Business Law, 6th edition (Business Review Series) (2023)

Business Law, 6th edition (Business Review Series) Business Law, 6th edition (Business Review Series) (1)

Business Law, 6th edition (Business Review Series) (2)

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by Barron’s Educational Series, Inc.

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Library of Congress Catalog Card No. 2015938004

eISBN: 978-1-4380-6789-6





The Origin of Law

Definitions of Law

Law and Morality

Development of Civil Law

Development of Common Law

Substantive Law and Procedural Law

Law, Ethics, and Attorneys

The Attorney’s Many Roles and Ethical Duties, Legal Fees, Attorney/Client Conflict, and the Businessperson’s Role 13 Uniform Laws

Researching the Law

A Review of Categories of Law, Via Six Examples





Sources of U.S. Law

The U.S. Constitution

Federal Statutes

The State Constitutions

State Statutes

Local Ordinances

Rulings of Federal, State, and Local Agencies (Administrative Law)

Decisions by Federal and State Courts





The Two Major U.S. Judicial Systems

Taking a Case to Court

Out-of-Court Procedures for Settling Disputes

Administrative Agency Proceedings

The Inquisitorial Approach and the Adversarial Model

How Cases Are Cited






Nature of Contracts

Classification of Contracts


Forming a Contract







Innocent (Nonfraudulent) Misrepresentation

Undue Influence







Capacity of the Parties

Legality of Subject Matter





The Statute of Frauds

Parol Evidence Rule








Other Remedies





Article 2 of the Uniform Commercial Code

Principal Changes for Sales Contracts in Article 2

The Convention on Contracts for the International Sale of Goods

Nonsales Transactions

Definition of a Sale

Transfer of Title

Risk of Loss

Performance of the Sales Contract

Remedies for Breach of Sales Contracts






The Negotiable Instrument as a Form of Commercial Paper

Development of the Law Governing Negotiable Instruments

The Uniform Commercial Code, Articles 3 and 4

Elements of Negotiability

Types of Negotiable Instruments

The Parties to a Negotiable Instrument

Advantages of Negotiable Instruments over Ordinary Contracts

The Assignee of a Contract Versus the Holder of a Negotiable Instrument







Holder in Due Course


Liabilities Among Parties






The Contract Between Bank and Customer

Rules Governing the Payment of Checks

Certification of Checks


Summary of Important Article 4 Rules

Electronic Funds Transfer Act





Creditors’ Rights: Collection of Debts

Protection for Debtors

Bankruptcy and Reorganization

Secured Transactions






Nature of Agency and Agency Law

Agency and Other Legal Concepts Whereby One Person May or May Not Perform Services for Another

Creation of Agency

The Agent/Principal Relationship

Liability of Principal and Agent to Third Parties

Termination of Agency





Types of Business Organizations

General Partnerships

Limited Partnerships






Nature of a Corporation

Background of Corporations

Corporate Attributes

Formation of the Corporation

Types of Corporations

Nature and Content of the Charter; Bylaws

Corporate Powers and Limitations on Them

Regulation of Foreign Corporations





Corporate Overview


Board of Directors


Other Employees

Termination of the Corporation





Corporate Financial Structure

Securities Regulation

Liability of Accountants






Important Facts About Crimes

Important Facts About Torts

Comparison of Crimes and Torts

Examples of Torts

Examples of Business Crimes, with Tort Equivalents

The Businessperson as Criminal Defendant

General Defenses to Crimes and Torts

Product Liability





Property as a Legal Concept

Personal Property

Joint Ownership of Property

Real Property

Comparison of Major Property Arrangements





Trusts and Wills






Sherman Act

Clayton Act

Monopoly Power: Some Important Concepts

Robinson-Patman Act

Federal Trade Commission Act

Antitrust Law Enforcement

Exemptions from Antitrust Laws





National Environmental Policy

Water Pollution

Air Pollution

Land Pollution

Nuclear Power Regulation

Protection of Wildlife

The Cost of Environmental Regulation

International Environmental Law





Health and Safety Legislation

Fair Labor Standards Act

Income Protection

Protection Against Discrimination





The National Labor Relations Act: Framework for Almost All Labor Law

The Role of the National Labor Relations Board

The Labor Negotiation Process

Labor Dispute Resolution: Concerted Activities





Intellectual Property

Copyright Protection for Computer Programs

Trademarks and Other Trade Symbols

Computer Crimes and Torts

Privacy Issues

International Law Topic





Historical Perspective

The Internal Revenue Service

Types of Taxes

The Income Tax

Employer Responsibilities: Taxes

Back Taxes

Independent Contractors

Statutory Employees

Self-Employment Taxes

Cash and Accrual Methods for Income and Expenses

Tax Deductions





International Law and U.S. Law

Treaties and Business

National Law and Foreign Governments



Regulation and Nationalization

International Dispute Resolution







This book presents both students and other interested persons with a simple and readily understandable explanation of essential and related business law and legal environment subjects.

For the citizen, corporate executive, and business manager, the book should serve as an independent explanation of fundamental law in both a practical and a technical setting. For the student, this overview should serve as a guide through the complex maze of the literally thousands of legal principles tossed out in a typical course on the law or legal environment of business.

Business law, including the legal environment of business, is a broad field; nearly every law school subject is covered or touched upon in this book. However, as an experienced teacher and practicing attorney, I have attempted to treat, in particular detail, the legal subjects that actually engage the attention of businesspersons and that are covered in university and college courses.

Legal theory is important in the “everyday business world” inhabited by corporate managers and all other persons making major business decisions, as well as buying and selling supplies and services. We expect businesspeople to know about tort responsibility and their duty to the public. Moreover, the modern business world now requires a general knowledge of governmental relations and activities, including the societal obligations described in the criminal and other statutory or regulatory law. This book deals with all of these concerns. For example, persons involved in production and transportation will find extensive information about contracts, environmental law, product liability, and international law. Those in marketing and sales will see much relevant material on contracts, consumer protection, antitrust laws, and torts. Personnel specialists can read much on contracts, employment law, and labor law, while finance or accounting concerns are often addressed in contracts, credit regulation, and securities regulation. Research and development (R & D) questions can be answered in torts and product liability law as well as intellectual property law.


This book covers all of the material in the general business law course offerings (usually two semesters). Among these subjects are (a) an introduction to the law, (b) crimes and torts, (c) contracts, (d) business organizations (especially corporations and partnerships), (e) commercial paper, (f) agency, (g) property, (h) creditor rights and obligations, and (i) a full review of the Uniform Commercial Code (including relevant international law concepts).

The text has been updated and expanded to include all relevant new topics and trends, as well as revisions of existing legislation, regulation, and case law. I examine the legal environment of business and delve at length into the conduct of litigation, the nature of governmental powers and individual rights, and specific areas of law with a strong impact on business. These include—in addition to “standard” business law topics—administrative and constitutional law, securities regulation, antitrust law, labor and employment law, consumer protection law, computer law, international law, insurance, attorneys and accountants, tax law, environmental law, and the general moral and social duties of business. Furthermore, the book contains an in-depth glossary of over 2,350 words, much more comprehensive than the glossaries of other books on business law or the legal environment of business. The glossary is a major asset of the book in that it can serve as an independent dictionary of legal terminology useful in the business world. Along these lines, a very thorough index also helps readers to find and understand legal topics in their overall context.


The material presented is designed to prepare all students, including accounting students, for their future profession. It is in keeping with American Institute of Certified Public Accountant (AICPA) education requirements. All AICPA law course topics are included, and the book should serve as an excellent review for practicing accountants.

For the more general business law or legal environment student, my breakdown of the subject by chapter ties in with standard textbook treatment. This, and the comprehensive glossary and index, should be of help to the student who may need to key the class lectures or work assignments into explanations developed here.

Second only to my desire that readers receive a practical education in law suitable for the everyday business world is my desire that this book be eminently “teachable.” I have tried to design a primary or supplementary text for the busy professors and lawyers who teach business law and the legal environment of business. The text presentation is easy to summarize and readily tied to related legal concepts. It is flexible enough to cover all subjects required in any current study of business law or the legal environment of business.


This book embodies my teaching philosophy and experience, years of legal research and writing, and day-to-day advice to businesspersons. I welcome the comments and suggestions of my readers.

I am extremely grateful to my late father-in-law, the Honorable John W. Hardwicke, the coauthor and instigator of this book in its initial version. He was a constant source of ideas and inspiration, both professionally and personally, for nearly three decades as my second father.

I also thank my students for their support, their ideas and, most importantly, their questions. I have received helpful suggestions from many individuals. Finally, I especially thank, for all her assistance, the love of my life—my muse, my wife, Heidi Hardwicke Emerson.

Gainesville, Florida

September 2015

Robert W. Emerson





law that which a judge will decide concerning matters properly brought before him/her; in a broader sense, any rule that society will enforce

code in the common law, a collection of statutes enacted by legislative bodies, including Congress and state legislatures

Civil Law codified law based on the Roman code of Justinian; the basis of the legal system of almost all European and Latin American countries as well as many African and Asian nations

common law law as developed and pronounced by the courts in deciding cases (“case law”), based on the common law of England and judicial precedent


The origin of law is as obscure as the origin of society, since the existence of law is a precondition of society. In its most primitive, unreasoned form, law rests on brute power—the ability of one individual to control other individuals through strength. The lex talionis, the law of retaliation (an eye for an eye, a tooth for a tooth), arose from the natural impulse of individuals. As societies formed, this impulse was sanctioned by government as law. The law of damages is the substitution of monetary compensation for blood or retribution in kind.

As time passed, however, it became necessary to adopt rules governing the conduct of individuals toward one another and the conduct of a single individual toward the body of individuals as a whole (society). Certain laws were enacted, or evolved and developed, for different purposes:

  1. To proscribe certain kinds of behavior that society finds objectionable. This is public law and concerns a citizen’s relationship with society constituted as government. Public law includes constitutional, administrative, and criminal law and many forms of antitrust law, environmental law, labor law, and securities regulation.

  2. To make an injured party (citizen, corporation, or other entity) whole. This is private law and concerns an individual’s relationship with another individual. In this sense, private law includes tort, agency, contract, corporation, partnership, and property law.

  3. To end disputes. This is again private law, specifically contract law, the law governing agreements. (If law is knowable, reasonable, fairly certain, and yet flexible, it may prevent disputes.)


The origin of law is obscure; society cannot exist without law. Individual power and cunning constituted the first law, and primitive governments merely presided over the lex talionis, or law of private retribution.

As societies became complex, it became necessary to adopt rules of conduct for various purposes (for example, to forbid objectionable behavior, to make an injured party whole, and to end disputes).


Only if the total collective, the society, enforces its rules can they have any meaning, or serve any purpose, in the regulation of conduct. One school of thought, sometimes called the school of American legal realism, considers law to be that which a judge will decide concerning matters properly brought before him/her; thus, in a broader sense, this approach defines law as any rule that society will enforce. For our purposes, we prefer this definition of law. During the course of this book we will refer to law in terms of judicial decisions as well as statutory enactment.

However, there are other widely accepted definitions of law. A school of thought sometimes called “legal positivism” defines law as the command of a constituted political authority; “natural law” theorists argue that there is a higher law grounded in absolute moral rules and that any law contrary to such natural law is not law. The English jurist Blackstone defined law as “a rule of civil conduct prescribed by the supreme power in a state, commanding what is right, and prohibiting what is wrong.”

Schools of Jurisprudence

Critical Legal Studies

Describing the legal system as using manipulable concepts to preserve the socioeconomic status quo while maintaining the fiction of a just decision-making process, adherents of this school often argue for more arbitrary, but less malleable rules tied to community values, egalitarianism, and actual fairness.

Historical School

The law is shaped by events, traditions, and customs; the past helps us to discern the principles of contemporary law.

Law and Economics

The link between law and economics cannot be severed; market efficiency is, or at least should be, the law’s prime focus.

Natural Law

Law is tied to morals and ethics, including some principles that are immutable.


The law is a set of rules developed and enforced by the governing authority.


More a social or economic philosophy than simply jurisprudence, this approach to life and law is often reduced to the phrase, “the greatest good for the greatest number,” with law therefore judged by how much pleasure or pain it creates—how much it produces a net “plus” in terms of societal progress.


Law generally represents the developing, common morality of human beings. Government almost always seeks to ally itself with prevailing customs, to proclaim as right only that which most citizens already perceive to be right, and to impose as law the rules considered by the majority or by more powerful or vocal minorities to be moral and therefore just. Thus, no matter how law is defined, there is a close, although imprecise, relationship between morality and any rule that society will enforce.

Since law is, or should be, reflective of prevailing morality, rigid societal control over all members of society should be unnecessary. The goal is self-control, based on the individual’s own moral philosophy or “instincts.” Indeed, the law’s typically majoritarian and moral origins serve to promote its enforcement, the ease or practicability of which depends on the acquiescence of a large preponderance of the population.

The relationship between law and morality is not mere speculation. Contracts may be found illegal if in violation of “public policy,” that is, contrary to the “public good,” and some case law even refers to lawful action as consistent with that of “right-thinking members of the community.” Juries are considered to be made up of ordinary people reflecting prevailing morality.

Important Principle:

Conduct that a reasonable person conscientiously deems moral and just is unlikely to collide with law.

Even if supposedly moral conduct proves illegal, that is, in violation of a rule that society will normally enforce, society’s enforcement in a specific case may be muted, otherwise restrained, or even suspended.

Example: Relationship Between Law and Morality

In criminal law (see Chapter 19), even when an action is criminal, a good motive is considered in mitigation of punishment. “Bad” motives can have the opposite effect, such as leading to punitive damages in tort cases.


There is a close relationship between law and morality. Law not only has its origin in morality, but also is easier to enforce when citizens yield to government for moral reasons.


As society became increasingly complex, various “lawgivers” attempted to provide orderly systems of laws that would promote security and justice. There are four landmark “codes,” each of which represents distinct progress in the development of law:

Lawgiver**Date**Noteworthy Aspects Hammurabi (Babylonian)1792–1750 B.C.Designed to promote “justice” but based on the lex talionis. A well-ordered system of 285 laws, arranged by titles. Solon (Athenian)594 B.C.Established a stable government operating under a system of rules imposed by a consenting citizenry. “Citizens” were equal under the law. JustinianA.D. 533Summarized and systematized the civil law (Roman) of Rome; remains the basis for the laws of most of Europe and Latin America and for parts of Asia and Africa. NapoleonA.D. 1804Preserved many democratic achievements of (French) the French Revolution, such as civil equality and jury trial. Influenced modern law, for example, the modern law of the state of Louisiana. Civil Law, or code law, is one of two major legal systems currently in use in the Western world. It is based primarily on the written codes of Justinian and Napoleon. The predominant feature of civil law is the attempt to establish a body of legal rules in one systematized code, a single comprehensive legislative enactment. In this system, judicial decisions, case law, are not a source of law, although judicial precedents may be useful in the decision of cases. Civil Law remains the basis of the legal system not just throughout Europe, but also in many other parts of the world once under European colonial influence (e.g., Latin America and many nations in Africa and Asia). Indeed, non-Western countries such as China have, on their own, adopted much of the Civil Law system as a move to modernize and encourage business growth and international commerce. The two most important modern streams of Civil Law jurisprudence emanate from France and Germany, with the French tradition going back to the Napoleonic Code and the elaborations since, and the German doctrine dating to the German Civil Code of 1896. France’s Code not only influenced almost all of Europe and Latin America, but also many countries in sub-Saharan Africa, the Maghreb, the Middle East, Southeast Asia, Oceania, and Francophone enclaves from North America (e.g., Quebec and Louisiana) to India. The French in fact heavily influenced Germany’s system, and in turn the German approach to Civil Law has been adopted comprehensively by Japan. The German Code has also influenced legal systems in Scandinavia, the Baltics, Greece, Ukraine, China, South Korea, Taiwan, Thailand, Taiwan, and Brazil. These dominant doctrines for Civil Law traditions have caused many to refer to them as the Franco-Germanic Civil Law.


The progress of law through the centuries can be traced through the activities of four “lawgivers” who attempted to state the law in keeping with their perceptions of evolving civilization and to provide remedies for those wronged.

The laws of certain countries are still based on the principles set forth in these codes.


One country did not follow the comprehensive code approach to law. In England, disputes were resolved on a case-by-case basis, binding the arbiter of a dispute to the rule elicited from the determination of an earlier, similar dispute—hence common law. Common law is the second of the two major legal systems currently in use in the Western world.

Today England (together with the United States, Canada, Australia, New Zealand, and—to a lesser extent—India and other Asian, African, and Caribbean countries colonized by the British) follows the common law. An understanding of the concepts underlying the common law of England is thus vital to any discussion of American law, including American business law. Sir William Blackstone’s Commentaries, published just before the American Revolution, are generally considered to be the best statement of English common law as it existed when the United States became an independent nation.

According to Blackstone, the common law is that “ancient collection of unwritten maxims and customs” which have “subsisted immemorially in this kingdom.” These principles are revealed by the courts of law “through experience in the rendering of judicial decision.” Common law is, therefore, the overall accumulation of judicial decisions, known as case law.

England has no written constitution. The basis of its constitution is the common law, derived mainly from precedent and incorporating also certain landmark documents, such as the Magna Carta (1215) and English Bill of Rights (1689).

American common law includes not only the “ancient maxims and customs” inherited from England, but also all subsequent and modern case law as developed and pronounced from time to time.


As common law developed, a judge confronted with a puzzling new case would search the literature for a similar case to determine whether a precedent had been established. If so, the judge would follow the prior decision.

Stare Decisis

The requirement that courts follow their own precedents is based on the legal principle of stare decisis or “stand by the decision.” Stare decisis binds all of the lower courts of a jurisdiction to determinations rendered by the highest court in that same jurisdiction.

Stare decisis is not absolute; a decision of the highest court can be amended either by this court’s changing its mind or by legislative mandate.

If a case arises for which no modern American or English precedent can be found, the court sometimes bases its decision on the Justinian code, from which some areas of the common law are derived. In the absence of a precedent, a court may follow its own sense of justice or fairness, with due regard for prevailing custom or morality.


Unless changes are constitutionally prohibited, Congress or the state legislatures may enact laws (statutes) that modify the common law. These statutes, also subject to judicial interpretation, are collected into codes: along with case law, the codes form the law generally applied in court. Unlike Civil Law codes, common law codes are not intended to be entire statements of the whole law; in fact, they often are meant to be supplemented by judicial opinions and also, for some areas of law, by administrative regulation.


After the conquest of England by William the Conqueror (A.D. 1066), Norman kings created an independent, but parallel, system of justice alongside the developing common law, with ultimate judicial responsibility residing in the king himself. This system, the equity system, had exclusive jurisdiction over injunctive relief (court-ordered action) and the specific performance of a contract as well as certain contract modifications. Since the kings were not learned in the common law, they based their decisions on sensible principles of fair play (equity) embodied in “maxims” or commonsense rules of Solomon-like justice. As the equity system functioned alongside the common law courts, the two systems of law gradually merged. Equity maxims—“He who comes to equity must come with clean hands (courts may consider the past behavior of the claimant),” “Equity regards as done that which ought to be done,” “Equity considers substance, not form,” “Whoever seeks equity must do equity (behave fairly),” “Equality is equity (if there is no contrary evidence, equity favors the equal division of property [funds] to which more than one person is entitled),” “Do not sleep on your rights (delay may indicate acquiescence),” “Equity suffers no wrong without a remedy,” and many other “fair play” principles—were adopted by the common law and are currently cited in judicial decisions.

Starting in the sixteenth century, before the equity courts merged into the common law system, the equity courts received responsibility for matters previously vested in the ecclesiastical (church) courts. Thus equity absorbed a number of functions involving the family (divorce, annulment, adoption). These equity responsibilities became part of the general legal system—and part of the common law—that developed in the United States.

