have liberally interpreted “investment contract” and “certificate of interest or participation in any profit-sharing agreement” to be securities interests in such property as real estate condominiums and cooperatives, commodity option contracts, and farm animals.
The Supreme Court ruled that notes that are not “investment contracts” under the Howey test can still be considered securities if certain factors are present, as discussed in Reves v. Ernst & Young, (see Section 24.3.1 “What Is a Security?”). These factors include (1) the motivations prompting a reasonable seller and buyer to enter into the transaction, (2) the plan of distribution and whether the instruments are commonly traded for speculation or investment, (3) the reasonable expectations of the investing public, and (4) the presence of other factors that significantly reduce risk so as to render the application of the Securities Act unnecessary.
The Securities and Exchange Commission
Functions
The Securities and Exchange Commission (SEC) is over half a century old, having been created by Congress in the Securities Exchange Act of 1934. It is an independent regulatory agency, subject to the rules of the Administrative Procedure Act (see Chapter 5). The commission is composed of five members, who have staggered five-year terms. Every June 5, the term of one of the commissioners expires. Although the president cannot remove commissioners during their terms of office, he does have the power to designate the chairman from among the sitting members. The SEC is bipartisan: not more than three commissioners may be from the same political party.
The SEC’s primary task is to investigate complaints or other possible violations of the law in securities transactions and to bring enforcement proceedings when it believes that violations have occurred. It is empowered to conduct information inquiries, interview witnesses, examine brokerage records, and review trading data. If its requests are refused, it can issue subpoenas and seek compliance in federal court. Its usual leads come from complaints of investors and the general public, but it has authority to conduct surprise inspections of the books and records of brokers and dealers. Another source of leads is price fluctuations that seem to have been caused by manipulation rather than regular market forces.
Among the violations the commission searches out are these: (1) unregistered sale of securities subject to the registration requirement of the Securities Act of 1933, (2) fraudulent acts and practices, (3) manipulation of market prices, (4) carrying out of a securities business while insolvent, (5) misappropriation of customers’ funds by brokers and dealers, and (4) other unfair dealings by brokers and dealers.
When the commission believes that a violation has occurred, it can take one of three courses. First, it can refer the case to the Justice Department with a recommendation for criminal prosecution in cases of fraud or other willful violation of law.
Second, the SEC can seek a civil injunction in federal court against further violations. As a result of amendments to the securities laws in 1990 (the Securities Enforcement Remedies and Penny Stock Reform Act), the commission can also ask the court to impose civil penalties. The maximum penalty is \$100,000 for each violation by a natural person and \$500,000 for each violation by an entity other than a natural person. Alternatively, the defendant is liable for the gain that resulted from violating securities law if the gain exceeds the statutory penalty. The court is also authorized to bar an individual who has committed securities fraud from serving as an officer or a director of a company registered under the securities law.
Third, the SEC can proceed administratively—that is, hold its own hearing, with the usual due process rights, before an administrative law judge. If the commissioners by majority vote accept the findings of the administrative law judge after reading briefs and hearing oral argument, they can impose a variety of sanctions: suspend or expel members of exchanges; deny, suspend, or revoke the registrations of broker-dealers; censure individuals for misconduct; and bar censured individuals (temporarily or permanently) from employment with a registered firm. The 1990 securities law amendments allow the SEC to impose civil fines similar to the court-imposed fines described. The amendments also authorize the SEC to order individuals to cease and desist from violating securities law.
Fundamental Mission
The SEC’s fundamental mission is to ensure adequate disclosure in order to facilitate informed investment decisions by the public. However, whether a particular security offering is worthwhile or worthless is a decision for the public, not for the SEC, which has no legal authority to pass on the merits of an offering or to bar the sale of securities if proper disclosures are made.
One example of SEC’s regulatory mandate with respect to disclosures involved the 1981 sale of \$274 million in limited partnership interests in a company called Petrogene Oil & Gas Associates, New York. The Petrogene offering was designed as a tax shelter. The company’s filing with the SEC stated that the offering involved “a high degree of risk” and that only those “who can afford the complete loss of their investment” should contemplate investing. Other disclosures included one member of the controlling group having spent four months in prison for conspiracy to commit securities fraud; that he and another principal were the subject of a New Mexico cease and desist order involving allegedly unregistered tax-sheltered securities; that the general partner, brother-in-law of one of the principals, had no experience in the company’s proposed oil and gas operations (Petrogene planned to extract oil from plants by using radio frequencies); that one of the oils to be produced was potentially carcinogenic; and that the principals “stand to benefit substantially” whether or not the company fails and whether or not purchasers of shares recovered any of their investment. The prospectus went on to list specific risks. Despite this daunting compilation of troublesome details, the SEC permitted the offering because all disclosures were made (Wall Street Journal, December 29, 1981). It is the business of the marketplace, not the SEC, to determine whether the risk is worth taking.
The SEC enforces securities laws through two primary federal acts: The Securities Act of 1933 and The Securities Exchange Act of 1934.
Securities Act of 1933
Goals
The Securities Act of 1933 is the fundamental “truth in securities” law. Its two basic objectives, which are written in its preamble, are “to provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof.”
Registration
The primary means for realizing these goals is the requirement of registration. Before securities subject to the act can be offered to the public, the issuer must file a registration statement and prospectus with the SEC, laying out in detail relevant and material information about the offering as set forth in various schedules to the act. If the SEC approves the registration statement, the issuer must then provide any prospective purchaser with the prospectus. Since the SEC does not pass on the fairness of price or other terms of the offering, it is unlawful to state or imply in the prospectus that the commission has the power to disapprove securities for lack of merit, thereby suggesting that the offering is meritorious.
The SEC has prepared special forms for registering different types of issuing companies. All call for a description of the registrant’s business and properties and of the significant provisions of the security to be offered, facts about how the issuing company is managed, and detailed financial statements certified by independent public accountants.
Once filed, the registration and prospectus become public and are open for public inspection. Ordinarily, the effective date of the registration statement is twenty days after filing. Until then, the offering may not be made to the public. Section 2(10) of the act defines prospectus as any “notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security.” (An exception: brief notes advising the public of the availability of the formal prospectus.) The import of this definition is that any communication to the public about the offering of a security is unlawful unless it contains the requisite information.
The SEC staff examines the registration statement and prospectus, and if they appear to be materially incomplete or inaccurate, the commission may suspend or refuse the effectiveness of the registration statement until the deficiencies are corrected. Even after the securities have gone on sale, the agency has the power to issue a stop order that halts trading in the stock.
Section 5(c) of the act bars any person from making any sale of any security unless it is first registered. Nevertheless, there are certain classes of exemptions from the registration requirement. Perhaps the most important of these is Section 4(3), which exempts “transactions by any person other than an issuer, underwriter or dealer.” Section 4(3) also exempts most transactions of dealers. So the net is that trading in outstanding securities (the secondary market) is exempt from registration under the Securities Act of 1933: you need not file a registration statement with the SEC every time you buy or sell securities through a broker or dealer, for example. Other exemptions include the following: (1) private offerings to a limited number of persons or institutions who have access to the kind of information registration would disclose and who do not propose to redistribute the securities; (2) offerings restricted to the residents of the state in which the issuing company is organized and doing business; (3) securities of municipal, state, federal and other government instrumentalities, of charitable institutions, of banks, and of carriers subject to the Interstate Commerce Act; (4) offerings not in excess of certain specified amounts made in compliance with regulations of the Commission…: and (5) offerings of “small business investment companies” made in accordance with rules and regulations of the Commission.
Penalties
Section 24 of the Securities Act of 1933 provides for fines not to exceed \$10,000 and a prison term not to exceed five years, or both, for willful violations of any provisions of the act. This section makes these criminal penalties specifically applicable to anyone who “willfully, in a registration statement filed under this title, makes any untrue statement of a material fact or omits to state any material fact required to be stated therein or necessary to make the statements therein not misleading.”
Sections 11 and 12 provide that anyone injured by false declarations in registration statements, prospectuses, or oral communications concerning the sale of the security—as well as anyone injured by the unlawful failure of an issuer to register—may file a civil suit to recover the net consideration paid for the security or for damages if the security has been sold.
Although these civil penalty provisions apply only to false statements in connection with the registration statement, prospectus, or oral communication, the Supreme Court held, in Case v. Borak,Case v. Borak, 377 U.S. 426 (1964). that there is an “implied private right of action” for damages resulting from a violation of SEC rules under the act. The Court’s ruling in Borak opened the courthouse doors to many who had been defrauded but were previously without a practical remedy.
Securities Exchange Act of 1934
Companies Covered
The Securities Act of 1933 is limited, as we have just seen, to new securities issues—that is the primary market. The trading that takes place in the secondary market is far more significant, however. In a normal year, trading in outstanding stock totals some twenty times the value of new stock issues.
To regulate the secondary market, Congress enacted the Securities Exchange Act of 1934. This law, which created the SEC, extended the disclosure rationale to securities listed and registered for public trading on the national securities exchanges. Amendments to the act have brought within its ambit every corporation whose equity securities are traded over the counter if the company has at least \$10 million in assets and five hundred or more shareholders.
Reporting Proxy Solicitation
Any company seeking listing and registration of its stock for public trading on a national exchange—or over the counter, if the company meets the size test—must first submit a registration application to both the exchange and the SEC. The registration statement is akin to that filed by companies under the Securities Act of 1933, although the Securities Exchange Act of 1934 calls for somewhat fewer disclosures. Thereafter, companies must file annual and certain other periodic reports to update information in the original filing.
The Securities Exchange Act of 1934 also covers proxy solicitation. Whenever management, or a dissident minority, seeks votes of holders of registered securities for any corporate purpose, disclosures must be made to the stockholders to permit them to vote yes or no intelligently.
Penalties
The logic of the Borak case (discussed in Section 24.1.3 “Securities Act of 1933”) also applies to this act, so that private investors may bring suit in federal court for violations of the statute that led to financial injury. Violations of any provision and the making of false statements in any of the required disclosures subject the defendant to a maximum fine of \$5 million and a maximum twenty-year prison sentence, but a defendant who can show that he had no knowledge of the particular rule he was convicted of violating may not be imprisoned. The maximum fine for a violation of the act by a person other than a natural person is \$25 million. Any issuer omitting to file requisite documents and reports is liable to pay a fine of \$100 for each day the failure continues.
Blue Sky Laws
Long before congressional enactment of the securities laws in the 1930s, the states had legislated securities regulations. Today, every state has enacted a blue sky law, so called because its purpose is to prevent “speculative schemes which have no more basis than so many feet of ‘blue sky.’”Hall v. Geiger-Jones Co., 242 U.S. 539 (1917). The federal Securities Act of 1933, discussed in Section 24.1.3 “Securities Act of 1933”, specifically preserves the jurisdiction of states over securities.
Blue sky laws are divided into three basic types of regulation. The simplest is that which prohibits fraud in the sale of securities. Thus at a minimum, issuers cannot mislead investors about the purpose of the investment. All blue sky laws have antifraud provisions; some have no other provisions. The second type calls for registration of broker-dealers, and the third type for registration of securities. Some state laws parallel the federal laws in intent and form of proceeding, so that they overlap; other blue sky laws empower state officials (unlike the SEC) to judge the merits of the offerings, often referred to as merit review laws. As part of a movement toward deregulation, several states have recently modified or eliminated merit provisions.
Many of the blue sky laws are inconsistent with each other, making national uniformity difficult. In 1956, the National Conference of Commissioners on Uniform State Laws approved the Uniform Securities Act. It has not been designed to reconcile the conflicting philosophies of state regulation but to take them into account and to make the various forms of regulation as consistent as possible. States adopt various portions of the law, depending on their regulatory philosophies. The Uniform Securities Act has antifraud, broker-dealer registration, and securities registration provisions. More recent acts have further increased uniformity. These include the National Securities Markets Improvement Act of 1996, which preempted differing state philosophies with regard to registration of securities and regulation of brokers and advisors, and the Securities Litigation Uniform Standards Act of 1998, which preempted state law securities fraud claims from being raised in class action lawsuits by investors.
Dodd-Frank Wall Street Reform and Consumer Protection Act
In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is the largest amendment to financial regulation in the United States since the Great Depression. This amendment was enacted in response to the economic recession of the late 2000s for the following purposes: (1) to promote the financial stability of the United States by improving accountability and transparency in the financial system, (2) to end “too big to fail” institutions, (3) to protect the American taxpayer by ending bailouts, and (4) to protect consumers from abusive financial services practices. The institutions most affected by the regulatory changes include those involved in monitoring the financial system, such as the Federal Deposit Insurance Corporation (FDIC) and the SEC. Importantly, the amendment ended the exemption for investment advisors who previously were not required to register with the SEC because they had fewer than fifteen clients during the previous twelve months and did not hold out to the public as investment advisors. This means that in practice, numerous investment advisors, as well as hedge funds and private equity firms, are now subject to registration requirements.For more information on the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173), see Thomas, “Major Actions,” Bill Summary & Status 111th Congress (2009–2010) H.R.4173, thomas.loc.gov/cgi-bin/bdquery/z?d111:HR04173:@@@L&summ2=m&#major%20actions.
Key Takeaway
The SEC administers securities laws to prevent the fraudulent practices in the sales of securities. The definition of security is intentionally broad to protect the public from fraudulent investments that otherwise would escape regulation. The Securities Act of 1933 focuses on the issuance of securities, and the Securities Exchange Act of 1934 deals predominantly with trading in issued securities. Numerous federal and state securities laws are continuously created to combat securities fraud, with penalties becoming increasingly severe.
Exercises
1. What differentiates an ordinary investment from a security? List all the factors.
2. What is the main objective of the SEC?
3. What are the three courses of action that the SEC may take against one who violates a securities law?
4. What is the difference between the Securities Act of 1933 and the Securities Exchange Act of 1934?
5. What do blue sky laws seek to protect? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/24%3A_Securities_Regulation/24.01%3A_The_Nature_of_Securities_Regulation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand how the Foreign Corrupt Practices Act prevents American companies from using bribes to enter into contracts or gain licenses from foreign governments.
• Understand the liability for insider trading for corporate insiders, “tippees,” and secondary actors under Sections 16(b) and 10(b) of the 1934 Securities Exchange Act.
• Recognize how the Sarbanes-Oxley Act has amended the 1934 act to increase corporate regulation, transparency, and penalties.
Corporations may be found liable if they engage in certain unlawful practices, several of which we explore in this section.
The Foreign Corrupt Practices Act
Investigations by the Securities and Exchange Commission (SEC) and the Watergate Special Prosecutor in the early 1970s turned up evidence that hundreds of companies had misused corporate funds, mainly by bribing foreign officials to induce them to enter into contracts with or grant licenses to US companies. Because revealing the bribes would normally be self-defeating and, in any event, could be expected to stir up immense criticism, companies paying bribes routinely hid the payments in various accounts. As a result, one of many statutes enacted in the aftermath of Watergate, the Foreign Corrupt Practices Act (FCPA) of 1977, was incorporated into the 1934 Securities Exchange Act. The SEC’s legal interest in the matter is not premised on the morality of bribery but rather on the falsity of the financial statements that are being filed.
Congress’s response to abuses of financial reporting, the FCPA, was much broader than necessary to treat the violations that were uncovered. The FCPA prohibits an issuer (i.e., any US business enterprise), a stockholder acting on behalf of an issuer, and “any officer, director, employee, or agent” of an issuer from using either the mails or interstate commerce corruptly to offer, pay, or promise to pay anything of value to foreign officials, foreign political parties, or candidates if the purpose is to gain business by inducing the foreign official to influence an act of the government to render a decision favorable to the US corporation.
But not all payments are illegal. Under 1988 amendments to the FCPA, payments may be made to expedite routine governmental actions, such as obtaining a visa. And payments are allowed if they are lawful under the written law of a foreign country. More important than the foreign-bribe provisions, the act includes accounting provisions, which broaden considerably the authority of the SEC. These provisions are discussed in SEC v. World-Wide Coin Investments, Ltd.,SEC v. World-Wide Coin Investments, Ltd., 567 F.Supp. 724 (N.D. Ga. 1983). the first accounting provisions case brought to trial.
Insider Trading
Corporate insiders—directors, officers, or important shareholders—can have a substantial trading advantage if they are privy to important confidential information. Learning bad news (such as financial loss or cancellation of key contracts) in advance of all other stockholders will permit the privileged few to sell shares before the price falls. Conversely, discovering good news (a major oil find or unexpected profits) in advance gives the insider a decided incentive to purchase shares before the price rises.
Because of the unfairness to those who are ignorant of inside information, federal law prohibits insider trading. Two provisions of the 1934 Securities Exchange Act are paramount: Section 16(b) and 10(b).
Recapture of Short-Swing Profits: Section 16(b)
The Securities Exchange Act assumes that any director, officer, or shareholder owning 10 percent or more of the stock in a corporation is using inside information if he or any family member makes a profit from trading activities, either buying and selling or selling and buying, during a six-month period. Section 16(b) penalizes any such person by permitting the corporation or a shareholder suing on its behalf to recover the short-swing profits. The law applies to any company with more than \$10 million in assets and at least five hundred or more shareholders of any class of stock.
Suppose that on January 1, Bob (a company officer) purchases one hundred shares of stock in BCT Bookstore, Inc., for \$60 a share. On September 1, he sells them for \$100 a share. What is the result? Bob is in the clear, because his \$4,000 profit was not realized during a six-month period. Now suppose that the price falls, and one month later, on October 1, he repurchases one hundred shares at \$30 a share and holds them for two years. What is the result? He will be forced to pay back \$7,000 in profits even if he had no inside information. Why? In August, Bob held one hundred shares of stock, and he did again on October 1—within a six-month period. His net gain on these transactions was \$7,000 (\$10,000 realized on the sale less the \$3,000 cost of the purchase).
As a consequence of Section 16(b) and certain other provisions, trading in securities by directors, officers, and large stockholders presents numerous complexities. For instance, the law requires people in this position to make periodic reports to the SEC about their trades. As a practical matter, directors, officers, and large shareholders should not trade in their own company stock in the short run without legal advice.
Insider Trading: Section 10(b) and Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 prohibits any person from using the mails or facilities of interstate commerce “to use or employ, in connection with the purchase or sale of any security…any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” In 1942, the SEC learned of a company president who misrepresented the company’s financial condition in order to buy shares at a low price from current stockholders. So the commission adopted a rule under the authority of Section 10(b). Rule 10b-5, as it was dubbed, has remained unchanged for more than forty years and has spawned thousands of lawsuits and SEC proceedings. It reads as follows:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,
(1) to employ any device, scheme, or artifice to defraud,
(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of circumstances under which they were made, not misleading, or
(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Rule 10b-5 applies to any person who purchases or sells any security. It is not limited to securities registered under the 1934 Securities Exchange Act. It is not limited to publicly held companies. It applies to any security issued by any company, including the smallest closely held company. In substance, it is an antifraud rule, enforcement of which seems, on its face, to be limited to action by the SEC. But over the years, the courts have permitted people injured by those who violate the statute to file private damage suits. This sweeping rule has at times been referred to as the “federal law of corporations” or the “catch everybody” rule.
Insider trading ran headlong into Rule 10b-5 beginning in 1964 in a series of cases involving Texas Gulf Sulphur Company (TGS). On November 12, 1963, the company discovered a rich deposit of copper and zinc while drilling for oil near Timmins, Ontario. Keeping the discovery quiet, it proceeded to acquire mineral rights in adjacent lands. By April 1964, word began to circulate about TGS’s find.
Newspapers printed rumors, and the Toronto Stock Exchange experienced a wild speculative spree. On April 12, an executive vice president of TGS issued a press release downplaying the discovery, asserting that the rumors greatly exaggerated the find and stating that more drilling would be necessary before coming to any conclusions. Four days later, on April 16, TGS publicly announced that it had uncovered a strike of 25 million tons of ore. In the months following this announcement, TGS stock doubled in value.
The SEC charged several TGS officers and directors with having purchased or told their friends, so-called tippees, to purchase TGS stock from November 12, 1963, through April 16, 1964, on the basis of material inside information. The SEC also alleged that the April 12, 1964, press release was deceptive. The US Court of Appeals, in SEC v. Texas Gulf Sulphur Co.,SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968). decided that the defendants who purchased the stock before the public announcement had violated Rule 10b-5. According to the court, “anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.” On remand, the district court ordered certain defendants to pay \$148,000 into an escrow account to be used to compensate parties injured by the insider trading.
The court of appeals also concluded that the press release violated Rule 10b-5 if “misleading to the reasonable investor.” On remand, the district court held that TGS failed to exercise “due diligence” in issuing the release. Sixty-nine private damage actions were subsequently filed against TGS by shareholders who claimed they sold their stock in reliance on the release. The company settled most of these suits in late 1971 for \$2.7 million.
Following the TGS episode, the Supreme Court refined Rule 10b-5 on several fronts. First, in Ernst & Ernst v. Hochfelder,Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). the Court decided that proof of scienter—defined as “mental state embracing intent to deceive, manipulate, or defraud”—is required in private damage actions under Rule 10b-5. In other words, negligence alone will not result in Rule 10b-5 liability. The Court also held that scienter, which is an intentional act, must be established in SEC injunctive actions.Aaron v. SEC, 446 U.S. 680 (1980).
The Supreme Court has placed limitations on the liability of tippees under Rule 10b-5. In 1980, the Court reversed the conviction of an employee of a company that printed tender offer and merger prospectuses. Using information obtained at work, the employee had purchased stock in target companies and later sold it for a profit when takeover attempts were publicly announced. In Chiarella v. United States, the Court held that the employee was not an insider or a fiduciary and that “a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.”Chiarella v. United States, 445 U.S. 222 (1980). Following Chiarella, the Court ruled in Dirks v. Securities and Exchange Commission (see Section 24.3.2 “Tippee Liability”), that tippees are liable if they had reason to believe that the tipper breached a fiduciary duty in disclosing confidential information and the tipper received a personal benefit from the disclosure.
The Supreme Court has also refined Rule 10b-5 as it relates to the duty of a company to disclose material information, as discussed in Basic, Inc. v. Levinson (see Section 24.3.3 “Duty to Disclose Material Information”). This case is also important in its discussion of the degree of reliance investors must prove to support a Rule 10b-5 action.
In 2000, the SEC enacted Rule 10b5-1, which defines trading “on the basis of” inside information as any time a person trades while aware of material nonpublic information. Therefore, a defendant is not saved by arguing that the trade was made independent of knowledge of the nonpublic information. However, the rule also creates an affirmative defense for trades that were planned prior to the person’s receiving inside information.
In addition to its decisions relating to intent (Ernst & Ernst), tippees (Dirks), materiality (Basic), and awareness of nonpublic information (10b5-1), the Supreme Court has considered the misappropriation theory, under which a person who misappropriates information from an employer faces insider trading liability. In a leading misappropriation theory case, the Second Circuit Court of Appeals reinstated an indictment against employees who traded on the basis of inside information obtained through their work at investment banking firms. The court concluded that the employees’ violation of their fiduciary duty to the firms violated securities law.United States v. Newman, 664 F.2d 12 (2d Cir. 1981). The US Supreme Court upheld the misappropriation theory in United States v. O’Hagan,United States v. O’Hagan, 521 U.S. 642 (1997). and the SEC adopted the theory as new Rule 10b5-2. Under this new rule, the duty of trust or confidence exists when (1) a person agrees to maintain information in confidence; (2) the recipient knows or should have known through history, pattern, or practice of sharing confidences that the person communicating the information expects confidentiality; and (3) a person received material nonpublic information from his or her spouse, parent, child, or sibling.
In 1987, in Carpenter v. United States,Carpenter v. United States, 484 U.S. 19 (1987). the Supreme Court affirmed the conviction of a Wall Street Journal reporter who leaked advanced information about the contents of his “Heard on the Street” column. The reporter, who was sentenced to eighteen months in prison, had been convicted on both mail and wire fraud and securities law charges for misappropriating information. The Court upheld the mail and wire fraud conviction by an 8–0 vote and the securities law conviction by a 4–4 vote. (In effect, the tie vote affirmed the conviction.)Carpenter v. United States, 484 U.S. 19 (1987).
Beyond these judge-made theories of liability, Congress had been concerned about insider trading, and in 1984 and 1988, it substantially increased the penalties. A person convicted of insider trading now faces a maximum criminal fine of \$1 million and a possible ten-year prison term. A civil penalty of up to three times the profit made (or loss avoided) by insider trading can also be imposed. This penalty is in addition to liability for profits made through insider trading. For example, financier Ivan Boesky, who was sentenced in 1987 to a three-year prison term for insider trading, was required to disgorge \$50 million of profits and was liable for another \$50 million as a civil penalty. In 2003, Martha Stewart was indicted on charges of insider trading but was convicted for obstruction of justice, serving only five months. More recently, in 2009, billionaire founder of the Galleon Group, Raj Rajaratnam, was arrested for insider trading; he was convicted in May 2011 of all 14 counts of insider trading. For the SEC release on the Martha Stewart case, see http://www.sec.gov/news/press/2003-69.htm.
Companies that knowingly and recklessly fail to prevent insider trading by their employees are subject to a civil penalty of up to three times the profit gained or loss avoided by insider trading or \$1 million, whichever is greater. Corporations are also subject to a criminal fine of up to \$2.5 million.
Secondary Actor
In Stoneridge Investment Partners v. Scientific-Atlanta,Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008). the US Supreme Court held that “aiders and abettors” of fraud cannot be held secondarily liable under 10(b) for a private cause of action. This means that secondary actors, such as lawyers and accountants, cannot be held liable unless their conduct satisfies all the elements for 10(b) liability.
For an overview of insider trading, go to http://www.sec.gov/answers/insider.htm.
Sarbanes-Oxley Act
Congress enacted the Sarbanes-Oxley Act in 2002 in response to major corporate and accounting scandals, most notably those involving Enron, Tyco International, Adelphia, and WorldCom. The act created the Public Company Accounting Oversight Board, which oversees, inspects, and regulates accounting firms in their capacity as auditors of public companies. As a result of the act, the SEC may include civil penalties to a disgorgement fund for the benefit of victims of the violations of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Key Takeaway
Corrupt practices, misuse of corporate funds, and insider trading unfairly benefit the minority and cost the public billions. Numerous federal laws have been enacted to create liability for these bad actors in order to prevent fraudulent trading activities. Both civil and criminal penalties are available to punish those actors who bribe officials or use inside information unlawfully.
Exercises
1. Why is the SEC so concerned with bribery? What does the SEC really aim to prevent through the FCPA?
2. What are short-swing profits?
3. To whom does Section 16(b) apply?
4. Explain how Rule 10b-5 has been amended “on the basis of” insider information.
5. Can a secondary actor (attorney, accountant) be liable for insider trading? What factors must be present? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/24%3A_Securities_Regulation/24.02%3A_Liability_under_Securities_Law.txt |
What Is a Security?
Reves v. Ernst & Young
494 U.S. 56, 110 S.Ct. 945 (1990)
JUSTICE MARSHALL delivered the opinion of the Court.
This case presents the question whether certain demand notes issued by the Farmer’s Cooperative of Arkansas and Oklahoma are “securities” within the meaning of § 3(a)(10) of the Securities and Exchange Act of 1934. We conclude that they are.
The Co-Op is an agricultural cooperative that, at the same time relevant here, had approximately 23,000 members. In order to raise money to support its general business operations, the Co-Op sold promissory notes payable on demand by the holder. Although the notes were uncollateralized and uninsured, they paid a variable rate of interest that was adjusted monthly to keep it higher than the rate paid by local financial institutions. The Co-Op offered the notes to both members and nonmembers, marketing the scheme as an “Investment Program.” Advertisements for the notes, which appeared in each Co-Op newsletter, read in part: “YOUR CO-OP has more than \$11,000,000 in assets to stand behind your investments. The Investment is not Federal [sic] insured but it is…Safe…Secure…and available when you need it.” App. 5 (ellipses in original). Despite these assurances, the Co-Op filed for bankruptcy in 1984. At the time of the filing, over 1,600 people held notes worth a total of \$10 million.
After the Co-Op filed for bankruptcy, petitioners, a class of holders of the notes, filed suit against Arthur Young & Co., the firm that had audited the Co-Op’s financial statements (and the predecessor to respondent Ernst & Young). Petitioners alleged, inter alia, that Arthur Young had intentionally failed to follow generally accepted accounting principles in its audit, specifically with respect to the valuation of one of the Co-Op’s major assets, a gasohol plant. Petitioners claimed that Arthur Young violated these principles in an effort to inflate the assets and net worth of the Co-Op. Petitioners maintained that, had Arthur Young properly treated the plant in its audits, they would not have purchased demand notes because the Co-Op’s insolvency would have been apparent. On the basis of these allegations, petitioners claimed that Arthur Young had violated the antifraud provisions of the 1934 Act as well as Arkansas’ securities laws.
Petitioners prevailed at trial on both their federal and state claims, receiving a \$6.1 million judgment. Arthur Young appealed, claiming that the demand notes were not “securities” under either the 1934 Act or Arkansas law, and that the statutes’ antifraud provisions therefore did not apply. A panel of the Eighth Circuit, agreeing with Arthur Young on both the state and federal issues, reversed. Arthur Young & Co. v. Reves, 856 F.2d 52 (1988). We granted certiorari to address the federal issue, 490 U.S. 1105, 109 S.Ct. 3154, 104 L.Ed.2d 1018 (1989), and now reverse the judgment of the Court of Appeals.
* * *
The fundamental purpose undergirding the Securities Acts is “to eliminate serious abuses in a largely unregulated securities market.” United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 2059, 44 L.Ed.2d 621 (1975). In defining the scope of the market that it wished to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of “countless and variable schemes devised by those who seek the use of the money of others on the promise of profits,” SEC v. W.J. Howey Co., 328 U.S. 293, 299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946), and determined that the best way to achieve its goal of protecting investors was “to define ‘the term “security” in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Forman, supra, 421 U.S., at 847-848, 95 S.Ct., at 2058-2059 (quoting H.R.Rep. No. 85, 73d Cong., 1st Sess., 11 (1933)). Congress therefore did not attempt precisely to cabin the scope of the Securities Acts. Rather, it enacted a definition of “security” sufficiently broad to encompass virtually any instrument that might be sold as an investment.
* * *
[In deciding whether this transaction involves a “security,” four factors are important.] First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.” Second, we examine the “plan of distribution” of the instrument to determine whether it is an instrument in which there is “common trading for speculation or investment.” Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.
* * *
[We] have little difficulty in concluding that the notes at issue here are “securities.”
Case Questions
1. What are the four factors the court uses to determine whether or not the transaction involves a security?
2. How does the definition of security in this case differ from the definition in Securities & Exchange Commission v. W. J. Howey?
Tippee Liability
Dirks v. Securities and Exchange Commission
463 U.S. 646 (1983)
[A] tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.
* * *
Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate “use of inside information for personal advantage.” Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.
* * *
Under the inside-trading and tipping rules set forth above, we find that there was no actionable violation by Dirks. It is undisputed that Dirks himself was a stranger to Equity Funding, with no preexisting fiduciary duty to its shareholders. He took no action, directly, or indirectly, that induced the shareholders or officers of Equity Funding to repose trust or confidence in him. There was no expectation by Dirk’s sources that he would keep their information in confidence. Nor did Dirks misappropriate or illegally obtain the information about Equity Funding. Unless the insiders breached their Cady, Roberts duty to shareholders in disclosing the nonpublic information to Dirks, he breached no duty when he passed it on to investors as well as to the Wall Street Journal.
* * *
It is clear that neither Secrist nor the other Equity Funding employees violated their Cady, Roberts duty to the corporation’s shareholders by providing information to Dirks. The tippers received no monetary or personal benefit for revealing Equity Funding’s secrets, nor was their purpose to make a gift of valuable information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to expose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by Dirks. Dirks therefore could not have been “a participant after the fact in [an] insider’s breach of a fiduciary duty.” Chiarella, 445 U.S., at 230, n. 12.
* * *
We conclude that Dirks, in the circumstances of this case, had no duty to abstain from the use of the inside information that he obtained. The judgment of the Court of Appeals therefore is reversed.
Case Questions
1. When does a tippee assume a fiduciary duty to shareholders of a corporation?
2. Did Dirks violate any insider trading laws? Why or why not?
3. How does this case refine Rule 10b-5?
Duty to Disclose Material Information
Basic Inc v. Levinson
485 U.S. 224 (1988)
[In December 1978, Basic Incorporated agreed to merge with Consolidated Engineering. Prior to the merger, Basic made three public statements denying it was involved in merger negotiations. Shareholders who sold their stock after the first of these statements and before the merger was announced sued Basic and its directors under Rule 10b-5, claiming that they sold their shares at depressed prices as a result of Basic’s misleading statements. The district court decided in favor of Basic on the grounds that Basic’s statements were not material and therefore were not misleading. The court of appeals reversed, and the Supreme Court granted certiorari.]
JUSTICE BLACKMUN.
We granted certiorari to resolve the split among the Courts of Appeals as to the standard of materiality applicable to preliminary merger discussions, and to determine whether the courts below properly applied a presumption of reliance in certifying the class, rather than requiring each class member to show direct reliance on Basic’s statements.
* * *
The Court previously has addressed various positive and common-law requirements for a violation of § 10(b) or of Rule 10b-5. The Court also explicitly has defined a standard of materiality under the securities laws, see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), concluding in the proxy-solicitation context that “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”…We now expressly adopt the TSC Industries standard of materiality for the 5 10(b) and Rule 10b-5 context.
The application of this materiality standard to preliminary merger discussions is not self-evident. Where the impact of the corporate development on the target’s fortune is certain and clear, the TSC Industries materiality definition admits straight-forward application. Where, on the other hand, the event is contingent or speculative in nature, it is difficult to ascertain whether the “reasonable investor” would have considered the omitted information significant at the time. Merger negotiations, because of the ever-present possibility that the contemplated transaction will not be effectuated, fall into the latter category.
* * *
Even before this Court’s decision in TSC Industries, the Second Circuit had explained the role of the materiality requirement of Rule 10b-5, with respect to contingent or speculative information or events, in a manner that gave that term meaning that is independent of the other provisions of the Rule. Under such circumstances, materiality “will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” SEC v. Texas Gulf Sulphur Co., 401 F.2d, at 849.
* * *
Whether merger discussions in any particular case are material therefore depends on the facts. Generally, in order to assess the probability that the event will occur, a factfinder will need to look to indicia of interest in the transactions at the highest corporate levels. Without attempting to catalog all such possible factors, we note by way of example that board resolutions, instructions to investment bankers, and actual negotiations between principals or their intermediaries may serve as indicia of interest. To assess the magnitude of the transaction to the issuer of the securities allegedly manipulated, a factfinder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value. No particular event or factor short of closing the transaction need to be either necessary or sufficient by itself to render merger discussions material.
As we clarify today, materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information. The fact-specific inquiry we endorse here is consistent with the approach a number of courts have taken in assessing the materiality of merger negotiations. Because the standard of materiality we have adopted differs from that used by both courts below, we remand the case for reconsideration of the question whether a grant of summary judgment is appropriate on this record.
We turn to the question of reliance and the fraud on-the-market theory. Succinctly put:
The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available information regarding the company and its business.…Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.…The causal connection between the defendants’ fraud and the plaintiff’s purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. Peil v. Speiser, 806 F.2d 1154, 1160-1161 (CA3 1986).
* * *
We agree that reliance is an element of a Rule 10b-5 cause of action. Reliance provides the requisite causal connection between a defendant’s misrepresentation and a plaintiff’s misrepresentation and a plaintiff’s injury. There is, however, more than one way to demonstrate the causal connection.
* * *
Presumptions typically serve to assist courts in managing circumstances in which direct proof, for one reason or another, is rendered difficult. The courts below accepted a presumption, created by the fraud-on-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had done so in reliance on the integrity of the price set by the market, but because of petitioners’ material misrepresentations that price had been fraudulently depressed. Requiring a plaintiff to show a speculative state of facts, i.e., how he would have acted if omitted material information had been disclosed, or if the misrepresentation had not been made, would place an unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an impersonal market.
Arising out of considerations of fairness, public policy, and probability, as well as judicial economy, presumptions are also useful devices for allocating the burdens of proof between parties. The presumption of reliance employed in this case is consistent with, and, by facilitating Rule 10b-5 litigation, supports, the congressional policy embodied in the 1934 Act.…
The presumption is also supported by common sense and probability. Recent empirical studies have tended to confirm Congress’ premise that the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations. It has been noted that “it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?” Schlanger v. Four-Phase Systems, Inc., 555 F.Supp. 535, 538 (SDNY 1982).…An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.
* * *
The judgment of the Court of Appeals is vacated and the case is remanded to that court for further proceedings consistent with this opinion.
Case Questions
1. How does the court determine what is or is not material information? How does this differ from its previous rulings?
2. What is the fraud-on-the-market theory? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/24%3A_Securities_Regulation/24.03%3A_Cases.txt |
Summary
Beyond state corporation laws, federal statutes—most importantly, the Securities Act of 1933 and the Securities Exchange Act of 1934—regulate the issuance and trading of corporate securities. The federal definition of security is broad, encompassing most investments, even those called by other names.
The law does not prohibit risky stock offerings; it bans only those lacking adequate disclosure of risks. The primary means for realizing this goal is the registration requirement: registration statements, prospectuses, and proxy solicitations must be filed with the Securities and Exchange Commission (SEC). Penalties for violation of securities law include criminal fines and jail terms, and damages may be awarded in civil suits by both the SEC and private individuals injured by the violation of SEC rules. A 1977 amendment to the 1934 act is the Foreign Corrupt Practices Act, which prohibits an issuer from paying a bribe or making any other payment to foreign officials in order to gain business by inducing the foreign official to influence his government in favor of the US company. This law requires issuers to keep accurate sets of books reflecting the dispositions of their assets and to maintain internal accounting controls to ensure that transactions comport with management’s authorization.
The Securities Exchange Act of 1934 presents special hazards to those trading in public stock on the basis of inside information. One provision requires the reimbursement to the company of any profits made from selling and buying stock during a six-month period by directors, officers, and shareholders owning 10 percent or more of the company’s stock. Under Rule 10b-5, the SEC and private parties may sue insiders who traded on information not available to the general public, thus gaining an advantage in either selling or buying the stock. Insiders include company employees.
The Sarbanes-Oxley Act amended the 1934 act, creating more stringent penalties, increasing corporate regulation, and requiring greater transparency.
Exercises
1. Assume that the United States enters into a multilateral treaty with several third-world countries under which then-existing private claims to molybdenum and certain other minerals in the United States are assigned to an international agency for exploitation. When the owner of a US mine continues to dig for ore covered by the treaty, the Justice Department sues to enjoin further mining. What is the result? Why?
2. A foreign government enters into a contract with a US company to provide computer equipment and services for the intelligence arm of its military forces. After the equipment has been supplied, the foreign government refuses to pay. The US company files suit in federal court in the United States, seeking to attach a US bank account owned by the foreign government. The foreign government claims that the US court has no jurisdiction and that even if it does, the government is immune from suit. What is the result?
3. Would the result in Exercise 2 be any different if the US company had maintained its own equipment on a lease basis abroad and the foreign government had then expropriated the equipment and refused to pay the US company its just value?
4. The Concentrated Phosphate Export Association consists of the five largest phosphate producers. The Agency for International Development (AID) undertook to sell fertilizer to Korea and solicited bids. The association set prices and submitted a single bid on 300,000 tons. A paid the contract price, determined the amounts to be purchased, coordinated the procedure for buying, and undertook to resell to Korea. The Justice Department sued the association and its members, claiming that their actions violated Section 1 of the Sherman Act. What defense might the defendants have? What is the result?
5. Canada and Russia have competing claims over fishing and mining rights in parts of the Arctic Ocean. Assuming they cannot settle their competing claims through diplomatic negotiation, where might they have their dispute settled?
SELF CHECK QUESTIONS
1. Anne operated a clothing store called Anne’s Rags, Inc. She owned all of the stock in the company. After several years in the clothing business, Anne sold her stock to Louise, who personally managed the business. Is the sale governed by the antifraud provisions of federal securities law? Why?
2. While waiting tables at a campus-area restaurant, you overhear a conversation between two corporate executives who indicate that their company has developed a new product that will revolutionize the computer industry. The product is to be announced in three weeks. If you purchase stock in the company before the announcement, will you be liable under federal securities law? Why?
3. Eric was hired as a management consultant by a major corporation to conduct a study, which took him three months to complete. While working on the study, Eric learned that someone working in research and development for the company had recently made an important discovery. Before the discovery was announced publicly, Eric purchased stock in the company. Did he violate federal securities law? Why?
4. While working for the company, Eric also learned that it was planning a takeover of another corporation. Before announcement of a tender offer, Eric purchased stock in the target company. Did he violate securities law? Why?
5. The commercial lending department of First Bank made a substantial loan to Alpha Company after obtaining a favorable confidential earnings report from Alpha. Over lunch, Heidi, the loan officer who handled the loan, mentioned the earnings report to a friend who worked in the bank’s trust department. The friend proceeded to purchase stock in Alpha for several of the bank’s trusts. Discuss the legal implications.
6. In Exercise 5, assume that a week after the loan to Alpha, First Bank financed Beta Company’s takeover of Alpha. During the financing negotiations, Heidi mentioned the Alpha earnings report to Beta officials; furthermore, the report was an important factor in Heidi’s decision to finance the takeover. Discuss the legal implications.
7. In Exercise 6, assume that after work one day, Heidi told her friend in the trust department that Alpha was Beta’s takeover target. The friend proceeded to purchase additional stock in Alpha for a bank trust he administered. Discuss the legal implications.
1. c
2. c
3. a
4. d
5. a
6. e | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/24%3A_Securities_Regulation/24.04%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• How a corporation can expand by purchasing assets of another company without purchasing stock or otherwise merging with the company whose assets are purchased
• The benefits of expanding through a purchase of assets rather than stock
• Both the benefits and potential detriments of merging with another company
• How a merger differs from a stock purchase or a consolidation
• Takeovers and tender offers
• Appraisal rights
• Foreign corporations and the requirements of the US Constitution
• The taxation of foreign corporations
• Corporate dissolution and its various types
This chapter begins with a discussion of the various ways a corporation can expand. We briefly consider successor liability—whether a successor corporation, such as a corporation that purchases all of the assets of another corporation, is liable for debts, lawsuits, and other liabilities of the purchased corporation. We then turn to appraisal rights, which are a shareholder’s right to dissent from a corporate expansion. Next, we look at several aspects, such as jurisdiction and taxation, of foreign corporations—corporations that are incorporated in a state that is different from the one in which they do business. We conclude the chapter with dissolution of the corporation.
25: Corporate Expansion State and Federal Regulation of Foreign Corporations and Corporate Dissolution
Learning Objectives
By the end of this section, you will be able to:
• Understand the four methods of corporate expansion: purchase of assets other than in the regular course of business, merger, consolidation, and purchase of stock in another corporation.
In popular usage, “merger” often is used to mean any type of expansion by which one corporation acquires part or all of another corporation. But in legal terms, merger is only one of four methods of achieving expansion other than by internal growth.
Antitrust law—an important aspect of corporate expansion—will be discussed in Chapter 26. There, in the study of Section 7 of the Clayton Act, we note the possible antitrust hazards of merging or consolidating with a competing corporation.
Purchase of Assets
One method of corporate expansion is the purchase of assets of another corporation. At the most basic level, ABC Corporation wishes to expand, and the assets of XYZ Corporation are attractive to ABC. So ABC purchases the assets of XYZ, resulting in the expansion of ABC. After the purchase, XYZ may remain in corporate form or may cease to exist, depending on how many of its assets were purchased by ABC.
There are several advantages to an asset purchase, most notably, that the acquiring corporation can pick what assets and liabilities (with certain limitations, discussed further on in this section) it wishes to acquire. Furthermore, certain transactions may avoid a shareholder vote. If the selling corporation does not sell substantially all of its assets, then its shareholders may not get a vote to approve the sale.
For example, after several years of successful merchandising, a corporation formed by Bob, Carol, and Ted (BCT Bookstore, Inc.) has opened three branch stores around town and discovered its transportation costs mounting. Inventory arrives in trucks operated by the Flying Truckman Co., Inc. The BCT corporation concludes that the economics of delivery do not warrant purchasing a single truck dedicated to hauling books for its four stores alone. Then Bob learns that the owners of Flying Truckman might be willing to part with their company because it has not been earning money lately. If BCT could reorganize Flying Truckman’s other routes, it could reduce its own shipping costs while making a profit on other lines of business.
Under the circumstances, the simplest and safest way to acquire Flying Truckman is by purchasing its assets. That way BCT would own the trucks and whatever routes it chooses, without taking upon itself the stigma of the association. It could drop the name Flying Truckman.
In most states, the board of directors of both the seller and the buyer must approve a transfer of assets. Shareholders of the selling corporation must also consent by majority vote, but shareholders of the acquiring company need not be consulted, so Ted’s opposition can be effectively mooted; see Figure 25.1. (When inventory is sold in bulk, the acquiring company must also comply with the law governing bulk transfers.) By purchasing the assets—trucks, truck routes, and the trademark Flying Truckman (to prevent anyone else from using it)—the acquiring corporation can carry on the functions of the acquired company without carrying on its business as such.For a discussion of asset purchases see Airborne Health v. Squid Soap, 984 A.2d 126 (Del. 2010).
Successor Liability
One of the principal advantages of this method of expansion is that the acquiring company generally is not liable for the debts and/or lawsuits of the corporation whose assets it purchased, generally known as successor liability. Suppose BCT paid Flying Truckman \$250,000 for its trucks, routes, and name. With that cash, Flying Truckman paid off several of its creditors. Its shareholders then voted to dissolve the corporation, leaving one creditor unsatisfied. The creditor can no longer sue Flying Truckman since it does not exist. So he sues BCT. Unless certain circumstances exist, as discussed in Ray v. Alad Corporation (see Section 25.4.1 “Successor Liability”), BCT is not liable for Flying Truckman’s debts.
Several states, although not a majority, have adopted the Ray product-line exception approach to successor liability. The general rule is that the purchasing corporation does not take the liabilities of the acquired corporation. Several exceptions exist, as described in Ray, the principal exception being the product-line approach. This minority exception has been further limited in several jurisdictions by applying it solely to cases involving products liability. Other jurisdictions also permit a continuity-of-enterprise exception, whereby the court examines how closely the acquiring corporation’s business is to the acquired corporation’s business (e.g., see Turner v. Bituminous Casualty Co.).Turner v. Bituminous Casualty Co., 244 N.W.2d 873 (Mich. 1976).
Merger
When the assets of a company are purchased, the selling company itself may or may not go out of existence. By contrast, in a merger, the acquired company goes out of existence by being absorbed into the acquiring company. In the example in Section 25.1.2 “Merger”, Flying Truck would merge into BCT, resulting in Flying Truckman losing its existence. The acquiring company receives all of the acquired company’s assets, including physical property and intangible property such as contracts and goodwill. The acquiring company also assumes all debts of the acquired company.
A merger begins when two or more corporations negotiate an agreement outlining the specifics of a merger, such as which corporation survives and the identities of management personnel. There are two main types of merger: a cash merger and a noncash merger. In a cash merger, the shareholders of the disappearing corporation surrender their shares for cash. These shareholders retain no interest in the surviving corporation, having been bought out. This is often called a freeze-out merger, since the shareholders of the disappearing corporation are frozen out of an interest in the surviving corporation.
In a noncash merger, the shareholders of the disappearing corporation retain an interest in the surviving corporation. The shareholders of the disappearing corporation trade their shares for shares in the surviving corporation; thus they retain an interest in the surviving corporation when they become shareholders of that surviving corporation.
Unless the articles of incorporation state otherwise, majority approval of the merger by both boards of directors and both sets of shareholders is necessary (see Figure 25.2). The shareholder majority must be of the total shares eligible to vote, not merely of the total actually represented at the special meeting called for the purpose of determining whether to merge.
Consolidation
Consolidation is virtually the same as a merger. The companies merge, but the resulting entity is a new corporation. Returning to our previous example, BCT and Flying Truckman could consolidate and form a new corporation. As with mergers, the boards and shareholders must approve the consolidation by majority votes (see Figure 25.3). The resulting corporation becomes effective when the secretary of state issues a certificate of merger or incorporation.
For more information on mergers and consolidation under Delaware law, see Del. Code Ann., Title 8, Sections 251–267 (2011), at http://delcode.delaware.gov/title8/index.shtml#TopOfPage.
Purchase of Stock
Takeovers
The fourth method of expanding, purchase of a company’s stock, is more complicated than the other methods. The takeover has become a popular method for gaining control because it does not require an affirmative vote by the target company’s board of directors. In a takeover, the acquiring company appeals directly to the target’s shareholders, offering either money or other securities, often at a premium over market value, in exchange for their shares. The acquiring company usually need not purchase 100 percent of the shares. Indeed, if the shares are numerous and widely enough dispersed, control can be achieved by acquiring less than half the outstanding stock. In our example, if Flying Truckman has shareholders, BCT would make an offer directly to those shareholders to acquire their shares.
Tender Offers
In the case of closely held corporations, it is possible for a company bent on takeover to negotiate with each stockholder individually, making a direct offer to purchase his or her shares. That is impossible in the case of large publicly held companies since it is impracticable and/or too expensive to reach each individual shareholder. To reach all shareholders, the acquiring company must make a tender offer, which is a public offer to purchase shares. In fact, the tender offer is not really an offer at all in the technical sense; the tender offer is an invitation to shareholders to sell their shares at a stipulated price. The tender offer might express the price in cash or in shares of the acquiring company. Ordinarily, the offeror will want to purchase only a controlling interest, so it will limit the tender to a specified number of shares and reserve the right not to purchase any above that number. It will also condition the tender offer on receiving a minimum number of shares so that it need buy none if stockholders do not offer a threshold number of shares for purchase.
Leveraged Buyouts
A tender offer or other asset purchase can be financed as a leveraged buyout (LBO), a purchase financed by debt. A common type of LBO involves investors who are members of the target corporation and/or outsiders who wish to take over the target or retain a controlling interest. These purchasers use the assets of the target corporation, such as its real estate or a manufacturing plant, as security for a loan to purchase the target. The purchasers also use other types of debt, such as the issuance of bonds or a loan, to implement the LBO.
For more information about tender offers and mergers, see Unocal v. MesaUnocal Corp. v. Mesa Petroleum, 493 A.2d 946 (Del. 1985). and Revlon v. MacAndrews & Forbes.Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1985). The Wall Street Journal provides comprehensive coverage of tender offers, mergers, and LBOs, at http://www.wsj.com.
State versus Federal Regulation of Takeovers
Under the federal Williams Act, upon commencement of a tender offer for more than 5 percent of the target’s stock, the offeror must file a statement with the Securities and Exchange Commission (SEC) stating the source of funds to be used in making the purchase, the purpose of the purchase, and the extent of its holdings in the target company. Even when a tender offer has not been made, the Williams Act requires any person who acquires more than 5 percent ownership of a corporation to file a statement with the SEC within ten days. The Williams Act, which made certain amendments to the Securities Exchange Act of 1934, can be viewed at taft.law.uc.edu/CCL/34Act/. The US Constitution is also implicated in the regulation of foreign corporations. The Commerce Clause of Article I, Section 8, of the Constitution provides that Congress has power “to regulate Commerce…among the several States.”
Because officers and directors of target companies have no legal say in whether stockholders will tender their shares, many states began, in the early 1970s, to enact takeover laws. The first generation of these laws acted as delaying devices by imposing lengthy waiting periods before a tender offer could be put into effect. Many of the laws expressly gave management of the target companies a right to a hearing, which could be dragged out for weeks or months, giving the target time to build up a defense. The political premise of the laws was the protection of incumbent managers from takeover by out-of-state corporations, although the “localness” of some managers was but a polite fiction. One such law was enacted in Illinois. It required notifying the Illinois secretary of state and the target corporation of the intent to make a tender offer twenty days prior to the offer. During that time, the corporation seeking to make the tender offer could not spread information about the offer. Finally, the secretary of state could delay the tender offer by ordering a hearing and could even deny the offer if it was deemed inequitable. In 1982, the Supreme Court, in Edgar v. Mite Corp., struck down the Illinois takeover law because it violated the Commerce Clause, which prohibits states from unduly burdening the flow of interstate commerce, and also was preempted by the Williams Act.Edgar v. Mite Corp., 457 U.S. 624 (1982).
Following the Mite decision, states began to enact a second generation of takeover laws. In 1987, in CTS Corporation v. Dynamics Corporation of America, the Supreme Court upheld an Indiana second-generation statute that prevents an offeror who has acquired 20 percent or more of a target’s stock from voting unless other shareholders (not including management) approve. The vote to approve can be delayed for up to fifty days from the date the offeror files a statement reporting the acquisition. The Court concluded that the Commerce Clause was not violated nor was the Williams Act, because the Indiana law, unlike the Illinois law in Mite, was consistent with the Williams Act, since it protects shareholders, does not unreasonably delay the tender offer, and does not discriminate against interstate commerce.CTS Corporation v. Dynamics Corporation of America, 481 U.S. 69 (1987).
Emboldened by the CTS decision, almost half the states have adopted a third-generation law that requires a bidder to wait several years before merging with the target company unless the target’s board agrees in advance to the merger. Because in many cases a merger is the reason for the bid, these laws are especially powerful. In 1989, the Seventh Circuit Court of Appeals upheld Wisconsin’s third-generation law, saying that it did not violate the Commerce Clause and that it was not preempted by the Williams Act. The Supreme Court decided not to review the decision.Amanda Acquisition Corp. v. Universal Foods Corp., 877 F.2d 496 (7th Cir. 1989).
Short-Form Mergers
If one company acquires 90 percent or more of the stock of another company, it can merge with the target company through the so-called short-form merger. Only the parent company’s board of directors need approve the merger; consent of the shareholders of either company is unnecessary.
Appraisal Rights
If a shareholder has the right to vote on a corporate plan to merge, consolidate, or sell all or substantially all of its assets, that shareholder has the right to dissent and invoke appraisal rights. Returning again to BCT, Bob and Carol, as shareholders, are anxious to acquire Flying Truckman, but Ted is not sure of the wisdom of doing that. Ted could invoke his appraisal rights to dissent from an expansion involving Flying Truckman. The law requires the shareholder to file with the corporation, before the vote, a notice of intention to demand the fair value of his shares. If the plan is approved and the shareholder does not vote in favor, the corporation must send a notice to the shareholder specifying procedures for obtaining payment, and the shareholder must demand payment within the time set in the notice, which cannot be less than thirty days. Fair value means the value of shares immediately before the effective date of the corporate action to which the shareholder has objected. Appreciation and depreciation in anticipation of the action are excluded, unless the exclusion is unfair.
If the shareholder and the company cannot agree on the fair value, the shareholder must file a petition requesting a court to determine the fair value. The method of determining fair value depends on the circumstances. When there is a public market for stock traded on an exchange, fair value is usually the price quoted on the exchange. In some circumstances, other factors, especially net asset value and investment value—for example, earnings potential—assume greater importance.
See Hariton v. Arco Electronics, Inc.Hariton v. Arco Electronics, Inc., 40 Del. Ch. 326; 182 A.2d 22 (Del. 1962). and M.P.M. Enterprises, Inc. v. GilbertM.P.M. Enterprises, Inc. v. Gilbert, 731 A.2d 790 (Del. 1999). for further discussion of appraisal rights and when they may be invoked.
Key Takeaway
There are four main methods of corporate expansion. The first involves the purchase of assets not in the ordinary course of business. Using this method, the purchase expands the corporation. The second and third methods, merger and consolidation, are very similar: two or more corporations combine. In a merger, one of the merging companies survives, and the other ceases to exist. In a consolidation, the merging corporations cease to exist when they combine to form a new corporation. The final method is a stock purchase, accomplished via a tender offer, takeover, or leveraged buyout. Federal and state regulations play a significant role in takeovers and tender offers, particularly the Williams Act. A shareholder who does not wish to participate in a stock sale may invoke his appraisal rights and demand cash compensation for his shares.
Exercises
1. What are some dangers in purchasing the assets of another corporation?
2. What are some possible rationales behind statutes such as the Williams Act and state antitakeover statutes?
3. When may a shareholder invoke appraisal rights? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/25%3A_Corporate_Expansion_State_and_Federal_Regulation_of_Foreign_Corporations_and_Corporate_Dissolution/25.01%3A_Corporate_Expansion.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss state-imposed conditions on the admission of foreign corporations.
• Discuss state court jurisdiction over foreign corporations.
• Explain how states may tax foreign corporations.
• Apply the US Constitution to foreign corporations.
A foreign corporation is a company incorporated outside the state in which it is doing business. A Delaware corporation, operating in all states, is a foreign corporation in forty-nine of them.
Conditions on Admission to Do Business
States can impose on foreign corporations conditions on admission to do business if certain constitutional barriers are surmounted. One potential problem is the Privileges and Immunities Clause in Article IV, Section 2, of the Constitution, which provides that “citizens shall be entitled to all privileges and immunities of citizens in the several states.” The Supreme Court has interpreted this murky language to mean that states may not discriminate between their own citizens and those of other states. For example, the Court voided a tax New Hampshire imposed on out-of-state commuters on the grounds that “the tax falls exclusively on the incomes of nonresidents.”Austin v. New Hampshire, 420 U.S. 656 (1975). However, corporations are uniformly held not to be citizens for purposes of this clause, so the states may impose burdens on foreign corporations that they do not put upon companies incorporated under their laws. But these burdens may only be imposed on companies that conduct intrastate business, having some level of business transactions within that state.
Other constitutional rights of the corporation or its members may also come into play when states attempt to license foreign corporations. Thus when Arkansas sought to revoke the license of a Missouri construction company to do business within the state, the Supreme Court held that the state had acted unconstitutionally (violating Article III, Section 2, of the US Constitution) in conditioning the license on a waiver of the right to remove a case from the state courts to the federal courts.Terral v. Burke Construction Co., 257 U.S. 529 (1922).
Typical Requirements for Foreign Corporations
Certain preconditions for doing business are common to most states. Foreign corporations are required to obtain from the secretary of state a certificate of authority to conduct business. The foreign corporation also must maintain a registered office with a registered agent who works there. The registered agent may be served with all legal process, demands, or notices required by law to be served on the corporation. Foreign corporations are generally granted every right and privilege enjoyed by domestic corporations.
These requirements must be met whenever the corporation transacts business within the state. As mentioned previously, some activities do not fall within the definition of transacting business and may be carried on even if the foreign corporation has not obtained a certificate of authority. These include filing or defending a lawsuit, holding meetings of directors or shareholders, maintaining bank accounts, maintaining offices for the transfer of the company’s own securities, selling through independent contractors, soliciting orders through agents or employees (but only if the orders become binding contracts upon acceptance outside the state), creating or acquiring security interests in real or personal property, securing or collecting debts, transacting any business in interstate commerce, and “conducting an isolated transaction that is completed within 30 days and that is not one in the course of repeated transactions of a like nature” (Revised Model Business Corporation Act, Section 15.01).
Penalties for Failure to Comply with a Statute
A corporation may not sue in the state courts to enforce its rights until it obtains a certificate of authority. It may defend any lawsuits brought against it, however. The state attorney general has authority to collect civil penalties that vary from state to state. Other sanctions in various states include fines and penalties on taxes owed; fines and imprisonment of corporate agents, directors, and officers; nullification of corporate contracts; and personal liability on contracts by officers and directors. In some states, contracts made by a corporation that has failed to qualify are void.
Jurisdiction over Foreign Corporations
Whether corporations are subject to state court jurisdiction depends on the extent to which they are operating within the state. If the corporation is qualified to do business within the state and has a certificate of authority or license, then state courts have jurisdiction and process may be served on the corporation’s registered agent. If the corporation has failed to name an agent or is doing business without a certificate, the plaintiff may serve the secretary of state on the corporation’s behalf.
Even if the corporation is not transacting enough business within the state to be required to qualify for a certificate or license, it may still be subject to suit in state courts under long-arm statutes. These laws permit state courts to exercise personal jurisdiction over a corporation that has sufficient contacts with the state.
The major constitutional limitation on long-arm statutes is the Due Process Clause. The Supreme Court upheld the validity of long-arm statutes applied to corporations in International Shoe Co. v. Washington.International Shoe Co. v. Washington, 326 U.S. 310 (1945). But the long-arm statute will only be constitutionally valid where there are minimum contacts—that is, for a state to exercise personal jurisdiction over a foreign corporation, the foreign corporation must have at least “minimum contacts” the state. That jurisdictional test is still applied many years after the International Shoe decision was handed down.Judas Priest v. District Court, 104 Nev. 424; 760 P.2d 137 (Nev. 1988); Pavlovich v. Superior Court, 29 Cal. 4th 262; 58 P.3d 2 (Cal. 2002). Since International Shoe, the nationalization of commerce has given way to the internationalization of commerce. This change has resulted in difficult jurisdictional questions that involve conflicting policy considerations.Asahi Metal Industry v. Superior Court of California, 480 U.S. 102, 107 S.Ct. 1026, 94 L. Ed. 92 (1987).
Taxing Authority
May states tax foreign corporations? Since a state may obviously tax its domestic corporations, the question might seem surprising. Why should a state ever be barred from taxing foreign corporations licensed to do business in the state? If the foreign corporation was engaged in purely local, intrastate business, no quarrel would arise. The constitutional difficulty is whether the tax constitutes an unreasonable burden on the company’s interstate business, in violation of the Commerce Clause. The basic approach, illustrated in D. H. Holmes Co., Ltd. v. McNamara (see Section 25.4.2 “Constitutional Issues Surrounding Taxation of a Foreign Corporation”), is that a state can impose a tax on activities for which the state gives legal protection, so long as the tax does not unreasonably burden interstate commerce.
State taxation of corporate income raises special concerns. In the absence of ground rules, a company doing business in many states could be liable for paying income tax to several different states on the basis of its total earnings. A company doing business in all fifty states, for example, would pay five times its earnings in income taxes if each state were to charge a 10 percent tax on those earnings. Obviously, such a result would seriously burden interstate commerce. The courts have long held, therefore, that the states may only tax that portion of the company’s earnings attributable to the business carried on in the state. To compute the proportion of a company’s total earnings subject to tax within the state, most states have adopted a formula based on the local percentage of the company’s total sales, property, and payroll.
Key Takeaway
A foreign corporation is a company incorporated outside of the state in which it is doing business. States can place reasonable limitations upon foreign corporations subject to constitutional requirements. A foreign corporation must do something that is sufficient to rise to the level of transacting business within a state in order to fall under the jurisdiction of that state. These transactions must meet the minimum-contacts requirement for jurisdiction under long-arm statutes. A state may tax a foreign corporation as long as it does not burden interstate commerce.
Exercises
1. What are some typical requirements that a corporation must meet in order to operate in a foreign state?
2. Provide examples of business activities that rise to the level of minimum contacts such as that a state may exercise jurisdiction over a foreign corporation.
3. What are some possible jurisdictional problems that arise from increasing globalization and from many corporations providing input for a particular product? For more information, see the Asahi Metal and Pavlovich court cases, cited in endnotes 13 and 14 below. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/25%3A_Corporate_Expansion_State_and_Federal_Regulation_of_Foreign_Corporations_and_Corporate_Dissolution/25.02%3A_Foreign_Corporations.txt |
Learning Objectives
By the end of this section, you will be able to:
• Define and distinguish dissolution and liquidation.
• Discuss the different types of dissolution and liquidation.
• Discuss claims against a dissolved corporation.
Dissolution is the end of the legal existence of the corporation, basically “corporate death.” It is not the same as liquidation, which is the process of paying the creditors and distributing the assets. Until dissolved, a corporation endures, despite the vicissitudes of the economy or the corporation’s internal affairs. As Justice Cardozo said while serving as chief judge of the New York court of appeals: “Neither bankruptcy…nor cessation of business…nor dispersion of stockholders, nor the absence of directors…nor all combined, will avail without more to stifle the breath of juristic personality. The corporation abides as an ideal creation, impervious to the shocks of these temporal vicissitudes. Not even the sequestration of the assets at the hands of a receiver will terminate its being.”Petrogradsky Mejdunarodny Kommerchesky Bank v. National City Bank, 170 N.E. 479, 482 (N.Y. 1930).
See www.irs.gov/businesses/small/article/0,,id=98703,00.html for the Internal Revenue Service’s checklist of closing and dissolving a business. State and local government regulations may also apply.
Voluntary Dissolution
Any corporation may be dissolved with the unanimous written consent of the shareholders; this is a voluntary dissolution. This provision is obviously applicable primarily to closely held corporations. Dissolution can also be accomplished even if some shareholders dissent. The directors must first adopt a resolution by majority vote recommending the dissolution. The shareholders must then have an opportunity to vote on the resolution at a meeting after being notified of its purpose. A majority of the outstanding voting shares is necessary to carry the resolution. Although this procedure is most often used when a company has been inactive, nothing bars its use by large corporations. In 1979, UV Industries, 357th on the Fortune 500 list, with profits of \$40 million annually, voted to dissolve and to distribute some \$500 million to its stockholders, in part as a means of fending off a hostile takeover. Fortune magazine referred to it as “a company that’s worth more dead than alive.”Fortune, February 26, 1979, 42–44.