Although law and equity are today merged into a common system in which equity principles are cited freely, the old equity domain (injunctive relief, specific performance of contract, contract modification, family law, divorce) is particularly influenced by the idea of fairness and is deliberately more relaxed in its concept of justice. Also, jury trial is not available in an equity-type proceeding, the jury having been a feature of the common law courts. Thus, although the equity court as a separate system of justice has ceased to exist, equity principles permeate all of the common law but are most diligently applied to traditional equity subject matter.


England, the British Commonwealth, and the United States follow the common law. Whereas Civil Law attempts to state the whole law in a comprehensive code, the common law is found in the collected cases of the various courts of law. American common law began with the common law of England as summarized by Blackstone in his Commentaries. It includes the English common law and all subsequent legal developments, including the principle of stare decisis.

Common law codes should not be confused with Civil Law codes. In the common law, a code is a collection of statutes passed by a legislature; a Civil Law code is intended as a full and comprehensive statement of the whole law.

Equity began as an independent legal system based on concepts of fair play. It covers injunctive relief, specific performance of contract, and certain contract revisions, as well as parts of family law. Many of the principles and maxims of equity have been merged into the common law. There is no jury trial in an equity case.


Substantive law refers to any body of law creating, defining, and regulating rights and obligations within the framework of a single subject, such as contracts, torts, crimes, or property.

Procedural law pertains to operating rules for obtaining substantive rights or defining substantive obligations in a court of law. Procedure may be as important as substance in obtaining justice, since access to the court and proper statement of the cause of action (basis for a lawsuit) are controlled by the rules of an orderly society.

In the federal legal system and in most state systems, procedural rules are promulgated by the judiciary, adopted after public hearings, and published along with editions of the various codes. The rules of procedure are intended to promote justice and are to be interpreted flexibly and broadly, in the interest of fairness. A trial attorney’s basic skills center around his/her mastery of procedure.

Lesser courts, such as small claims courts or probate courts, have developed simplified procedures so that citizens may handle their own cases without benefit of attorneys.


Substantive law defines legal rights and obligations in regard to a specific subject.

Procedural law is concerned with the enforcement of substantive law in a court of law.


Ethics and law are not the same, but there is an overlap, with enormous influence of one on the other. Law is easier to enforce when viewed as moral, when almost everyone agrees with it, when many people follow the law without even really thinking about it because they support the underlying rationale for the law.

If a law is perceived as having no ethical component, then people tend to have little respect for the law; perhaps they have just a “fear of getting caught.” However, we usually want the law to lag somewhat behind ethics; law—more conservative force (not way out ahead), but subject to gradual conservative change (trailing ethics, as becomes well understood and generally supported).

Knowledge Is Only the Start Toward Wisdom

Be wary of simply noting the details and adopting a strictly technical view of the law, if doing so flies in the face of the spirit of the law and of common sense and decency. Do not get absorbed in details and miss the “big picture” of societal or attitudinal changes. Businesses sometimes wrongly assume that law and ethics are far apart. They thus stick with a technical, literal interpretation of the law that worked a decade ago, but ignores the trends and moral notions recently imbued in the law.


The Sarbanes and Oxley Act (2002) at Section 406 mandates that all corporations whose stock is publicly traded have a code of ethics for their upper-level financial officers. Even without that requirement, nearly every publicly held business (e.g., a large corporation) has adopted a “Code of Ethics” for all of its employees to follow. Likewise, almost all professional associations, such as the American Institute of Certified Public Accountants, the American Bar Association, the National Society of Professional Engineers, and the American Medical Association, have ethics codes for their members. These codes may require specific conduct in particular situations—more likely, disclosure to the employee’s superior—but most codes are general statements of values more than anything else: (1) honesty; (2) transparency; (3) loyalty; (4) being respectful; and (5) obedience to the law. Some codes, especially those of professionals, create standards that courts may cite when interpreting contracts, professional norms, or industry customs. Many codes of ethics, especially professional codes, provide sanctions for noncompliance even though they do not constitute criminal penalties.



Businesses increasingly rely on attorneys not only when they are sued or encounter other crises, but also to prevent problems. The hope is to improve business practices and thus reduce the risks of lawsuits, fines, or other legal penalties or expenses.

Lawyers do not so much “know the law” as they are familiar with general legal principles and able to find specific cases, statutes, or other law applicable to a particular set of facts. A lawyer often has several functions: investigator, drafter, negotiator, advisor, and advocate. A lawyer has a duty to advise against illegal actions, but also must maintain confidences shared with him/her during the course of the attorney/client relationship.


Although U.S. Supreme Court decisions permit advertising by lawyers, there still are restrictions on an attorney’s individual solicitation of clients. Therefore, except for “in-house” counsel (lawyers who are employees of a business, perhaps in a company’s “legal department”), the businessperson usually contacts an attorney rather than vice-versa. Only if a business has already had dealings with outside counsel can it sometimes expect these attorneys to take the initiative concerning new legal problems.

The attorney/client privilege permits clients to keep confidential matters discussed by or with their attorneys. This privilege can be waived by the client; for instance, he/she may subsequently disclose attorney/client communications to a third party. Also, because the attorney/client privilege depends on confidential communications, it does not extend to statements made in the presence of, or letters sent to, persons in addition to the attorney and client. Nor can confidentiality protections ordinarily extend to nonclients. Thus, what an employee tells the corporate employer’s lawyer may not be protected because the attorney is not the employee’s lawyer, but the corporation’s; even if there is such confidentiality, the corporation may choose to waive any confidentiality.

International Comparison:

Most European countries do not extend the attorney-client privilege to cover any communications with in-house attorneys.

In extreme cases, lawyers may reveal to the court a client’s spoken criminal intent. Most states have adopted the American Bar Association’s (ABA’s) Model Rules of Professional Conduct, in which Rule 1.6 says, “a lawyer may reveal [emphasis added] such information to the extent the lawyer reasonably believes necessary: to prevent the client from committing a criminal act that the lawyer believes is likely to result in imminent death or substantial bodily harm . . .” When that rule was adopted, some lawyers argued for a mandatory disclosure rule, but the ABA made it optional. As for corporate fraud, lawyers tend to be free—under state law—to act in the corporation’s best interests as the lawyer sees it. Critics, however, say lawyers have been hesitant to expose paying clients, and that shareholders thus have suffered. The Sarbanes-Oxley Act of 2002, as well as Securities and Exchange Commission rules, impose certain whistleblowing requirements on lawyers that exceed anything under state law. (See Chapter 18.)

For lawyers to do their work, they must be able to work with a certain degree of privacy. Only if extreme necessity is shown, such as hardship and injustice toward the other party, may work-related material be obtained. The work-product doctrine is broader than the attorney-client privilege. For example, in cases where the attorney-client privilege has been waived, a lawyer’s notes, or those of his/her assistant, have remained protected under the work-product doctrine.

Each state has ethical codes of conduct governing lawyers. These concern the attorney’s responsibilities, sometimes conflicting, both to the client and to the legal system. In general, the attorney must:

(a) only take cases that he/she can handle competently;

(b) zealously advocate the client’s cause, while remaining faithful to the attorney’s own obligation, as an officer of the court, not to undermine the overall purposes of the system itself;

(c) keep the client reasonably informed (e.g., concerning settlement offers);

(d) abide by the restrictions of attorney/client privilege; and

(e) when withdrawing from a case, take measures to protect the client’s interests (e.g., try to obtain new counsel for the client).

These rules help to delineate duties in specific situations. Published opinions of courts and bar association panels, as well as telephone “hotline” services, may also furnish lawyers with guidance. Violation of the rules can result in disciplinary action, with punishment ranging from reprimand to disbarment.

Businesses’ Social Responsibility

The ethical duties of businesspersons are not as firmly or as long established as the duties for lawyers, medical doctors, accountants, and others with extensive training and testing accompanied by specialty credentials and, in effect, exclusive or near-monopoly licenses to practice a particular profession. However, the development and elaboration of standards for business—both in particular fields and generally—is growing rapidly.

One approach is to recognize that, regardless of whether there are actual laws requiring certain behavior, businesses have certain duties to society. The traditional view is that a business’ dominant, if not only, duty is, as long as it acts lawfully, to maximize profits—hence, to maximize the owners’ (e.g., corporate shareholders) return on their investment. Three other approaches expect more social awareness and thus more activity in line with a general duty to the public. A business should consider its overall impact on society (perhaps comparable to, in terms of environmentalism, how persons should measure and then seek to reduce their carbon “footprint”). Effects, both long-term and immediate, both intended and entirely coincidental, should be understood and, if deleterious, corrected or at least mitigated.

The stakeholder-interest approach to businesses’ social responsibility compels businesspersons and entities, such as corporations, to consider the effects that their actions have on all stakeholders (constituents), not just the business owners (the shareholders). These other stakeholders include employees, customers, suppliers, creditors, and the community as a whole. Benefit corporations are a recent example of stakeholder interests in action.

Another approach is to demand of a business that it meet a moral minimum. This is, at the very least, a “do no harm” or a “clean up your mess” standard. The business is free to earn as much profit as is lawful so long as it avoids causing harm to other, innocent third parties. Under laws concerning the environment, occupational safety, product liability, consumer protection, business competition (antitrust), and other fields, a business may not be judged so as to blame as much as it is expected to rectify its errors. That is, the business must pay for any iniquity it causes, often with damage awards and also corrective measures meant to make injured parties whole and to prevent future harm (e.g., to clean up a toxic spill, to correct a product defect, to warn consumers of helpful safety or health measures they should take).

The highest of the approaches typically is one concerning corporate citizenship.


Ordinarily, unless a statute provides that a winning party may recover attorney’s fees or a claim or defense was outrageously wrong, the parties pay their own counsel. So it is still somewhat unusual that a loser must pay the winner’s attorney’s fees. In Britain and many other countries, though, the loser must customarily pay the winner’s attorney’s fees. (That occurs to discourage and punish risky litigation.)

Legal ethics and consumer protection concerns generally require professional clarity about legal fees. For example, the fee arrangement should be put in writing and explained in-depth before a client hires a lawyer (a requirement in most states, particularly for contingency-fee arrangements). Retainers are often requested, and sometimes attorneys will not represent a client without them. Clients may see the retainer as assurance that, if work is needed, the lawyer will be available. Actually, it is instead an assurance to the lawyer that the client is able and willing to pay for the lawyer’s services, with the retainer simply being advance payment. If there is any unused, but paid for, lawyer’s time, the lawyer is obliged to return that portion of the retainer to the client.

As legal costs have soared, a growing number of states have relaxed the centuries-old, common law ban on outsiders (nonlawyers, nonparties) investing in lawsuits (financing the costs in return for a percentage of the winnings if there is a victory). Moreover, bar associations, private firms, and the states increasingly have pushed for lawyers to engage in reduced-fee or pro bono (free) legal representation for those who need legal counsel in civil (noncriminal) matters but cannot afford to hire a lawyer.1


As a professional, the attorney cannot always be expected to do the client’s bidding; the attorney may believe that the client’s interest would best be served by another course of action. But occasionally attorney/client differences stem from what the attorney perceives to be his/her professional, ethical obligations. Whenever differences arise, no matter what the reason, frank discussions are usually necessary and may, in fact, resolve the differences.

The businessperson, armed with some knowledge of the legal system, the role of lawyers, and the substantive and procedural law, can play an active role in the lawyer’s endeavors to resolve problems and/or prepare cases for litigation. Although taking a few courses, reading law books, and participating in past cases are no substitute for professional advice, the businessperson’s basic, if limited, knowledge of the law should help him/her to realize when the services of a lawyer are necessary, and what assistance the attorney and the client can provide one another. Although businesspersons may turn to published legal guides and form books for specific answers to some basic, obvious problems, often the most valuable service lawyers perform is noticing potential difficulties that the client did not even consider.


Attorneys can be used not only to resolve problems, but also to prevent them. Familiar with general legal principles, the lawyer directs his/her knowledge toward finding and applying the law to a particular set of facts.

A lawyer may have several roles: investigator, drafter, negotiator, advisor, and advocate. Each state’s code of attorney conduct governs the lawyer’s duties to his/her client and to the legal system.

The attorney/client privilege protects communications between attorney and client. The client may waive the privilege, and it arises only for confidential communications (ones not shared with third parties).


Theoretically there would be 50 bodies of common law (combined case and statutory law) among the 50 states. Actually, however, there is great interdependence, as well as conscious parallelism, among the various federal and state court systems. Moreover, there has long been a disciplined effort to develop uniform legislation, with states enacting the same set of statutes so as to reduce uncertainty about the laws of sister states, particularly in commercial law.

The Uniform Commercial Code (UCC—adopted in 49 states and partly in Louisiana) is the most successful of the proposed uniform laws. This comprehensive statute covers numerous subjects within the framework of substantive commercial law, including sales, commercial paper, and secured transactions. The UCC is thoroughly discussed in Chapters 9–13.

Summary of the Coverage of the Uniform Commercial Code (UCC)



Article 1 General Provisions

General principles, rules of interpretation, and definitions applicable to the entire UCC

Article 2 Sales

Contracts for the sale of goods

Article 2A Leases

Leases of goods

Article 3 Negotiable Instruments

Negotiable instrument payable in money, primarily promissory notes and checks

Article 4 Bank Deposits and Collections

Bank collection process and the legal relationship between a bank and its checking account customers

Article 4A Funds Transfers

Wholesale wire transfers

Article 5 Letters of Credit

Rights and obligations of parties to a letter of credit, a financing device used primarily in international trade

Article 6 Bulk Sales

Protection for creditors of a merchant who sells his entire stock in trade not in the ordinary course of business (most states have dropped Article 6 of the UCC, but—even if they have—these states have other laws dealing with bulk transfers)

Article 7 Documents of Title

Rights and duties of parties to documents of title issued in exchange for the carriage or storage of goods

Article 8 Investment Securities

Rules for transfer of stocks, bonds, and other securities traded on exchanges or in other organized markets

Article 9 Secured Transactions

Security interests in personal property created by agreement of the parties and all sales of accounts, chattel paper, payment intangibles, and promissory notes

The UCC has not achieved complete uniformity, however. As with any such enactment, the various state legislatures can make changes, and courts are free to give varying interpretations to the same words and phraseology. Nevertheless, there is a general consistency (if not uniformity) of subject matter, sufficiently definite and ascertainable for the businessperson operating within several states.

The National Conference of Commissioners on Uniform State Laws (NCCUSL) proposes new uniform laws, and changes to existing laws, for states to adopt. The NCCUSL spends years drafting and reaching consensus on uniform proposals that can then be submitted to state legislatures. The NCCUSL commissioners tend to be judges, professors, legislators, and practicing lawyers appointed by each state. The commission holds open drafting meetings so the public can comment on proposals.

Another enormously influential organization is the American Law Institute (ALI), a group of prominent lawyers, judges, and academics that studies laws, issues reports, and sometimes recommends legal reforms. The ALI is responsible for, among other things, the Restatements of Law.


Modern attorneys operate in two main areas: the law office and the courtroom. All practicing attorneys bring to their profession a general working knowledge of legal principles. In addition, both sound office advice and courtroom skill require the ability to find specific and detailed application of legal principles within the large body of case law and statute law. Therefore a student of business law should have a general understanding of the kinds of legal materials needed to research the law.

Statutory law is found in a state code or in the federal code. These codes are published with annotations, footnotes, and cross references to other statutes and to key cases interpreting and applying the statute in question. A lawyer will instinctively turn to the statutes, whether online or in books, for information about criminal law, taxation, and governmental regulation of all kinds. Moreover, familiarity with the Uniform Commercial Code is essential for the student of commercial law.

Case law is collected in the opinions of the appellate courts of the states and of the United States. Opinions of trial courts are usually not published, except for federal trial courts. (Even those courts that do publish opinions, such as federal appeals and trial courts, often issue unpublished decisions.)

Besides the statutory annotations, case law may be found in legal encyclopedias, textbooks, treatises, case digests, Internet sites, and computer data banks. All law books are based on principles developed and enunciated in the cases. Indeed, the cases themselves follow, distinguish, and discuss other cases, all of which are meticulously referenced and cited. Finally, most law books include comprehensive tables of contents and indices.

Restatements of Law do not bind the courts, but serve as guidance to which the courts often give great weight. Restatements contain general points of law, accumulated by legal scholars; these points “restate” the case law generally found in the United States. The Restatements typically delineate trends in the common law, and they also occasionally put forth what scholars and practitioners believe is the “best” law (the optimal approach to an area where the law is unclear or the courts disagree). Although courts do not have to follow an approach adopted in a Restatement, many often do.


Which category of law applies to the following six examples?

• A prominent athlete is accused of rape. The accuser goes to the local prosecutor, who begins formal proceedings against the athlete. CRIMINAL (not civil).

• Ultimately, charges against the athlete are dismissed. However, his accuser wants to sue him for battery. CIVIL (not criminal).

• Esmeralda enters into a contract with her neighbor, Neddie, to clean Neddie’s garage for $50. Esmeralda cleans the garage, but Neddie refuses to pay. Esmeralda sues Neddie for breach of contract. PRIVATE (not public).

• A defendant’s attorney files a pleading asking the court to dismiss the complaint against her client because the client was not served with process (given the proper notice). PROCEDURAL LAW (not substantive).

• The Uniform Commercial Code §2-201 details, for the sale of goods, a statute of frauds provision (requiring a writing for the sale of goods costing more than $500). STATUTORY LAW (not case law).

• A lawyer cites MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005), a U.S. Supreme Court decision concerning online file sharing, as a controlling precedent showing how strong copyright is to be protected, even on the Internet. CASE LAW (not statutory law).

Note: One category may not exclude another category. For example, most lawsuits, such as that brought by Esmerelda, above, involve not just civil law but also private law, moreover, the law a court applies for its decision will likely have both substantive and procedural aspects.



  1. In what major way does the common law differ from the Civil Law?

  2. Why should a definition of law emphasize enforcement?

  3. When we say that law “improved” or “progressed” from Hammurabi to Napoleon, what is meant by “improved” or “progressed”?

  4. Are there any circumstances under which society could exist without law?

  5. If the law requires that a person take some action (salute the flag, report or spy on an unpopular minority group or person) he/she considers immoral, should the person obey the law? Give other examples of such a conflict.

  6. Why is it difficult to make law “uniform” by enacting uniform statutes?

  7. Which is more important, procedural law or substantive law?

  8. Why is it likely that the common law system will produce a greater number of lawyers than the Civil Law system?

  9. Is it easier to know your “rights” in a Civil Law country or in a common law country?

  10. Which of the following may waive the attorney/client privilege: (a) the attorney; (b) the client; (c) a third party; (d) a judge?

  11. Name at least four general, ethical duties of an attorney.


attorney/client privilege

attorney’s fees

case law

Civil Law


common law



lex talionis


procedural law

Restatements of Law


stare decisis


substantive law

Uniform Commercial Code

Work-product doctrine


  1. If you were a citizen in the following societies at the times indicated, how would you conduct yourself in regard to a conflict between personal morality and the law?

(a) Nazi Germany in 1937.

(b) Boston, Massachusetts, at the time of the Boston Tea Party (1773).

(c) A slave owner in a Southern state in 1850.

  1. The right of appeal to a higher court usually expires 30 days after a decision is rendered in a trial court. Suppose that your lawyer forgets to “note” your appeal within that period of time, although you have instructed her to do so. Under the law, you lose your right to appeal under these circumstances. Do you agree with the law?

  2. Under what circumstances would an American court consider the Justinian code in deciding a case?

  3. Bernhard Goetz shot and wounded four young men who apparently were attempting to rob him in a New York subway in 1984. He had been robbed before under similar circumstances. Discuss the morality and legality of Goetz’s conduct.

  4. In what sense is the “constitution” of England a “creature” of the common law?



  1. The common law emphasizes precedent; Civil Law emphasizes the wording of the applicable code. Common law codes are collections of statutes and do not try to set out the entire law on a particular subject.

  2. If law is not enforced, it has no effect on society—it is ignored, a “dead letter” without meaning. If government passes many laws but does not attempt to police them, the citizenry loses its respect for government and law, and society is greatly weakened.

  3. “Improvement” and “progress” are relative terms and must be evaluated in accordance with principles or criteria. If our evaluations are based on democracy or self-determination, then clearly there has been “improvement” and “progress.” If, however, the criterion is order or governmental control, Justinian’s code may have been the best of the codes.

  4. To the extent that society necessarily involves several persons or millions of persons, it is hard to imagine common existence without enforced rules. Insofar as individuals are “self-enlightened” or “self-controlled,” friction may be minimized, but will not be eliminated.

  5. When the law conflicts with personal morality, the individual has a hard choice. When a person has strong feelings about the moral principle involved and enforcement of the conflicting law is weak, the individual may (at his/her peril) choose to ignore the law. However, there are many variations in regard to these conflicting forces, and no simple rule can be stated. Be wary of unlawful conduct that implies a gain or profit from the act, even though disobedience to the law (draft evasion; nonpayment of unjust, oppressive taxes) may be stated in moral terms.

  6. Each of the 50 states is a “sovereign” state with the right to judge its own citizens and to define and carry out its own laws, subject, of course, to constitutional limitations. Also, even when uniform laws are uniformly enacted, judges may interpret them differently.

  7. Substance is probably more important, but incorrect or improper procedures can deprive the individual of his/her substantive rights and remedies. Procedural law is (or should be) more flexible, but this flexibility is not without limits.

  8. The fact that there are many precedents in the common law system, and hence, much scope for argument and disagreement, encourages litigation, which produces a need for lawyers.

  9. The Civil Law, written in more comprehensive detail, may seem more definitive as to “rights.” However, a clear code may not lead to strong, understandable rights in actual practice. A society’s willingness to sustain rights as well as the actual trial of cases involving rights both may be more uncertain in Civil Law countries.

  10. (a) No; (b) Yes; (c) No—if a communication was made in the presence of a third party, then no confidentiality existed and no privilege ever arose in the first place; (d) No (a very rare exception might be an emergency in which a lawyer’s client posed immediate danger of inflicting deadly force on others and the lawyer’s revelation of confidential information could be narrowly tailored to the prevention of such harm, not building a case against the client).

  11. An attorney should: handle cases competently, zealously advocate the client’s cause, remain true to his/her duties as an officer of the court, keep the client reasonably informed, abide by the strictures of attorney/client privilege, and try to protect a client from problems caused by the attorney’s withdrawal from a case.


  1. For the individual, the three situations presented involve moral conflicts between society and law, and many answers are possible. In your answer, consider the morality of (a) acquiescence, (b) feigned or actual ignorance of the law, (c) patriotic activity that is unlawful, (d) the “right” to rebel against unjust government (note the Declaration of Independence), and (e) profit making in an immoral but “legal” situation.

  2. The loss of the right to appeal after passage of a specified time is fairly rigid. The reason is that cases must end; it is unfair to the winning side to leave appeals open and unresolved. This is one of many examples of procedure superseding substance.

  3. If there are no modern American or English precedents for a specific case, our courts can, and sometimes do, consider Justinian’s code. Some areas of the common law, such as the law of negotiable instruments, are derived from Roman law.

  4. This classic case of “taking the law into one’s own hands” was the subject of much discussion. As noted in this chapter, if Goetz acted in a way that seemed to him “moral” or “right,” this may be considered in assessing his punishment, but guilt of the crime is still a fact. Even if society is failing in its duty to protect its citizens, a return to the lex talionis does not seem to be a workable solution.

  5. The “constitution” of England is unwritten and is largely based on precedent; hence it is a true creation of the common law. Several documents, such as the Magna Carta and the English Bill of Rights, are incorporated into the precedent.

1 At the criminal level, constitutional protections are in place for people facing criminal charges and possible incarceration but unable to pay for defense counsel; these people are entitled to a public defender. Gideon v. Wainwright, 372 U.S. 335 (1963) (interpreting the U.S. Constitution’s Sixth Amendment).




constitution a nation’s or state’s supreme set of laws, outlining the basic organization, powers, and responsibilities of the government and guaranteeing certain specified rights to the people

statute a law passed by the U.S. Congress or a state legislature

ordinance a law passed by a governmental body below the state level and dealing with a local concern

rule a regulation issued by a federal state, or local administrative agency (or court) and governing procedure or conduct in a specific field


There are eight important sources of law in the United States:

  1. The U.S. Constitution.

  2. Federal statutes, executive orders, and treaties (including customs, conventions, and international law).

  3. The 50 state constitutions.

  4. State statutes and executive orders.

  5. Local ordinances.

  6. The rules and rulings of federal, state, and local agencies.

  7. Decisions by federal and state courts.

  8. Private laws and custom (e.g., contracts, leases, internal company “rules,” and business traditions as practiced in an industry).

The first six sources are roughly in the order of importance. Agency and court actions, however, are found throughout the hierarchy, from interpretations of constitutions to statutes to rules and regulations, and from federal to state to local laws.


The U.S. Constitution (also known as “the federal constitution”) outlines the organization, powers, responsibilities, and limits of the federal government. Federal and state judges are bound by the U.S. Constitution; any law that violates the Constitution is null and void.

The supremacy clause—in the second sentence of Article VI of the U.S. Constitution—states that the federal constitution, laws made in pursuit of the Constitution, and treaties are “the supreme law of the land.” If the federal government has the right to regulate in a particular subject area (e.g., interstate commerce), then its laws in that area may expressly or implicitly cover the subject so completely that the states are barred from making their own laws on the subject. That effect is termed preemption.


The U.S. Constitution sets forth a division of powers among the three major branches of government: legislative, executive, and judicial. Each branch of government has a major area of responsibility:

• Congress (the federal legislature) makes the laws. A bill may be introduced in either the Senate or the House of Representatives, where it is referred to the appropriate committee. After consideration and sometimes public hearings, the committee returns the bill with pro and con recommendations. The bill is then debated on the floor, often amended, and brought to a vote. A bill passed by both houses goes to a conference committee of the Senate and the House of Representatives to resolve any differences. If both houses approve the compromise bill, it is then sent to the President. If he signs it, the bill becomes a law. A bill vetoed by the President may become a law if repassed by a two-thirds vote of both houses.

• The President (the chief executive) enforces the laws. The modern President has broad powers in both domestic and foreign affairs. Domestically, he may sign or veto bills, issue pardons for federal crimes, and remove executive officials (e.g., cabinet officers) without legislative or judicial approval. Subject to the majority consent of the Senate, he makes appointments to the executive branch, to ambassadorships, to federal regulatory commissions, and to federal judgeships.

In foreign relations, the President may recognize or withdraw recognition of foreign governments, enter into executive agreements with other nations without obtaining congressional approval, make treaties with the approval of two thirds of the Senators voting, and—as commander-in-chief—oversee military affairs.

• The courts (judiciary) pass on the constitutionality of laws enacted by Congress or a state legislature. They also interpret the law, using as guidelines:

(a) the “plain meaning rule,” that is, the obvious or customary meaning of the words in a law;

(b) the legislative history of the bill, that is, the purpose for which it was enacted.

Finally, the courts make law in the sense that, under the principle of stare decisis, judicial decisions in cases for which no legal precedent exists become binding, or at least serve as precedent, when similar cases arise.

In a very important U.S. Supreme Court case, Marbury v. Madison, 5 U.S. 137 (1803), Chief Justice John Marshall announced the doctrine of judicial review: the courts can declare federal or state actions to be in violation of the Constitution (unconstitutional). Although state courts may base decisions upon the U.S. Constitution, when opinions conflict, it is the federal judiciary, led by the Supreme Court, whose interpretations control.

Of course, there are many more limits and areas of overlapping powers. Some are not part of the constitutional, statutory, or common law framework, but are nevertheless universally recognized. For example, Senators from the President’s party have long held a de facto power to veto the confirmation of executive appointments to federal positions within their home states. As another example, courts traditionally refuse to decide cases that they believe present predominantly political questions (such as foreign policy). This is a form of self-limitation.

Rather than simply declaring a statute unconstitutional, the judiciary is to construe a statute narrowly enough so as to render it constitutional, if that is possible. In fact, if there is an adequate and independent basis in state law for a decision, the federal courts are not to reverse the state court holding even if the constitutional issues were decided erroneously.

In conclusion, courts are to presume that governmental action is constitutional. Courts are not even supposed to consider constitutional issues if the facts of the case can support alternative grounds for disposition.

U.S. constitutional rights do not protect American citizens if they are subject to legal action in another nation. Similarly, U.S. constitutional rights generally do not cover noncitizens who are outside the United States. For example, in United States v. Verdugo-Urquidez, 495 U.S. 259 (1990), the Supreme Court held that the Constitution’s Fourth Amendment does not apply to American agents’ search and seizure of property owned by a non-U.S. citizen and located outside the United States. The Constitution should protect people in the United States against arbitrary governmental action; it typically does not restrain the federal government’s actions against aliens outside U.S. territory.


Fearing the accumulation of excessive power in any one person or group, the Founding Fathers established a system of checks and balances. Overlapping powers impinge upon each area. The President can veto bills passed by Congress and is responsible for selecting federal judges. Congress may override the President’s veto, it may conduct hearings and compel the attendance of witnesses from the executive branch, and the Senate may refuse to confirm the President’s nominees for federal judgeships or for certain high-level positions in the executive branch. The judiciary may limit or invalidate laws or other actions by Congress or the President. In turn, Congress may limit the scope of judicial review or increase the number of federal judges, including the number on the U.S. Supreme Court.

As with all other civil officers of the United States (including federal judges), the President may be impeached by a majority vote of the House of Representatives and removed from office via conviction by a two-thirds vote of the Senate. Grounds for such impeachment are “Treason, Bribery, or other high Crimes and Misdemeanors.”

Each state government also has three branches, with powers and checks and balances similar to those found at the federal level.

International Comparison: In parliamentary forms of government, the legislature tends to predominate. The executive and his cabinet are usually members of the legislature, and the courts’ power to strike down parliamentary actions (exercise judicial review) is generally nonexistent or highly limited. In short, there are fewer checks and balances (hence, more concentrations of power) in the Parliament itself. (Among the relatively few countries with strong courts exercising judicial review are Australia, Canada, Germany, India, Israel, the Philippines, South Africa, and the United States.)


The U.S. Constitution is the supreme law of the land. There are three branches of government: the legislative, executive, and judiciary. Each has certain powers, and there is a system of checks and balances among the three branches.

Judicial review permits courts to declare governmental actions unconstitutional. Courts may avoid deciding issues in a case (particularly constitutional issues) because of a policy of judicial self-restraint.


Congress has only such legislative powers as are granted to it by the U.S. Constitution, either expressly (enumerated powers) or implicitly; other powers (reserved powers) are granted to the states.


Article I, Section 8, of the U.S. Constitution expressly authorizes a number of Congressional legislative powers, including to tax, to coin money, to establish roads and post offices, to control immigration and naturalization, to regulate foreign and interstate commerce, to govern bankruptcy proceedings, and to provide for the nation’s defense and general welfare. Section 8 also states that Congress may make laws “necessary and proper” for carrying out any of the government’s enumerated powers under the Constitution. The implied powers under this necessary and proper clause have been interpreted to include any law not prohibited by or violative of the letter and spirit of the Constitution, so long as the law advances a legislative goal within the scope of the Constitution.

Such a broad reading of the “necessary and proper” clause first occurred in McCulloch v. Maryland, 17 U.S. 316 (1819), a key decision written by the great Chief Justice John Marshall. In McCulloch, the U.S. Supreme Court held that Congress had the power to incorporate the Bank of the United States; although such an incorporation is not an enumerated power under the Constitution, it is, the Court found, appropriate to Congressional exercise of its enumerated fiscal powers.

Since the 1930s, the implied powers have been interpreted as permitting all kinds of federal powers.


Congress has passed statutes that bar discrimination, regulate even small businesses, or are otherwise directed toward local commercial activities. In almost all cases, courts have refused to probe Congressional motives and have upheld the legislation under the affectation doctrine: as long as the activity sought to be regulated affects interstate commerce, it is within Congressional regulatory authority.

The term “affects” has been quite broadly interpreted. For example, the Supreme Court has upheld (1) a federal ban on racial discrimination even in a small restaurant whose out-of-state purchases and customers were minimal (Katzenbach v. McClung, 379 U.S. 294 (1964)); and (2) federal regulation of wheat production even when a particular crop was not placed in interstate commerce. (In the latter case, Wickard v. Filburn, 317 U.S. 111 (1942), the Court found that, in effect, this crop freed another crop to be used in interstate commerce.)

States’ Rights

However, for the first time in 60 years, the U.S. Supreme Court in U.S. v. Lopez, 514 U.S. 549 (1995), declared a federal law unconstitutional on the grounds that the law exceeded Congressional powers over commerce. The decision voided the 1990 Gun-Free School Zones Act, a statute prohibiting the possession of a gun within 1,000 feet of a school. The legislation failed to include findings showing a link between education, safety, and the economy. Lopez signals that, at the very least, Congress needs to articulate clearly how a bill touches upon matters of interstate commerce. Even then, its regulation may fail, as the high court has since ruled several times. In U.S. v. Morrison, 529 U.S. 598 (2000), for example, the Supreme Court ruled 5-4 that Congress lacked authority under the Constitution’s Commerce Clause to enact civil remedies in the 1994 Violence Against Women Act because “gender-motivated crimes of violence are not, in any sense of the phrase, economic activity.” Rejecting the notion that Congress can regulate any crime as long as it has substantial effects on employment, production, transit, or consumption, the Court spoke of the need to maintain the Constitution’s “carefully crafted balance of power between states and the national government.” (Along these lines, the Constitution’s 11th Amendment bars citizens of one state from suing another state in federal court. Moreover, in a series of rulings since 1999 upholding states’ rights, the Supreme Court has also held that Congress cannot give state workers the power to sue their state employer for some types of employment discrimination (e.g., based on age or disability), nor can Congress extend to citizens the power to sue states for alleged fraud, patent infringement, or overtime violations.)


Courts generally uphold any taxing measure, even one that serves to regulate an activity, so long as the measure purports to be and is, in fact, revenue-producing. For example, the Supreme Court, in National Federation of Independent Business v. Sebelius (2012), rejected a constitutional challenge to the 2010 Patient Protection and Affordable Care Act (ACA, often called Obamacare). The 5–4 decision to uphold the ACA was not made on the grounds of Congress’ power to regulate interstate commerce, but rather on the grounds that the ACA’s individual penalties could be deemed a tax (thus, within Congressional authority). If, however, the measure is intended to punish rather than to raise money, it is likely to be judged an invalid penalty rather than a valid tax.

Example: Invalidating a Tax Law Passed for the Wrong Purpose

A statute placing a substantial tax on employers using child labor was found to be an invalid penalty because it applied only to employers who knowingly hired under-age children. (A valid tax would have applied to all employers of children rather than just the intentional wrongdoers whom Congress wished to punish.)


With its power to levy taxes for the general welfare, Congress has the implicit right to spend money for any general welfare purpose. In implementing this spending power, Congress may impose reasonable conditions on state and local governments, corporations, and individuals; failure to meet such conditions precludes participation in that spending program. Hence Congress can often induce compliance with a regulatory scheme by using a “carrot and stick” tandem: revenue-sharing and eligibility requirements.

While the U.S. Constitution’s Tenth Amendment reserves to the states or the people all powers not delegated to the federal government, this amendment has not barred the use of national regulation ancillary to (meaning, “that comes along with”) valid spending or taxing measures.


Two fundamental rights in the U.S. Constitution are found in the Fourteenth Amendment: due process and equal protection. The amendment not only restricts governmental acts (“state action”) infringing these rights, but also expressly authorizes Congressional legislation to enforce its provisions. Such authorization has been broadly interpreted to permit any legislation Congress rationally concludes is appropriate for enforcing the amendment. Probably the most important “enforcement” role, though, has been played by the courts. U.S. Supreme Court decisions have served to “incorporate” almost all of the fundamental rights in the Bill of Rights (U.S. Constitution, First through Tenth Amendments) into the due process clause of the Fourteenth Amendment, thus making these rights applicable to the states as well as the federal government.

Bill of Rights Provisions

Amendment 1

Establishment Clause—freedom from governmental establishment of religion

Free Exercise Clause—freedom to exercise one’s religious beliefs

Freedom of Speech and

Freedom of the Press

Right to Assemble and Petition the government

Amendment 2

Well-regulated militia and right to bear arms

Amendment 3

Restrictions on quartering soldiers

Amendment 4

Warrants requirements

No unreasonable searches and seizures

Amendment 5

Grand jury indictment or presentment needed for a federal capital or infamous crime

No compulsory self-incrimination

No double jeopardy

Due process must be provided before taking life, liberty, or property

Eminent domain—compensation for taking private property

Amendment 6

For criminal cases, the right to counsel, to a speedy and public trial, to confront witnesses, and to a jury trial

Amendment 7

Right to a jury trial in civil, common law cases

Amendment 8

No excessive bail or fines

No cruel and unusual punishment

Amendment 9

Rights of the people not limited to those stated in the Constitution

Amendment 10

Powers the Constitution does not delegate to the national government are reserved to the people and the states

The due process provision, and its case-law progeny, protect persons from being “deprived of life, liberty, or property, without due process of law” and outline the steps that must be followed to ensure a “fundamentally fair” process. Under the equal protection provision no person may be denied “the equal protection of the laws”; “equal protection” does not prohibit all differences in the treatment of persons but rather requires that, at the very least, any distinctions be reasonable, not arbitrary or invidious. Corporations, as well as individuals, are covered under the due process and equal protection provisions. Moreover, via the Fifth Amendment’s “due process” provision, the federal government also must not violate due process or equal protection.

Due Process and Equal Protection

Due process requires procedural protections: a fundamentally fair process including notice, a hearing, an unbiased factfinder, presentation of evidence and cross-examination, and appeals. Due process also encompasses fundamental substantive rights, including, but certainly not limited to, some of the “incorporated” Bill of Rights provisions. From roughly the 1880s to the 1930s, courts used “substantive due process” to invalidate numerous state and federal laws regulating commercial, industrial, and labor conditions. This approach, in business or economic areas, has been replaced by a much more relaxed standard: As long as the government (state or federal) does not violate some other provision of the Constitution, it is free to regulate economic activity in any manner it so chooses.

For most cases involving regulation of business and for other “ordinary” cases, equal protection simply requires that differential treatment be reasonable and related to a legitimate, governmental purpose (the “rational basis” test). For cases involving “suspect” classes (particularly racial, religious, or nationality minorities) or fundamental rights (voting, marriage, privacy, interstate movement, access to the courts), equal protection is violated unless the differential treatment is as narrow as possible and is necessary to achieve a compelling governmental interest (the “strict scrutiny” test).

In cases involving sex, geography, age, or illegitimacy classifications, the class is not “suspect,” but courts often require more than a mere rational basis for differential treatment. Although a “compelling” governmental interest (the “strict scrutiny” test) is unnecessary, the differential treatment must be substantially related to achieving an important governmental goal. This “intermediate scrutiny” test is perhaps most difficult for predicting court outcomes, whereas the other two tests lean heavily toward one party or the other: (1) strict scrutiny leaves governmental action highly vulnerable to a finding of unconstitutionality; and (2) rational basis is highly deferential to (prone to support the constitutionality of) governmental action.