Once dissolution has been approved, the corporation may dissolve by filing a certificate or articles of dissolution with the secretary of state. The certificate may be filed as the corporation begins to wind up its affairs or at any time thereafter. The process of winding up is liquidation. The company must notify all creditors of its intention to liquidate. It must collect and dispose of its assets, discharge all obligations, and distribute any remainder to its stockholders.
Involuntary Dissolution
In certain cases, a corporation can face involuntary dissolution. A state may bring an action to dissolve a corporation on one of five grounds: failure to file an annual report or pay taxes, fraud in procuring incorporation, exceeding or abusing authority conferred, failure for thirty days to appoint and maintain a registered agent, and failure to notify the state of a change of registered office or agent. State-specific differences exist as well. Delaware permits its attorney general to involuntarily dissolve a corporation for abuse, misuse, or nonuse of corporate powers, privileges, or franchise.Del. Code Ann. tit. 8, § 282 (2011). California, on the other hand, permits involuntary dissolution for abandonment of a business, board deadlocks, internal strife and deadlocked shareholders, mismanagement, fraud or abuse of authority, expiration of term of corporation, or protection of a complaining shareholder if there are fewer than thirty-five shareholders.Cal. Corp. Code § 1800 et seq. (West 2011). California permits the initiation of involuntary dissolution by either half of the directors in office or by a third of shareholders.
Judicial Liquidation
Action by Shareholder
A shareholder may file suit to have a court dissolve the company on a showing that the company is being irreparably injured because the directors are deadlocked in the management of corporate affairs and the shareholders cannot break the deadlock. Shareholders may also sue for liquidation if corporate assets are being misapplied or wasted, or if directors or those in control are acting illegally, oppressively, or fraudulently.
Claims against a Dissolved Corporation
Under Sections 14.06 and 14.07 of the Revised Model Business Corporation Act, a dissolved corporation must provide written notice of the dissolution to its creditors. The notice must state a deadline, which must be at least 120 days after the notice, for receipt of creditors’ claims. Claims not received by the deadline are barred. The corporation may also publish a notice of the dissolution in a local newspaper. Creditors who do not receive written notice or whose claim is not acted on have five years to file suit against the corporation. If the corporate assets have been distributed, shareholders are personally liable, although the liability may not exceed the assets received at liquidation.
Bankruptcy
As an alternative to dissolution, a corporation in financial trouble may look to federal bankruptcy law for relief. A corporation may use liquidation proceedings under Chapter 7 of the Bankruptcy Reform Act or may be reorganized under Chapter 11 of the act. Both remedies are discussed in detail in Chapter 13.
Key Takeaway
Dissolution is the end of the legal existence of a corporation. It usually occurs after liquidation, which is the process of paying debts and distributing assets. There are several methods by which a corporation may be dissolved. The first is voluntary dissolution, which is an elective decision to dissolve the entity. A second is involuntary dissolution, which occurs upon the happening of statute-specific events such as a failure to pay taxes. Last, a corporation may be dissolved judicially, either by shareholder or creditor lawsuit. A dissolved corporation must provide notice to its creditors of upcoming dissolution.
Exercises
1. What are the main types of dissolution?
2. What is the difference between dissolution and liquidation?
3. What are the rights of a stockholder to move for dissolution? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/25%3A_Corporate_Expansion_State_and_Federal_Regulation_of_Foreign_Corporations_and_Corporate_Dissolution/25.03%3A_Dissolution.txt |
Successor Liability
Ray v. Alad Corporation
19 Cal. 3d 22; 560 P2d 3; 136 Cal. Rptr. 574 (Cal. 1977)
Claiming damages for injury from a defective ladder, plaintiff asserts strict tort liability against defendant Alad Corporation (Alad II) which neither manufactured nor sold the ladder but prior to plaintiff’s injury succeeded to the business of the ladder’s manufacturer, the now dissolved “Alad Corporation” (Alad I), through a purchase of Alad I’s assets for an adequate cash consideration. Upon acquiring Alad I’s plant, equipment, inventory, trade name, and good will, Alad II continued to manufacture the same line of ladders under the “Alad” name, using the same equipment, designs, and personnel, and soliciting Alad I’s customers through the same sales representatives with no outward indication of any change in the ownership of the business. The trial court entered summary judgment for Alad II and plaintiff appeals.…
Our discussion of the law starts with the rule ordinarily applied to the determination of whether a corporation purchasing the principal assets of another corporation assumes the other’s liabilities. As typically formulated, the rule states that the purchaser does not assume the seller’s liabilities unless (1) there is an express or implied agreement of assumption, (2) the transaction amounts to a consolidation or merger of the two corporations, (3) the purchasing corporation is a mere continuation of the seller, or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.
If this rule were determinative of Alad II’s liability to plaintiff it would require us to affirm the summary judgment. None of the rule’s four stated grounds for imposing liability on the purchasing corporation is present here. There was no express or implied agreement to assume liability for injury from defective products previously manufactured by Alad I. Nor is there any indication or contention that the transaction was prompted by any fraudulent purpose of escaping liability for Alad I’s debts.
With respect to the second stated ground for liability, the purchase of Alad I’s assets did not amount to a consolidation or merger. This exception has been invoked where one corporation takes all of another’s assets without providing any consideration that could be made available to meet claims of the other’s creditors or where the consideration consists wholly of shares of the purchaser’s stock which are promptly distributed to the seller’s shareholders in conjunction with the seller’s liquidation. In the present case the sole consideration given for Alad I’s assets was cash in excess of \$ 207,000. Of this amount Alad I was paid \$ 70,000 when the assets were transferred and at the same time a promissory note was given to Alad I for almost \$ 114,000. Shortly before the dissolution of Alad I the note was assigned to the Hamblys, Alad I’s principal stockholders, and thereafter the note was paid in full. The remainder of the consideration went for closing expenses or was paid to the Hamblys for consulting services and their agreement not to compete. There is no contention that this consideration was inadequate or that the cash and promissory note given to Alad I were not included in the assets available to meet claims of Alad I’s creditors at the time of dissolution. Hence the acquisition of Alad I’s assets was not in the nature of a merger or consolidation for purposes of the aforesaid rule.
Plaintiff contends that the rule’s third stated ground for liability makes Alad II liable as a mere continuation of Alad I in view of Alad II’s acquisition of all Alad I’s operating assets, its use of those assets and of Alad I’s former employees to manufacture the same line of products, and its holding itself out to customers and the public as a continuation of the same enterprise. However, California decisions holding that a corporation acquiring the assets of another corporation is the latter’s mere continuation and therefore liable for its debts have imposed such liability only upon a showing of one or both of the following factual elements: (1) no adequate consideration was given for the predecessor corporation’s assets and made available for meeting the claims of its unsecured creditors; (2) one or more persons were officers, directors, or stockholders of both corporations.…
We therefore conclude that the general rule governing succession to liabilities does not require Alad II to respond to plaintiff’s claim.…
[However], we must decide whether the policies underlying strict tort liability for defective products call for a special exception to the rule that would otherwise insulate the present defendant from plaintiff’s claim.
The purpose of the rule of strict tort liability “is to insure that the costs of injuries resulting from defective products are borne by the manufacturers that put such products on the market rather than by the injured persons who are powerless to protect themselves.” However, the rule “does not rest on the analysis of the financial strength or bargaining power of the parties to the particular action. It rests, rather, on the proposition that ‘The cost of an injury and the loss of time or health may be an overwhelming misfortune to the person injured, and a needless one, for the risk of injury can be insured by the manufacturer and distributed among the public as a cost of doing business. (Escola v. Coca Cola Bottling Co., 24 Cal.2d 453, 462 [150 P.2d 436] [concurring opinion]) Thus, “the paramount policy to be promoted by the rule is the protection of otherwise defenseless victims of manufacturing defects and the spreading throughout society of the cost of compensating them.” Justification for imposing strict liability upon a successor to a manufacturer under the circumstances here presented rests upon (1) the virtual destruction of the plaintiff’s remedies against the original manufacturer caused by the successor’s acquisition of the business, (2) the successor’s ability to assume the original manufacturer’s risk-spreading role, and (3) the fairness of requiring the successor to assume a responsibility for defective products that was a burden necessarily attached to the original manufacturer’s good will being enjoyed by the successor in the continued operation of the business.
We therefore conclude that a party which acquires a manufacturing business and continues the output of its line of products under the circumstances here presented assumes strict tort liability for defects in units of the same product line previously manufactured and distributed by the entity from which the business was acquired.
The judgment is reversed.
Case Questions
1. What is the general rule regarding successor liability?
2. How does the Ray court deviate from this general rule?
3. What is the court’s rationale for this deviation?
4. What are some possible consequences for corporations considering expansion?
Constitutional Issues Surrounding Taxation of a Foreign Corporation
D. H. Holmes Co. Ltd. V. McNamara
486 U.S. 24; 108 S.Ct. 1619, 100 L. Ed. 2d 21 (1988)
Appellant D. H. Holmes Company, Ltd., is a Louisiana corporation with its principal place of business and registered office in New Orleans. Holmes owns and operates 13 department stores in various locations throughout Louisiana that employ about 5,000 workers. It has approximately 500,000 credit card customers and an estimated 1,000,000 other customers within the State.
In 1979–1981, Holmes contracted with several New York companies for the design and printing of merchandise catalogs. The catalogs were designed in New York, but were actually printed in Atlanta, Boston, and Oklahoma City. From these locations, 82% of the catalogs were directly mailed to residents of Louisiana; the remainder of the catalogs was mailed to customers in Alabama, Mississippi, and Florida, or was sent to Holmes for distribution at its flagship store on Canal Street in New Orleans. The catalogs were shipped free of charge to the addressee, and their entire cost (about \$ 2 million for the 3-year period), including mailing, was borne by Holmes. Holmes did not, however, pay any sales tax where the catalogs were designed or printed.
Although the merchandise catalogs were mailed to selected customers, they contained instructions to the postal carrier to leave them with the current resident if the addressee had moved, and to return undeliverable catalogs to Holmes’ Canal Street store. Holmes freely concedes that the purpose of the catalogs was to promote sales at its stores and to instill name recognition in future buyers. The catalogs included inserts which could be used to order Holmes’ products by mail.
The Louisiana Department of Revenue and Taxation, of which appellee is the current Secretary, conducted an audit of Holmes’ tax returns for 1979–1981 and determined that it was liable for delinquent use taxes on the value of the catalogs. The Department of Revenue and Taxation assessed the use tax pursuant to La. Rev. Stat. Ann. §§ 47:302 and 47:321 (West 1970 and Supp. 1988), which are set forth in the margin. Together, §§ 47:302(A)(2) and 47:321(A)(2) impose a use tax of 3% on all tangible personal property used in Louisiana. “Use,” as defined elsewhere in the statute, is the exercise of any right or power over tangible personal property incident to ownership, and includes consumption, distribution, and storage. The use tax is designed to compensate the State for sales tax that is lost when goods are purchased out-of-state and brought for use into Louisiana, and is calculated on the retail price the property would have brought when imported.
When Holmes refused to pay the use tax assessed against it, the State filed suit in Louisiana Civil District Court to collect the tax. [The lower courts held for the State.]…
The Commerce Clause of the Constitution, Art. I, § 8, cl. 3, provides that Congress shall have the power “to regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” Even where Congress has not acted affirmatively to protect interstate commerce, the Clause prevents States from discriminating against that commerce. The “distinction between the power of the State to shelter its people from menaces to their health or safety and from fraud, even when those dangers emanate from interstate commerce, and its lack of power to retard, burden or constrict the flow of such commerce for their economic advantage, is one deeply rooted in both our history and our law.” H. P. Hood & Sons v. Du Mond, 336 U.S. 525, 533, 93 L. Ed. 865, 69 S.Ct. 657 (1949).
One frequent source of conflict of this kind occurs when a State seeks to tax the sale or use of goods within its borders. This recurring dilemma is exemplified in what has come to be the leading case in the area. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 51 L. Ed. 2d 326, 97 S.Ct. 1076 (1977). In Complete Auto, Mississippi imposed a tax on appellant’s business of in-state transportation of motor vehicles manufactured outside the State. We found that the State’s tax did not violate the Commerce Clause, because appellant’s activity had a substantial nexus with Mississippi, and the tax was fairly apportioned, did not discriminate against interstate commerce, and was fairly related to benefits provided by the State.
Complete Auto abandoned the abstract notion that interstate commerce “itself” cannot be taxed by the States. We recognized that, with certain restrictions, interstate commerce may be required to pay its fair share of state taxes. Accordingly, in the present case, it really makes little difference for Commerce Clause purposes whether Holmes’ catalogs “came to rest” in the mailboxes of its Louisiana customers or whether they were still considered in the stream of interstate commerce.…
In the case before us, then, the application of Louisiana’s use tax to Holmes’ catalogs does not violate the Commerce Clause if the tax complies with the four prongs of Complete Auto. We have no doubt that the second and third elements of the test are satisfied. The Louisiana taxing scheme is fairly apportioned, for it provides a credit against its use tax for sales taxes that have been paid in other States. Holmes paid no sales tax for the catalogs where they were designed or printed; if it had, it would have been eligible for a credit against the use tax exacted. Similarly, Louisiana imposed its use tax only on the 82% of the catalogs distributed in-state; it did not attempt to tax that portion of the catalogs that went to out-of-state customers.
The Louisiana tax structure likewise does not discriminate against interstate commerce. The use tax is designed to compensate the State for revenue lost when residents purchase out-of-state goods for use within the State. It is equal to the sales tax applicable to the same tangible personal property purchased in-state; in fact, both taxes are set forth in the same sections of the Louisiana statutes.
Complete Auto requires that the tax be fairly related to benefits provided by the State, but that condition is also met here. Louisiana provides a number of services that facilitate Holmes’ sale of merchandise within the State: It provides fire and police protection for Holmes’ stores, runs mass transit and maintains public roads which benefit Holmes’ customers, and supplies a number of other civic services from which Holmes profits. To be sure, many others in the State benefit from the same services; but that does not alter the fact that the use tax paid by Holmes, on catalogs designed to increase sales, is related to the advantages provided by the State which aid Holmes’ business.
Finally, we believe that Holmes’ distribution of its catalogs reflects a substantial nexus with Louisiana. To begin with, Holmes’ contention that it lacked sufficient control over the catalogs’ distribution in Louisiana to be subject to the use tax verges on the nonsensical. Holmes ordered and paid for the catalogs and supplied the list of customers to whom the catalogs were sent; any catalogs that could not be delivered were returned to it. Holmes admits that it initiated the distribution to improve its sales and name recognition among Louisiana residents. Holmes also has a significant presence in Louisiana, with 13 stores and over \$100 million in annual sales in the State. The distribution of catalogs to approximately 400,000 Louisiana customers was directly aimed at expanding and enhancing its Louisiana business. There is “nexus” aplenty here. [Judgment affirmed.]
Case Questions
1. What is the main constitutional issue in this case?
2. What are the four prongs to test whether a tax violates the Constitution, as laid out in Complete Auto?
3. Does this case hold for the proposition that a state may levy any tax upon a foreign corporation? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/25%3A_Corporate_Expansion_State_and_Federal_Regulation_of_Foreign_Corporations_and_Corporate_Dissolution/25.04%3A_Cases.txt |
Summary
Beyond the normal operations of business, a corporation can expand in one of four ways: (1) purchase of assets, (2) merger, (3) consolidation, and (4) purchase of another corporation’s stock.
A purchase of assets occurs when one corporation purchases some or all of the assets of another corporation. When assets are purchased, the purchasing corporation is not generally liable for the debts of the corporation whose assets were sold. There are several generally recognized exceptions, such as when the asset purchase is fraudulent or to avoid creditors. Some states have added additional exceptions, such as in cases involving products liability.
In a merger, the acquired company is absorbed into the acquiring company and goes out of business. The acquiring corporation assumes the other company’s debts. Unless the articles of incorporation say otherwise, a majority of directors and shareholders of both corporations must approve the merger. There are two main types of merger: a cash merger and a noncash merger. A consolidation is virtually the same as a merger, except that the resulting entity is a new corporation.
A corporation may take over another company by purchasing a controlling interest of its stock, commonly referred to as a takeover. This is accomplished by appealing directly to the target company’s shareholders. In the case of a large publicly held corporation, the appeal is known as a tender offer, which is not an offer but an invitation to shareholders to tender their stock at a stated price. A leveraged buyout involves using the target corporation’s assets as security for a loan used to purchase the target.
A shareholder has the right to fair value for his stock if he dissents from a plan to merge, consolidate, or sell all or substantially all of the corporate assets, referred to as appraisal rights. If there is disagreement over the value, the shareholder has the right to a court appraisal. When one company acquires 90 percent of the stock of another, it may merge with the target through a short-form merger, which eliminates the requirement of consent of shareholders and the target company’s board.
Certain federal regulations are implicated in corporate expansion, particularly the Williams Act. States may impose conditions on admission of a foreign corporation to do business of a purely local nature but not if its business is exclusively interstate in character, which would violate the Commerce Clause. Among the requirements are obtaining a certificate of authority from the secretary of state and maintaining a registered office with a registered agent. But certain activities do not constitute doing business, such as filing lawsuits and collecting debts, and may be carried on even if the corporation is not licensed to do business in a state. Under long-arm statutes, state courts have jurisdiction over foreign corporations as long as the corporations have minimum contacts in the state. States may also tax corporate activities as long as the tax does not unduly burden interstate commerce.
Dissolution is the legal termination of a corporation’s existence, as distinguished from liquidation, the process of paying debts and distributing assets. A corporation may be dissolved by shareholders if they unanimously agree in writing, or by majority vote of the directors and shareholders. A corporation may also be dissolved involuntarily on one of five grounds, including failure to file an annual report or to pay taxes. Shareholders may sue for judicial liquidation on a showing that corporate assets are being wasted or directors or officers are acting illegally or fraudulently.
Exercises
1. Preston Corporation sold all of its assets to Adam Corporation in exchange for Adam stock. Preston then distributed the stock to its shareholders, without paying a debt of \$150,000 owed to a major supplier, Corey. Corey, upon discovery that Preston is now an empty shell, attempts to recover the debt from Adam. What is the result? Why?
2. Would the result in Exercise 1 be different if Adam and Preston had merged? Why?
3. Would the result in Exercise 1 be different if Gorey had a products-liability claim against Preston? Why? What measures might you suggest to Adam to prevent potential losses from such claims?
4. In Exercise 1, assuming that Preston and Adam had merged, what are the rights of Graham, a shareholder who opposed the merger? Explain the procedure for enforcing his rights.
5. A bus driver from Massachusetts was injured when his seat collapsed while he was driving his bus through Maine. He brought suit in Massachusetts against the Ohio corporation that manufactured the seat. The Ohio corporation did not have an office in Massachusetts but occasionally sent a sales representative there and delivered parts to the state. Assuming that process was served on the company at its Ohio office, would a Massachusetts court have jurisdiction over the Ohio corporation? Why?
SELF CHECK QUESTIONS
1. In a merger, the acquired company
1. goes out of existence
2. stays in existence
3. is consolidated into a new corporation
4. does none of the above
2. An offer by an acquiring company to buy shareholders’ stock at a stipulated price is called
1. an appraisal
2. a short-form merger
3. a tender offer
4. none of the above
3. The legal termination of a corporation’s existence is called
1. liquidation
2. bankruptcy
3. extinguishment
4. dissolution
4. The most important constitutional provision relating to a state’s ability to tax foreign corporations is
1. the Commerce Clause
2. the First Amendment
3. the Due Process Clause
4. the Privileges and Immunities Clause
5. An act that is considered to be a corporation’s “transacting business” in a state is
1. collecting debts
2. holding directors’ meetings
3. filing lawsuits
4. none of the above
1. a
2. c
3. d
4. a
5. d | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/25%3A_Corporate_Expansion_State_and_Federal_Regulation_of_Foreign_Corporations_and_Corporate_Dissolution/25.05%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The history and basic framework of antitrust laws on horizontal restraints of trade
• The distinction between vertical restraints of trade and horizontal restraints of trade
• The various exemptions from antitrust law that Congress has created
• Why monopolies pose a threat to competitive markets, and what kinds of monopolies are proscribed by the Sherman Act and the Clayton Act
This chapter will describe the history and current status of federal laws to safeguard the US market from anticompetitive practices, especially those of very large companies that may have a monopoly. Companies that have a monopoly in any market segment have the potential to exercise monopoly power in ways that are harmful to consumers and competitors. Economic theory assures us that for the most part, competition is good: that sound markets will offer buyers lots of choices and good information about products and services being sold and will present few barriers to entry for buyers and sellers. By encouraging more, rather than fewer, competitors in a given segment of the market, US antitrust law attempts to preserve consumer choice and to limit barriers to entry, yet it does allow some businesses to achieve considerable size and market share on the belief that size can create efficiencies and pass along the benefits to consumers.
26: Antitrust Law
Learning Objectives
By the end of this section, you will be able to:
• Know the history and basic framework of antitrust laws in the United States.
• Understand how US antitrust laws may have international application.
• Explain how US antitrust laws are enforced and what kinds of criminal and civil penalties may apply.
In this chapter, we take up the origins of the federal antitrust laws and the basic rules governing restraints of trade.Sherman Act, Section 1; Clayton Act, Section 3. We also look at concentrations of market power: monopoly and acquisitions and mergers.Sherman Act, Section 2; Clayton Act, Section 7. In Chapter 27, we explore the law of deceptive acts and unfair trade practices, both as administered by the Federal Trade Commission (FTC) and as regulated at common law.
The antitrust laws are aimed at maintaining competition as the driving force of the US economy. The very word antitrust implies opposition to the giant trusts that began to develop after the Civil War. Until then, the economy was largely local; manufacturers, distributors, and retailers were generally small. The Civil War demonstrated the utility of large-scale enterprise in meeting the military’s ferocious production demands, and business owners were quick to understand the advantage of size in attracting capital. For the first time, immense fortunes could be made in industry, and adventurous entrepreneurs were quick to do so in an age that lauded the acquisitive spirit.
The first great business combinations were the railroads. To avoid ruinous price wars, railroad owners made private agreements, known as “pools,” through which they divided markets and offered discounts to favored shippers who agreed to ship goods on certain lines. The pools discriminated against particular shippers and certain geographic regions, and public resentment grew.
Farmers felt the effects first and hardest, and they organized politically to express their opposition. In time, they persuaded many state legislatures to pass laws regulating railroads. In Munn v. Illinois, the Supreme Court rejected a constitutional attack on a state law regulating the transportation and warehousing of grain; the court declared that the “police powers” of the states permit the regulation of property put to public uses.Munn v. Illinois, 94 U.S. 113 (1877). But over time, many state railroad laws were struck down because they interfered with interstate commerce, which only Congress may regulate constitutionally. The consequence was federal legislation: the Interstate Commerce Act of 1887, establishing the first federal administrative agency, the Interstate Commerce Commission.
In the meantime, the railroads had discovered that their pools lacked enforcement power. Those who nominally agreed to be bound by the pooling arrangement could and often did cheat. The corporate form of business enterprise allowed for potentially immense accumulations of capital to be under the control of a small number of managers; but in the 1870s and 1880s, the corporation was not yet established as the dominant legal form of operation. To overcome these disadvantages, clever lawyers for John D. Rockefeller organized his Standard Oil of Ohio as a common-law trust. Trustees were given corporate stock certificates of various companies; by combining numerous corporations into the trust, the trustees could effectively manage and control an entire industry. Within a decade, the Cotton Trust, Lead Trust, Sugar Trust, and Whiskey Trust, along with oil, telephone, steel, and tobacco trusts, had become, or were in the process of becoming, monopolies.
Consumers howled in protest. The political parties got the message: In 1888, both Republicans and Democrats put an antitrust plank in their platforms. In 1889, the new president, Republican Benjamin Harrison, condemned monopolies as “dangerous conspiracies” and called for legislation to remedy the tendency of monopolies that would “crush out” competition.
The result was the Sherman Antitrust Act of 1890, sponsored by Senator John Sherman of Ohio. Its two key sections forbade combinations in restraint of trade and monopolizing. Senator Sherman and other sponsors declared that the act had roots in a common-law policy that frowned on monopolies. To an extent, it did, but it added something quite important for the future of business and the US economy: the power of the federal government to enforce a national policy against monopoly and restraints of trade. Nevertheless, passage of the Sherman Act did not end the public clamor, because fifteen years passed before a national administration began to enforce the act, when President Theodore Roosevelt—”the Trustbuster”—sent his attorney general after the Northern Securities Corporation, a transportation holding company.
During its seven years, the Roosevelt administration initiated fifty-four antitrust suits. The pace picked up under the Taft administration, which in only four years filed ninety antitrust suits. But the pressure for further reform did not abate, especially when the Supreme Court, in the Standard Oil case of 1911,Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911). declared that the Sherman Act forbids only “unreasonable” restraints of trade. A congressional investigation of US Steel Corporation brought to light several practices that had gone unrestrained by the Sherman Act. It also sparked an important debate, one that has echoes in our own time, about the nature of national economic policy: should it enforce competition or regulate business in a partnership kind of arrangement?
Big business was firmly on the side of regulation, but Congress opted for the policy followed waveringly to the present: competition enforced by government, not a partnership of government and industry, must be the engine of the economy. Accordingly, in 1914, at the urging of President Woodrow Wilson, Congress enacted two more antitrust laws, the Clayton Act and the Federal Trade Commission Act. The Clayton Act outlawed price discrimination, exclusive dealing and tying contracts, acquisition of a company’s competitors, and interlocking directorates. The FTC Act outlawed “unfair methods” of competition, established the FTC as an independent administrative agency, and gave it power to enforce the antitrust laws alongside the Department of Justice.
The Sherman, Clayton, and FTC Acts remain the basic texts of antitrust law. Over the years, many states have enacted antitrust laws as well; these laws govern intrastate competition and are largely modeled on the federal laws. The various state antitrust laws are beyond the scope of this textbook.
Two additional federal statutes were adopted during the next third of a century as amendments to the Clayton Act. Enacted in the midst of the Depression in 1936, the Robinson-Patman Act prohibits various forms of price discrimination. The Celler-Kefauver Act, strengthening the Clayton Act’s prohibition against the acquisition of competing companies, was enacted in 1950 in the hopes of stemming what seemed to be a tide of corporate mergers and acquisitions. We will examine these laws in turn.
The Sherman Act
Section 1 of the Sherman Act declares, “Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several states, or with foreign nations, is declared to be illegal.” This is sweeping language. What it embraces seems to depend entirely on the meaning of the words “restraint of trade or commerce.” Whatever they might mean, every such restraint is declared unlawful. But in fact, as we will see, the proposition cannot be stated quite so categorically, for in 1911 the Supreme Court limited the reach of this section to unreasonable restraints of trade.
What does “restraint of trade” mean? The Sherman Act’s drafters based the act on a common-law policy against monopolies and other infringements on competition. But common law regarding restraints of trade had been developed in only rudimentary form, and the words have come to mean whatever the courts say they mean. In short, the antitrust laws, and the Sherman Act in particular, authorize the courts to create a federal “common law” of competition.
Section 2 of the Sherman Act prohibits monopolization: “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several states, or with foreign nations, shall be deemed guilty of a misdemeanor.” In 1976, Congress upped the ante: violations of the Sherman Act are now felonies. Unlike Section 1, Section 2 does not require a combination between two or more people. A single company acting on its own can be guilty of monopolizing or attempting to monopolize.
The Clayton Act
The Clayton Act was enacted in 1914 to plug what many in Congress saw as loopholes in the Sherman Act. Passage of the Clayton Act was closely linked to that of the FTC Act. Unlike the Sherman Act, the Clayton Act is not a criminal statute; it merely declares certain defined practices as unlawful and leaves it to the government or to private litigants to seek to enjoin those practices. But unlike the FTC Act, the Clayton Act does spell out four undesirable practices. Violations of the Sherman Act require an actual adverse impact on competition, whereas violations of the Clayton Act require merely a probable adverse impact. Thus the enforcement of the Clayton Act involves a prediction that the defendant must rebut in order to avoid an adverse judgment.
The four types of proscribed behavior are these:
1. Discrimination in prices charged different purchasers of the same commodities.
2. Conditioning the sale of one commodity on the purchaser’s refraining from using or dealing in commodities of the seller’s competitors.Clayton Act, Section 3.
3. Acquiring the stock of a competing corporation.Clayton Act, Section 7. Because the original language did not prohibit various types of acquisitions and mergers that had grown up with modem corporate law and finance, Congress amended this section in 1950 (the Celler-Kefauver Act) to extend its prohibition to a wide variety of acquisitions and mergers.
4. Membership by a single person on more than one corporate board of directors if the companies are or were competitors.Clayton Act, Section 8.
The Federal Trade Commission Act
Like the Clayton Act, the FTC Act is a civil statute, involving no criminal penalties. Unlike the Clayton Act, its prohibitions are broadly worded. Its centerpiece is Section 5, which forbids “unfair methods of competition in commerce, and unfair or deceptive acts or practices in commerce.” We examine Section 5 in Chapter 27.
Enforcement of Antitrust Laws
General Enforcement
There are four different means of enforcing the antitrust laws.
First, the US Department of Justice may bring civil actions to enjoin violations of any section of the Sherman and Clayton Acts and may institute criminal prosecutions for violations of the Sherman Act. Both civil and criminal actions are filed by the offices of the US attorney in the appropriate federal district, under the direction of the US attorney general. In practice, the Justice Department’s guidance comes through its Antitrust Division in Washington, headed by an assistant attorney general. With several hundred lawyers and dozens of economists and other professionals, the Antitrust Division annually files fewer than one hundred civil and criminal actions combined. On average, far more criminal cases are filed than civil cases. In 2006, thirty-four criminal cases and twelve civil cases were filed; in 2007, forty criminal cases and six civil cases; in 2008, fifty-four criminal cases and nineteen civil cases; and in 2009, seventy-two criminal cases and nine civil cases.
The number of cases can be less important than the complexity and size of a particular case. For example, U.S. v. American Telephone & Telegraph and U.S. v. IBM were both immensely complicated, took years to dispose of, and consumed tens of thousands of hours of staff time and tens of millions of dollars in government and defense costs.
Second, the FTC hears cases under the Administrative Procedure Act, as described in Chapter 5. The commission’s decisions may be appealed to the US courts of appeals. The FTC may also promulgate “trade regulation rules,” which define fair practices in specific industries. The agency has some five hundred lawyers in Washington and a dozen field offices, but only about half the lawyers are directly involved in antitrust enforcement. The government’s case against Microsoft was, like the cases against AT&T and IBM, a very complex case that took a large share of time and resources from both the government and Microsoft.
Third, in the Antitrust Improvements Act of 1976, Congress authorized state attorneys general to file antitrust suits in federal court for damages on behalf of their citizens; such a suit is known as a parens patriae claim. Any citizen of the state who might have been injured by the defendant’s actions may opt out of the suit and bring his or her own private action. The states have long had the authority to file antitrust suits seeking injunctive relief on behalf of their citizens.
Fourth, private individuals and companies may file suits for damages or injunctions if they have been directly injured by a violation of the Sherman or Clayton Act. Private individuals or companies may not sue under the FTC Act, no matter how unfair or deceptive the behavior complained of; only the FTC may do so. In the 1980s, more than 1,500 private antitrust suits were filed in the federal courts each year, compared with fewer than 100 suits filed by the Department of Justice. More recently, from 2006 to 2008, private antitrust suits numbered above 1,000 but dropped significantly, to 770, in 2009. The pace was even slower for the first half of 2010. Meanwhile, the Department of Justice filed 40 or fewer criminal antitrust cases from 2006 to 2008; that pace has quickened under the Obama administration (72 cases in 2009).
Enforcement in International Trade
The Sherman and Clayton Acts apply when a company’s activities affect US commerce. This means that these laws apply to US companies that agree to fix the price of goods to be shipped abroad and to the acts of a US subsidiary of a foreign company. It also means that non–US citizens and business entities can be prosecuted for violations of antitrust laws, even if they never set foot in the United States, as long as their anticompetitive activities are aimed at the US market. For example, in November of 2010, a federal grand jury in San Francisco returned an indictment against three former executives in Taiwan. They had conspired to fix prices on color display tubes (CDTs), a type of cathode-ray tube used in computer monitors and other specialized applications.
The indictment charged Seung-Kyu “Simon” Lee, Yeong-Ug “Albert” Yang, and Jae-Sik “J. S.” Kim with conspiring with unnamed coconspirators to suppress and eliminate competition by fixing prices, reducing output, and allocating market shares of CDTs to be sold in the United States and elsewhere. Lee, Yang, and Kim allegedly participated in the conspiracy during various time periods between at least as early as January 2000 and as late as March 2006. The conspirators met in Taiwan, Korea, Malaysia, China, and elsewhere, but not in the United States. They allegedly met for the purpose of exchanging CDT sales, production, market share, and pricing information for the purpose of implementing, monitoring, and enforcing their agreements. Because the intended effects of their actions were to be felt in the United States, the US antitrust laws could apply.
Criminal Sanctions
Until 1976, violations of the Sherman Act were misdemeanors. The maximum fine was \$50,000 for each count on which the defendant was convicted (only \$5,000 until 1955), and the maximum jail sentence was one year. But in the CDT case just described, each of the three conspirators was charged with violating the Sherman Act, which carries a maximum penalty of ten years in prison and a \$1 million fine for individuals. The maximum fine may be increased to twice the gain derived from the crime or twice the loss suffered by the victims if either of those amounts is greater than the statutory maximum fine of \$1 million.
Forfeitures
One provision in the Sherman Act, not much used, permits the government to seize any property in transit in either interstate or foreign commerce if it was the subject of a contract, combination, or conspiracy outlawed under Section 1.
Injunctions and Consent Decrees
The Justice Department may enforce violations of the Sherman and Clayton Acts by seeking injunctions in federal district court. The injunction can be a complex set of instructions, listing in some detail the practices that a defendant is to avoid and even the way in which it will be required to conduct its business thereafter. Once an injunction is issued and affirmed on appeal, or the time for appeal has passed, it confers continuing jurisdiction on the court to hear complaints by those who say the defendant is violating it. In a few instances, the injunction or a consent decree is in effect the basic “statute” by which an industry operates. A 1956 decree against American Telephone & Telegraph Company (AT&T) kept the company out of the computer business for a quarter-century, until the government’s monopoly suit against AT&T was settled and a new decree issued in 1983. The federal courts also have the power to break up a company convicted of monopolizing or to order divestiture when the violation consists of unlawful mergers and acquisitions.
The FTC may issue cease and desist orders against practices condemned under Section 5 of the FTC Act—which includes violations of the Sherman and Clayton Acts—and these orders may be appealed to the courts.
Rather than litigate a case fully, defendants may agree to consent decrees, in which, without admitting guilt, they agree not to carry on the activity complained of. Violations of injunctions, cease and desist orders, and consent decrees subject companies to a fine of \$10,000 a day for every day the violation continues. Companies frequently enter into consent decrees—and not just because they wish to avoid the expense and trouble of trial. Section 5 of the Clayton Act says that whenever an antitrust case brought by the federal government under either the Clayton Act or the Sherman Act goes to final judgment, the judgment can be used, in a private suit in which the same facts are at issue, as prima facie evidence that the violation was committed. This is a powerful provision, because it means that a private plaintiff need prove only that the violation in fact injured him. He need not prove that the defendant committed the acts that amount to antitrust violations. Since this provision makes it relatively easy for private plaintiffs to prevail in subsequent suits, defendants in government suits have a strong inducement to enter into consent decrees, because these are not considered judgments. Likewise, a guilty plea in a criminal case gives the plaintiff in a later private civil suit prima facie evidence of the defendant’s liability. However, a plea of nolo contendere will avoid this result. Section 5 has been the spur for a considerable proportion of all private antitrust suits. For example, the government’s price-fixing case against the electric equipment industry that sent certain executives of General Electric to jail in the 1950s led to more than 2,200 private suits.
Treble Damages
The crux of the private suit is its unique damage award: any successful plaintiff is entitled to collect three times the amount of damages actually suffered—treble damages, as they are known—and to be paid the cost of his attorneys. These fees can be huge: defendants have had to pay out millions of dollars for attorneys’ fees alone in single cases. The theory of treble damages is that they will serve as an incentive to private parties to police industry for antitrust violations, thus saving the federal government the immense expense of maintaining an adequate staff for that job.
Class Actions
One of the most important developments in antitrust law during the 1970s was the rise of the class action. Under liberalized rules of federal procedure, a single plaintiff may sue on behalf of the entire class of people injured by an antitrust violation. This device makes it possible to bring numerous suits that would otherwise never have been contemplated. A single individual who has paid one dollar more than he would have been charged in a competitive market obviously will not file suit. But if there are ten million consumers like him, then in a class action he may seek—on behalf of the entire class, of course—\$30 million (\$10 million trebled), plus attorneys’ fees. Critics charge that the class action is a device that in the antitrust field benefits only the lawyers, who have a large incentive to find a few plaintiffs willing to have their names used in a suit run entirely by the lawyers. Nevertheless, it is true that the class action permits antitrust violations to be rooted out that could not otherwise be attacked privately. During the 1970s, suits against drug companies and the wallboard manufacturing industry were among the many large-scale antitrust class actions.
Interpreting the Laws
Vagueness
The antitrust laws, and especially Section 1 of the Sherman Act, are exceedingly vague. As Chief Justice Charles Evans Hughes once put it, “The Sherman Act, as a charter of freedom, has a generality and adaptability comparable to that found to be desirable in constitutional provisions.”Appalachian Coals v. United States, 288 U.S. 344, 359 (1933). Without the sweeping but vague language, the antitrust laws might quickly have become outdated. As written, they permit courts to adapt the law to changing circumstances. But the vagueness can lead to uncertainty and uneven applications of the law.
The “Rule of Reason”
Section 1 of the Sherman Act says that “every” restraint of trade is illegal. But is a literal interpretation really possible? No, for as Justice Louis Brandeis noted in 1918 in one of the early price-fixing cases, “Every agreement concerning trade, every regulation of trade restrains. To bind, to restrain, is of their very essence.”Chicago Board of Trade v. United States, 246 U.S. 231 (1918). When a manufacturing company contracts to buy raw materials, trade in those goods is restrained: no one else will have access to them. But to interpret the Sherman Act to include such a contract is an absurdity. Common sense says that “every” cannot really mean every restraint.
Throughout this century, the courts have been occupied with this question. With the hindsight of thousands of cases, the broad outlines of the answer can be confidently stated. Beginning with Standard Oil Co. of New Jersey v. United States, the Supreme Court has held that only unreasonable restraints of trade are unlawful.Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911).
Often called the rule of reason, the interpretation of Section 1 made in Standard Oil itself has two possible meanings, and they have been confused over the years. The rule of reason could mean that a restraint is permissible only if it is ancillary to a legitimate business purpose. The standard example is a covenant not to compete. Suppose you decide to purchase a well-regarded bookstore in town. The proprietor is well liked and has developed loyal patrons. He says he is going to retire in another state. You realize that if he changed his mind and stayed in town to open another bookstore, your new business would suffer considerably. So you negotiate as a condition of sale that he agrees not to open another bookstore within ten miles of the town for the next three years. Since your intent is not to prevent him from going into business—as it would be if he had agreed never to open a bookstore anywhere—but merely to protect the value of your purchase, this restraint of trade is ancillary to your business purpose. The rule of reason holds that this is not an unlawful restraint of trade.
Another interpretation of the rule of reason is even broader. It holds that agreements that might directly impair competition are not unlawful unless the particular impairment itself is unreasonable. For example, several retailers of computer software are distraught at a burgeoning price war that will possibly reduce prices so low that they will not be able to offer their customers proper service. To avert this “cutthroat competition,” the retailers agree to set a price floor—a floor that, under the circumstances, is reasonable. Chief Justice Edward White, who wrote the Standard Oil opinion, might have found that such an agreement was reasonable because, in view of its purposes, it was not unduly restrictive and did not unduly restrain trade.
But this latter view is not the law. Almost any business agreement could enhance the market power of one or more parties to the agreement, and thus restrain trade. “The true test of legality,” Justice Brandeis wrote in 1918 in Chicago Board of Trade, “is whether the restraint imposed is such as merely regulates and perhaps thereby promotes competition or whether it is such as may suppress or even destroy competition.”Chicago Board of Trade v. United States, 246 U.S. 231 (1918). Section 1 violations analyzed under the rule of reason will look at several factors, including the purpose of the agreement, the parties’ power to implement the agreement to achieve that purpose, and the effect or potential effect of the agreement on competition. If the parties could have used less restrictive means to achieve their purpose, the Court would more likely have seen the agreement as unreasonable.Chicago Board of Trade v. United States, 246 U.S. 231 (1918).
“Per Se” Rules
Not every act or commercial practice needs to be weighed by the rule of reason. Some acts have come to be regarded as intrinsically or necessarily impairing competition, so that no further analysis need be made if the plaintiff can prove that the defendant carried them out or attempted or conspired to do so. Price-fixing is an example. Price-fixing is said to be per se illegal under the Sherman Act—that is, unlawful on its face. The question in a case alleging price-fixing is not whether the price was reasonable or whether it impaired or enhanced competition, but whether the price in fact was fixed by two sellers in a market segment. Only that question can be at issue.
Under the Clayton Act
The rule of reason and the per se rules apply to the Sherman Act. The Clayton Act has a different standard. It speaks in terms of acts that may tend substantially to lessen competition. The courts must construe these terms too, and in the sections that follow, we will see how they have done so.
Key Takeaway
The preservation of competition is an important part of public policy in the United States. The various antitrust laws were crafted in response to clear abuses by companies that sought to claim easier profits by avoiding competition through the exercise of monopoly power, price-fixing, or territorial agreements. The Department of Justice and the Federal Trade Commission have substantial criminal and civil penalties to wield in their enforcement of the various antitrust laws.
Exercises
1. Why did industries become so much larger after the US Civil War, and how did this lead to abusive practices? What role did politics play in creating US laws fostering competition?
2. Go to the Department of Justice website and see how many antitrust enforcement actions have taken place since 2008.
3. Consider whether the US government should break up the biggest US banks. Why or why not? If the United States does so, and other nations have very large government banks, or have very large private banks, can US banks remain competitive? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.01%3A_History_and_Basic_Framework_of_Antitrust_Laws_in_the_United_States.txt |
Learning Objectives
By the end of this section, you will be able to:
• Know why competitors are the likely actors in horizontal restraints of trade.
• Explain what it means when the Supreme Court declares a certain practice to be a per se violation of the antitrust laws.
• Describe at least three ways in which otherwise competing parties can fix prices.
• Recognize why dividing territories is a horizontal restraint of trade.
Classification of antitrust cases and principles is not self-evident because so many cases turn on complex factual circumstances. One convenient way to group the cases is to look to the relationship of those who have agreed or conspired. If the parties are competitors—whether competing manufacturers, wholesalers, retailers, or others—there could be a horizontal restraint of trade. If the parties are at different levels of the distribution chain—for example, manufacturer and retailer—their agreement is said to involve a vertical restraint of trade. These categories are not airtight: a retailer might get competing manufacturers to agree not to supply a competitor of the retailer. This is a vertical restraint with horizontal effects.
Price-Fixing
Direct Price-Fixing Agreements
Price-fixing agreements are per se violations of Section 1 of the Sherman Act. The per se rule was announced explicitly in United States v. Trenton Potteries.United States v. Trenton Potteries, 273 U.S. 392 (1927). In that case, twenty individuals and twenty-three corporations, makers and distributors of 82 percent of the vitreous pottery bathroom fixtures used in the United States, were found guilty of having agreed to establish and adhere to a price schedule. On appeal, they did not dispute that they had combined to fix prices. They did argue that the jury should have been permitted to decide whether what they had done was reasonable. The Supreme Court disagreed, holding that any fixing of prices is a clear violation of the Sherman Act.
Twenty-four years later, the Court underscored this categorical per se rule in Kiefer-Stewart Co. v. Joseph E. Seagram & Sons.Kiefer-Stewart Co. v. Joseph E. Seagram & Sons, 340 U.S. 211 (1951). The defendants were distillers who had agreed to sell liquor only to those wholesalers who agreed to resell it for no more than a maximum price set by the distillers. The defendants argued that setting maximum prices did not violate the Sherman Act because such prices promoted rather than restrained competition. Again, the Supreme Court disagreed: “[S]uch agreements, no less than those to fix minimum prices, cripple the freedom of traders and thereby restrain their ability to sell in accordance with their own judgment.”
The per se prohibition against price-fixing is not limited to agreements that directly fix prices. Hundreds of schemes that have the effect of controlling prices have been tested in court and found wanting, some because they were per se restraints of trade, others because their effects were unreasonable—that is, because they impaired competition—under the circumstances. In the following sections, we examine some of these cases briefly.
Exchanging Price Information
Knowledge of competitors’ prices can be an effective means of controlling prices throughout an industry. Members of a trade association of hardwood manufacturers adopted a voluntary “open competition” plan. About 90 percent of the members adhered to the plan. They accounted for one-third of the production of hardwood in the United States. Under the plan, members reported daily on sales and deliveries and monthly on production, inventory, and prices. The association, in turn, sent out price, sales, and production reports to the participating members. Additionally, members met from time to time to discuss these matters, and they were exhorted to refrain from excessive production in order to keep prices at profitable levels. In American Column and Lumber Company v. United States, the Supreme Court condemned this plan as a per se violation of Section 1 of the Sherman Act.American Column and Lumber Company v. United States, 257 U.S. 377 (1921).
Not every exchange of information is necessarily a violation, however. A few years after American Column and Lumber, in Maple Flooring Manufacturers’ Association v. United States, the Court refused to find a violation in the practice of an association of twenty-two hardwood-floor manufacturers in circulating a list to all members of average costs and freight rates, as well as summaries of sales, prices, and inventories.Maple Flooring Manufacturers’ Association v. United States, 268 U.S. 563 (1925). The apparent difference between American Column and Lumber and Maple Flooring was that in the latter, the members did not discuss prices at their meetings, and their rules permitted them to charge individually whatever they wished. It is not unlawful, therefore, for members of an industry to meet to discuss common problems or to develop statistical information about the industry through a common association, as long as the discussions do not border on price or on techniques of controlling prices, such as by restricting output. Usually, it takes evidence of collusion to condemn the exchange of prices or other data.
Controlling Output
Competitors also fix prices by controlling an industry’s output. For example, competitors could agree to limit the amount of goods each company makes or by otherwise limiting the amount that comes to market. This latter technique was condemned in United States v. Socony-Vacuum Oil Co.United States v. Socony-Vacuum Oil Co., 310 U.S. 150 (1940). To prevent oil prices from dropping, dominant oil companies agreed to and did purchase from independent refiners surplus gasoline that the market was forcing them to sell at distress prices. By buying up this gasoline, the large companies created a price floor for their own product. This conduct, said the Court, is a per se violation.
Regulating Competitive Methods
Many companies may wish to eliminate certain business practices—for example, offering discounts or premiums such as trading stamps on purchase of goods—but are afraid or powerless to do so unless their competitors also stop. The temptation is strong to agree with one’s competitors to jointly end these practices; in most instances, doing so is unlawful when the result would be to affect the price at which the product is sold. But not every agreed-on restraint or standard is necessarily unlawful. Companies might decide that it would serve their customers’ interests as well as their own if the product could be standardized, so that certain names or marks signify a grade or quality of product. When no restriction is placed on what grades are to be sold or at what prices, no restraint of trade has occurred.
In National Society of Professional Engineers v. United States, Section 26.8.1 “Horizontal Restraints of Trade”, a canon of ethics of the National Society of Professional Engineers prohibited members from making competitive bids. This type of prohibition has been common in the codes of ethics of all kinds of occupational groups that claim professional status. These groups justify the ban by citing public benefits, though not necessarily price benefits, that flow from observance of the “ethical” rule.
Nonprice Restraints of Trade
Allocating Territories
Suppose four ice-cream manufacturers decided one day that their efforts to compete in all four corners of the city were costly and destructive. Why not simply strike a bargain: each will sell ice cream to retail shops in only one quadrant of the city. This is not a pricing arrangement; each is free to sell at whatever price it desires. But it is a restraint of trade, for in carving up the territory in which each may sell, they make it impossible for grocery stores to obtain a choice among all four manufacturers. The point becomes obvious when the same kind of agreement is put on a national scale: suppose Ford and Toyota agreed that Ford would not sell its cars in New York and Toyota would not sell Toyotas in California.
Most cases of territorial allocation are examples of vertical restraints in which manufacturers and distributors strike a bargain. But some cases deal with horizontal allocation of territories. In United States v. Sealy, the defendant company licensed manufacturers to use the Sealy trademark on beds and mattresses and restricted the territories in which the manufacturers could sell.United States v. Sealy, 388 U.S. 350 (1967). The evidence showed that the licensees, some thirty small bedding manufacturers, actually owned the licensor and were using the arrangement to allocate the territory. It was held to be unlawful per se.
Exclusionary Agreements
We said earlier that it might be permissible for manufacturers, through a trade association, to establish certain quality standards for the convenience of the public. As long as these standards are not exclusionary and do not reflect any control over price, they might not inhibit competition. The UL mark on electrical and other equipment—a mark to show that the product conforms to specifications of the private Underwriters Laboratory—is an example. But suppose that certain widget producers establish the Scientific Safety Council, a membership association whose staff ostensibly assigns quality labels, marked SSC, to those manufacturers who meet certain engineering and safety standards. In fact, however, the manufacturers are using the widespread public acceptance of the SSC mark to keep the market to themselves by refusing to let nonmembers join and by refusing to let nonmembers use the SSC mark, even if their widgets conform to the announced standards. This subterfuge would be a violation of Section 1 of the Sherman Act.
Boycotts
Agreements by competitors to boycott (refuse to deal with) those who engage in undesirable practices are unlawful. In an early case, a retailers’ trade association circulated a list of wholesale distributors who sold directly to the public. The intent was to warn member retailers not to buy from those wholesalers. Although each member was free to act however it wanted, the Court saw in this blacklist a plan to promote a boycott.Eastern State Lumber Dealers’ Association v. United States, 234 U.S. 600 (1914).
This policy remains true even if the objective of the boycott is to prevent unethical or even illegal activities. Members of a garment manufacturers association agreed with a textile manufacturers association not to use any textiles that had been “pirated” from designs made by members of the textile association. The garment manufacturers also pledged, among other things, not to sell their goods to any retailer who did not refrain from using pirated designs. The argument that this was the only way to prevent unscrupulous design pirates from operating fell on deaf judicial ears; the Supreme Court held the policy unlawful under Section 5 of the Federal Trade Commission (FTC) Act, the case having been brought by the FTC.Fashion Originators’ Guild of America v. Federal Trade Commission, 312 U.S. 457 (1941).
Proof of Agreement
It is vital for business managers to realize that once an agreement or a conspiracy is shown to have existed, they or their companies can be convicted of violating the law even if neither agreement nor conspiracy led to concrete results. Suppose the sales manager of Extremis Widget Company sits down over lunch with the sales manager of De Minimis Widget Company and says, “Why are we working so hard? I have a plan that will let us both relax.” He explains that their companies can put into operation a data exchange program that will stabilize prices. The other sales manager does not immediately commit himself, but after lunch, he goes to the stationery store and purchases a notebook in which to record the information he will get from a telephone test of the plan. That action is probably enough to establish a conspiracy to fix prices, and the government could file criminal charges at that point. Discussion with your competitors of prices, discounts, production quotas, rebates, bid rigging, trade-in allowances, commission rates, salaries, advertising, and the like is exceedingly dangerous. It can lead to criminal conduct and potential jail terms.
Proof of Harm
It is unnecessary to show that the public is substantially harmed by a restraint of trade as long as the plaintiff can show that the restraint injured him. In Klor’s, Inc. v. Broadway-Hale Stores, the plaintiff was a small retail appliance shop in San Francisco.Klor’s, Inc. v. Broadway-Hale Stores, 359 U.S. 207 (1959). Next door to the shop was a competing appliance store, one of a chain of stores run by Broadway-Hale. Klor’s alleged that Broadway-Hale, using its “monopolistic buying power,” persuaded ten national manufacturers and their distributors, including GE, RCA, Admiral, Zenith, and Emerson, to cease selling to Klor’s or to sell at discriminatory prices. The defendants did not dispute the allegations. Instead, they moved for summary judgment on the ground that even if true, the allegations did not give rise to a legal claim because the public could not conceivably have been injured as a result of their concerted refusal to deal. As evidence, they cited the uncontradicted fact that within blocks of Klor’s, hundreds of household appliance retailers stood ready to sell the public the very brands Klor’s was unable to stock as a result of the boycott. The district court granted the motion and dismissed Klor’s complaint. The court of appeals affirmed. But the Supreme Court reversed, saying as follows:
This combination takes from Klor’s its freedom to buy appliances in an open competitive market and drives it out of business as a dealer in the defendants’ products. It deprives the manufacturers and distributors of their freedom to sell to Klor’s.…It interferes with the natural flow of interstate commerce. It clearly has, by its “nature” and “character,” a “monopolistic tendency.” As such it is not to be tolerated merely because the victim is just one merchant whose business is so small that his destruction makes little difference to the economy. Monopoly can surely thrive by the elimination of such small businessmen, one at a time, as it can by driving them out in large groups.
We have been exploring the Sherman Act as it applies to horizontal restraints of trade—that is, restraints of trade between competitors. We now turn our attention to vertical restraints—those that are the result of agreements or conspiracies between different levels of the chain of distribution, such as manufacturer and wholesaler or wholesaler and retailer.
Key Takeaway
Competitors can engage in horizontal restraints of trade by various means of price-fixing. They can also engage in horizontal price restraints of trade by allocating territories or by joint boycotts (refusals to deal). These restraints need not be substantial in order to be actionable as a violation of US antitrust laws.
Exercises
1. Suppose that BMW of North America tells its dealers that the prestigious M100 cannot be sold for more than \$230,000. Explain why this could be a violation of antitrust law.
2. Suppose that JPMorgan Chase, the Bank of England, and the Bank of China agree that they will not compete for investment services, and that JPMorgan Chase is given an exclusive right to North and South America, Bank of England is given access rights to Europe, and Bank of China is given exclusive rights to Asia, India, and Australia. Is there a violation of US antitrust law here? If not, why not? If so, what act does it violate, and how?
3. “It’s a free country.” Why are agreements by competitors to boycott (to refuse to deal with) certain others considered a problem that needs to be dealt with by law? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.02%3A_Horizontal_Restraints_of_Trade.txt |
Learning Objectives
By the end of this section, you will be able to:
• Distinguish vertical restraints of trade from horizontal restraints of trade.
• Describe exclusive dealing, and explain why exclusive dealing is anticompetitive in any way.
• Explain how tying one product’s sale to that of another could be anticompetitive.
We have been exploring the Sherman Act as it applies to horizontal restraints of trade, restraints that are created between competitors. We now turn to vertical restraints—those that result from agreements between different levels of the chain of distribution, such as manufacturer and wholesaler or wholesaler and retailer.
Resale Price Maintenance
Is it permissible for manufacturers to require distributors or retailers to sell products at a set price? Generally, the answer is no, but the strict per se rule against any kind of resale price maintenance has been somewhat relaxed.
But why would a manufacturer want to fix the price at which the retailer sells its goods? There are several possibilities. For instance, sustained, long-term sales of many branded appliances and other goods depend on reliable servicing by the retailer. Unless the retailer can get a fair price, it will not provide good service. Anything less than good service will ultimately hurt the brand name and lead to fewer sales. Another possible argument for resale price maintenance is that unless all retailers must abide by a certain price, some goods will not be stocked at all. For instance, the argument runs, bookstores will not stock slow-selling books if they cannot be guaranteed a good price on best sellers. Stores free to discount best sellers will not have the profit margin to stock other types of books. To guarantee sales of best sellers to bookstores carrying many lines of books, it is necessary to put a floor under the price of books. Still another argument is that brand-name goods are inviting targets for loss-leader sales; if one merchant drastically discounts Extremis Widgets, other merchants may not want to carry the line, and the manufacturer may experience unwanted fluctuations in sales.
None of these reasons has completely appeased the critics of price-fixing, including the most important critics—the US federal judges. As long ago as 1910, in Dr. Miles Medical Co. v. John D. Park & Sons Co., the Supreme Court declared vertical price-fixing (what has come to be called resale price maintenance) unlawful under the Sherman Act. Dr. Miles Medical Company required wholesalers that bought its proprietary medicines to sign an agreement in which they agreed not to sell below a certain price and not to sell to retailers who did not have a “retail agency contract” with Dr. Miles. The retail agency contract similarly contained a price floor. Dr. Miles argued that since it was free to make or not make the medicines, it should be free to dictate the prices at which purchasers could sell them. The Court said that Dr. Miles’s arrangement with more than four hundred jobbers (wholesale distributors) and twenty-five thousand retailers was no different than if the wholesalers or retailers agreed among themselves to fix the price. Dr. Miles “having sold its product at prices satisfactory to itself, the public is entitled to whatever advantage may be derived from a competition in the subsequent traffic.”Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1910).
In Dr. Miles, the company’s restrictions impermissibly limited the freedom of choice of other drug distributors and retailers. Society was therefore deprived of various benefits it would have received from unrestricted distribution of the drugs. But academics and some judges argue that most vertical price restraints do not limit competition among competitors, and manufacturers retain the power to restrict output, and the power to raise prices. Arguably, vertical price restraints help to ensure economic efficiencies and maximize consumer welfare. Some of the same arguments noted in this section—such as the need to ensure good service for retail items—continue to be made in support of a rule of reason.
The Supreme Court has not accepted these arguments with regard to minimum prices but has increased the plaintiff’s burden of proof by requiring evidence of an agreement on specific price levels. Where a discounter is terminated by a manufacturer, it will probably not be told exactly why, and very few manufacturers would be leaving evidence in writing that insists on dealers agreeing to minimum prices.
Moreover, in State Oil Company v. Khan, the Supreme Court held that “vertical maximum price fixing, like the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the rule of reason.”State Oil Company v. Khan, 522 U.S. 3 (1997). Vertical maximum price-fixing is not legal per se but should be analyzed under a rule of reason “to identify the situations in which it amounts to anti-competitive conduct.” The Khan case is at the end of this chapter, in Section 26.8.2 “Vertical Maximum Price Fixing and the Rule of Reason”.
Exclusive Dealing and Tying
We move now to a nonprice vertical form of restraint. Suppose you went to the grocery store intent on purchasing a bag of potato chips to satisfy a late-night craving. Imagine your surprise—and indignation—if the store manager waved a paper in your face and said, “I’ll sell you this bag only on the condition that you sign this agreement to buy all of your potato chips in the next five years from me.” Or if he said, “I’ll sell only if you promise never to buy potato chips from my rival across the street.” This is an exclusive dealing agreement, and if the effect may be to lessen competition substantially, it is unlawful under Section 3 of the Clayton Act. It also may be unlawful under Section 1 of the Sherman Act and Section 5 of the Federal Trade Commission (FTC) Act. Another form of exclusive dealing, known as a tying contract, is also prohibited under Section 3 of the Clayton Act and under the other statutes. A tying contract results when you are forced to take a certain product in order to get the product you are really after: “I’ll sell you the potato chips you crave, but only if you purchase five pounds of my Grade B liver.”
Section 3 of the Clayton Act declares it unlawful for any person engaged in commerce to lease or make a sale or contract for sale of goods, wares, merchandise, machinery, supplies or other commodities, whether patented or unpatented, for use, consumption or resale…or fix a price charged therefore, or discount from or rebate upon, such price, on the condition…that the lessee or purchaser…shall not use or deal in the goods, wares, merchandise, machinery, supplies, or other commodities of a competitor or competitors of the lessor or seller, where the effect of such lease, sale, or contract for sale or such condition…may be to substantially lessen competition or tend to erect a monopoly in any line of commerce. (emphasis added)
Under Section 3, the potato chip example is not unlawful, for you would not have much of an effect on competition nor tend to create a monopoly if you signed with your corner grocery. But the Clayton Act has serious ramifications for a producer who might wish to require a dealer to sell only its products—such as a fast-food franchisee that can carry cooking ingredients bought only from the franchisor (Chapter 27), an appliance store that can carry only one national brand of refrigerators, or an ice-cream parlor that must buy ice-cream supplies from the supplier of its machinery.
A situation like the one in the ice-cream example came under review in International Salt Co. v. United States.International Salt Co. v. United States, 332 U.S. 392 (1947). International Salt was the largest US producer of salt for industrial uses. It held patents on two machines necessary for using salt products; one injected salt into foodstuffs during canning. It leased most of these machines to canners, and the lease required the lessees to purchase from International Salt all salt to be used in the machines. The case was decided on summary judgment; the company did not have the chance to prove the reasonableness of its conduct. The Court held that it was not entitled to. International Salt’s valid patent on the machines did not confer on it the right to restrain trade in unpatented salt. Justice Tom Clark said that doing so was a violation of both Section 1 of the Sherman Act and Section 3 of the Clayton Act:
Not only is price-fixing unreasonable, per se, but also it is unreasonable, per se, to foreclose competitors from any substantial market. The volume of business affected by these contracts cannot be said to be insignificant or insubstantial, and the tendency of the arrangement to accomplishment of monopoly seems obvious. Under the law, agreements are forbidden which “tend to create a monopoly,” and it is immaterial that the tendency is a creeping one rather than one that proceeds at full gallop; nor does the law await arrival at the goal before condemning the direction of the movement.
In a case involving the sale of newspaper advertising space (to purchase space in the morning paper, an advertiser would have to take space in the company’s afternoon paper), the government lost because it could not use the narrower standards of Section 3 and could not prove that the defendant had monopoly power over the sale of advertising space. (Another afternoon newspaper carried advertisements, and its sales did not suffer.) In the course of his opinion, Justice Clark set forth the rule for determining legality of tying arrangements under both the Clayton and Sherman Acts:
When the seller enjoys a monopolistic position in the market for the “tying” product [i.e., the product that the buyer wants] or if a substantial volume of commerce in the “tied” product [i.e., the product that the buyer does not want] is restrained, a tying arrangement violates the narrower standards expressed in section 3 of the Clayton Act because from either factor the requisite potential lessening of competition is inferred. And because for even a lawful monopolist it is “unreasonable per se to foreclose competitors from any substantial market” a tying arrangement is banned by section 1 of the Sherman Act wherever both conditions are met.Times-Picayune Publishing Co. v. United States, 345 U.S. 594 (1953).
This rule was broadened in 1958 in a Sherman Act case involving the Northern Pacific Railroad Company, which had received forty million acres of land from Congress in the late nineteenth century in return for building a rail line from the Great Lakes to the Pacific. For decades, Northern Pacific leased or sold the land on condition that the buyer or lessee use Northern Pacific to ship any crops grown on the land or goods manufactured there. To no avail, the railroad argued that unlike International Salt’s machines, the railroad’s “tying product” (its land) was not patented, and that the land users were free to ship on other lines if they could find cheaper rates. Wrote Justice Hugo Black,
[A] tying arrangement may be defined as an agreement by a party to sell one product but only on the condition that the buyer also purchases a different (or tied) product, or at least agrees that he will not purchase that product from any other supplier. Where such conditions are successfully exacted competition on the merits with respect to the tied product is inevitably curbed.…They deny competitors free access to the market for the tied product, not because the party imposing the tying requirements has a better product or a lower price but because of his power or leverage in another market. At the same time buyers are forced to forego their free choice between competing products.…They are unreasonable in and of themselves whenever a party has sufficient economic power with respect to the tying product to appreciably restrain free competition in the market for the tied product and a “not insubstantial” amount of interstate commerce is affected. In this case…the undisputed facts established beyond any genuine question that the defendant possessed substantial economic power by virtue of its extensive landholdings which it used as leverage to induce large numbers of purchasers and lessees to give it preference.Northern Pacific Railway Co. v. United States, 356 U.S. 1 (1958). (emphasis in original)
Taken together, the tying cases suggest that anyone with certain market power over a commodity or other valuable item (such as a trademark) runs a serious risk of violating the Clayton Act or Sherman Act or both if he insists that the buyer must also take some other product as part of the bargain. Microsoft learned about the perils of “tying” in a case brought by the United States, nineteen individual states, and the District of Columbia. The allegation was that Microsoft had tied together various software programs on its operating system, Microsoft Windows. Windows came prepackaged with Microsoft’s Internet Explorer (IE), its Windows Media Player, Outlook Express, and Microsoft Office. The United States claimed that Microsoft had bundled (or “tied”) IE to sales of Windows 98, making IE difficult to remove from Windows 98 by not putting it on the Remove Programs list.
The government alleged that Microsoft had designed Windows 98 to work “unpleasantly” with Netscape Navigator and that this constituted an illegal tying of Windows 98 and IE. Microsoft argued that its web browser and mail reader were just parts of the operating system, included with other personal computer operating systems, and that the integration of the products was technologically justified. The United States Court of Appeals for the District of Columbia Circuit rejected Microsoft’s claim that IE was simply one facet of its operating system, but the court held that the tie between Windows and IE should be analyzed deferentially under the rule of reason. The case settled before reaching final judicial resolution. (See United States v. Microsoft.United States v. Microsoft, 253 F.3d 34 (D.C. Cir. 2001).)