Some important U.S. Constitutional rights for businesses, as well as individuals, are these:

  1. Due process. For example, in State Farm Mutual Automobile Insurance Co. v. Campbell, 538 U.S. 408 (2003), plaintiffs had won a case against their auto liability insurer for bad-faith failure to settle a claim. The Supreme Court ruled that, inasmuch as due process prohibits grossly excessive or arbitrary punishment on a tortfeasor (someone who commits a tort) and that it is rarely constitutional for a punitive damages award to be ten times or more higher than the compensatory damages award, a punitive damages award of $145 million on a $1 million compensatory judgment violated due process, as it was neither reasonable nor proportionate. However, the law remains murky. More recent court decisions, including those of the Supreme Court, indicate that the State Farm standard is hard to apply and that, in practice, judgments far above the ten-to-one, punitive damages to compensatory damages ratio may often be upheld on appeal.

  2. Equal protection. Three famous equal protection cases are Brown v. Board of Education, 347 U.S. 483 (1954) (outlawing state-mandated racially segregated public schools); Baker v. Carr, 369 U.S. 186 (1962) (holding that legislative districts should be of equal size so that each person’s vote is of equal value); and Bush v. Gore, 531 U.S. 98 (2000) (in the disputed 2000 presidential election, ruling that the Florida Supreme Court’s order favoring manual vote recounts, without specific standards to discern a voter’s intent, failed to satisfy the Equal Protection Clause’s requirement of nonarbitrary treatment of voters.)

  3. Freedom of expression (First Amendment). Commercial speech (e.g., advertising) is not as well protected as political speech. However, governments may not prohibit commercial speech that accurately presents information unless there is a substantial state interest in doing so and the governmental prohibition is as narrowly drawn as possible, i.e., the least burdensome method of accomplishing the state’s interest. (Also, courts have upheld restrictions on speech deemed obscene, defamatory, posing a “clear and present danger” to public safety, or going beyond speech into unprotected conduct.)

There are four key factors that courts consider when assessing the harm that the government seeks to prevent when it suppresses expression: (1) the speaker’s state of mind, (2) the likelihood that harm will result, (3) the nature of the harm, and (4) the gravity of the harm. The Supreme Court increasingly has turned to an empirical, fact-based assessment of these four factors.

For speech as expressed through political campaign expenditures independent of the candidates themselves, the Supreme Court held, 5–4, in Citizens United v. Federal Election Commission, 558 U.S. ___ (2010), for federal laws and 5–4 in American Tradition Partnership, Inc. v. Bullock, 567 U.S. ___ (2012), for state and local laws. The Court wrote that “independent expenditures, including those made by corporations, do not give rise to corruption or the appearance of corruption”; therefore, “[n]o sufficient governmental interest justifies limits on the political speech of non-political or for-profit corporations.”

Employees who set up blogs or otherwise communicate via Internet websites have a direct method of communicating with the public about their employer; customers, competitors, and others can easily find these communications. The employees may wrongly use trademarked or copyrighted materials, post information about yet-to-be-released products, or defame someone (e.g., a coworker). Many companies have instituted policies to protect the business, such as requiring these employees to disclaim any company involvement, to not engage in harassing, libelous, or otherwise tortious posts, and to not disclose any proprietary information or violate anyone’s privacy. That employers can require the employees to agree to these and other policies, can use the violation of these policies as grounds for an employee’s dismissal, and can monitor the employee’s Internet activities is not a free speech issue, ordinarily, in that the First Amendment protections are from governmental restrictions, not those by private organizations.

  1. Protection from laws impairing contractual obligations (Article I, Section 10).

  2. Compensation for the public taking of private property—eminent domain (Fifth Amendment). The Supreme Court has held that when a regulation (a) denies the property owner of all “economically viable use of his land” (Lucas v. South Carolina Coastal Council, 505 U.S. 1003 (1992)), or (b) requires a property owner to dedicate for public use a disproportionate share of his land considering the probable impact of land developments the owner is permitted to make (Dolan v. City of Tigard, 512 U.S. 374 (1994)), fair compensation must be paid. However, in Tahoe-Sierra Preservation Council v. Tahoe Regional Planning Agency, 535 U.S. 302 (2002), the Supreme Court ruled that a government-imposed moratorium on property development, even one that lasts for years, does not automatically amount to a taking of private property for which taxpayers must compensate the landowners.

As for a governmental purpose permitting eminent domain, the Supreme Court in Kelo v. City of New London, 545 U.S. 469 (2005), held that the U.S. Constitution lets local governments seize (and, of course, pay for) people’s homes or businesses to use that seized property for tax-producing projects such as shopping malls. In response, though, almost all states enacted laws denying themselves, or their local governments, the right to follow the broad Kelo interpretation: These states forbid the use of eminent domain to transfer land from one private party to another private party for economic development purposes.

  1. Protection against some state regulations, including taxes, that discriminate against interstate commerce in favor of local businesses.

A few constitutional provisions that apply to individuals, such as the Fourteenth Amendment’s privileges and immunities clause and the Fifth Amendment’s protection against self-incrimination, do not extend to business entities.


Legislative power must be expressly or implicitly delegated to Congress by the U.S. Constitution, or else it belongs solely to the states.

Many such Congressional powers are stated in Article I, Section 8, of the Constitution, including three whose expansive interpretation has permitted national regulation of numerous activities. These three powers are (1) to regulate interstate commerce, (2) to tax, and (3) to provide (spend) for the general welfare.

The Fourteenth Amendment authorizes Congress to pass any legislation necessary to enforce the due process and equal protection provisions of the amendment.


Each of the 50 states has a constitution that establishes the general organization, powers, responsibilities, and limits of the state’s government. The state constitution is the supreme law of the state, but it cannot contain any provision that violates a provision of the U.S. Constitution. Under this system of governance, federalism, the state governments have their own spheres of power and do not look to the federal government as the source of their authority.


  1. Argentina, Australia, Austria, Belgium, Bosnia, Brazil, Canada, Ethiopia, Germany, India, Iraq, Malaysia, Mexico, Nepal, Nigeria, Pakistan, Russia, South Africa, Spain, Switzerland, Tanzania, the United Arab Emirates, and Venezuela each have—at least to a certain extent—a federal system like that of the United States (spheres of power for both the national government and the states/provinces). These and a few other federal nations, although still a minority of the world’s total, are growing in number and represent about 40% of the world’s population. The powers of the states or provinces vary from one federal system to another, but in all such systems, the national government—while typically superior to the states in core areas such as foreign relations and territorial integrity (e.g., no secession)—is not absolute, and power must be shared with the state/provincial sovereigns. Because the division of powers between the two levels of government is embodied within the national constitution and is formally guaranteed, any significant change must be mutually agreed upon (as constitutional amendments require the consent of both levels).

  2. Bangladesh, Bulgaria, Colombia, Chile, China, Egypt, France, Indonesia, Iran, Japan, the Netherlands, Norway, the Philippines, Poland, Romania, Sweden, Thailand, Turkey, Vietnam, and a very large majority of countries have a unitary form of government. Unlike a federal system, the unitary system is centralized, with only one true zone of power—the national government. There may be some powers granted to local authorities, but these regional officials serve in that role only because the national, unitary government permits them to do so; whenever it wants, the national government may eliminate or reconfigure regional governments in any way it desires because governments below the national level exist only as a matter of administrative efficiency or convenience in implementing national programs.

  3. In a confederacy, the member-states are, ultimately, supreme. A province within a nation—or, in a multinational arrangement such as the European Union, the national membership—has the greater powers, whether directly stated or not, such as to secede from (leave) the larger governing structure. Some prominent past confederacies have included the early United States under the Articles of Confederation (1781–89) and the Confederate States of America (1861–65), or, more recently, Senegambia (1982–89) and Serbia-Montenegro (2003–06). Also, there are current supranational organizations, such as the European Union (EU), with confederacy characteristics. In the EU, for example, the national members have ceded to it some powers, but these members retain so much control over foreign policy, national defense, and other aspects of sovereignty that the entity is not a federal system. Confederation thus may be a step between federalism and independent statehood as a federal system disintegrates (e.g., the former Soviet Union, Czechoslovakia, and Yugoslavia); or confederation can be a step in the opposite direction, as independent nations move toward federalism.


State statutes constitute another important source of U.S. law. Just as some legislative powers are exclusively federal, others (reserved powers) remain exclusively or primarily within the domain of the states—for instance, divorce law and the common law of torts and contracts.

Examples of Regulatory Responsibilities

Federal Regulatory Power:

Overlapping Power:

State Regulatory Power:


Foreign trade




Environmental law


Consumer protection




Corporations Property

A third class of powers is shared by the state and federal governments. Sometimes the absence of Congressional action in regard to a shared power permits the states to act, even though Congress could preempt (bar) state action. (Preemption can be express, or it can arise implicitly from a Congressional legislative scheme intended to have uniform, national application.) Regulation of commerce tends to be such a shared power.

So long as a nonpreempted state regulation: (a) does not directly regulate interstate commerce, (b) concerns essentially local matters, (c) does not discriminate against out-of-state commerce, and (d) is the least burdensome method for achieving legitimate state objectives, it will usually be permitted if the state interest in maintaining the regulation outweighs any burdens imposed on interstate commerce. The courts ultimately make this determination.

Exception: Courts sometimes hold that even without federal regulations, the commerce clause bars certain state legislation because an area requires national uniformity or is otherwise unsuited to state action. However, just as Congress may preempt state actions, so it may overturn these “negative implications” of the commerce clause and allow state regulation.


In determining the validity of a state law involving a shared power, the court must first determine (1) whether the state law conflicts with a federal law, that is, whether a person obeying the state law would violate a federal law, and (2) whether Congress intended to preempt state legislation in that area. If the answer to either question is “yes,” the state law is void.


In addition to rights discussed previously, two other fundamental rights stated in the U.S. Constitution apply to the states as well as the national government. These rights, specifically set forth in Article I, Sections 9 and 10, are individual freedom from (1) ex post facto laws (laws making criminal past actions that were not defined as criminal when they occurred), and (2) bills of attainder (laws intended to single out an individual and/or punish him/her without benefit of a trial).


Major legislative powers are divided between the state and federal governments. They are exclusively federal, exclusively or primarily state, or shared. Congress may preempt some areas that would otherwise be shared with the states.

The power to regulate commerce is an important example of a shared power, although certain areas are barred from state regulation.

Neither Congress nor the state legislatures may pass an ex post facto law or a bill of attainder.


An ordinance is an enactment by a legislative body below the state level (a city council, a county legislature, a town board, etc.). Ordinances deal with local concerns such as zoning, on-street parking, area speed zones, and littering, and are designed to promote the safety and general welfare of the community to which they apply.


Legislation or case law cannot cover every actual or potential problem that arises in a dynamic, increasingly complex society facing numerous social, economic, and technological issues. Also, legislatures or courts cannot develop or retain the expertise to handle all specialties. Therefore administrative agencies have been created by legislative acts known as enabling acts, whereby the government—federal, state, or local—delegates some of its authority to the agency.

A typical enabling act sets forth the objectives and standards by which an agency is to administer the law in a particular field. The agency then develops technical expertise in order to fill legislative gaps with detailed rules and to render sound decisions in individual cases.

Agencies can monitor regulated industries continuously, whether or not there have been violations. While still bound by constitutional protections (e.g., due process), agencies can proceed more quickly and informally than ordinary judicial processes entail.

The courts have usually upheld even very broad delegations of authority. However, Congress may not completely abdicate its legislative responsibilities; before delegating authority to an agency, Congress must first determine the basic legislative policy and state some standards for the agency to follow. The standards may simply be to do what is just, reasonable, fair and/or equitable.

Most important federal agencies have a mixture of legislative, judicial, and executive powers. (Administrative agency judicial proceedings are discussed in Chapter 3.) Agencies perform some or all of seven functions, with certain functions being more important in some agencies than in others: (1) advising, (2) reviewing, (3) supervising, (4) rule making, (5) investigating, (6) prosecuting, (7) adjudicating. Enforcement powers may include fines, prohibitions, restrictions on or revocation of licenses, and the threat of public exposure.

Some agencies are directly under the supervision of one of the three branches of government, usually the executive. However, a large number are independent agencies, and their legislative hearings and the rules they make are generally free from outside control. Examples of independent federal agencies include the Federal Communications Commission, Federal Reserve Board, Federal Trade Commission, International Trade Commission, National Labor Relations Board, and Securities and Exchange Commission.

The federal Government in the Sunshine Act (1976) requires that most agencies have open public meetings with agendas published in advance. Meetings concerning national defense, trade secrets, foreign policy, law enforcement, or personnel matters need not be public. All federal rules can be viewed in the U.S. Code of Federal Regulations (the CFR).

The Freedom of Information Act (FOIA) requires federal agencies to disclose information that the agencies have in their possession. A citizen’s proper, narrowly worded request for information may not be refused. However, while Congress cannot be denied information, there are ten areas in which agencies are exempt from FOIA requirements (i.e., do not have to turn over information to private parties): (1) national defense, (2) foreign policy, (3) trade secrets or other commercial or financial information that was obtained from an outside source and should be deemed privileged or confidential, (4) bank examiners’ reports and other material in the reports of agencies responsible for regulating financial institutions, (5) geological or geophysical data (including maps) concerning wells, (6) personnel, medical, and similar files whose disclosure would clearly be an unwarranted invasion of personal privacy, (7) investigatory records compiled for law enforcement purposes, (8) interagency or intra-agency memoranda or letters, (9) an agency’s internal personnel rules and practices, (10) subjects on which another federal statute specifically allows the agency to keep information secret.

The actions of an administrative agency must conform with:

(a) constitutional law,

(b) relevant general acts governing administrative procedure (e.g., the federal Administrative Procedure Act),

(c) requirements in the agency’s own enabling act, and

(d) rules of the agency itself.

When exercising its legislative (rule-making) powers, the typical agency does not need to hold a hearing. However, the agency’s own rules, or general statutes such as the federal Administrative Procedure Act, may require that the agency give notice of a proposed rule (e.g., through publication of the proposed rule in the Federal Register) and afford interested parties the opportunity to submit written or oral comments. The federal Negotiated Rulemaking Act (1990) is intended to foster cooperative rulemaking—rules negotiated between agencies and affected parties. Also, the Regulatory Flexibility Act of 1980 (RFA), as strengthened via several amendments (e.g., the Small Business Regulatory Enforcement Fairness Act of 1996), requires agencies to consider their proposed regulations’ impact on small entities, to analyze alternatives that minimize such impacts, and to make these analyses available and subject to public comment. The covered “small entities” are small businesses, nonprofit enterprises, and governments for municipalities or for school or other special districts for a population of under 50,000. Nearly every state has enacted a similar law meant to make regulations proportionate to the size of affected entities.

Courts have the power to review rules promulgated by regulatory agencies in much the same way as they are empowered to review legislative enactments. However, with respect to areas in which an agency presumably has expertise, its decisions (executive, legislative, or judicial) generally are overturned only if found to be clearly erroneous, arbitrary, based on bias, or exceeding the agency’s authority.


Certain legislative, judicial, and/or executive powers have been delegated to federal, state, and local administrative agencies. Many agencies are not directly supervised by the legislature or executive; they are independent agencies.

An administrative agency may have to give interested parties both notice and an opportunity to comment before making a rule or regulation.


In the United States, as in England, decisions handed down by federal and state courts, that is, case law, constitute a primary source of the common law. New cases requiring the interpretation of statutes arise continually. When no precedent can be found, the judge’s decision will produce a new legal principle.

A case may originate in either a federal or a state court, depending on the nature of the suit.

Under Article III of the U.S. Constitution, the federal courts’ power is limited to actual “cases or controversies.” This provision has prevented federal courts from furnishing advisory opinions, even if requested by another branch of government. (Many state courts can and do issue advisory opinions.) The case must be a real dispute between opposing parties with actual interests in the case (standing to sue, because of direct and immediate injury from, or other such connection with, the matter at issue). The proceeding must be in an adversarial format. Federal district courts have original jurisdiction (meaning that proceedings commence there) over federal criminal cases and certain specified civil cases.

The U.S. Supreme Court has original jurisdiction when the parties include ambassadors or other foreign officials, or when two states are the opposing parties. However, almost all of the cases heard by the Supreme Court arise out of its appellate jurisdiction: the power to hear appeals from other courts’ decisions. Appeals generally involve interpretation of constitutional law and/or federal statutes.

The various types of courts and the cases they handle are discussed more fully in Chapter 3.


Decisions by state and federal courts are a primary source of U.S. common law.

To originate in a federal court, a case must involve a real dispute between opposing parties.

The U.S. Supreme Court has original jurisdiction over certain cases, but its main function is to review lower court decisions that have been appealed.



  1. For each of the three branches of the federal government, describe the system of checks and balances on the powers of the other branches.

  2. Name three Congressional powers specifically enumerated in the U.S. Constitution.

  3. By what constitutional provision does Congress have the implied powers to take legislative action not specifically mentioned in the U.S. Constitution?

  4. State the general test for determining whether a tax is constitutional.

  5. How does Congress use its power to spend as a method for national regulation?

  6. What two types of bills may neither Congress nor a state legislature pass?

  7. Name the seven general functions that may be performed by an administrative agency.

  8. State the two major standards for review in equal protection cases, including the type of cases that fall under each standard.

  9. Name three independent federal agencies.

  10. Over what types of cases does the U.S. Supreme Court have original jurisdiction?

  11. Name two fundamental rights set forth in the Fourteenth Amendment to the U.S. Constitution.


affectation doctrine

appellate jurisdiction

bill of attainder

Bill of Rights

checks and balances

commercial speech



delegated authority

due process

eminent domain

enabling act

equal protection

ex post facto law


judicial review

“necessary and proper” clause


original jurisdiction



states’ rights


“supremacy” clause

unitary system


  1. Commerce-in-Claus is an interstate shipper of Santa Claus outfits. A neighboring state has passed a law raising fees on its toll roads for all trucks with out-of-state registration, but no one else. Is this constitutional? Discuss. What bearing does Santa Claus have on your answer?

  2. Suppose that a dissatisfied customer brings his complaint against XYZ, Inc., to the state legislature, which passes a law making illegal XYZ’s sales arrangement with the customer. Effective 30 days after the law’s enactment, XYZ’s sales license is to be suspended for 3 months. What should XYZ do? What arguments should XYZ make?

  3. Congress has enacted a broad statutory scheme covering most aspects of labor/management relations. Fearing that unionization would increase operational costs for the town’s private employers, Poor Town’s board of commissioners wants to keep a national union from organizing any of the workers. What legislation may the commissioners enact?

  4. A state statute prohibits businesses from contributing to election campaigns. This statute is challenged in court by a group of law students. What will be the outcome?

  5. In Problem 4, on what grounds should the law be challenged?

  6. Scott Sneaky wants the state legislature to pass a law that would provide his business with a series of windfall profits. A friend has persuaded him to go to a state administrative agency to obtain a rule that would serve essentially the same purpose and, Scott hopes, would avoid the publicity that would probably kill the chance for a new law in his favor. Assuming that there are no constitutional problems with Scott’s plan, will it succeed?



  1. Executive: veto legislation, appoint federal judges.

Legislative: override veto, compel executive official’s attendance at hearings, refuse to confirm appointments, limit scope of judicial review, increase the number of federal judges, impeach executive or judicial officials.

Judiciary: limit or invalidate laws or executive actions.

  1. To regulate foreign and interstate commerce, to tax, and to provide for the nation’s defense and general welfare.

  2. The “necessary and proper” clause of Article I, Section 8.

  3. A tax may serve to regulate an activity. However, the more a tax acts as a punishment rather than as a source of revenue, the more likely it is to be judged an invalid penalty.

  4. By placing conditions (compliance with a regulatory framework) upon participation in a federal program. Without compliance, the would-be participant—be it a state or local government, a corporation, or an individual—cannot receive the federal money.

  5. An ex post facto law and a bill of attainder.

  6. Advising, reviewing, supervising, rule making, investigating, prosecuting, and adjudicating.

  7. “Strict scrutiny” (differential treatment constitutional only if (1) drawn as narrowly as possible, and (2) necessary to achieve a compelling governmental interest): cases involving adverse impact on racial, religious, and nationality minorities.

“Rational basis” (differential treatment constitutional when reasonable and related to a permissible governmental goal): cases involving business regulation or “nonsuspect” classes.

A third, intermediate standard for review is sometimes used for differential treatment based upon sex or illegitimacy. There, the differential treatment must be substantially related to achieving an important governmental goal.

  1. Federal Communications Commission, Federal Trade Commission, National Labor Relations Board.

  2. Cases involving ambassadors or other foreign officials and cases in which two states are adversaries.

  3. Due process and equal protection.


  1. No. The state’s action violates the commerce clause by purposely imposing a greater burden on interstate commerce than on local interests. Moreover, Congress may have preempted such state legislation.

The state’s action also appears to violate the Fourteenth Amendment’s guarantee of equal protection. The court may not believe that the state had a reasonable justification (rational basis) for the law.

Re: Santa Claus

A claim based on religious freedom, or one asking for the equal protection clause’s “strict scrutiny” test because there is a suspect class (religion), would probably fail. Regardless of whether the Santa Claus aspect of the company gives it a religious affiliation, the legislation does not discriminate based on religion; the basis of the discrimination is whether or not a vehicle is an out-of-state truck.

  1. Challenge the law in the courts. It seems to be both an ex post facto law and a bill of attainder, which are prohibited by Article I, Sections 9 and 10, of the Constitution.

  2. None. The commissioners must follow the federal law. Inasmuch as the subject of unionizing has been preempted, no state, let alone a local government, can pass laws in this area (e.g., an ordinance prohibiting or limiting union activities).

  3. The law students will be dismissed as plaintiffs. They are not members of the class affected by the statute (businesses), and therefore do not have standing to sue. The businesses themselves should be able to have the same statute declared an unconstitutional infringement of their right to free speech.

  4. Violation of equal protection: the law treats businesses, including individuals and corporations, differently from other persons, and this differential treatment is neither reasonable nor related to a permissible, governmental purpose.

Violation of due process: The Fourteenth Amendment’s due process clause incorporates the First Amendment of the Bill of Rights, and thus protects persons from a state’s infringement of their right to free speech. In First National Bank of Boston v. Bellotti, 435 U.S. 765 (1978), the Supreme Court held unconstitutional a Massachusetts statute that prohibited most corporate spending on political referendum proposals.

  1. It is difficult to say. The agency rule-making process may indeed be less publicized, and thus Scott may be able to get a new rule promulgated. However, either of two factors may keep Scott from succeeding: (1) since this is an area apparently still open to the state’s customary legislative oversight, it may not have been delegated to the agency in the enabling act; (2) the rulemaking process usually requires notice to the public and an opportunity for comment. Thus publicity and/or opposition is, in fact, possible.




jurisdiction the power to hear and decide the issues in a case (subject-matter jurisdiction) and to bind the parties (personal jurisdiction)

pleadings the papers filed in court, with copies to other parties concerned, in preparation for bringing or defending a lawsuit before the court

discovery pretrial procedures by which the parties to a lawsuit obtain information from other parties and from potential witnesses

trial the proceedings before a competent tribunal in which a civil or criminal case is heard and adjudicated

Most of this book focuses on substantive law, such as contracts, business associations, and commercial paper. This chapter, though, concerns the places and methods for resolving disputes and applying the substantive law to individual cases.


There are two main court systems in the United States, the federal and the various state systems.


The hierarchical structure of federal courts is comparable to that of the various state court systems. Therefore, by way of example, we will look at the federal court system.

At the bottom rung are 94 U.S. district courts, with 677 judges altogether. These are trial courts. In each state there is at least one federal district court. Each district court may include any number of judges, one of whom will hear a particular case.

If a party wishes to appeal the district court’s judgment, he/she brings the case before the appeals court, the circuit court, for that district. Besides the U.S. Court of Appeals for the Federal Circuit, a specialized court based in Washington, D.C. for specific subject matter such as patents, trade, and government contracts, there are 12 geographic circuits. Altogether, there are 179 circuit judges, 12 of whom serve on the federal circuit. These are the geographic circuits, their principal court locations, and the states or territories from which federal district court appeals are heard:

First Circuit—Boston; Maine, Massachusetts, New Hampshire, Rhode Island, and also Puerto Rico

Second Circuit—New York City; Connecticut, New York, and Vermont

Third Circuit—Philadelphia; Delaware, New Jersey, Pennsylvania, and also the Virgin Islands

Fourth Circuit—Richmond; Maryland, North Carolina, South Carolina, Virginia, and West Virginia

Fifth Circuit—New Orleans; Louisiana, Mississippi, and Texas

Sixth Circuit—Cincinnati; Kentucky, Michigan, Ohio, and Tennessee

Seventh Circuit—Chicago; Illinois, Indiana, and Wisconsin

Eighth Circuit—St. Louis; Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota

Ninth Circuit—San Francisco; Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, Washington, and also Guam and Northern Mariana Islands

Tenth Circuit—Denver; Colorado, Kansas, New Mexico, Oklahoma, Utah, and Wyoming

Eleventh Circuit—Atlanta; Alabama, Florida, and Georgia.

D.C. Circuit—Washington, D.C. (Because of its heavy volume of work, for example, in administrative law, the District of Columbia—with just one district trial court [for Washington, D.C., of course]—has its own circuit.)

Lastly, appeals from circuit court decisions (or from holdings of the highest court of the state) may be heard by the U.S. Supreme Court. In a few cases, a party has an absolute right of appeal. Supreme Court review by appeal is a matter of right when:

(1) a state court declares a treaty or federal statute invalid or holds that a state law does not violate a treaty, the U.S. Constitution, or federal statutes; or

(2) a federal court

(a) decides that a state law violates federal law; or

(b) if the federal government or its employees are parties, rules that a Congressional statute is unconstitutional.

In most cases, however, it is within the sole discretion of the Supreme Court whether to hear an appeal. Usually the case must involve a federal question (e.g., about the U.S. Constitution and/or a federal statute). Only if four of the nine Justices agree to it is a writ of certiorari granted so that a discretionary appeal is heard by the U.S. Supreme Court. Instead, although the Supreme Court issues about 75 to 100 opinions annually, it refuses to hear an appeal (states “cert. denied”) for some 7,000 to 8,000 petitions each year.

Federal judges—appointed for life (at age 70, a judge may go on “inactive status” at full pay).

State judges—usually for a set, renewable term and with a mandatory retirement age; sometimes appointed but usually elected; some elections are “contested” elections (between different candidates); some elections are “retention” elections (voters vote “yes” or “no” on whether to retain a judge); sometimes a mixed approach—first appointed, then subject to retention elections.

Of course, there are other types of courts. For instance, many federal and state administrative agencies have their own judicial systems. There are specialized courts (e.g., federal bankruptcy courts), and states generally have special courts (ones without juries) for cases involving small amounts or special litigants, such as orphans or landlords and tenants. However, the general trial courts, with juries available, remain the crucial arena for most important cases.

The following diagrams show the structures of the federal court system and a typical state system.


As discussed in Chapter 2, the national and state governments have different, but sometimes overlapping, spheres of power. This holds true also for their court systems. The power of a court system to hear and decide a case is called its jurisdiction.


Subject-matter jurisdiction:

judicial power to decide the issues in a case.

Business Law, 6th edition (Business Review Series) (3)

Business Law, 6th edition (Business Review Series) (4)

The federal courts are limited to hearing cases specifically placed within their power (subject-matter jurisdiction) by the U.S. Constitution or other laws. Numerous federal statutes, as well as certain exclusively federal areas under the Constitution (e.g., admiralty, bankruptcy, patents, copyrights), give the federal courts a vast array of subjects to decide: these areas are called federal questions (cases involving the federal constitution, statutes, or treaties). While sometimes federal court jurisdiction is exclusive (e.g., prosecution of persons charged with violating federal criminal laws), in some areas jurisdiction is concurrent, that is, state courts can also hear cases on these subjects.

In addition to federal questions, Congress has provided another form of subject-matter jurisdiction to the federal courts: diversity jurisdiction. This means that, when the opposing parties in a civil lawsuit are citizens of different states, a matter based on state law (and normally brought before a state court) can be heard in federal court if one of the parties requests it and if the amount in controversy is above $75,000. (Corporations are treated as being “citizens” of both their place of incorporation and their principal business location. Under Hertz Corp. v. Friend, 559 U.S. 77 (2010), that place is defined as the state where the corporation’s headquarters is located.) For partnerships (including general partnerships, limited partnerships, and limited liability partnerships), as well as limited liability companies and unincorporated associations, however, courts look to the citizenship of each general partner; so those entities are citizens of every state in which partners/members are citizens.

Diversity must be complete; that is, in cases involving multiple parties not even one party may have the same state citizenship as an opposing party. (It does not matter if parties on the same side, for example, two plaintiffs, come from the same state.) Except when the U.S. Constitution or federal statutes apply, the federal courts deciding a diversity case must apply state substantive law—both the state’s statutes and its common law. That is the approach mandated by the U.S. Supreme Court’s landmark decision in Erie Railroad Co. v. Tomkins, 304 U.S. 64 (1938). Federal courts, however, follow federal procedural law, even in diversity cases.

If a defendant wishes to transfer a case from one state to another, or from state court to federal court, his/her request will be for removal. Such requests must be made at the beginning of the case and are premised on the claim that the correct jurisdiction lies in another court. In seeking a transfer from state to federal court, the defendant is often simply exercising a right to invoke diversity jurisdiction, or some other concurrent federal jurisdiction, which the plaintiff failed to use but the defendant also has a right to choose.

As for the state courts, they are generally open to hear any type of case unless it is precluded by the U.S. Constitution or federal statutes or treaties. Most common law areas—for instance, torts, contracts, crimes—tend to be brought before state courts.


In addition to subject-matter jurisdiction, for each particular case a court needs jurisdiction over the litigants themselves.

Personal (in personam ) jurisdiction:

judicial power over the parties in a case.

By filing a lawsuit the plaintiff voluntarily submits to the court’s personal jurisdiction. Personal jurisdiction over the defendant depends on: (1) his/her being properly served with the complaint and summons; and (2) his/her having sufficient ties to the state in which the lawsuit was filed. Obviously, if the defendant resides or works in the state (or a business is incorporated or has an office in the state), personal jurisdiction is well founded. Also, states have passed “long-arm statutes,” which extend personal jurisdiction over people or corporations that do business in the state, own real property there, or (in cases involving a tort or contract) committed the alleged tort in the state or entered the contract in the state.

There are many other grounds for “long-arm” personal jurisdiction. For each case, the key constitutional question is whether the defendant has had enough “minimal contacts” within the state so that requiring him/her to defend the lawsuit in that state does not violate due process of law (Fifth and/or Fourteenth Amendments) by offending “traditional notions of fair play and substantial justice” [International Shoe Co. v. Washington, 326 U.S. 310, 316 (1945).] Any presence in a state, other than a passive Internet site accessible there,1 may leave a firm subject to personal jurisdiction.

But the possibility of personal jurisdiction often depends upon whether it is specific or general. Specific personal jurisdiction arises from the defendant’s contacts with the state where the case has been filed (the forum) and how the case relates to issues (e.g., an accident, a contract) arising from those contacts. As stated in International Shoe, 326 U.S. at 318, general personal jurisdiction occurs when “continuous corporate operations within a state [are] so substantial and of such a nature as to justify suit against [the defendant] on causes of action arising from dealings entirely distinct from those activities.” In other words, an out-of-state corporation’s “affiliations with the State [must be] so ‘continuous and systematic’ as to render [it] essentially at home in the foreign state” (and thus it is fair to subject it to a lawsuit having nothing specifically to do with the corporation’s in-state conduct). Goodyear Dunlop Tires Operations, S.A. v. Brown, 564 U.S. __ (2011).

As a further refinement of personal jurisdiction concepts, the Supreme Court’s decision in Daimler AG v. Bauman, 571 U.S. __ (2013), rejects the notion that it reaches a corporate defendant whenever a party related to that corporation performed a function, in the forum state, “important” to the corporation. Such logic would mean that anything a corporation does through an agent, distributor, independent contractor, subsidiary, or other relations could subject the corporation to general jurisdiction—a “sprawling view of general jurisdiction.” The Daimler holding’s main effect is to maintain the distinction between specific and general personal jurisdiction first established in International Shoe.

A defendant who does not challenge the court’s personal jurisdiction over him/her is deemed to have consented to that court’s determination of his/her rights and obligations. However, the defense, that subject matter jurisdiction is lacking, cannot be waived.



When a court has authority over the subject matter and parties of a lawsuit, it has jurisdiction. However, there still may be problems with venue, that is, the place (usually the county) where the case will be tried.

Generally, a lawsuit is to be brought in the judicial district where the parties work or reside, where the disputed interest in land is located, or where the occurrence leading to the lawsuit took place. Proper venue is defined by statute, and is usually based on the notion of convenience to the parties, especially the defendant. If there is to be a change in venue, it usually must be requested at the outset of the case. In rare instances, pretrial publicity or other factors may force a change of venue later in the case.


Obviously, the law varies from state to state. The doctrine of stare decisis (see Chapter 1) does not require one state to follow another state’s precedents.

What makes matters even more confusing is that disputes often arise out of transactions occurring in more than one state. Which state’s substantive laws are to govern the resolution of such a dispute? This question is covered by a body of law known as conflict of laws (or choice of laws).

Although a court will almost always apply its own procedural law (rules about form of pleadings, discovery, and the like), it must look to conflict-of-laws principles to choose between differing substantive laws (e.g., on contracts, torts, agency). The forum jurisdiction (where the dispute is being tried) determines that most basic question: whether something is a matter of procedure or of substance. The following matters usually are classified as procedural (hence, governed by the trial court’s rules) when a conflict of laws occurs: (1) whether a claim is actionable (ripe; a legally sound claim in front of the appropriate court); (2) identity of the proper parties able to sue or to defend a suit; (3) admissibility of evidence; (4) relative priority of protected interests; (5)set-off claims and rights; (6) the nature and extent of remedies; (7) methods of enforcing a judgment; and (8) the right to appeal.

Example: Conflict of Laws

A Colorado court is deciding a case involving a contract executed in New York, performed in Missouri, and involving Delaware corporations with principal offices in Colorado. So long as the lawsuit remains before a Colorado court, it will be governed by Colorado rules of procedure. However, interpretation of the contract may be based on the law of another state, such as New York or Missouri.

For torts, the applicable law is usually the law of the state where the injury occurred.

For contracts, the courts usually look to the law intended by the parties. A court ordinarily honors an express stipulation in a contract that the contract is to be governed by a particular state’s laws. Even if no such express statement is made, courts will often look to the parties’ implied intentions. At that point, though, the courts may turn to an earlier approach (still followed in some states) governing conflicts of law in contract cases: use of the law where the contract was made or performed. (In very complex tort or contract cases, some courts seek to determine, and then apply, the law of the state with the most significant ties to the parties and the matter in dispute.)

Usually the parties’ choice-of-law provision controls. But there are some exceptions to the idea that a contract’s “choice of law” provision governs. Sometimes a court finds that its state’s laws overcome a choice-of-law clause favoring the law of another state. A survey of decisions indicates that courts have found the following laws embody public policies that warrant overriding the contractual choice-of-law clause: (1) prohibitions of covenants not to compete; (2) unconscionability doctrines; (3) fair dealership laws; (4) boxing licensing schemes; (5) state bankruptcy laws; (6) contractor licensing schemes; (7) statutes of frauds; (8) usury statutes; and (9) insurance laws barring suicide exception clauses.

In criminal cases, conflicts of law simply do not arise. Courts apply their own substantive as well as procedural laws, even for acts committed elsewhere. Of course, if another jurisdiction’s interests are paramount (i.e., because the crime took place on its soil), then the alleged criminal can be extradited (sent, via a legal process, to the other jurisdiction). Thus the accused is almost always tried in the place where the crime supposedly occurred.

Extradition (to send the accused to the jurisdiction in which the crime was committed) is usually an easy formality between states within the United States; but extradition can be difficult between foreign countries, depending on:

  1. treaty obligations (or lack thereof),

  2. the status of the accused (e.g., diplomatic immunity, or powerful business interests),

  3. the two nations’ substantive law and culture concerning the alleged crime(s), and

  4. the similarities and differences between the two nations’ criminal law procedures—e.g., what sort of trial; what rights to have counsel, subpoenaing of witnesses, and cross-examination; what sorts of presumptions for or against the defendant; what range and likelihood of punishment; and what type of decision-maker—e.g., an independent judge, a jury, a bureaucrat, or a “political flunky.”


Article IV, Section I, of the U.S. Constitution states, “full faith and credit shall be given in each State to the public acts, records and judicial proceedings of every other State.” This “full faith and credit” clause does not mean that other states must adopt the reasoning on which a decision was based; one state’s precedents are not binding on another state. It simply means that other states must recognize the validity of a civil or criminal judgment as it specifically affects the rights and duties of the parties subject to that judgment (i.e., involved as parties in the original case), provided, however, that the original court had personal and subject-matter jurisdiction.


Although there are many types of courts, the main state and federal judicial systems involve general, trial courts, with appeals taken to one or more higher courts.

Federal courts have particularized subject-matter jurisdiction, usually based on “federal questions” or diversity jurisdiction.

State courts have general subject-matter jurisdiction.

Personal (in personam) jurisdiction requires that the defendant reside or work in the state in which the lawsuit was filed, or have other clear-cut ties to the state. Long-arm statutes grant courts power over out-of-state individuals and corporations in certain specified circumstances.

Courts follow their own procedural law. However, in some cases, they may apply the substantive law of another state.

For torts, the applicable law is usually that where the injury occurred.

For contracts, courts generally look to the law intended (expressly or implicitly) by the parties to the contract.

In criminal cases, courts apply their own substantive and procedural laws, regardless of where the acts were committed; however, almost all criminal prosecutions take place in the same state where the alleged crime occurred.

Once a court with jurisdiction renders a judgment, the U.S. Constitution’s “full faith and credit” clause requires that, as between the parties to the lawsuit, the judgment must be honored by other states’ courts.


Assume that Paul Plaintiff decides to sue Doris Defendant for breach of contract. Paul must file his lawsuit in an appropriate court and thereafter, since this is a civil case, meet the procedural rules governing civil litigation.

Procedural law is very complex and varies from court to court. There are federal rules of procedure, and each state court system also has its own set of procedures. Appellate courts have different rules from trial courts, and even the same type of courts, in the same jurisdiction (e.g., the same state), may have different local rules for each court. Moreover, criminal and civil cases follow different rules.

Nevertheless, it is also fair to say that, despite the differences, most cases follow a general pattern of procedure. In our case (Paul Plaintiff v. Doris Defendant), we will follow the general procedural pattern usually found in any American court of law. (For all cases, settlement can come at any point in the process.)


The person who initiates a lawsuit is called the plaintiff. The person sued is the defendant. In equity cases (see Chapter 1), these parties are instead often called the petitioner and the respondent, respectively. In a criminal case, there is no “plaintiff”; rather, the criminal defendant is opposed by the state itself, often called “the prosecution” or even “the people.” (Criminal cases are brought on behalf of the public as a whole.)