Nonprice Vertical Restraints: Allocating Territory and Customers
With horizontal restraints of trade, we have already seen that it is a per se violation of Section 1 of the Sherman Act for competitors to allocate customers and territory. But a vertical allocation of customers or territory is only illegal if competition to the markets as a whole is adversely affected. The key here is distinguishing intrabrand competition from interbrand competition. Suppose that Samsung electronics has relationships with ten different retailers in Gotham City. If Samsung decides to limit its contractual relationships to only six retailers, the market for consumer electronics in Gotham City is still competitive in terms of interbrand competition. Intrabrand competition, however, is now limited. It could be that consumers will pay slightly higher prices for Samsung electronics with only six different retailers selling those products in Gotham City. That is, intrabrand competition is lowered, but interbrand competition remains strong.
Notice that it is unlikely that the six remaining retailers will raise their prices substantially, since there is still strong interbrand competition. If the retailer only deals in Samsung electronics, it is unlikely to raise prices that much, given the strength of interbrand competition.
If the retailer carries Samsung and other brands, it will also not want to raise prices too much, for then its inventory of Samsung electronics will pile up, while its inventory of other electronics products will move off the shelves.
Why would Samsung want to limit its retail outlets in Gotham City at all? It may be that Samsung has decided that by firming up its dealer network, it can enhance service, offer a wider range of products at each of the remaining retailers, ensure improved technical and service support, increase a sense of commitment among the remaining retail outlets, or other good business reasons. Where the retailer deals in other electronic consumer brands as well, making sure that well-trained sales and service support is available for Samsung products can promote interbrand competition in Gotham City. Thus vertical allocation of retailers within the territory is not a per se violation of the Sherman Act. It is instead a rule of reason violation, or the law will intervene only if Samsung’s activities have an anticompetitive effect on the market as a whole. Notice here that the only likely objections to the new allocation would come from those dealers who were contractually terminated and who are then effectively restricted from selling Samsung electronics.
There are other potentially legitimate territorial restrictions, and limits on what kind of customer the retailer can sell to will prevent a dealer or distributor from selling outside a certain territory or to a certain class of customers. Samsung may reduce its outlets in Iowa from four to two, and it may also impose limits on those retail outlets from marketing beyond certain areas in and near Iowa.
Suppose that a Monsanto representative selling various kinds of fertilizers and pesticides was permitted to sell only to individual farmers and not to co-ops or retail distributors, or was limited to the state of Iowa. The Supreme Court has held that such vertical territorial or customer searches are not per se violations of Section 1 of the Sherman Act, as the situations often increase “interbrand competition.” Thus the rule of reason will apply to vertical allocation of customers and territory.
Nonprice Vertical Restraints: Exclusive Dealing Agreements
Often, a distributor or retailer agrees with the manufacturer or supplier not to carry the products of any other supplier. This is not in itself (per se) illegal under Section 1 of the Sherman Act or Section 3 of the Clayton Act. Only if these exclusive dealing contracts have an anticompetitive effect will there be an antitrust violation. Ideally, in a competitive market, there are no significant barriers to entry. In the real world, however, various deals are made that can and do restrict entry. Suppose that on his farm in Greeley, Colorado, Richard Tucker keeps goats, and he creates a fine, handcrafted goat cheese for the markets in Denver, Fort Collins, and Boulder, Colorado, and Cheyenne, Wyoming. In these markets, if Safeway, Whole Foods, Albertsons, and King Soopers already have suppliers, and the suppliers have gained exclusive dealing agreements, Tucker will be effectively barred from the market.
Suppose that Billy Goat Cheese is a nationally distributed brand of goat cheese and has created exclusive dealing arrangements with the four food chains in the four cities. Tucker could sue Billy Goat for violating antitrust laws if he finds out about the arrangements. But the courts will not assume a per se violation has taken place. Instead, the courts will look at the number of other distributors available, the portion of the market foreclosed by the exclusive dealing arrangements, the ease with which new distributors could enter the market, the possibility that Tucker could distribute the product himself, and legitimate business reasons that led the distributors to accept exclusive dealing contracts from Billy Goat Cheese.
Key Takeaway
Vertical restraints of trade can be related to price, can be in the form of tying arrangements, and can be in the form of allocating customers and territories. Vertical restraints can also come in the form of exclusive dealing agreements.
Exercises
1. Explain how a seller with a monopoly in one product and tying the sale of that product to a new product that has no such monopoly is in any way hurting competition. How “free” is the buyer to choose a product different from the seller’s?
2. If your company wants to maintain its image as a high-end product provider, is it legal to create a floor for your product’s prices? If so, under what circumstances? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.03%3A_Vertical_Restraints_of_Trade.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand why Congress legislated against price-cutting by large companies.
• Recognize why price discrimination is not per se illegal.
• Identify and explain the defenses to a Robinson-Patman price discrimination charge.
If the relatively simple and straightforward language of the Sherman Act can provide litigants and courts with interpretive headaches, the law against price discrimination—the Robinson-Patman Act—can strike the student with a crippling migraine. Technically, Section 2 of the Clayton Act, the Robinson-Patman Act, has been verbally abused almost since its enactment in 1936. It has been called the “Typhoid Mary of Antitrust,” a “grotesque manifestation of the scissors and paste-pot method” of draftsmanship. Critics carp at more than its language; many have asserted over the years that the act is anticompetitive because it prevents many firms from lowering their prices to attract more customers.
Despite this rhetoric, the Robinson-Patman Act has withstood numerous attempts to modify or repeal it, and it can come into play in many everyday situations. Although in recent years the Justice Department has declined to enforce it, leaving government enforcement efforts to the Federal Trade Commission (FTC), private plaintiffs are actively seeking treble damages in numerous cases. So whether it makes economic sense or not, the act is a living reality for marketers. This section introduces certain problems that lurk in deciding how to price goods and how to respond to competitors’ prices.
The Clayton Act’s original Section 2, enacted in 1914, was aimed at the price-cutting practice of the large trusts, which would reduce the price of products below cost where necessary in a particular location to wipe out smaller competitors who could not long sustain such losses. But the original Clayton Act exempted from its terms any “discrimination in price…on account of differences in the quantity of the commodity sold.” This was a gaping loophole that made it exceedingly difficult to prove a case of price discrimination.
Not until the Depression in the 1930s did sufficient cries of alarm over price discrimination force Congress to act. The alarm was centered on the practices of large grocery chains. Their immense buying power was used as a lever to pry out price discounts from food processors and wholesalers. Unable to extract similar price concessions, the small mom-and-pop grocery stores found that they could not offer the retail customer the lower food prices set by the chains. The small shops began to fail. In 1936, Congress strengthened Section 2 by enacting the Robinson-Patman Act. Although prompted by concern about how large buyers could use their purchasing power, the act in fact places most of its restrictions on the pricing decisions of sellers.
The Statutory Framework
The heart of the act is Section 2(a), which reads in pertinent part as follows: “[I]t shall be unlawful for any person engaged in commerce…to discriminate in price between different purchasers of commodities of like grade and quality…where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy or prevent competition with any person who either grants or knowingly receives the benefit of such discrimination, or with customers of either of them.”
This section provides certain defenses to a charge of price discrimination. For example, differentials in price are permissible whenever they “make only due allowances for differences in the cost of manufacture, sale, or delivery resulting from the differing methods or quantities in which such commodities are to such purchasers sold or delivered.” This section also permits sellers to change prices in response to changing marketing conditions or the marketability of the goods—for example, if perishable goods begin to deteriorate, the seller may drop the price in order to move the goods quickly.
Section 2(b) provides the major defense to price discrimination: any price is lawful if made in good faith to meet competition.
Discrimination by the Seller
Preliminary Matters
Simultaneous Sales
To be discriminatory, the different prices must have been charged in sales made at the same time or reasonably close in time. What constitutes a reasonably close time depends on the industry and the circumstances of the marketplace. The time span for dairy sales would be considerably shorter than that for sales of mainframe computers, given the nature of the product, the frequency of sales, the unit cost, and the volatility of the markets.
Identity of Purchaser
Another preliminary issue is the identity of the actual purchaser. A supplier who deals through a dummy wholesaler might be charged with price discrimination even though on paper only one sale appears to have been made. Under the “indirect purchaser” doctrine, a seller who deals with two or more retail customers but passes their orders on to a single wholesaler and sells the total quantity to the wholesaler in one transaction, can be held to have violated the act. The retailers are treated as indirect purchasers of the supplier.
Sales of Commodities
The act applies only to sales of commodities. A lease, a rental, or a license to use a product does not constitute a sale; hence price differentials under one of those arrangements cannot be unlawful under Robinson-Patman. Likewise, since the act applies only to commodities—tangible things—the courts have held that it does not apply to the sale of intangibles, such as rights to license or use patents, shares in a mutual fund, newspaper or television advertising, or title insurance.
Goods of Like Grade and Quality
Only those sales involving goods of “like grade and quality” can be tested under the act for discriminatory pricing. What do these terms mean? The leading case is FTC v. Borden Co., in which the Supreme Court ruled that trademarks and labels do not, for Robinson-Patman purposes, distinguish products that are otherwise the same.FTC v. Borden Co., 383 U.S. 637 (1966). Grade and quality must be determined “by the characteristics of the product itself.” When the products are physically or chemically identical, they are of like grade and quality, regardless of how imaginative marketing executives attempt to distinguish them. But physical differences that affect marketability can serve to denote products as being of different grade and quality, even if the differences are slight and do not affect the seller’s cost in manufacturing or marketing.
Competitive Injury
To violate the Robinson-Patman Act, the seller’s price discrimination must have an anticompetitive effect. The usual Clayton Act standard for measuring injury applies to Robinson-Patman violations—that is, a violation occurs when the effect may be substantially to lessen competition or tend to create a monopoly in any line of commerce. But because the Robinson-Patman Act has a more specific test of competitive injury, the general standard is rarely cited.
The more specific test measures the impact on particular persons affected. Section 2(a) says that it is unlawful to discriminate in price where the effect is “to injure, destroy, or prevent competition with any person who grants or knowingly receives the benefit of such discrimination or to customers of either of them.” The effect—injury, destruction, or prevention of competition—is measured against three types of those suffering it: (1) competitors of the seller or supplier (i.e., competitors of the person who “grants” the price discrimination), (2) competitors of the buyer (i.e., competitors of the buyer who “knowingly receives the benefit” of the price differential), and (3) customers of either of the two types of competitors. As we will see, the third category presents many difficulties.
For purposes of our discussion, assume the following scenario: Ace Brothers Widget Company manufactures the usual sizes and styles of American domestic widgets. It competes primarily with National Widget Corporation, although several smaller companies make widgets in various parts of the country. Ace Brothers is the largest manufacturer and sells throughout the United States. National sells primarily in the western states. The industry has several forms of distribution. Many retailers buy directly from Ace and National, but several regional and national wholesalers also operate, including Widget Jobbers, Ltd. and Widget Pushers, LLC. The retailers in any particular city compete directly against each other to sell to the general public. Jobbers and Pushers are in direct competition. Jobbers also sells directly to the public, so that it is in direct competition with retailers as well as Widget Pushers. As everyone knows, widgets are extremely price sensitive, being virtually identical in physical appearance and form.
Primary-Line Injury
Now consider the situation in California, Oregon, and Wisconsin. The competing manufacturers, Ace Brothers and National Widgets, both sell to wholesalers in California and Oregon, but only Ace has a sales arm in Wisconsin. Seeing an opportunity, Ace drops its prices to wholesalers in California and Oregon and raises them in Wisconsin, putting National at a competitive disadvantage. This situation, illustrated in Figure \(1\), is an example of primary-line injury—the injury is done directly to a competitor of the company that differentiates its prices. This is price discrimination, and it is prohibited under Section 2(a).
Most forms of primary-line injury have a geographical basis, but they need not. Suppose National sells exclusively to Jobbers in northern California, and Ace Brothers sells both to Jobbers and several other wholesalers. If Ace cuts its prices to Jobbers while charging higher prices to the other wholesalers, the effect is also primary-line injury to National. Jobbers will obviously want to buy more from Ace at lower prices, and National’s reduced business is therefore a direct injury. If Ace intends to drive National out of business, this violation of Section 2(a) could also be an attempt to monopolize in violation of Section 2 of the Sherman Act.
Secondary-Line Injury
Next, we consider injury done to competing buyers. Suppose that Ace Brothers favors Jobbers—or that Jobbers, a powerful and giant wholesaler, induces Ace to act favorably by threatening not to carry Ace’s line of widgets otherwise. Although Ace continues to supply both Jobbers and Widget Pushers, it cuts its prices to Jobbers. As a result, Jobbers can charge its retail customers lower prices than can Pushers, so that Pushers’s business begins to slack off. This is secondary-line injury at the buyer’s level. Jobbers and Pushers are in direct competition, and by impairing Pushers’s ability to compete, the requisite injury has been committed. This situation is illustrated in Figure \(2\).
Variations on this secondary-line injury are possible. Assume Ace Brothers sells directly to Fast Widgets, a retail shop, and also to Jobbers. Jobbers sells to retail shops that compete with Fast Widgets and also directly to consumers. The situation is illustrated in Figure \(3\)).
If Ace favors Jobbers by cutting its prices, discriminating against Fast Widgets, the transaction is unlawful, even though Jobbers and Fast Widgets do not compete for sales to other retailers. Their competition for the business of ultimate consumers is sufficient to establish the illegality of the discrimination. A variation on this situation was at issue in the first important case to test Section 2(a) as it affects buyers. Morton Salt sold to both wholesalers and retailers, offering quantity discounts. Its pricing policy was structured to give large buyers great savings, computed on a yearly total, not on shipments made at any one time. Only five retail chains could take advantage of the higher discounts, and as a result, these chains could sell salt to grocery shoppers at a price below that at which the chains’ retail competitors could buy it from their wholesalers. See Figure \(4\) for a schematic illustration. In this case, FTC v. Morton Salt Co., the Supreme Court for the first time declared that the impact of the discrimination does not have to be actual; it is enough if there is a “reasonable possibility” of competitive injury.FTC v. Morton Salt Co., 334 U.S. 37 (1948).
In order to make out a case of secondary-line injury, it is necessary to show that the buyers purchasing at different prices are in fact competitors. Suppose that Ace Brothers sells to Fast Widgets, the retailer, and also to Boron Enterprises, a manufacturer that incorporates widgets in most of its products. Boron does not compete against Fast Widgets, and therefore Ace Brothers may charge different prices to Boron and Fast without fearing Robinson-Patman repercussions. Figure \(5\) shows the Boron-Fast schematic.
Third-Line Injury
Second-line injury to buyers does not exhaust the possibilities. Robinson-Patman also works against so-called third-line or tertiary-line injury. At stake here is injury another rung down the chain of distribution. Ace Brothers sells to Pushers, which processes unfinished widgets in its own factory and sells them in turn directly to retail customers. Ace also sells to Jobbers, a wholesaler without processing facilities. Jobbers sells to retail shops that can process the goods and sell directly to consumers, thus competing with Pushers for the retail business. This distribution chain is shown schematically in Figure \(6\).
If Ace’s price differs between Pushers and Jobbers so that Jobbers is able to sell at a lower price to the ultimate consumers than Pushers, a Robinson-Patman violation has occurred.
Fourth-Line Injury
In a complex economy, the distribution chain can go on and on. So far, we have examined discrimination on the level of competing supplier-sellers, on the level of competing customers of the supplier-seller, and on the level of competing customers of customers of the supplier-seller. Does the vigilant spotlight of Robinson-Patman penetrate below this level? The Supreme Court has said yes. In Perkins v. Standard Oil Co., the Court said that “customer” in Section 2(a) means any person who distributes the supplier-seller’s product, regardless of how many intermediaries are involved in getting the product to him.Perkins v. Standard Oil Co., 395 U.S. 642 (1969).
Seller’s Defenses
Price discrimination is not per se unlawful. The Robinson-Patman Act allows the seller two general defenses: (1) cost justification and (2) meeting competition. If the seller can demonstrate that sales to one particular buyer are cheaper than sales to others, a price differential is permitted if it is based entirely on the cost differences. For example, if one buyer is willing to have the goods packed in cheaper containers or larger crates that save money, that savings can be passed along to the buyer. Similarly, a buyer who takes over a warehousing function formerly undertaken by the seller is entitled to have the cost saving reflected in the selling price. Suppose the buyer orders its entire requirements for the year from the manufacturer, a quantity many times greater than that taken by any other customer. This large order permits the manufacturer to make the goods at a considerably reduced unit cost. May the manufacturer pass those savings along to the quantity buyer? It may, as long as it does not pass along the entire savings but only that attributable to the particular buyer, for other buyers add to its total production run and thus contribute to the final unit production cost. The marketing manager should be aware that the courts strictly construe cost-justification claims, and few companies have succeeded with this defense.
Meeting Competition
Lowering a price to meet competition is a complete defense to a charge of price discrimination. Assume Ace Brothers is selling widgets to retailers in Indiana and Kentucky at \$100 per dozen. National Widgets suddenly enters the Kentucky market and, because it has lower manufacturing costs than Ace, sells widgets to the four Kentucky widget retailers at \$85 per dozen. Ace may lower its price to that amount in Kentucky without lowering its Indiana price. However, if National’s price violated the Robinson-Patman Act and Ace knew or should have known that it did, Ace may not reduce its price.
The defense of meeting competition has certain limitations. For example, the seller may not use this defense as an excuse to charge different customers a price differential over the long run. Moreover, if National’s lower prices result from quantity orders, Ace may reduce its prices only for like quantities. Ace may not reduce its price for lesser quantities if National charges more for smaller orders. And although Ace may meet National’s price to a given customer, Ace may not legally charge less.
Section 2(c) prohibits payment of commissions by one party in a transaction to the opposite party (or to the opposite party’s agent) in a sale of goods unless services are actually rendered for them. Suppose the buyer’s broker warehouses the goods. May the seller pass along this cost to the broker in the form of a rebate? Isn’t that “services rendered”? Although it might seem so, the courts have said no, because they refuse to concede that a buyer’s broker or agent can perform services for the seller. Because Section 2(c) of the Robinson-Patman Act stands on its own, the plaintiff need prove only that a single payment was made. Further proof of competitive impact is unnecessary. Hence Section 2(c) cases are relatively easy to win once the fact of a brokerage commission is uncovered.
Allowances for Merchandising and Other Services
Sections 2(d) and 2(e) of the Robinson-Patman Act prohibit sellers from granting discriminatory allowances for merchandising and from performing other services for buyers on a discriminatory basis. These sections are necessary because price alone is far from the only way to offer discounts to favored buyers. Allowances and services covered by these sections include advertising allowances, floor and window displays, warehousing, return privileges, and special packaging.
Key Takeaway
Under the Robinson-Patman Act, it is illegal to charge different prices to different purchasers if the items are the same and the price discrimination lessens competition. It is legal, however, to charge a lower price to a specific buyer if the cost of serving that buyer is lower or if the seller is simply “meeting competition.”
Exercises
1. Nikon sells its cameras to retailers at 5 percent less in the state of California than in Nevada or Arizona. Without knowing more, can you say that this is illegal?
2. Tysons Foods sells its chicken wings to GFS and other very large distributors at a price per wing that is 10 percent less than it sells to most grocery store chains. The difference is attributable to transportation costs, since GFS and others accept shipments in very large containers, which cost less to deliver than smaller containers. Is the price differential legal?
3. Your best customer, who has high volume with your company, asks you for a volume discount. Actually, he demands this, rather than just asking. Under what circumstances, if any, can you grant this request without violating antitrust laws? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.04%3A_Price_Discrimination-_The_Robinson-Patman_Act.txt |
Learning Objectives
By the end of this section, you will be able to:
• Know and describe the various exemptions from US antitrust law.
Regulated Industries
Congress has subjected several industries to oversight by specific regulatory agencies. These include banking, securities and commodities exchanges, communications, transportation, and fuel and energy. The question often arises whether companies within those industries are immune to antitrust attack. No simple answer can be given. As a general rule, activities that fall directly within the authority of the regulatory agency are immune. The agency is said to have exclusive jurisdiction over the conduct—for example, the rate structure of the national stock exchanges, which are supervised by the Securities and Exchange Commission. But determining whether a particular case falls within a specific power of an agency is still up to the courts, and judges tend to read the antitrust laws broadly and the regulatory laws narrowly when they seem to clash. A doctrine known as primary jurisdiction often dictates that the question of regulatory propriety must first be submitted to the agency before the courts will rule on an antitrust question. If the agency decides the activity complained of is otherwise impermissible, the antitrust question becomes moot.
Organized Labor
In the Clayton Act, Congress explicitly exempted labor unions from the antitrust laws in order to permit workers to band together. Section 6 says that “the labor of a human being is not a commodity or article of commerce. Nothing contained in the antitrust laws shall be construed to forbid the existence and operation of labor…organizations,…nor shall such organizations, or the members thereof, be held or construed to be illegal combinations or conspiracies in restraint of trade, under the antitrust laws.” This provision was included to reverse earlier decisions of the courts that had applied the Sherman Act more against labor than business. Nevertheless, the immunity is not total, and unions have run afoul of the laws when they have combined with nonlabor groups to achieve a purpose unlawful under the antitrust laws. Thus a union could not bargain with an employer to sell its products above a certain price floor.
Insurance Companies
Under the McCarran-Ferguson Act of 1945, insurance companies are not covered by the antitrust laws to the extent that the states regulate the business of insurance. Whether or not the states adequately regulate insurance and the degree to which the exemption applies are complex questions, and there has been some political pressure to repeal the insurance exemption.
State Action
In 1943, the Supreme Court ruled in Parker v. Brown that when a valid state law regulates a particular industry practice and the industry members are bound to follow that law, then they are exempt from the federal antitrust laws.Parker v. Brown, 317 U.S. 341 (1943). Such laws include regulation of public power and licensing and regulation of the professions. This exemption for “state action” has proved troublesome and, like the other exemptions, a complex matter to apply. But it is clear that the state law must require or compel the action and not merely permit it. No state law would be valid if it simply said, “Bakers in the state may jointly establish tariffs for the sale of cookies.”
The recent trend of Supreme Court decisions is to construe the exemption as narrowly as possible. A city, county, or other subordinate unit of a state is not immune under the Parker doctrine. A municipality can escape the consequences of antitrust violations—for example, in its operation of utilities—only if it is carrying out express policy of the state. Even then, a state-mandated price-fixing scheme may not survive a federal antitrust attack. New York law required liquor retailers to charge a certain minimum price, but because the state itself did not actively supervise the policy it had established, it fell to the Supreme Court’s antitrust axe.
Group Solicitation of Government
Suppose representatives of the railroad industry lobby extensively and eventually successfully for state legislation that hampers truckers, the railroads’ deadly enemies. Is this a combination or conspiracy to restrain trade? In Eastern Railroad President’s Conference v. Noerr Motor Freight, Inc., the Supreme Court said no.Eastern Railroad President’s Conference v. Noerr Motor Freight, Inc., 365 U.S. 127 (1961). What has come to be known as the Noerr doctrine holds that applying the antitrust laws to such activities would violate First Amendment rights to petition the government. One exception to this rule of immunity for soliciting action by the government comes when certain groups seek to harass competitors by instituting state or federal proceedings against them if the claims are baseless or known to be false. Nor does the Noerr doctrine apply to horizontal boycotts even if the object is to force the government to take action. In FTC v. Superior Court Trial Lawyers Assn., the Supreme Court held that a group of criminal defense lawyers had clearly violated the Sherman Act when they agreed among themselves to stop handling cases on behalf of indigent defendants to force the local government to raise the lawyers’ fees.FTC v. Superior Court Trial Lawyers Assn., 493 U.S. 411 (1990). The Court rejected their claim that they had a First Amendment right to influence the government through a boycott to pay a living wage so that indigent defendants could be adequately represented.
Baseball
Baseball, the Supreme Court said back in 1923, is not “in commerce.” Congress has never seen fit to overturn this doctrine. Although some inroads have been made in the way that the leagues and clubs may exercise their power, the basic decision stands. Some things are sacred.
Key Takeaway
For various reasons over time, certain industries and organized groups have been exempted from the operation of US antitrust laws. These include organized labor, insurance companies, and baseball. In addition, First Amendment concerns allow trade groups to solicit both state and federal governments, and state law may sometimes provide a “state action” exemption.
Exercises
1. Do a little Internet research. Find out why Curt Flood brought an antitrust lawsuit against Major League Baseball and what the Supreme Court did with his case. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.05%3A_Exemptions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the ways in which monopoly power can be injurious to competition.
• Explain why not all monopolies are illegal under the Sherman Act.
• Recognize the importance of defining the relevant market in terms of both geography and product.
• Describe the remedies for Sherman Act Section 2 violations.
Introduction
Large companies, or any company that occupies a large portion of any market segment, can thwart competition through the exercise of monopoly power. Indeed, monopoly means the lack of competition, or at least of effective competition. As the Supreme Court has long defined it, monopoly is “the power to control market prices or exclude competition.”United States v. Grinnell Corp., 384 U.S. 563, 571 (1966). Public concern about the economic and political power of the large trusts, which tended to become monopolies in the late nineteenth century, led to Section 2 of the Sherman Act in 1890 and to Section 7 of the Clayton Act in 1914. These statutes are not limited to the giants of American industry, such as ExxonMobil, Microsoft, Google, or AT&T. A far smaller company that dominates a relatively small geographic area or that merges with another company in an area where few others compete can be in for trouble under Sections 2 or 7. These laws should therefore be of concern to all businesses, not just those on the Fortune 500 list. In this section, we will consider how the courts have interpreted both the Section 2 prohibition against monopolizing and the Section 7 prohibition against mergers and acquisitions that tend to lessen competition or to create monopolies.
Section 2 of the Sherman Act reads as follows: “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several states, or with foreign nations, shall be deemed guilty of a [felony].”
We begin the analysis of Section 2 with the basic proposition that a monopoly is not per se unlawful. Section 2 itself makes this proposition inescapable: it forbids the act of monopolizing, not the condition or attribute of monopoly. Why should that be so? If monopoly power is detrimental to a functioning competitive market system, why shouldn’t the law ban the very existence of a monopoly?
The answer is that we cannot hope to have “perfect competition” but only “workable competition.” Any number of circumstances might lead to monopolies that we would not want to eliminate. Demand for a product might be limited to what one company could produce, there thus being no incentive for any competitor to come into the market. A small town may be able to support only one supermarket, newspaper, or computer outlet. If a company is operating efficiently through economies of scale, we would not want to split it apart and watch the resulting companies fail. An innovator may have a field all to himself, yet we would not want to penalize the inventor for his very act of invention. Or a company might simply be smarter and more efficient, finally coming to stand alone through the very operation of competitive pressures. It would be an irony indeed if the law were to condemn a company that was forged in the fires of competition itself. As the Supreme Court has said, the Sherman Act was designed to protect competition, not competitors.
A company that has had a monopoly position “thrust upon it” is perfectly lawful. The law penalizes not the monopolist as such but the competitor who gains his monopoly power through illegitimate means with an intent to become a monopolist, or who after having become a monopolist acts illegitimately to maintain his power.
A Section 2 case involves three essential factors:
1. What is the relevant market for determining dominance? The question of relevant market has two aspects: a geographic market dimension and a relevant product market dimension. It makes a considerable difference whether the company is thought to be a competitor in ten states or only one. A large company in one state may appear tiny matched against competitors operating in many states. Likewise, if the product itself has real substitutes, it makes little sense to brand its maker a monopolist. For instance, Coca-Cola is made by only one company, but that does not make the Coca-Cola Company a monopoly, for its soft drink competes with many in the marketplace.
2. How much monopoly power is too much? What share of the market must a company have to be labeled a monopoly? Is a company with 50 percent of the market a monopoly? 75 percent? 90 percent?
3. What constitutes an illegitimate means of gaining or maintaining monopoly power?
These factors are often closely intertwined, especially the first two. This makes it difficult to examine each separately, but to the extent possible, we will address each factor in the order given.
Relevant Markets: Product Market and Geographic Market
Product Market
The monopolist never exercises power in the abstract. When exercised, monopoly power is used to set prices or exclude competition in the market for a particular product or products. Therefore it is essential in any Section 2 case to determine what products to include in the relevant market.
The Supreme Court looks at “cross-elasticity of demand” to determine the relevant market. That is, to what degree can a substitute be found for the product in question if the producer sets the price too high? If consumers stay with the product as its price rises, moving to a substitute only at a very high price, then the product is probably in a market by itself. If consumers shift to another product with slight rises in price, then the product market is “elastic” and must include all such substitutes.
Geographic Market
A company doesn’t have to dominate the world market for a particular product or service in order to be held to be a monopolist. The Sherman Act speaks of “any part” of the trade or commerce. The Supreme Court defines this as the “area of effective competition.” Ordinarily, the smaller the part the government can point to, the greater its chances of prevailing, since a company usually will have greater control over a single marketplace than a regional or national market. Because of this, alleged monopolists will usually argue for a broad geographic market, while the government tries to narrow it by pointing to such factors as transportation costs and the degree to which consumers will shop outside the defined area.
Monopoly Power
After the relevant product and geographic markets are defined, the next question is whether the defendant has sufficient power within them to constitute a monopoly. The usual test is the market share the alleged monopolist enjoys, although no rigid rule or mathematical formula is possible. In United States v. Aluminum Company of America, presented in Section 26.8.3 “Acquiring and Maintaining a Monopoly” of this chapter, Judge Learned Hand said that Alcoa’s 90 percent share of the ingot market was enough to constitute a monopoly but that 64 percent would have been doubtful.United States v. Aluminum Co. of America, 148 F.2d 416 (2d Cir. 1945). In a case against DuPont many years ago, the court looked at a 75 percent market share in cellophane but found that the relevant market (considering the cross-elasticity of demand) was not restricted to cellophane.
Monopolization: Acquiring and Maintaining a Monopoly
Possessing a monopoly is not per se unlawful. Once a company has been found to have monopoly power in a relevant market, the final question is whether it either acquired its monopoly power in an unlawful way or has acted unlawfully to maintain it. This additional element of “deliberateness” does not mean that the government must prove that the defendant intended monopolization, in the sense that what it desired was the complete exclusion of all competitors. It is enough to show that the monopoly would probably result from its actions, for as Judge Hand put it, “No monopolist monopolizes unconscious of what he is doing.”
What constitutes proof of unlawful acquisition or maintenance of a monopoly? In general, proof is made by showing that the defendant’s acts were aimed at or had the probable effect of excluding competitors from the market. Violations of Section 1 or other provisions of the antitrust laws are examples. “Predatory pricing”—charging less than cost—can be evidence that the defendant’s purpose was monopolistic, for small companies cannot compete with large manufacturers capable of sustaining continued losses until the competition folds up and ceases operations.
In United States v. Lorain Journal Company, the town of Lorain, Ohio, could support only one newspaper.United States v. Lorain Journal Company, 342 U.S. 143 (1951). With a circulation of twenty thousand, the Lorain Journal reached more than 99 percent of the town’s families. The Journal had thus lawfully become a monopoly. But when a radio station was set up, the paper found itself competing directly for local and national advertising. To retaliate, the Journal refused to accept advertisements unless the advertiser agreed not to advertise on the local station. The Court agreed that this was an unlawful attempt to boycott and hence was a violation of Section 2 because the paper was using its monopoly power to exclude a competitor. (Where was the interstate commerce that would bring the activity under federal law? The Court said that the radio station was in interstate commerce because it broadcast national news supported by national advertising.)
Practices that help a company acquire or maintain its monopoly position need not be unlawful in themselves. In the Aluminum Company case, Alcoa claimed its monopoly power was the result of superior business skills and techniques. These superior skills led it to constantly build plant capacity and expand output at every opportunity. But Judge Hand thought otherwise, given that for a quarter of a century other producers could not break into the market because Alcoa acted at every turn to make it impossible for them to compete, even as Alcoa increased its output by some 800 percent. Judge Hand’s explanation remains the classic exposition.
Innovation as Evidence of Intent to Monopolize
During the 1970s, several monopolization cases seeking huge damages were filed against a number of well-known companies, including Xerox, International Business Machines (IBM), and Eastman Kodak. In particular, IBM was hit with several suits as an outgrowth of the Justice Department’s lawsuit against the computer maker. (United States v. IBM was filed in 1969 and did not terminate until 1982, when the government agreed to drop all charges, a complete victory for the company.) The plaintiffs in many of these suits—SCM Corporation against Xerox, California Computer Products Incorporated against IBM (the Calcomp case), Berkey Photo Incorporated against Kodak—charged that the defendants had maintained their alleged monopolies by strategically introducing key product innovations that rendered competitive products obsolete. For example, hundreds of computer companies manufacture peripheral equipment “plug-compatible” with IBM computers. Likewise, Berkey manufactured film usable in Kodak cameras. When the underlying products are changed—mainframe computers, new types of cameras—the existing manufacturers are left with unusable inventory and face a considerable time lag in designing new peripheral equipment. In some of these cases, the plaintiffs managed to obtain sizable treble damage awards—SCM won more than \$110 million, IBM initially lost one case in the amount of \$260 million, and Berkey bested Kodak to the tune of \$87 million. Had these cases been sustained on appeal, a radical new doctrine would have been imported into the antitrust laws—that innovation for the sake of competing is unlawful.
None of these cases withstood appellate scrutiny. The Supreme Court has not heard cases in this area, so the law that has emerged is from decisions of the federal courts of appeals. A typical case is ILC Peripherals Leasing Corp. v. International Business Machines (the Memorex case).ILC Peripherals Leasing Corp. v. International Business Machines, 458 F.Supp. 423 (N.D. Cal. 1978). Memorex argued that among other things, IBM’s tactic of introducing a new generation of computer technology at lower prices constituted monopolization. The court disagreed, noting that other companies could “reverse engineer” IBM equipment much more cheaply than IBM could originally design it and that IBM computers and related products were subject to intense competition to the benefit of plug-compatible equipment users. The actions of IBM undoubtedly hurt Memorex, but they were part and parcel of the competitive system, the very essence of competition. “This kind of conduct by IBM,” the court said, “is precisely what the antitrust laws were meant to encourage.…Memorex sought to use the antitrust laws to make time stand still and preserve its very profitable position. This court will not assist it and the others who would follow after in this endeavor.”
The various strands of the innovation debate are perhaps best summed up in Berkey Photo, Inc. v. Eastman Kodak Company, Section 26.8.4 “Innovation and Intent to Monopolize”.
Attempts to Monopolize
Section 2 prohibits not only actual monopolization but also attempts to monopolize. An attempt need not succeed to be unlawful; a defendant who tries to exercise sway over a relevant market can take no legal comfort from failure. In any event, the plaintiff must show a specific intent to monopolize, not merely an intent to commit the act or acts that constitute the attempt.
Remedies
Since many of the defendant’s acts that constitute Sherman Act Section 2 monopolizing are also violations of Section 1 of the Clayton Act, why should plaintiffs resort to Section 2 at all? What practical difference does Section 2 make? One answer is that not every act of monopolizing is a violation of another law. Leasing and pricing practices that are perfectly lawful for an ordinary competitor may be unlawful only because of Section 2. But the more important reason is the remedy provided by the Sherman Act: divestiture. In the right case, the courts may order the company broken up.
In the Standard Oil decision of 1911, the Supreme Court held that the Standard Oil Company constituted a monopoly and ordered it split apart into separate companies. Several other trusts were similarly dealt with. In many of the early cases, doing so posed no insuperable difficulties, because the companies themselves essentially consisted of separate manufacturing plants knit together by financial controls. But not every company is a loose confederation of potentially separate operating companies.
The Alcoa case (Section 26.8.3 “Acquiring and Maintaining a Monopoly”) was fraught with difficult remedial issues. Judge Hand’s opinion came down in 1945, but the remedial side of the case did not come up until 1950. By then the industry had changed radically, with the entrance of Reynolds and Kaiser as effective competitors, reducing Alcoa’s share of the market to 50 percent. Because any aluminum producer needs considerable resources to succeed and because aluminum production is crucial to national security, the later court refused to order the company broken apart. The court ordered Alcoa to take a series of measures that would boost competition in the industry. For example, Alcoa stockholders had to divest themselves of the stock of a closely related Canadian producer in order to remove Alcoa’s control of that company; and the court rendered unenforceable a patent-licensing agreement with Reynolds and Kaiser that required them to share their inventions with Alcoa, even though neither the Canadian tie nor the patent agreements were in themselves unlawful.
Although the trend has been away from breaking up the monopolist, it is still employed as a potent remedy. In perhaps the largest monopolization case ever brought—United States v. American Telephone & Telegraph Company—the government sought divestiture of several of AT&T’s constituent companies, including Western Electric and the various local operating companies. To avoid prolonged litigation, AT&T agreed in 1982 to a consent decree that required it to spin off all its operating companies, companies that had been central to AT&T’s decades-long monopoly.
Key Takeaway
Aggressive competition is good for consumers and for the market, but if the company has enough power to control a market, the benefits to society decrease. Under Section 2 of the Sherman Act, it is illegal to monopolize or attempt to monopolize the market. If the company acquires a monopoly in the wrong way, using wrongful tactics, it is illegal under Section 2. Courts will look at three questions to see if a company has illegally monopolized a market: (1) What is the relevant market? (2) Does the company control the market? and (3) How did the company acquire or maintain its control?
Exercises
1. Mammoth Company, through three subsidiaries, controls 87 percent of the equipment to operate central station hazard-detecting devices; these devices are used to prevent burglary and detect fires and to provide electronic notification to police and fire departments at a central location. In an antitrust lawsuit, Mammoth Company claims that there are other means of protecting against burglary and it therefore does not have monopoly power. Explain how the Justice Department may be able to prove its claim that Mammoth Company is operating an illegal monopoly.
2. Name the sanctions used to enforce Section 2 of the Sherman Act.
3. Look at any news database or the Department of Justice antitrust website for the past three years and describe a case involving a challenge to the exercise of a US company’s monopoly power. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.06%3A_Sherman_Act_Section_2-_Concentrations_of_Market_Power.txt |
Learning Objectives
By the end of this section, you will be able to:
• Distinguish the three kinds of mergers.
• Describe how the courts will define the relevant market in gauging the potential anticompetitive effects of mergers and acquisitions.
Neither Section 1 nor Section 2 of the Sherman Act proved particularly useful in barring mergers between companies or acquisition by one company of another. As originally written, neither did the Clayton Act, which prohibited only mergers accomplished through the sale of stock, not mergers or acquisitions carried out through acquisition of assets. In 1950, Congress amended the Clayton Act to cover the loophole concerning acquisition of assets. It also narrowed the search for relevant market; henceforth, if competition might be lessened in any line of commerce in any section of the country, the merger is unlawful.
As amended, the pertinent part of Section 7 of the Clayton Act reads as follows:
[N]o corporation engaged in commerce shall acquire, directly or indirectly, the whole or any part of the stock or other share capital and no corporation subject to the jurisdiction of the Federal Trade Commission shall acquire the whole or any part of the assets of another corporation engaged also in commerce, where in any line of commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly.
No corporation shall acquire, directly or indirectly, the whole or any part of the stock or other share capital and no corporation subject to the jurisdiction of the Federal Trade Commission shall acquire the whole or any part of the assets of one or more corporations engaged in commerce, where in any line of commerce in any section of the country, the effect of such acquisition, of such stock or assets, or of the use of such stock by the voting or granting of proxies or otherwise, may be substantially to lessen competition, or to tend to create a monopoly.
Definitions
Mergers and Acquisitions
For the sake of brevity, we will refer to both mergers and acquisitions as mergers. Mergers are usually classified into three types: horizontal, vertical, and conglomerate.
Horizontal
A horizontal merger is one between competitors—for example, between two bread manufacturers or two grocery chains competing in the same locale.
Vertical
A vertical merger is that of a supplier and a customer. If the customer acquires the supplier, it is known as backward vertical integration; if the supplier acquires the customer, it is forward vertical integration. For example, a book publisher that buys a paper manufacturer has engaged in backward vertical integration. Its purchase of a bookstore chain would be forward vertical integration.
Conglomerate Mergers
Conglomerate mergers do not have a standard definition but generally are taken to be mergers between companies whose businesses are not directly related. Many commentators have subdivided this category into three types. In a “pure” conglomerate merger, the businesses are not related, as when a steel manufacturer acquires a movie distributor. In a product-extension merger, the manufacturer of one product acquires the manufacturer of a related product—for instance, a producer of household cleansers, but not of liquid bleach, acquires a producer of liquid bleach. In a market-extension merger, a company in one geographic market acquires a company in the same business in a different location. For example, suppose a bakery operating only in San Francisco buys a bakery operating only in Palo Alto. Since they had not competed before the merger, this would not be a horizontal merger.
General Principles
As in monopolization cases, a relevant product market and geographic market must first be marked out to test the effect of the merger. But Section 7 of the Clayton Act has a market definition different from that of Section 2. Section 7 speaks of “any line of commerce in any section of the country” (emphasis added). And its test for the effect of the merger is the same as that which we have already seen for exclusive dealing cases governed by Section 3: Taken together, this language makes it easier to condemn an unlawful merger than an unlawful monopoly. The relevant product market is any line of commerce, and the courts have taken this language to permit the plaintiff to prove the existence of “submarkets” in which the relative effect of the merger is greater. The relevant geographic market is any section of the country, which means that the plaintiff can show the appropriate effect in a city or a particular region and not worry about having to show the effect in a national market. Moreover, as we have seen, the effect is one of probability, not actuality. Thus the question is, Might competition be substantially lessened? rather than, Was competition in fact substantially lessened? Likewise, the question is, Did the merger tend to create a monopoly? rather than, Did the merger in fact create a monopoly?
In United States v. du Pont, the government charged that du Pont’s “commanding position as General Motors’ supplier of automotive finishes and fabrics” was not achieved on competitive merit alone but because du Pont had acquired a sizable block of GM stock, and the “consequent close intercompany relationship led to the insulation of most of the General Motors’ market from free competition,” in violation of Section 7.United States v. du Pont, 353 U.S. 586 (1957). Between 1917 and 1919, du Pont took a 23 percent stock interest in GM. The district court dismissed the complaint, partly on the grounds that at least before the 1950 amendment to Section 7, the Clayton Act did not condemn vertical mergers and partly on the grounds that du Pont had not dominated GM’s decision to purchase millions of dollars’ worth of automotive finishes and fabrics. The Supreme Court disagreed with this analysis and sent the case back to trial. The Court specifically held that even though the stock acquisition had occurred some thirty-five years earlier, the government can resort to Section 7 whenever it appears that the result of the acquisition will violate the competitive tests set forth in the section.
Defining the Market
In the seminal Brown Shoe case, the Supreme Court said that the outer boundaries of broad markets “are determined by the reasonable interchangeability of use or the cross elasticity of demand between the product itself and substitutes for it” but that narrower “well defined submarkets” might also be appropriate lines of commerce.Brown Shoe Co., Inc. v. United States, 370 U.S. 294 (1962). In drawing market boundaries, the Court said, courts should realistically reflect “[c]ompetition where, in fact, it exists.” Among the factors to consider are “industry or public recognition of the submarket as a separate economic entity, the product’s peculiar characteristics and uses, unique production facilities, distinct customers, distinct prices, sensitivity to price changes and specialized vendors.” To select the geographic market, courts must consider both “the commercial realities” of the industry and the economic significance of the market.
The Failing Company Doctrine
One defense to a Section 7 case is that one of the merging companies is a failing company. In Citizen Publishing Company v. United States, the Supreme Court said that the defense is applicable if two conditions are satisfied.Citizen Publishing Company v. United States, 394 U.S. 131 (1969). First, a company must be staring bankruptcy in the face; it must have virtually no chance of being resuscitated without the merger. Second, the acquiring company must be the only available purchaser, and the failing company must have made bona fide efforts to search for another purchaser.
Beneficial Effects
That a merger might produce beneficial effects is not a defense to a Section 7 case. As the Supreme Court said in United States v. Philadelphia National Bank, “[A] merger, the effect of which ‘may be substantially to lessen competition’ is not saved because, on some ultimate reckoning of social or economic debits or credits, it may be deemed beneficial.”United States v. Philadelphia National Bank, 374 U.S. 321, 371 (1963). And in FTC v. Procter & Gamble Co., the Court said, “Possible economies cannot be used as a defense to illegality.”FTC v. Procter & Gamble Co., 386 U.S. 568, 580 (1967). Congress was also aware that some mergers which lessen competition may also result in economies but it struck the balance in favor of protecting competition.
Tests of Competitive Effect
Horizontal Mergers
Three factors are critical in assessing whether a horizontal merger may substantially lessen competition: (1) the market shares of the merging companies, (2) the concentration ratios, and (3) the trends in the industry toward concentration.
The first factor is self-evident. A company with 10 percent or even 5 percent of the market is in a different position from one with less than 1 percent. A concentration ratio indicates the number of firms that constitute an industry. An industry with only four firms is obviously much more concentrated than one with ten or seventy firms. Concentration trends indicate the frequency with which firms in the relevant market have been merging. The first merger in an industry with a low concentration ratio might be predicted to have no likely effect on competition, but a merger of two firms in a four-firm industry would obviously have a pronounced effect.
In the Philadelphia National Bank case, the court announced this test in assessing the legality of a horizontal merger: “[A] merger which produces a firm controlling an undue percentage share of the relevant market, and results in a significant increase in the concentration of firms in that market is so inherently likely to lessen competition substantially that it must be enjoined in the absence of evidence clearly showing that the merger is not likely to have such anticompetitive effects.” In this case, the merger led to a 30 percent share of the commercial banking market in a four-county region around Philadelphia and an increase in concentration by more than one-third, and the court held that those numbers amounted to a violation of Section 7. The court also said that “if concentration is already great, the importance of preventing even slight increases in concentration and so preserving the possibility of eventual de-concentration is correspondingly great.”
The Hart-Scott-Rodino Antitrust Improvements Act of 1976 requires certain companies to notify the Justice Department before actually completing mergers or acquisitions, whether by private negotiation or by public tender offer. When one of the companies has sales or assets of \$100 million or more and the other company \$10 million or more, premerger notification must be provided at least thirty days prior to completion of the deal—or fifteen days in the case of a tender offer of cash for publicly traded shares if the resulting merger would give the acquiring company \$50 million worth or 15 percent of assets or voting securities in the acquired company. The rules are complex, but they are designed to give the department time to react to a merger before it has been secretly accomplished and then announced. The 1976 act gives the department the authority to seek an injunction against the completion of any such merger, which of course greatly simplifies the remedial phase of the case should the courts ultimately hold that the merger would be unlawful. (Note: Section 7 is one of the “tools” in the kit of the lawyer who defends companies against unwelcomed takeover attempts: if the target company can point to lines of its business in which it competes with the acquiring company, it can threaten antitrust action in order to block the merger.)
Vertical Mergers
To prove a Section 7 case involving a vertical merger, the plaintiff must show that the merger forecloses competition “in a substantial share of” a substantial market. But statistical factors alone do not govern in a vertical merger. To illustrate, we see that in Ford Motor Co. v. United States, the merger between Ford and Autolite (a manufacturer of spark plugs) was held unlawful because it eliminated Ford’s potential entry into the market as an independent manufacturer of spark plugs and because it foreclosed Ford “as a purchaser of about ten percent of total industry output” of spark plugs.Ford Motor Co. v. United States, 405 U.S. 562 (1972). This decision underscores the principle that a company may serve to enhance competition simply by waiting in the wings as a potential entrant to a market. If other companies feel threatened by a company the size of Ford undertaking to compete where it had not done so before, the existing manufacturers will likely keep their prices low so as not to tempt the giant in. Of course, had Ford entered the market on its own by independently manufacturing spark plugs, it might ultimately have caused weak competitors to fold. As the Court said, “Had Ford taken the internal-expansion route, there would have been no illegality; not, however, because the result necessarily would have been commendable, but simply because that course has not been proscribed.”
Conglomerate Mergers
Recall the definition of a conglomerate merger given in Section 26.7.1 “Definitions”. None of the three types listed has a direct impact on competition, so the test for illegality is more difficult to state and apply than for horizontal or vertical mergers. But they are nonetheless within the reach of Section 7. In the late 1960s and early 1970s, the government filed a number of divestiture suits against conglomerate mergers. It did not win them all, and none reached the Supreme Court; most were settled by consent decree, leading in several instances to divestiture either of the acquired company or of another division of the acquiring company. Thus International Telephone & Telegraph Company agreed to divest itself of Canteen Corporation and either of the following two groups: (1) Avis, Levin & Sons, and Hamilton Life Insurance Company; or (2) Hartford Fire Insurance Company. Ling-Temco-Vought agreed to divest itself of either Jones & Laughlin Steel or Braniff Airways and Okonite Corporation. In these and other cases, the courts have looked to specific potential effects, such as raising the barriers to entry into a market and eliminating potential competition, but they have rejected the more general claim of “the rising tide of economic concentration in American industry.”
Entrenching Oligopoly
One way to attack conglomerate mergers is to demonstrate that by taking over a dominant company in an oligopolistic industry, a large and strong acquiring company will further entrench the oligopoly. In an oligopolistic industry, just a few major competitors so dominate the industry that competition is quelled. In FTC v. Procter & Gamble Co., the government challenged Procter & Gamble’s (P&G’s) acquisition of Clorox. P&G was the leading seller of household cleansers, with annual sales of more than \$1 billion.FTC v. Procter & Gamble Co., 386 U.S. 568 (1967). In addition, it was the “nation’s largest advertiser,” promoting its products so heavily that it was able to take advantage of substantial advertising discounts from the media. Clorox had more than 48 percent of national sales for liquid bleach in a heavily concentrated industry. Since all liquid bleach is chemically identical, advertising and promotion plays the dominant role in selling the product. Prior to the merger, P&G did not make or sell liquid bleach; hence it was a product-extension merger rather than a horizontal one.
The Supreme Court concluded that smaller firms would fear retaliation from P&G if they tried to compete in the liquid bleach market and that “a new entrant would be much more reluctant to face the giant Procter than it would have been to face the smaller Clorox.” Hence “the substitution of the powerful acquiring firm for the smaller, but already dominant firm may substantially reduce the competitive structure of the industry by raising entry barriers and by dissuading the smaller firms from aggressively competing.” The entrenchment theory probably applies only to highly concentrated industries and dominant firms, however. Many subsequent cases have come out in favor of the defendants on a variety of grounds—that the merger led simply to a more efficient acquired firm, that the existing competitors were strong and able to compete, or even that the acquiring firm merely gives the acquired company a deep pocket to better finance its operations.
Eliminating Potential Competition
This theory holds that but for the merger, the acquiring company might have competed in the acquired company’s market. In Procter & Gamble, for example, P&G might have entered the liquid bleach market itself and thus given Clorox a run for its money. An additional strong company would then have been in the market. When P&G bought Clorox, however, it foreclosed that possibility. This theory depends on proof of some probability that the acquiring company would have entered the market. When the acquired company is small, however, a Section 7 violation is unlikely; these so-called toehold mergers permit the acquiring company to become a competitive force in an industry without necessarily sacrificing any preexisting competition.
Reciprocity
Many companies are both heavy buyers and heavy sellers of products. A company may buy from its customers as well as sell to them. This practice is known in antitrust jargon as reciprocity. Reciprocity is the practice of a seller who uses his volume of purchases from the buyer to induce the buyer to purchase from him. The clearest example arose in FTC v. Consolidated Foods Corp.FTC v. Consolidated Foods Corp., 380 U.S. 592 (1965). Consolidated owned wholesale grocery outlets and retail food stores. It wanted to merge with Gentry, which made dehydrated onions and garlic. The Supreme Court agreed that the merger violated Section 7 because of the possibility of reciprocity: Consolidated made bulk purchases from several food processors, which were purchasers of dehydrated onions and garlic from Gentry and others. Processors who did not buy from Gentry might feel pressured to do so in order to keep Consolidated as a customer for their food supplies. If so, other onion and garlic processors would be foreclosed from competing for sales. A merger that raises the mere possibility of reciprocity is not per se unlawful, however. The plaintiff must demonstrate that it was probable the acquiring company would adopt the practice—for example, by conditioning future orders for supplies on the receipt of orders for onions and garlic—and that doing so would have an anticompetitive effect given the size of the reciprocating companies and their positions in the market.
Joint Ventures
Section 7 can also apply to joint ventures, a rule first announced in 1964. Two companies, Hooker and American Potash, dominated sales of sodium chlorate in the Southeast, with 90 percent of the market. Pennsalt Chemicals Corporation produced the rest in the West and sold it in the Southeast through Olin Mathieson Chemical Corporation. The latter two decided to team up, the better to compete with the giants, and so they formed Penn-Olin, which they jointly owned. The district court dismissed the government’s suit, but the Supreme Court reinstated it, saying that a joint venture can serve to blunt competition, or at least potential competition, between the parent companies. The Court said that the lower court must look to a number of factors to determine whether the joint venture was likely to lessen competition substantially:
The number and power of the competitors in the relevant market; the background of their growth; the power of the joint venturers; the relationship of their lines of commerce; competition existing between them and the power of each in dealing with the competitors of the other; the setting in which the joint venture was created; the reasons and necessities for its existence; the joint venture’s line of commerce and the relationship thereof to that of its parents; the adaptability of its line of commerce to non-competitive practices; the potential power of the joint venture in the relevant market; and appraisal of what the competition in the relevant market would have been if one of the joint venturers had entered it alone instead of through Penn-Olin; the effect, in the event of this occurrence, of the other joint venturer’s potential competition; and such other factors as might indicate potential risk to competition in the relevant market.United States v. Penn-Olin Chemical Co., 378 U.S. 158 (1964).
These numerous factors illustrate how the entire economic environment surrounding the joint venture and mergers in general must be assessed to determine the legalities.
Remedies
The Clayton Act provides that the government may seek divestiture when an acquisition or a merger violates the act. Until relatively recently, however, it was unresolved whether a private plaintiff could seek divestiture after proving a Clayton Act violation. In 1990, the Supreme Court unanimously agreed that divestiture is an available remedy in private suits, even in suits filed by a state’s attorney general on behalf of consumers.California v. American Stores, 58 U.S.L.W. 4529 (1990). This ruling makes it more likely that antimerger litigation will increase in the future.
During the years of the Reagan administration in the 1980s, the federal government became far less active in prosecuting antitrust cases, especially merger cases, than it had been in previous decades. Many giant mergers went unchallenged, like the merger between two oil behemoths, Texaco and Getty, resulting in a company with nearly \$50 billion in assets in 1984. With the arrival of the first Bush administration in 1989, the talk in Washington antitrust circles was of a renewed interest in antitrust enforcement. The arrival of the second Bush administration in 2000 brought about an era of less antitrust enforcement than had been undertaken during the Clinton administration. Whether the Obama administration reinvigorates antitrust enforcement remains to be seen.
Key Takeaway
Section 7 prohibits mergers or acquisitions that might tend to lessen competition in any line of commerce in any section of the country. Mergers and acquisitions are usually classified in one of three ways: horizontal (between competitors), vertical (between different levels of the distribution chain), or conglomerate (between businesses that are not directly related). The latter may be divided into product-extension and market-expansion mergers. The relevant market test is different than in monopolization cases; in a Section 7 action, relevance of market may be proved.
In assessing horizontal mergers, the courts will look to the market shares of emerging companies, industry concentration ratios, and trends toward concentration in the industry. To prove a Section 7 case, the plaintiff must show that the merger forecloses competition “in a substantial share of” a substantial market. Conglomerate merger cases are harder to prove and require a showing of specific potential effects, such as raising barriers to entry into an industry and thus entrenching monopoly, or eliminating potential competition. Joint ventures may also be condemned by Section 7. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 requires certain companies to get premerger notice to the Justice Department.
Exercises
1. Sirius Satellite radio and XM satellite radio proposed to merge. Was this a horizontal merger, a vertical merger, or a conglomerate merger? How is the market defined, in terms of both product or service and geographic area?
2. In 2010, Live Nation and Ticketmaster proposed to merge. Was this a horizontal merger, a vertical merger, or a conglomerate merger? How should the market be defined, in terms of both product or service and geographic area? Should the US government approve the merger? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.07%3A_Acquisitions_and_Mergers_under_Section_7_of_the_Clayton_Act.txt |
Horizontal Restraints of Trade
National Society of Professional Engineers v. United States
435 U.S. 679 (1978)
MR. JUSTICE STEVENS delivered the opinion of the Court.
This is a civil antitrust case brought by the United States to nullify an association’s canon of ethics prohibiting competitive bidding by its members. The question is whether the canon may be justified under the Sherman Act, 15 U.S. c. § 1 et seq. (1976 ed.), because it was adopted by members of a learned profession for the purpose of minimizing the risk that competition would produce inferior engineering work endangering the public safety. The District Court rejected this justification without making any findings on the likelihood that competition would produce the dire consequences foreseen by the association. The Court of Appeals affirmed. We granted certiorari to decide whether the District Court should have considered the factual basis for the proffered justification before rejecting it. Because we are satisfied that the asserted defense rests on a fundamental misunderstanding of the Rule of Reason frequently applied in antitrust litigation, we affirm.
Engineering is an important and learned profession. There are over 750,000 graduate engineers in the United States, of whom about 325,000 are registered as professional engineers. Registration requirements vary from State to State, but usually require the applicant to be a graduate engineer with at least four years of practical experience and to pass a written examination. About half of those who are registered engage in consulting engineering on a fee basis. They perform services in connection with the study, design, and construction of all types of improvements to real property—bridges, office buildings, airports, and factories are examples. Engineering fees, amounting to well over \$2 billion each year, constitute about 5% of total construction costs. In any given facility, approximately 50% to 80% of the cost of construction is the direct result of work performed by an engineer concerning the systems and equipment to be incorporated in the structure.
The National Society of Professional Engineers (Society) was organized in 1935 to deal with the nontechnical aspects of engineering practice, including the promotion of the professional, social, and economic interests of its members. Its present membership of 69,000 resides throughout the United States and in some foreign countries. Approximately 12,000 members are consulting engineers who offer their services to governmental, industrial, and private clients. Some Society members are principals or chief executive officers of some of the largest engineering firms in the country.
The charges of a consulting engineer may be computed in different ways. He may charge the client a percentage of the cost of the project, may charge fixed rates per hour for different types of work, may perform an assignment for a specific sum, or he may combine one or more of these approaches.…This case…involves a charge that the members of the Society have unlawfully agreed to refuse to negotiate or even to discuss the question of fees until after a prospective client has selected the engineer for a particular project. Evidence of this agreement is found in § II(c) of the Society’s Code of Ethics, adopted in July 1964.
The District Court found that the Society’s Board of Ethical Review has uniformly interpreted the “ethical rules against competitive bidding for engineering services as prohibiting the submission of any form of price information to a prospective customer which would enable that customer to make a price comparison on engineering services.” If the client requires that such information be provided, then § II(c) imposes an obligation upon the engineering firm to withdraw from consideration for that job.
[P]etitioner argues that its attempt to preserve the profession’s traditional method of setting fees for engineering services is a reasonable method of forestalling the public harm which might be produced by unrestrained competitive bidding. To evaluate this argument it is necessary to identify the contours of the Rule of Reason and to discuss its application to the kind of justification asserted by petitioner.
* * *
The test prescribed in Standard Oil is whether the challenged contracts or acts “were unreasonably restrictive of competitive conditions.” Unreasonableness under that test could be based either (I) on the nature or character of the contracts, or (2) on surrounding circumstances giving rise to the inference or presumption that they were intended to restrain trade and enhance prices. Under either branch of the test, the inquiry is confined to a consideration of impact on competitive conditions.
* * *
Price is the “central nervous system of the economy,” United States v. Socony-Vacuum Oil Co., 310 U.S. 150, 226 n. 59, and an agreement that “interfere[s] with the setting of price by free market forces” is illegal on its face, United States v. Container Corp., 393 U.S. 333,337. In this case we are presented with an agreement among competitors to refuse to discuss prices with potential customers until after negotiations have resulted in the initial selection of an engineer. While this is not price fixing as such, no elaborate industry analysis is required to demonstrate the anticompetitive character of such an agreement. It operates as an absolute ban on competitive bidding, applying with equal force to both complicated and simple projects and to both inexperienced and sophisticated customers. As the District Court found, the ban “impedes the ordinary give and take of the market place,” and substantially deprives the customer of “the ability to utilize and compare prices in selecting engineering services.” On its face, this agreement restrains trade within the meaning of § 1 of the Sherman Act.
The Society’s affirmative defense confirms rather than refutes the anticompetitive purpose and effect of its agreement. The Society argues that the restraint is justified because bidding on engineering services is inherently imprecise, would lead to deceptively low bids, and would thereby tempt individual engineers to do inferior work with consequent risk to public safety and health. The logic of this argument rests on the assumption that the agreement will tend to maintain the price level; if it had no such effect, it would not serve its intended purpose. The Society nonetheless invokes the Rule of Reason, arguing that its restraint on price competition ultimately inures to the public benefit by preventing the production of inferior work and by insuring ethical behavior. As the preceding discussion of the Rule of Reason reveals, this Court has never accepted such an argument.
It may be, as petitioner argues, that competition tends to force prices down and that an inexpensive item may be inferior to one that is more costly. There is some risk, therefore, that competition will cause some suppliers to market a defective product. Similarly, competitive bidding for engineering projects may be inherently imprecise and incapable of taking into account all the variables which will be involved in the actual performance of the project. Based on these considerations, a purchaser might conclude that his interest in quality—which may embrace the safety of the end product—outweighs the advantages of achieving cost savings by pitting one competitor against another. Or an individual vendor might independently refrain from price negotiation until he has satisfied himself that he fully understands the scope of his customers’ needs. These decisions might be reasonable; indeed, petitioner has provided ample documentation for that thesis. But these are not reasons that satisfy the Rule; nor are such individual decisions subject to antitrust attack.
The Sherman Act does not require competitive bidding; it prohibits unreasonable restraints on competition. Petitioner’s ban on competitive bidding prevents all customers from making price comparisons in the initial selection of an engineer, and imposes the Society’s views of the costs and benefits of competition on the entire marketplace. It is this restraint that must be justified under the Rule of Reason, and petitioner’s attempt to do so on the basis of the potential threat that competition poses to the public safety and the ethics of its profession is nothing less than a frontal assault on the basic policy of the Sherman Act.
The Sherman Act reflects a legislative judgment that ultimately competition will produce not only lower prices, but also better goods and services. “The heart of our national economic policy long has been faith in the value of competition.” Standard Oil Co. v. FTC, 340 U.S. 231, 248. The assumption that competition is the best method of allocating resources in a free market recognizes that all elements of a bargain—quality, service, safety, and durability—and not just the immediate cost, are favorably affected by the free opportunity to select among alternative offers. Even assuming occasional exceptions to the presumed consequences of competition, the statutory policy precludes inquiry into the question whether competition is good or bad.
* * *
In sum, the Rule of Reason does not support a defense based on the assumption that competition itself is unreasonable. Such a view of the Rule would create the “sea of doubt” on which Judge Taft refused to embark in Addyston, 85 F. 271 (1898), at 284, and which this Court has firmly avoided ever since.
* * *
The judgment of the Court of Appeals is affirmed.
Case Questions
1. What kinds of harms are likely if there is unrestrained competitive bidding among engineering firms?
2. By what other means (i.e., not including deliberate nondisclosure of price information up to the time of contracting) could the National Society of Professional Engineers protect the public from harm?
More Horizontal Restraints of Trade
State Oil Company v. Barkat U Khan and Khan & Associates
522 U.S. 3 (1997)
Barkat U. Khan and his corporation entered into an agreement with State Oil Company to lease and operate a gas station and convenience store owned by State Oil. The agreement provided that Khan would obtain the station’s gasoline supply from State Oil at a price equal to a suggested retail price set by State Oil, less a margin of 3.25 cents per gallon. Under the agreement, respondents could charge any amount for gasoline sold to the station’s customers, but if the price charged was higher than State Oil’s suggested retail price, the excess was to be rebated to State Oil. Respondents could sell gasoline for less than State Oil’s suggested retail price, but any such decrease would reduce their 3.25 cents-per-gallon margin.
About a year after respondents began operating the gas station, they fell behind in lease payments. State Oil then gave notice of its intent to terminate the agreement and commenced a state court proceeding to evict respondents. At State Oil’s request, the state court appointed a receiver to operate the gas station. The receiver operated the station for several months without being subject to the price restraints in respondents’ agreement with State Oil. According to respondents, the receiver obtained an overall profit margin in excess of 3.25 cents per gallon by lowering the price of regular-grade gasoline and raising the price of premium grades.
Respondents sued State Oil in the United States District Court for the Northern District of Illinois, alleging in part that State Oil had engaged in price fixing in violation of § 1 of the Sherman Act by preventing respondents from raising or lowering retail gas prices. According to the complaint, but for the agreement with State Oil, respondents could have charged different prices based on the grades of gasoline, in the same way that the receiver had, thereby achieving increased sales and profits. State Oil responded that the agreement did not actually prevent respondents from setting gasoline prices, and that, in substance, respondents did not allege a violation of antitrust laws by their claim that State Oil’s suggested retail price was not optimal.
The District Court entered summary judgment for State Oil on this claim, [finding] that [Khan’s allegations, if true]…did not establish the sort of “manifestly anticompetitive implications or pernicious effect on competition” that would justify per se prohibition of State Oil’s conduct. The Seventh Circuit reversed. The Court of Appeals for the Seventh Circuit reversed the District Court’s grant of summary judgment for State Oil on the basis of Albrecht v. Herald Co., 390 U.S. 14 (1968). 93 F.3d 1358 (1996). The court first noted that the agreement between respondents and State Oil did indeed fix maximum gasoline prices by making it “worthless” for respondents to exceed the suggested retail prices. After reviewing legal and economic aspects of price fixing, the court concluded that State Oil’s pricing scheme was a per se antitrust violation under Albrecht v. Herald Co., supra. Although the Court of Appeals characterized Albrecht as “unsound when decided” and “inconsistent with later decisions” of this Court, it felt constrained to follow that decision. The Supreme Court granted certiorari.
Justice Sandra Day O’Connor
We granted certiorari to consider two questions, whether State Oil’s conduct constitutes a per se violation of the Sherman Act and whether respondents are entitled to recover damages based on that conduct.
* * * *
Although the Sherman Act, by its terms, prohibits every agreement “in restraint of trade,” this Court has long recognized that Congress intended to outlaw only unreasonable restraints. See, e.g., Arizona v. Maricopa County Medical Soc., U.S. Supreme Court (1982). As a consequence, most antitrust claims are analyzed under a “rule of reason,” according to which the finder of fact must decide whether the questioned practice imposes an unreasonable restraint on competition, taking into account a variety of factors, including specific information about the relevant business, its condition before and after the restraint was imposed, and the restraint’s history, nature, and effect.
Some types of restraints, however, have such predictable and pernicious anticompetitive effect, and such limited potential for pro-competitive benefit, that they are deemed unlawful per se. Northern Pacific R. Co. v. United States, U.S. Supreme Court (1958). Per se treatment is appropriate “once experience with a particular kind of restraint enables the Court to predict with confidence that the rule of reason will condemn it.” Maricopa County (1982). Thus, we have expressed reluctance to adopt per se rules with regard to “restraints imposed in the context of business relationships where the economic impact of certain practices is not immediately obvious.” FTC v. Indiana Federation of Dentists, U.S. Supreme Court (1986).
A review of this Court’s decisions leading up to and beyond Albrecht is relevant to our assessment of the continuing validity of the per se rule established in Albrecht. Beginning with Dr. Miles Medical Co. v. John D. Park & Sons Co., U.S. Supreme Court (1911), the Court recognized the illegality of agreements under which manufacturers or suppliers set the minimum resale prices to be charged by their distributors. By 1940, the Court broadly declared all business combinations “formed for the purpose and with the effect of raising, depressing, fixing, pegging, or stabilizing the price of a commodity in interstate or foreign commerce” illegal per se. United States v. Socony-Vacuum Oil Co., U.S. Supreme Court (1940). Accordingly, the Court condemned an agreement between two affiliated liquor distillers to limit the maximum price charged by retailers in Kiefer-Stewart Co. v. Joseph E. Seagram & Sons, Inc., U.S. Supreme Court (1951), noting that agreements to fix maximum prices, “no less than those to fix minimum prices, cripple the freedom of traders and thereby restrain their ability to sell in accordance with their own judgment.”
In subsequent cases, the Court’s attention turned to arrangements through which suppliers imposed restrictions on dealers with respect to matters other than resale price. In White Motor Co. v. United States, U.S. Supreme Court (1963), the Court considered the validity of a manufacturer’s assignment of exclusive territories to its distributors and dealers. The Court determined that too little was known about the competitive impact of such vertical limitations to warrant treating them as per se unlawful. Four years later, in United States v. Arnold, Schwinn & Co., U.S. Supreme Court (1967), the Court reconsidered the status of exclusive dealer territories and held that, upon the transfer of title to goods to a distributor, a supplier’s imposition of territorial restrictions on the distributor was “so obviously destructive of competition” as to constitute a per se violation of the Sherman Act. In Schwinn, the Court acknowledged that some vertical restrictions, such as the conferral of territorial rights or franchises, could have pro-competitive benefits by allowing smaller enterprises to compete, and that such restrictions might avert vertical integration in the distribution process. The Court drew the line, however, at permitting manufacturers to control product marketing once dominion over the goods had passed to dealers.
Albrecht, decided [a year after Schwinn], involved a newspaper publisher who had granted exclusive territories to independent carriers subject to their adherence to a maximum price on resale of the newspapers to the public. Influenced by its decisions in Socony-Vacuum, Kiefer-Stewart, and Schwinn, the Court concluded that it was per se unlawful for the publisher to fix the maximum resale price of its newspapers. The Court acknowledged that “maximum and minimum price fixing may have different consequences in many situations,” but nonetheless condemned maximum price fixing for “substituting the perhaps erroneous judgment of a seller for the forces of the competitive market.”
Nine years later, in Continental T. V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36, 53 L. Ed. 2d 568, 97 S. Ct. 2549 (1977), the Court overruled Schwinn, thereby rejecting application of a per se rule in the context of vertical nonprice restrictions. The Court acknowledged the principle of stare decisis, but explained that the need for clarification in the law justified reconsideration of Schwinn:
“Since its announcement, Schwinn has been the subject of continuing controversy and confusion, both in the scholarly journals and in the federal courts. The great weight of scholarly opinion has been critical of the decision, and a number of the federal courts confronted with analogous vertical restrictions have sought to limit its reach. In our view, the experience of the past 10 years should be brought to bear on this subject of considerable commercial importance.”
The Court then reviewed scholarly works supporting the economic utility of vertical nonprice restraints.…The Court concluded that, because “departure from the rule-of-reason standard must be based upon demonstrable economic effect rather than—as in Schwinn—upon formalistic line drawing,” the appropriate course would be “to return to the rule of reason that governed vertical restrictions prior to Schwinn.” Sylvania (1977)
* * *
Subsequent decisions of the Court…have hinted that the analytical underpinnings of Albrecht were substantially weakened by Sylvania. We noted in Maricopa County that vertical restraints are generally more defensible than horizontal restraints…and that decisions such as Sylvania “recognize the possibility that a vertical restraint imposed by a single manufacturer or wholesaler may stimulate interbrand competition even as it reduces intrabrand competition.”
[I]n Atlantic Richfield Co. v. USA Petroleum Co. (ARCO), U.S. Supreme Court (1990), although Albrecht’s continuing validity was not squarely before the Court, some disfavor with that decision was signaled by our statement that we would “assume, arguendo, that Albrecht correctly held that vertical, maximum price fixing is subject to the per se rule.” More significantly, we specifically acknowledged that vertical maximum price fixing “may have procompetitive interbrand effects,” and pointed out that, in the wake of GTE Sylvania, “the procompetitive potential of a vertical maximum price restraint is more evident…than it was when Albrecht was decided, because exclusive territorial arrangements and other nonprice restrictions were unlawful per se in 1968.”
Thus, our reconsideration of Albrecht’s continuing validity is informed by several of our decisions, as well as a considerable body of scholarship discussing the effects of vertical restraints. Our analysis is also guided by our general view that the primary purpose of the antitrust laws is to protect interbrand competition. See, e.g., Business Electronics Corp. v. Sharp Electronics Corp., 485 U.S. 717, 726, 99 L. Ed. 2d 808, 108 S. Ct. 1515 (1988). “Low prices,” we have explained, “benefit consumers regardless of how those prices are set, and so long as they are above predatory levels, they do not threaten competition.” ARCO, supra, at 340. Our interpretation of the Sherman Act also incorporates the notion that condemnation of practices resulting in lower prices to consumers is “especially costly” because “cutting prices in order to increase business often is the very essence of competition.”
So informed, we find it difficult to maintain that vertically-imposed maximum prices could harm consumers or competition to the extent necessary to justify their per se invalidation. As Chief Judge Posner wrote for the Court of Appeals in this case:
As for maximum resale price fixing, unless the supplier is a monopsonist he cannot squeeze his dealers’ margins below a competitive level; the attempt to do so would just drive the dealers into the arms of a competing supplier. A supplier might, however, fix a maximum resale price in order to prevent his dealers from exploiting a monopoly position.…Suppose that State Oil, perhaps to encourage…dealer services…has spaced its dealers sufficiently far apart to limit competition among them (or even given each of them an exclusive territory); and suppose further that Union 76 is a sufficiently distinctive and popular brand to give the dealers in it at least a modicum of monopoly power. Then State Oil might want to place a ceiling on the dealers’ resale prices in order to prevent them from exploiting that monopoly power fully. It would do this not out of disinterested malice, but in its commercial self-interest. The higher the price at which gasoline is resold, the smaller the volume sold, and so the lower the profit to the supplier if the higher profit per gallon at the higher price is being snared by the dealer.” 93 F.3d at 1362.
We recognize that the Albrecht decision presented a number of theoretical justifications for a per se rule against vertical maximum price fixing. But criticism of those premises abounds. The Albrecht decision was grounded in the fear that maximum price fixing by suppliers could interfere with dealer freedom. 390 U.S. at 152. In response, as one commentator has pointed out, “the ban on maximum resale price limitations declared in Albrecht in the name of ‘dealer freedom’ has actually prompted many suppliers to integrate forward into distribution, thus eliminating the very independent trader for whom Albrecht professed solicitude.” 7 P. Areeda, Antitrust Law, P1635, p. 395 (1989). For example, integration in the newspaper industry since Albrecht has given rise to litigation between independent distributors and publishers.
The Albrecht Court also expressed the concern that maximum prices may be set too low for dealers to offer consumers essential or desired services. 390 U.S. at 152-153. But such conduct, by driving away customers, would seem likely to harm manufacturers as well as dealers and consumers, making it unlikely that a supplier would set such a price as a matter of business judgment.…In addition, Albrecht noted that vertical maximum price fixing could effectively channel distribution through large or specially-advantaged dealers. 390 U.S. at 153. It is unclear, however, that a supplier would profit from limiting its market by excluding potential dealers. See, e.g., Easterbrook, supra, at 905-908. Further, although vertical maximum price fixing might limit the viability of inefficient dealers, that consequence is not necessarily harmful to competition and consumers.
Finally, Albrecht reflected the Court’s fear that maximum price fixing could be used to disguise arrangements to fix minimum prices, 390 U.S. at 153, which remain illegal per se. Although we have acknowledged the possibility that maximum pricing might mask minimum pricing, see Maricopa County, 457 U.S. at 348, we believe that such conduct—as with the other concerns articulated in Albrecht—can be appropriately recognized and punished under the rule of reason.…After reconsidering Albrecht’s rationale and the substantial criticism the decision has received, however, we conclude that there is insufficient economic justification for per se invalidation of vertical maximum price fixing.
* * *
Despite what Chief Judge Posner aptly described as Albrecht’s “infirmities, [and] its increasingly wobbly, moth-eaten foundations,” there remains the question whether Albrecht deserves continuing respect under the doctrine of stare decisis. The Court of Appeals was correct in applying that principle despite disagreement with Albrecht, for it is this Court’s prerogative alone to overrule one of its precedents.…We approach the reconsideration of decisions of this Court with the utmost caution. Stare decisis reflects “a policy judgment that ‘in most matters it is more important that the applicable rule of law be settled than that it be settled right.’” Agostini v. Felton, U.S. Supreme Court (1997).
But “stare decisis is not an inexorable command.” Payne v. Tennessee, U.S. Supreme Court (1991). In the area of antitrust law, there is a competing interest, well-represented in this Court’s decisions, in recognizing and adapting to changed circumstances and the lessons of accumulated experience.
…With the views underlying Albrecht eroded by this Court’s precedent, there is not much of that decision to salvage.…[W]e find its conceptual foundations gravely weakened. In overruling Albrecht, we of course do not hold that all vertical maximum price fixing is per se lawful. Instead, vertical maximum price fixing, like the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the rule of reason.
Case Questions
1. What does Judge Posner of the Seventh Circuit mean when he uses the term monopsonist? Is he referring to the respondent (Khan and Associates) or to the State Oil Company?
2. Explain why State Oil Company would want to set a maximum price. What business benefit is it for State Oil Company?
3. The court clearly states that setting maximum price is no longer a per se violation of the Sherman Act and is thus a rule of reason analysis in each case. What about setting minimum prices? Is setting minimum prices per se illegal, illegal if it does not pass the rule of reason standard, or entirely legal?
Acquiring and Maintaining a Monopoly
United States v. Aluminum Company of America
148 F.2d 416 (2d Cir. 1945)
JUDGE LEARNED HAND
It does not follow because “Alcoa” had such a monopoly that it “monopolized” the ingot market: it may not have achieved monopoly; monopoly may have been thrust upon it. If it had been a combination of existing smelters which united the whole industry and controlled the production of all aluminum ingot, it would certainly have “monopolized” the market.…We may start therefore with the premise that to have combined ninety percent of the producers of ingot would have been to “monopolize” the ingot market; and, so far as concerns the public interest, it can make no difference whether an existing competition is put an end to, or whether prospective competition is prevented.…
Nevertheless, it is unquestionably true that from the very outset the courts have at least kept in reserve the possibility that the origin of a monopoly may be critical in determining its legality; and for this they had warrant in some of the congressional debates which accompanied the passage of the Act.…This notion has usua1ly been expressed by saying that size does not determine guilt; that there must be some “exclusion” of competitors; that the growth must be something else than “natural” or “normal”; that there must be a “wrongful intent,” or some other specific intent; or that some “unduly” coercive means must be used. At times there has been emphasis upon the use of the active verb, “monopolize,” as the judge noted in the case at bar.
A market may, for example, be so limited that it is impossible to produce at all and meet the cost of production except by a plant large enough to supply the whole demand. Or there may be changes in taste or in cost which drive out all but one purveyor. A single producer may be the survivor out of a group of active competitors, merely by virtue of his superior skill, foresight, and industry. In such cases a strong argument can be made that, although the result may expose the public to the evils of monopoly, the Act does not mean to condemn the resultant of those very forces which it is its prime object to foster: finis opus coronal. The successful competitor, having been urged to compete, must not be turned upon when he wins.
* * *
[As] Cardozo, J., in United States v. Swift & Co., 286 U.S. 106, p. 116, 52 S. Ct. 460, 463, 76 L.Ed. 999,…said, “Mere size…is not an offense against the Sherman Act unless magnified to the point at which it amounts to a monopoly…but size carries with it an opportunity for abuse that is not to be ignored when the opportunity is proved to have been utilized in the past.” “Alcoa’s” size was “magnified” to make it a “monopoly”; indeed, it has never been anything else; and its size not only offered it an “opportunity for abuse,” but it “utilized” its size for “abuse,” as can easily be shown.
It would completely misconstrue “Alcoa’s” position in 1940 to hold that it was the passive beneficiary of a monopoly, following upon an involuntary elimination of competitors by automatically operative economic forces. Already in 1909, when its last lawful monopoly ended, it sought to strengthen its position by unlawful practices, and these concededly continued until 1912. In that year it had two plants in New York, at which it produced less than 42 million pounds of ingot; in 1934 it had five plants (the original two, enlarged; one in Tennessee; one in North Carolina; one in Washington), and its production had risen to about 327 million pounds, an increase of almost eight-fold. Meanwhile not a pound of ingot had been produced by anyone else in the United States. This increase and this continued and undisturbed control did not fall undesigned into “Alcoa’s” lap; obviously it could not have done so. It could only have resulted, as it did result, from a persistent determination to maintain the control, with which it found itself vested in 1912. There were at least one or two abortive attempts to enter the industry, but “Alcoa” effectively anticipated and forestalled all competition, and succeeded in holding the field alone. True, it stimulated demand and opened new uses for the metal, but not without making sure that it could supply what it had evoked. There is no dispute as to this; “Alcoa” avows it as evidence of the skill, energy and initiative with which it has always conducted its business: as a reason why, having won its way by fair means, it should be commended, and not dismembered. We need charge it with no moral derelictions after 1912; we may assume that all its claims for itself are true. The only question is whether it falls within the exception established in favor of those who do not seek, but cannot avoid, the control of a market. It seems to us that that question scarcely survives its statement. It was not inevitable that it should always anticipate increases in the demand for ingot and be prepared to supply them. Nothing compelled it to keep doubling and redoubling its capacity before others entered the field. It insists that it never excluded competitors; but we can think of no more effective exclusion than progressively to embrace each new opportunity as it opened, and to face every newcomer with new capacity already geared into a great organization, having the advantage of experience, trade connections and the elite of personnel. Only in case we interpret “exclusion” as limited to maneuvers not honestly industrial, but actuated solely by a desire to prevent competition, can such a course, indefatigably pursued, be deemed not “exclusionary.” So to limit it would in our judgment emasculate the Act; would permit just such consolidations as it was designed to prevent.
We disregard any question of “intent.” Relatively early in the history of the Act—1905—Holmes, J., in Swift & Co. v. United States, explained this aspect of the Act in a passage often quoted. Although the primary evil was monopoly, the Act also covered preliminary steps, which, if continued, would lead to it. These may do no harm of themselves; but if they are initial moves in a plan or scheme which, carried out, will result in monopoly, they are dangerous and the law will nip them in the bud.…In order to fall within § 2, the monopolist must have both the power to monopolize, and the intent to monopolize. To read the passage as demanding any “specific,” intent, makes nonsense of it, for no monopolist monopolizes unconscious of what he is doing. So here, “Alcoa” meant to keep, and did keep, that complete and exclusive hold upon the ingot market with which it started. That was to “monopolize” that market, however innocently it otherwise proceeded. So far as the judgment held that it was not within § 2, it must be reversed.
Case Questions
1. Judge Learned Hand claims there would be no violation of the Sherman Act in any case where a company achieves monopoly through “natural” or “normal” operation of the market.
1. What language in the Sherman Act requires the plaintiff to show something more than a company’s monopoly status?
2. What specifics, if any, does Judge Hand provide that indicate that Alcoa not only had market dominance but sought to increase its dominance and to exclude competition?
2. Can you think of a single producer in a given product or geographic market that has achieved that status because of “peer skill, foresight, and industry”? Is there anything wrong with Alcoa’s selling the concept of aluminum products to an ever-increasing set of customers and then also ensuring that it had the capacity to meet the increasing demand?
3. To stimulate interbrand competition, would you recommend that Congress change Section 2 so that any company that had over 80 percent of market share would be “broken up” to ensure competition? Why is this a bad idea? Or why do you think it is a good idea?
Innovation and Intent to Monopolize
Berkey Photo, Inc. v. Eastman Kodak Company
603 F.2d 263 (2d Cir. 1979)
IRVING R. KAUFMAN, CHIEF JUDGE
To millions of Americans, the name Kodak is virtually synonymous with photography.…It is one of the giants of American enterprise, with international sales of nearly \$6 billion in 1977 and pre-tax profits in excess of \$1.2 billion.
This action, one of the largest and most significant private antitrust suits in history, was brought by Berkey Photo, Inc., a far smaller but still prominent participant in the industry. Berkey competes with Kodak in providing photofinishing services—the conversion of exposed film into finished prints, slides, or movies. Until 1978, Berkey sold cameras as well. It does not manufacture film, but it does purchase Kodak film for resale to its customers, and it also buys photofinishing equipment and supplies, including color print paper, from Kodak.
The two firms thus stand in a complex, multifaceted relationship, for Kodak has been Berkey’s competitor in some markets and its supplier in others. In this action, Berkey claims that every aspect of the association has been infected by Kodak’s monopoly power in the film, color print paper, and camera markets, willfully acquired, maintained, and exercised in violation of § 2 of the Sherman Act, 15 U.S.C. § 2.…Berkey alleges that these violations caused it to lose sales in the camera and photofinishing markets and to pay excessive prices to Kodak for film, color print paper, and photofinishing equipment.
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[T]he jury found for Berkey on virtually every point, awarding damages totalling \$37,620,130. Judge Frankel upheld verdicts aggregating \$27,154,700 for lost camera and photofinishing sales and for excessive prices on film and photofinishing equipment.…Trebled and supplemented by attorneys’ fees and costs pursuant to § 4 of the Clayton Act, 15 U.S.C. § 15, Berkey’s judgment reached a grand total of \$87,091,309.47, with interest, of course, continuing to accrue.
Kodak now appeals this judgment.
The principal markets relevant here, each nationwide in scope, are amateur conventional still cameras, conventional photographic film, photofinishing services, photofinishing equipment, and color print paper.
The “amateur conventional still camera” market now consists almost entirely of the so-called 110 and 126 instant-loading cameras. These are the direct descendants of the popular “box” cameras, the best-known of which was Kodak’s so-called “Brownie.” Small, simple, and relatively inexpensive, cameras of this type are designed for the mass market rather than for the serious photographer.
Kodak has long been the dominant firm in the market thus defined. Between 1954 and 1973 it never enjoyed less than 61% of the annual unit sales, nor less than 64% of the dollar volume, and in the peak year of 1964, Kodak cameras accounted for 90% of market revenues. Much of this success is no doubt due to the firm’s history of innovation.
Berkey has been a camera manufacturer since its 1966 acquisition of the Keystone Camera Company, a producer of movie cameras and equipment. In 1968 Berkey began to sell amateur still cameras made by other firms, and the following year the Keystone Division commenced manufacturing such cameras itself. From 1970 to 1977, Berkey accounted for 8.2% of the sales in the camera market in the United States, reaching a peak of 10.2% in 1976. In 1978, Berkey sold its camera division and thus abandoned this market.
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One must comprehend the fundamental tension—one might almost say the paradox—that is near the heart of § 2.…
The conundrum was indicated in characteristically striking prose by Judge Hand, who was not able to resolve it. Having stated that Congress “did not condone ‘good trusts’ and condemn ‘bad’ ones; it forbad all,” he declared with equal force, “The successful competitor, having been urged to compete, must not be turned upon when he wins.”…We must always be mindful lest the Sherman Act be invoked perversely in favor of those who seek protection against the rigors of competition.
* * *
In sum, although the principles announced by the § 2 cases often appear to conflict, this much is clear. The mere possession of monopoly power does not ipso facto condemn a market participant. But, to avoid the proscriptions of § 2, the firm must refrain at all times from conduct directed at smothering competition. This doctrine has two branches. Unlawfully acquired power remains anathema even when kept dormant. And it is no less true that a firm with a legitimately achieved monopoly may not wield the resulting power to tighten its hold on the market.
* * *
As Kodak had hoped, the 110 system proved to be a dramatic success. In 1972—the system’s first year—the company sold 2,984,000 Pocket Instamatics, more than 50% of its sales in the amateur conventional still camera market. The new camera thus accounted in large part for a sharp increase in total market sales, from 6.2 million units in 1971 to 8.2 million in 1972.…
Berkey’s Keystone division was a late entrant in the 110 sweepstakes, joining the competition only in late 1973. Moreover, because of hasty design, the original models suffered from latent defects, and sales that year were a paltry 42,000. With interest in the 126 dwindling, Keystone thus suffered a net decline of 118,000 unit sales in 1973. The following year, however, it recovered strongly, in large part because improvements in its pocket cameras helped it sell 406,000 units, 7% of all 110s sold that year.
Berkey contends that the introduction of the 110 system was both an attempt to monopolize and actual monopolization of the camera market.
* * *
It will be useful at the outset to present the arguments on which Berkey asks us to uphold its verdict: Kodak, a film and camera monopolist, was in a position to set industry standards. Rivals could not compete effectively without offering products similar to Kodak’s. Moreover, Kodak persistently refused to make film available for most formats other than those in which it made cameras. Since cameras are worthless without film, this policy effectively prevented other manufacturers from introducing cameras in new formats. Because of its dominant position astride two markets, and by use of its film monopoly to distort the camera market, Kodak forfeited its own right to reap profits from such innovations without providing its rivals with sufficient advance information to enable them to enter the market with copies of the new product on the day of Kodak’s introduction. This is one of several “predisclosure” arguments Berkey has advanced in the course of this litigation.
* * *
Through the 1960s, Kodak followed a checkered pattern of predisclosing innovations to various segments of the industry. Its purpose on these occasions evidently was to ensure that the industry would be able to meet consumers’ demand for the complementary goods and services they would need to enjoy the new Kodak products. But predisclosure would quite obviously also diminish Kodak’s share of the auxiliary markets. It was therefore, in the words of Walter Fallon, Kodak’s chief executive officer, “a matter of judgment on each and every occasion” whether predisclosure would be for or against Kodak’s self-interest. Kodak decided not to release advance information about the new film and format. The decision was evidently based on the perception of Dr. Louis K. Eilers, Kodak’s chief executive officer at that time, that Kodak would gain more from being first on the market for the sale of all goods and services related to the 110 system than it would lose from the inability of other photofinishers to process Kodacolor II.
Judge Frankel did not decide that Kodak should have disclosed the details of the 110 to other camera manufacturers prior to introduction. Instead, he left the matter to the jury.…We hold that this instruction was in error and that, as a matter of law, Kodak did not have a duty to predisclose information about the 110 system to competing camera manufacturers.
As Judge Frankel indicated, and as Berkey concedes, a firm may normally keep its innovations secret from its rivals as long as it wishes, forcing them to catch up on the strength of their own efforts after the new product is introduced. It is the possibility of success in the marketplace, attributable to superior performance, that provides the incentives on which the proper functioning of our competitive economy rests.…
Withholding from others advance knowledge of one’s new products, therefore, ordinarily constitutes valid competitive conduct. Because, as we have already indicated, a monopolist is permitted, and indeed encouraged, by § 2 to compete aggressively on the merits, any success that it may achieve through “the process of invention and innovation” is clearly tolerated by the antitrust laws.
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Moreover, enforced predisclosure would cause undesirable consequences beyond merely encouraging the sluggishness the Sherman Act was designed to prevent. A significant vice of the theory propounded by Berkey lies in the uncertainty of its application. Berkey does not contend, in the colorful phrase of Judge Frankel, that “Kodak has to live in a goldfish bowl,” disclosing every innovation to the world at large. However predictable in its application, such an extreme rule would be insupportable. Rather, Berkey postulates that Kodak had a duty to disclose limited types of information to certain competitors under specific circumstances. But it is difficult to comprehend how a major corporation, accustomed though it is to making business decisions with antitrust considerations in mind, could possess the omniscience to anticipate all the instances in which a jury might one day in the future retrospectively conclude that predisclosure was warranted. And it is equally difficult to discern workable guidelines that a court might set forth to aid the firm’s decision. For example, how detailed must the information conveyed be? And how far must research have progressed before it is “ripe” for disclosure? These inherent uncertainties would have an inevitable chilling effect on innovation. They go far, we believe, towards explaining why no court has ever imposed the duty Berkey seeks to create here.
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We do not perceive, however, how Kodak’s introduction of a new format was rendered an unlawful act of monopolization in the camera market because the firm also manufactured film to fit the cameras. “The 110 system was in substantial part a camera development.…”
Clearly, then, the policy considerations militating against predisclosure requirements for monolithic monopolists are equally applicable here. The first firm, even a monopolist, to design a new camera format has a right to the lead time that follows from its success. The mere fact that Kodak manufactured film in the new format as well, so that its customers would not be offered worthless cameras, could not deprive it of that reward.
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Conclusion
We have held that Kodak did not have an obligation, merely because it introduced film and camera in a new format, to make any predisclosure to its camera-making competitors. Nor did the earlier use of its film monopoly to foreclose format innovation by those competitors create of its own force such a duty where none had existed before. In awarding Berkey \$15,250,000, just \$828,000 short of the maximum amount demanded, the jury clearly based its calculation of lost camera profits on Berkey’s central argument that it had a right to be “at the starting line when the whistle blew” for the new system. The verdict, therefore, cannot stand.
Case Questions
1. Consider patent law. Did Kodak have a legal monopoly on the 110 system (having invented it) for seventeen years? Did it have any legal obligation to share the technology with others?
2. Might it have been better business strategy to give predisclosure to Berkey and others about the necessary changes in film that would come about with the introduction of the 110 camera? How so, or why not? Is there any way that some sort of predisclosure to Berkey and others would maintain or sustain good relations with competitors? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.08%3A_Cases.txt |
Summary
Four basic antitrust laws regulate the competitive activities of US business: the Sherman Act, the Clayton Act, the Federal Trade Commission Act, and the Robinson-Patman Act. The Sherman Act prohibits restraints of trade and monopolizing. The Clayton Act prohibits a variety of anticompetitive acts, including mergers and acquisitions that might tend to lessen competition. The Federal Trade Commission Act prohibits unfair methods of competition and unfair and deceptive acts or practices in commerce. The Robinson-Patman Act prohibits a variety of price discriminations. (This act is actually an amendment to the Clayton Act.) These laws are enforced in four ways: (1) by the US Department of Justice, Antitrust Division; (2) by the Federal Trade Commission; (3) by state attorneys general; and (4) by private litigants.
The courts have interpreted Section 1 of the Sherman Act, prohibiting every contract, combination, or conspiracy in restraint of trade, by using a rule of reason. Thus reasonable restraints that are ancillary to legitimate business practices are lawful. But some acts are per se unreasonable, such as price-fixing, and will violate Section 1. Section 1 restraints of trade include both horizontal and vertical restraints of trade. Vertical restraints of trade include resale price maintenance, refusals to deal, and unreasonable territorial restrictions on distributors. Horizontal restraints of trade include price-fixing, exchanging price information when doing so permits industry members to control prices, controlling output, regulating competitive methods, allocating territories, exclusionary agreements, and boycotts.
Exclusive dealing contracts and tying contracts whose effects may be to substantially lessen competition violate Section 3 of the Clayton Act and may also violate both Section 1 of the Sherman Act and Section 5 of the Federal Trade Commission Act. Requirements and supply contracts are unlawful if they tie up so much of a commodity that they tend substantially to lessen competition or might tend to do so.
The Robinson-Patman Act (Section 2 of the Clayton Act) prohibits price discrimination for different purchasers of commodities of like grade and quality if the effect may be substantially to (1) lessen competition or tend to create a monopoly in any line of commerce or (2) impair competition with (a) any person who grants or (b) knowingly receives the benefit of the discrimination, or (c) with customers of either of them.
Some industries and groups are insulated from the direct reach of the antitrust laws. These include industries separately regulated under federal law, organized labor, insurance companies, activities mandated under state law, group solicitation government action, and baseball.
Section 2 of the Sherman Act prohibits monopolizing or attempting to monopolize any part of interstate or foreign trade or commerce. The law does not forbid monopoly as such but only acts or attempts or conspiracies to monopolize. The prohibition includes the monopolist who has acquired his monopoly through illegitimate means.
Three factors are essential in a Section 2 case: (1) relevant market for determining dominance, (2) the degree of monopoly power, and (3) the particular acts claimed to be illegitimate.
Relevant market has two dimensions: product market and geographic market. Since many goods have close substitutes, the courts look to the degree to which consumers will shift to other goods or suppliers if the price of the commodity or service in question is priced in a monopolistic way. This test is known as cross-elasticity of demand. If the cross-elasticity is high—meaning that consumers will readily shift—then the other goods or services must be included in the product market definition, thus reducing the share of the market that the defendant will be found to have. The geographic market is not the country as a whole, because Section 2 speaks in terms of “any part” of trade or commerce. Usually the government or private plaintiff will try to show that the geographic market is small, since that will tend to give the alleged monopolist a larger share of it.
Market power in general means the share of the relevant market that the alleged monopolist enjoys. The law does not lay down fixed percentages, though various decisions seem to suggest that two-thirds of the market might be too low but three-quarters high enough to constitute monopoly power.
Acts that were aimed at or had the probable effect of excluding competitors from the market are acts of monopolizing. Examples are predatory pricing and boycotts. Despite repeated claims during the 1970s and 1980s by smaller competitors, large companies have prevailed in court against the argument that innovation suddenly sprung on the market without notice is per se evidence of intent to monopolize.
Remedies for Sherman Act Section 2 violations include damages, injunction, and divestiture. These remedies are also available in Clayton Act Section 7 cases.
Section 7 prohibits mergers or acquisitions that might tend to lessen competition in any line of commerce in any section of the country. Mergers and acquisitions are usually classified in one of three ways: horizontal (between competitors), vertical (between different levels of the distribution chain), or conglomerate (between businesses that are not directly related). The latter may be divided into product-extension and market-expansion mergers. The relevant market test is different than in monopolization cases; in a Section 7 action, relevance of market may be proved.
In assessing horizontal mergers, the courts will look to the market shares of emerging companies, industry concentration ratios, and trends toward concentration in the industry. To prove a Section 7 case, the plaintiff must show that the merger forecloses competition “in a substantial share of” a substantial market. Conglomerate merger cases are harder to prove and require a showing of specific potential effects, such as raising barriers to entry into an industry and thus entrenching monopoly, or eliminating potential competition. Joint ventures may also be condemned by Section 7. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 requires certain companies to get premerger notice to the Justice Department.
Exercises
1. To protect its state’s businesses against ruinous price wars, a state legislature has passed a law permitting manufacturers to set a “suggested resale price” on all goods that they make and sell direct to retailers. Retailers are forbidden to undercut the resale price by more than 10 percent. A retailer who violates the law may be sued by the manufacturer for treble damages: three times the difference between the suggested resale price and the actual selling price. But out-of-state retailers are bound by no such law and are regularly discounting the goods between 35 and 40 percent. As the general manager of a large discount store located within a few miles of a city across the state line, you wish to offer the public a price of only 60 percent of the suggested retail price on items covered by the law in order to compete with the out-of-state retailers to which your customers have easy access. May you lower your price in order to compete? How would you defend yourself if sued by a manufacturer whose goods you discounted in violation of the law?
2. The DiForio Motor Car Company is a small manufacturer of automobiles and sells to three distributors in the city of Peoria. The largest distributor, Hugh’s Auras, tells DiForio that it is losing money on its dealership and will quit selling the cars unless DiForio agrees to give it an exclusive contract. DiForio tells the other distributors, whose contracts were renewed from year to year, that it will no longer sell them cars at the end of the contract year. Smith Autos, one of the other dealers, protests, but DiForio refuses to resupply it. Smith Autos sues DiForio and Hugh’s. What is the result? Why?
3. Twenty-five local supermarket chains banded together as Topco Associates Incorporated to sell groceries under a private label. Topco was formed in 1940 to compete with the giant chains, which had the economic clout to sell private-label merchandise unavailable to the smaller chains. Topco acted as a purchasing agent for the members. By the late 1960s, Topco’s members were doing a booming business: \$1.3 billion in retail sales, with market share ranging from 1.5 percent to 16 percent in the markets that members served. Topco-brand groceries accounted for no more than 10 percent of any store’s total merchandise. Under Topco’s rules, members were assigned exclusive territories in which to sell Topco-brand goods. A member chain with stores located in another member’s exclusive territory could not sell Topco-brand goods in those stores. Topco argued that the market division was necessary to give each chain the economic incentive to advertise and develop brand consciousness and thus to be able to compete more effectively against the large nonmember supermarkets’ private labels. If other stores in the locality could also carry the Topco brand, then it would not be a truly “private” label and there would be no reason to tout it; it would be like any national brand foodstuff, and Topco members did not have the funds to advertise the brand nationally. Which, if any, antitrust laws has Topco violated? Why?
4. In 1983, Panda Bears Incorporated, a small manufacturer, began to sell its patented panda bear robot dolls (they walk, smile, and eat bamboo shoots) to retail toy shops. The public took an immediate fancy to panda bears, and the company found it difficult to meet the demand. Retail shops sold out even before their orders arrived. In order to allocate the limited supply fairly while it tooled up to increase production runs, the company announced to its distributors that it would not sell to any retailers that did not also purchase its trademarked Panda Bear’s Bambino Bamboo Shoots. It also announced that it would refuse to supply any retailer that sold the robots for less than \$59.95. Finally, it said that it would refuse to sell to retailers unless they agreed to use the company’s repair services exclusively when customers brought bears back to repair malfunctions in their delicate, patented computerized nervous system. By the following year, with demand still rising, inferior competitive panda robots and bamboo shoots began to appear. Some retailers began to lower the Panda Bear price to meet the competition. The company refused to resupply them. Panda Bears Incorporated also decreed that it would refuse to sell to retailers who carried any other type of bamboo shoot. What antitrust violations, if any, has Panda Bear Incorporated committed? What additional information might be useful in helping you to decide?
5. Elmer has invented a new battery-operated car. The battery, which Elmer has patented, functions for five hundred miles before needing to be recharged. The car, which he has named The Elmer, is a sensation when announced, and his factory can barely keep up with the orders. Worried about the impact, all the other car manufacturers ask Elmer for a license to use the battery in their cars. Elmer refuses because he wants the car market all to himself. Banks are eager to lend him the money to expand his production, and within three years he has gained a 5 percent share of the national market for automobiles. During these years, Elmer has kept the price of The Elmer high, to pay for his large costs in tooling up a factory. But then it dawns on him that he can expand his market much more rapidly if he drops his price, so he prices the car to yield the smallest profit margin of any car being sold in the country. Its retail price is far lower than that of any other domestic car on the market. Business begins to boom. Within three more years, he has garnered an additional 30 percent of the market, and he announces at a press conference that he confidently expects to have the market “all to myself” within the next five years. Fighting for their lives now, the Big Three auto manufacturers consult their lawyers about suing Elmer for monopolizing. Do they have a case? What is Elmer’s defense?
6. National Widget Company is the dominant manufacturer of widgets in the United States, with 72 percent of the market for low-priced widgets and 89 percent of the market for high-priced widgets. Dozens of companies compete with National in the manufacture and sale of compatible peripheral equipment for use with National’s widgets, including countertops, holders, sprockets and gear assemblies, instruction booklets, computer software, and several hundred replacements parts. Revenues of these peripherals run upwards of \$100 million annually. Beginning with the 1981 model year, National Widget sprang a surprise: a completely redesigned widget that made most of the peripheral equipment obsolete. Moreover, National set the price for its peripherals below that which would make economic sense for competitors to invest in new plants to tool up for producing redesigned peripherals. Five of the largest peripheral-equipment competitors sued National under Section 2 of the Sherman Act. One of these, American Widget Peripherals, Inc., had an additional complaint: on making inquiries in early 1980, American was assured by National’s general manager that it would not be redesigning any widgets until late 1985 at the earliest. On the basis of that statement, American invested \$50 million in a new plant to manufacture the now obsolescent peripheral equipment, and as a result, it will probably be forced into bankruptcy. What is the result? Why? How does this differ, if at all, from the Berkey Camera case?
7. In 1959, The Aluminum Company of America (Alcoa) acquired the stock and assets of the Rome Cable Corporation. Alcoa and Rome both manufactured bare and insulated aluminum wire and cable, used for overhead electric power transmission lines. Rome, but not Alcoa, manufactured copper conductor, used for underground transmissions. Insulated aluminum wire and cable is quite inferior to copper, but it can be used effectively for overhead transmission, and Alcoa increased its share of annual installations from 6.5 percent in 1950 to 77.2 percent in 1959. During that time, copper lost out to aluminum for overhead transmission. Aluminum and copper conductor prices do not respond to one another; lower copper conductor prices do not put great pressure on aluminum wire and cable prices. As the Supreme Court summarized the facts in United States v. Aluminum Co. of America,United States v. Aluminum Co. of America, 377 U.S. 271 (1964).In 1958—the year prior to the merger—Alcoa was the leading producer of aluminum conductor, with 27.8% of the market; in bare aluminum conductor, it also led the industry with 32.5%. Alcoa plus Kaiser controlled 50% of the aluminum conductor market and, with its three leading competitors, more than 76%. Only nine concerns (including Rome with 1.3%) accounted for 95.7% of the output of aluminum conductor, Alcoa was third with 11.6%, and Rome was eighth with 4.7%. Five companies controlled 65.4% and four smaller ones, including Rome, added another 22.8%. The Justice Department sued Alcoa-Rome for violation of Section 7 of the Clayton Act. What is the government’s argument? What is the result?
8. Quality Graphics has been buying up the stock of companies that manufacture billboards. Quality now owns or controls 23 of the 129 companies that make billboards, and its sales account for 3.2 percent of the total national market of \$72 million. In Texas, Quality has acquired 27 percent of the billboard market, and in the Dallas–Ft. Worth area alone, about 25 percent. Billboard advertising accounts for only 0.001 percent of total national advertising sales; the majority goes to newspaper, magazine, television, and radio advertising. What claims could the Justice Department assert in a suit against Quality? What is Quality’s defense? What is the result?
9. The widget industry consists of six large manufacturers who together account for 62 percent of output, which in 1985 amounted to \$2.1 billion in domestic US sales. The remaining 38 percent is supplied by more than forty manufacturers. All six of the large manufacturers and thirty-one of the forty small manufacturers belong to the Widget Manufacturers Trade Association (WMTA). An officer from at least two of the six manufacturers always serves on the WMTA executive committee, which consists of seven members. The full WMTA board of directors consists of one member from each manufacturer. The executive committee meets once a month for dinner at the Widgeters Club; the full board meets semiannually at the Widget Show. The executive committee, which always meets with the association’s lawyer in attendance, discusses a wide range of matters, including industry conditions, economic trends, customer relations, technological developments, and the like, but scrupulously refrains from discussing price, territories, or output. However, after dinner at the bar, five of the seven members meet for drinks and discuss prices in an informal manner. The chairman of the executive committee concludes the discussion with the following statement: “If I had to guess, I’d guess that the unit price will increase by 5 percent the first of next month.” On the first of the month, his prediction is proven to be correct among the five companies whose officers had a drink, and within a week, most of the other manufacturers likewise increase their prices. At the semiannual meeting of the full board, the WMTA chairman notes that prices have been climbing steadily, and he ventures the hope that they will not continue to do so because otherwise they will face stiff competition from the widget industry. However, following the next several meetings of the executive committee, the price continues to rise as before. The Justice Department gets wind of these discussions and sues the companies whose officers are members of the board of directors and also sues individually the members of the executive committee and the chairman of the full board. What laws have they violated, if any, and who has violated them? What remedies or sanctions may the department seek?
SELF CHECK QUESTIONS
1. International law derives from
1. A company with 95 percent of the market for its product is
1. a monopolist
2. monopolizing
3. violating Section 2 of the Sherman Act
4. violating Section 1 of the Sherman Act
2. Which of the following may be evidence of an intent to monopolize?
1. innovative practices
2. large market share
3. pricing below cost of production
4. low profit margins
3. A merger that lessens competition in any line of commerce is prohibited by
1. Section 1 of the Sherman Act
2. Section 2 of the Sherman Act
3. Section 7 of the Clayton Act
4. none of the above
4. Which of the following statements is true?
1. A horizontal merger is always unlawful.
2. A conglomerate merger between companies with unrelated products is always lawful.
3. A vertical merger violates Section 2 of the Sherman Act.
4. A horizontal merger that unduly increases the concentration of firms in a particular market is always unlawful.
5. A line of commerce is a concept spelled out in
1. Section 7 of the Clayton Act
2. Section 2 of the Sherman Act
3. Section 1 of the Sherman Act
4. none of the above
1. a
2. c
3. c
4. d
5. d | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/26%3A_Antitrust_Law/26.09%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The general powers of the Federal Trade Commission
• The general principles of law that govern deceptive acts and practices
• Several categories of deceptive acts and practices, with examples
• The remedies that the Federal Trade Commission has at its disposal to police unfair trade practices
27: Unfair Trade Practices and the Federal Trade Commission
Learning Objectives
By the end of this section, you will be able to:
• Describe the general powers of the Federal Trade Commission.
• Describe the general principles that guide laws and regulations against unfair and deceptive trade practices.
General Powers of the Federal Trade Commission
Common law prohibited a variety of trade practices unfair either to competitors or to consumers. These included passing off one’s products as though they were made by someone else, using a trade name confusingly similar to that of another, stealing trade secrets, and various forms of misrepresentation. In the Federal Trade Commission Act of 1912, Congress for the first time empowered a federal agency to investigate and deter acts of unfair competition.
Section 5 of the act gave the Federal Trade Commission (FTC) power to enforce a law that said “unfair methods of competition in commerce are hereby declared unlawful.” By “unfair methods of competition,” Congress originally intended acts that constituted violations of the Sherman and Clayton Antitrust Acts. But from the beginning, the commissioners of the FTC took a broader view of their mandate. Specifically, they were concerned about the problem of false and deceptive advertising and promotional schemes. But the original Section 5 was confining; it seemed to authorize FTC action only when the deceptive advertising injured a competitor of the company. In 1931, the Supreme Court ruled that this was indeed the case: an advertisement that deceived the public was not within the FTC’s jurisdiction unless a competitor was injured by the misrepresentation also. Congress responded in 1938 with the Wheeler-Lea Amendments to the FTC Act. To the words “unfair methods of competition” were added these words: “unfair or deceptive acts or practices in commerce.” Now it became clear that the FTC had a broader role to play than as a second agency enforcing the antitrust laws. Henceforth, the FTC would be the guardian also of consumers.
Deceptive practices that the FTC has prosecuted are also amenable to suit at common law. A tire manufacturer who advertises that his “special tire” is “new” when it is actually a retread has committed a common-law misrepresentation, and the buyer could sue for rescission of the contract or for damages. But having a few buyers sue for misrepresentation does not stop the determined fraudster. Moreover, such lawsuits are expensive to bring, and the amount of damages awarded is usually small; thus law actions alone cannot adequately address deliberately fraudulent practices.
Through Section 5, however, the FTC can seek far-reaching remedies against the sham and the phony; it is not limited to proving damages to individual customers case by case. The FTC can issue cease and desist orders and has other sanctions to wield as well. So do its counterpart agencies at the state level.
As an administrative agency, the FTC has broader powers than those vested in the ordinary prosecutorial authority, such as the Department of Justice. It can initiate administrative proceedings in accordance with the Administrative Procedure Act to enforce the several statutes that it administers. In addition to issuing cease and desist orders and getting them enforced in court, the FTC can seek temporary and permanent injunctions, fines, and monetary damages and promulgate trade regulation rules (TRRs). Although the FTC’s authority to issue TRRs had long been assumed (and was approved by the US court of appeals in Washington in 1973), Congress formalized it in 1975 in the FTC Improvement Act (part of the Magnuson-Moss Warranty Act), which gives the FTC explicit authority to prescribe rules defining unfair or deceptive acts or practices.
A TRR is like a statute. It is a detailed statement of procedures and substantive dos and don’ts. Before promulgating a TRR, the commission must publish its intention to do so in the Federal Register and must hold open hearings on its proposals. Draft versions of a TRR must be published to allow the public to comment. Once issued, the final version is published as part of the Code of Federal Regulations and becomes a permanent part of the law unless modified or repealed by the FTC itself or by Congress—or overturned by a court on grounds of arbitrariness, lack of procedural regularity, or the like. A violation of a TRR is treated exactly like a violation of a federal statute. Once the FTC proves that a defendant violated a TRR, no further proof is necessary that the defendant’s act was unfair or deceptive. Examples of TRRs include the Retail Food Store Advertising and Marketing Practices Rule, Games of Chance in the Food Retailing and Gasoline Industries Rule, Care Labeling of Textile Wearing Apparel Rule, Mail Order Merchandise Rule, Cooling-Off Period for Door-to-Door Sales Rule, and Use of Negative Option Plans by Sellers in Commerce.
General Principles of Law Governing Deceptive Acts and Practices
With a staff of some sixteen hundred and ten regional offices, the FTC is, at least from time to time, an active regulatory agency. The FTC’s enforcement vigor waxes and wanes with the economic climate. Critics have often charged that what the FTC chooses to investigate defies common sense because so many of the cases seem to involve trivial, or at least relatively unimportant, offenses: Does the nation really need a federal agency to guard us against pronouncements by singer Pat Boone on the efficacy of acne medication or to ensure the authenticity of certain crafts sold to tourists in Alaska as “native”? One answer is that through such cases, important principles of law are declared and ratified.
To be sure, most readers of this book, unlikely to be gulled by false claims, may see a certain Alice-in-Wonderland quality to FTC enforcement. But the first principle of FTC action is that it gauges deceptive acts and practices as interpreted by the general public, not by the more sophisticated. As a US court of appeals once said, the FTC Act was not “made for the protection of experts, but for the public—that vast multitude which includes the ignorant, the unthinking, and the credulous.” The deceptive statement or act need not actually deceive. Before 1983, it was sufficient that the statement had a “capacity to deceive.” According to a standard adopted in 1983, however, the FTC will take action against deceptive advertising “if there is a representation, omission or practice that is likely to mislead the consumer acting reasonably in the circumstances, to the consumer’s detriment.” Critics of the new standard have charged that it will be harder to prove deception because an advertisement must be “likely to mislead” rather than merely have a “capacity to deceive.” The FTC might also be put to the burden of showing that consumers reasonably interpreted the ad and that they relied on the ad. Whether the standard will reduce the volume of FTC actions against deceptive advertising remains to be seen.
The FTC also has the authority to proceed against “unfair…acts or practices.” These need not be deceptive but, instead, of such a character that they offend a common sense of propriety or justice or of an honest way of comporting oneself. See Figure 27.1 for a diagram of the unfair and deceptive practices discussed in this chapter.
Key Takeaway
Although common law still serves to prohibit certain kinds of trade practices, the FTC has far more extensive powers to police unfair and deceptive trade practices. The FTC’s rules, once passed through the processes defined in the Administrative Procedure Act, have the same authority as a federal statute. Trade regulation rules issued by the FTC, if violated, can trigger injunctions, fines, and other remedial actions.
Exercises
1. Go to the FTC website and look at its most recent annual report. Find a description of a loan modification scam, and discuss with another student why a regulatory agency is needed. Ask yourselves whether leaving it up to individual consumers to sue the scammers, using common law, would create greater good for society. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/27%3A_Unfair_Trade_Practices_and_the_Federal_Trade_Commission/27.01%3A_The_Federal_Trade_Commission-_Powers_and_Law_Governing_Deceptive_Acts.txt |
Learning Objectives
By the end of this section, you will be able to:
• Name the categories of deceptive acts and practices that the Federal Trade Commission has found, and give examples.
Failure to Disclose Pertinent Facts
Businesses are under no general obligation to disclose everything. Advertisers may put a bright face on their products as long as they do not make a direct material misrepresentation or misstatement. But under certain circumstances, a business may be required to disclose more than it did in order not to be involved in unfair or deceptive acts and practices. For example, failure to state the cost of a service might constitute deception. Thus a federal court has ruled that it is deceptive for a telephone service to fail to disclose that it cost fifteen dollars per call for customers dialing a special 900 number listed in newspaper advertisements offering jobs.FTC v. Transworld Courier Services, Inc., 59 A&TR Rpt. 174 (N.D. Ga. 1990). Likewise, if a fact not disclosed might have a material bearing on a consumer’s decision whether to purchase the product, its omission might be tantamount to deception, as J. B. Williams Co. v. FTC (see Section 27.5.1 “False and Misleading Representations”), suggests.
Descriptions of Products
Although certain words are considered mere puffery (greatest, best), other words, which have more precise connotations, can cause trouble if they are misused. One example is the word new. In most cases, the Federal Trade Commission (FTC) has held that if a product is more than six months old, it is not new and may not lawfully be advertised as such.
The efficacy of products is perhaps their most often advertised aspect. An ad stating that a product will do more than it can is almost always deceptive if the claim is specific. Common examples that the FTC continues to do battle over are claims that a cream, pill, or other substance will “rejuvenate” the body, “cure” baldness, “permanently remove” wrinkles, or “restore” the vitality of hair.
The composition of goods is another common category of deceptive claims. For example, a product advertised as “wool” had better be 100 percent wool; a mixture of wool and synthetic fabrics cannot be advertised as wool. The FTC has lists of dozens of descriptive words with appropriate definitions.
Labeling of certain products is strictly regulated by specific statutes. Under the Food, Drug, and Cosmetic Act, artificial colors and flavors must be disclosed. Other specific federal statutes include the Wool Products Labeling Act, the Textile Fiber Products Identification Act, the Fur Products Labeling Act, and the Flammable Fabrics Act; these acts are enforced by the FTC. In 1966, Congress enacted the Fair Packaging and Labeling Act. It governs most consumer products and gives the FTC authority to issue regulations for proper labeling of most of them. In particular, the statute is designed to help standardize quantity descriptions (“small,” “medium,” and “large”) and enable shoppers to compare the value of competing goods in the stores.
Misleading Price and Savings Claims
“Buy one, get another for half price.” “Suggested retail price: \$25. Our price: \$5.95.” “Yours for only \$95. You save \$50.” Claims such as these assault the eye and ear daily. Unless these ads are strictly true, they are violations of Section 5 of the FTC Act. To regulate deceptive price and savings claims, the FTC has issued a series of Guides against Deceptive Pricing that set forth certain principles by which the commission will judge the merits of price claims. These guides are not themselves law, but they are important clues to how the FTC will act when faced with a price claim case and they may even provide guidance to state courts hearing claims of deceptive pricing ads.
In general, the guides deal with five claims, as follows:
• Comparisons of the sale price to a former price. The former price must have been offered for a substantial period of time in the near past for a seller to be justified in referring to it. A product that once had a price tag of \$50, but that never actually sold for more than \$40, cannot be hawked at “the former price of \$50.” Under the FTC guides, a reduction of at least 10 percent is necessary to make the claim true.
• Comparable products. “This same mattress and box spring would cost you \$450 at retail.” The advertisement is true only if the seller is in fact offering the same merchandise and if the price quoted is genuine.
• “Suggested” retail price. The same rules apply as those just mentioned. But in the case of a “manufacturer’s suggested” price, an additional wrinkle can occur: the manufacturer might help the retailer deceive by listing a “suggested” price that is in fact considerably greater than the going price in the retailer’s trading area. Whether it is the manufacturer who is doing his own selling or the retailer who takes advantage of the “list price” ticket on the goods, the resulting claim of a bargain is deceptive if the product does not sell for the list price in any market or in the market of the retailer.
• Bargain based on the purchase of something else. The usual statement in these cases is “Buy one, get one free” (or at some percentage of the usual selling price). Again, the watchwords are literal accuracy. If the package of batteries normally sells in the advertiser’s store for ninety-nine cents, and two packages are now selling for that price, then the advertisement is unexceptionable. But advertisers are often tempted to raise the original selling price or reduce the size or quantity of the bargain product; doing so is deceptive.
• False claims to explain a “sale” price. “Giant clearance sale” or “going out of business” or “limited offer” are common advertising gimmicks. If true, they are legitimate, but it takes very little to make them deceptive. A “limited offer” that goes on forever (or a sale price charged beyond the date on which a sale is said to end) is deceptive. Likewise, false claims that imply the manufacturer is charging the customer a small price are illegitimate. These include claims like “wholesale price,” “manufacturer’s close-outs,” “irregulars,” or “seconds.”
Bait-and-Switch Advertisements
A common sales pitch in retail is the bait and switch. The retailer “baits” the prospective customer by dangling an alluring offer, but the offer either disappears or is disparaged once the customer arrives. Suppose someone sees this advertisement: “Steinway Grand Piano—only \$1,000.” But when the customer arrives at the store, he finds that the advertised product has “sold out.” The retailer then tries to sell the disappointed customer a higher priced product. Or the salesperson may have the product, but she will disparage it—pointing out that it does not really live up to the advertised expectations—and will exhort the customer to buy the “better,” more expensive model. These and related tactics are all violations of Section 5 of the FTC Act. In its Guides Against Bait Advertising, the FTC lists several such unfair practices, including the following: (1) refusing to demonstrate the advertised product, (2) disparaging the product (e.g., by exhibiting a visibly inferior grade of product next to higher-priced merchandise), (3) failing to stock enough of the advertised product to meet anticipated demand (although the advertiser may say “supplies limited,” if that is the case), (4) stating that delivery of the advertised product will take an inordinate amount of time, (5) demonstrating a defective product, and (6) deliberately discouraging the would-be buyer from purchasing the advertised product.
Free Offers
Careless advertisers will discover that free, perhaps the most powerful word in advertising, comes at a cost. As just noted, a product is not free if it is conditional on buying another product and the price of the “free” product is included in the purchased product (“Buy one tube and get another tube free”). Just how far the commission is prepared to take this rule is clear from F.T.C. v. Mary Carter Paint Co.F.T.C. v. Mary Carter Paint Co., 382 U.S. 46 (1965). In that case, the company offered, from the time it began business, to sell on a two-for-one basis: “every second can FREE, gallon or quart.” The problem was that it had never priced and sold single cans of paint, so the FTC assumed that the price of the second can was included in the first, even though Mary Carter claimed it had established single-can prices that were comparable to those for paint of comparable quality sold by competing manufacturers. The Supreme Court sustained the commission’s finding of deception.
Product Comparisons and Disparagements
Product disparagement—saying defamatory things about a competitor’s product—is a common-law tort, actionable under state law. It is also actionable under Section 5 of the FTC Act. The FTC brands as disparagement the making of specific untrue statements about a competitor’s product. The agency labels an indirect form of disparagement “comparative misrepresentation”—making false claims of superiority of one’s own product. Again, the common-law puffing rule would permit the manufacturer of an over-the-counter pain reliever to make the general statement “Our pill is the best.” But the claim that a pill “works three times as fast as the leading competitor’s” violates Section 5 if untrue.
Truth has always been a defense to claims of product disparagement, but even that common-law rule has been eroded in recent years with the application of the significance doctrine. A statement may be technically true but insignificant and made in such a way as to be misleading. For example, P. Lorillard Co. v. Federal Trade Commission (Section 27.5.2 “Product Comparisons”) concerned a comparative study published in Reader’s Digest of tar and nicotine in cigarettes. The article suggested that the differences were inconsequential to health, but the company making the cigarette with the smallest amount of tar and nicotine touted the fact anyway.
During the 1970s, to help enforce its rules against comparative misrepresentations, the FTC began to insist that advertisers fully document any quantitative claims that their products were superior to others. This meant that the advertiser should have proof of accuracy not only if the commission comes calling; the advertiser should collect the information beforehand. If it does not, the claim will be held presumptively deceptive.
The FTC Act and state laws against misleading advertising are not the only statutes aimed at product comparisons. One important more recent federal law is the Trademark Law Revision Act of 1988, amending the original Lanham Act that protects trademarks as intellectual property (see Chapter 30). For many years, the federal courts had ruled that a provision in the Lanham Act prohibiting false statements in advertisements was limited to an advertiser’s false statements about its own goods or services only. The 1988 amendments overturned that line of court cases, broadening the rule to cover false statements about someone else’s goods or services as well. The amendments also prohibit false or misleading claims about another company’s commercial activities, such as the nature of its warranties. The revised Lanham Act now permits a company injured by a competitor’s false advertising to sue directly in federal court.
Endorsements
How wonderful to have a superstar (or maybe yesterday’s superstar) appear on television drooling over your product. Presumably, millions of people would buy a throat spray if Lady Gaga swore by it, or a pair of jeans if Justin Bieber wore them, or a face cream if Paris Hilton blessed it. In more subtle ways, numerous products are touted every day with one form of testimonial or another: “Three out of four doctors recommend…” or “Drivers across the country use.…” In this area, there are endless opportunities for deception.
It is not a deception for a well-known personality to endorse a product without disclosing that she is being paid to do so. But the person giving the testimonial must in fact use the product; if she does not, the endorsement is deceptive. Suppose an astronaut just returned to Earth is talked into endorsing suspenders (“They keep your pants from floating away”) that he was seen to be wearing on televised shots of the orbital mission. If he has customarily worn them, he may properly endorse them. But if he stops wearing them for another brand or because he has decided to go back to wearing belts, reruns of the TV commercials must be pulled from the air.
Figure 27.2
Consent Decree: Pat Boone and Cooga Mooga, Inc.
That a particular consumer is in fact ecstatic about a product does not save a false statement: it is deceptive to present this glowing testimonial to the public if there are no facts to back up the customer’s claim. The assertion “I was cured by apricot pits” to market a cancer remedy would not pass FTC muster. Nor may an endorser give a testimonial involving subjects known only to experts if the endorser is not himself that kind of expert, as shown in the consent decree negotiated by the FTC with singer Pat Boone (Figure 27.2).
Pictorial and Television Advertising
Pictorial representations create special problems because the picture can belie the caption or the announcer’s words. A picture showing an expensive car may be deceptive if the dealer does not stock those cars or if the only readily available cars are different models. The ways of deceiving by creating false inferences through pictures are limited only by imagination. White-coated “doctors,” seals of the British monarchy, and plush offices can connote various things about a product, even if the advertisement never says that the man in the white coat is a doctor, that the product is related to the British crown, or that the company has its operations in the building depicted.
Television demonstrations may also suggest nonexistent properties or qualities in a product. In one case, the commission ordered the manufacturer of a liquid cleaner to cease showing it in use near hot stoves and candles, implying falsely that it was nonflammable. A commercial showing a knife cutting through nails is deceptive if the nails were precut and different knives were used for the before and after shots.
Key Takeaway
A variety of fairly common acts and practices have been held by the FTC to be deceptive (and illegal). These include the failure to disclose pertinent facts, misleading price and savings claims, bait and switch advertisements, careless use of the word “free,” and comparative misrepresentation—making misleading comparisons between your product and the product of another company.
Exercises
1. Look around this week for an example of a merchant offering something for “free.” Do you think there is anything deceptive about the merchant’s offer? If they offer “free shipping,” how do you know that the shipping cost is not hidden in the price? In any case, why do consumers need protection from an agency that polices merchant offerings that include the word free?
2. Find the FTC’s guide against deceptive pricing (http://www.ftc.gov/bcp/guides/decptprc.htm). Can you find any merchants locally that appear to be in violation of the FTC’s rules and principles? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/27%3A_Unfair_Trade_Practices_and_the_Federal_Trade_Commission/27.02%3A_Deceptive_Acts_and_Practices.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how unfair trade practices are different from deceptive trade practices.
• Name three categories of unfair trade practices, and give examples.
We turn now to certain practices that not only have deceptive elements but also operate unfairly in ways beyond mere deception. In general, three types of unfair practices will be challenged: (1) failing to substantiate material representations in advertisements before publishing them or putting them on the air, (2) failing to disclose certain material information necessary for consumers to make rational comparisons of price and quality of products, and (3) taking unconscionable advantage of certain consumers or exploiting their weakness. The Federal Trade Commission (FTC) has enjoined many ads of the first type. The second type of unfairness has led the commission to issue a number of trade regulation rules (TRRs) setting forth what must be disclosed—for example, octane ratings of gasoline. In this section, we focus briefly on the third type.
Contests and Sweepstakes
In 1971, the FTC obtained a consent order from Reader’s Digest barring it from promoting a mail-order sweepstakes—a sweepstakes in which those responding had a chance to win large monetary or other prizes by returning numbered tickets—unless the magazine expressly disclosed how many prizes would be awarded and unless all such prizes were in fact awarded. Reader’s Digest had heavily promoted the size and number of prizes, but few of the winning tickets were ever returned, and consequently few of the prizes were ever actually awarded. Reader’s Digest Assoc., 79 F.T.C. 599 (1971).
Beginning in the 1960s, the retail food and gasoline industries began to heavily promote games of chance. Investigations by the FTC and a US House of Representatives small business subcommittee showed that the games were rigged: winners were “picked” early by planting the winning cards early on in the distribution, winning cards were sent to geographic areas most in need of the promotional benefits of announcing winners, not all prizes were awarded before many games terminated, and local retailers could spot winning cards and cash them in or give them to favored customers. As a result of these investigations, the FTC in 1969 issued its Trade Regulation Rule for Games of Chance in the Food Retailing and Gasoline Industries, strictly regulating how the games may operate and be promoted.
Many marketers use contests, as opposed to sweepstakes, in merchandising their products. In a contest, the consumer must actually do something other than return a ticket, such as fill in a bingo card or come up with certain words. It is an unfair practice for the sponsoring company not to abide by its own rules in determining winners.
Door-to-Door, Direct Mail, and Unsolicited Merchandise
In 1974, the FTC promulgated a TRR requiring a three-day cooling-off period within which any door-to-door sales contract can be cancelled. The contract must state the buyer’s right to the cooling-off period.
For many years, certain unscrupulous distributors would mail unsolicited merchandise to consumers and demand payment through a series of dunning letters and bills. In 1970, Congress enacted legislation that declares any unsolicited mailing and subsequent dunning to be an unfair trade practice under Section 5 of the FTC Act. Under this law, if you receive an unsolicited product in the mail, you may treat it as a gift and use it; you are under no obligation to return it or pay for it.
Another regulation of mail-order sales is the FTC’s TRR concerning mail-order merchandise. Any direct-mail merchandiser must deliver the promised goods within thirty days or give the consumer an option to accept delayed delivery or a prompt refund of his money or cancellation of the order if it has not been prepaid.