The papers required to bring the issues in a lawsuit before the court are termed the pleadings. Paul’s lawsuit (action) against Doris starts when he or his lawyer files a complaint (sometimes called a declaration, petition, or bill of complaint) with the clerk of a trial court having proper jurisdiction and venue. The complaint should include a statement of facts, the basis of the suit (in this case, alleged breach of contract), and a request for one or more remedies (e.g., damages or an injunction). Often a complaint must also include information showing that the court has jurisdiction and venue. Paul’s complaint might be as follows:

Business Law, 6th edition (Business Review Series) (5)


The plaintiff, Paul Plaintiff, by his attorney, Lucretia Lawyer, sues the defendant, Doris Defendant, and says:

  1. Paul Plaintiff (hereinafter, “Plaintiff”) and Doris Defendant (hereinafter, “Defendant”) are both residents of the State of Bliss. This action concerns a contract entered into in Bliss between Plaintiff and Defendant. The amount due and owing to Plaintiff by Defendant is more than $10,000.00.

  2. Based on the facts stated in paragraph 1, jurisdiction over this subject matter and over the person of Defendant is found upon Bliss Code, Courts Article, Sections 21 and 22.

  3. Defendant resides in Anytown, Our County, State of Bliss. Venue is thus founded upon Bliss Code, Courts Article, Section 31.

  4. At various times in or around August, September, and October, 2015, Plaintiff, at the request of Defendant, delivered certain XYZ computers and ABC software programs to Defendant. The price agreed upon by Defendant was $29,000.00, and Defendant has made only one payment of $2,000.00.

  5. Payment was to be made within thirty (30) days of delivery. Despite Plaintiff’s repeated demands for payment, Defendant has refused and continues to refuse to pay the remaining amount owed.

WHEREFORE, Plaintiff demands judgment against Defendant for damages in the sum of Twenty-Seven Thousand Dollars ($27,000.00), plus prejudgment interest, costs of suit, attorney’s fees, and such other relief as the Court deems just and equitable.


Lucretia Lawyer

Attorney for Paul Plaintiff

100 Lawyers Lane

Big City, Bliss

The sheriff or other such official then serves a summons and a copy of the complaint on Doris Defendant. Alternative methods of “service of process” include using a private process server or sending the summons and complaint by certified mail (receipt returned to sender); in either case, an affidavit is usually filed attesting to the fact that the defendant received the summons and complaint. In a case involving land or certain corporate defendants, service may be made by publishing notices in a newspaper or elsewhere and/or serving the summons and complaint upon an authorized state official, such as the state secretary of state or other registrar of corporations. There are many other variations on these procedures, which differ from state to state. Electronic service of process (e-service) and, even more so once the case has been filed, electronic filing of pleadings (e-filing) increasingly are used.

International Law: The Hague Service Convention (1965) established procedures for serving process in another country, whether by using

  1. a central governing authority in that other country;

  2. diplomatic channels; or

  3. any other method of service permitted by the laws of that other country (even just via mail, although some nations have chosen not to permit that type of service).

The Convention’s signatories encompass about 70 countries, including every European nation other than Austria and a few microstates (e.g., Andorra). Of the top twenty trading or producing nations worldwide, only three—Brazil, Indonesia, and Saudi Arabia—are not signatories.

The Convention’s language indicates that its purpose is to give notice to a party, not grant jurisdiction. In fact, the Convention provides no basis for personal jurisdiction, which must first be established through a long-arm statute or other domestic law. Thus, the Convention does not replace, but instead supplements, the domestic law requirements for jurisdiction.

Direct mail, fax, or Internet transmissions are typical methods for filing and exchanging documents once the lawsuit has been answered, but—at the initial stage—service of process usually requires more, such as use of a government agency and providing the defendant with a translated copy of the complaint and the summons.

The summons notifies Doris Defendant that she must file her answer to the complaint with both the court and the plaintiff’s attorney within a certain time period (usually 20 or 30 days, though often longer for out-of-state defendants). The summons also tells the defendant that failure to file an answer will lead to a judgment by default for the plaintiff.

An answer, though, is not Doris Defendant’s only choice. She may file a motion to dismiss, sometimes called a demurrer, in which she contends that, even if the complaint’s allegations are true, there is no legal basis for finding the defendant liable.

Major Reasons Why Dismissals May Be Granted

  1. The court lacks subject-matter jurisdiction.

  2. The time period to sue (statute of limitations) has expired.

  3. The allegations do not set forth a breach of contract, tort, or whatever else could lead to a judgment for the plaintiff.

In most jurisdictions, as in Doris’s case, a motion to dismiss may be raised in lieu of an answer. Only if the court rules that part or all of the complaint remains viable, must the answer be filed.

The answer generally admits or denies each of the various allegations set forth in the complaint. It also may include affirmative defenses, that is, allegations of facts that, if proved by the defendant, defeat the plaintiff’s claim.

Since the court does not uphold Doris’s motion to dismiss, she files the following answer:

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Doris Defendant, by her attorneys, Atilla Attorney and Dewey, Cheatham & Howe, answers Paul Plaintiff’s Complaint, and says:

  1. Defendant admits the allegations in the first sentence of paragraph one of the Complaint, and denies the allegations in the second and third sentences.

  2. Paragraph two of the Complaint is a legal conclusion rather than a factual allegation, and thus Defendant need not admit or deny said paragraph.

  3. Defendant admits the allegations in the first sentence of paragraph three of the Complaint. Defendant need not admit or deny the second sentence, which is a legal conclusion.

  4. Defendant acknowledges that, after she paid plaintiff $2,000.00, some computers and software were delivered to defendant by plaintiff on one occasion in or around September 2015. In all other respects, defendant denies the allegations stated in paragraph four of the Complaint.

  5. Defendant admits that she has refused and continues to refuse to pay additional money to plaintiff. Defendant denies all other allegations in paragraph five of the Complaint, including any inference that defendant owes money to plaintiff.

Affirmative Defenses

  1. There was no contract between the parties.

  2. In the alternative, the contract was not as alleged by plaintiff.

  3. Plaintiff failed to deliver goods promised.

  4. Plaintiff delivered defective goods.

  5. The court lacks jurisdiction over the subject matter.


Atilla Attorney

Dewey, Cheatham & Howe

5 Esquire Court

Big City, Bliss

(Generally, a complaint or answer may be amended unless a statute or rule specifically bars such amendment or unless the amendment is made at such a late date that its acceptance as a new pleading would be grossly unfair to another party.)

When answering the complaint, or shortly thereafter, a defendant generally has the option to file a counterclaim, which is, in effect, a “reverse” complaint: one by the defendant against the plaintiff. Two other claims are cross claims, brought by a plaintiff against one or more coplaintiffs or, more likely, by a defendant against one or more codefendants, and third-party claims, whereby a defendant brings a new party into a lawsuit. In addition, large numbers of similarly situated plaintiffs may join together in a class action.


Class actions are lawsuits in which a few persons represent a group of similarly situated persons, perhaps huge in number (the “class”). Lawyers usually gather the representatives and file an action either in the federal courts under Federal Rule of Civil Procedure 23 or in a state court where the procedural rules are similar. Class action status is only to be granted if the plaintiffs are similarly situated, and thus having one large case is a fair and efficient use of court resources. For the court to grant the required class certification, the plaintiffs must show, under Rule 23(a): (1) claimants too large in number for affected persons joining together as plaintiffs in a single, traditional lawsuit (numerosity); (2) questions of law or fact common to the class (commonality); (3) representatives fairly and adequately protecting the class’ interests (adequacy); and (4) claims and defenses typical for the class (typicality).

Assuming the four elements of commonality, adequacy, numerosity, and typicality2 are present, then under Rule 23(b), a class action can proceed if:

(1) individual lawsuits, rather than a class action, would create a risk of inconsistent decisions (e.g., requiring the employer to treat an employee in a way that might undermine the employer’s ability to treat other employees equally) or would impair the interests of other class members (e.g., in cases with large potential damage awards and limited funds for payment, the first to collect damage awards may end up with the lion’s share of the total payout); or

(2) the defendant’s actions or inaction were on grounds applicable to the whole class, thereby making an injunction or other declaration of relief appropriate for the entire class; or

(3) questions of law or fact common to the class members predominate, with a class action superior to all alternatives for dealing with the issues in the case.

Most class actions fall under this last category of “predominance” and “superiority,” and it is only this form of class membership that is not mandatory. For this last category, notice must be given to potential class members, who can opt out of the class—thereby preserving their right to sue individually and waiving any right to whatever recovery the class members may receive.

In a case alleging sex discrimination against female employees, Wal-Mart Stores, Inc. v. Dukes, 564 U.S. ___ (2011), the U.S. Supreme Court overturned certification for a class of present and former Wal-Mart workers from more than 3,400 stores in a multitude of varying jobs and time periods involving thousands of different supervisors. There was, the court held, little evidence of commonality in terms of the plaintiffs’ circumstances or a corporate-wide practice—only that supervisors at each store had their own discretion concerning employment decisions. Furthermore, the court held that the Wal-Mart employees’ claims for back pay should have been interpreted as the type of claim requiring predominant, common questions of law or fact (not simply relief that might come with an injunction under Rule 23(b)(2)). So, even assuming the case could have proceeded as a class action, it should have featured notice to class members along with their ability to opt out.

The Class Action Fairness Act of 2005 (CAFA) shifts most large class-action lawsuits involving parties from different states to federal courts, removing them from the jurisdiction of state courts that historically have been more receptive to such suits. Under CAFA, class-action suits seeking more than $5 million are in federal court if fewer than a third of the plaintiffs are from the same state as the primary defendant. If the primary defendant and more than a third of the plaintiffs are from the same state, the case can still be heard in state court. CAFA also may limit the fees of class-action lawyers in that their fees from settlements must be based on rewards plaintiffs actually received (e.g., coupons redeemed), not just those issued.

Class Actions in Europe

Some countries, such as Australia, China, India, Israel, Japan, and South Africa, have followed America’s lead and now permit class actions. However, a class action or something akin thereto is a foreign concept in many nations, including much of Europe. For example, while the United Kingdom and Sweden generally allow class actions, in France and Spain class actions tend to be limited to consumer rights cases.

Without calling it a class action, many countries (e.g., Germany, the Netherlands) let settlements in some cases, such as shareholder suits against corporations, have the same effect as class action compromises. A representative case binds all plaintiffs, so that individual plaintiffs share the costs of litigation, allow one case to proceed to a resolution, and agree to have all interested parties bound to the result of that one case.

In our hypothetical case, Doris Defendant might file a counterclaim against Paul Plaintiff for return of the $2,000.00 already paid. The grounds for such a counterclaim would probably be the same as the third and fourth affirmative defenses raised in the answer: plaintiff breached the contract by failing to deliver goods and/or by delivering defective goods.

Besides the motion to dismiss, many other types of motions, that is, requests to the court, may be made before the case goes to trial. Such motions may ask for rulings on evidence, or may seek orders compelling a party or witness to provide discovery (see the next section). In fact, each party is generally free to make any motion that he/she wishes.

The most important motion is probably the motion for summary judgment, which is based on the pleadings, discovery, disclosure materials on file, and any affidavits. This motion may be filed at any time, by either party.

In the federal courts, there is a little more leeway for the court to reduce caseloads by entering a summary judgment than is the case in state courts. The U.S. Supreme Court has elaborated on the summary judgment standard found in Federal Rule of Civil Procedure 56(c)(2) by noting that summary judgment must be granted if there can be only one reasonable conclusion as to the verdict. So, for example, an opposing party cannot simply deny the facts or assert uncorroborated inadmissible hearsay statements. That is because, before a judge denies a properly asserted, factually and legally supported, summary judgment motion, the judge must find sufficient evidence that a jury could reasonably rely upon in reaching a verdict for the party opposing summary judgment.

Summary judgment is to be awarded if the judge decides that

(1) there is no genuine issue as to material (potentially determinative) facts, and

(2) when the law is applied to these facts, one party is entitled to a verdict in his/her favor.

Summary judgment may be granted on all or part of a lawsuit. For instance, if a complaint sets forth different theories of liability (e.g., negligence and breach of warranty), the defendant may be able to get one of them stricken, even if the judge will not grant summary judgment on all counts. The summary judgment process may also be used to limit or eliminate certain types of damages, such as punitive damages. Of course, plaintiffs may also gain a partial summary judgment.

The party seeking to avoid trial (summary judgment), to take a case away from the jury (directed verdict), or to overturn a jury verdict (J.N.O.V.) must meet the same high standards.

The “Virtual” Courtroom of the Internet

The cybercourtroom increasingly found in state and federal courts includes teleconferences from scattered locations, Internet court filings, computer-simulated exhibits and digital evidence, electronically stored documents, and transcripts stored on CD-ROM. More and more courts now accept electronic filing of lawsuits and paperless record keeping. Additionally, almost every court has a website where the public can look up real estate assessments, civil cases, deed information, judges’ opinions, and other matters.

Representing Oneself (Proceeding pro se)

A small but growing number of lawyers agree to let some clients do part of the work themselves. For example, a lawyer may let clients draft letters, conduct research, file certain documents with courts or government agencies, and deal with expert witnesses. A lawyer may limit his/her work to simply appearing in court, reviewing correspondence, helping out with the procedures for an appeal, or acting as a “court coach” for people who want to represent themselves in minor disputes: everything else is handled by the client. Problems include: (1) the lawyer still may be subject to malpractice claims, even for matters handled by the client on his own; and (2) judges may consider lawyer “ghost-writing” of court pleadings or other legal documents an unethical subterfuge (making it look like the party is pro se (acting on his/her own) when he/she actually is not). But some who have reviewed the process view the hiring of a legal “coach” as a welcome middle ground as opposed to going completely pro se.

Many state and local courts offer services to people who are proceeding pro se, or who otherwise are in search of some legal self-help (often especially related to family law).


Before there is a trial, each party is entitled to obtain information from other parties and from other potential witnesses. These pretrial procedures are known as discovery.

Ordinarily, the discovery process requires little, if any, direct judicial involvement. However, courts can order parties to comply with discovery requirements. If noncompliance continues, courts can issue an array of sanctions, including not just fines but—in extreme cases (e.g., a corporate defendant’s deliberate policy of withholding important evidence)—a default judgment for the other party.

The scope of discovery is far broader than what is permitted at trial. Going beyond what is usually allowed in the courtroom, discovery operates under rules that allow for more flexibility in questioning and in other requests for information: probing into all evidence that is admissible in court and all other information that could lead to admissible evidence.

Discovery may serve several purposes:

  1. By providing parties with access to evidence that might otherwise be hidden, it prevents surprises at the trial.

  2. It may narrow the issues at trial (i.e., some questions may be resolved).

  3. It preserves witnesses’ testimony prior to trial (important when witnesses may be unavailable at trial, their memories may fade, or their testimony may change).

  4. It may place the case in a posture suitable for summary judgment.

  5. It may lead to a pretrial settlement, as opposing parties come to see their strengths and weaknesses.

The main methods of discovery are depositions, interrogatories, requests for admissions, and the production of documents. Other methods include physical and mental examinations and, in cases involving land, inspections of premises.

A deposition is sworn testimony, by one of the parties or any other witness, usually recorded and transcribed by a notary public. The testimony is ordinarily taken in response to oral questions from the parties’ attorneys, although it also can be in response to written questions.

Under the federal rules, one side—no matter how many parties there are (whether co-plaintiffs or co-defendants) on that side—may call only 10 oral depositions. For more, or to depose someone a second time, one needs court permission.

“Apex” Corporate Officers

Most courts will accede to a corporation’s request that plaintiffs conduct less intrusive discovery—depose only high-level company officials—if (1) these “apex” officers have specific, direct knowledge of relevant facts, and (2) the subordinate company employees (who normally could be expected to answer questions at depositions and furnish documents if need be) actually are less informed about the particulars of the case. The apex corporate officials may be insulated from depositions when affidavits (prepared by corporate counsel and signed by these apex officers) contained express denials that these people had any “unique,” “superior,” or “personal” knowledge of relevant facts. Sometimes, a court may even require the use of interrogatories before permitting the scheduling of the deposition of an apex corporate employee (e.g., the CEO).

Interrogatories are written questions, to be answered in writing, and under oath, by another party (generally, the opposing party). Unlike depositions, interrogatories can be directed only toward the parties themselves. Their usefulness is further limited by the fact that the answering party’s attorney can, in effect, prepare the answers. However, interrogatories usually cost less (both in legal fees and other expenses such as transcripts) than depositions, and their scope can be broader.

Requests for admissions are, like interrogatories, made and answered in writing and can be directed only toward another party. The requesting party asks the other side to admit particular facts or acknowledge the genuineness of certain documents. Admissions are conclusive. Thus the requests, with the admissions they elicit, can save trial time because the parties have already agreed on some matters.

Finally, parties may be required to produce, for inspection and copying, all their documents that may be relevant to the case. Likewise, a deposition may include document production by the witness.


In electronic discovery (“e-discovery”), parties seek or provide information in electronic format (Electronically Stored Information—“ESI”). This data evidence could be text, images, databases, spreadsheets, websites, animation, audio files, instant messaging chats, calendar files, computer programs, and even malware (e.g., viruses, spyware, and Trojan horses). Probably the most frequent and valuable ESI is electronic mail (e-mail), as people are often less careful with this correspondence than with postal letters, memoranda, faxes, or other writings. Computer forensics (“cyberforensics”) is an investigation of a computer’s hard drive.

The Federal Rules of Civil Procedure (FRCP) address e-discovery and “legal hold.” Organizations must retain all paper and electronic records until each legal matter has been formally settled. The duty remains even if an organization only reasonably anticipates litigation. The FRCP explicitly names, among other things, e-mails and instant message (IM) chats as electronic records to be archived and produced when relevant. Systems must prevent changes to or deletions of original messages, with archived records kept in a form allowing efficient and timely production. The failure to meet ESI retention and management requirements puts parties at risk of claims for spoliation of evidence, summary judgment, adverse inferences about the missing evidence, and sanctions, including attorneys’ possible suspension or disbarment.


Federal Rule of Civil Procedure 37, as well as comparable rules in most states, permits judges to impose numerous sanctions for discovery abuses (e.g., for a party’s failing to provide documents or other information). Sanctions may include judicial orders (1) mandating that certain facts at issue are deemed conclusively established against the abusive party; (2) forbidding the abusive party from making or opposing certain claims or defenses; (3) prohibiting the abusive party from putting certain matters into evidence; (4) striking certain pleadings or parts of pleadings; (5) suspending all proceedings until a violation is rectified; (6) dismissing an abusive plaintiff’s action, or entering a default judgment against an abusive defendant; and (7) requiring the abusive party to pay the reasonable expenses, including attorneys’ fees, incurred by the other parties as a result of the discovery abuse. Other sanctions could be (1) a contempt of court finding, and (2) informing the jury of the abusive party’s violation.

Comparative Law on Discovery

Many other nations, particularly those with inquisitorial traditions (e.g., France, Germany), provide for little, if any, pretrial discovery by parties or their attorneys. (Any such discovery would be by the court itself.) Even countries such as the United Kingdom, with a legal system similar to the U.S. system, permit only limited discovery. Also, other countries often require a judge to be present at depositions, making the procedure more formal and controlled than it is in the United States, where only lawyers and witnesses are present.


Informal discovery techniques are distinct from “formal” discovery (e.g., depositions, interrogatories, requests for admissions or documents, e-discovery). Litigators also perform these informal tasks: (1) Internet searches concerning everyone pertinent to the case, such as all parties and witnesses; (2) reviewing credit, stock, or other reports (e.g., medical reports, with the patient’s permission), as well as all public filings (e.g., 10-K and 10-Q filings under the securities laws); (3) reading news articles and government records; and (4) interviewing third parties (e.g., neighbors, acquaintances, current and former co-workers or employers). Rules, if any, are scattered, and new developments—e.g., growing and changing social media—make informal, often Internet-related discovery likely to receive much future attention by courts and regulators. So far, for instance, other than some privacy norms and regulations, there are few well-established institutional rules governing social network sites.