Negative-Option Plans
The “negative option” was devised in the 1920s by the Book-of-the-Month Club. It is a marketing device through which the consumer responds to the seller only if she wishes not to receive the product. As used by book clubs and other distributors of goods that are sent out periodically, the customer agrees, when “joining,” to accept and pay for all items unless she specifically indicates, before they arrive, that she wishes to reject them. If she does nothing, she must pay. Difficulties arise when the negative-option notice arrives late in the mail or when a member quits and continues to receive the monthly notices. Internet users will recognize the negative option in current use as the “opt out” process, where you are “in” unless you notice what’s going on and specifically opt out.
In 1974, the FTC issued a TRR governing use of negative-option plans by sellers. The TRR laid down specific notice requirements. Among other things, a subscriber is entitled to ten days in which to notify sellers that she has rejected the particular item about to be sent. If a customer has cancelled hers membership, the seller must take back and pay the former member’s mailing expenses for any merchandise mailed after cancellation. The former member may treat any shipments beyond one after cancellation as unsolicited merchandise and keep it without having to pay for it or return it.
Breach of Contract
Under certain circumstances, a company’s willful breach of contract can constitute an unfair trade practice, thus violating section 5 of the FTC Act. In one recent case, a termite and pest exterminating company signed contracts with its customers guaranteeing “lifetime” protection against termite damage to structures that the company treated. The contract required a customer to renew the service each year by paying an unchanging annual fee. Five years after signing these contracts, the company notified 207,000 customers that it was increasing the annual fee because of inflation. The FTC challenged the fee hike on the ground that it was a breach of contract amounting to an unfair trade practice. The FTC’s charges were sustained on appeal. The eleventh circuit approved the FTC’s three-part test for determining unfairness: (1) the injury “must be substantial,” (2) “it must not be outweighed by countervailing benefits to consumers,” and (3) “it must be an injury that consumers themselves could not reasonably have avoided.” In the termite case, all three parts were met: consumers were forced to pay substantially higher fees, they received no extra benefits, and they could not have anticipated or prevented the price hike, since the contract specifically precluded them.Orkin Exterminating Co. v. FTC, 849 F.2d 1354 (11th Cir. 1988), cert. denied, 488 U.S. 1041 (1989).
Key Takeaway
Market efficiency is premised on buyers being able to make rational choices about their purchases. Where sellers fail to substantiate material representations or to disclose material information that is necessary for buyers to act rationally, the FTC may find an unfair trade practice. In addition, some sellers will take “unconscionable advantage” of certain buyers or exploit their weakness. This takes place in various contests and sweepstakes, door-to-door and mail-order selling, and negative-option plans. The FTC has issued a number of TRRs to combat some of these unfair practices.
Exercises
1. The FTC receives over ten thousand complaints every year about sweepstakes and prizes. Using the Internet or conversations with people you know, name two ways that sweepstakes or contests can be unfair to consumers.
2. As economic hard times return, many scam artists have approached people in debt or people who are in danger of losing their homes. Describe some of the current practices of such people and companies, and explain why they are unfair.
3. With regard to Exercise 2, discuss and decide whether government serves a useful public function by protecting consumers against such scam artists or whether use of the common law—by the individuals who have been taken advantage of—would create greater good for society. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/27%3A_Unfair_Trade_Practices_and_the_Federal_Trade_Commission/27.03%3A_Unfair_Trade_Practices.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe the various remedies the Federal Trade Commission has used against unfair and deceptive acts and practices.
• Understand that the states also have power to regulate unfair and deceptive trade practices and often do.
The Federal Trade Commission (FTC) has a host of weapons in its remedial arsenal. It may issue cease and desist orders against unfair and deceptive acts and practices and let the punishment fit the crime. For instance, the FTC can order a company to remove or modify a deceptive trade name. It may order companies to substantiate their advertising. Or if a company fails to disclose facts about a product, the commission may order the company to affirmatively disclose the facts in future advertising. In the J. B.Williams case (Section 27.5.2 “Product Comparisons”), the court upheld the commission’s order that the company tell consumers in future advertising that the condition Geritol is supposed to treat—iron-poor blood—is only rarely the cause of symptoms of tiredness that Geritol would help cure.
The FTC has often exercised its power to order affirmative disclosures during the past decade, but its power to correct advertising deceptions is even broader. In Warner Lambert Co. v. Federal Trade Commission, the US court of appeals in Washington, using corrective advertising, approved the commission’s power to order a company to correct in future advertisements its former misleading and deceptive statements regarding Listerine mouthwash should it choose to continue to advertise the product.Warner Lambert Co. v. Federal Trade Commission, 562 F.2d 749 (D.C. Cir. 1977), cert. denied, 435 U.S. 950 (1978). The court also approved the FTC’s formula for determining how much the company must spend: an amount equal to the average annual expenditure on advertising the mouthwash during the ten years preceding the case.
In addition to its injunctive powers, the FTC may seek civil penalties of \$10,000 for violation of final cease and desist orders, and if the violation is a continuing one—an advertising campaign that lasts for weeks or months—each day is considered a separate violation. The commission may also sue for up to \$10,000 per violation, as just described, for violations of its trade regulation rules (TRRs). Under the FTC Improvement Act of 1975, the commission is authorized to seek injunctions and collect monetary damages on behalf of injured consumers in cases involving violations of TRRs. It may also seek restitution for consumers in cases involving cease and desist orders if the party continuing to commit the unfair or deceptive practice should have known that it would be dishonest or fraudulent to continue doing so. The exact reach of this power to seek restitution, which generally had not been available before 1975, remains to be tested in the courts. As for private parties, though they have rights under the antitrust statutes, they have no right to sue under Section 5 of the FTC Act.
Little FTC Acts
Even when consumers have no direct remedy under federal law for unfair or deceptive acts and practices, they may have recourse under state laws modeled on the FTC Act, known as little FTC acts. All states have some sort of consumer protection act, and these acts are often more liberal than the federal unfair trade rules; they permit consumers—and in several states, even aggrieved businesses—to sue when injured by a host of “immoral, unethical, oppressive, or unscrupulous” commercial acts. Often, a successful plaintiff can recover treble damages and attorneys’ fees.
The acts are helpful to consumers because common-law fraud is difficult to prove. Its elements are rigorous and unyielding: an intentional misrepresentation of material facts, reliance by the recipient, causation, and damages. Many of these elements are omitted from consumer fraud statutes. While most statutes require some aspect of willfulness, some do not. In fact, many states relax or even eliminate the element of reliance, and some states do not even require a showing of causation or injury.
Key Takeaway
The FTC has many weapons to remedy unfair and deceptive trade practices. These include civil penalties, cease and desist orders, restitution for consumers, and corrective advertising. States have supplemented common law with their own consumer protection acts, known as little FTC acts. Remedies are similar for state statutes, and private parties may bring lawsuits directly.
Exercises
1. Doan’s Pills are an over-the-counter medicine for low back pain. Using the Internet, find out what claims Doan’s was making and why the FTC thought corrective advertising was necessary. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/27%3A_Unfair_Trade_Practices_and_the_Federal_Trade_Commission/27.04%3A_Remedies.txt |
False and Misleading Representations
J. B. Williams Co. v. FTC
381 F.2d 884 (6th Cir. 1967)
CELEBREEZE, CIRCUIT JUDGE
The question presented by this appeal is whether Petitioners’ advertising of a product, Geritol, for the relief of iron deficiency anemia, is false and misleading so as to violate Sections 5 and 12 of the Federal Trade Commission Act.
The J. B. Williams Company, Inc. is a New York corporation engaged in the sale and distribution of two products known as Geritol liquid and Geritol tablets. Geritol liquid was first marketed in August, 1950; Geritol tablets in February, 1952. Geritol is sold throughout the United States and advertisements for Geritol have appeared in newspapers and on television in all the States of the United States.
Parkson Advertising Agency, Inc. has been the advertising agency for Williams since 1957. Most of the advertising money for Geritol is spent on television advertising.…
The Commission’s Order requires that not only must the Geritol advertisements be expressly limited to those persons whose symptoms are due to an existing deficiency of one or more of the vitamins contained in the preparation, or due to an existing deficiency of iron, but also the Geritol advertisements must affirmatively disclose the negative fact that a great majority of persons who experience these symptoms do not experience them because they have a vitamin or iron deficiency; that for the great majority of people experiencing these symptoms, Geritol will be of no benefit. Closely related to this requirement is the further requirement of the Order that the Geritol advertisements refrain from representing that the symptoms are generally reliable indications of iron deficiency.
* * *
The main thrust of the Commission’s Order is that the Geritol advertising must affirmatively disclose the negative fact that a great majority of persons who experience these symptoms do not experience them because there is a vitamin or iron deficiency.
The medical evidence on this issue is conflicting and the question is not one which is susceptible to precise statistical analysis.
* * *
While the advertising does not make the affirmative representation that the majority of people who are tired and rundown are so because of iron deficiency anemia and the product Geritol will be an effective cure, there is substantial evidence to support the finding of the Commission that most tired people are not so because of iron deficiency anemia, and the failure to disclose this fact is false and misleading because the advertisement creates the impression that the tired feeling is caused by something which Geritol can cure.
* * *
Here the advertisements emphasize the fact that if you are often tired and run-down you will feel stronger fast by taking Geritol. The Commission, in looking at the overall impression created by the advertisements on the general public, could reasonably find these advertisements were false and misleading. The finding that the advertisements link common, non-specific symptoms with iron deficiency anemia, and thereby create a false impression because most people with these symptoms are not suffering from iron deficiency anemia, is both reasonable and supported by substantial evidence. The Commission is not bound to the literal meaning of the words, nor must the Commission take a random sample to determine the meaning and impact of the advertisements.
Petitioners argue vigorously that the Commission does not have the legal power to require them to state the negative fact that “in the great majority of persons who experience such symptoms, these symptoms are not caused by a deficiency of one or more of the vitamins contained in the preparation or by iron deficiency or iron deficiency anemia”; and “for such persons the preparation will be of no benefit.”
We believe the evidence is clear that Geritol is of no benefit in the treatment of tiredness except in those cases where tiredness has been caused by a deficiency of the ingredients contained in Geritol. The fact that the great majority of people who experience tiredness symptoms do not suffer from any deficiency of the ingredients in Geritol is a “material fact” under the meaning of that term as used in Section 15 of the Federal Trade Commission Act and Petitioners’ failure to reveal this fact in this day when the consumer is influenced by mass advertising utilizing highly developed arts of persuasion, renders it difficult for the typical consumer to know whether the product will in fact meet his needs unless he is told what the product will or will not do.…
* * *
The Commission forbids the Petitioners’ representation that the presence of iron deficiency anemia can be self-diagnosed or can be determined without a medical test. The danger to be remedied here has been fully and adequately taken care of in the other requirements of the Order. We can find no Congressional policy against self-medication on a trial and error basis where the consumer is fully informed and the product is safe as Geritol is conceded to be. In fact, Congressional policy is to encourage such self-help. In effect the Commission’s Order l(f) tends to place Geritol in the prescription drug field. We do not consider it within the power of the Federal Trade Commission to remove Geritol from the area of proprietary drugs and place it in the area of prescription drugs. This requirement of the Order will not be enforced. We also find this Order is not unduly vague and fairly apprises the Petitioners of what is required of them. Petition denied and, except for l(f) of the Commission’s Order, enforcement of the Order will be granted
Video 49.1
“>(click to see video)
Students may be interested in a Geritol ad from 1960.
Case Questions
1. Did the defendant actually make statements that were false? If so, what were they? Or, rather than being clearly false, were the statements deceptive? If so, how so?
2. Whether or not you feel that you have “tired blood” or “iron-poor blood,” you may be amused by a Geritol ad from 1960. See Video 49.1. Do the disclaimers at the start of the ad that “the majority of tired people don’t feel that way because of iron-poor blood” sound like corrective advertising? Is the ad still deceptive in some way? If so, how? If not, why not?
Product Comparisons
P. Lorillard Co. v. Federal Trade Commission
186 F.2d 52 (4th Cir. 1950)
Parker, Chief Judge
This is a petition to set aside an order of the Federal Trade Commission which directed that the P. Lorillard Company cease and desist from making certain representations found to be false in the advertising of its tobacco products. The Commission has filed an answer asking that its order be enforced. The company was ordered to cease and desist “from representing by any means directly or indirectly”:
That Old Gold cigarettes or the smoke therefrom contains less nicotine, or less tars and resins, or is less irritating to the throat than the cigarettes or the smoke therefrom of any of the six other leading brands of cigarettes.
* * *
Laboratory tests introduced in evidence show that the difference in nicotine, tars and resins of the different leading brands of cigarettes is insignificant in amount; and there is abundant testimony of medical experts that such difference as there is could result in no difference in the physiological effect upon the smoker. There is expert evidence, also, that the slight difference in the nicotine, tar and resin content of cigarettes is not constant between different brands, but varies from place to place and from time to time, and that it is a practical impossibility for the manufacturer of cigarettes to determine or to remove or substantially reduce such content or to maintain constancy of such content in the finished cigarette. This testimony gives ample support to the Commission’s findings.
* * *
The company relies upon the truth of the advertisements complained of, saying that they merely state what had been truthfully stated in an article in the Reader’s Digest. An examination of the advertisements, however, shows a perversion of the meaning of the Reader’s Digest article which does little credit to the company’s advertising department—a perversion which results in the use of the truth in such a way as to cause the reader to believe the exact opposite of what was intended by the writer of the article. A comparison of the advertisements with the article makes this very plain. The article, after referring to laboratory tests that had been made on cigarettes of the leading brands, says:
“The laboratory’s general conclusion will be sad news for the advertising copy writers, but good news for the smoker, who need no longer worry as to which cigarette can most effectively nail down his coffin. For one nail is just about as good as another. Says the laboratory report: ‘The differences between brands are, practically speaking, small, and no single brand is so superior to its competitors as to justify its selection on the ground that it is less harmful.’ How small the variations are may be seen from the data tabulated on page 7.”
The table referred to in the article was inserted for the express purpose of showing the insignificance of the difference in the nicotine and tar content of the smoke from the various brands of cigarettes. It appears therefrom that the Old Gold cigarettes examined in the test contained less nicotine, tars and resins than the others examined, although the difference, according to the uncontradicted expert evidence, was so small as to be entirely insignificant and utterly without meaning so far as effect upon the smoker is concerned. The company proceeded to advertise this difference as though it had received a citation for public service instead of a castigation from the Reader’s Digest. In the leading newspapers of the country and over the radio it advertised that the Reader’s Digest had had experiments conducted and had found that Old Gold cigarettes were lowest in nicotine and lowest in irritating tars and resins, just as though a substantial difference in such content had been found. The following advertisement may be taken as typical:
OLD GOLDS FOUND LOWEST IN NICOTINE
OLD GOLDS FOUND LOWEST IN
THROAT-IRRITATING TARS AND RESINS
“See Impartial Test by Reader’s Digest July Issue.” See How Your Brand Compares with Old Gold.
“Reader’s Digest assigned a scientific testing laboratory to find out about cigarettes. They tested seven leading cigarettes and Reader’s Digest published the results.
“The cigarette whose smoke was lowest in nicotine was Old Gold. The cigarette with the least throat-irritating tars and resins was Old Gold.
“On both these major counts Old Gold was best among all seven cigarettes tested.
“Get July Reader’s Digest. Turn to Page 5. See what this highly respected magazine reports.
“You’ll say, ‘From now on, my cigarette is Old Gold.’ Light one? Note the mild, interesting flavor. Easier on the throat? Sure: And more smoking pleasure: Yes, it’s the new Old Gold—finer yet, since ‘something new has been added’.”
The fault with this advertising was not that it did not print all that the Reader’s Digest article said, but that it printed a small part thereof in such a way as to create an entirely false and misleading impression, not only as to what was said in the article, but also as to the quality of the company’s cigarettes. Almost anyone reading the advertisements or listening to the radio broadcasts would have gained the very definite impression that Old Gold cigarettes were less irritating to the throat and less harmful than other leading brands of cigarettes because they contained substantially less nicotine, tars and resins, and that the Reader’s Digest had established this fact in impartial laboratory tests; and few would have troubled to look up the Reader’s Digest to see what it really had said. The truth was exactly the opposite. There was no substantial difference in Old Gold cigarettes and the other leading brands with respect to their content of nicotine, tars and resins and this was what the Reader’s Digest article plainly said. The table whose meaning the advertisements distorted for the purpose of misleading and deceiving the public was intended to prove that there was no practical difference and did prove it when properly understood. To tell less than the whole truth is a well-known method of deception; and he who deceives by resorting to such method cannot excuse the deception by relying upon the truthfulness per se of the partial truth by which it has been accomplished.
In determining whether or not advertising is false or misleading within the meaning of the statute regard must be had, not to fine spun distinctions and arguments that may be made in excuse, but to the effect which it might reasonably be expected to have upon the general public. “The important criterion is the net impression which the advertisement is likely to make upon the general populace.” As was well said by Judge Coxe in Florence Manufacturing Co. v. J. C Dowd & Co., with reference to the law relating to trademarks: “The law is not made for the protection of experts, but for the public—that vast multitude which includes the ignorant, the unthinking and the credulous, who, in making purchases, do not stop to analyze, but are governed by appearances and general impressions.”
* * *
For the reasons stated, the petition to set aside the order will be denied and the order will be enforced.
Case Questions
1. From a practical perspective, what (if anything) is wrong with caveat emptor—”let the buyer beware”? The careful consumer could have looked at the Reader’s Digest article; the magazine was widely available in libraries and newsstands.
2. Why isn’t this just an example of “puffing” the company’s wares? (Puffing presents opinions rather than facts; statements like “This car is a real winner” and “Your wife will love this watch” constitute puffing.) | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/27%3A_Unfair_Trade_Practices_and_the_Federal_Trade_Commission/27.05%3A_Cases.txt |
Summary
Section 5 of the Federal Trade Commission (FTC) Act gives the FTC the power to enforce a provision prohibiting “unfair methods of competition and unfair or deceptive acts or practices in commerce.” Under this power, the FTC may bring enforcement proceedings against companies on a case-by-case basis or may promulgate trade regulation rules.
A deceptive act or practice need not actually deceive as long as it is “likely to mislead.” An unfair act or practice need not deceive at all but must offend a common sense of propriety or justice or of an honest way of acting. Among the proscribed acts or practices are these: failure to disclose pertinent facts, false or misleading description of products, misleading price and savings claims, bait-and-switch advertisements, free-offer claims, false product comparisons and disparagements, and endorsements by those who do not use the product or who have no reasonable basis for making the claims. Among the unfair trade practices that the FTC has sought to deter are certain types of contests and sweepstakes, high-pressure door-to-door and mail-order selling, and certain types of negative-option plans.
The FTC has a number of remedial weapons: cease and desist orders tailored to the particular deception or unfair act (including affirmative disclosure in advertising and corrections in future advertising), civil monetary penalties, and injunctions, damages, and restitution on behalf of injured consumers. Only the FTC may sue to correct violations of Section 5; private parties have no right to sue under Section 5, but they can sue for certain kinds of false advertising under the federal trademark laws.
Exercises
1. Icebox Ike, a well-known tackle for a professional football team, was recently signed to a multimillion-dollar contract to appear in a series of nationally televised advertisements touting the pleasures of going to the ballet and showing him in the audience watching a ballet. In fact, Icebox has never been to a ballet, although he has told his friends that he “truly believes” ballet is a “wonderful thing.” The FTC opens an investigation to determine whether there are grounds to take legal action against Icebox and the ballet company ads. What advice can you give Icebox Ike? What remedies can the FTC seek?
2. Door-to-door salespersons of an encyclopedia company offer a complete set of encyclopedias to “selected” customers. They tell customers that their only obligation is to pay for a ten-year updating service. In fact, the price of the updating service includes the cost of the encyclopedias. The FTC sues, charging deception under Section 5 of the FTC Act. The encyclopedia company defends itself on the ground that no one could possibly have been misled because everyone must have understood that no company could afford to give away a twenty-volume set of books for free. What is the result?
3. Vanessa Cosmetics takes out full-page advertisements in the local newspaper stating that “this Sunday only” the Vanessa Makeup Kit will be “reduced to only \$25.” In fact, the regular price has been \$25.50. Does this constitute deceptive advertising? Why?
4. Lilliputian Department Stores advertises a “special” on an electric carrot slicer, priced “this week only at \$10.” When customers come to the store, they find the carrot slicer in frayed boxes, and the advertised special is clearly inferior to a higher-grade carrot slicer priced at \$25. When customers ask about the difference, the store clerk tells them, “You wouldn’t want to buy the cheaper one; it wears out much too fast.” What grounds, if any, exist to charge Lilliputian with violations of the FTC Act?
5. A toothpaste manufacturer advertises that special tests demonstrate that use of its toothpaste results in fewer cavities than a “regular toothpaste.” In fact, the “regular” toothpaste was not marketed but was merely the advertiser’s brand stripped of its fluoride. Various studies over the years have demonstrated, however, that fluoride in toothpaste will reduce the number of cavities a user will get. Is this advertisement deceptive under Section 5 of the FTC Act?
6. McDonald’s advertises a sweepstakes through a mailing that says prizes are to be reserved for 15,610 “lucky winners.” The mailing further states, “You may be [a winner] but you will never know if you don’t claim your prize. All prizes not claimed will never be given away, so hurry.” The mailing does not give the odds of winning. The FTC sues to enjoin the mailing as deceptive. What is the result?
SELF CHECK QUESTIONS
1. Section 5 of the Federal Trade Commission Act is enforceable by
1. a consumer in federal court
2. a consumer in state court
3. the FTC in an administrative proceeding
4. the FTC suing in federal court
2. The FTC
1. is an independent federal agency
2. is an arm of the Justice Department
3. supersedes Congress in defining deceptive trade practices
4. speaks for the president on consumer matters
3. A company falsely stated that its competitor’s product “won’t work.” Which of the following statements is false?
1. The competitor may sue the company under state law.
2. The competitor may sue the company for violating the FTC Act.
3. The competitor may sue the company for violating the Lanham Act.
4. The FTC may sue the company for violating the FTC Act.
4. The FTC may order a company that violated Section 5 of the FTC Act by false advertising
1. to go out of business
2. to close down the division of the company that paid for false advertising
3. to issue corrective advertising
4. to buy back from its customers all the products sold by the advertising
5. The ingredients in a nationally advertised cupcake must be disclosed on the package under
1. state common law
2. a trade regulation rule promulgated by the FTC
3. the federal Food, Drug, and Cosmetic Act
4. an executive order of the president
1. c
2. a
3. b
4. c
5. b | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/27%3A_Unfair_Trade_Practices_and_the_Federal_Trade_Commission/27.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The various kinds of interests (or “estates”) in real property
• The various rights that come with ownership of real property
• What easements are, how they are created, and how they function
• How ownership of real property is regulated by tort law, by agreement, and by the public interest (through eminent domain)
• The various ways in which environmental laws affect the ownership and use of real property
Real property is an important part of corporate as well as individual wealth. As a consequence, the role of the corporate real estate manager has become critically important within the corporation. The real estate manager must be aware not only of the value of land for purchase and sale but also of proper lease negotiation, tax policies and assessments, zoning and land development, and environmental laws.
In this chapter, we focus on regulation of land use and the environment. We divide our discussion of the nature of real estate into three major categories: (1) estates; (2) rights that are incidental to the possession and ownership of land—for example, the right to air, water, and minerals; and (3) easements—the rights in lands of others.
28: The Nature and Regulation of Real Estate and the Environment
Learning Objectives
By the end of this section, you will be able to:
• Distinguish between the various kinds of estates, or interests, in real property that the law recognizes.
In property law, an estate is an interest in real property, ranging from absolute dominion and control to bare possession. Ordinarily when we think of property, we think of only one kind: absolute ownership. The owner of a car has the right to drive it where and when she wants, rebuild it, repaint it, and sell it or scrap it. The notion that the owner might lose her property when a particular event happens is foreign to our concept of personal property. Not so with real property. You would doubtless think it odd if you were sold a used car subject to the condition that you not paint it a different color—and that if you did, you would automatically be stripped of ownership. But land can be sold that way. Land and other real property can be divided into many categories of interests, as we will see. (Be careful not to confuse the various types of interests in real property with the forms of ownership, such as joint tenancy. An interest in real property that amounts to an estate is a measure of the degree to which a thing is owned; the form of ownership deals with the particular person or persons who own it.)
The common law distinguishes estates along two main axes: (1) freeholds versus leaseholds and (2) present versus future interests. A freehold estate is an interest in land that has an uncertain duration. The freehold can be outright ownership—called the fee simple absolute—or it can be an interest in the land for the life of the possessor; in either case, it is impossible to say exactly how long the estate will last. In the case of one who owns property outright, her estate will last until she sells or transfers it; in the case of a life estate, it will last until the death of the owner or another specified individual. A leasehold estate is one whose termination date is usually known. A one-year lease, for example, will expire precisely at the time stated in the lease agreement.
A present estate is one that is currently owned and enjoyed; a future estate is one that will come into the owner’s possession upon the occurrence of a particular event. In this chapter, we consider both present and future freehold interests; leasehold interests we save for Chapter 32.
Present Estates (Freeholds)
Fee Simple Absolute
The strongest form of ownership is known as the fee simple absolute (or fee simple, or merely fee). This is what we think of when we say that someone “owns” the land. As one court put it, “The grant of a fee in land conveys to the grantee complete ownership, immediately and forever, with the right of possession from boundary to boundary and from the center of the earth to the sky, together with all the lawful uses thereof.”Magnolia Petroleum Co. v. Thompson, 106 F.2d 217 (8th Cir. 1939). Although the fee simple may be encumbered by a mortgage (you may borrow money against the equity in your home) or an easement (you may grant someone the right to walk across your backyard), the underlying control is in the hands of the owner. Though it was once a complex matter in determining whether a person had been given a fee simple interest, today the law presumes that the estate being transferred is a fee simple, unless the conveyance expressly states to the contrary. (In her will, Lady Gaga grants her five-thousand-acre ranch “to my screen idol, Tilda Swinton.” On the death of Lady Gaga, Swinton takes ownership of the ranch outright in fee simple absolute.)
Fee Simple Defeasible
Not every transfer of real property creates a fee simple absolute. Some transfers may limit the estate. Any transfer specifying that the ownership will terminate upon a particular happening is known as a fee simple defeasible. Suppose, for example, that Mr. Warbucks conveys a tract of land “to Miss Florence Nightingale, for the purpose of operating her hospital and for no other purpose. Conveyance to be good as long as hospital remains on the property.” This grant of land will remain the property of Miss Nightingale and her heirs as long as she and they maintain a hospital. When they stop doing so, the land will automatically revert to Mr. Warbucks or his heirs, without their having to do anything to regain title. Note that the conveyance of land could be perpetual but is not absolute, because it will remain the property of Miss Nightingale only so long as she observes the conditions in the grant.
Life Estates
An estate measured by the life of a particular person is called a life estate. A conventional life estate is created privately by the parties themselves. The simplest form is that conveyed by the following words: “to Scarlett for life.” Scarlett becomes a life tenant; as such, she is the owner of the property and may occupy it for life or lease it or even sell it, but the new tenant or buyer can acquire only as much as Scarlett has to give, which is ownership for her life (i.e., all she can sell is a life estate in the land, not a fee simple absolute). If Scarlett sells the house and dies a month later, the buyer’s interest would terminate. A life estate may be based on the life of someone other than the life tenant: “to Scarlett for the life of Rhett.”
The life tenant may use the property as though he were the owner in fee simple absolute with this exception: he may not act so as to diminish the value of the property that will ultimately go to the remainderman—the person who will become owner when the life estate terminates. The life tenant must pay the life estate for ordinary upkeep of the property, but the remainderman is responsible for extraordinary repairs.
Some life estates are created by operation of law and are known as legal life estates. The most common form is a widow’s interest in the real property of her husband. In about one-third of the states, a woman is entitled to dower, a right to a percentage (often one-third) of the property of her husband when he dies. Most of these states give a widower a similar interest in the property of his deceased wife. Dower is an alternative to whatever is bequeathed in the will; the widow has the right to elect the share stated in the will or the share available under dower. To prevent the dower right from upsetting the interests of remote purchasers, the right may be waived on sale by having the spouse sign the deed.
Future Estates
To this point, we have been considering present estates. But people also can have future interests in real property. Despite the implications of its name, the future interest is owned now but is not available to be used or enjoyed now. For the most part, future interests may be bought and sold, just as land held in fee simple absolute may be bought and sold. There are several classes of future interests, but in general there are two major types: reversion and remainder.
Reversion
A reversion arises whenever the estate transferred has a duration less than that originally owned by the transferor. A typical example of a simple reversion is that which arises when a life estate is conveyed. The ownership conveyed is only for the life; when the life tenant dies, the ownership interest reverts to the grantor. Suppose the grantor has died in the meantime. Who gets the reversion interest? Since the reversion is a class of property that is owned now, it can be inherited, and the grantor’s heirs would take the reversion at the subsequent death of the life tenant.
Remainder
The transferor need not keep the reversion interest for himself. He can give that interest to someone else, in which case it is known as a remainder interest, because the remainder of the property is being transferred. Suppose the transferor conveys land with these words: “to Scarlett for life and then to Rhett.” Scarlett has a life estate; the remainder goes to Rhett in fee simple absolute. Rhett is said to have a vested remainder interest, because on Scarlett’s death, he or his heirs will automatically become owners of the property. Some remainder interests are contingent—and are therefore known as contingent remainder interests—on the happening of a certain event: “to my mother for her life, then to my sister if she marries Harold before my mother dies.” The transferor’s sister will become the owner of the property in fee simple only if she marries Harold while her mother is alive; otherwise, the property will revert to the transferor or his heirs. The number of permutations of reversions and remainders can become quite complex, far more than we have space to discuss in this text.
Key Takeaway
An estate is an interest in real property. Estates are of many kinds, but one generic difference is between ownership estates and possessory estates. Fee simple estates and life estates are ownership estates, while leasehold interests are possessory. Among ownership estates, the principal division is between present estates and future estates. An owner of a future estate has an interest that can be bought and sold and that will ripen into present possession at the end of a period of time, at the end of the life of another, or with the happening of some contingent event.
Exercises
1. Jessa owns a house and lot on 9th Avenue. She sells the house to the Hartley family, who wish to have a conveyance from her that says, “to Harriet Hartley for life, remainder to her son, Alexander Sandridge.” Alexander is married to Chloe, and they have three children, Carmen, Sarah, and Michael. Who has a future interest, and who has a present interest? What is the correct legal term for Harriet’s estate? Does Alexander, Carmen, Sarah, or Michael have any part of the estate at the time Jessa conveys to Harriet using the stated language?
2. After Harriet dies, Alexander wants to sell the property. Alexander and Chloe’s children are all eighteen years of age or older. Can he convey the property by his signature alone? Who else needs to sign? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.01%3A_Estates.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand that property owners have certain rights in the airspace above their land, in the minerals beneath their land, and even in water that adjoins their land.
Rights to Airspace
The traditional rule was stated by Lord Coke: “Whoever owns the soil owns up to the sky.” This traditional rule remains valid today, but its application can cause problems. A simple example would be a person who builds an extension to the upper story of his house so that it hangs out over the edge of his property line and thrusts into the airspace of his neighbor. That would clearly be an encroachment on the neighbor’s property. But is it trespass when an airplane—or an earth satellite—flies over your backyard? Obviously, the courts must balance the right to travel against landowners’ rights. In U.S. v. Causby,U.S. v. Causby, 328 U.S. 256 (1946). the Court determined that flights over private land may constitute a diminution in the property value if they are so low and so frequent as to be a direct and immediate interference with the enjoyment and use of land.
Rights to the Depths
Lord Coke’s dictum applies to the depths as well as the sky. The owner of the surface has the right to the oil, gas, and minerals below it, although this right can be severed and sold separately. Perplexing questions may arise in the case of oil and gas, which can flow under the surface. Some states say that oil and gas can be owned by the owner of the surface land; others say that they are not owned until actually extracted—although the property owner may sell the exclusive right to extract them from his land. But states with either rule recognize that oil and gas are capable of being “captured” by drilling that causes oil or gas from under another plot of land to run toward the drilled hole. Since the possibility of capture can lead to wasteful drilling practices as everyone nearby rushes to capture the precious commodities, many states have enacted statutes requiring landowners to share the resources.
Rights to Water
The right to determine how bodies of water will be used depends on basic property rules. Two different approaches to water use in the United States—eastern and western—have developed over time (see Figure 28.2). Eastern states, where water has historically been more plentiful, have adopted the so-called riparian rights theory, which itself can take two forms. Riparian refers to land that includes a part of the bed of a waterway or that borders on a public watercourse. A riparian owner is one who owns such land. What are the rights of upstream and downstream owners of riparian land regarding use of the waters? One approach is the “natural flow” doctrine: Each riparian owner is entitled to have the river or other waterway maintained in its natural state. The upstream owner may use the river for drinking water or for washing but may not divert it to irrigate his crops or to operate his mill if doing so would materially change the amount of the flow or the quality of the water. Virtually all eastern states today are not so restrictive and rely instead on a “reasonable use” doctrine, which permits the benefit to be derived from use of the waterway to be weighed against the gravity of the harm. This approach is illustrated in Hoover v. Crane, (see Section 28.6.1 “Reasonable Use Doctrine”.Hoover v. Crane, 362 Mich. 36, 106 N.W.2d 563 (1960).
In contrast to riparian rights doctrines, western states have adopted the prior appropriation doctrine. This rule looks not to equality of interests but to priority in time: first in time is first in right. The first person to use the water for a beneficial purpose has a right superior to latecomers. This rule applies even if the first user takes all the water for his own needs and even if other users are riparian owners. This rule developed in water-scarce states in which development depended on incentives to use rather than hoard water. Today, the prior appropriation doctrine has come under criticism because it gives incentives to those who already have the right to the water to continue to use it profligately, rather than to those who might develop more efficient means of using it.
Key Takeaway
Property owners have certain rights in the airspace above their land. They also have rights in subsurface minerals, which include oil and gas. Those property owners who have bodies of water adjacent to their land will also have certain rights to withdraw or impound water for their own use. Regarding US water law, the reasonable use doctrine in the eastern states is distinctly different from the prior appropriation doctrine in western states.
Exercises
1. Steve Hannaford farms in western Nebraska. The farm has passed to succeeding generations of Hannafords, who use water from the North Platte River for irrigation purposes. The headlands of the North Platte are in Colorado, but use of the water from the North Platte by Nebraskans preceded use of the water by settlers in Colorado. What theory of water rights governs Nebraska and Colorado residents? Can the state of Colorado divert and use water in such a way that less of it reaches western Nebraska and the Hannaford farm? Why or why not?
2. Jamie Stoner decides to put solar panels on the south face of his roof. Jamie lives on a block of one- and two-bedroom bungalows in South Miami, Florida. In 2009, someone purchases the house next door and within two years decides to add a second and third story. This proposed addition will significantly decrease the utility of Jamie’s solar array. Does Jamie have any rights that would limit what his new neighbors can do on their own land? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.02%3A_Rights_Incident_to_Possession_and_Ownership_of_Real_Estate.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the difference between an easement and a license.
• Describe the ways in which easements can be created.
Definition
An easement is an interest in land created by agreement that permits one person to make use of another’s estate. This interest can extend to a profit, the taking of something from the other’s land. Though the common law once distinguished between an easement and profit, today the distinction has faded, and profits are treated as a type of easement. An easement must be distinguished from a mere license, which is permission, revocable at the will of the owner, to make use of the owner’s land. An easement is an estate; a license is personal to the grantee and is not assignable.
The two main types of easements are affirmative and negative. An affirmative easement gives a landowner the right to use the land of another (e.g., crossing it or using water from it), while a negative easement, by contrast, prohibits the landowner from using his land in ways that would affect the holder of the easement. For example, the builder of a solar home would want to obtain negative easements from neighbors barring them from building structures on their land that would block sunlight from falling on the solar home. With the growth of solar energy, some states have begun to provide stronger protection by enacting laws that regulate one’s ability to interfere with the enjoyment of sunlight. These laws range from a relatively weak statute in Colorado, which sets forth rules for obtaining easements, to the much stronger statute in California, which says in effect that the owner of a solar device has a vested right to continue to receive the sunlight.
Another important distinction is made between easements appurtenant and easements in gross. An easement appurtenant benefits the owner of adjacent land. The easement is thus appurtenant to the holder’s land. The benefited land is called the dominant tenement, and the burdened land—that is, the land subject to the easement—is called the servient tenement (see Figure 28.3). An easement in gross is granted independent of the easement holder’s ownership or possession of land. It is simply an independent right—for example, the right granted to a local delivery service to drive its trucks across a private roadway to gain access to homes at the other end.
Unless it is explicitly limited to the grantee, an easement appurtenant “runs with the land.” That is, when the dominant tenement is sold or otherwise conveyed, the new owner automatically owns the easement. A commercial easement in gross may be transferred—for instance, easements to construct pipelines, telegraph and telephone lines, and railroad rights of way. However, most noncommercial easements in gross are not transferable, being deemed personal to the original owner of the easement. Rochelle sells her friend Mrs. Nanette—who does not own land adjacent to Rochelle—an easement across her country farm to operate skimobiles during the winter. The easement is personal to Mrs. Nanette; she could not sell the easement to anyone else.
Creation
Easements may be created by express agreement, either in deeds or in wills. The owner of the dominant tenement may buy the easement from the owner of the servient tenement or may reserve the easement for himself when selling part of his land. But courts will sometimes allow implied easements under certain circumstances. For instance, if the deed refers to an easement that bounds the premises—without describing it in any detail—a court could conclude that an easement was intended to pass with the sale of the property.
An easement can also be implied from prior use. Suppose a seller of land has two lots, with a driveway connecting both lots to the street. The only way to gain access to the street from the back lot is to use the driveway, and the seller has always done so. If the seller now sells the back lot, the buyer can establish an easement in the driveway through the front lot if the prior use was (1) apparent at the time of sale, (2) continuous, and (3) reasonably necessary for the enjoyment of the back lot. The rule of implied easements through prior use operates only when the ownership of the dominant and servient tenements was originally in the same person.
Use of the Easement
The servient owner may use the easement—remember, it is on or under or above his land—as long as his use does not interfere with the rights of the easement owner. Suppose you have an easement to walk along a path in the woods owned by your neighbor and to swim in a private lake that adjoins the woods. At the time you purchased the easement, your neighbor did not use the lake. Now he proposes to swim in it himself, and you protest. You would not have a sound case, because his swimming in the lake would not interfere with your right to do so. But if he proposed to clear the woods and build a mill on it, obliterating the path you took to the lake and polluting the lake with chemical discharges, then you could obtain an injunction to bar him from interfering with your easement.
The owner of the dominant tenement is not restricted to using his land as he was at the time he became the owner of the easement. The courts will permit him to develop the land in some “normal” manner. For example, an easement on a private roadway for the benefit of a large estate up in the hills would not be lost if the large estate were ultimately subdivided and many new owners wished to use the roadway; the easement applies to the entire portion of the original dominant tenement, not merely to the part that abuts the easement itself. However, the owner of an easement appurtenant to one tract of land cannot use the easement on another tract of land, even if the two tracts are adjacent.
Key Takeaway
An easement appurtenant runs with the land and benefits the dominant tenement, burdening the servient tenement. An easement, generally, has a specific location or description within or over the servient tenement. Easements can be created by deed, by will, or by implication.
Exercises
1. Beth Delaney owns property next to Kerry Plemmons. The deed to Delaney’s property notes that she has access to a well on the Plemmons property “to obtain water for household use.” The well has been dry for many generations and has not been used by anyone on the Plemmons property or the Delaney property for as many generations. The well predated Plemmons’s ownership of the property; as the servient tenement, the Plemmons property was burdened by this easement dating back to 1898. Plemmons hires a company to dig a very deep well near one of his outbuildings to provide water for his horses. The location is one hundred yards from the old well. Does the Delaney property have any easement to use water from the new well? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.03%3A_Easements-_Rights_in_the_Lands_of_Others.txt |
Learning Objectives
By the end of this section, you will be able to:
• Compare the various ways in which law limits or restricts the right to use your land in any way that you decide is best for you.
• Distinguish between regulation by common law and regulation by public acts such as zoning or eminent domain.
• Understand that property owners may restrict the uses of land by voluntary agreement, subject to important public policy considerations.
Land use regulation falls into three broad categories: (1) restriction on the use of land through tort law, (2) private regulation by agreement, and (3) public ownership or regulation through the powers of eminent domain and zoning.
Regulation of Land Use by Tort Law
Tort law is used to regulate land use in two ways: (1) The owner may become liable for certain activities carried out on the real estate that affect others beyond the real estate. (2) The owner may be liable to persons who, upon entering the real estate, are injured.
Landowner’s Activities
The two most common torts in this area are nuisance and trespass. A common-law nuisance is an interference with the use and enjoyment of one’s land. Examples of nuisances are excessive noise (especially late at night), polluting activities, and emissions of noxious odors. But the activity must produce substantial harm, not fleeting, minor injury, and it must produce those effects on the reasonable person, not on someone who is peculiarly allergic to the complained-of activity. A person who suffered migraine headaches at the sight of croquet being played on a neighbor’s lawn would not likely win a nuisance lawsuit. While the meaning of nuisance is difficult to define with any precision, this common-law cause of action is a primary means for landowners to obtain damages for invasive environmental harms.
A trespass is the wrongful physical invasion of or entry upon land possessed by another. Loud noise blaring out of speakers in the house next door might be a nuisance but could not be a trespass, because noise is not a physical invasion. But spraying pesticides on your gladiolas could constitute a trespass on your neighbor’s property if the pesticide drifts across the boundary.
Nuisance and trespass are complex theories, a full explanation of which would consume far more space than we have. What is important to remember is that these torts are two-edged swords. In some situations, the landowner himself will want to use these theories to sue trespassers or persons creating a nuisance, but in other situations, the landowner will be liable under these theories for his own activities.
Injury to Persons Entering the Real Estate
Traditionally, liability for injury has depended on the status of the person who enters the real estate.
Trespassers
If the person is an intruder without permission—a trespasser—the landowner owes him no duty of care unless he knows of the intruder’s presence, in which case the owner must exercise reasonable care in his activities and warn of hidden dangers on his land of which he is aware. A known trespasser is someone whom the landowner actually sees on the property or whom he knows frequently intrudes on the property, as in the case of someone who habitually walks across the land. If a landowner knows that people frequently walk across his property and one day he puts a poisonous chemical on the ground to eliminate certain insects, he is obligated to warn those who continue to walk on the grounds. Intentional injury to known trespassers is not allowed, even if the trespasser is a criminal intent on robbery, for the law values human life above property rights.
Children
If the trespasser is a child, a different rule applies in most states. This is the doctrine of attractive nuisance. Originally this rule was enunciated to deal with cases in which something on the land attracted the child to it, like a swimming pool. In recent years, most courts have dropped the requirement that the child must have been attracted to the danger. Instead, the following elements of proof are necessary to make out a case of attractive nuisance (Restatement of Torts, Section 339):
1. The child must have been injured by a structure or other artificial condition.
2. The possessor of the land (not necessarily the owner) must have known or should have known that young children would be likely to trespass.
3. The possessor must have known or should have known that the artificial condition exists and that it posed an unreasonable risk of serious injury.
4. The child must have been too young to appreciate the danger that the artificial condition posed.
5. The risk to the child must have far outweighed the utility of the artificial condition to the possessor.
6. The possessor did not exercise reasonable care in protecting the child or eliminating the danger.
Old refrigerators, open gravel pits, or mechanisms that a curious child would find inviting are all examples of attractive nuisance. Suppose Farmer Brown keeps an old buggy on his front lawn, accessible from the street. A five-year-old boy clambers up the buggy one day, falls through a rotted floorboard, and breaks his leg. Is Farmer Brown liable? Probably so. The child was too young to appreciate the danger posed by the buggy, a structure. The farmer should have appreciated that young children would be likely to come onto the land when they saw the buggy and that they would be likely to climb up onto the buggy. Moreover, he should have known, if he did not know in fact, that the buggy, left outside for years without being tended, would pose an unreasonable risk. The buggy’s utility as a decoration was far overbalanced by the risk that it posed to children, and the farmer failed to exercise reasonable care.
Licensees
A nontrespasser who comes onto the land without being invited, or if invited, comes for purposes unconnected with any business conducted on the premises, is known as a licensee. This class of visitors to the land consists of (1) social guests (people you invite to your home for a party); (2) a salesman, not invited by the owner, who wishes to sell something to the owner or occupier of the property; and (3) persons visiting a building for a purpose not connected with the business on the land (e.g., students who visit a factory to see how it works). The landowner owes the same duty of care to licensees that he owes to known trespassers. That is, he must warn them against hidden dangers of which he is aware, and he must exercise reasonable care in his activities to ensure that they are not injured.
Invitees
A final category of persons entering land is that of invitee. This is one who has been invited onto the land, usually, though not necessarily, for a business purpose of potential economic benefit to the owner or occupier of the premises. This category is confusing because it sounds as though it should include social guests (who clearly are invited onto the premises), but traditionally social guests are said to be licensees.
Invitees include customers of stores, users of athletic and other clubs, customers of repair shops, strollers through public parks, restaurant and theater patrons, hotel guests, and the like. From the owner’s perspective, the major difference between licensees and invitees is that he is liable for injuries resulting to the latter from hidden dangers that he should have been aware of, even if he is not actually aware of the dangers. How hidden the dangers are and how broad the owner’s liability is depends on the circumstances, but liability sometimes can be quite broad. Difficult questions arise in lawsuits brought by invitees (or business invitees, as they are sometimes called) when the actions of persons other than the landowner contribute to the injury.
The foregoing rules dealing with liability for persons entering the land are the traditional rules at common law. In recent years, some courts have moved away from the rigidities and sometimes perplexing differences between trespassers, licensees, and invitees. By court decision, several states have now abolished such distinctions and hold the proprietor, owner, or occupier liable for failing to maintain the premises in a reasonably safe condition. According to the California Supreme Court,
A man’s life or limb does not become less worthy of protection by the law nor a loss less worthy of compensation under the law because he has come upon the land of another without permission or with permission but without a business purpose. Reasonable people do not ordinarily vary their conduct depending upon such matters, and to focus upon the status of the injured party as a trespasser, licensee, or invitee in order to determine the question whether the landowner has a duty of care, is contrary to our modern social mores and humanitarian values. Where the occupier of land is aware of a concealed condition involving in the absence of precautions an unreasonable risk of harm to those coming in contact with it and is aware that a person on the premises is about to come in contact with it, the trier of fact can reasonably conclude that a failure to warn or to repair the condition constitutes negligence. Whether or not a guest has a right to expect that his host will remedy dangerous conditions on his account, he should reasonably be entitled to rely upon a warning of the dangerous condition so that he, like the host, will be in a position to take special precautions when he comes in contact with it.Rowland v. Christian, 443 P.2d 561 (Cal. 1968).
Private Regulation of Land Use by Agreement
A restrictive covenant is an agreement regarding the use of land that “runs with the land.” In effect, it is a contractual promise that becomes part of the property and that binds future owners. Violations of covenants can be redressed in court in suits for damages or injunctions but will not result in reversion of the land to the seller.
Usually, courts construe restrictive covenants narrowly—that is, in a manner most conducive to free use of the land by the ultimate owner (the person against whom enforcement of the covenant is being sought). Sometimes, even when the meaning of the covenant is clear, the courts will not enforce it. For example, when the character of a neighborhood changes, the courts may declare the covenant a nullity. Thus a restriction on a one-acre parcel to residential purposes was voided when in the intervening thirty years a host of businesses grew up around it, including a bowling alley, restaurant, poolroom, and sewage disposal plant.Norris v. Williams, 54 A.2d 331 (Md. 1947).
An important nullification of restrictive covenants came in 1947 when the US Supreme Court struck down as unconstitutional racially restrictive covenants, which barred blacks and other minorities from living on land so burdened. The Supreme Court reasoned that when a court enforces such a covenant, it acts in a discriminatory manner (barring blacks but not whites from living in a home burdened with the covenant) and thus violates the Fourteenth Amendment’s guarantee of equal protection of the laws.Shelley v. Kraemer, 334 U.S. 1 (1947).
Public Control of Land Use through Eminent Domain
The government may take private property for public purposes. Its power to do so is known as eminent domain. The power of eminent domain is subject to constitutional limitations. Under the Fifth Amendment, the property must be put to public use, and the owner is entitled to “just compensation” for his loss. These requirements are sometimes difficult to apply.
Public Use
The requirement of public use normally means that the property will be useful to the public once the state has taken possession—for example, private property might be condemned to construct a highway. Although not allowed in most circumstances, the government could even condemn someone’s property in order to turn around and sell it to another individual, if a legitimate public purpose could be shown. For example, a state survey in the mid-1960s showed that the government owned 49 percent of Hawaii’s land. Another 47 percent was controlled by seventy-two private landowners. Because this concentration of land ownership (which dated back to feudal times) resulted in a critical shortage of residential land, the Hawaiian legislature enacted a law allowing the government to take land from large private estates and resell it in smaller parcels to homeowners. In 1984, the US Supreme Court upheld the law, deciding that the land was being taken for a public use because the purpose was “to attack certain perceived evils of concentrated property ownership.”Hawaii Housing Authority v. Midkiff, 467 U.S. 229 (1984). Although the use must be public, the courts will not inquire into the necessity of the use or whether other property might have been better suited. It is up to government authorities to determine whether and where to build a road, not the courts.
The limits of public use were amply illustrated in the Supreme Court’s 2002 decision of Kelo v. New London,Kelo v. New London, 545 U.S. 469 (2005). in which Mrs. Kelo’s house was condemned so that the city of New London, in Connecticut, could create a marina and industrial park to lease to Pfizer Corporation. The city’s motives were to create a higher tax base for property taxes. The Court, following precedent in Midkiff and other cases, refused to invalidate the city’s taking on constitutional grounds. Reaction from states was swift; many states passed new laws restricting the bases for state and municipal governments to use powers of eminent domain, and many of these laws also provided additional compensation to property owners whose land was taken.
Just Compensation
The owner is ordinarily entitled to the fair market value of land condemned under eminent domain. This value is determined by calculating the most profitable use of the land at the time of the taking, even though it was being put to a different use. The owner will have a difficult time collecting lost profits; for instance, a grocery store will not usually be entitled to collect for the profits it might have made during the next several years, in part because it can presumably move elsewhere and continue to make profits and in part because calculating future profits is inherently speculative.
Taking
The most difficult question in most modern cases is whether the government has in fact “taken” the property. This is easy to answer when the government acquires title to the property through condemnation proceedings. But more often, a government action is challenged when a law or regulation inhibits the use of private land. Suppose a town promulgates a setback ordinance, requiring owners along city sidewalks to build no closer to the sidewalk than twenty feet. If the owner of a small store had only twenty-five feet of land from the sidewalk line, the ordinance would effectively prevent him from housing his enterprise, and the ordinance would be a taking. Challenging such ordinances can sometimes be difficult under traditional tort theories because the government is immune from suit in some of these cases. Instead, a theory of inverse condemnation has developed, in which the plaintiff private property owner asserts that the government has condemned the property, though not through the traditional mechanism of a condemnation proceeding.
Public Control of Land Use through Zoning
Zoning is a technique by which a city or other municipality regulates the type of activity to be permitted in geographical areas within its boundaries. Though originally limited to residential, commercial, and industrial uses, today’s zoning ordinances are complex sets of regulations. A typical municipality might have the following zones: residential with a host of subcategories (such as for single-family and multiple-family dwellings), office, commercial, industrial, agricultural, and public lands. Zones may be exclusive, in which case office buildings would not be permitted in commercial zones, or they may be cumulative, so that a more restricted use would be allowed in a less restrictive zone. Zoning regulations do more than specify the type of use: they often also dictate minimum requirements for parking, open usable space, setbacks, lot sizes, and the like, and maximum requirements for height, length of side lots, and so on.
Nonconforming Uses
When a zoning ordinance is enacted, it will almost always affect existing property owners, many of whom will be using their land in ways no longer permitted under the ordinance. To avoid the charge that they have thereby “taken” the property, most ordinances permit previous nonconforming uses to continue, though some ordinances limit the nonconforming uses to a specified time after becoming effective. But this permission to continue a nonconforming use is narrow; it extends only to the specific use to which the property was put before the ordinance was enacted. A manufacturer of dresses that suddenly finds itself in an area zoned residential may continue to use its sewing machines, but it could not develop a sideline in woodworking.
Variances
Sometimes an owner may desire to use his property in ways not permitted under an existing zoning scheme and will ask the zoning board for a variance—authority to carry on a nonconforming use. The board is not free to grant a variance at its whim. The courts apply three general tests to determine the validity of a variance: (1) The land must be unable to yield a reasonable return on the uses allowed by the zoning regulation. (2) The hardship must be unique to the property, not to property generally in the area. (3) If granted, the variance must not change the essential character of the neighborhood.
Key Takeaway
Land use regulation can mean (1) restrictions on the use of land through tort law, (2) private regulation—by agreement, or (3) regulation through powers of eminent domain or zoning.
Exercises
1. Give one example of the exercise of eminent domain. In order to exercise its power under eminent domain, must the government actually take eventual ownership of the property that is “taken”?
2. Felix Unger is an adult, trespassing for the first time on Alan Spillborghs’s property. Alan has been digging a deep grave in his backyard for his beloved Saint Bernard, Maximilian, who has just died. Alan stops working on the grave when it gets dark, intending to return to the task in the morning. He seldom sees trespassers cutting through his backyard. Felix, in the dark, after visiting the local pub, decides to take a shortcut through Alan’s yard and falls into the grave. He breaks his leg. What is the standard of care for Alan toward Felix or other infrequent trespassers? If Alan has no insurance for this accident, would the law make Alan responsible?
3. Atlantic Cement owns and operates a cement plant in New York State. Nearby residents are exposed to noise, soot, and dust and have experienced lowered property values as a result of Atlantic Cement’s operations. Is there a common-law remedy for nearby property owners for losses occasioned by Atlantic’s operations? If so, what is it called? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.04%3A_Regulation_of_Land_Use.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe the major federal laws that govern business activities that may adversely affect air quality and water quality.
• Describe the major federal laws that govern waste disposal and chemical hazards including pesticides.
In one sense, environmental law is very old. Medieval England had smoke control laws that established the seasons when soft coal could be burned. Nuisance laws give private individuals a limited control over polluting activities of adjacent landowners. But a comprehensive set of US laws directed toward general protection of the environment is largely a product of the past quarter-century, with most of the legislative activity stemming from the late 1960s and later, when people began to perceive that the environment was systematically deteriorating from assaults by rapid population growth and greatly increased automobile driving, vast proliferation of factories that generate waste products, and a sharp rise in the production of toxic materials. Two of the most significant developments in environmental law came in 1970, when the National Environmental Policy Act took effect and the Environmental Protection Agency became the first of a number of new federal administrative agencies to be established during the decade.
National Environmental Policy Act
Signed into law by President Nixon on January 1, 1970, the National Environmental Policy Act (NEPA) declared that it shall be the policy of the federal government, in cooperation with state and local governments, “to create and maintain conditions under which man and nature can exist in productive harmony, and fulfill the social, economic, and other requirements of present and future generations of Americans.…The Congress recognizes that each person should enjoy a healthful environment and that each person has a responsibility to contribute to the preservation and enhancement of the environment.”42 United States Code, Section 4321 et seq.
The most significant aspect of NEPA is its requirement that federal agencies prepare an environmental impact statement in every recommendation or report on proposals for legislation and whenever undertaking a major federal action that significantly affects environmental quality. The statement must (1) detail the environmental impact of the proposed action, (2) list any unavoidable adverse impacts should the action be taken, (3) consider alternatives to the proposed action, (4) compare short-term and long-term consequences, and (5) describe irreversible commitments of resources. Unless the impact statement is prepared, the project can be enjoined from proceeding. Note that NEPA does not apply to purely private activities but only to those proposed to be carried out in some manner by federal agencies.
Environmental Protection Agency
The Environmental Protection Agency (EPA) has been in the forefront of the news since its creation in 1970. Charged with monitoring environmental practices of industry, assisting the government and private business to halt environmental deterioration, promulgating regulations consistent with federal environmental policy, and policing industry for violations of the various federal environmental statutes and regulations, the EPA has had a pervasive influence on American business. Business Week noted the following in 1977: “Cars rolling off Detroit’s assembly line now have antipollution devices as standard equipment. The dense black smokestack emissions that used to symbolize industrial prosperity are rare, and illegal, sights. Plants that once blithely ran discharge water out of a pipe and into a river must apply for permits that are almost impossible to get unless the plants install expensive water treatment equipment. All told, the EPA has made a sizable dent in man-made environmental filth.”“The Tricks of the Trade-off,” Business Week, April 4, 1977, 72.
The EPA is especially active in regulating water and air pollution and in overseeing the disposition of toxic wastes and chemicals. To these problems we now turn.
Water Pollution
Clean Water Act
Legislation governing the nation’s waterways goes back a long time. The first federal water pollution statute was the Rivers and Harbors Act of 1899. Congress enacted new laws in 1948, 1956, 1965, 1966, and 1970. But the centerpiece of water pollution enforcement is the Clean Water Act of 1972 (technically, the Federal Water Pollution Control Act Amendments of 1972), as amended in 1977 and by the Water Quality Act of 1987. The Clean Water Act is designed to restore and maintain the “chemical, physical, and biological integrity of the Nation’s waters.”33 United States Code, Section 1251. It operates on the states, requiring them to designate the uses of every significant body of water within their borders (e.g., for drinking water, recreation, commercial fishing) and to set water quality standards to reduce pollution to levels appropriate for each use.
Congress only has power to regulate interstate commerce, and so the Clean Water Act is applicable only to “navigable waters” of the United States. This has led to disputes over whether the act can apply, say, to an abandoned gravel pit that has no visible connection to navigable waterways, even if the gravel pit provides habitat for migratory birds. In Solid Waste Agency of Northern Cook County v. Army Corps of Engineers, the US Supreme Court said no.Solid Waste Agency of Northern Cook County v. Army Corps of Engineers, 531 U.S. 159 (2001).
Private Industry
The Clean Water Act also governs private industry and imposes stringent standards on the discharge of pollutants into waterways and publicly owned sewage systems. The act created an effluent permit system known as the National Pollutant Discharge Elimination System. To discharge any pollutants into navigable waters from a “point source” like a pipe, ditch, ship, or container, a company must obtain a certification that it meets specified standards, which are continually being tightened. For example, until 1983, industry had to use the “best practicable technology” currently available, but after July 1, 1984, it had to use the “best available technology” economically achievable. Companies must limit certain kinds of “conventional pollutants” (such as suspended solids and acidity) by “best conventional control technology.”
Other EPA Water Activities
Federal law governs, and the EPA regulates, a number of other water control measures. Ocean dumping, for example, is the subject of the Marine Protection, Research, and Sanctuaries Act of 1972, which gives the EPA jurisdiction over wastes discharged into the oceans. The Clean Water Act gives the EPA and the US Army Corps of Engineers authority to protect waters, marshlands, and other wetlands against degradation caused by dredging and fills. The EPA also oversees state and local plans for restoring general water quality to acceptable levels in the face of a host of non-point-source pollution. The Clean Water Act controls municipal sewage systems, which must ensure that wastewater is chemically treated before being discharged from the sewage system.
Obviously, of critical importance to the nation’s health is the supply of drinking water. To ensure its continuing purity, Congress enacted the Safe Drinking Water Act of 1974, with amendments passed in 1986 and 1996. This act aims to protect water at its sources: rivers, lakes, reservoirs, springs, and groundwater wells. (The act does not regulate private wells that serve fewer than twenty-five individuals.) This law has two strategies for combating pollution of drinking water. It establishes national standards for drinking water derived from both surface reservoirs and underground aquifers. It also authorizes the EPA to regulate the injection of solid wastes into deep wells (as happens, for instance, by leakage from underground storage tanks).
Air Pollution
The centerpiece of the legislative effort to clean the atmosphere is the Clean Air Act of 1970 (amended in 1975, 1977, and 1990). Under this act, the EPA has set two levels of National Ambient Air Quality Standards (NAAQS). The primary standards limit the ambient (i.e., circulating) pollution that affects human health; secondary standards limit pollution that affects animals, plants, and property. The heart of the Clean Air Act is the requirement that subject to EPA approval, the states implement the standards that the EPA establishes. The setting of these pollutant standards was coupled with directing the states to develop state implementation plans (SIPs), applicable to appropriate industrial sources in the state, in order to achieve these standards. The act was amended in 1977 and 1990 primarily to set new goals (dates) for achieving attainment of NAAQS since many areas of the country had failed to meet the deadlines.
Beyond the NAAQS, the EPA has established several specific standards to control different types of air pollution. One major type is pollution that mobile sources, mainly automobiles, emit. The EPA requires new cars to be equipped with catalytic converters and to use unleaded gasoline to eliminate the most noxious fumes and to keep them from escaping into the atmosphere. To minimize pollution from stationary sources, the EPA also imposes uniform standards on new industrial plants and those that have been substantially modernized. And to safeguard against emissions from older plants, states must promulgate and enforce SIPs.
The Clean Air Act is even more solicitous of air quality in certain parts of the nation, such as designated wilderness areas and national parks. For these areas, the EPA has set standards to prevent significant deterioration in order to keep the air as pristine and clear as it was centuries ago.
The EPA also worries about chemicals so toxic that the tiniest quantities could prove fatal or extremely hazardous to health. To control emission of substances like asbestos, beryllium, mercury, vinyl chloride, benzene, and arsenic, the EPA has established or proposed various National Emissions Standards for Hazardous Air Pollutants.
Concern over acid rain and other types of air pollution prompted Congress to add almost eight hundred pages of amendments to the Clean Air Act in 1990. (The original act was fifty pages long.) As a result of these amendments, the act was modernized in a manner that parallels other environmental laws. For instance, the amendments established a permit system that is modeled after the Clean Water Act. And the amendments provide for felony convictions for willful violations, similar to penalties incorporated into other statutes.
The amendments include certain defenses for industry. Most important, companies are protected from allegations that they are violating the law by showing that they were acting in accordance with a permit. In addition to this “permit shield,” the law also contains protection for workers who unintentionally violate the law while following their employers’ instructions.
Waste Disposal
Though pollution of the air by highly toxic substances like benzene or vinyl chloride may seem a problem removed from that of the ordinary person, we are all in fact polluters. Every year, the United States generates approximately 230 million tons of “trash”—about 4.6 pounds per person per day. Less than one-quarter of it is recycled; the rest is incinerated or buried in landfills. But many of the country’s landfills have been closed, either because they were full or because they were contaminating groundwater. Once groundwater is contaminated, it is extremely expensive and difficult to clean it up. In the 1965 Solid Waste Disposal Act and the 1970 Resource Recovery Act, Congress sought to regulate the discharge of garbage by encouraging waste management and recycling. Federal grants were available for research and training, but the major regulatory effort was expected to come from the states and municipalities.
But shocking news prompted Congress to get tough in 1976. The plight of homeowners near Love Canal in upstate New York became a major national story as the discovery of massive underground leaks of toxic chemicals buried during the previous quarter century led to evacuation of hundreds of homes. Next came the revelation that Kepone, an exceedingly toxic pesticide, had been dumped into the James River in Virginia, causing a major human health hazard and severe damage to fisheries in the James and downstream in the Chesapeake Bay. The rarely discussed industrial dumping of hazardous wastes now became an open controversy, and Congress responded in 1976 with the Resource Conservation and Recovery Act (RCRA) and the Toxic Substances Control Act (TSCA) and in 1980 with the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA).
Resource Conservation and Recovery Act
The RCRA expresses a “cradle-to-grave” philosophy: hazardous wastes must be regulated at every stage. The act gives the EPA power to govern their creation, storage, transport, treatment, and disposal. Any person or company that generates hazardous waste must obtain a permit (known as a “manifest”) either to store it on its own site or ship it to an EPA-approved treatment, storage, or disposal facility. No longer can hazardous substances simply be dumped at a convenient landfill. Owners and operators of such sites must show that they can pay for damage growing out of their operations, and even after the sites are closed to further dumping, they must set aside funds to monitor and maintain the sites safely.
This philosophy can be severe. In 1986, the Supreme Court ruled that bankruptcy is not a sufficient reason for a company to abandon toxic waste dumps if state regulations reasonably require protection in the interest of public health or safety. The practical effect of the ruling is that trustees of the bankrupt company must first devote assets to cleaning up a dump site, and only from remaining assets may they satisfy creditors.Midlantic National Bank v. New Jersey, 474 U.S. 494 (1986). Another severity is RCRA’s imposition of criminal liability, including fines of up to \$25,000 a day and one-year prison sentences, which can be extended beyond owners to individual employees, as discussed in U.S. v. Johnson & Towers, Inc., et al., (see Section 28.6.2 “Criminal Liability of Employees under RCRA”).
Comprehensive Environmental Response, Compensation, and Liability Act
The CERCLA, also known as the Superfund, gives the EPA emergency powers to respond to public health or environmental dangers from faulty hazardous waste disposal, currently estimated to occur at more than seventeen thousand sites around the country. The EPA can direct immediate removal of wastes presenting imminent danger (e.g., from train wrecks, oil spills, leaking barrels, and fires). Injuries can be sudden and devastating; in 1979, for example, when a freight train derailed in Florida, ninety thousand pounds of chlorine gas escaped from a punctured tank car, leaving 8 motorists dead and 183 others injured and forcing 3,500 residents within a 7-mile radius to be evacuated. The EPA may also carry out “planned removals” when the danger is substantial, even if immediate removal is not necessary.
The EPA prods owners who can be located to voluntarily clean up sites they have abandoned. But if the owners refuse, the EPA and the states will undertake the task, drawing on a federal trust fund financed mainly by taxes on the manufacture or import of certain chemicals and petroleum (the balance of the fund comes from general revenues). States must finance 10 percent of the cost of cleaning up private sites and 50 percent of the cost of cleaning up public facilities. The EPA and the states can then assess unwilling owners’ punitive damages up to triple the cleanup costs.
Cleanup requirements are especially controversial when applied to landowners who innocently purchased contaminated property. To deal with this problem, Congress enacted the Superfund Amendment and Reauthorization Act in 1986, which protects innocent landowners who—at the time of purchase—made an “appropriate inquiry” into the prior uses of the property. The act also requires companies to publicly disclose information about hazardous chemicals they use. We now turn to other laws regulating chemical hazards.
Chemical Hazards
Toxic Substances Control Act
Chemical substances that decades ago promised to improve the quality of life have lately shown their negative side—they have serious adverse side effects. For example, asbestos, in use for half a century, causes cancer and asbestosis, a debilitating lung disease, in workers who breathed in fibers decades ago. The result has been crippling disease and death and more than thirty thousand asbestos-related lawsuits filed nationwide. Other substances, such as polychlorinated biphenyls (PCBs) and dioxin, have caused similar tragedy. Together, the devastating effects of chemicals led to enactment of the TSCA, designed to control the manufacture, processing, commercial distribution, use, and disposal of chemicals that pose unreasonable health or environmental risks. (The TSCA does not apply to pesticides, tobacco, nuclear materials, firearms and ammunition, food, food additives, drugs, and cosmetics—all are regulated by other federal laws.)
The TSCA gives the EPA authority to screen for health and environmental risks by requiring companies to notify the EPA ninety days before manufacturing or importing new chemicals. The EPA may demand that the companies test the substances before marketing them and may regulate them in a number of ways, such as requiring the manufacturer to label its products, to keep records on its manufacturing and disposal processes, and to document all significant adverse reactions in people exposed to the chemicals. The EPA also has authority to ban certain especially hazardous substances, and it has banned the further production of PCBs and many uses of asbestos.
Both industry groups and consumer groups have attacked the TSCA. Industry groups criticize the act because the enforcement mechanism requires mountainous paperwork and leads to widespread delay. Consumer groups complain because the EPA has been slow to act against numerous chemical substances. The debate continues.
Pesticide Regulation
The United States is a major user of pesticides, substances that eliminate troublesome insects, rodents, fungi, and bacteria, consuming more than a billion pounds a year in the form of thirty-five thousand separate chemicals. As useful as they can be, like many chemical substances, pesticides can have serious side effects on humans and plant and animal life. Beginning in the early 1970s, Congress enacted major amendments to the Federal Insecticide, Fungicide, and Rodenticide Act of 1947 and the Federal Food, Drug, and Cosmetic Act (FFDCA) of 1906.
These laws direct the EPA to determine whether pesticides properly balance effectiveness against safety. If the pesticide can carry out its intended function without causing unreasonable adverse effects on human health or the environment, it may remain on the market. Otherwise, the EPA has authority to regulate or even ban its distribution and use. To enable the EPA to carry out its functions, the laws require manufacturers to provide a wealth of data about the way individual pesticides work and their side effects. The EPA is required to inspect pesticides to ensure that they conform to their labeled purposes, content, and safety, and the agency is empowered to certify pesticides for either general or restricted use. If a pesticide is restricted, only those persons certified in approved training programs may use it. Likewise, under the Pesticide Amendment to the FFDCA, the EPA must establish specific tolerances for the residue of pesticides on feed crops and both raw and processed foods. The Food and Drug Administration (for agricultural commodities) and the US Department of Agriculture (for meat, poultry, and fish products) enforce these provisions.
Other Types of Environmental Controls
Noise Regulation
Under the Noise Regulation Act of 1972, Congress has attempted to combat a growing menace to US workers, residents, and consumers. People who live close to airports and major highways, workers who use certain kinds of machinery (e.g., air compressors, rock drills, bulldozers), and consumers who use certain products, such as power mowers and air conditioners, often suffer from a variety of ailments. The Noise Regulation Act delegates to the EPA power to limit “noise emissions” from these major sources of noise. Under the act, manufacturers may not sell new products that fail to conform to the noise standards the EPA sets, and users are forbidden from dismantling noise control devices installed on these products. Moreover, manufacturers must label noisy products properly. Private suits may be filed against violators, and the act also permits fines of up to \$25,000 per day and a year in jail for those who seek to avoid its terms.
Radiation Controls
The terrifying effects of a nuclear disaster became frighteningly clear when the Soviet Union’s nuclear power plant at Chernobyl exploded in early 1986, discharging vast quantities of radiation into the world’s airstream and affecting people thousands of miles away. In the United States, the most notorious nuclear accident occurred at the Three Mile Island nuclear utility in Pennsylvania in 1979, crippling the facility for years because of the extreme danger and long life of the radiation. Primary responsibility for overseeing nuclear safety rests with the Nuclear Regulatory Commission, but many other agencies and several federal laws (including the Clean Air Act; the Federal Water Pollution Control Act; the Safe Drinking Water Act; the Uranium Mill Tailings Radiation Control Act; the Marine Protection, Research, and Sanctuaries Act; the Nuclear Waste Policy Act of 1982; the CERCLA; and the Ocean Dumping Act) govern the use of nuclear materials and the storage of radioactive wastes (some of which will remain severely dangerous for thousands of years). Through many of these laws, the EPA has been assigned the responsibility of setting radiation guidelines, assessing new technology, monitoring radiation in the environment, setting limits on release of radiation from nuclear utilities, developing guidance for use of X-rays in medicine, and helping to plan for radiation emergencies.
Key Takeaway
Laws limiting the use of one’s property have been around for many years; common-law restraints (e.g., the law of nuisance) exist as causes of action against those who would use their property to adversely affect the life or health of others or the value of their neighbors’ property. Since the 1960s, extensive federal laws governing the environment have been enacted. These include laws governing air, water, chemicals, pesticides, solid waste, and nuclear activities. Some laws include criminal penalties for noncompliance.
Exercises
1. Who is responsible for funding CERCLA? That is, what is the source of funds for cleanups of hazardous waste?
2. Why is it necessary to have criminal penalties for noncompliance with environmental laws?
3. What is the role of states in setting standards for clean air and clean water?
4. Which federal act sets up a “cradle-to-grave” system for handling waste?
5. Why are federal environmental laws necessary? Why not let the states exclusively govern in the area of environmental protection? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.05%3A_Environmental_Law.txt |
Reasonable Use Doctrine
Hoover v. Crane
362 Mich. 36, 106 N.W.2d 563 (1960)
EDWARDS, JUSTICE
This appeal represents a controversy between plaintiff cottage and resort owners on an inland Michigan lake and defendant, a farmer with a fruit orchard, who was using the lake water for irrigation. The chancellor who heard the matter ruled that defendant had a right to reasonable use of lake water. The decree defined such reasonable use in terms which were unsatisfactory to plaintiffs who have appealed.
The testimony taken before the chancellor pertained to the situation at Hutchins Lake, in Allegan county, during the summer of 1958. Defendant is a fruit farmer who owns a 180-acre farm abutting on the lake. Hutchins Lake has an area of 350 acres in a normal season. Seventy-five cottages and several farms, including defendant’s, abut on it. Defendant’s frontage is approximately 1/4 mile, or about 10% of the frontage of the lake.
Hutchins Lake is spring fed. It has no inlet but does have an outlet which drains south. Frequently in the summertime the water level falls so that the flow at the outlet ceases.
All witnesses agreed that the summer of 1958 was exceedingly dry and plaintiffs’ witnesses testified that Hutchins Lake’s level was the lowest it had ever been in their memory. Early in August, defendant began irrigation of his 50-acre pear orchard by pumping water out of Hutchins Lake. During that month the lake level fell 6 to 8 inches—the water line receded 50 to 60 feet and cottagers experienced severe difficulties with boating and swimming.
* * *
The tenor of plaintiffs’ testimony was to attribute the 6- to 8-inch drop in the Hutchins Lake level in that summer to defendant’s irrigation activities. Defendant contended that the decrease was due to natural causes, that the irrigation was of great benefit to him and contributed only slightly to plaintiff’s discomfiture. He suggests to us:
One could fairly say that because plaintiffs couldn’t grapple with the unknown causes that admittedly occasioned a greater part of the injury complained of, they chose to grapple mightily with the defendant because he is known and visible.
The circuit judge found it impossible to determine a normal lake level from the testimony, except that the normal summer level of the lake is lower than the level at which the lake ceases to drain into the outlet. He apparently felt that plaintiffs’ problems were due much more to the abnormal weather conditions of the summer of 1958 than to defendant’s irrigation activities.
His opinion concluded:
Accepting the reasonable use theory advanced by plaintiffs it appears to the court that the most equitable disposition of this case would be to allow defendant to use water from the lake until such time when his use interferes with the normal use of his neighbors. One quarter inch of water from the lake ought not to interfere with the rights and uses of defendant’s neighbors and this quantity of water ought to be sufficient in time of need to service 45 acres of pears. A meter at the pump, sealed if need be, ought to be a sufficient safeguard. Pumping should not be permitted between the hours of 11 p.m. and 7 a.m. Water need be metered only at such times as there is no drainage into the outlet.
The decree in this suit may provide that the case be kept open for the submission of future petitions and proofs as the conditions permit or require.
* * *
Michigan has adopted the reasonable-use rule in determining the conflicting rights of riparian owners to the use of lake water.
In 1874, Justice COOLEY said:
It is therefore not a diminution in the quantity of the water alone, or an alteration in its flow, or either or both of these circumstances combined with injury, that will give a right of action, if in view of all the circumstances, and having regard to equality of right in others, that which has been done and which causes the injury is not unreasonable. In other words, the injury that is incidental to a reasonable enjoyment of the common right can demand no redress. Dumont v. Kellogg, 29 Mich 420, 425.
And in People v. Hulbert, the Court said:
No statement can be made as to what is such reasonable use which will, without variation or qualification, apply to the facts of every case. But in determining whether a use is reasonable we must consider what the use is for; its extent, duration, necessity, and its application; the nature and size of the stream, and the several uses to which it is put; the extent of the injury to the one proprietor and of the benefit to the other; and all other facts which may bear upon the reasonableness of the use. Red River Roller Mills v. Wright, 30 Minn 249, 15 NW 167, and cases cited.
The Michigan view is in general accord with 4 Restatement, Torts, §§ 851–853.
* * *
We interpret the circuit judge’s decree as affording defendant the total metered equivalent in pumpage of 1/4 inch of the content of Hutchins Lake to be used in any dry period in between the cessation of flow from the outlet and the date when such flow recommences. Where the decree also provides for the case to be kept open for future petitions based on changed conditions, it would seem to afford as much protection for plaintiffs as to the future as this record warrants.
Both resort use and agricultural use of the lake are entirely legitimate purposes. Neither serves to remove water from the watershed. There is, however, no doubt that the irrigation use does occasion some water loss due to increased evaporation and absorption. Indeed, extensive irrigation might constitute a threat to the very existence of the lake in which all riparian owners have a stake; and at some point the use of the water which causes loss must yield to the common good.
The question on this appeal is, of course, whether the chancellor’s determination of this point was unreasonable as to plaintiffs. On this record, we cannot overrule the circuit judge’s view that most of plaintiffs’ 1958 plight was due to natural causes. Nor can we say, if this be the only irrigation use intended and the only water diversion sought, that use of the amount provided in the decree during the dry season is unreasonable in respect to other riparian owners.
Affirmed.
Case Questions
1. If the defendant has caused a diminution in water flow, an alteration of the water flow, and the plaintiff is adversely affected, why would the Supreme Court of Michigan not provide some remedy?
2. Is it possible to define an injury that is “not unreasonable”?
3. Would the case even have been brought if there had not been a drought?
More Reasonable Use Doctrine
U.S. v. Johnson & Towers, Inc., Jack W. Hopkins, and Peter Angel
741 F.2d 662 (1984)
SLOVITER, Circuit Judge
Before us is the government’s appeal from the dismissal of three counts of an indictment charging unlawful disposal of hazardous wastes under the Resource Conservation and Recovery Act. In a question of first impression regarding the statutory definition of “person,” the district court concluded that the Act’s criminal penalty provision imposing fines and imprisonment could not apply to the individual defendants. We will reverse.
The criminal prosecution in this case arose from the disposal of chemicals at a plant owned by Johnson & Towers in Mount Laurel, New Jersey. In its operations the company, which repairs and overhauls large motor vehicles, uses degreasers and other industrial chemicals that contain chemicals such as methylene chloride and trichlorethylene, classified as “hazardous wastes” under the Resource Conservation and Recovery Act (RCRA), 42 U.S.C. §§ 6901–6987 (1982) and “pollutants” under the Clean Water Act, 33 U.S.C. §§ 1251–1376 (1982). During the period relevant here, the waste chemicals from cleaning operations were drained into a holding tank and, when the tank was full, pumped into a trench. The trench flowed from the plant property into Parker’s Creek, a tributary of the Delaware River. Under RCRA, generators of such wastes must obtain a permit for disposal from the Environmental Protection Agency (E.P.A.). The E.P.A. had neither issued nor received an application for a permit for Johnson & Towers’ operations.
The indictment named as defendants Johnson & Towers and two of its employees, Jack Hopkins, a foreman, and Peter Angel, the service manager in the trucking department. According to the indictment, over a three-day period federal agents saw workers pump waste from the tank into the trench, and on the third day observed toxic chemicals flowing into the creek.
Count 1 of the indictment charged all three defendants with conspiracy under 18 U.S.C. § 371 (1982). Counts 2, 3, and 4 alleged violations under the RCRA criminal provision, 42 U.S.C. § 6928(d) (1982). Count 5 alleged a violation of the criminal provision of the Clean Water Act, 33 U.S.C. § 1319(c) (1982). Each substantive count also charged the individual defendants as aiders and abettors under 18 U.S.C. § 2 (1982).
The counts under RCRA charged that the defendants “did knowingly treat, store, and dispose of, and did cause to be treated, stored and disposed of hazardous wastes without having obtained a permit…in that the defendants discharged, deposited, injected, dumped, spilled, leaked and placed degreasers…into the trench.…” The indictment alleged that both Angel and Hopkins “managed, supervised and directed a substantial portion of Johnson & Towers’ operations…including those related to the treatment, storage and disposal of the hazardous wastes and pollutants” and that the chemicals were discharged by “the defendants and others at their direction.” The indictment did not otherwise detail Hopkins’ and Angel’s activities or responsibilities.
Johnson & Towers pled guilty to the RCRA counts. Hopkins and Angel pled not guilty, and then moved to dismiss counts 2, 3, and 4. The court concluded that the RCRA criminal provision applies only to “owners and operators,” i.e., those obligated under the statute to obtain a permit. Since neither Hopkins nor Angel was an “owner” or “operator,” the district court granted the motion as to the RCRA charges but held that the individuals could be liable on these three counts under 18 U.S.C. § 2 for aiding and abetting. The court denied the government’s motion for reconsideration, and the government appealed to this court under 18 U.S.C. § 3731 (1982).
* * *
The single issue in this appeal is whether the individual defendants are subject to prosecution under RCRA’s criminal provision, which applies to:
any person who—
.…
(2) knowingly treats, stores, or disposes of any hazardous waste identified or listed under this subchapter either—
(A) without having obtained a permit under section 6925 of this title…or
(B) in knowing violation of any material condition or requirement of such permit.
42 U.S.C. § 6928(d) (emphasis added). The permit provision in section 6925, referred to in section 6928(d), requires “each person owning or operating a facility for the treatment, storage, or disposal of hazardous waste identified or listed under this subchapter to have a permit” from the E.P.A.
The parties offer contrary interpretations of section 6928(d)(2)(A). Defendants consider it an administrative enforcement mechanism, applying only to those who come within section 6925 and fail to comply; the government reads it as penalizing anyone who handles hazardous waste without a permit or in violation of a permit. Neither party has cited another case, nor have we found one, considering the application of this criminal provision to an individual other than an owner or operator.
As in any statutory analysis, we are obliged first to look to the language and then, if needed, attempt to divine Congress’ specific intent with respect to the issue.
First, “person” is defined in the statute as “an individual, trust, firm, joint stock company, corporation (including a government corporation), partnership, association, State, municipality, commission, political subdivision of a State, or any interstate body.” 42 U.S.C. § 6903(15) (1982). Had Congress meant in section 6928(d)(2)(A) to take aim more narrowly, it could have used more narrow language. Since it did not, we attribute to “any person” the definition given the term in section 6903(15).
Second, under the plain language of the statute the only explicit basis for exoneration is the existence of a permit covering the action. Nothing in the language of the statute suggests that we should infer another provision exonerating persons who knowingly treat, store or dispose of hazardous waste but are not owners or operators.
Finally, though the result may appear harsh, it is well established that criminal penalties attached to regulatory statutes intended to protect public health, in contrast to statutes based on common law crimes, are to be construed to effectuate the regulatory purpose.
* * *
Congress enacted RCRA in 1976 as a “cradle-to-grave” regulatory scheme for toxic materials, providing “nationwide protection against the dangers of improper hazardous waste disposal.” H.R. Rep. No. 1491, 94th Cong., 2d Sess. 11, reprinted in 1976 U.S. Code Cong. & Ad. News 6238, 6249. RCRA was enacted to provide “a multifaceted approach toward solving the problems associated with the 3–4 billion tons of discarded materials generated each year, and the problems resulting from the anticipated 8% annual increase in the volume of such waste.” Id. at 2, 1976 U.S. Code Cong. & Ad. News at 6239. The committee reports accompanying legislative consideration of RCRA contain numerous statements evincing the Congressional view that improper disposal of toxic materials was a serious national problem.
The original statute made knowing disposal (but not treatment or storage) of such waste without a permit a misdemeanor. Amendments in 1978 and 1980 expanded the criminal provision to cover treatment and storage and made violation of section 6928 a felony. The fact that Congress amended the statute twice to broaden the scope of its substantive provisions and enhance the penalty is a strong indication of Congress’ increasing concern about the seriousness of the prohibited conduct.
We conclude that in RCRA, no less than in the Food and Drugs Act, Congress endeavored to control hazards that, “in the circumstances of modern industrialism, are largely beyond self-protection.” United States v. Dotterweich, 320 U.S. at 280. It would undercut the purposes of the legislation to limit the class of potential defendants to owners and operators when others also bear responsibility for handling regulated materials. The phrase “without having obtained a permit under section 6925” (emphasis added) merely references the section under which the permit is required and exempts from prosecution under section 6928(d)(2)(A) anyone who has obtained a permit; we conclude that it has no other limiting effect. Therefore we reject the district court’s construction limiting the substantive criminal provision by confining “any person” in section 6928(d)(2)(A) to owners and operators of facilities that store, treat or dispose of hazardous waste, as an unduly narrow view of both the statutory language and the congressional intent.
Case Questions
1. The district court (trial court) accepted the individual defendants’ argument. What was that argument?
2. On what reasoning did the appellate court reject that argument?
3. If employees of a company that is violating the RCRA carry out disposal of hazardous substances in violation of the RCRA, they would presumably lose their jobs if they didn’t. What is the moral justification for applying criminal penalties to such employees (such as Hopkins and Angel)? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.06%3A_Cases.txt |
Summary
An estate is an interest in real property; it is the degree to which a thing is owned. Freehold estates are those with an uncertain duration; leaseholds are estates due to expire at a definite time. A present estate is one that is currently owned; a future estate is one that is owned now but not yet available for use.
Present estates are (1) the fee simple absolute; (2) the fee simple defeasible, which itself may be divided into three types, and (3) the life estate.
Future estates are generally of two types: reversion and remainder. A reversion arises whenever a transferred estate will endure for a shorter time than that originally owned by the transferor. A remainder interest arises when the transferor gives the reversion interest to someone else.
Use of air, earth, and water are the major rights incident to ownership of real property. Traditionally, the owner held “up to the sky” and “down to the depths,” but these rules have been modified to balance competing rights in a modern economy. The law governing water rights varies with the states; in general, the eastern states with more plentiful water have adopted either the natural flow doctrine or the reasonable use doctrine of riparian rights, giving those who live along a waterway certain rights to use the water. By contrast, western states have tended to apply the prior appropriation doctrine, which holds that first in time is first in right, even if those downstream are disadvantaged.
An easement is an interest in land—created by express agreement, prior use, or necessity—that permits one person to make use of another’s estate. An affirmative easement gives one person the right to use another’s land; a negative easement prevents the owner from using his land in a way that will affect another person’s land. In understanding easement law, the important distinctions are between easements appurtenant and in gross, and between dominant and servient owners.
The law not only defines the nature of the property interest but also regulates land use. Tort law regulates land use by imposing liability for (1) activities that affect those off the land and (2) injuries caused to people who enter it. The two most important theories relating to the former are nuisance and trespass. With respect to the latter, the common law confusingly distinguishes among trespassers, licensees, and invitees. Some states are moving away from the perplexing and rigid rules of the past and simply require owners to maintain their property in a reasonably safe condition.
Land use may also be regulated by private agreement through the restrictive covenant, an agreement that “runs with the land” and that will be binding on any subsequent owner. Land use is also regulated by the government’s power under eminent domain to take private land for public purposes (upon payment of just compensation), through zoning laws, and through recently enacted environmental statutes, including the National Environmental Policy Act and laws governing air, water, treatment of hazardous wastes, and chemicals.
Exercises
1. Dorothy deeded an acre of real estate that she owns to George for the life of Benny and then to Ernie. Describe the property interests of George, Benny, Ernie, and Dorothy.
2. In Exercise 1, assume that George moves into a house on the property. During a tornado, the roof is destroyed and a window is smashed. Who is responsible for repairing the roof and window? Why?
3. Dennis likes to spend his weekends in his backyard, shooting his rifle across his neighbor’s yard. If Dennis never sets foot on his neighbor’s property, and if the bullets strike neither persons nor property, has he violated the legal rights of the neighbor? Explain.
4. Dennis also drills an oil well in his backyard. He “slant drills” the well; that is, the well slants from a point on the surface in his yard to a point four hundred feet beneath the surface of his neighbor’s yard. Dennis has slanted the drilling in order to capture his neighbor’s oil. Can he do this legally? Explain.
5. Wanda is in charge of acquisitions for her company. Realizing that water is important to company operations, Wanda buys a plant site on a river, and the company builds a plant that uses all of the river water. Downstream owners bring suit to stop the company from using any water. What is the result? Why?
6. Sunny decides to build a solar home. Before beginning construction, she wants to establish the legal right to prevent her neighbors from constructing buildings that will block the sunlight. She has heard that the law distinguishes between licenses and easements, easements appurtenant and in gross, and affirmative and negative easements. Which of these interests would you recommend for Sunny? Why?
SELF CHECK QUESTIONS
1. A freehold estate is defined as an estate
1. with an uncertain duration
2. due to expire at a definite time
3. owned now but not yet available for use
4. that is leased or rented
2. A fee simple defeasible is a type of
1. present estate
2. future estate
3. life estate
4. leasehold estate
3. A reversion is
1. a present estate that prevents transfer of land out of the family
2. a form of life estate
3. a future estate that arises when the estate transferred has a duration less than that originally owned by the transferor
4. identical to a remainder interest
4. An easement is an interest in land that may be created by
1. express agreement
2. prior use
3. necessity
4. all of the above
5. The prior appropriation doctrine
1. tends to be applied by eastern states
2. holds that first in time is first in right
3. gives those that live along a waterway special rights to use the water
4. all of the above
1. a
2. a
3. c
4. d
5. b | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/28%3A_The_Nature_and_Regulation_of_Real_Estate_and_the_Environment/28.07%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The difference between personal property and other types of property
• How rights in personal property are acquired and maintained
• How some kinds of personal property can become real property, and how to determine who has rights in fixtures that are part of real property
In this chapter, we examine the general nature of property rights and the law relating to personal property—with special emphasis on acquisition and fixtures. We discuss intellectual property, a kind of personal property that is increasingly profitable. We focus on real property, including its nature and regulation, its acquisition by purchase (and some other methods), and its acquisition by lease (landlord and tenant law).
29: Personal Property and Fixtures
Learning Objectives
By the end of this section, you will be able to:
• Understand the elastic and evolving boundaries of what the law recognizes as property that can be bought or sold on the market.
• Distinguish real property from personal property.
Definition of Property
Property, which seems like a commonsense concept, is difficult to define in an intelligible way; philosophers have been striving to define it for the past 2,500 years. To say that “property is what we own” is to beg the question—that is, to substitute a synonym for the word we are trying to define. Blackstone’s famous definition is somewhat wordy: “The right of property is that sole and despotic dominion which one man claims and exercises over the external things of the world, in total exclusion of the right of any other individual in the universe. It consists in the free use, enjoyment, and disposal of all a person’s acquisitions, without any control or diminution save only by the laws of the land.” A more concise definition, but perhaps too broad, comes from the Restatement of the Law of Property, which defines property as the “legal relationship between persons with respect to a thing.”
The Restatement’s definition makes an important point: property is a legal relationship, the power of one person to use objects in ways that affect others, to exclude others from the property, and to acquire and transfer property. Still, this definition does not contain a specific list of those nonhuman “objects” that could be in such a relationship. We all know that we can own personal objects like iPods and DVDs, and even more complex objects like homes and minerals under the ground. Property also embraces objects whose worth is representative or symbolic: ownership of stock in a corporation is valued not for the piece of paper called a stock certificate but for dividends, the power to vote for directors, and the right to sell the stock on the open market. Wholly intangible things or objects like copyrights and patents and bank accounts are capable of being owned as property. But the list of things that can be property is not fixed, for our concept of property continues to evolve. Collateralized debt obligations (CDOs) and structured investment vehicles (SIVs), prime players in the subprime mortgage crisis, were not on anyone’s list of possible property even fifteen years ago.
The Economist’s View
Property is not just a legal concept, of course, and different disciplines express different philosophies about the purpose of property and the nature of property rights. To the jurist, property rights should be protected because it is just to do so. To an economist, the legal protection of property rights functions to create incentives to use resources efficiently. For a truly efficient system of property rights, some economists would require universality (everything is owned), exclusivity (the owners of each thing may exclude all others from using it), and transferability (owners may exchange their property). Together, these aspects of property would lead, under an appropriate economic model, to efficient production and distribution of goods. But the law of property does not entirely conform to the economic conception of the ownership of productive property by private parties; there remain many kinds of property that are not privately owned and some parts of the earth that are considered part of “the commons.” For example, large areas of the earth’s oceans are not “owned” by any one person or nation-state, and certain land areas (e.g., Yellowstone National Park) are not in private hands.
Classification of Property
Property can be classified in various ways, including tangible versus intangible, private versus public, and personal versus real. Tangible property is that which physically exists, like a building, a popsicle stand, a hair dryer, or a steamroller. Intangible property is something without physical reality that entitles the owner to certain benefits; stocks, bonds, and intellectual property would be common examples. Public property is that which is owned by any branch of government; private property is that which is owned by anyone else, including a corporation.
Perhaps the most important distinction is between real and personal property. Essentially, real property is immovable; personal property is movable. At common law, personal property has been referred to as “chattels.” When chattels become affixed to real property in a certain manner, they are called fixtures and are treated as real property. (For example, a bathroom cabinet purchased at Home Depot and screwed into the bathroom wall may be converted to part of the real property when it is affixed.) Fixtures are discussed in Section 29.3 of this chapter.
Importance of the Distinction between Real and Personal Property
In our legal system, the distinction between real and personal property is significant in several ways. For example, the sale of personal property, but not real property, is governed by Article 2 of the Uniform Commercial Code (UCC). Real estate transactions, by contrast, are governed by the general law of contracts. Suppose goods are exchanged for realty. Section 2-304 of the UCC says that the transfer of the goods and the seller’s obligations with reference to them are subject to Article 2, but not the transfer of the interests in realty nor the transferor’s obligations in connection with them.
The form of transfer depends on whether the property is real or personal. Real property is normally transferred by a deed, which must meet formal requirements dictated by state law. By contrast, transfer of personal property often can take place without any documents at all.
Another difference can be found in the law that governs the transfer of property on death. A person’s heirs depend on the law of the state for distribution of his property if he dies intestate—that is, without a will. Who the heirs are and what their share of the property will be may depend on whether the property is real or personal. For example, widows may be entitled to a different percentage of real property than personal property when their husbands die intestate.
Tax laws also differ in their approach to real and personal property. In particular, the rules of valuation, depreciation, and enforcement depend on the character of the property. Thus real property depreciates more slowly than personal property, and real property owners generally have a longer time than personal property owners to make good unpaid taxes before the state seizes the property.
Key Takeaway
Property is difficult to define conclusively, and there are many different classifications of property. There can be public property as well as private property, tangible property as well as intangible property, and, most importantly, real property as well as personal property. These are important distinctions, with many legal consequences.
Exercises
1. Kristen buys a parcel of land on Marion Street, a new and publicly maintained roadway. Her town’s ordinances say that each property owner on a public street must also provide a sidewalk within ten feet of the curb. A year after buying the parcel, Kristen commissions a house to be built on the land, and the contractor begins by building a sidewalk in accordance with the town’s ordinance. Is the sidewalk public property or private property? If it snows, and if Kristen fails to remove the snow and it melts and ices over and a pedestrian slips and falls, who is responsible for the pedestrian’s injuries?
2. When can private property become public property? Does public property ever become private property? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/29%3A_Personal_Property_and_Fixtures/29.01%3A_The_General_Nature_of_Property_Rights.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the various ways that personal property can be acquired by means other than purchase.
Most legal issues about personal property center on its acquisition. Acquisition by purchase is the most common way we acquire personal property, but there are at least five other ways to legally acquire personal property: (1) possession, (2) finding lost or misplaced property, (3) gift, (4) accession, and (5) confusion.
Possession
It is often said that “possession is nine-tenths of the law.” There is an element of truth to this, but it’s not the whole truth. For our purposes, the more important question is, what is meant by “possession”? Its meaning is not intuitively obvious, as a moment’s reflection will reveal. For example, you might suppose than you possess something when it is physically within your control, but what do you say when a hurricane deposits a boat onto your land? What if you are not even home when this happens? Do you possess the boat? Ordinarily, we would say that you don’t, because you don’t have physical control when you are absent. You may not even have the intention to control the boat; perhaps instead of a fancy speedboat in relatively good shape, the boat is a rust bucket badly in need of repair, and you want it removed from your front yard.
Even the element of physical domination of the object may not be necessary. Suppose you give your new class ring to a friend to examine. Is it in the friend’s possession? No: the friend has custody, not possession, and you retain the right to permit a second friend to take it from her hands. This is different from the case of a bailment, in which the bailor gives possession of an object to the bailee. For example, a garage (a bailee) entrusted with a car for the evening, and not the owner, has the right to exclude others from the car; the owner could not demand that the garage attendants refrain from moving the car around as necessary.
From these examples, we can see that possession or physical control must usually be understood as the power to exclude others from using the object. Otherwise, anomalies arise from the difficulty of physically controlling certain objects. It is more difficult to exercise control over a one-hundred-foot television antenna than a diamond ring. Moreover, in what sense do you possess your household furniture when you are out of the house? Only, we suggest, in the power to exclude others. But this power is not purely a physical one: being absent from the house, you could not physically restrain anyone. Thus the concept of possession must inevitably be mixed with legal rules that do or could control others.
Possession confers ownership in a restricted class of cases only: when no person was the owner at the time the current owner took the object into his possession. The most obvious categories of objects to which this rule of possession applies are wild animals and abandoned goods. The rule requires that the would-be owner actually take possession of the animal or goods; the hunter who is pursuing a particular wild animal has no legal claim until he has actually captured it. Two hunters are perfectly free to pursue the same animal, and whoever actually grabs it will be the owner.
But even this simple rule is fraught with difficulties in the case of both wild animals and abandoned goods. We examine abandoned goods in Section 29.2.2 “Lost or Misplaced Property”. In the case of wild game, fish in a stream, and the like, the general rule is subject to the rights of the owner of the land on which the animals are caught. Thus even if the animals caught by a hunter are wild, as long as they are on another’s land, the landowner’s rights are superior to the hunter’s. Suppose a hunter captures a wild animal, which subsequently escapes, and a second hunter thereafter captures it. Does the first hunter have a claim to the animal? The usual rule is that he does not, for once an animal returns to the wild, ownership ceases.
Lost or Misplaced Property
At common law, a technical distinction arose between lost and misplaced property. An object is lost if the owner inadvertently and unknowingly lets it out of his possession. It is merely misplaced if the owner intentionally puts it down, intending to recover it, even if he subsequently forgets to retrieve it. These definitions are important in considering the old saying “Finders keepers, losers weepers.” This is a misconception that is, at best, only partially true, and more often false. The following hierarchy of ownership claims determines the rights of finders and losers.
First, the owner is entitled to the return of the property unless he has intentionally abandoned it. The finder is said to be a quasi-bailee for the true owner, and as bailee she owes the owner certain duties of care. The finder who knows the owner or has reasonable means of discovering the owner’s identity commits larceny if she holds on to the object with the intent that it be hers. This rule applies only if the finder actually takes the object into her possession. For example, if you spot someone’s wallet on the street you have no obligation to pick it up; but if you do pick it up and see the owner’s name in it, your legal obligation is to return it to the rightful owner. The finder who returns the object is not automatically entitled to a reward, but if the loser has offered a reward, the act of returning it constitutes performance of a unilateral contract. Moreover, if the finder has had expenses in connection with finding the owner and returning the property, she is entitled to reasonable reimbursement as a quasi-bailee. But the rights of the owner are frequently subject to specific statutes, such as the one discussed in Bishop v. Ellsworth in Section 29.4.1 “Lost or Misplaced Property”.
Second, if the owner fails to claim the property within the time allowed by statute or has abandoned it, then the property goes to the owner of the real estate on which it was found if (1) the finder was a trespasser, (2) the goods are found in a private place (though what exactly constitutes a private place is open to question: is the aisle of a grocery store a private place? the back of the food rack? the stockroom?), (3) the goods are buried, or (4) the goods are misplaced rather than lost.
If none of these conditions apply, then the finder is the owner. These rules are considered in the Bishop case, (see Section 29.4.1 “Lost or Misplaced Property”).
Gift
A gift is a voluntary transfer of property without consideration or compensation. It is distinguished from a sale, which requires consideration. It is distinguished from a promise to give, which is a declaration of an intention to give in the future rather than a present transfer. It is distinguished from a testamentary disposition (will), which takes effect only upon death, not upon the preparation of the documents. Two other distinctions are worth noting. An inter vivos (enter VYE vos) gift is one made between living persons without conditions attached. A causa mortis (KAW zuh mor duz) gift is made by someone contemplating death in the near future.
Requirements
To make an effective gift inter vivos or causa mortis, the law imposes three requirements: (1) the donor must deliver a deed or object to the donee; (2) the donor must actually intend to make a gift, and (3) the donee must accept (Figure \(1\)).
Delivery
Although it is firmly established that the object be delivered, it is not so clear what constitutes delivery. On the face of it, the requirement seems to be that the object must be transferred to the donee’s possession. Suppose your friend tells you he is making a gift to you of certain books that are lying in a locked trunk. If he actually gives you the trunk so that you can carry it away, a gift has been made. Suppose, however, that he had merely given you the key, so that you could come back the next day with your car. If this were the sole key, the courts would probably construe the transfer of the key as possession of the trunk. Suppose, instead, that the books were in a bank vault and the friend made out a legal document giving both you and him the power to take from the bank vault. This would not be a valid gift, since he retained power over the goods.
Intent
The intent to make a gift must be an intent to give the property at the present time, not later. For example, suppose a person has her savings account passbook put in her name and a friend’s name, intending that on her death the friend will be able to draw out whatever money is left. She has not made a gift, because she did not intend to give the money when she changed the passbook. The intent requirement can sometimes be sidestepped if legal title to the object is actually transferred, postponing to the donee only the use or enjoyment of the property until later. Had the passbook been made out in the name of the donee only and delivered to a third party to hold until the death of the donor, then a valid gift may have been made. Although it is sometimes difficult to discern this distinction in practice, a more accurate statement of the rule of intent is this: Intention to give in the future does not constitute the requisite intent, whereas present gifts of future interests will be upheld.
Acceptance
In the usual case, the rule requiring acceptance poses no difficulties. A friend hands you a new book and says, “I would like you to have this.” Your taking the book and saying “thank-you” is enough to constitute your acceptance. But suppose that the friend had given you property without your knowing it. For example, a secret admirer puts her stock certificates jointly in your name and hers without telling you. Later, you marry someone else, and she asks you to transfer the certificates back to her name. This is the first you have heard of the transaction. Has a gift been made? The usual answer is that even though you had not accepted the stock when the name change was made, the transaction was a gift that took effect immediately, subject to your right to repudiate when you find out about it. If you do not reject the gift, you have joint rights in the stock. But if you expressly refuse to accept a gift or indicate in some manner that you might not have accepted it, then the gift is not effective. For example, suppose you are running for office. A lobbyist whom you despise gives you a donation. If you refuse the money, no gift has been made.
Gifts Causa Mortis
Even though the requirements of delivery, intent, and acceptance apply to gifts causa mortis as well as inter vivos, a gift causa mortis (one made in contemplation of death) may be distinguished from a gift inter vivos on other grounds. The difference between the two lies in the power of the donor to revoke the gift before he dies; in other words, the gift is conditional on his death. Since the law does not permit gifts that take place in the future contingent on some happening, how can it be that a gift causa mortis is effective? The answer lies in the nature of the transfer: the donee takes actual title when the gift is made; should the donor not in fact die or should he revoke the gift before he dies, then and only then will the donee lose title. The difference is subtle and amounts to the difference between saying “If I die, the watch is yours” and “The watch is yours, unless I survive.” In the former case, known as a condition precedent, there is no valid gift; in the latter case, known as a condition subsequent, the gift is valid.
Gifts to Minors
Every state has adopted either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), both of which establish the manner by which irrevocable gifts are made to minors. Under these acts, a custodian holds the gifts until the minor reaches the age of eighteen, twenty-one, or twenty-five, depending on state law. Gifts under UGMA are limited for the most part to money or securities, while UTMA allows other types of gifts as well, such as real estate or tangible personal property.
Gift Tax
The federal government and many states impose gift taxes on gifts above a certain dollar amount.
Accession
An accession is something that is added to what one already possesses. In general, the rule is that the owner of the thing owns the additional thing that comes to be attached to it. For example, the owner of a cow owns her calves when she gives birth. But when one person adds value to another person’s property, either through labor alone or by adding new materials, the rule must be stated somewhat differently. The general rule is this: when goods are added to goods, the owner of the principal goods becomes the owner of the enhanced product. For example, a garage uses its paint to repaint its customer’s automobile. The car owner, not the painter, is the owner of the finished product.
When someone has wrongfully converted—that is, taken as her own—the property of another, the owner may sue for damages, either to recover his property or its value. But a problem arises when the converter has added to the value of that property. In general, the courts hold that when the conversion is willful, the owner is entitled to the full value of the goods as enhanced by the converter. Suppose that a carpenter enters a ten-acre forest that he knows belongs to his neighbor, cuts down one hundred trees, transports them to his shop, and cuts them up into standard lumber, thus increasing their market value. The owner is entitled to this full value, and the carpenter will get nothing for his trouble. Thus the willful converter loses the value of his labor or materials. If, on the other hand, the conversion was innocent, or at most negligent, the rule is somewhat more uncertain. Generally the courts will award the forest owner the value of the standing timber, giving the carpenter the excess attributable to his labor and transportation. A more favorable treatment of the owner is to give her the full value of the lumber as cut, remitting to the carpenter the value of his expenses.
Confusion
In accession, the goods of one owner are transformed into a more valuable commodity or are inextricably united with the goods of another to form a constituent part. Still another type of joining is known as confusion, and it occurs when goods of different owners, while maintaining their original form, are commingled. A common example is the intermingling of grain in a silo. But goods that are identifiable as belonging to a particular person—branded cattle, for instance—are not confused, no matter how difficult it may be to separate herds that have been put together.
When the goods are identical, no particular problem of division arises. Assuming that each owner can show how much he has contributed to the confused mass, he is entitled to that quantity, and it does not matter which particular grains or kernels he extracts. So if a person, seeing a container of grain sitting on the side of the road, mistakes it for his own and empties it into a larger container in his truck, the remedy is simply to restore a like quantity to the original owner. When owners of like substances consent to have those substances combined (such as in a grain silo), they are said to be tenants in common, holding a proportional share in the whole.
In the case of willful confusion of goods, many courts hold that the wrongdoer forfeits all his property unless he can identify his particular property. Other courts have modified this harsh rule by shifting the burden of proof to the wrongdoer, leaving it up to him to claim whatever he can establish was his. If he cannot establish what was his, then he will forfeit all. Likewise, when the defendant has confused the goods negligently, without intending to do so, most courts will tend to shift to the defendant the burden of proving how much of the mass belongs to him.
Key Takeaway
Other than outright purchase of personal property, there are various ways in which to acquire legal title. Among these are possession, gift, accession, confusion, and finding property that is abandoned, lost, or mislaid, especially if the abandoned, lost, or mislaid property is found on real property that you own.
Exercises
1. Dan captures a wild boar on US Forest Service land. He takes it home and puts it in a cage, but the boar escapes and runs wild for a few days before being caught by Romero, some four miles distant from Dan’s house. Romero wants to keep the boar. Does he “own” it? Or does it belong to Dan, or to someone else?
2. Harriet finds a wallet in the college library, among the stacks. The wallet has \$140 in it, but no credit cards or identification. The library has a lost and found at the circulation desk, and the people at the circulation desk are honest and reliable. The wallet itself is unique enough to be identified by its owner. (a) Who owns the wallet and its contents? (b) As a matter of ethics, should Harriet keep the money if the wallet is “legally” hers? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/29%3A_Personal_Property_and_Fixtures/29.02%3A_Personal_Property.txt |
Learning Objectives
By the end of this section, you will be able to:
• Know the three tests for when personal property becomes a fixture and thus becomes real property.
Definition
A fixture is an object that was once personal property but that has become so affixed to land or structures that it is considered legally a part of the real property. For example, a stove bolted to the floor of a kitchen and connected to the gas lines is usually considered a fixture, either in a contract for sale, or for testamentary transfer (by will). For tax purposes, fixtures are treated as real property.
Tests
Obviously, no clear line can be drawn between what is and what is not a fixture. In general, the courts look to three tests to determine whether a particular object has become a fixture: annexation, adaptation, and intention (Figure \(2\)).
Annexation
The object must be annexed or affixed to the real property. A door on a house is affixed. Suppose the door is broken and the owner has purchased a new door made to fit, but the house is sold before the new door is installed. Most courts would consider that new door a fixture under a rule of constructive annexation. Sometimes courts have said that an item is a fixture if its removal would damage the real property, but this test is not always followed. Must the object be attached with nails, screws, glue, bolts, or some other physical device? In one case, the court held that a four-ton statue was sufficiently affixed merely by its weight.Snedeker v. Warring, 12 N.Y. 170 (1854).
Adaptation
Another test is whether the object is adapted to the use or enjoyment of the real property. Examples are home furnaces, power equipment in a mill, and computer systems in bank buildings.
Intention
Recent decisions suggest that the controlling test is whether the person who actually annexes the object intends by so doing to make it a permanent part of the real estate. The intention is usually deduced from the circumstances, not from what a person might later say her intention was. If an owner installs a heating system in her house, the law will presume she intended it as a fixture because the installation was intended to benefit the house; she would not be allowed to remove the heating system when she sold the house by claiming that she had not intended to make it a fixture.
Fixture Disputes
Because fixtures have a hybrid nature (once personal property, subsequently real property), they generate a large number of disputes. We have already examined disputes between mortgagees and secured parties (Chapter 11). Two other types of disputes are discussed here.
Transfer of Real Estate
When a homeowner sells her house, the problem frequently crops up as to whether certain items in the home have been sold or may be removed by the seller. Is a refrigerator, which simply plugs into the wall, a fixture or an item of personal property? If a dispute arises, the courts will apply the three tests—annexation, adaptation, and intention. Of course, the simplest way of avoiding the dispute is to incorporate specific reference to questionable items in the contract for sale, indicating whether the buyer or the seller is to keep them.
Tenant’s Fixtures
Tenants frequently install fixtures in the buildings they rent or the property they occupy. A company may install tens of thousands of dollars worth of equipment; a tenant in an apartment may bolt a bookshelf into the wall or install shades over a window. Who owns the fixtures when the tenant’s lease expires? The older rule was that any fixture, determined by the usual tests, must remain with the landlord. Today, however, certain types of fixtures—known as tenant’s fixtures—stay with the tenant. These fall into three categories: (1) trade fixtures—articles placed on the premises to enable the tenant to carry on his or her trade or business in the rented premises; (2) agricultural fixtures—devices installed to carry on farming activities (e.g., milling plants and silos); (3) domestic fixtures—items that make a tenant’s personal life more comfortable (carpeting, screens, doors, washing machines, bookshelves, and the like).
The three types of tenant’s fixtures remain personal property and may be removed by the tenant if the following three conditions are met: (1) They must be installed for the requisite purposes of carrying on the trade or business or the farming or agricultural pursuits or for making the home more comfortable, (2) they must be removable without causing substantial damage to the landlord’s property, and (3) they must be removed before the tenant turns over possession of the premises to the landlord. Again, any debatable points can be resolved in advance by specifying them in the written lease.
Key Takeaway
Personal property is often converted to real property when it is affixed to real property. There are three tests that courts use to determine whether a particular object has become a fixture and thus has become real property: annexation, adaptation, and intention. Disputes over fixtures often arise in the transfer of real property and in landlord-tenant relations.
Exercises
1. Jim and Donna Stoner contract to sell their house in Rochester, Michigan, to Clem and Clara Hovenkamp. Clara thinks that the decorative chandelier in the entryway is lovely and gives the house an immediate appeal. The chandelier was a gift from Donna’s mother, “to enhance the entryway” and provide “a touch of beauty” for Jim and Donna’s house. Clem and Clara assume that the chandelier will stay, and nothing specific is mentioned about the chandelier in the contract for sale. Clem and Clara are shocked when they move in and find the chandelier is gone. Have Jim and Donna breached their contract of sale?
2. Blaine Goodfellow rents a house from Associated Properties in Abilene, Texas. He is there for two years, and during that time he installs a ceiling fan, custom-builds a bookcase for an alcove on the main floor, and replaces the screening on the front and back doors, saving the old screening in the furnace room. When his lease expires, he leaves, and the bookcase remains behind. Blaine does, however, take the new screening after replacing it with the old screening, and he removes the ceiling fan and puts back the light. He causes no damage to Associated Properties’ house in doing any of this. Discuss who is the rightful owner of the screening, the bookcase, and the ceiling fan after the lease expires. | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/29%3A_Personal_Property_and_Fixtures/29.03%3A_Fixtures.txt |
Lost or Misplaced Property
Bishop v. Ellsworth
91 Ill. App.2d 386, 234 N.E. 2d 50 (1968)
OPINION BY: STOUDER, Presiding Justice
Dwayne Bishop, plaintiff, filed a complaint alleging that on July 21, 1965, defendants, Mark and Jeff Ellsworth and David Gibson, three small boys, entered his salvage yard premises at 427 Mulberry Street in Canton, without his permission, and while there happened upon a bottle partially embedded in the loose earth on top of a landfill, wherein they discovered the sum of \$12,590 in US currency. It is further alleged that said boys delivered the money to the municipal chief of police who deposited it with defendant, Canton State Bank. The complaint also alleges defendants caused preliminary notices to be given as required by Ill. Rev. Stats., chapter 50, subsections 27 and 28 (1965), but that such statute or compliance therewith does not affect the rights of the plaintiff. [The trial court dismissed the plaintiff’s complaint.]
…It is defendant’s contention that the provisions of Ill Rev Stats, chapter 50, subsections 27 and 28 govern this case. The relevant portions of this statute are as follows:
“27. Lost goods…If any person or persons shall hereafter find any lost goods, money, bank notes, or other choses in action, of any description whatever, such person or persons shall inform the owner thereof, if known, and shall make restitution of the same, without any compensation whatever, except the same shall be voluntarily given on the part of the owner. If the owner be unknown, and if such property found is of the value of \$ 15 or upwards, the finder…shall, within five days after such finding…appear before some judge or magistrate…and make affidavit of the description thereof, the time and place when and where the same was found, that no alteration has been made in the appearance thereof since the finding of the same, that the owner thereof is unknown to him and that he has not secreted, withheld or disposed of any part thereof. The judge or magistrate shall enter the value of the property found as near as he can ascertain in his estray book together with the affidavit of the finder, and shall also, within ten days after the proceedings have been entered on his estray book, transmit to the county clerk a certified copy thereof, to be by him recorded in his estray book and to file the same in his office…28. Advertisement…If the value thereof exceeds the sum of \$ 15, the county clerk, within 20 days after receiving the certified copy of the judge or magistrate’s estray record shall cause an advertisement to be set up on the court house door, and in 3 other of the most public places in the county, and also a notice thereof to be published for 3 weeks successively in some public newspaper printed in this state and if the owner of such goods, money, bank notes, or other choses in action does not appear and claim the same and pay the finder’s charges and expenses within one year after the advertisement thereof as aforesaid, the ownership of such property shall vest in the finder.”
* * *
We think it apparent that the statute to which defendants make reference provides a means of vesting title to lost property in the finder where the prescribed search for the owner proves fruitless. This statute does not purport to provide for the disposition of property deemed mislaid or abandoned nor does it purport to describe or determine the right to possession against any party other than the true owner. The plain meaning of this statute does not support plaintiff’s position that common law is wholly abrogated thereby. The provisions of the statute are designed to provide a procedure whereby the discoverer of “lost” property may be vested with the ownership of said property even as against the true owner thereof, a right which theretofore did not exist at common law. In the absence of any language in the statute from which the contrary can be inferred it must be assumed that the term “lost” was used in its generally accepted legal sense and no extension of the term was intended. Thus the right to possession of discovered property still depends upon the relative rights of the discoverer and the owner of the locus in quo and the distinctions which exist between property which is abandoned, mislaid, lost or is treasure trove. The statute assumes that the discoverer is in the rightful possession of lost property and proceedings under such statute is (sic) not a bar where the issue is a claim to the contrary. There is a presumption that the owner or occupant of land or premises has custody of property found on it or actually imbedded in the land. The ownership or possession of the locus in quo is related to the right to possession of property discovered thereon or imbedded therein in two respects. First, if the premises on which the property is discovered are private it is deemed that the property discovered thereon is and always has been in the constructive possession of the owner of said premises and in a legal sense the property can be neither mislaid nor lost. Pyle v. Springfield Marine Bank, 330 Ill App 1, 70 NE2d 257. Second, the question of whether the property is mislaid or lost in a legal sense depends upon the intent of the true owner. The ownership or possession of the premises is an important factor in determining such intent. If the property be determined to be mislaid, the owner of the premises is entitled to the possession thereof against the discoverer. It would also appear that if the discoverer is a trespasser such trespasser can have no claim to possession of such property even if it might otherwise be considered lost.
…The facts as alleged in substance are that the Plaintiff was the owner and in possession of real estate, that the money was discovered in a private area of said premises in a bottle partially imbedded in the soil and that such property was removed from the premises by the finders without any right or authority and in effect as trespassers. We believe the averment of facts in the complaint substantially informs the defendants of the nature of and basis for the claim and is sufficient to state a cause of action. [The trial court’s dismissal of the Plaintiff’s complaint is reversed and the case is remanded.]
Case Questions
1. What is the actual result in this case? Do the young boys get any of the money that they found? Why or why not?
2. Who is Dwayne Bishop, and why is he a plaintiff here? Was it Bishop that put the \$12,590 in US currency in a bottle in the landfill at the salvage yard? If not, then who did?
3. If Bishop is not the original owner of the currency, what are the rights of the original owner in this case? Did the original owner “lose” the currency? Did the original owner “misplace” the currency? What difference does it make whether the original owner “lost” or “misplaced” the currency? Can the original owner, after viewing the legal advertisement, have a claim superior to Dwayne Bishop’s claim? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/29%3A_Personal_Property_and_Fixtures/29.04%3A_Case.txt |
Summary
Property is the legal relationship between persons with respect to things. The law spells out what can be owned and the degree to which one person can assert an interest in someone else’s things. Property is classified in several ways: personal versus real, tangible versus intangible, private versus public. The first distinction, between real and personal, is the most important, for different legal principles often apply to each. Personal property is movable, whereas real property is immovable.
Among the ways personal property can be acquired are: by (1) possession, (2) finding, (3) gift, (4) accession, and (5) confusion.
Possession means the power to exclude others from using an object. Possession confers ownership only when there is no owner at the time the current owner takes possession. “Finders keepers, losers weepers” is not a universal rule; the previous owner is entitled to return of his goods if it is reasonably possible to locate him. If not, or if the owner does not claim his property, then it goes to the owner of the real estate on which it was found, if the finder was a trespasser, or the goods were buried, were in a private place, or were misplaced rather than lost. If none of these conditions applies, the property goes to the finder.
A gift is a voluntary transfer of property without consideration. Two kinds of gifts are possible: inter vivos and causa mortis. To make an effective gift, (1) the donor must make out a deed or physically deliver the object to the donee, (2) the donor must intend to make a gift, and (3) the donee must accept the gift. Delivery does not always require physical transfer; sometimes, surrender of control is sufficient. The donor must intend to give the gift now, not later.
Accession is an addition to that which is already owned—for example, the birth of calves to a cow owned by a farmer. But when someone else, through labor or by supplying material, adds value, the accession goes to the owner of the principal goods.
Confusion is the intermingling of like goods so that each, while maintaining its form, becomes a part of a larger whole, like grain mixed in a silo. As long as the goods are identical, they can easily enough be divided among their owners.
A fixture is a type of property that ceases to be personal property and becomes real property when it is annexed or affixed to land or buildings on the land and adapted to the use and enjoyment of the real property. The common-law rules governing fixtures do not employ clear-cut tests, and sellers and buyers can avoid many disputes by specifying in their contracts what goes with the land. Tenant’s fixtures remain the property of the tenant if they are for the convenience of the tenant, do not cause substantial damage to the property when removed, and are removed before possession is returned to the landlord.
Exercises
1. Kate owns a guitar, stock in a corporation, and an antique bookcase that is built into the wall of her apartment. How would you classify each kind of property?
2. After her last business law class, Ingrid casually throws her textbook into a trash can and mutters to herself, “I’m glad I don’t have to read that stuff anymore.” Tom immediately retrieves the book from the can. Days later, Ingrid realizes that the book will come in handy, sees Tom with it, and demands that he return the book. Tom refuses. Who is entitled to the book? Why?
3. In Exercise 2, suppose that Ingrid had accidentally left the book on a table in a restaurant. Tom finds it, and chanting “Finders keepers, losers weepers,” he refuses to return the book. Is Ingrid entitled to the book? Why?
4. In Exercise 3, if the owner of the book (Ingrid) is never found, who is entitled to the book—the owner of the restaurant or Tom? Why?
5. Matilda owned an expensive necklace. On her deathbed, Matilda handed the necklace to her best friend, Sadie, saying, “If I die, I want you to have this.” Sadie accepted the gift and placed it in her safe-deposit box. Matilda died without a will, and now her only heir, Ralph, claims the necklace. Is he entitled to it? Why or why not?
SELF CHECK QUESTIONS
1. Personal property is defined as property that is
1. not a chattel
2. owned by an individual
3. movable
4. immovable
2. Personal property can be acquired by
1. accession
2. finding
3. gift
4. all of the above
3. A gift causa mortis is
1. an irrevocable gift
2. a gift made after death
3. a gift made in contemplation of death
4. none of the above
4. To make a gift effective,
1. the donor must intend to make a gift
2. the donor must either make out a deed or deliver the gift to the donee
3. the donee must accept the gift
4. all of the above are required
5. Tenant’s fixtures
1. remain with the landlord in all cases
2. remain the property of the tenant in all cases
3. remain the property of the tenant if they are removable without substantial damage to the landlord’s property
4. refer to any fixture installed by a tenant
1. c
2. d
3. c
4. d
5. c | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/29%3A_Personal_Property_and_Fixtures/29.05%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The principal kinds of intellectual property
• The difference between patents and trade secrets, and why a company might choose to rely on trade secrets rather than obtain a patent
• What copyrights are, how to obtain them, and how they differ from trademarks
• Why some “marks” may not be eligible for trademark protection, and how to obtain trademark protection for those that are
30: Intellectual Property
Few businesses of any size could operate without being able to protect their rights to a particular type of intangible personal property: intellectual property. The major forms of intellectual property are patents, copyrights, and trademarks. Unlike tangible personal property (machines, inventory) or real property (land, office buildings), intellectual property is formless. It is the product of the human intellect that is embodied in the goods and services a company offers and by which the company is known.
A patent is a grant from government that gives an inventor the exclusive right to make, use, and sell an invention for a period of twenty years from the date of filing the application for a patent. A copyright is the right to exclude others from using or marketing forms of expression. A trademark is the right to prevent others from using a company’s product name, slogan, or identifying design. Other forms of intellectual property are trade secrets (particular kinds of information of commercial use to a company that created it) and right of publicity (the right to exploit a person’s name or image). Note that the property interest protected in each case is not the tangible copy of the invention or writing—not the machine with a particular serial number or the book lying on someone’s shelf—but the invention or words themselves. That is why intellectual property is said to be intangible: it is a right to exclude any others from gaining economic benefit from your own intellectual creation. In this chapter, we examine how Congress, the courts, and the Patent and Trademark Office have worked to protect the major types of intellectual property.
30.02: Patents
Learning Objectives
By the end of this section, you will be able to:
• Explain why Congress would grant exclusive monopolies (patents) for certain periods of time.
• Describe what kinds of things may be patentable and what kinds of things may not be patentable.
• Explain the procedures for obtaining a patent, and how patent rights may be an issue where the invention is created by an employee.
• Understand who can sue for patent infringement, on what basis, and with what potential remedies.
Source of Authority and Duration
Patent and copyright law are federal, enacted by Congress under the power given by Article I of the Constitution “to promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.” Under current law, a patent gives an inventor exclusive rights to make, use, or sell an invention for twenty years. (If the patent is a design patent—protecting the appearance rather than the function of an item—the period is fourteen years.) In return for this limited monopoly, the inventor must fully disclose, in papers filed in the US Patent and Trademark Office (PTO), a complete description of the invention.
Patentability
What May Be Patented
The patent law says that “any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof” may be patented.35 United States Code, Section 101. A process is a “process, art or method, and includes a new use of a known process, machine, manufacture, composition of matter, or material.”35 United States Code, Section 101. A process for making rolled steel, for example, qualifies as a patentable process under the statute. A machine is a particular apparatus for achieving a certain result or carrying out a distinct process—lathes, printing presses, motors, and the cotton gin are all examples of the hundreds of thousands of machines that have received US patents since the first Patent Act in 1790. A manufacture is an article or a product, such as a television, an automobile, a telephone, or a lightbulb. A composition of matter is a new arrangement of elements so that the resulting compound, such as a metal alloy, is not found in nature. In Commissioner of Patents v. Chakrabarty,Commissioner of Patents v. Chakrabarty, 444 U.S. 1028 (1980). the Supreme Court said that even living organisms—in particular, a new “genetically engineered” bacterium that could “eat” oil spills—could be patented. The Chakrabarty decision has spawned innovation: a variety of small biotechnology firms have attracted venture capitalists and other investors.
According to the PTO, gene sequences are patentable subject matter, provided they are isolated from their natural state and processed in a way that separates them from other molecules naturally occurring with them. Gene patenting, always controversial, generated new controversy when the PTO issued a patent to Human Genome Sciences, Inc. for a gene found to serve as a platform from which the AIDS virus can infect cells of the body. Critics faulted the PTO for allowing “ownership” of a naturally occurring human gene and for issuing patents without requiring a showing of the gene’s utility. New guidelines from the PTO followed in 2000; these focused on requiring the applicant to make a strong showing on the utility aspect of patentability and somewhat diminished the rush of biotech patent requests.
There are still other categories of patentable subjects. An improvement is an alteration of a process, machine, manufacture, or composition of matter that satisfies one of the tests for patentability given later in this section. New, original ornamental designs for articles of manufacture are patentable (e.g., the shape of a lamp); works of art are not patentable but are protected under the copyright law. New varieties of cultivated or hybridized plants are also patentable, as are genetically modified strains of soybean, corn, or other crops.
What May Not Be Patented
Many things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3) abstract ideas, including algorithms (step-by-step formulas for accomplishing a specific task).
One frequently asked question is whether patents can be issued for computer software. The PTO was reluctant to do so at first, based on the notion that computer programs were not “novel”—the software program either incorporated automation of manual processes or used mathematical equations (which were not patentable). But in 1998, the Supreme Court held in Diamond v. DiehrDiamond v. Diehr, 450 U.S. 175 (1981). that patents could be obtained for a process that incorporated a computer program if the process itself was patentable.
A business process can also be patentable, as the US Court of Appeals for the Federal Circuit ruled in 1998 in State Street Bank and Trust v. Signature Financial Group, Inc.State Street Bank and Trust v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998). Signature Financial had a patent for a computerized accounting system that determined share prices through a series of mathematical calculations that would help manage mutual funds. State Street sued to challenge that patent. Signature argued that its model and process was protected, and the court of appeals upheld it as a “practical application of a mathematical, algorithm, formula, or calculation,” because it produces a “useful, concrete and tangible result.” Since State Street, many other firms have applied for business process patents. For example, Amazon.com obtained a business process patent for its “one-click” ordering system, a method of processing credit-card orders securely. (But see Amazon.com v. Barnesandnoble.com, Amazon.com v. Barnesandnoble.com, Inc., 239 F.3d 1343 (Fed. Cir. 2001). in which the court of appeals rejected Amazon’s challenge to Barnesandnoble.com using its Express Land one-click ordering system.)
Tests for Patentability
Just because an invention falls within one of the categories of patentable subjects, it is not necessarily patentable. The Patent Act and judicial interpretations have established certain tests that must first be met. To approve a patent application, the PTO (as part of the Department of Commerce) will require that the invention, discovery, or process be novel, useful, and nonobvious in light of current technology.
Perhaps the most significant test of patentability is that of obviousness. The act says that no invention may be patented “if the differences between the subject matter sought to be patented and the prior art are such that the subject matter as a whole would have been obvious at the time the invention was made to a person having ordinary skill in the art to which said subject matter pertains.” This provision of the law has produced innumerable court cases, especially over improvement patents, when those who wish to use an invention on which a patent has been issued have refused to pay royalties on the grounds that the invention was obvious to anyone who looked.
Procedures for Obtaining a Patent
In general, the United States (unlike many other countries) grants a patent right to the first person to invent a product or process rather than to the first person to file for a patent on that product or process. As a practical matter, however, someone who invents a product or process but does not file immediately should keep detailed research notes or other evidence that would document the date of invention. An inventor who fails to apply for a patent within a year of that date would forfeit the rights granted to an inventor who had published details of the invention or offered it for sale. But until the year has passed, the PTO may not issue a patent to X if Y has described the invention in a printed publication here or abroad or the invention has been in public use or on sale in this country.
An inventor cannot obtain a patent automatically; obtaining a patent is an expensive and time-consuming process, and the inventor will need the services of a patent attorney, a highly specialized practitioner. The attorney will help develop the required specification, a description of the invention that gives enough detail so that one skilled in the art will be able to make and use the invention. After receiving an application, a PTO examiner will search the records and accept or reject the claim. Usually, the attorney will negotiate with the examiner and will rewrite and refine the application until it is accepted. A rejection may be appealed, first to the PTO’s Board of Appeals and then, if that fails, to the federal district court in the District of Columbia or to the US Court of Appeals for the Federal Circuit, the successor court to the old US Court of Customs and Patent Appeals.
Once a patent application has been filed, the inventor or a company to which she has assigned the invention may put the words “patent pending” on the invention. These words have no legal effect. Anyone is free to make the invention as long as the patent has not yet been issued. But they do put others on notice that a patent has been applied for. Once the patent has been granted, infringers may be sued even if the infringed has made the product and offered it for sale before the patent was granted.
In today’s global market, obtaining a US patent is important but is not usually sufficient protection. The inventor will often need to secure patent protection in other countries as well. Under the Paris Convention for the Protection of Industrial Property (1883), parties in one country can file for patent or trademark protection in any of the other member countries (172 countries as of 2011). The World Trade Organization’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) established standards for protecting intellectual property rights (patents, trademarks, and copyrights) and provides that each member nation must have laws that protect intellectual property rights with effective access to judicial systems for pursuing civil and criminal penalties for violations of such rights.