There are some basic rubrics for informal discovery as to witnesses and Internet searches. Ex parte interviews with witnesses are largely unrestricted by the federal rules and in most state litigation. Typically, no party to litigation has a proprietary right to a witness’s evidence; unless a privilege (e.g., attorney-client) is affected, one side in litigation cannot restrict the other side’s access to a witness. Indeed, while the Federal Rules of Civil Procedure and many state rules provide specific means for parties to compel the taking of testimony or other evidence from recalcitrant sources, this does not preclude the use of informal discovery techniques such as interviews of a willing witness. That witness may demand compensation for his/her reasonable expenses (e.g., travel costs) as well as, for experts, their time.

As for Internet searches, collecting information from online sources such as social media websites may violate professional disciplinary standards. For example, bar standards may find an attempt to deceive, and thus grounds for disciplining (e.g., censuring or even disbarring), the lawyer who uses “friending” as an investigative tool—sending a Facebook friend request to a represented party. While lawyers representing a client in litigation can access the public pages of another party’s social networking website to obtain material to impeach that party, they are not permitted to access social networking websites under false pretenses, whether directly or through agents.


The trial issues can be narrowed via a pretrial conference. Except for some smaller cases, such conferences may be called by the parties or the court itself; they are routinely held in most federal civil cases. Although judges may use these conferences to encourage settlement, the main purpose is to ensure that the trial will proceed as smoothly as possible: witnesses, exhibits, areas of dispute, and agreed upon facts are all identified ahead of time.


Aside from any pretrial motions (discussed previously), the next step is the trial itself.

Jury trial is available in criminal cases and most civil lawsuits. Major exceptions:

  1. Certain types of cases (e.g., divorce) historically based on equity.

  2. Administrative agency proceedings.

Plaintiff or defendant can ask for trial by jury; this right is usually waived if not requested in plaintiff’s complaint or defendant’s answer. A contract clause waiving the parties’ right to a jury is generally upheld in business-to-business or other commercial dealings, but much less so for employment contracts, particularly if the clause is inconspicuous or not in conjunction with an arbitration clause.

A jury trial involves a petit jury (12 members ordinarily in federal court and some state courts, although many states have as few as 6). The petit jury decides whether the defendant is guilty in criminal cases or is liable in civil cases; in federal courts and most state courts, the jury’s decision must be unanimous. [The federal courts and most states also have grand juries (around 18 to 24 jurors), which, under the guidance of prosecutors, decide whether a person should be charged with a crime (indicted).]

In jury selection, the first step in the trial, prospective jurors are questioned by the attorneys for both sides and by the judge. This examination is known as voir dire. Any number of potential jurors can be kept off the panel “for cause” (e.g., bias), and the attorneys for each side also have the right to reject a few (generally about three) without offering a reason, that is, by peremptory challenge. The Supreme Court has ruled, though, that a peremptory strike may not be used to remove a potential criminal or civil juror simply because of his race or sex.

Most other nations do not have juries. Of those that do, a jury trial tends to be rare when compared with its use in the United States. In England, for example, jury trials are available only for criminal cases. Even in the United States, where juries are common, only about one in seven civil trials is before a jury.

After the jury has been selected, the next step is the presentation of opening statements. These provide each attorney with the opportunity to indicate what he/she expects to prove.

The plaintiff’s case is then presented. Witnesses, called by the plaintiff’s attorney, testify in response to the attorneys’ questions: f”irst, direct examination by the attorney that called them, and then cross-examination by the opposing attorney. Also, exhibits, documents, and other evidence that may advance the plaintiff’s cause are offered. At the close of the plaintiff’s case, the defendant may file for dismissal of the case or for a directed verdict, that is, a judgment rendered by the court, in his/her favor.

Federal Rule of Civil Procedure 50 calls both the motion for a directed verdict and the motion for a judgment notwithstanding the verdict a motion for a judgment as a matter of law.

The standard for granting these motions is generally the same as for granting a summary judgment motion.

If the trial is to continue, the next step is to present the defendant’s case, following the same procedures as above but offering witnesses and evidence for the defense. The plaintiff may submit rebuttal evidence; then, in turn, the defendant may submit rebuttal evidence. When the defendant’s case has been completed, the plaintiff may move for a directed verdict in his/her favor. Also, in jury trials this may be the proper time for the defendant to request a directed verdict.

In the summation (the closing argument or final argument), each attorney has the opportunity to review the testimony and other evidence and make his/her closing arguments.

Throughout the trial, the judge makes legal rulings on evidence or other matters. Generally, only after the summations does he/she instruct the jury concerning the law that is applicable to the case and the various verdicts that the jury may render.

The jury then retires and attempts, in its deliberations, to resolve all factual (not legal) issues. As stated previously, in federal courts and in most states, it is only when all members agree that the jury renders a verdict. In a nonjury trial the judge makes the decision.

In reaching a verdict, consideration of evidence is governed by the burden of proof. This refers to:

  1. A party’s obligation, when asserting a fact, to come forward with evidence establishing this fact.

Example: Come forward

If party A alleges fact x, party A must produce evidence in support of x before opposing party B is expected to disprove x.

  1. The necessity for one party (in civil cases, almost always the plaintiff) to persuade the trier of fact (judge or jury) that a preponderance of the evidence supports his/her contentions—that his/her version of the facts is, at the very least, slightly more credible than the opposing party’s. If dead-even, the opposing party (generally the defendant) wins. (“Persuasion,” not “coming forward,” is the more common usage of the term “burden of proof.”)

A few special types of allegations (e.g., fraud) may demand a higher standard of persuasion, such as “clear and convincing” proof; and, of course, in a criminal case, the prosecution has a much higher burden of persuasion: “beyond a reasonable doubt.” (See Chapter 19.)


The two types of evidence generally presented during a trial are direct evidence and circumstantial evidence. Direct evidence is testimony from someone (e.g., an eyewitness) who claims to have actual knowledge of one or more facts. Circumstantial evidence constitutes the proof of a chain of circumstances indicating the existence of one or more facts. In other words, circumstantial evidence, if true, leads to an inference about the existence of other facts. While the layperson may assume courts require a higher degree of certainty to introduce or use circumstantial evidence than direct evidence, that is not so. The law does not distinguish between the two types of evidence as to the degree of proof for admissibility in court, or as to the weight or the value to be given such evidence by a judge or jury.

Categorization of evidence (whether direct or circumstantial) is dictated not by set rules, but by the particular aspects of a case and—if it is a jury trial—by the judge’s jury instructions. Some rules, however, do affect the admissibility of certain types of evidence. For example, the use of documentary evidence is governed in federal court proceedings by Federal Rule of Evidence 1002, which ordinarily requires parties to use as evidence the original document, not a copy—the “Best Evidence Rule.”

Demonstrative evidence is placed directly before the jury without requiring testimony. The use of physical objects is either “real” or “demonstrative” evidence, with use of such evidence allowed when the object is relevant to an issue in the case and the evidence in effect helps to explain something important for a judge or jury to understand. The trial judge normally has wide discretion in deciding the admissibility or not of demonstrative evidence, with a decision to bar such evidence as irrelevant, not explanatory, or misleading (e.g., an inaccurate model or picture).


Eyewitnesses are the most important type of witness, in most cases. The primary utility of eyewitnesses may be their memory of what they saw, read, heard, or otherwise experienced.

Character witnesses generally are only used for criminal cases, such as the sentencing stage. In the civil context, character witnesses are just used for a special type of civil case, one in which character is actually a main issue in the case (e.g., defamation).

Expert witnesses testify not so much about what the facts are, but what the facts mean. There are many different types of experts, such as economists, architects, accountants, plumbers, medical doctors, and accident reconstruction specialists. The U.S. Supreme Court and other federal and state courts typically demand that there be some scientific or other support as a prerequisite for expert testimony. Among the basic criteria that an expert’s testimony must meet are relevance, reliability, and helpfulness to the trier of fact. To testify, the witness must have sufficient knowledge of the pertinent field (e.g., a medical specialty) and of the facts in the case itself so as to enable the expert to express a reasonably accurate conclusion.


Federal Rule of Evidence 702 presents the basic qualifications a witness must have to be qualified as an expert: “knowledge, skill, experience, training, or education.” Federal Rule of Evidence 703 lays out what information may form the basis of an expert opinion (“facts or data in the case that the expert has been made aware of or personally observed”). These two categories (facts and data made aware of and those that arise from personal knowledge) in effect describe three bases for expert testimony: firsthand knowledge, facts learned at trial, and outside information (facts on which others in the field can reasonably rely). Rule 703 often allows experts to rely on otherwise inadmissible evidence to reach their conclusions.

Federal Rule of Evidence 704 allows experts to do something they could not do under earlier rules: give an opinion on an ultimate issue in a case, such as whether the defendant is liable. One limitation exists in Rule 704(b), which prohibits an opinion on a criminal defendant’s mental state if that mental state is an element of the criminal charges or defenses.

Federal Rule of Evidence 706 allows judges to appoint expert witnesses who are to be made available to both sides, to work for the court, or otherwise to assist the judge in reaching a just outcome. This practice has seen limited use in the United States but is commonly practiced in many nations, especially civil law countries such as France.

As for nonexperts, Federal Rule of Evidence 701 limits a lay witness’ opinion testimony to statements “(a) rationally based on the witness’s perception; (b) helpful to clearly understanding the witness’s testimony or to determining a fact in issue; and (c) not based on scientific, technical, or other specialized knowledge within the scope of Rule 702” (a true expert is, of course, the witness best suited for offering testimony based on any special knowledge). Rule 701 recognizes that facts and opinion are not completely separable, so a lay witness can testify in the form of an opinion as long as such testimony is based on his/her own perceptions and is necessary for the jury or judge to understand the testimony.

For their court proceedings, most states have rules of evidence similar to the federal rules.


Under rare circumstances, in civil cases the judge may grant a motion for judgment notwithstanding the verdict (sometimes called “J.N.O.V.,” for judgment non obstante veredicto); there, after the jury has rendered a verdict for one party, the judge finds that there was insufficient evidence to support the jury’s conclusions, and enters a judgment for the other side. This is a serious measure, and the judge’s interpretation of evidence at the trial must meet very high standards.

Either attorney can request that the trial court grant a new trial, usually for one or more of the following reasons: (1) erroneous interpretations of the substantive law, (2) erroneous admission or exclusion of evidence, (3) insufficient evidence and/or a verdict contrary to law, (4) excessive or inadequate damages award, (5) jury misconduct or other irregularities, and (6) newly discovered evidence. Often these grounds, particularly (1) through (4), serve as the basis for an appeal requesting reversal or a new trial.


Each party to a lawsuit generally is entitled to one appeal, which is held in an appellate court. Consideration of further appeals (e.g., to the state or U.S. Supreme Court) is usually discretionary: such appeals can be, and often are, summarily denied (without any hearing).

Appellate courts do not hold trials. There are no witnesses or juries. The court simply reviews the record of the trial and the briefs submitted by the parties’ attorneys. In an especially important case, a nonparty (usually a governmental or other institutional group) may file an amicus curiae (“friend of the court”) brief.

A brief is a written argument supported by citations of prior court decisions, statutes, or other authorities. (Alas, briefs often are not brief.)

The attorneys may present oral arguments, which are usually not so much polished speeches as short statements of key points. They must also answer searching questions from the judges. When the court reaches a decision, it issues a written opinion that can provide future guidance in similar cases.

Opinions—in whole or in part—may affirm the original judgment, reverse it, instruct the lower court to issue a new judgment, and/or remand (i.e., send back) the case to the lower court for further proceedings. Appellate courts rarely reverse the trial court for its factual findings; to do so requires that the findings be unsupported or contradicted by the evidence. (Mere belief that the lower court, or jury, did not draw the right factual conclusions is insufficient grounds for reversal.) Any holding other than affirmance almost always must be based on errors of law.


A monetary judgment is a debt. If the losing party does not pay the judgment, the judgment creditor (winning party) may collect by using one or more of the debt-collection methods discussed in Chapter 13.


Some of the more important pleadings are the complaint, answer, motion to dismiss, counterclaim, and motion for summary judgment.

There are four major types of discovery: depositions, interrogatories, requests for admissions, and document production. Each has its advantages and limitations.

The scenario for a lawsuit is as follows:

  1. Alleged injury to plaintiff.

  2. Complaint filed by plaintiff or his/her attorney.

  3. Answer and/or preliminary motions by defendant or his/her attorney.

  4. Discovery and pretrial motions.

  5. Pretrial conference.

  6. Trial.

  7. Posttrial motions.

  8. Appeal.

Summary judgment motions can occur from the time the complaint is filed until the trial. Attempts to settle the case are almost always possible, from before the case is filed through the appeals stage.

In a jury trial, the jury decides the factual disputes, while the judge interprets the law and instructs the jury on the law.

The plaintiff generally has the burden of proof (persuasion). In civil cases, he/she need only have a preponderance of evidence in his/her favor; criminal cases require that the prosecution produce proof of guilt beyond a reasonable doubt.

A trial judge can overturn a jury verdict, but to do so requires much more than simply a belief that the jury drew the wrong factual conclusions.

An appeal does not entail a new trial. The appellate court must consider the law as a whole; its function is to furnish future guidance, not simply resolve an individual dispute.

An appellate court usually affirms the lower court’s judgment. However, if the appeal is well founded in law, not merely a claim that the facts are different from what was decided by the jury or trial judge, an appeals court may reverse, instruct the lower court to issue a new judgment, or remand for further proceedings.


The vast majority of disputes are settled out of court. Most do not even reach the point where a suit is actually filed. If a complaint is filed, settlement usually occurs before trial.

Several factors may spur compromise, including (1) anxiety about going to court (more broadly, the psychological costs of bringing or defending legal claims), (2) the time and expense of lawsuits, (3) concern about bad publicity, (4) the need for a speedier resolution, (5) uncertainty as to outcome, (6) the amount of potential damages awards, including any prejudgment interest, and (7) a desire to maintain good business or personal relationships with the other party.

Alternative Dispute Resolution (ADR)—rather than going to court—is a fast-growing phenomenon featuring such private approaches as using “early neutral evaluations” of the case, “renting” retired judges, or holding summary (expedited and nonbinding) jury trials or “minitrials.” (The Judicial Improvements Act (1990) and the Alternative Dispute Resolution Act (1998) encourage and in some cases require the use of ADR by federal district courts. Many states have comparable laws for their courts. Also, ADR is often sought in administrative disputes—e.g., the Administrative Dispute Resolution Act (1990) authorizes federal agencies to use ADR.)

The two most frequently used out-of-court methods of dispute resolution are mediation and arbitration. Both involve neutral third parties who often are familiar with, or even experts in, the contested subjects.


In mediation, a third party (mediator) helps the disputing parties to settle the case. Mediators cannot impose a settlement on the parties, but often, by such means as separate, private consultations with each party and neutral recommendations to both sides, mediators can effect a compromise. Besides possibly leading to a settlement agreement between the disputants, mediation can also assist them in investigating the facts, defining and clarifying issues, understanding others’ perspectives, identifying common interests, and evaluating potential solutions.

Mediation is increasingly used in settling labor disputes (the function of the Federal Mediation and Conciliation Service) and in resolving consumer complaints (via state or local government agencies or such private groups as the Better Business Bureau). Indeed, some laws mandate the use of mediation; for instance, when a business has an informal dispute-resolution system for complaints about its product warranties, an amendment to the Federal Trade Commission Act requires that parties first attempt mediation before filing a lawsuit for breach of warranty.


Of course, mediation can accomplish little when the parties themselves are unwilling to compromise. In such cases, arbitration may work. Unlike a mediator, an arbitrator has the power to make a final, binding decision. Arbitration is usually a shorter, cheaper version of litigation. Both sides present evidence and arguments, although often in a more informal manner than in court trials.

A dispute usually goes to arbitration because a contract either requires it or permits a party to request it. In certain instances (e.g., medical malpractice), a state law may mandate arbitration. Parties seeking to avoid arbitration, despite a contractual provision requiring it, may run headlong into either the Federal Arbitration Act (1925) (FAA) or the Uniform Arbitration Act (adopted by most states). Both acts broadly support arbitration, and courts almost always will compel parties to keep their agreements to arbitrate. For example, in CompuCredit Corp. v. Greenwood, 565 U.S. __ (2012), the U.S. Supreme Court held that since the Credit Repair Organizations Act (1996) is silent on whether claims can proceed in an arbitration forum, the FAA requires the parties’ arbitration agreement to be enforced against consumers according to that agreement’s terms. Likewise, in cases where plaintiffs were employees, clients of talent agents, consumers, or franchisees challenging arbitration clauses, the U.S. Supreme Court has routinely overturned as superseded by the FAA various state laws lodging primary jurisdiction in any other nonarbitration forum, whether judicial or administrative.3 Also, in 14 Penn Plaza LLC v. Pyett, 556 U.S. 247 (2009) the U.S. Supreme Court upheld contract clauses that required arbitration rather than litigation, for age discrimination claims, per a collective bargaining agreement.

The arbitrator’s power may extend to transactions between foreign and American businesses and to the establishment of policy related to contracts. In Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, 473 U.S. 614 (1985), the U.S. Supreme Court significantly bolstered the use of arbitration when it upheld a contract clause requiring arbitration abroad, even though that meant certain claims or defenses recognized under American law might not be available to the parties. In Nitro-Lift Technologies, LLC v. Howard, 568 U.S. __ (2012), the U.S. Supreme Court held that an employee’s non-compete agreement with the employer was to be interpreted by an arbitrator, not state courts, per the employment agreement’s arbitration clause. The FAA rendered the arbitrator’s decision-making power superior to that of state law.

Most arbitration decisions are binding throughout almost all of the world under the UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards (ratified by the United States and 153 other nations).

State Approaches to Arbitration Legislation

  1. A few states have no legislation; they just have the common law. A final arbitration award is enforceable, but until that point the agreement to arbitrate likely is revocable.

  2. Some state statutes provide only a method for enforcing arbitration awards. An agreement to arbitrate remains, for the most part, revocable until arbitration has actually occurred.

  3. Most states have comprehensive statutes covering all aspects of submission to arbitration, the issuance of an award, and enforcement. A party cannot unilaterally revoke his/her agreement to arbitrate if that submission to arbitration has followed the statutory rules (otherwise, it is treated as common law arbitration, thus remaining revocable, like the first two approaches).

  4. Some states make their state statutory provisions exclusive. Submission to arbitration, the proceedings, any award, and enforcement must all follow the state legislation. If not followed, the arbitration agreement and any award are a nullity; if followed, the agreement is irrevocable and the award is enforceable.

Most states require that arbitration agreements must be in writing to be binding. Except for the exclusive approach of the fourth approach, above, a failure to follow the state statute (e.g., to not have the arbitration agreement in writing) does not necessarily doom an attempt to arbitrate, as the parties may still pursue any form of arbitration allowed under the common law.

Once arbitration is completed, grounds for appeal are extremely limited. Courts are to overturn an arbitration award only if (1) it went beyond the matters submitted to the arbitrator(s), or (2) the arbitrator(s) failed to follow statutory requirements (e.g., acted in complete disregard of evidence), or (3) the award arose out of fraud, partiality, or corruption. Clearly, an arbitration award is even less susceptible to reversal than is a court judgment. Because arbitration usually saves money and time, often promotes less hostile relations than litigation, and can, when necessary, submit complex issues to experts, arbitration clauses are routinely placed in many business contracts. Information about arbitration clauses, as well as experienced arbitrators, can be obtained from the American Arbitration Association, a nonprofit, private organization founded in 1926 to improve and promote arbitration techniques.


The vast majority of cases never come to trial; they are settled beforehand. Mediation and arbitration entail the out-of-court use of third persons (mediators or arbitrators) to resolve disputes. A mediator cannot impose a settlement, but an arbitrator’s decision is final (subject only to very narrow grounds for appeal).