Patent Ownership
The patent holder is entitled to make and market the invention and to exclude others from doing so. Because the patent is a species of property, it may be transferred. The inventor may assign part or all of his interest in the patent or keep the property interest and license others to manufacture or use the invention in return for payments known as royalties. The license may be exclusive with one licensee, or the inventor may license many to exploit the invention. One important limitation on the inventor’s right to the patent interest is the so-called shop right. This is a right created by state courts on equitable grounds giving employers a nonexclusive royalty-free license to use any invention made by an employee on company time and with company materials. The shop right comes into play only when a company has no express or implied understanding with its employees. Most corporate laboratories have contractual agreements with employees about who owns the invention and what royalties will be paid.
Infringement and Invalidity Suits
Suits for patent infringement can arise in three ways: (1) the patent holder may seek damages and an injunction against the infringer in federal court, requesting damages for royalties and lost profits as well; (2) even before being sued, the accused party may take the patent holder to court under the federal Declaratory Judgment Act, seeking a court declaration that the patent is invalid; (3) the patent holder may sue a licensee for royalties claimed to be due, and the licensee may counterclaim that the patent is invalid. Such a suit, if begun in state court, may be removed to federal court.
In a federal patent infringement lawsuit, the court may grant the winning party reimbursement for attorneys’ fees and costs. If the infringement is adjudged to be intentional, the court can triple the amount of damages awarded. Prior to 2006, courts were typically granting permanent injunctions to prevent future infringement. Citing eBay, Inc. v. Merc Exchange, LLC,eBay, Inc. v. Merc Exchange, LLC, 546 U.S. 388 (2006). the Supreme Court ruled that patent holders are not automatically entitled to a permanent injunction against infringement during the life of the patent. Courts have the discretion to determine whether justice requires a permanent injunction, and they may conclude that the public interest and equitable principles may be better satisfied with compensatory damages only.
Proving infringement can be a difficult task. Many companies employ engineers to “design around” a patent product—that is, to seek ways to alter the product to such an extent that the substitute product no longer consists of enough of the elements of the invention safeguarded by the patent. However, infringing products, processes, or machines need not be identical; as the Supreme Court said in Sanitary Refrigerator Co. v. Winers,Sanitary Refrigerator Co. v. Winers, 280 U.S. 30 (1929). “one device is an infringement of another…if two devices do the same work in substantially the same way, and accomplish substantially the same result…even though they differ in name, form, or shape.” This is known as the doctrine of equivalents. In an infringement suit, the court must choose between these two extremes: legitimate “design around” and infringement through some equivalent product.
An infringement suit can often be dangerous because the defendant will almost always assert in its answer that the patent is invalid. The plaintiff patent holder thus runs the risk that his entire patent will be taken away from him if the court agrees. In ruling on validity, the court may consider all the tests, such as prior art and obviousness, discussed in Section 30.1.2 “Patentability” and rule on these independently of the conclusions drawn by the PTO.
Patent Misuse
Although a patent is a monopoly granted to the inventor or his assignee or licensee, the monopoly power is legally limited. An owner who misuses the patent may find that he will lose an infringement suit. One common form of misuse is to tie the patented good to some unpatented one—for example, a patented movie projector that will not be sold unless the buyer agrees to rent films supplied only by the manufacturer of the movie projector, or a copier manufacturer that requires buyers to purchase plain paper from it. As we will see in Chapter 26, various provisions of the federal antitrust laws, including, specifically, Section 3 of the Clayton Act, outlaw certain kinds of tying arrangements. Another form of patent misuse is a provision in the licensing agreement prohibiting the manufacturer from also making competing products. Although the courts have held against several other types of misuse, the general principle is that the owner may not use his patent to restrain trade in unpatented goods.
Key Takeaway
Many different “things” are patentable, include gene sequences, business processes, and any other “useful invention.” The US Patent and Trademark Office acts on initial applications and may grant a patent to an applicant. The patent, which allows a limited-time monopoly, is for twenty years. The categories of patentable things include processes, machines, manufactures, compositions of matter, and improvements. Ideas, mental processes, naturally occurring substances, methods of doing business, printed matter, and scientific principles cannot be patented. Patent holders may sue for infringement and royalties from an infringer user.
Exercises
1. Calera, Inc. discovers a way to capture carbon dioxide emissions at a California power plant and use them to make cement. This is a win for the power company, which needs to reduce its carbon dioxide emissions, and a win for Calera. Calera decides to patent this invention. What kind of patent would this be? A machine? A composition of matter? A manufacture?
2. In your opinion, what is the benefit of allowing companies to isolate genetic material and claim a patent? What kind of patent would this be? A machine? A composition of matter? A manufacture?
3. How could a “garage inventor,” working on her own, protect a patentable invention while yet demonstrating it to a large company that could bring the invention to market? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/30%3A_Intellectual_Property/30.01%3A_Introduction_to_Intellectual_Property.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe the difference between trade secrets and patents, and explain why a firm might prefer keeping a trade secret rather than obtaining a patent.
• Understand the dimensions of corporate espionage and the impact of the federal Economic Espionage Act.
Definition of Trade Secrets
A patent is an invention publicly disclosed in return for a monopoly. A trade secret is a means to a monopoly that a company hopes to maintain by preventing public disclosure. Why not always take out a patent? There are several reasons. The trade secret might be one that is not patentable, such as a customer list or an improvement that does not meet the tests of novelty or nonobviousness. A patent can be designed around; but if the trade secret is kept, its owner will be the exclusive user of it. Patents are expensive to obtain, and the process is extremely time consuming. Patent protection expires in twenty years, after which anyone is free to use the invention, but a trade secret can be maintained for as long as the secret is kept.
However, a trade secret is valuable only so long as it is kept secret. Once it is publicly revealed, by whatever means, anyone is free to use it. The critical distinction between a patent and a trade secret is this: a patent gives its owner the right to enjoin anyone who infringes it from making use of it, whereas a trade secret gives its “owner” the right to sue only the person who improperly took it or revealed it.
According to the Restatement of Torts, Section 757, Comment b, a trade secret may consist of any formula, pattern, device or compilation of information which is used in one’s business, and which gives him an opportunity to obtain an advantage over competitors who do not know or use it. It may be a formula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern for a machine or other device, or a list of customers.…A trade secret is a process or device for continuous use in the operation of a business. Generally it relates to the production of goods, as, for example, a machine or formula for the production of an article.
Other types of trade secrets are customer information, pricing data, marketing methods, sources of supply, and secret technical know-how.
Elements of Trade Secrets
To be entitled to protection, a trade secret must be (1) original and (2) secret.
Originality
The trade secret must have a certain degree of originality, although not as much as would be necessary to secure a patent. For example, a principle or technique that is common knowledge does not become a protectable trade secret merely because a particular company taught it to one of its employees who now wants to leave to work for a competitor.
Secrecy
Some types of information are obviously secret, like the chemical formula that is jealously guarded through an elaborate security system within the company. But other kinds of information might not be secret, even though essential to a company’s business. For instance, a list of suppliers that can be devised easily by reading through the telephone directory is not secret. Nor is a method secret simply because someone develops and uses it, if no steps are taken to guard it. A company that circulates a product description in its catalog may not claim a trade secret in the design of the product if the description permits someone to do “reverse engineering.” A company that hopes to keep its processes and designs secret should affirmatively attempt to do so—for example, by requiring employees to sign a nondisclosure agreement covering the corporate trade secrets with which they work. However, a company need not go to every extreme to guard a trade secret.
Trade-secrets espionage has become a big business. To protect industrial secrets, US corporations spend billions on security arrangements. The line between competitive intelligence gathering and espionage can sometimes be difficult to draw. The problem is by no means confined to the United States; companies and nations all over the world have become concerned about theft of trade secrets to gain competitive advantage, and foreign governments are widely believed to be involved in espionage and cyberattacks.
Economic Espionage Act
The Economic Espionage Act (EEA) of 1996 makes the theft or misappropriation of a trade secret a federal crime. The act is aimed at protecting commercial information rather than classified national defense information. Two sorts of activities are criminalized. The first section of the actEconomic Espionage Act, 18 United States Code, Section 1831(a) (1996) criminalizes the misappropriation of trade secrets (including conspiracy to misappropriate trade secrets and the subsequent acquisition of such misappropriated trade secrets) with the knowledge or intent that the theft will benefit a foreign power. Penalties for violation are fines of up to US\$500,000 per offense and imprisonment of up to fifteen years for individuals, and fines of up to US\$10 million for organizations.
The second sectionEconomic Espionage Act, 18 United States Code, Section 1832 (1996). criminalizes the misappropriation of trade secrets related to or included in a product that is produced for or placed in interstate (including international) commerce, with the knowledge or intent that the misappropriation will injure the owner of the trade secret. Penalties for violation are imprisonment for up to ten years for individuals (no fines) and fines of up to US\$5 million for organizations.
In addition to these specific penalties, the fourth section of the EEAEconomic Espionage Act, 18 United States Code, Section 1834 (1996). also requires criminal forfeiture of (1) any proceeds of the crime and property derived from proceeds of the crime and (2) any property used, or intended to be used, in commission of the crime.
The EEA authorizes civil proceedings by the Department of Justice to enjoin violations of the act but does not create a private cause of action. This means that anyone believing they have been victimized must go through the US attorney general in order to obtain an injunction.
The EEA is limited to the United States and has no extraterritorial application unless (1) the offender is a US company or a citizen operating from abroad against a US company or (2) an act in furtherance of the espionage takes place in the United States. Other nations lack such legislation, and some may actively support industrial espionage using both their national intelligence services. The US Office of the National Counterintelligence Executive publishes an annual report, mandated by the US Congress, on foreign economic collection and industrial espionage, which outlines these espionage activities of many foreign nations.
Right of Employees to Use Trade Secrets
A perennial source of lawsuits in the trade secrets arena is the employee who is hired away by a competitor, allegedly taking trade secrets along with him. Companies frequently seek to prevent piracy by requiring employees to sign confidentiality agreements. An agreement not to disclose particular trade secrets learned or developed on the job is generally enforceable. Even without an agreement, an employer can often prevent disclosure under principles of agency law. Sections 395 and 396 of the Restatement (Second) of Agency suggest that it is an actionable breach of duty to disclose to third persons information given confidentially during the course of the agency. However, every person is held to have a right to earn a living. If the rule were strictly applied, a highly skilled person who went to another company might be barred from using his knowledge and skills. The courts do not prohibit people from using elsewhere the general knowledge and skills they developed on the job. Only specific trade secrets are protected.
To get around this difficulty, some companies require their employees to sign agreements not to compete. But unless the agreements are limited in scope and duration to protect a company against only specific misuse of trade secrets, they are unenforceable.
Key Takeaway
Trade secrets, if they can be kept, have indefinite duration and thus greater potential value than patents. Trade secrets can be any formula, pattern, device, process, or compilation of information to be used in a business. Customer information, pricing data, marketing methods, sources of supply, and technical know-how could all be trade secrets. State law has protected trade secrets, and federal law has provided criminal sanctions for theft of trade secrets. With the importance of digitized information, methods of theft now include computer hacking; theft of corporate secrets is a burgeoning global business that often involves cyberattacks.
Exercises
1. Wu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and “steals” plans and specifications for HP’s latest products. The HP server is located in the United States. He sells this information to a Chinese company in Shanghai. Has he violated the US Economic Espionage Act?
2. What are the advantages of keeping a formula as a trade secret rather than getting patent protection? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/30%3A_Intellectual_Property/30.03%3A_Trade_Secrets.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe and explain copyrights, how to obtain one, and how they differ from trademarks.
• Explain the concept of fair use and describe its limits.
Definition and Duration
Copyright is the legal protection given to “authors” for their “writings.” Copyright law is federal; like patent law, its source lies in the Constitution. Copyright protects the expression of ideas in some tangible form, but it does not protect the ideas themselves. Under the 1976 Copyright Act as amended, a copyright in any work created after January 1, 1978, begins when the work is fixed in tangible form—for example, when a book is written down or a picture is painted—and generally lasts for the life of the author plus 70 years after his or her death. This is similar to copyright protection in many countries, but in some countries, the length of copyright protection is the life of the author plus 50 years. For copyrights owned by publishing houses, done as works for hire, common copyright expires 95 years from the date of publication or 120 years from the date of creation, whichever is first. For works created before 1978, such as many of Walt Disney’s movies and cartoons, the US Sonny Bono Copyright Term Extension Act of 1998 provided additional protection of up to 95 years from publication date. Thus works created in 1923 by Disney would not enter the public domain until 2019 or after, unless the copyright had expired prior to 1998 or unless the Disney company released the work into the public domain. In general, after expiration of the copyright, the work enters the public domain.
In 1989, the United States signed the Berne Convention, an international copyright treaty. This law eliminated the need to place the symbol © or the word Copyright or the abbreviation Copr. on the work itself. Copyrights can be registered with the US Copyright Office in Washington, DC.
Protected Expression
The Copyright Act protects a variety of “writings,” some of which may not seem written at all. These include literary works (books, newspapers, and magazines), music, drama, choreography, films, art, sculpture, and sound recordings. Since copyright covers the expression and not the material or physical object, a book may be copyrighted whether it is on paper, microfilm, tape, or computer disk.
Rights Protected by the Copyright Act
Preventing Copying
A copyright gives its holder the right to prevent others from copying his or her work. The copyright holder has the exclusive right to reproduce the work in any medium (paper, film, sound recording), to perform it (e.g., in the case of a play), or to display it (a painting or film). A copyright also gives its holder the exclusive right to prepare derivative works based on the copyrighted work. Thus a playwright could not adapt to the stage a novelist’s book without the latter’s permission.
Fair Use
One major exception to the exclusivity of copyrights is the fair use doctrine. Section 107 of the Copyright Act provides as follows:
Fair use of a copyrighted work, including such use by reproduction in copies or phonorecords or by any other means specified by section 106 of the copyright, for purposes such as criticism, comment, news reporting, teaching (including multiple copies for classroom use), scholarship, or research, is not an infringement of copyright. In determining whether the use made of a work in any particular case is a fair use, the factors to be considered shall include–
(1) the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes;
(2) the nature of the copyrighted work;
(3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
(4) the effect of the use upon the potential market for or value of the copyrighted work.17 United States Code, Section 107.
These are broad guidelines. Accordingly, any copying could be infringement, and fair use could become a question of fact on a case-by-case basis. In determining fair use, however, courts have often considered the fourth factor (effect of the use upon the potential market for the copyrighted work) to be the most important.
Clear examples of fair use would be when book reviewers or writers quote passages from copyrighted books. Without fair use, most writing would be useless because it could not readily be discussed. But the doctrine of fair use grew more troublesome with the advent of plain-paper copiers and is now even more troublesome with electronic versions of copyrighted materials that are easily copied and distributed. The 1976 act took note of the new copier technology, listing “teaching (including multiple copies for classroom use)” as one application of fair use. The Copyright Office follows guidelines specifying just how far the copying may go—for example, multiple copies of certain works may be made for classroom use, but copies may not be used to substitute for copyrighted anthologies.
Infringement
Verbatim use of a copyrighted work is easily provable. The more difficult question arises when the copyrighted work is altered in some way. As in patent law, the standard is one of substantial similarity.
Copyrightability Standards
To be subject to copyright, the writing must be “fixed” in some “tangible medium of expression.” A novelist who composes a chapter of her next book in her mind and tells it to a friend before putting it on paper could not stop the friend from rushing home, writing it down, and selling it (at least the federal copyright law would offer no protection; some states might independently offer a legal remedy, however).
The work also must be creative, at least to a minimal degree. Words and phrases, such as names, titles, and slogans, are not copyrightable; nor are symbols or designs familiar to the public. But an author who contributes her own creativity—like taking a photograph of nature—may copyright the resulting work, even if the basic elements of the composition were not of her making.
Finally, the work must be “original,” which means simply that it must have originated with the author. The law does not require that it be novel or unique. This requirement was summarized pithily by Judge Learned Hand: “If by some magic a man who had never known it were to compose anew Keats’s Ode on a Grecian Urn, he would be an author, and, if he copyrighted it, others might not copy that poem, though they might of course copy Keats’s.”Sheldon v. Metro-Goldwyn Pictures Corp., 81 F.2d 49 (2d Cir. 1936). Sometimes the claim is made that a composer, for example, just happened to compose a tune identical or strikingly similar to a copyrighted song; rather than assume the unlikely coincidence that Judge Hand hypothesized, the courts will look for evidence that the alleged copier had access to the copyrighted song. If he did—for example, the song was frequently played on the air—he cannot defend the copying with the claim that it was unconscious, because the work would not then have been original.
Section 102 of the Copyright Act excludes copyright protection for any “idea, procedure, process, system, method of operation, concept, principle, or discovery, regardless of the form in which it is described, explained, illustrated, or embodied.”17 United States Code, Section 102.
Einstein copyrighted books and monographs he wrote on the theory of relativity, but he could not copyright the famous formula E = mc2, nor could he prevent others from writing about the theory. But he could protect the particular way in which his ideas were expressed. In general, facts widely known by the public are not copyrightable, and mathematical calculations are not copyrightable. Compilations of facts may be copyrightable, if the way that they are coordinated or arranged results in a work that shows some originality. For example, compiled information about yachts listed for sale may qualify for copyright protection.BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d 1129 (11th Cir. 2007).
One of the most troublesome recent questions concerning expression versus ideas is whether a computer program may be copyrighted. After some years of uncertainty, the courts have accepted the copyrightability of computer programs.Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1240 (3d Cir. 1983). Now the courts are wrestling with the more difficult question of the scope of protection: what constitutes an “idea” and what constitutes its mere “expression” in a program.
How far the copyright law will protect particular software products is a hotly debated topic, sparked by a federal district court’s ruling in 1990 that the “look and feel” of Lotus 1-2-3’s menu system is copyrightable and was in fact infringed by Paperback Software’s VP-Planner, a competing spreadsheet.Lotus Development Corp. v. Paperback Software International, 740 F.Supp. 37 (D. Mass. 1990). The case has led some analysts to “fear that legal code, rather than software code, is emerging as the factor that will determine which companies and products will dominate the 1990s.”Peter H. Lewis, “When Computing Power Is Generated by the Lawyers,” New York Times, July 22 1990.
Who May Obtain a Copyright?
With one important exception, only the author may hold the initial copyright, although the author may assign it or license any one or more of the rights conveyed by the copyright. This is a simple principle when the author has written a book or painted a picture. But the law is unclear in the case of a motion picture or a sound recording. Is the author the script writer, the producer, the performer, the director, the engineer, or someone else? As a practical matter, all parties involved spell out their rights by contract.
The exception, which frequently covers the difficulties just enumerated, is for works for hire. Any person employed to write—a journalist or an advertising jingle writer, for example—is not the “author.” For purposes of the statute, the employer is the author and may take out the copyright. When the employee is in fact an “independent contractor” and the work in question involves any one of nine types (book, movies, etc.) spelled out in the Copyright Act, the employer and the creator must spell out their entitlement to the copyright in a written agreement.Community for Creative Non-Violence v. Reid, 109 S.Ct. 2166 (1989).
Obtaining a Copyright
Until 1978, a work could not be copyrighted unless it was registered in the Copyright Office or was published and unless each copy of the work carried a copyright notice, consisting of the word Copyright, the abbreviation Copr., or the common symbol ©, together with the date of first publication and the name of the copyright owner. Under the 1976 act, copyright became automatic whenever the work was fixed in a tangible medium of expression (e.g., words on paper, images on film or videotape, sound on tape or compact disc), even if the work remained unpublished or undistributed. However, to retain copyright protection, the notice had to be affixed once the work was “published” and copies circulated to the public. After the United States entered the Berne Convention, an international treaty governing copyrights, Congress enacted the Berne Implementation Act, declaring that, effective in 1989, notice, even after publication, was no longer required.
Notice does, however, confer certain benefits. In the absence of notice, a copyright holder loses the right to receive statutory damages (an amount stated in the Copyright Act and not required to be proved) if someone infringes the work. Also, although it is no longer required, an application and two copies of the work (for deposit in the Library of Congress) filed with the Copyright Office, in Washington, DC, will enable the copyright holder to file suit should the copyright be infringed. Unlike patent registration, which requires elaborate searching of Patent and Trademark Office (PTO) records, copyright registration does not require a reading of the work to determine whether it is an original creation or an infringement of someone else’s prior work. But copyright registration does not immunize the holder from an infringement suit. If a second work has been unlawfully copied from an earlier work, the second author’s copyright will not bar the infringed author from collecting damages and obtaining an injunction.
Computer Downloads and the Digital Millennium Copyright Act
The ubiquity of the Internet and the availability of personal computers with large capacities have greatly impacted the music business. Sharing of music files took off in the late 1990s with Napster, which lost a legal battle on copyright and had to cease doing business. By providing the means by which individuals could copy music that had been purchased, major record labels were losing substantial profits. Grokster, a privately owned software company based in the West Indies, provided peer-to-peer file sharing from 2001 to 2005 until the US Supreme Court’s decision in MGM Studios, Inc. v. Grokster, Ltd.MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005).
For computers with the Microsoft operating system, the Court disallowed the peer-to-peer file sharing, even though Grokster claimed it did not violate any copyright laws because no files passed through its computers. (Grokster had assigned certain user computers as “root supernodes” that acted as music hubs for the company and was not directly involved in controlling any specific music-file downloads.)
Grokster had argued, based on Sony v. Universal Studios, Sony v. Universal Studios, 464 U.S. 417 (1984). that the sale of its copying equipment (like the Betamax videocassette recorders at issue in that case) did not constitute contributory infringement “if the product is widely used for legitimate, unobjectionable purposes.” Plaintiffs successfully argued that the Sony safe-harbor concept requires proof that the noninfringing use is the primary use in terms of the product’s utility.
The Digital Millennium Copyright Act (DMCA), passed into law in 1998, implements two 1996 treaties of the World Intellectual Property Organization. It criminalizes production and sale of devices or services intended to get around protective measures that control access to copyrighted works. In addition, the DMCA heightens the penalties for copyright infringement on the Internet. The DMCA amended Title 17 of the United States Code to extend the reach of copyright, while limiting the liability of the providers of online services for copyright infringement by their users.
Key Takeaway
Copyright is the legal protection given to “authors” for their “writings.” It protects ideas in fixed, tangible form, not ideas themselves. Copyright protection can extend as long as 120 years from the date of creation or publication. Expression found in literary works, music, drama, film, art, sculpture, sound recordings, and the like may be copyrighted. The fair use doctrine limits the exclusivity of copyright in cases where scholars, critics, or teachers use only selected portions of the copyrighted material in a way that is unlikely to affect the potential market for or value of the copyrighted work.
Exercises
1. Explain how a list could be copyrightable.
2. An author wrote a novel, Brunch at Bruno’s, in 1961. She died in 1989, and her heirs now own the copyright. When do the rights of the heirs come to an end? That is, when does Brunch at Bruno’s enter the public domain?
3. Keith Bradsher writes a series of articles on China for the New York Times and is paid for doing so. Suppose he wants to leave the employ of the Times and be a freelance writer. Can he compile his best articles into a book, Changing Times in China, and publish it without the New York Times’s permission? Does it matter that he uses the word Times in his proposed title?
4. What kind of file sharing of music is now entirely legal? Shaunese Collins buys a Yonder Mountain String Band CD at a concert at Red Rocks in Morrison, Colorado. With her iMac, she makes a series of CDs for her friends. She does this six times. Has she committed six copyright violations? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/30%3A_Intellectual_Property/30.04%3A_Copyright.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand what a trademark is and why it deserves protection.
• Know why some “marks” may not be eligible for trademark protection, and how to obtain trademark protection for those that are.
• Explain what “blurring” and “tarnishment” are and what remedies are available to the holder of the mark.
Definitions of Trademarks
A trademark is defined in the federal Lanham Act of 1946 as “any word, name, symbol, or device or any combination thereof adopted and used by a manufacturer or merchant to identify his goods and distinguish them from goods manufactured or sold by others.”15 United States Code, Section 1127.
Examples of well-known trademarks are Coca-Cola, Xerox, and Apple. A service mark is used in the sale or advertising of services to identify the services of one person and distinguish them from the services of others. Examples of service marks are McDonald’s, BP, and Hilton. A certification mark is used in connection with many products “to certify regional or other origin, material, mode of manufacture, quality, accuracy or other characteristics of such goods or services or that the work or labor on the goods or services was performed by members of a union or other organization.” Examples are the Good Housekeeping Seal of Approval and UL (Underwriters Laboratories, Inc., approval mark). Unlike other forms of trademark, the owner of the certification mark (e.g., Good Housekeeping, or the Forest Stewardship Council’s FSC mark) is not the owner of the underlying product.
Extent of Trademark Protection
Kinds of Marks
Trademarks and other kinds of marks may consist of words and phrases, pictures, symbols, shapes, numerals, letters, slogans, and sounds. Trademarks are a part of our everyday world: the sounds of a radio or television network announcing itself (NBC, BBC), the shape of a whiskey bottle (Haig & Haig’s Pinch Bottle), a series of initials (GE, KPMG, IBM), or an animal’s warning growl (MGM’s lion).
Limitations on Marks
Although trademarks abound, the law limits the subjects that may fall into one of the defined categories. Not every word or shape or symbol will be protected in an infringement action. To qualify for protection, a trademark must be used to identify and distinguish. The courts employ a four-part test: (1) Is the mark so arbitrary and fanciful that it merits the widest protection? (2) Is it “suggestive” enough to warrant protection without proof of secondary meaning? (3) Is it “descriptive,” warranting protection if secondary meaning is proved? (4) Is the mark generic and thus unprotectable?
These tests do not have mechanical answers; they call for judgment. Some marks are wholly fanciful, clearly identify origin of goods, and distinguish them from others—Kodak, for example. Other marks may not be so arbitrary but may nevertheless be distinctive, either when adopted or as a result of advertising—for example, Crest, as the name of a toothpaste.
Marks that are merely descriptive of the product are entitled to protection only if it can be shown that the mark has acquired secondary meaning. This term reflects a process of identification on the mark in the public mind with the originator of the product. Holiday Inn was initially deemed too descriptive: an inn where people might go on holiday. But over time, travelers came to identify the source of the Great Sign and the name Holiday Inn as the Holiday Inn Corporation in Memphis, and secondary meaning was granted. Holiday Inn could thus protect its mark against other innkeepers, hoteliers, and such; however, the trademark protection for the words Holiday Inn was limited to the corporation’s hotel and motel business, and no other.
Certain words and phrases may not qualify at all for trademark protection. These include generic terms like “straw broom” (for a broom made of straw) and ordinary words like “fast food.” In one case, a federal appeals court held that the word “Lite” is generic and cannot be protected by a beer manufacturer to describe a low-calorie brew.Miller Brewing Co. v. Falstaff Brewing Corp., 655 F.2d 5 (1st Cir. 1981). Donald Trump’s effort to trademark “You’re fired!” and Paris Hilton’s desire to trademark “That’s hot!” were also dismissed as being generic.
Deceptive words will not be accepted for registration. Thus the US Patent and Trademark Office (PTO) denied registration to the word Vynahyde because it suggested that the plastic material to which it was applied came from animal skin. Geographic terms are descriptive words and may not be used as protected trademarks unless they have acquired a secondary meaning, such as Hershey when used for chocolates. (Hershey’s chocolates are made in Hershey, Pennsylvania.) A design that reflects a common style cannot be protected in a trademark to exclude other similar designs in the same tradition. Thus the courts have ruled that a silverware pattern that is a “functional feature” of the “baroque style” does not qualify for trademark protection. Finally, the Lanham Act denies federal registration to certain marks that fall within categories of words and shapes, including the following: the flag; the name, portrait, or signature of any living person without consent, or of a deceased US president during the lifetime of his widow; and immoral, deceptive, or scandalous matter (in an earlier era, the phrase “Bubby Trap” for brassieres was denied registration).
Dilution, Tarnishment, and Blurring
Under the federal Trademark Dilution Act of 1995, companies with marks that dilute the value of a senior mark may be liable for damages. The act provides that owners of marks of significant value have property rights that should not be eroded, blurred, tarnished, or diluted in any way by another. But as a plaintiff, the holder of the mark must show (1) that it is a famous mark, (2) that the use of a similar mark is commercial, and (3) that such use causes dilution of the distinctive quality of the mark. Thus a T-shirt maker who promotes a red-and-white shirt bearing the mark Buttweiser may be liable to Anheuser-Busch, or a pornographic site called Candyland could be liable to Parker Brothers, the board game company. Interesting cases have already been brought under this act, including a case brought by Victoria’s Secret against a small adult store in Kentucky called Victor’s Little Secret. Notice that unlike most prior trademark law, the purpose is not to protect the consumer from confusion as to the source or origin of the goods or services being sold; for example, no one going to the Candyland site would think that Parker Brothers was the source.
Acquiring Trademark Rights
For the first time in more than forty years, Congress, in 1988, changed the way in which trademarks can be secured. Under the Lanham Act, the fundamental means of obtaining a trademark was through use. The manufacturer or distributor actually must have placed the mark on its product—or on related displays, labels, shipping containers, advertisements, and the like—and then have begun selling the product. If the product was sold in interstate commerce, the trademark was entitled to protection under the Lanham Act (or if not, to protection under the common law of the state in which the product was sold).
Under the Trademark Law Revision Act of 1988, which went into effect in 1989, trademarks can be obtained in advance by registering with the PTO an intention to use the mark within six months (the applicant can gain extensions of up to thirty more months to put the mark into use). Once obtained, the trademark will be protected for ten years (before the 1988 revision, a federal trademark remained valid for twenty years); if after that time the mark is still being used, the registration can be renewed. Obtaining a trademark registration lies between obtaining patents and obtaining copyrights in difficulty. The PTO will not routinely register a trademark; it searches its records to ensure that the mark meets several statutory tests and does not infringe another mark. Those who feel that their own marks would be hurt by registration of a proposed mark may file an opposition proceeding with the PTO. Until 1990, the office received about 77,000 applications each year. With the change in procedure, some experts predicted that applications would rise by 30 percent.
In many foreign countries, use need not be shown to obtain trademark registration. It is common for some people in these countries to register marks that they expect to be valuable so that they can sell the right to use the mark to the company that established the mark’s value. Companies that expect to market abroad should register their marks early.
Loss of Rights
Trademark owners may lose their rights if they abandon the mark, if a patent or copyright expires on which the mark is based, or if the mark becomes generic. A mark is abandoned if a company goes out of business and ceases selling the product. Some marks are based on design patents; when the patent expires, the patent holder will not be allowed to extend the patent’s duration by arguing that the design or name linked with the design is a registrable trademark.
The most widespread difficulty that a trademark holder faces is the prospect of too much success: if a trademark comes to stand generically for the product itself, it may lose exclusivity in the mark. Famous examples are aspirin, escalator, and cellophane. The threat is a continual one. Trademark holders can protect themselves from their marks’ becoming generic in several ways.
1. Use a descriptive term along with the trademark. Look on a jar of Vaseline and you will see that the label refers to the contents as Vaseline petroleum jelly.
2. Protest generic use of the mark in all publications by writing letters and taking out advertisements.
3. Always put the words Trademark, Registered Trademark, or the symbol ® (meaning “registered”) next to the mark itself, which should be capitalized.
Key Takeaway
Trademark protection is federal, under the Lanham Act. Branding of corporate logos, names, and products is essential to business success, and understanding trademarks is pivotal to branding. A “mark” must be distinctive, arbitrary, or fanciful to merit protection: this means that it must not be generic or descriptive. Marks can be words, symbols, pictures, slogans, sounds, phrases, and even shapes. In the United States, rights to marks are obtained by registration and intent to use in commerce and must be renewed every ten years.
Exercises
1. How will Google protect its trademark, assuming that people begin using “google” as a verb substitute for “Internet search,” just like people began using the word “cellophane” for all brands of plastic wrap?
2. Do a small amount of web searching and find out what “trade dress” protection is, and how it differs from trademark protection.
3. LexisNexis is a brand for a database collection offered by Mead Data Central. Lexus is a high-end automobile. Can Lexus succeed in getting Mead Data Central to stop using “Lexis” as a mark? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/30%3A_Intellectual_Property/30.05%3A_Trademarks.txt |
Fair Use in Copyright
Elvis Presley Enterprises et al. v. Passport Video et al.
349 F.3d 622 (9th Circuit Court of Appeals, 2003)
TALLMAN, CIRCUIT JUDGE:
Plaintiffs are a group of companies and individuals holding copyrights in various materials relating to Elvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered owner of several Elvis appearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns the copyright to two television specials featuring Elvis: The Elvis 1968 Comeback Special and Elvis Aloha from Hawaii.…Many Plaintiffs are in the business of licensing their copyrights. For example, SOFA Entertainment charges \$10,000 per minute for use of Elvis’ appearances on The Ed Sullivan Show.
Passport Entertainment and its related entities (collectively “Passport”) produced and sold The Definitive Elvis, a 16-hour video documentary about the life of Elvis Presley. The Definitive Elvis sold for \$99 at retail. Plaintiffs allege that thousands of copies were sent to retail outlets and other distributors. On its box, The Definitive Elvis describes itself as an all-encompassing, in-depth look at the life and career of a man whose popularity is unrivaled in the history of show business and who continues to attract millions of new fans each year.…
The Definitive Elvis uses Plaintiffs’ copyrighted materials in a variety of ways. With the video footage, the documentary often uses shots of Elvis appearing on television while a narrator or interviewee talks over the film. These clips range from only a few seconds in length to portions running as long as 30 seconds. In some instances, the clips are the subject of audio commentary, while in other instances they would more properly be characterized as video “filler” because the commentator is discussing a subject different from or more general than Elvis’ performance on a particular television show. But also significant is the frequency with which the copyrighted video footage is used. The Definitive Elvis employs these clips, in many instances, repeatedly. In total, at least 5% to 10% of The Definitive Elvis uses Plaintiffs’ copyrighted materials.
Use of the video footage, however, is not limited to brief clips.…Thirty-five percent of his appearances on The Ed Sullivan Show is replayed, as well as three minutes from The 1968 Comeback Special.
* * *
Plaintiffs sued Passport for copyright infringement.…Passport, however, asserts that its use of the copyrighted materials was “fair use” under 17 U.S.C. § 107. Plaintiffs moved for a preliminary injunction, which was granted by the district court after a hearing. The district court found that Passport’s use of Plaintiffs’ copyrighted materials was likely not fair use. The court enjoined Passport from selling or distributing The Definitive Elvis. Passport timely appeals.
* * *
We first address the purpose and character of Passport’s use of Plaintiffs’ copyrighted materials. Although not controlling, the fact that a new use is commercial as opposed to non-profit weighs against a finding of fair use. Harper & Row Publishers, Inc. v. Nation Enters., 471 U.S. 539, 562, 85 L. Ed. 2d 588, 105 S.Ct. 2218 (1985). And the degree to which the new user exploits the copyright for commercial gain—as opposed to incidental use as part of a commercial enterprise—affects the weight we afford commercial nature as a factor. More importantly for the first fair-use factor, however, is the “transformative” nature of the new work. Specifically, we ask “whether the new work…merely supersedes the objects of the original creation, or instead adds something new, with a further purpose or different character, altering the first with new expression, meaning, or message.…” The more transformative a new work, the less significant other inquiries, such as commercialism, become.
* * *
The district court below found that the purpose and character of The Definitive Elvis will likely weigh against a finding of fair use. We cannot say, based on this record, that the district court abused its discretion.
First, Passport’s use, while a biography, is clearly commercial in nature. But more significantly, Passport seeks to profit directly from the copyrights it uses without a license. One of the most salient selling points on the box of The Definitive Elvis is that “Every Film and Television Appearance is represented.” Passport is not advertising a scholarly critique or historical analysis, but instead seeks to profit at least in part from the inherent entertainment value of Elvis’ appearances on such shows as The Steve Allen Show, The Ed Sullivan Show, and The 1968 Comeback Special. Passport’s claim that this is scholarly research containing biographical comments on the life of Elvis is not dispositive of the fair use inquiry.
Second, Passport’s use of Plaintiffs’ copyrights is not consistently transformative. True, Passport’s use of many of the television clips is transformative because the clips play for only a few seconds and are used for reference purposes while a narrator talks over them or interviewees explain their context in Elvis’ career. But voice-overs do not necessarily transform a work.…
It would be impossible to produce a biography of Elvis without showing some of his most famous television appearances for reference purposes. But some of the clips are played without much interruption, if any. The purpose of showing these clips likely goes beyond merely making a reference for a biography, but instead serves the same intrinsic entertainment value that is protected by Plaintiffs’ copyrights.
* * *
The third factor is the amount and substantiality of the portion used in relation to the copyrighted work as a whole. This factor evaluates both the quantity of the work taken and the quality and importance of the portion taken. Regarding the quantity, copying “may not be excused merely because it is insubstantial with respect to the infringing work.” Harper & Row, 471 U.S. at 565 (emphasis in original). But if the amount used is substantial with respect to the infringing work, it is evidence of the value of the copy-righted work.
Passport’s use of clips from television appearances, although in most cases of short duration, were repeated numerous times throughout the tapes. While using a small number of clips to reference an event for biographical purposes seems fair, using a clip over and over will likely no longer serve a biographical purpose. Additionally, some of the clips were not short in length. Passport’s use of Elvis’ appearance on The Steve Allen Show plays for over a minute and many more clips play for more than just a few seconds.
Additionally, although the clips are relatively short when compared to the entire shows that are copyrighted, they are in many instances the heart of the work. What makes these copyrighted works valuable is Elvis’ appearance on the shows, in many cases singing the most familiar passages of his most popular songs. Plaintiffs are in the business of licensing these copyrights. Taking key portions extracts the most valuable part of Plaintiffs’ copyrighted works. With respect to the photographs, the entire picture is often used. The music, admittedly, is usually played only for a few seconds.
* * *
The last, and “undoubtedly the single most important” of all the factors, is the effect the use will have on the potential market for and value of the copyrighted works. Harper & Row, 471 U.S. at 566. We must “consider not only the extent of market harm caused by the particular actions of the alleged infringer, but also whether unrestricted and widespread conduct of the sort engaged in by the defendant…would result in a substantially adverse impact on the potential market for the original.” Campbell, 510 U.S. at 590. The more transformative the new work, the less likely the new work’s use of copyrighted materials will affect the market for the materials. Finally, if the purpose of the new work is commercial in nature, “the likelihood [of market harm] may be presumed.” A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S. at 451).
The district court found that Passport’s use of Plaintiffs’ copyrighted materials likely does affect the market for those materials. This conclusion was not clearly erroneous.
First, Passport’s use is commercial in nature, and thus we can assume market harm. Second, Passport has expressly advertised that The Definitive Elvis contains the television appearances for which Plaintiffs normally charge a licensing fee. If this type of use became wide-spread, it would likely undermine the market for selling Plaintiffs’ copyrighted material. This conclusion, however, does not apply to the music and still photographs. It seems unlikely that someone in the market for these materials would purchase The Definitive Elvis instead of a properly licensed product. Third, Passport’s use of the television appearances was, in some instances, not transformative, and therefore these uses are likely to affect the market because they serve the same purpose as Plaintiffs’ original works.
* * *
We emphasize that our holding today is not intended to express how we would rule were we examining the case ab initio as district judges. Instead, we confine our review to whether the district court abused its discretion when it weighed the four statutory fair-use factors together and determined that Plaintiffs would likely succeed on the merits. Although we might view this case as closer than the district court saw it, we hold there was no abuse of discretion in the court’s decision to grant Plaintiffs’ requested relief.
AFFIRMED.
Case Questions
1. How would you weigh the four factors in this case? If the trial court had found fair use, would the appeals court have overturned its ruling?
2. Why do you think that the fourth factor is especially important?
3. What is the significance of the discussion on “transformative” aspects of the defendant’s product?
More Fair Use in Copyright
Playboy Enterprises v. Welles
279 F.3d 796 (9th Circuit Court of Appeals, 2001)
T. G. NELSON, Circuit Judge:
Terri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of the Year for 1981. Her use of the title “Playboy Playmate of the Year 1981,” and her use of other trademarked terms on her website are at issue in this suit. During the relevant time period, Welles’ website offered information about and free photos of Welles, advertised photos for sale, advertised memberships in her photo club, and promoted her services as a spokesperson. A biographical section described Welles’ selection as Playmate of the Year in 1981 and her years modeling for PEI. The site included a disclaimer that read as follows: “This site is neither endorsed, nor sponsored, nor affiliated with Playboy Enterprises, Inc. PLAYBOY tm PLAYMATE OF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered trademarks of Playboy Enterprises, Inc.”
Wells used (1) the terms “Playboy ”and “Playmate” in the metatags of the website; (2) the phrase “Playmate of the Year 1981” on the masthead of the website; (3) the phrases “Playboy Playmate of the Year 1981” and “Playmate of the Year 1981” on various banner ads, which may be transferred to other websites; and (4) the repeated use of the abbreviation “PMOY ’81” as the watermark on the pages of the website. PEI claimed that these uses of its marks constituted trademark infringement, dilution, false designation of origin, and unfair competition. The district court granted defendants’ motion for summary judgment. PEI appeals the grant of summary judgment on its infringement and dilution claims. We affirm in part and reverse in part.
A. Trademark Infringement
Except for the use of PEI’s protected terms in the wallpaper of Welles’ website, we conclude that Welles’ uses of PEI’s trademarks are permissible, nominative uses. They imply no current sponsorship or endorsement by PEI. Instead, they serve to identify Welles as a past PEI “Playmate of the Year.”
We articulated the test for a permissible, nominative use in New Kids On The Block v. New America Publishing, Inc. The band, New Kids On The Block, claimed trademark infringement arising from the use of their trademarked name by several newspapers. The newspapers had conducted polls asking which member of the band New Kids On The Block was the best and most popular. The papers’ use of the trademarked term did not fall within the traditional fair use doctrine. Unlike a traditional fair use scenario, the defendant newspaper was using the trademarked term to describe not its own product, but the plaintiff’s. Thus, the factors used to evaluate fair use were inapplicable. The use was nonetheless permissible, we concluded, based on its nominative nature.
We adopted the following test for nominative use.
First, the product or service in question must be one not readily identifiable without use of the trademark; second, only so much of the mark or marks may be used as is reasonably necessary to identify the product or service; and third, the user must do nothing that would, in conjunction with the mark, suggest sponsorship or endorsement by the trademark holder.
We group the uses of PEI’s trademarked terms into three for the purpose of applying the test for nominative use.
1. Headlines and banner advertisements.
. . .
The district court properly identified Welles’ situation as one which must… be excepted. No descriptive substitute exists for PEI’s trademarks in this context.…Just as the newspapers in New Kids could only identify the band clearly by using its trademarked name, so can Welles only identify herself clearly by using PEI’s trademarked title.
The second part of the nominative use test requires that “only so much of the mark or marks may be used as is reasonably necessary to identify the product or service[.]” New Kids provided the following examples to explain this element: “[A] soft drink competitor would be entitled to compare its product to Coca-Cola or Coke, but would not be entitled to use Coca-Cola’s distinctive lettering.” Similarly, in a past case, an auto shop was allowed to use the trademarked term “Volkswagen” on a sign describing the cars it repaired, in part because the shop “did not use Volkswagen’s distinctive lettering style or color scheme, nor did he display the encircled ‘VW’ emblem.” Welles’ banner advertisements and headlines satisfy this element because they use only the trademarked words, not the font or symbols associated with the trademarks.
The third element requires that the user do “nothing that would, in conjunction with the mark, suggest sponsorship or endorsement by the trademark holder.” As to this element, we conclude that aside from the wallpaper, which we address separately, Welles does nothing in conjunction with her use of the marks to suggest sponsorship or endorsement by PEI. The marks are clearly used to describe the title she received from PEI in 1981, a title that helps describe who she is. It would be unreasonable to assume that the Chicago Bulls sponsored a website of Michael Jordan’s simply because his name appeared with the appellation “former Chicago Bull.” Similarly, in this case, it would be unreasonable to assume that PEI currently sponsors or endorses someone who describes herself as a “Playboy Playmate of the Year in 1981.” The designation of the year, in our case, serves the same function as the “former” in our example. It shows that any sponsorship or endorsement occurred in the past.
For the foregoing reasons, we conclude that Welles’ use of PEI’s marks in her headlines and banner advertisements is a nominative use excepted from the law of trademark infringement.
2. Metatags
Welles includes the terms “playboy” and “playmate” in her metatags. Metatags describe the contents of a website using keywords. Some search engines search metatags to identify websites relevant to a search. Thus, when an internet searcher enters “playboy” or “playmate” into a search engine that uses metatags, the results will include Welles’ site. Because Welles’ metatags do not repeat the terms extensively, her site will not be at the top of the list of search results. Applying the three-factor test for nominative use, we conclude that the use of the trademarked terms in Welles’ metatags is nominative.
As we discussed above with regard to the headlines and banner advertisements, Welles has no practical way of describing herself without using trademarked terms. In the context of metatags, we conclude that she has no practical way of identifying the content of her website without referring to PEI’s trademarks.
. . .
Precluding their use would have the unwanted effect of hindering the free flow of information on the internet, something which is certainly not a goal of trademark law. Accordingly, the use of trademarked terms in the metatags meets the first part of the test for nominative use.…We conclude that the metatags satisfy the second and third elements of the test as well. The metatags use only so much of the marks as reasonably necessary and nothing is done in conjunction with them to suggest sponsorship or endorsement by the trademark holder. We note that our decision might differ if the metatags listed the trademarked term so repeatedly that Welles’ site would regularly appear above PEI’s in searches for one of the trademarked terms.
3. Wallpaper/watermark.
The background, or wallpaper, of Welles’ site consists of the repeated abbreviation “PMOY ’81,” which stands for “Playmate of the Year 1981.” Welles’ name or likeness does not appear before or after “PMOY ’81.” The pattern created by the repeated abbreviation appears as the background of the various pages of the website. Accepting, for the purposes of this appeal, that the abbreviation “PMOY” is indeed entitled to protection, we conclude that the repeated, stylized use of this abbreviation fails the nominative use test.
The repeated depiction of “PMOY ‘81” is not necessary to describe Welles. “Playboy Playmate of the Year 1981” is quite adequate. Moreover, the term does not even appear to describe Welles—her name or likeness do not appear before or after each “PMOY ’81.” Because the use of the abbreviation fails the first prong of the nominative use test, we need not apply the next two prongs of the test.
Because the defense of nominative use fails here, and we have already determined that the doctrine of fair use does not apply, we remand to the district court. The court must determine whether trademark law protects the abbreviation “PMOY,” as used in the wallpaper.
Conclusion
For the foregoing reasons, we affirm the district court’s grant of summary judgment as to PEI’s claims for trademark infringement and trademark dilution, with the sole exception of the use of the abbreviation “PMOY.” We reverse as to the abbreviation and remand for consideration of whether it merits protection under either an infringement or a dilution theory.
Case Questions
1. Do you agree with the court’s decision that there is no dilution here?
2. If PMOY is not a registered trademark, why does the court discuss it?
3. What does “nominative use” mean in the context of this case?
4. In business terms, why would PEI even think that it was losing money, or could lose money, based on Welles’s use of its identifying marks? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/30%3A_Intellectual_Property/30.06%3A_Cases.txt |
Summary
The products of the human mind are at the root of all business, but they are legally protectable only to a certain degree. Inventions that are truly novel may qualify for a twenty-year patent; the inventor may then prohibit anyone from using the art (machine, process, manufacture, and the like) or license it on his own terms. A business may sue a person who improperly gives away its legitimate trade secrets, but it may not prevent others from using the unpatented trade secret once publicly disclosed. Writers or painters, sculptors, composers, and other creative artists may generally protect the expression of their ideas for the duration of their lives plus seventy years, as long as the ideas are fixed in some tangible medium. That means that they may prevent others from copying their words (or painting, etc.), but they may not prevent anyone from talking about or using their ideas. Finally, one who markets a product or service may protect its trademark or service or other mark that is distinctive or has taken on a secondary meaning, but may lose it if the mark becomes the generic term for the goods or services.
Exercises
1. Samuel Morse filed claims in the US Patent Office for his invention of the telegraph and also for the “use of the motive power of the electric or galvanic current…however developed, for marking or printing intelligible characters, signs or letters at any distances.” For which claim, if any, was he entitled to a patent? Why?
2. In 1957, an inventor dreamed up and constructed a certain new kind of computer. He kept his invention a secret. Two years later, another inventor who conceived the same machine filed a patent application. The first inventor, learning of the patent application, filed for his own patent in 1963. Who is entitled to the patent, assuming that the invention was truly novel and not obvious? Why?
3. A large company discovered that a small company was infringing one of its patents. It wrote the small company and asked it to stop. The small company denied that it was infringing. Because of personnel changes in the large company, the correspondence file was lost and only rediscovered eight years later. The large company sued. What would be the result? Why?
4. Clifford Witter was a dance instructor at the Arthur Murray Dance Studios in Cleveland. As a condition of employment, he signed a contract not to work for a competitor. Subsequently, he was hired by the Fred Astaire Dancing Studios, where he taught the method that he had learned at Arthur Murray. Arthur Murray sued to enforce the noncompete contract. What would be result? What additional information, if any, would you need to know to decide the case?
5. Greenberg worked for Buckingham Wax as its chief chemist, developing chemical formulas for products by testing other companies’ formulas and modifying them. Brite Products bought Buckingham’s goods and resold them under its own name. Greenberg went to work for Brite, where he helped Brite make chemicals substantially similar to the ones it had been buying from Buckingham. Greenberg had never made any written or oral commitment to Buckingham restricting his use of the chemical formulas he developed. May Buckingham stop Greenberg from working for Brite? May it stop him from working on formulas learned while working at Buckingham? Why?
SELF CHECK QUESTIONS
1. Which of the following cannot be protected under patent, copyright, or trademark law?
1. a synthesized molecule
2. a one-line book title
3. a one-line advertising jingle
4. a one-word company name
2. Which of the following does not expire by law?
1. a closely guarded trade secret not released to the public
2. a patent granted by the US Patent and Trademark Office
3. a copyright registered in the US Copyright Office
4. a federal trademark registered under the Lanham Act
3. A sculptor casts a marble statue of a three-winged bird. To protect against copying, the sculptor can obtain which of the following?
1. a patent
2. a trademark
3. a copyright
4. none of the above
4. A stock analyst discovers a new system for increasing the value of a stock portfolio. He may protect against use of his system by other people by securing
1. a patent
2. a copyright
3. a trademark
4. none of the above
5. A company prints up its customer list for use by its sales staff. The cover page carries a notice that says “confidential.” A rival salesman gets a copy of the list. The company can sue to recover the list because the list is
1. patented
2. copyrighted
3. a trade secret
4. none of the above
1. b
2. a
3. c
4. d
5. c | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/30%3A_Intellectual_Property/30.07%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The various forms of real estate ownership, including fee simple, tenancy in common, and joint tenancy
• The mechanics of finding, financing, and closing a real estate transaction
• How adverse possession may sometimes vest title in real property despite the nonconsent of the owner
31: The Transfer of Real Estate By Sale
This chapter follows the steps taken when real estate is transferred by sale.
1. The buyer selects a form of ownership.
2. The buyer searches for the real estate to be purchased. In doing so, the buyer will usually deal with real estate brokers.
3. After a parcel is selected, the seller and buyer will negotiate and sign a sales agreement.
4. The seller will normally be required to provide proof of title.
5. The buyer will acquire property insurance.
6. The buyer will arrange financing.
7. The sale and purchase will be completed at a closing.
During this process, the buyer and seller enter into a series of contracts with each other and with third parties such as brokers, lenders, and insurance companies. In this chapter, we focus on the unique features of these contracts, with the exception of mortgages and property insurance. We conclude by briefly examining adverse possession—a method of acquiring property for free.
31.02: Forms of Ownership
Learning Objectives
By the end of this section, you will be able to:
• Be familiar with the various kinds of interest in real property.
• Know the ways that two or more people can own property together.
• Understand the effect of marriage, divorce, and death on various forms of property ownership.
One form of ownership of real property is legally quite simple, although lawyers refer to it with a complicated-sounding name. This is ownership by one individual, known as ownership in severalty. In purchasing real estate, however, buyers frequently complicate matters by grouping together—because of marriage, close friendship, or simply in order to finance the purchase more easily
When purchasers group together for investment purposes, they often use the various forms of organization—corporations, partnerships, limited partnerships, joint ventures, and business trusts. The most popular of these forms of organization for owning real estate is the limited partnership. A real estate limited partnership is designed to allow investors to take substantial deductions that offset current income from the partnership and other similar investments, while at the same time protecting the investor from personal liability if the venture fails.
But you do not have to form a limited partnership or other type of business in order to acquire property with others; many other forms are available for personal or investment purposes. To these we now turn.
Joint Tenancy
Joint tenancy is an estate in land owned by two or more persons. It is distinguished chiefly by the right of survivorship. If two people own land as joint tenants, then either becomes the sole owner when the other dies. For land to be owned jointly, four unities must coexist:
1. Unity of time. The interests of the joint owners must begin at the same time.
2. Unity of title. The joint tenants must acquire their title in the same conveyance—that is, the same will or deed.
3. Unity of interest. Each owner must have the same interest in the property; for example, one may not hold a life estate and the other the remainder interest.
4. Unity of possession. All parties must have an equal right to possession of the property (see Figure 31.1).
Suppose a woman owns some property and upon marriage wishes to own it jointly with her husband. She deeds it to herself and her husband “as joint tenants and not tenants in common.” Strictly speaking, the common law would deny that the resulting form of ownership was joint because the unities of title and time were missing. The wife owned the property first and originally acquired title under a different conveyance. But the modern view in most states is that an owner may convey directly to herself and another in order to create a joint estate.
When one or more of the unities is destroyed, however, the joint tenancy lapses. Fritz and Gary own a farm as joint tenants. Fritz decides to sell his interest to Jesse (or, because Fritz has gone bankrupt, the sheriff auctions off his interest at a foreclosure sale). Jesse and Gary would hold as tenants in common and not as joint tenants. Suppose Fritz had made out his will, leaving his interest in the farm to Reuben. On Fritz’s death, would the unities be destroyed, leaving Gary and Reuben as tenants in common? No, because Gary, as joint tenant, would own the entire farm on Fritz’s death, leaving nothing behind for Reuben to inherit.
Tenancy by the Entirety
About half the states permit husbands and wives to hold property as tenants by the entirety. This form of ownership is similar to joint tenancy, except that it is restricted to husbands and wives. This is sometimes described as the unity of person. In most of the states permitting tenancy by the entirety, acquisition by husband and wife of property as joint tenants automatically becomes a tenancy by the entirety. The fundamental importance of tenancy by the entirety is that neither spouse individually can terminate it; only a joint decision to do so will be effective. One spouse alone cannot sell or lease an interest in such property without consent of the other, and in many states a creditor of one spouse cannot seize the individual’s separate interest in the property, because the interest is indivisible.
Tenancy in Common
Two or more people can hold property as tenants in common when the unity of possession is present, that is, when each is entitled to occupy the property. None of the other unities—of time, title, or interest—is necessary, though their existence does not impair the common ownership. Note that the tenants in common do not own a specific portion of the real estate; each has an undivided share in the whole, and each is entitled to occupy the whole estate. One tenant in common may sell, lease, or mortgage his undivided interest. When a tenant in common dies, his interest in the property passes to his heirs, not to the surviving tenants in common.
Because tenancy in common does not require a unity of interest, it has become a popular form of “mingling,” by which unrelated people pool their resources to purchase a home. If they were joint tenants, each would be entitled to an equal share in the home, regardless of how much each contributed, and the survivor would become sole owner when the other owner dies. But with a tenancy-in-common arrangement, each can own a share in proportion to the amount invested.
Community Property
In ten states—Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin—property acquired during a marriage is said to be community property. There are differences among these states, but the general theory is that with certain exceptions, each spouse has an undivided equal interest in property acquired while the husband and wife are married to each other. The major exception is for property acquired by gift or inheritance during the marriage. (By definition, property owned by either spouse before the marriage is not community property.) Property acquired by gift of inheritance or owned before the marriage is known as separate property. Community property states recognize other forms of ownership; specifically, husbands and wives may hold property as joint tenants, permitting the survivor to own the whole.
The consequence of community property laws is that either the husband or the wife may manage the community property, borrow against it, and dispose of community personal property. Community real estate may only be sold or encumbered by both jointly. Each spouse may bequeath only half the community property in his or her will. In the absence of a will, the one-half property interest will pass in accordance with the laws of intestate succession. If the couple divorces, the states generally provide for an equal or near-equal division of the community property, although a few permit the court in its discretion to divide in a different proportion.
Condominiums
In popular parlance, a condominium is a kind of apartment building, but that is not its technical legal meaning. Condominium is a form of ownership, not a form of structure, and it can even apply to space—for example, to parking spaces in a garage. The word condominium means joint ownership or control, and it has long been used whenever land has been particularly scarce or expensive. Condominiums were popular in ancient Rome (especially near the Forum) and in the walled cities of medieval Europe.
In its modern usage, condominium refers to a form of housing involving two elements of ownership. The first is the living space itself, which may be held in common, in joint tenancy, or in any other form of ownership. The second is the common space in the building, including the roof, land under the structure, hallways, swimming pool, and the like. The common space is held by all purchasers as tenants in common. The living space may not be sold apart from the interest in the common space.
Two documents are necessary in a condominium sale—the master deed and the bylaws. The master deed (1) describes the condominium units, the common areas, and any restrictions that apply to them; (2) establishes the unit owner’s interest in the common area, his number of votes at owners’ association meetings, and his share of maintenance and operating expenses (sometimes unit owners have equal shares, and sometimes their share is determined by computing the ratio of living area or market price or original price of a single unit to the whole); and (3) creates a board of directors to administer the affairs of the whole condominium. The bylaws usually establish the owners’ association, set out voting procedures, list the powers and duties of the officers, and state the obligations of the owners for the use of the units and the common areas.
Cooperatives
Another popular form of owning living quarters with common areas is the cooperative. Unlike the person who lives in a condominium, the tenant of a cooperative does not own a particular unit. Instead, he owns a share of the entire building. Since the building is usually owned by a corporation (a cooperative corporation, hence the name), this means that the tenant owns stock in the corporation. A tenant occupies a unit under a lease from the corporation. Together, the lease and stock in the building corporation are considered personal, not real, property.
In a condominium, an owner of a unit who defaults in paying monthly mortgage bills can face foreclosure on the unit, but neighbors in the building suffer no direct financial impact, except that the defaulter probably has not paid monthly maintenance charges either. In a cooperative, however, a tenant who fails to pay monthly charges can jeopardize the entire building, because the mortgage is on the building as a whole; consequently, the others will be required to make good the payments or face foreclosure.
Time-Shares
A time-share is an arrangement by which several people can own the same property while being entitled to occupy the premises exclusively at different times on a recurring basis. In the typical vacation property, each owner has the exclusive right to use the apartment unit or cottage for a specified period of time each year—for example, Mr. and Mrs. Smith may have possession from December 15 through December 22, Mr. and Mrs. Jones from December 23 through December 30, and so on. The property is usually owned as a condominium but need not be. The sharers may own the property in fee simple, hold a joint lease, or even belong to a vacation club that sells time in the unit.
Time-share resorts have become popular in recent years. But the lure of big money has brought unscrupulous contractors and salespersons into the market. Sales practices can be unusually coercive, and as a result, most states have sets of laws specifically to regulate time-share sales. Almost all states provide a cooling-off period, or rescission period; these periods vary from state to state and provide a window where buyers can change their minds without forfeiting payments or deposits already made.
Key Takeaway
Property is sometimes owned by one person or one entity, but more often two or more persons will share in the ownership. Various forms of joint ownership are possible, including joint tenancies, tenancy by the entirety, and tenancy in common. Married persons should be aware of whether the state they live in is a community property state; if it is, the spouse will take some interest in any property acquired during the marriage. Beyond traditional landholdings, modern real estate ownership may include interests in condominiums, cooperatives, or time-shares.
Exercises
1. Miguel and Maria Ramirez own property in Albuquerque, New Mexico, as tenants by the entirety. Miguel is a named defendant in a lawsuit that alleges defamation, and an award is made for \$245,000 against Miguel. The property he owns with Maria is worth \$320,000 and is owned free of any mortgage interest. To what extent can the successful plaintiff recover damages by forcing a sale of the property?
2. Miguel and Maria Ramirez own property in Albuquerque, New Mexico, as tenants by the entirety. They divorce. At the time of the divorce, there are no new deeds signed or recorded. Are they now tenants in common or joint tenants? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/31%3A_The_Transfer_of_Real_Estate_By_Sale/31.01%3A_Introduction_to_the_Transfer_of_Real_Estate_by_Sale.txt |
Learning Objectives
By the end of this section, you will be able to:
• Know the duties of the real estate broker and how brokers are licensed.
• Be able to discuss the impact of constitutonal and statutory law on real estate sellers and brokers.
• Describe the various kinds of listing contracts and their import.
• Know the elements of a sales agreement and the various types of deeds to real estate.
• Understand the closing process and how “good title” is obtained through the title search and insurance process.
Once the buyer (or buyers) knows what form of ownership is most desirable, the search for a suitable property can begin. This search often involves contact with a broker hired by the seller. The seller’s contract with the broker, known as the listing agreement, is the first of the series of contracts in a typical real estate transaction. As you consider these contracts, it is important to keep in mind that despite the size of the transaction and the dire financial consequences should anything go awry, the typical person (buyer or seller) usually acts as his or her own attorney. An American Bar Association committee has noted the following:
It is probably safe to say that in a high percentage of cases the seller is unrepresented and signs the contracts of brokerage and sale on the basis of his faith in the broker. The buyer does not employ a lawyer. He signs the contract of sale without reading it and, once financing has been obtained, leaves all the details of title search and closing to the lender or broker. The lender or broker may employ an attorney but, where title insurance is furnished by a company maintaining its own title plant, it is possible that no lawyer, not even house counsel, will appear.
This being so, the material that follows is especially important for buyers and sellers who are not represented in the process of buying or selling real estate.
Regulation of the Real Estate Business
State Licensing
Real estate brokers, and the search for real estate generally, are subject to state and federal government regulation. Every state requires real estate brokers to be licensed. To obtain a license, the broker must pass an examination covering the principles of real estate practice, transactions, and instruments. Many states additionally insist that the broker take several courses in finance, appraisal, law, and real estate practice and apprentice for two years as a salesperson in a real estate broker’s office.
Civil Rights Act
Two federal civil rights laws also play an important role in the modern real estate transaction. These are the Civil Rights Act of 1866 and the Civil Rights Act of 1968 (Fair Housing Act). In Jones v. Alfred H. Mayer Co.,Jones v. Alfred H. Mayer Co., 392 U.S. 409 (1968). the Supreme Court upheld the constitutionality of the 1866 law, which expressly gives all citizens of the United States the same rights to inherit, purchase, lease, sell, hold, and convey real and personal property. A minority buyer or renter who is discriminated against may sue for relief in federal court, which may award damages, stop the sale of the house, or even direct the seller to convey the property to the plaintiff.
The 1968 Fair Housing Act prohibits discrimination on the grounds of race, color, religion, sex, national origin, handicap, or family status (i.e., no discrimination against families with children) by any one of several means, including the following:
1. Refusing to sell or rent to or negotiate with any person
2. Discriminating in the terms of sale or renting
3. Discriminating in advertising
4. Denying that the housing is available when in fact it is
5. “Blockbusting” (panicking owners into selling or renting by telling them that minority groups are moving into the neighborhood)
6. Creating different terms for granting or denying home loans by commercial lenders
7. Denying anyone the use of real estate services
However, the 1968 act contains several exemptions:
1. Sale or rental of a single-family house if the seller
1. owns less than four such houses,
2. does not use a broker,
3. does not use discriminatory advertising,
4. within two years sells no more than one house in which the seller was not the most recent occupant.
5. Rentals in a building occupied by the owner as long as it houses fewer than five families and the owner did not use discriminatory advertising
6. Sale or rental of space in buildings or land restricted by religious organization owners to people of the same religion (assuming that the religion does not discriminate on the basis of race, color, or national origin)
7. Private clubs, if they limit their noncommercial rentals to members
The net impact of these laws is that discrimination based on color or race is flatly prohibited and that other types of discrimination are also barred unless one of the enumerated exemptions applies.
Hiring the Broker: The Listing Agreement
When the seller hires a real estate broker, he will sign a listing agreement. (In several states, the Statute of Frauds says that the seller must sign a written agreement; however, he should do so in all states in order to provide evidence in the event of a later dispute.) This listing agreement sets forth the broker’s commission, her duties, the length of time she will serve as broker, and other terms of her agency relationship. Whether the seller will owe a commission if he or someone other than the broker finds a buyer depends on which of three types of listing agreements has been signed.
Exclusive Right to Sell
If the seller agrees to an exclusive-right-to-sell agency, he will owe the broker the stated commission regardless of who finds the buyer. Language such as the following gives the broker an exclusive right to sell: “Should the seller or anyone acting for the seller (including his heirs) sell, lease, transfer, or otherwise dispose of the property within the time fixed for the continuance of the agency, the broker shall be entitled nevertheless to the commission as set out herein.”
Exclusive Agency
Somewhat less onerous from the seller’s perspective (and less generous from the broker’s perspective) is the exclusive agency. The broker has the exclusive right to sell and will be entitled to the commission if anyone other than the seller finds the buyer (i.e., the seller will owe no commission if he finds a buyer). Here is language that creates an exclusive agency: “A commission is to be paid the broker whether the purchaser is secured by the broker or by any person other than the seller.”
Open Listing
The third type of listing, relatively rarely used, is the open listing, which authorizes “the broker to act as agent in securing a purchaser for my property.” The open listing calls for payment to the broker only if the broker was instrumental in finding the buyer; the broker is not entitled to her commission if anyone else, seller or otherwise, locates the buyer.
Suppose the broker finds a buyer, but the seller refuses at that point to sell. May the seller simply change his mind and avoid having to pay the broker’s commission? The usual rule is that when a broker finds a buyer who is “ready, willing, and able” to purchase or lease the property, she has earned her commission. Many courts have interpreted this to mean that even if the buyers are unable to obtain financing, the commission is owed nevertheless once the prospective buyers have signed a purchase agreement. To avoid this result, the seller should insist on either a “no deal, no commission” clause in the listing agreement (entitling the broker to payment only if the sale is actually consummated) or a clause in the purchase agreement making the purchase itself contingent on the buyer’s finding financing.
Broker’s Duties
Once the listing agreement has been signed, the broker becomes the seller’s agent—or, as occasionally happens, the buyer’s agent, if hired by the buyer. A broker is not a general agent with broad authority. Rather, a broker is a special agent with authority only to show the property to potential buyers. Unless expressly authorized, a broker may not accept money on behalf of the seller from a prospective buyer. Suppose Eunice hires Pete’s Realty to sell her house. They sign a standard exclusive agency listing, and Pete cajoles Frank into buying the house. Frank writes out a check for \$10,000 as a down payment and offers it to Pete, who absconds with the money. Who must bear the loss? Ordinarily, Frank would have to bear the loss, because Pete was given no authority to accept money. If the listing agreement explicitly said that Pete could accept the down payment from a buyer, then the loss would fall on Eunice.
Although the broker is but a special agent, she owes the seller, her principal, a fiduciary duty. (See Chapter 14 on relations between principal and agent.) A fiduciary duty is a duty of the highest loyalty and trust. It means that the broker cannot buy the property for herself through an intermediary without full disclosure to the seller of her intentions. Nor may the broker secretly receive a commission from the buyer or suggest to a prospective buyer that the property can be purchased for less than the asking price.
The Sales Agreement
Once the buyer has selected the real estate to be acquired, an agreement of sale will be negotiated and signed. Our discussion here will focus on specific aspects of the real estate contract. The Statute of Frauds requires that contracts for sale of real estate must be in writing. The writing must contain certain information.
Names of Buyers and Sellers
The agreement must contain the names of the buyers and sellers. As long as the parties sign the agreement, however, it is not necessary for the names of buyers and sellers to be included within the body of the agreement.
Real Estate Description
The property must be described sufficiently for a court to identify the property without having to look for evidence outside the agreement. The proper address, including street, city, and state, is usually sufficient.
Price
The price terms must be clear enough for a court to enforce. A specific cash price is always clear enough. But a problem can arise when installment payments are to be made. To say “\$50,000, payable monthly for fifteen years at 12 percent” is not sufficiently detailed, because it is impossible to determine whether the installments are to be equal each month or are to be equal principal payments with varying interest payments, declining monthly as the balance decreases.
Signature
As a matter of prudence, both buyer and seller should sign the purchase agreement. However, the Statute of Frauds requires only the signature of the party against whom the agreement is to be enforced. So if the seller has signed the agreement, he cannot avoid the agreement on the grounds that the buyer has not signed it. However, if the buyer, not having signed, refuses to go to closing and take title, the seller would be unable to enforce the agreement against him.
Easements and Restrictive Covenants
Unless the contract specifically states otherwise, the seller must deliver marketable title. A marketable title is one that is clear of restrictions to which a reasonable buyer would object. Most buyers would refuse to close the deal if there were potential third-party claims to all or part of the title. But a buyer would be unreasonable if, at closing, he refused to consummate the transaction on the basis that there were utility easements for the power company or a known and visible driveway easement that served the neighboring property. As a precaution, a seller must be sure to say in the contract for sale that the property is being sold “subject to easements and restrictions of record.” A buyer who sees only such language should insist that the particular easements and restrictive covenants be spelled out in the agreement before he signs.
Risk of Loss
Suppose the house burns down after the contract is signed but before the closing. Who bears the loss? Once the contract is signed, most states apply the rule of equitable conversion, under which the buyer’s interest (his executory right to enforce the contract to take title to the property) is regarded as real property, and the seller’s interest is regarded as personal property. The rule of equitable conversion stems from an old maxim of the equity courts: “That which ought to be done is regarded as done.” That is, the buyer ought to have the property and the seller ought to have the money. A practical consequence of this rule is that the loss of the property falls on the buyer. Because most buyers do not purchase insurance until they take title, eleven states have adopted the Uniform Vendor and Purchaser Risk Act, which reverses the equitable conversion rule and places risk of loss on the seller. The parties may themselves reverse the application of the rule; the buyer should always insist on a clause in a contract stating that risk of loss remains with the seller until a specified date, such as the closing.
Earnest Money
As protection against the buyer’s default, the seller usually insists on a down payment known as earnest money. This is intended to cover such immediate expenses as proof of marketable title and the broker’s commission. If the buyer defaults, he forfeits the earnest money, even if the contract does not explicitly say so.
Contingencies
Performance of most real estate contracts is subject to various contingencies—that is, it is conditioned on the happening of certain events. For example, the buyer might wish to condition his agreement to buy the house on his ability to find a mortgage or to find one at a certain rate of interest. Thus the contract for sale might read that the buyer “agrees to buy the premises for \$50,000, subject to his obtaining a \$40,000 mortgage at 5 percent.” The person protected by the contingency may waive it; if the lowest interest rate the buyer could find was 5.5 percent, he could either refuse to buy the house or waive the condition and buy it anyway.
Times for Performance
A frequent difficulty in contracting to purchase real estate is the length of time it takes to receive an acceptance to an offer. If the acceptance is not received in a reasonable time, the offeror may treat the offer as rejected. To avoid the uncertainty, an offeror should always state in his offer that it will be held open for a definite period of time (five working days, two weeks, or whatever). The contract also ought to spell out the times by which the following should be done: (1) seller’s proof that he has title, (2) buyer’s review of the evidence of title, (3) seller’s correction of title defects, (4) closing date, and (5) possession by the buyer. The absence of explicit time provisions will not render the contract unenforceable—the courts will infer a reasonable time—but their absence creates the possibility of unnecessary disputes.
Types of Deeds
Most real estate transactions involve two kinds of deeds, the general warranty deed and the quitclaim deed.
1. General warranty deed. In a warranty deed, the seller warrants to the buyer that he possesses certain types of legal rights in the property. In the general warranty deed, the seller warrants that (a) he has good title to convey, (b) the property is free from any encumbrance not stated in the deed (the warranty against encumbrances), and (c) the property will not be taken by someone with a better title (the warranty of quiet enjoyment). Breach of any of these warranties exposes the seller to damages.
2. Quitclaim deed. The simplest form of deed is the quitclaim deed, in which the seller makes no warranties. Instead, he simply transfers to the buyer whatever title he had, defects and all. A quitclaim deed should not be used in the ordinary purchase and sale transaction. It is usually reserved for removing a cloud on the title—for instance, a quitclaim deed by a widow who might have a dower interest in the property.If the purchase agreement is silent about the type of deed, courts in many states will require the seller to give the buyer a quitclaim deed. In the contract, the buyer should therefore specify that the seller is to provide a warranty deed at closing.
When buyers move in after the closing, they frequently discover defects (the boiler is broken, a pipe leaks, the electrical power is inadequate). To obtain recourse against such an eventuality, the buyer could attempt to negotiate a clause in the contract under which the seller gives a warranty covering named defects. However, even without an express warranty, the law implies two warranties when a buyer purchases a new house from a builder. These are warranties that (1) the house is habitable and (2) the builder has completed the house in a workmanlike manner. Most states have refused to extend these warranties to subsequent purchasers—for example, to the buyer from a seller who had bought from the original builder. However, a few states have begun to provide limited protection to subsequent purchasers—in particular, for defects that a reasonable inspection will not reveal but that will show up only after purchase.
Proof of Title
Contracts are often formed and performed simultaneously, but in real estate transactions there is more often a gap between contract formation and performance (the closing). The reason is simple: the buyer must have time to obtain financing and to determine whether the seller has marketable title. That is not always easy; at least, it is not as straightforward as looking at a piece of paper. To understand how title relates to the real estate transaction, some background on recording statutes will be useful.
Recording Statutes
Suppose Slippery Sam owned Whispering Pines, a choice resort hotel on Torch Lake. On October 1, Slippery deeded Whispering Pines to Lorna for \$1,575,000. Realizing the profit potential, Slippery decided to sell it again, and did so on November 1, without bothering to tell Malvina, the new buyer to whom he gave a new deed, that he had already sold it to Lorna. He then departed for a long sailing trip to the British Virgin Islands.
When Malvina arrives on the doorstep to find Lorna already tidying up, who should prevail? At common law, the first deed prevailed over subsequent deeds. So in our simple example, if this were a pure common-law state, Lorna would have title and Malvina would be out of luck, stuck with a worthless piece of paper. Her only recourse, probably futile, would be to search out and sue Slippery Sam for fraud. Most states, however, have enacted recording statutes, which award title to the person who has complied with the requirement to place the deed in a publicly available file in a public office in the county, often called the recorder’s office or the register of deeds.
Notice Statute
Under the most common type of recording statute, called a notice statute, a deed must be recorded in order for the owner to prevail against a subsequent purchaser. Assume in our example that Lorna recorded her deed on November 2 and that Malvina recorded on November 4. In a notice-statute state, Malvina’s claim to title would prevail over Lorna’s because on the day that Malvina received title (November 1), Lorna had not yet recorded. For this rule to apply, Malvina must have been a bona fide purchaser, meaning that she must have (1) paid valuable consideration, (2) bought in good faith, and (3) had no notice of the earlier sale. If Lorna had recorded before Malvina took the deed, Lorna would prevail if Malvina did not in fact check the public records; she should have checked, and the recorded deed is said to put subsequent purchasers on constructive notice.
Notice-Race Statute
Another common type of recording statute is the notice-race statute. To gain priority under this statute, the subsequent bona fide purchaser must also record—that is, win the race to the recorder’s office before the earlier purchaser. So in our example, in a notice-race jurisdiction, Lorna would prevail, since she recorded before Malvina did.
Race Statute
A third, more uncommon type is the race statute, which gives title to whoever records first, even if the subsequent purchaser is not bona fide and has actual knowledge of the prior sale. Suppose that when she received the deed, Malvina knew of the earlier sale to Lorna. Malvina got to the recording office the day she got the deed, November 1, and Lorna came in the following day. In a race-statute jurisdiction, Malvina would take title.
Chain of Title
Given the recording statutes, the buyer must check the deed on record to determine (1) whether the seller ever acquired a valid deed to the property—that is, whether a chain of title can be traced from earlier owners to the seller—and (2) whether the seller has already sold the property to another purchaser, who has recorded a deed. There are any number of potential “clouds” on the title that would defeat a fee simple conveyance: among others, there are potential judgments, liens, mortgages, and easements that might affect the value of the property. There are two ways to protect the buyer: the abstract of title and opinion, and title insurance.
Abstract and Opinion
An abstract of title is a summary of the chain of title, listing all previous deeds, mortgages, tax liens, and other instruments recorded in the county land records office. The abstract is prepared by either an attorney or a title company. Since the list itself says nothing about whether the recorded instruments are legally valid, the buyer must also have the opinion of an attorney reviewing the abstract, or must determine by doing his own search of the public records, that the seller has valid title. The attorney’s opinion is known as a title opinion or certificate of title. The problem with this method of proving title is that the public records do not reveal hidden defects. One of the previous owners might have been a minor or an incompetent person who can still void his sale, or a previous deed might have been forged, or a previous seller might have claimed to be single when in fact he was married and his wife failed to sign away her dower rights. A search of the records would not detect these infirmities.
Title Insurance
To overcome these difficulties, the buyer should obtain title insurance. This is a one-premium policy issued by a title insurance company after a search through the same public records. When the title company is satisfied that title is valid, it will issue the insurance policy for a premium that could be as high as 1 percent of the selling price. When the buyer is taking out a mortgage, he will ordinarily purchase two policies, one to cover his investment in the property and the other to cover the mortgagee lender’s loan. In general, a title policy protects the buyer against losses that would occur if title (1) turns out to belong to someone else; (2) is subject to a lien, encumbrance, or other defect; or (3) does not give the owner access to the land. A preferred type of title policy will also insure the buyer against losses resulting from an unmarketable title.
Note that in determining whether to issue a policy, the title company goes through the process of searching through the public records again. The title policy as such does not guarantee that title is sound. A buyer could conceivably lose part or all of the property someday to a previous rightful owner, but if he does, the title insurance company must reimburse him for his losses.
Although title insurance is usually a sound protection, most policies are subject to various exclusions and exceptions. For example, they do not provide coverage for zoning laws that restrict use of the property or for a government’s taking of the property under its power of eminent domain. Nor do the policies insure against defects created by the insured or known by the insured but unknown to the company. Some companies will not provide coverage for mechanics’ liens, public utility easements, and unpaid taxes. (If the accrued taxes are known, the insured will be presented with a list, and if he pays them on or before the closing, they will be covered by the final policy.) Furthermore, as demonstrated in Title and Trust Co. of Florida v. Barrows, (see Section 31.4.1 “Title Insurance”), title insurance covers title defects only, not physical defects in the property.
The Closing
Closing can be a confusing process because in most instances several contracts are being performed simultaneously:
1. The seller and purchaser are performing the sales contract.
2. The seller is paying off a mortgage, while the buyer is completing arrangements to borrow money and mortgage the property.
3. Title and other insurance arrangements will be completed.
4. The seller will pay the broker.
5. If buyer and seller are represented, attorneys for each party will be paid.
Despite all these transactions, the critical players are the seller, the purchaser, and the bank. To place the closing process in perspective, assume that one bank holds the existing (seller’s) mortgage on the property and is also financing the buyer’s purchase. We can visualize the three main players sitting at a table, ready to close the transaction. The key documents and the money will flow as illustrated in Figure 31.2.
Form of the Deed
The deed must satisfy two fundamental legal requirements: it must be in the proper form, and there must be a valid delivery. Deeds are usually prepared by attorneys, who must include not only information necessary for a valid deed but also information required in order to be able to record the deed. The following information is typically required either for a valid deed or by the recording statutes.
Grantor
The grantor—the person who is conveying the property—must be designated in some manner. Obviously, it is best to give the grantor’s full name, but it is sufficient that the person or persons conveying the deed are identifiable from the document. Thus “the heirs of Lockewood Filmer” is sufficient identification if each of the heirs signs the deed.
Grantee
Similarly, the deed should identify the grantee—the person to whom the property is being conveyed. It does not void the deed to misspell a person’s name or to omit part of a name, or even to omit the name of one of the grantees (as in “Lockewood Filmer and wife”). Although not technically necessary, the deed ought to detail the interests being conveyed to each grantee in order to avoid considerable legal difficulty later. “To Francis Lucas, a single man, and Joseph Lucas and Matilda Lucas, his wife” was a deed of unusual ambiguity. Did each party have a one-third interest? Or did Joseph and Matilda hold half as tenants by the entirety and Francis have a one-half interest as a tenant in common? Or perhaps Francis had a one-third interest as a tenant in common and Joseph and Matilda held two-thirds as tenants by the entirety? Or was there some other possible combination? The court chose the second interpretation, but considerable time and money could have been saved had the deed contained a few simple words of explanation.Heatter v. Lucas, 80 A.2d 749 (Pa. 1951).
Addresses
Addresses of the parties should be included, although their absence will not usually invalidate the deed. However, in some states, failure to note the addresses will bar the deed from being recorded.
Words of Conveyance
The deed must indicate that the grantor presently intends to convey his interest in the property to the grantee. The deed may recite that the grantor “conveys and warrants” the property (warranty deed) or “conveys and quitclaims” the property (quitclaim deed). Some deeds use the words “bargain and sell” in place of convey.
Description
The deed must contain an accurate description of the land being conveyed, a description clear enough that the land can be identified without resorting to other evidence. Four general methods are used.
1. The US government survey. This is available west of the Mississippi (except in Texas) and in Alabama, Florida, Illinois, Indiana, Michigan, Mississippi, Ohio, and Wisconsin. With this survey, it is possible to specify with considerable exactitude any particular plot of land in any township in these states.
2. Metes and bounds. The description of metes and bounds begins with a particular designated point (called a monument)—for example, a drainpipe, an old oak tree, a persimmon stump—and then defines the boundary with distances and angles until returning to the monument. As you can tell, using monuments that are biological (like trees and stumps) will have a limited utility as time goes on. Most surveyors put in stakes (iron pins), and the metes and bounds description will go from points where stakes have been put in the ground.
3. Plats. Many land areas have been divided into numbered lots and placed on a map called a plat. The plats are recorded. The deed, then, need only refer to the plat and lot number—for example, “Lot 17, Appledale Subdivision, record in Liber 2 of Plats, page 62, Choctaw County Records.”
4. Informal description. If none of the preceding methods can be used, an informal description, done precisely enough, might suffice. For instance, “my home at 31 Fernwood Street, Maplewood, Idaho” would probably pass muster.
Statement of Consideration
Statutes usually require that some consideration be stated in the deed, even though a grantor may convey property as a gift. When there is a selling price, it is easy enough to state it, although the actual price need not be listed. When land is being transferred as a gift, a statement of nominal consideration—for example, one dollar—is sufficient.
Date
Dates are customary, but deeds without dates will be enforced.
Execution
The deed must be signed by the grantor and, in some states, witnesses, and these signatures must be acknowledged by a notary public in order to make the deed eligible for recording. If someone is signing for the grantor under a power of attorney, a written instrument authorizing one person to sign for another, the instrument must be recorded along with the deed.
Delivery
To validly convey title to the property, the deed must not only be in proper form but also be delivered. This technical legal requirement is sometimes misunderstood. Delivery entails (1) physical delivery to the grantee, (2) an intention by the grantor to convey title, and (3) acceptance of title by the grantee. Because the grantor must intend to convey title, failure to meet the other two elements during the grantor’s lifetime will void title on his death (since at that point he of course cannot have an intention). Thus when a grantee is unaware of the grantor’s intention to deed the property to him, an executed deed sitting in a safe-deposit box will be invalid if discovered after the grantor’s death.
Delivery to Grantee
If the deed is physically delivered to the grantee or recorded, there is a rebuttable presumption that legal delivery has been made. That is, the law presumes, in the absence of evidence to the contrary, that all three conditions have been met if delivery or recording takes place. But this presumption can be rebutted, as shown in Havens v. Schoen, (see Section 31.4.2 “Delivery of a Deed”).
Delivery to Third Party (Commercial Escrow)
The grantor may deliver the deed to a third party to hold until certain conditions have been met. Thus to avoid the problem of the deed sitting in the grantor’s own safe-deposit box, he could deliver it to a third party with instructions to hold it until his death and then to deliver it to the grantee. This would be an effective delivery, even though the grantee could not use the property until the grantor died. For this method to be effective, the grantor must lose all control over the deed, and the third party must be instructed to deliver the deed when the specified conditions occur.
This method is most frequently used in the commercial escrow. Escrow is a method by which a third party holds a document or money or both until specified conditions have been met. A typical example would be a sale in which the buyer is afraid of liens that might be filed after the closing. A contractor that has supplied materials for the building of a house, for example, might file a lien against the property for any amounts due but unpaid under the contract. The effectiveness of the lien would relate back to the time that the materials were furnished. Thus, at closing, all potential liens might not have been filed. The buyer would prefer to pay the seller after the time for filing materialmen’s liens has lapsed. But sellers ordinarily want to ensure that they will receive their money before delivering a deed. The solution is for the buyer to pay the money into escrow (e.g., to a bank) and for the seller to deliver the deed to the same escrow agent. The bank would be instructed to hold both the money and the deed until the time for filing mechanics’ liens has ended. If no materialmen’s liens have been filed, then the money is paid out of escrow to the seller and the deed is released to the buyer. If a lien has been filed, then the money will not be paid until the seller removes the lien (usually by paying it off).
Key Takeaway
Most real estate is bought and sold through real estate brokers, who must be licensed by the state. Brokers have different kinds of agreements with clients, including exclusive right to sell, exclusive agency, and open listing. Brokers will usually arrange a sales agreement that includes standard provisions such as property description, earnest money, and various contingencies. A deed, usually a warranty deed, will be exchanged at the closing, but not before the buyer has obtained good proof of title, usually by getting an abstract and opinion and paying for title insurance. The deed will typically be delivered to the buyer and recorded at the county courthouse in the register of deeds’ office.
Exercises
1. Kitty Korniotis is a licensed real estate broker. Barney Woodard and his wife, Carol, sign an exclusive agency listing with Kitty to sell their house on Woodvale Avenue. At a social gathering, Carol mentions to a friend, Helen Nearing, that the house on Woodvale is for sale. The next day, Helen drives by the property and calls the number on Kitty’s sign. Helen and Scott Nearing sign a contract to buy the house from the Woodards. Is Kitty entitled to the commission?
2. Deepak Abhishek, a single man, lives in a race-notice state. He contracts to buy a large parcel of land from his friend, Ron Khurana, for the sum of \$280,000. Subsequent to the contract, Khurana finds another buyer, who is willing to pay \$299,000. Khurana arranges for two closings on the same day, within two hours of each other. At 10 a.m., he sells the property to Beverly Hanks and her husband, John, for \$299,000. The Hanks are not represented by an attorney. Khurana hands them the deed at closing, but he takes it back from them and says, “I will record this at the courthouse this afternoon.” The Hankses take a copy of the deed with them and are satisfied that they have bought the property; moreover, Khurana gives them a commitment from Lawyer’s Title Company that the company will insure that they are receiving fee simple title from Khurana, subject to the deed’s being recorded in the county register of deeds’ office.At noon, Khurana has a closing with Abhishek, who is represented by an attorney. The attorney went to the courthouse earlier, at 11:30 a.m., and saw nothing on record that would prevent Khurana from conveying fee simple title. As the deal closes, and as Khurana prepares to leave town, Abhishek’s attorney goes to the courthouse and records the deed at 1:15 p.m. At 2:07 p.m., on his way out of town, Abhishek records the deed to the Hankses.
1. Who has better claim to the property—the Hankses or Deepak Abhishek?
2. Does it matter if the state is a notice jurisdiction or a notice-race jurisdiction?
3. A warranty deed is given in both closings. What would be the best remedy for whichever buyer did not get the benefit of clear title from these two transactions? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/31%3A_The_Transfer_of_Real_Estate_By_Sale/31.03%3A_Brokers_Contracts_Proof_of_Title_and_Closing.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how it is possible to own land without paying for it.
In some instances, real property can be acquired for free—or at least without paying the original owner anything. (Considerable cost may be involved in meeting the requisite conditions.) This method of acquisition—known as adverse possession—is effective when five conditions are met: (1) the person claiming title by adverse possession must assert that he has a right to possession hostile to the interest of the original owner, (2) he must actually possess the property, (3) his possession must be “open and notorious,” (4) the possession must be continuous, and (5) the possession must be exclusive.
Hostile Possession
Suppose Jean and Jacques are tenants in common of a farm. Jean announces that he no longer intends to pursue agricultural habits and leaves for the city. Jacques continues to work on the land, making improvements and paying taxes and the mortgage. Years later, Jacques files suit for title, claiming that he now owns the land outright by adverse possession. He would lose, since his possession was not hostile to Jacques. To be hostile, possession of the land must be without permission and with the intention to claim ownership. Possession by one cotenant is deemed permissive, since either or both are legally entitled to possession. Suppose, instead, that Jean and Jacques are neighboring farmers, each with title to his own acreage, and that Jean decides to fence in his property. Just to be on the safe side, he knowingly constructs the fence twenty feet over on Jacques’s side. This is adverse possession, since it is clearly hostile to Jacques’s possession of the land.
Actual Possession
Not only must the possession be hostile but it must also be actual. The possessor must enter onto the land and make some use of it. Many state statutes define the permissible type of possession—for example, substantial enclosure or cultivation and improvement. In other states, the courts will look to the circumstances of each case to determine whether the claimant had in fact possessed the land (e.g., by grazing cattle on the land each summer).
Open and Notorious Possession
The possessor must use the land in an open way, so that the original owner could determine by looking that his land was being claimed and so that people in the area would know that it was being used by the adverse possessor. In the melodramatic words of one court, the adverse possessor “must unfurl his flag on the land, and keep it flying so that the owner may see, if he will, that an enemy has invaded his domains, and planted the standard of conquest.”Robin v. Brown, 162 A. 161 (Pa. 1932). Construction of a building on the owner’s property would be open and notorious; development of a cave or tunnel under the owner’s property would not be.
Continuous Possession
The adverse possessor must use the land continuously, not intermittently. In most states, this continuous period must last for at least twenty years. If the adverse possession is passed on to heirs or the interest is sold, the successor adverse possessors may tack on the time they claim possession to reach the twenty years. Should the original owner sell his land, the time needed to prove continuous possession will not lapse. Of course, the original owner may interrupt the period—indeed, may terminate it—by moving to eject the adverse possessor any time before the twenty years has elapsed.
Exclusive Possession
The adverse possessor must claim exclusive possession of the land. Sharing the land with the owner is insufficient to ground a claim of legal entitlement based on adverse possession, since the sharing is not fully adverse or hostile. Jean finds a nice wooded lot to enjoy weekly picnics. The lot belongs to Jacques, who also uses it for picnics. This use would be insufficient to claim adverse possession because it is neither continuous nor exclusive.
If the five tests are met, then the adverse possessor is entitled to legal title. If any one of the tests is missing, the adverse possession claim will fail.
Key Takeaway
Real property can be acquired without paying the lawful owner if five conditions of adverse possession are met: (1) the person claiming title by adverse possession must assert that he has a right to possession hostile to the interest of the original owner, (2) he must actually possess the property, (3) his possession must be “open and notorious,” (4) the possession must be continuous, and (5) the possession must be exclusive.
Exercises
1. Tyler decides to camp out on a sandy beach lot near Isle of Palms, South Carolina. The owner, who had hoped to build a large house there, lived out of state. Tyler made no secret of his comings and goings, and after several weeks, when no one challenged his right to be there, he built a sturdy lean-to. After a while, he built a “micro house” and put a propane tank next to it. Although there was no running water, Tyler was plenty comfortable. His friends came often, they partied on the beach, and life was good. Five years after he first started camping out there, an agent of the owner came and told him to deconstruct his shelter and “move on.” Does Tyler have any rights in the property? Why or why not? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/31%3A_The_Transfer_of_Real_Estate_By_Sale/31.04%3A_Adverse_Possession.txt |
Title Insurance
Title and Trust Co. of Florida v. Barrows
381 So.2d 1088 (Fla. App. 1979)
McCORD, ACTING CHIEF JUDGE.
This appeal is from a final judgment awarding money damages to appellees (Barrows) for breach of title insurance policy. We reverse.
Through a realtor, the Barrowses purchased, for \$ 12,500, a lot surrounded on three sides by land owned by others, all of which is a part of a beach subdivision. The fourth side of their lot borders on a platted street called Viejo Street, the right-of-way for which has been dedicated to and accepted by St. Johns County. The right-of-way line opposite their lot abuts a Corps of Engineers’ right-of-way in which there is a stone breakwater. The intracoastal waterway flows on the other side of the breakwater.
The realtor who sold the lot to the Barrows represented to them that the county would build a road in the right-of-way along Viejo Street when they began plans for building on their lot. There have been no street improvements in the dedicated right-of-way, and St. Johns County has no present plans for making any improvements. The “road” is merely a continuation of a sandy beach.
A year after purchasing the land the Barrowses procured a survey which disclosed that the elevation of their lot is approximately one to three feet above the mean high water mark. They later discovered that their lot, along with the Viejo Street right-of-way abutting it, is covered by high tide water during the spring and fall of each year.
At the time appellees purchased their lot, they obtained title insurance coverage from appellant. The title policy covered:
Any defect in or lien or encumbrance on the title to the estate or title covered hereby…or a lack of a right of access to and from the land.…
Appellees’ complaint of lack of right of access was founded on the impassable condition of the platted street. After trial without a jury, the trial court entered final judgment finding that appellees did not have access to their property and, therefore, were entitled to recover \$ 12,500 from appellant the face amount of the policy.
Appellant and Florida Land Title Association, appearing as amicus curiae, argue that appellant cannot be held liable on grounds of “lack of right of access to and from the land” since there is no defect shown by the public record as to their right of access; that the public record shows a dedicated and accepted public right-of-way abutting the lot. They contend that title insurance does not insure against defects in the physical condition of the land or against infirmities in legal right of access not shown by the public record. See Pierson v. Bill, 138 Fla. 104, 189 So. 679 (1939). They argue that defects in the physical condition of the land such as are involved here are not covered by title insurance. We agree. Title insurance only insures against title defects.
The Supreme Court of North Carolina in Marriott Financial Services, Inc. v. Capitol Funds, Inc., 288 N.C. 122, 217 S.E.2d 551 (1975), construed “right of access” to mean the right to go to and from the public right-of-way without unreasonable restrictions. Compare Hocking v. Title Insurance & Trust Company, 37 Cal.2d 644, 234 P.2d 625 (1951), where, in ruling that the plaintiff failed to state a cause of action in a suit brought under her title policy, the court said:
She appears to possess fee simple title to the property for whatever it may be worth; if she has been damaged by false representations in respect to the condition and value of the land her remedy would seem to be against others than the insurers of the title she acquired.
In Mafetone, et al., v. Forest Manor Homes, Inc., et al., 34 A.D.2d 566, 310 N.Y.S.2d 17 (N.Y.1970), the plaintiff brought an action against a title insurance company for damages allegedly flowing from a change in the grade of a street. There the court said:
The title company is not responsible to plaintiffs for the damages incurred by reason of the change in elevating the abutting street to its legal grade, since the provisions of the standard title insurance policy here in question are concerned with matters affecting title to property and do not concern themselves with physical conditions of the abutting property absent a specific request by the person ordering a title report and policy.…
In McDaniel v. Lawyers’ Title Guaranty Fund, 327 So.2d 852 (Fla. 2 D.C.A. 1976), our sister court of the Second District said:
The man on the street buys a title insurance policy to insure against defects in the record title. The title insurance company is in the business of guaranteeing the insured’s title to the extent it is affected by the public records.
In the case here before us, there is no dispute that the public record shows a legal right of access to appellant’s property via the platted Viejo Street. The title insurance policy only insured against record title defects and not against physical infirmities of the platted street.
Reversed.
Case Questions
1. Do you think that the seller (or the seller’s agent) actually took the Barrowses to see the property when it was underwater? Why or why not?
2. Before buying, should the Barrowses have actually gone to the property to see for themselves “the lay of the land” or made inquiries of neighboring lot owners?
3. Assuming that they did not make inspection of the property or make other inquiries, do you think the seller or the seller’s agent made any misrepresentations about the property that would give the Barrowses any remedies in law or equity?
Delivery of a Deed
Havens v. Schoen
108 Mich. App. 758; 310 N.W.2d 870 (Mich. App. 1981)
[Norma Anderson Havens, the owner of certain farm property in Marlette, Michigan, in contemplation of her death executed a quit-claim deed to the property to her only daughter, Linda Karen Anderson. The deed was subsequently recorded. Subsequently, Linda Karen Anderson married and became Linda Karen Adams and died. Thereafter, Norma Anderson Havens and Norman William Scholz, a nephew of Havens who has an interest in the property as the beneficiary of a trust, brought a suit in Sanilac Circuit Court against Ernest E. Schoen, Administrator of the estate of Linda Karen Adams, deceased, and other heirs of James W. Anderson, the ex-husband of Norma Anderson Havens, seeking to set aside the deed or to impose a constructive trust on the farm property which was the subject of the deed. Arthur E. Moore, J., found no cause of action and entered judgment for defendants. The plaintiffs appeal alleging error because there never was a delivery of the deed or an intent by Havens to then presently and unconditionally convey an interest in the property.]
PER CURIAM.
In 1962, plaintiff Dr. [Norma Anderson] Havens purchased the Scholz family farm from the estate of her twin brother, Norman Scholz. She gave a deed of trust to her other brother Earl Scholz in 1964, naming her daughter Linda Karen Adams as the principal beneficiary. In 1969, she filed suit against Earl and Inez Scholz and, in settlement of that suit, the property was conveyed to Dr. Havens and her daughter, now deceased. On August 13, 1969, Dr. Havens executed a quit-claim deed to her daughter of her remaining interest in the farm. It is this deed which Dr. Havens wishes to set aside.
The trial court found that plaintiffs failed to meet the burden of proving an invalid conveyance. Plaintiffs claim that there was never a delivery or an intent to presently and unconditionally convey an interest in the property to the daughter. The deed was recorded but defendants presented no other evidence to prove delivery. The recording of a deed raises a presumption of delivery. Hooker v Tucker, 335 Mich 429, 434; 56 NW2d 246 (1953). The only effect of this presumption is to cast upon the opposite party the burden of moving forward with the evidence. Hooker v Tucker, supra. The burden of proving delivery by a preponderance of the evidence remains with the party relying on the deed. Camp v Guaranty Trust Co, 262 Mich 223, 226; 247 NW 162 (1933). Acknowledging that the deed was recorded, plaintiffs presented substantial evidence showing no delivery and no intent to presently and unconditionally convey an interest in the property. The deed, after recording, was returned to Dr. Havens. She continued to manage the farm and pay all expenses for it. When asked about renting the farm, the daughter told a witness to ask her mother. Plaintiffs presented sufficient evidence to dispel the presumption. We find that the trial court erred when it stated that plaintiffs had the burden of proof on all issues. The defendants had the burden of proving delivery and requisite intent.
In Haasjes v Woldring, 10 Mich App 100; 158 NW2d 777 (1968), leave denied 381 Mich 756 (1968), two grandparents executed a deed to property to two grandchildren. The grandparents continued to live on the property, pay taxes on it and subsequent to the execution of the deed they made statements which this Court found inconsistent with a prior transfer of property. These circumstances combined with the fact that the deed was not placed beyond the grantors’ control led the Haasjes Court to conclude that a valid transfer of title had not been effected. The Haasjes Court, citing Wandel v Wandel, 336 Mich 126; 57 NW2d 468 (1953), and Resh v Fox, 365 Mich 288, 112 NW2d 486 (1961), held that in considering whether there was a present intent to pass title, courts may look to the subsequent acts of the grantor.
This Court reviews de novo the determinations of a trial court sitting in an equity case. Chapman v Chapman, 31 Mich App 576, 579; 188 NW2d 21 (1971). Having reviewed the evidence presented by the defendants to prove delivery, we find that the defendants failed to meet their burden of proof. Under the circumstances, the recording itself and the language of the deed were not persuasive proof of delivery or intent. Defendants presented no evidence of possession of the deed by anyone but the grantor and presented no evidence showing knowledge of the deed by the grantee. No evidence was presented showing that the daughter was ever aware that she owned the property. The showing made by defendants was inadequate to carry their burden of proof. The deed must be set aside.
Plaintiffs alleged none of the grounds which have traditionally been recognized as justifying the imposition of a constructive trust. See Chapman v Chapman, supra. A constructive trust is imposed only when it would be inequitable to do otherwise. Arndt v Vos, 83 Mich App 484; 268 NW2d 693 (1978). Although plaintiffs claim relief for a mutual mistake, plaintiffs have presented no facts suggesting a mistake on the part of the grantee. Creation of a constructive trust is not warranted by the facts as found by the trial court. There has been no claim that those findings are erroneous.
We remand to the trial court to enter an order setting aside the August 13, 1969, deed from Norma Anderson Havens to Linda Karen Anderson Adams purporting to convey the interest of Dr. Havens in the farm. The decision of the trial court finding no justification for imposing a trust upon the property is affirmed.
Affirmed in part, reversed in part, and remanded.
DISSENT BY:
MacKenzie, J. (dissenting).
I respectfully dissent. The deed was recorded with the knowledge and assent of the grantor, which creates a presumption of delivery. See Schmidt v Jennings, 359 Mich 376, 383; 102 NW2d 589 (1960), Reed v Mack, 344 Mich 391, 397; 73 NW2d 917 (1955). Crucial evidence was conflicting and I would disagree that the trial court’s findings were clearly erroneous.
In Reed v Mack, the Court affirmed the trial court’s finding that there had been delivery where the grantor defendant, who had owned the property with her husband, recorded a deed conveying a property jointly to herself and the two other grantees, stating:
“We are in agreement with the trial court. The defendant-appellant, a grantor in the deed, caused the recording of the deed, the delivery of which she attacks. The recording of a warranty deed may, under some circumstances, be effectual to show delivery. A delivery to one of several joint grantees, in absence of proof to the contrary, is delivery to all. Mayhew v Wilhelm, 249 Mich 640 [229 NW 459 (1930)]. While placing a deed on record does not in itself necessarily establish delivery, the recording of a deed raises a presumption of delivery, and the whole object of delivery is to indicate an intent by the grantor to give effect to the instrument.” [Citations]
In McMahon v Dorsey, 353 Mich 623, 626; 91 NW2d 893 (1958), the significance of delivery was characterized as the manifestation of the grantor’s intent that the instrument be a completed act.
* * *
The evidence herein indicates that plaintiff Norma Anderson Havens, after she had been told she was dying from cancer, executed a quit-claim deed on August 16, 1969, to her daughter, Linda Karen Anderson. Plaintiff Havens testified that the reason she executed the deed was that she felt “if something should happen to me, at least Karen would be protected”. The deed was recorded the same day by plaintiff Havens’s attorney. Plaintiff Havens either knew that the deed was recorded then or learned of the recording shortly thereafter. Although plaintiff Havens testified that she intended only a testamentary disposition, she apparently realized that the deed was effective to convey the property immediately because her testimony indicated an intention to execute a trust agreement. Linda Karen lived on the farm for five years after the deed was recorded until her death in 1974, yet plaintiff Havens did not attempt to have Linda Karen deed the farm back to her so she could replace the deed with a trust agreement or a will. Plaintiff Havens testified that she approached her attorneys regarding a trust agreement, but both attorneys denied this. The trial judge specifically found the testimony of the attorneys was convincing and he, of course, had the benefit of observing the witnesses.
Haasjes v Woldring, 10 Mich App 100; 158 NW2d 777 (1968), relied upon by the majority, involved unrecorded deeds which remained in a strongbox under control of the grantors until after their deaths. The grantors continued to live alone on the property and pay taxes thereon. Based on the lack of recording, I find Haasjes distinguishable from the present case.
In Hooker v Tucker, 335 Mich 429; 56 NW2d 246 (1953), delivery was held not to have occurred where the grantor handed her attorney a copy of a deed containing a legal description of property she wished included in a will to be drawn by him and he subsequently mailed the deed to the grantee without the grantor’s knowledge or permission. The purported delivery by mailing being unauthorized distinguishes Hooker from this case where there was no indication the recording was done without the grantor’s authorization.
The majority relies on the grantee’s purported lack of knowledge of the conveyance but the record is not at all clear in this regard. Further, if a deed is beneficial to the grantee, its acceptance is presumed. Tackaberry v Monteith, 295 Mich 487, 493; 295 NW 236 (1940), see also Holmes v McDonald, 119 Mich 563; 78 NW 647 (1899). While the burden of proving delivery is on the person relying upon the instrument, the burden shifts upon its recordation so that the grantor must go forward with the evidence of showing nondelivery, once recordation and beneficial interest have been shown. Hooker v Tucker, supra, and Tackaberry, supra. The trial court properly found that plaintiffs failed to go forward with the evidence and found that the deed conveyed title to the farm.
Factually, this is a difficult case because plaintiff Havens executed a deed which she intended to be a valid conveyance at the time it was executed and recorded. Subsequently, when her daughter unexpectedly predeceased her, the deed created a result she had not foreseen. She seeks to eradicate the unintended result by this litigation.
I am reluctant to set aside an unambiguous conveyance which was on record and unchallenged for five years on the basis of the self-serving testimony of the grantor as to her intent at the time she executed the deed and authorized its recordation.
I would affirm.
Case Questions
1. Which opinion, the majority or the dissenting opinion, do you agree with, and why? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/31%3A_The_Transfer_of_Real_Estate_By_Sale/31.05%3A_Cases.txt |
Summary
Real property can be held in various forms of ownership. The most common forms are tenancy in common, joint tenancy, and tenancy by the entirety. Ten states recognize the community property form of ownership.
In selling real property, various common-law and statutory provisions come into play. Among the more important statutory provisions are the Civil Rights Acts of 1866 and 1968. These laws control the manner in which property may be listed and prohibit discrimination in sales. Sellers and buyers must also be mindful of contract and agency principles governing the listing agreement. Whether the real estate broker has an exclusive right to sell, an exclusive agency, or an open listing will have an important bearing on the fee to which the broker will be entitled when the property is sold.
The Statute of Frauds requires contracts for the sale of real property to be in writing. Such contracts must include the names of buyers and sellers, a description of the property, the price, and signatures. Unless the contract states otherwise, the seller must deliver marketable title, and the buyer will bear the loss if the property is damaged after the contract is signed but before the closing. The seller will usually insist on being paid earnest money, and the buyer will usually protect himself contractually against certain contingencies, such as failure to obtain financing. The contract should also specify the type of deed to be given to the buyer.
To provide protection to subsequent buyers, most states have enacted recording statutes that require buyers to record their purchases in a county office. The statutes vary: which of two purchasers will prevail depends on whether the state has a notice, notice-race, or race statute. To protect themselves, buyers usually purchase an abstract and opinion or title insurance. Although sale is the usual method of acquiring real property, it is possible to take legal title without the consent of the owner. That method is adverse possession, by which one who openly, continuously, and exclusively possesses property and asserts his right to do so in a manner hostile to the interest of the owner will take title in twenty years in most states.
Exercises
1. Rufus enters into a contract to purchase the Brooklyn Bridge from Sharpy. The contract provides that Sharpy is to give Rufus a quitclaim deed at the closing. After the closing, Rufus learns that Sharpy did not own the bridge and sues him for violating the terms of the deed. What is the result? Why?
2. Pancho and Cisco decide to purchase ten acres of real estate. Pancho is to provide 75 percent of the purchase price, Cisco the other 25 percent. They want to use either a joint tenancy or tenancy in common form of ownership. What do you recommend? Why?
3. Suppose in Exercise 2 that a friend recommends that Pancho and Cisco use a tenancy by the entirety. Would this form of ownership be appropriate? Why?
4. Richard and Elizabeth, a married couple, live in a community property state. During their marriage, they save \$500,000 from Elizabeth’s earnings. Richard does not work, but during the marriage, he inherits \$500,000. If Richard and Elizabeth are divorced, how will their property be divided? Why?
5. Jack wants to sell his house. He hires Walter, a real estate broker, to sell the house and signs an exclusive-right-to-sell listing agreement. Walter finds a buyer, who signs a sales contract with Jack. However, the buyer later refuses to perform the contract because he cannot obtain financing. Does Jack owe a commission to Walter? Why?
6. Suppose in Exercise 5 that Jack found the buyer, the buyer obtained financing, and the sale was completed. Does Jack owe a commission to Walter, who provided no assistance in finding the buyer and closing the deal? Why?
7. Suppose in Exercise 5 that Jack’s house is destroyed by fire before the closing. Who bears the loss—Jack or the buyer? Must Jack pay a commission to Walter? Why?
8. Suppose in Exercise 5 that the buyer paid \$15,000 in earnest money when the contract was signed. Must Jack return the earnest money when the buyer learns that financing is unavailable? Why?
SELF CHECK QUESTIONS
1. A contract for a sale of property must include
1. a description of the property
2. price
3. signatures of buyer and seller
4. all of the above
2. If real property is damaged after a contract for sale is signed but before closing, it is generally true that the party bearing the loss is
1. the seller
2. the buyer
3. both parties, who split the loss evenly
4. none of the above
3. The following deeds extend warranties to the buyer:
1. quitclaim and special warranty
2. quitclaim and general warranty
3. general and special warranty
4. all of the above
4. Under a notice-race statute,
1. whoever records first is given title, regardless of the good faith of the purchaser
2. whoever records first and is a bona fide purchaser is given title
3. either of the above may be acceptable
4. none of the above is acceptable
5. The elements of adverse possession do not include
1. actual possession
2. open and notorious use
3. consent of the owner
4. continuous possession
1. d
2. b
3. c
4. b
5. c | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/31%3A_The_Transfer_of_Real_Estate_By_Sale/31.06%3A_Summary_and_Exercises.txt |
Learning Objectives
After reading this chapter, you should understand the following:
• The various types of leasehold estates
• How leasehold states are created and extended
• The rights and duties of landlords
• The rights and duties of tenants
• The potential tort liability of landlords
32: Landlord and Tenant Laws
Learning Objectives
By the end of this section, you will be able to:
• Distinguish between the different types of leasehold estates.
• Describe how leasehold states can be created, both orally and in writing, and the requirements for creating leases that last for more than one year.
Real property can be divided into types of interests: freehold estates and leasehold estates. The freehold estate is characterized by indefinite duration, and the owner has title and the right to possess. The leasehold estate, by contrast, lasts for a specific period. The owner of the leasehold estate—the tenant—may take possession but does not have title to the underlying real property. When the period of the leasehold ends, the right to possession reverts to the landlord—hence the landlord’s interest during the tenant’s possession is known as a reversionary interest. Although a leasehold estate is said to be an interest in real property, the leasehold itself is in fact personal property. The law recognizes three types of leasehold estates: the estate for years, the periodic tenancy, and the tenancy at will.
Types of Leasehold Estates
Estate for Years
The estate for years is characterized by a definite beginning and a definite end. When you rent an apartment for two years, beginning September 1 and ending on the second August 31, you are the owner of an estate for years. Virtually any period will do; although it is called an estate “for years,” it can last but one day or extend one thousand years or more. Some statutes declare that any estate for years longer than a specified period—one hundred years in Massachusetts, for instance—is a fee simple estate.
Unless the lease—the agreement creating the leasehold interest—provides otherwise, the estate for years terminates automatically at midnight of the last day specified in the lease. The lease need not refer explicitly to calendar dates. It could provide that “the tenant may occupy the premises for six months to commence one week from the date of signing.” Suppose the landlord and tenant sign on June 23. Then the lease term begins at 12:00 a.m. on July 1 and ends just before midnight of December 31. Unless a statute provides otherwise, the landlord is not obligated to send the tenant a notice of termination. Should the tenant die before the lease term ends, her property interest can be inherited under her will along with her other personal property or in accordance with the laws of intestate succession.
Periodic Tenancy
As its name implies, a periodic tenancy lasts for a period that is renewed automatically until either landlord or tenant notifies the other that it will end. The periodic tenancy is sometimes called an estate from year to year (or month to month, or week to week). The lease may provide explicitly for the periodic tenancy by specifying that at the expiration of, say, a one-year lease, it will be deemed renewed for another year unless one party notifies the other to the contrary within six months prior to the expiration of the term. Or the periodic tenancy may be created by implication, if the lease fails to state a term or is defective in some other way, but the tenant takes possession and pays rent. The usual method of creating a periodic tenancy occurs when the tenant remains on the premises (“holds over”) when an estate for years under a lease has ended. The landlord may either reject or accept the implied offer by the tenant to rent under a periodic tenancy. If he rejects the implied offer, the tenant may be ejected, and the landlord is entitled to rent for the holdover period. If he accepts the offer, the original lease determines the rent and length of the renewable period, except that no periodic tenancy may last longer than from year to year—that is, the renewable period may never be any longer than twelve months.
At common law, a party was required to give notice at least six months prior to the end of a year-to-year tenancy, and notice equal to the term for any other periodic tenancy. In most states today, the time period for giving notice is regulated by statute. In most instances, a year-to-year tenancy requires a month’s notice, and shorter tenancies require notice equal to the term. To illustrate the approach typically used, suppose Simone rents from Anita on a month-to-month tenancy beginning September 15. On March 30, Simone passes the orals for her doctorate and decides to leave town. How soon may she cancel her tenancy? If she calls Anita that afternoon, she will be two weeks shy of a full month’s notice for the period ending April 15, so the earliest she can finish her obligation to pay rent is May 15. Suppose her term had been from the first of each month. On April 1, she notifies Anita of her intention to leave at the end of April, but she is stuck until the end of May, because notice on the first of the month is not notice for a full month. She would have had to notify Anita by March 31 to terminate the tenancy by April 30.
Tenancy at Will
If the landlord and tenant agree that the lease will last only as long as both want it to, then they have created a tenancy at will. Statutes in most states require some notice of intention to terminate. Simone comes to the university to study, and Anita gives her a room to stay in for free. The arrangement is a tenancy at will, and it will continue as long as both want it to. One Friday night, after dinner with classmates, Simone decides she would rather move in with Bob. She goes back to her apartment, packs her suitcase, and tells Anita she’s leaving. The tenancy at will terminates that day.
Creation of Leasehold Estates
Oral Leases
Leases can be created orally, unless the term of the lease exceeds the period specified by the Statute of Frauds. In most states, that period is one year. Any oral lease for a period longer than the statutory period is invalid. Suppose that Simone, in a state with a one-year Statute of Frauds period, orally agrees with Anita to rent Anita’s apartment for two years, at a monthly rent of \$250. The lease is invalid, and either could repudiate it.
Written Leases
A lease required to be in writing under the Statute of Frauds must contain the following items or provisions: (1) it must identify the parties, (2) it must identify the premises, (3) it must specify the duration of the lease, (4) it must state the rent to be paid, and (5) it must be signed by the party against whom enforcement is sought (known as “the party to be charged”).
The provisions need not be perfectly stated. As long as they satisfy the five requirements, they will be adequate to sustain the lease under the Statute of Frauds. For instance, the parties need not necessarily be named in the lease itself. Suppose that the prospective tenant gives the landlord a month’s rent in advance and that the landlord gives the tenant a receipt listing the property and the terms of the lease but omitting the name of the tenant. The landlord subsequently refuses to let the tenant move in. Who would prevail in court? Since the tenant had the receipt in her possession, that would be sufficient to identify her as the tenant to whom the terms of the lease were meant to apply. Likewise, the lease need not specify every aspect of the premises to be enjoyed. Thus the tenant who rents an apartment in a building will be entitled to the use of the common stairway, the roof, and so on, even though the lease is silent on these points. And as long as a specific amount is ascertainable, the rent may be stated in other than absolute dollar terms. For example, it could be expressed in terms of a cost-of-living index or as a percentage of the tenant’s dollar business volume.
Key Takeaway
A leasehold estate, unlike a freehold estate, has a definite duration. The landlord’s interest during the term of a leasehold estate is a reversionary interest. Leasehold estates can last for short terms or very long terms; in the case of long-term leases, a property right is created that can be passed to heirs. The usual landlord-tenant relationship is a periodic tenancy, which carries with it various common-law and statutory qualifications regarding renewal and termination. In a tenancy at will, either landlord or tenant can end the leasehold estate as soon as notice is provided by either party.
Exercises
1. What is the difference between a periodic tenancy and a tenancy at will?
2. What are the essential terms that must be in a written lease? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/32%3A_Landlord_and_Tenant_Laws/32.01%3A_Types_and_Creation_of_Leasehold_Estates.txt |
Learning Objectives
By the end of this section, you will be able to:
• Itemize and explain the rights and duties of landlords.
• List and describe the rights and duties of tenants.
• Understand the available remedies for tenants when a landlord is in breach of his or her duties.
Rights and Duties of Landlords
The law imposes a number of duties on the landlord and gives the tenant a number of corresponding rights. These include (1) possession, (2) habitable condition, and (3) noninterference with use.
Possession
The landlord must give the tenant the right of possession of the property. This duty is breached if, at the time the tenant is entitled to take possession, a third party has paramount title to the property and the assertion of this title would deprive the tenant of the use contemplated by the parties. Paramount title means any legal interest in the premises that is not terminable at the will of the landlord or at the time the tenant is entitled to take possession.
If the tenant has already taken possession and then discovers the paramount title, or if the paramount title only then comes into existence, the landlord is not automatically in breach. However, if the tenant thereafter is evicted from the premises and thus deprived of the property, then the landlord is in breach. Suppose the landlord rents a house to a doctor for ten years, knowing that the doctor intends to open a medical office in part of the home and knowing also that the lot is restricted to residential uses only. The doctor moves in. The landlord is not yet in default. The landlord will be in default if a neighbor obtains an injunction against maintaining the office. But if the landlord did not know (and could not reasonably have known) that the doctor intended to use his home for an office, then the landlord would not be in default under the lease, since the property could have been put to normal—that is, residential—use without jeopardizing the tenant’s right to possession.
Warranty of Habitability
As applied to leases, the old common-law doctrine of caveat emptor said that once the tenant has signed the lease, she must take the premises as she finds them. Since she could inspect them before signing the lease, she should not complain later. Moreover, if hidden defects come to light, they ought to be easy enough for the tenant herself to fix. Today this rule no longer applies, at least to residential rentals. Unless the parties specifically agree otherwise, the landlord is in breach of his lease if the conditions are unsuitable for residential use when the tenant is due to move in. The landlord is held to an implied warranty of habitability.
The change in the rule is due in part to the conditions of the modern urban setting: tenants have little or no power to walk away from an available apartment in areas where housing is scarce. It is also due to modem construction and technology: few tenants are capable of fixing most types of defects. A US court of appeals has said the following:
Today’s urban tenants, the vast majority of whom live in multiple dwelling houses, are interested not in the land, but solely in “a house suitable for occupation.” Furthermore, today’s city dweller usually has a single, specialized skill unrelated to maintenance work; he is unable to make repairs like the “jack-of-all-trades” farmer who was the common law’s model of the lessee. Further, unlike his agrarian predecessor who often remained on one piece of land for his entire life, urban tenants today are more mobile than ever before. A tenant’s tenure in a specific apartment will often not be sufficient to justify efforts at repairs. In addition, the increasing complexity of today’s dwellings renders them much more difficult to repair than the structures of earlier times. In a multiple dwelling, repairs may require access to equipment and areas in control of the landlord. Low and middle income tenants, even if they were interested in making repairs, would be unable to obtain financing for major repairs since they have no long-term interest in the property.Javins v. First National Realty Corp., 428 F.2d 1071, 1078-79 (D.C. Cir.), cert. denied, 400 U.S. 925 (1970).
At common law, the landlord was not responsible if the premises became unsuitable once the tenant moved in. This rule was often harshly applied, even for unsuitable conditions caused by a sudden act of God, such as a tornado. Even if the premises collapsed, the tenant would be liable to pay the rent for the duration of the lease. Today, however, many states have statutorily abolished the tenant’s obligation to pay the rent if a non-man-made force renders the premises unsuitable. Moreover, most states today impose on the landlord, after the tenant has moved in, the responsibility for maintaining the premises in a safe, livable condition, consistent with the safety, health, and housing codes of the jurisdiction.
These rules apply only in the absence of an express agreement between the parties. The landlord and tenant may allocate in the lease the responsibility for repairs and maintenance. But it is unlikely that any court would enforce a lease provision waiving the landlord’s implied warranty of habitability for residential apartments, especially in areas where housing is relatively scarce.
Noninterference with Use
In addition to maintaining the premises in a physically suitable manner, the landlord has an obligation to the tenant not to interfere with a permissible use of the premises. Suppose Simone moves into a building with several apartments. One of the other tenants consistently plays music late in the evening, causing Simone to lose sleep. She complains to the landlord, who has a provision in the lease permitting him to terminate the lease of any tenant who persists in disturbing other tenants. If the landlord does nothing after Simone has notified him of the disturbance, he will be in breach. This right to be free of interference with permissible uses is sometimes said to arise from the landlord’s implied covenant of quiet enjoyment.
Tenant’s Remedies
When the landlord breaches one of the foregoing duties, the tenant has a choice of three basic remedies: termination, damages, or rent adjustment.
In virtually all cases where the landlord breaches, the tenant may terminate the lease, thus ending her obligation to continue to pay rent. To terminate, the tenant must (1) actually vacate the premises during the time that she is entitled to terminate and (2) either comply with lease provisions governing the method of terminating or else take reasonable steps to ensure that the landlord knows she has terminated and why.
When the landlord physically deprives the tenant of possession, he has evicted the tenant; wrongful eviction permits the tenant to terminate the lease. Even if the landlord’s conduct falls short of actual eviction, it may interfere substantially enough with the tenant’s permissible use so that they are tantamount to eviction. This is known as constructive eviction, and it covers a wide variety of actions by both the landlord and those whose conduct is attributable to him, as illustrated by Fidelity Mutual Life Insurance Co. v Kaminsky, (see Section 32.5.1 “Constructive Eviction”).
Damages
Another traditional remedy is money damages, available whenever termination is an appropriate remedy. Damages may be sought after termination or as an alternative to termination. Suppose that after the landlord had refused Simone’s request to repair the electrical system, Simone hired a contractor to do the job. The cost of the repair work would be recoverable from the landlord. Other recoverable costs can include the expense of relocating if the lease is terminated, moving costs, expenses connected with finding new premises, and any increase in rent over the period of the terminated lease for comparable new space. A business may recover the loss of anticipated business profits, but only if the extent of the loss is established with reasonable certainty. In the case of most new businesses, it would be almost impossible to prove loss of profits.
In all cases, the tenant’s recovery will be limited to damages that would have been incurred by a tenant who took all reasonable steps to mitigate losses. That is, the tenant must take reasonable steps to prevent losses attributable to the landlord’s breach, to find new space if terminating, to move efficiently, and so on.
Rent Remedies
Under an old common-law rule, the landlord’s obligation to provide the tenant with habitable space and the tenant’s obligation to pay rent were independent covenants. If the landlord breached, the tenant was still legally bound to pay the rent; her only remedies were termination and suit for damages. But these are often difficult remedies for the tenant. Termination means the aggravation of moving, assuming that new quarters can be found, and a suit for damages is time consuming, uncertain, and expensive. The obvious solution is to permit the tenant to withhold rent, or what we here call rent adjustment. The modern rule, adopted in several states (but not yet in most), holds that the mutual obligations of landlord and tenant are dependent. States following this approach have developed three types of remedies: rent withholding, rent application, and rent abatement.
The simplest approach is for the tenant to withhold the rent until the landlord remedies the defect. In some states, the tenant may keep the money. In other states, the rent must be paid each month into an escrow account or to the court, and the money in the escrow account becomes payable to the landlord when the default is cured.
Several state statutes permit the tenant to apply the rent money directly to remedy the defect or otherwise satisfy the landlord’s performance. Thus Simone might have deducted from her rent the reasonable cost of hiring an electrician to repair the electrical system.
In some states, the rent may be reduced or even eliminated if the landlord fails to cure specific types of defects, such as violations of the housing code. The abatement will continue until the default is eliminated or the lease is terminated.
Rights and Duties of Tenants
In addition to the duties of the tenant set forth in the lease itself, the common law imposes three other obligations: (1) to pay the rent reserved (stated) in the lease, (2) to refrain from committing waste (damage), and (3) not to use the premises for an illegal purpose.
Duty to Pay Rent
What constitutes rent is not necessarily limited to the stated periodic payment usually denominated “rent.” The tenant may also be responsible for such assessments as taxes and utilities, payable to the landlord as rent. Simone’s lease calls for her to pay taxes of \$500 per year, payable in quarterly installments. She pays the rent on the first of each month and the first tax bill on January 1. On April 1, she pays the rent but defaults on the next tax bill. She has failed to pay the rent reserved in the lease.
The landlord in the majority of states is not obligated to mitigate his losses should the tenant abandon the property and fail thereafter to pay the rent. As a practical matter, this means that the landlord need not try to rent out the property but instead can let it sit vacant and sue the defaulting tenant for the balance of the rent as it becomes due. However, the tenant might notify the landlord that she has abandoned the property or is about to abandon it and offer to surrender it. If the landlord accepts the surrender, the lease then terminates. Unless the lease specifically provides for it, a landlord who accepts the surrender will not be able to recover from the tenant the difference between the amount of her rent obligation and the new tenant’s rent obligation.
Many leases require the tenant to make a security deposit—a payment of a specific sum of money to secure the tenant’s performance of duties under the lease. If the tenant fails to pay the rent or otherwise defaults, the landlord may use the money to make good the tenant’s performance. Whatever portion of the money is not used to satisfy the tenant’s obligations must be repaid to the tenant at the end of the lease. In the absence of an agreement to the contrary, the landlord must pay interest on the security deposit when he returns the sum to the tenant at the end of the lease.
Alteration and Restoration of the Premises
In the absence of a specific agreement in the lease, the tenant is entitled to physically change the premises in order to make the best possible permissible use of the property, but she may not make structural alterations or damage (waste) the property. A residential tenant may add telephone lines, put up pictures, and affix bookshelves to the walls, but she may not remove a wall in order to enlarge a room.
The tenant must restore the property to its original condition when the lease ends, but this requirement does not include normal wear and tear. Simone rents an apartment with newly polished wooden floors. Because she likes the look of oak, she decides against covering the floors with rugs. In a few months’ time, the floors lose their polish and become scuffed. Simone is not obligated to refinish the floors, because the scuffing came from normal walking, which is ordinary wear and tear.
Use of the Property for an Illegal Purpose
It is a breach of the tenant’s obligation to use the property for an illegal purpose. A landlord who found a tenant running a numbers racket, for example, or making and selling moonshine whisky could rightfully evict her.
Landlord’s Remedies
In general, when the tenant breaches any of the three duties imposed by the common law, the landlord may terminate the lease and seek damages. One common situation deserves special mention: the holdover tenant. When a tenant improperly overstays her lease, she is said to be a tenant at sufferance, meaning that she is liable to eviction. Some cultures, like the Japanese, exhibit a considerable bias toward the tenant, making it exceedingly difficult to move out holdover tenants who decide to stay. But in the United States, landlords may remove tenants through summary (speedy) proceedings available in every state or, in some cases, through self-help. Self-help is a statutory remedy for landlords or incoming tenants in some states and involves the peaceful removal of a holdover tenant’s belongings. If a state has a statute providing a summary procedure for removing a holdover tenant, neither the landlord nor the incoming tenant may resort to self-help, unless the statute specifically allows it. A provision in the lease permitting self-help in the absence of statutory authority is unenforceable. Self-help must be peaceful, must not cause physical harm or even the expectation of harm to the tenant or anyone on the premises with his permission, and must not result in unreasonable damage to the tenant’s property. Any clause in the lease attempting to waive these conditions is void.
Self-help can be risky, because some summary proceeding statutes declare it to be a criminal act and because it can subject the landlord to tort liability. Suppose that Simone improperly holds over in her apartment. With a new tenant scheduled to arrive in two days, the landlord knocks on her door the evening after her lease expires. When Simone opens the door, she sees the landlord standing between two 450-pound Sumo wrestlers with menacing expressions. He demands that she leave immediately. Fearing for her safety, she departs instantly. Since she had a reasonable expectation of harm had she not complied with the landlord’s demand, Simone would be entitled to recover damages in a tort suit against her landlord, although she would not be entitled to regain possession of the apartment.
Besides summary judicial proceedings and self-help, the landlord has another possible remedy against the holdover tenant: to impose another rental term. In order to extend the lease in this manner, the landlord need simply notify the holdover tenant that she is being held to another term, usually measured by the periodic nature of the rent payment. For example, if rent was paid each month, then imposition of a new term results in a month-to-month tenancy. One year is the maximum tenancy that the landlord can create by electing to hold the tenant to another term.
Key Takeaway
Both landlords and tenants have rights and duties. The primary duty of a landlord is to meet the implied warranty of habitability: that the premises are in a safe, livable condition. The tenant has various remedies available if the landlord fails to meet that duty, or if the landlord fails to meet the implied covenant of quiet enjoyment. These include termination, damages, and withholding of rent. The tenant has duties as well: to pay the rent, refrain from committing waste, and not use the property for an illegal purpose.
Exercises
1. Consistent with the landlord’s implied warranty of habitability, can the landlord and tenant agree in a lease that the tenant bear any and all expenses to repair the refrigerator, the stove, and the microwave?
2. Under what conditions is it proper for a tenant to withhold rent from the landlord? | textbooks/biz/Civil_Law/Foundations_of_Business_Law_and_the_Legal_Environment/32%3A_Landlord_and_Tenant_Laws/32.02%3A_Rights_and_Duties_of_Landlords_and_Tenants.txt |
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