All government, both state and federal, operates through agencies which are generally legislatively created. These agencies are given carefully drawn duties and responsibilities among which are the duties to promulgate rules and regulations, a quasi-legislative function. The agency may also exercise a quasi judicial function since due process under the Fifth and Fourteenth Amendments requires that notice be given and a hearing held whenever a person is to be deprived of “life, liberty or property.” Generally, this hearing must be held before the agency.

Examples: Administrative Deprivations of Liberty or Property (thus requiring a hearing)

• Revocation or suspension of a license to operate a motor vehicle.

• Revocation of a professional or business operating license.

• Cessation or reduction of welfare.

• Cessation or reduction of unemployment or social security benefits.

• Firing of a tenured teacher or—in most instances—a public employee.

• Revocation of parole.

• Termination of parental custodial rights.

The adoption of rules and regulations, as well as the holding of hearings, is governed by federal and state Administrative Procedure Acts. Under these Acts, the rules of evidence are relaxed (even hearsay evidence may be given some weight) and the hearing officer may play a more active, inquisitive role than is customary in U.S. courts. Nevertheless, basic fairness may not be disregarded. For instance, as in a court trial, each party has a right to counsel and is entitled to state his/her case and to cross-examine opposing witnesses. Moreover, although an agency may have considerable discretion in outlining the format of its hearings, it must, like a court of law, render decisions based only on the evidence presented. In cases involving administrative law, there is no right to a trial by jury. However, a dissatisfied party may appeal for judicial review of the case on the hearing record.

Many agencies have a staff of administrative law judges (hearing examiners) who are separate from the investigatory or prosecutory personnel. Most important federal agencies provide for intraagency appeals from the rulings of the administrative law judges to the board or commission at the top of the agency; some agencies also have intermediate review boards. Many states have created independent offices of administrative hearings; this completely separates the judicial function from a particular agency’s executive, enforcement function and assures the citizen of an unbiased due process hearing.

Exhaustion of remedies: The doctrine whereby court appeals are not permitted until administrative remedies are exhausted. Before complaining to a court of law, the appellant must use all available agency procedures that are required by statute or regulation.

The exhaustion of remedies doctrine may be discarded in certain rare circumstances:

  1. An administrative procedure is unconstitutional, illegal, or otherwise exceeds agency authority.

  2. The case involves fundamental constitutional guarantees (e.g., free speech).

  3. The agency is deadlocked or hopelessly behind in its docket schedule.

  4. Irreparable harm is likely to occur if court relief is not permitted.

  5. An appeal within the agency is not required by agency rule or by statute.


Most Civil Law nations follow the inquisitorial approach for their trials. This means there is an inquiry into the facts, directed from above, by the judge or magistrate.4 As a result, inquisitorial judges have a strong role in finding and developing the facts, not just applying the law to the facts. In Germany, for example, the judge, not the lawyers, (1) decides which witnesses to call, and (2) interrogates the witnesses.

In the United States and the countries following the adversarial model (basically, the common law nations), the judge’s role is usually limited to applying the law to the facts of the case. However, there is a similarity to the inquisitorial system, although rarely used: Since 1975 the Federal Rules of Evidence have permitted federal trial judges to appoint independent experts to help them assess the expert testimony or otherwise sort through the evidence. The American judge typically makes such an appointment, if he/she ever does, only for highly complex, scientifically challenging cases. (For example, it was done in a silicone breast implant federal class-action case.)

Especially since 2003, Federal Rule of Civil Procedure 53 affords to federal judges broad rights to appoint special masters (people with broad judicial power for a particular case). The master’s work could be on any or all aspects of a case: pretrial, trial, and post-trial. State rules may also provide for court appointment of masters or neutral experts, but that, too, is not the tradition. In contrast, Civil Law judges, such as in France, routinely rely upon such assistance.

Common law judges generally have far more of a role developing the law than do Civil Law judges. On the other hand, as part of an adversarial system, common law judges usually have a much lesser role developing the facts than do the Civil Law judges presiding under an inquisitorial system. In the adversarial system, the attorneys and parties develop and present the facts. The idea is that as the opposing sides clash, the truth will arise. These parties have the time and incentives to find the facts much better than a judge or magistrate (the inquisitorial model) might.

However, how events are described often depends drastically on who is telling the story. Lawyers thus have been criticized as hired guns practicing “the tricks of the trade.” Increasingly, for big adversarial system trials with well-heeled parties, a battery of consultants may help to choreograph the trial. The concern is that lawyers’ actions and personalities may come to dominate how juries decide cases, and—for close cases—the adversarial system may exacerbate the potential for unfair results due to inequality of resources and/or experience.5 So, whereas the inquisitorial process often resembles a routine business meeting, American trials, perhaps the most adversarial in the world, often are compared to theater.

An argument for the adversarial system is that its lawyers often serve as strong advocates for individual rights. The system may be better for ferreting out the truth and for bringing fully developed cases than the inquisitorial approach if both sides have competent counsel and there is no gross disparity in resources. It also probably reflects a free-market, individualistic culture better than does the government-centered inquisitorial approach.


Due process under the Fifth and Fourteenth Amendments generally requires that notice be given and a hearing held before an administrative agency can render a decision that deprives a person of liberty or property. Administrative hearings are usually more informal than court cases but must be conducted fairly. In almost all cases, courts will not review an agency’s decision until the administrative remedies have been exhausted.


For the key case of Marbury v. Madison, 5 U.S. 137, 2 L. Ed. 60 (1803), in which Chief Justice John Marshall announced the doctrine of judicial review of federal and state actions, the citation means the following: 5 stands for the fifth volume of the United States Reports (the official record of the rulings, orders, case tables, and other U.S. Supreme Court proceedings), and 137 is the page number of that volume on which the case begins; 2 stands for the second volume of the Lawyers Edition (L. Ed.), and 60 is the beginning page number for the case; 1803 is the year of the decision. To identify a quotation or point taken from a case, a second page number may be added to show the page(s) from which the quotation or point is derived. For instance, if a point in Marbury v. Madison were taken from page 176 of the United States Reports and page 73 of the Lawyers Edition, the citation would be 5 U.S. 137, 176, 2 L. Ed. 60, 73 (1803).

Federal circuit court of appeals cases are found in the Federal Reporter, 1st, 2nd, or 3rd series (F., F.2d, or F.3d, respectively, with cases from the years 1880–1924 (F.), 1924–93 (F.2d), and 1993–present (F.3d)). Also, the Federal Supplement (F. Supp. and F. Supp. 2d—the latter from late 1997 onward) and the Federal Rules Decisions (F.R.D.) contain federal district court opinions.

Cases from the state appellate courts, including the District of Columbia, are found in the National Reporter System of the West Publishing Company. The states are divided among seven regional reports: Atlantic (Atl. or A.), North Eastern (N.E.), North Western (N.W.), Pacific (Pac. or P.), South Eastern (S.E.), South Western (S.W.), and Southern (So.). Each of these reports has reached a second series (cited as A.2d., N.W.2d, S.E.2d, etc.) containing more recent cases, and three—the Pacific, the Southern, and the Southwestern—have reached a third (P.3d, So.3d, S.W.3d).


Published opinions by the U.S. Supreme Court, federal circuit courts of appeals, federal district courts, and state appellate courts are cited in U.S. Supreme Court Reports, the Federal Reporter, the Federal Supplement, and the National Reporter System, respectively.



  1. State the three main levels of courts in the federal system.

  2. Describe the differences between the functions of a trial court and an appellate court.

  3. What is the key constitutional question concerning “long-arm” personal jurisdiction?

  4. Distinguish jurisdiction from venue.

  5. What state’s substantive laws usually govern a tort case?

  6. (a) State the general order of pleadings filed before a trial.

(b) What are the four main methods of discovery?

  1. (a) Who usually has the burden of persuasion?

(b) Who has the burden of coming forward?

  1. Name at least four reasons why disputes are compromised.

  2. What is the most important difference between mediation and arbitration?

  3. Give at least four examples of administrative deprivations of liberty or property (thus requiring a hearing).

  4. Explain what each part of this citation means: Brown v. Board of Education, 347 U.S. 483 (1954).


Administrative Procedure Act

adversarial model

affirmative defenses

alternative dispute resolution






circuit court

class action


conflict of laws






direct verdict


district court

diversity jurisdiction

exhaustion of remedies


federal questions

“full faith and credit” clause

grand jury


inquisitorial approach


J.N.O.V. (judgment non obstante veredicto)


“long-arm statutes”



motion to dismiss

opening statements

personal (in personam)



petit jury



requests for admissions


summary judgment





voir dire


  1. Susie Sharp wants to sue Hap Hapless for breach of contract. Susie lives in New York, and Hap lives in Massachusetts. The contract was signed at a business meeting in Boston. Hap has not been outside Massachusetts for years, nor has he done any business elsewhere.

(a) In what court can Susie sue?

(b) In what court does Susie’s right to sue depend on the amount in controversy?

(c) Why is Susie unlikely to be able to sue elsewhere?

(d) What happens if the contract specifies that it is to be governed by New York law? Discuss both personal jurisdiction and conflict of laws.

(e) Assume that New York gives defendants a longer time to answer a complaint than does Massachusetts. Which time period can Hap use?

  1. Hap refuses to answer Susie’s complaint. Susie obtains a judgment, including a damages award, by default. Hap moves to another state, one that generally does not enforce the type of contract that Susie and Hap had. May Susie use the new state’s courts to collect her money (damages) from Hap?

  2. Hap does not leave Massachusetts. He answers and files a motion for summary judgment, with an affidavit saying that he has never met anyone named Susie Sharp, that there was no contract, and that the signature on the alleged contract is not his. Will he win? What is the standard for granting summary judgment?

  3. On Monday, a dissatisfied customer files a complaint about Dew Processing, Incorporated (Dew). On Tuesday, an official at the State Board of Business calls the president of Dew and informs him of the complaint. On Wednesday, Dew receives notice that its consumer sales license has been suspended. What preliminary request for relief should Dew make? Discuss the problems of administrative procedure presented by this case.

  4. At an administrative hearing, the Administrative Law Judge (ALJ) bases his decision on inadmissible evidence, unauthenticated records, and the ALJ’s own knowledge of customs in the industry. He also talked about the case while on the telephone with one of the parties.

The ALJ permitted testimony from all witnesses but allowed cross-examination of only the witnesses who were also parties. In an oral opinion announcing his holding, the ALJ did not clearly state the reasons for his decision. What problems, if any, are there with the ALJ’s conduct of the case?

  1. A case is cited as follows: 63 A.2d 221. Where would you find that case?



  1. District courts, circuit courts, U.S. Supreme Court.

  2. In a jury trial, the trial judge interprets the law and instructs the jury on the law. He/she makes rulings on evidence and any motions. In a nonjury trial, the trial judge also assumes the jury’s role and decides factual disputes.

An appellate court does not retry the case. It does not hear witnesses. Rather, it reviews the lower court case for errors of law. Factual findings can be overturned only if they are not at all supported by the evidence.

  1. The key question is: Has the defendant had enough “minimal contacts” within the state so that requiring him/her to defend a lawsuit there does not violate due process of law?

  2. Jurisdiction involves a court’s power to decide the issues in a case (subject-matter jurisdiction) and to bind parties (personal jurisdiction). Once jurisdiction has been established, the question of venue is merely a matter of deciding whether a particular locale (e.g., county) is the proper place to bring suit.

  3. The state where the injury occurred.

  4. (a) (1) Complaint, (2) motion to dismiss (optional), (3) answer, (4) counterclaim (optional). At any time, until shortly before trial, discovery requests, summary judgment motions, and other motions are possible.

(b) Depositions, interrogatories, requests for admissions, and document production.

  1. (a) The plaintiff.

(b) Whichever party alleges the fact in question.

  1. (1) Anxiety about going to court, (2) time and expense of lawsuits, (3) worries about bad publicity, (4) need for a speedy resolution, (5) uncertainty as to outcome, (6) desire to maintain personal or business relationship with other side.

  2. Mediation cannot force a settlement; arbitration can. Arbitration, in essence, substitutes for a court trial.

  3. Revocation of a professional or business operating license, cessation or reduction of welfare, cessation or reduction of unemployment or social security benefits, firing of a tenured teacher or (in most cases) another public employee, revocation of parole, termination of parental custodial rights.

  4. Brown was a plaintiff and the Board of Education was the defendant. The U.S. Supreme Court opinion is in Volume 347 of the United States Reports, starting at page 483. The case was decided in 1954.


  1. (a) Massachusetts state court.

(b) Susie can sue in the federal court in Massachusetts if the alleged contract was worth more than $75,000 (diversity jurisdiction).

(c) It does not appear that Hap would be subject to another state’s (e.g., New York’s) long-arm jurisdiction; thus, no personal jurisdiction.

(d) This probably would have no effect on personal jurisdiction. However, it should mean that the Massachusetts court must interpret the contract according to New York law, as that is the law intended by the contracting parties.

(e) The one allowed by the court where he has been sued (presumably, Massachusetts). This is a matter of procedure, not substantive law.

  1. Yes. The Massachusetts judgment is entitled to “full faith and credit.”

  2. Most unlikely because summary judgments can be granted only if there is (1) no genuine issue about the material facts, and (2) entitlement to judgment on the law applicable to the material facts.

Susie’s complaint probably sets forth enough facts to show that there is a material factual dispute between the parties as to whether there was a contract and whether Hap was a party to it. To be on the safe side (especially since Hap asserts that he never met Susie), Susie should probably file her own affidavit countering Hap’s contentions and/or showing why his points are irrelevant (e.g., she acted through her agent and hence never met Hap).

  1. Request that the suspension be lifted until a hearing has taken place. The State Board’s action in suspending Dew’s license without a hearing and perhaps without proper notice (telephone call enough?) may supersede agency authority and/or due process.

Dew has a property interest in the license. Generally, administrative deprivations of property (or liberty) can only follow due notice and a hearing. The main exception is an emergency situation, which does not appear to be the case here.

Dew may attempt to exhaust its administrative remedies before going to court, although on these facts some courts would not let the exhaustion of remedies doctrine operate to bar judicial relief.

  1. ALJs usually have much more discretion than courts of law with respect to rules of evidence and the overall conduct of a trial. The improper activities were (1) talking about the case with one party while the other party was not present, and (2) not permitting cross-examination of all witnesses. Due process and, more likely, the enabling act and/or agency regulations would require that the ALJ’s findings of fact (reasons for his decision) be stated to the parties.

  2. In volume 63 of the Atlantic Reports (second series), starting on page 221.

1 For example, a New York business that has an interactive, informational web site, even one allowing customers to download order forms and to e-mail with inquiries, does not subject that business to personal jurisdiction in any other state where a plaintiff thereby accessed the site. However, once sales occur over the Internet, even relatively minor transactions, those “contacts” outside of New York may subject the New York seller to jurisdiction where the plaintiff-buyer was when he/she placed his/her order(s). Resolving this jurisdictional issue may depend on whether the buyer initiated the order(s). If the defendant’s marketing efforts did not lead the buyer to the defendant’s web site but the buyer found the site on his/her own, then that may undermine the rationale for personal jurisdiction outside of New York if the resulting sales were quite small.

Between business parties, courts usually let the parties—including those who contract over the Internet—stipulate their choice of jurisdiction, venue, and substantive law. Inasmuch as consumers often lack adequate bargaining power to negotiate effectively the terms proposed in a seller’s click-wrap agreement, consumers may receive special protection: perhaps being permitted to sue in their home states under local law, especially when a nonresident defendant knowingly and repeatedly uses the Internet to transact business in that state.

2 The first letter of each of these four terms, in order, spell the acronym, CANT.

Note: Denial of class-action status does not necessarily end a dispute. The denial may have that practical effect if there is no logical or economic way for individual parties to pursue claims. However, as a legal matter the denial ordinarily means that claims still can be brought, but individually, not as one large class action.

3 A typical case is AT&T Mobility LLC v. Concepcion, 563 U.S. __ (2011). The U.S. Supreme Court concluded that states must enforce arbitration clauses in consumer contracts even if a state law would deem unenforceable the clause’s waiver of class action rights. For these cases, the FAA trumps state law and requires individual arbitration rather than allowing class action litigation. In American Express Co. v. Italian Colors Restaurant, 569 U.S. __ (2013), the Supreme Court held that the FAA does not permit courts to invalidate a contractual waiver if such arbitration requirements are enforceable even when the cost of a plaintiff’s pursuing an individual claim is likely to exceed the damage recovery.

4 In France and many other countries following the French legal tradition, judicial officers—huissiers—may conduct extensive inquiries, including the examination of documents, the viewing of premises, and the questioning of witnesses; these legally-trained officials then draft statements of facts for the court to use in deciding the case. These statements (constats) supplant much of the discovery and eyewitness testimony that occurs in the United States. This neutral, inquisitorial approach even extends to matters of expert testimony, where the judge often appoints experts in that field to compile a comprehensive report summarizing the relevant facts and providing an opinion about those facts.

5 The adversarial system can be quite advantageous to those with more money or other resources. One may, for example, “paper the other side to death”; if a party does not have enough money, then it cannot respond on certain points and it cannot hire that effective-but-expensive expert. Unlike criminal cases, there tend to be no constitutional issues associated with having an inadequate civil lawyer.





contract a legally enforceable agreement, express or implied

agreement a meeting of the minds

consideration something (a promise, an action, forbearance) a party provides in exchange for something from the other party (a promise, an act, forbearance)

statute of limitations a statute setting forth the period during which a lawsuit must be brought after a right to sue arises


Contract law is a foundation upon which is built many other areas of business law, such as corporations, agency, employment, partnerships, sales, commercial paper, and secured transactions. The law of contracts is a framework to ensure that lawful expectations are met or that remedies are provided.


A contract is a legally enforceable agreement, express or implied. There are four essential elements of a valid contract:

  1. Capacity of the parties.

  2. Mutual agreement (assent) or meeting of the minds (a valid offer and acceptance).

  3. Consideration (something of value given in exchange for a promise).

  4. Legality of subject matter.

Just as law is a rule that society will enforce, so a contract is also an enforced rule of society. That the rule to be enforced is derived from voluntary agreements between individuals does not make it any less a rule, or any less enforceable. Once a contract has been made, that contract is as binding upon the parties as any statute or any other law, and one party cannot withdraw without additional agreement by the other party or parties.

Most people make a number of contracts during each day. Every cab ride, purchase of a grocery item, use of a soft drink machine, or appointment with a doctor involves a contractual relationship. It does not matter that these contracts are oral, or are based on gestures or even on a course of conduct. Mere informality does not render a contract less binding.

As defined above, a contract is a legally enforceable agreement; an agreement is a meeting of the minds. Since courts and juries are not mind readers, the existence of this mental condition must be manifest in words, oral or written, or in actions. (“Verbal” is not a synonym for “oral”; verbal includes all words, written as well as oral.) The mental condition that forms the agreement should be distinguished from the words or actions giving evidence of the mental condition. Although we sometimes call a written document a “contract,” the document is only evidence of the mental agreement that constitutes the actual contract.


Let’s assume that the words used, the action taken, or both the words and the actions would convince a reasonable person, such as a member of a jury, that there is a meeting of the minds and hence a contract. But suppose that there is trouble determining precisely what the agreement is, that the intent is clouded by ambiguity, contradiction, or vagueness. How can an observer arrive at an understanding of the real agreement existing in the minds of the parties? The basic principle of contract interpretation is to determine the intent of the parties from words or actions taken as a whole, not from isolated words, actions, or events.

Certain commonsense rules may be used to resolve contradictions and uncertainties. Fine print, obscurely placed, is given less weight than large, boldface type; handwritten interlineations, especially if initialed, are strong evidence of firm intention. Formal documents, diligently executed, may yield to conduct of the parties if that conduct clearly shows a mutual intent contrary to the written document.


The four essential elements of a contract are competent parties, mutual agreement, consideration, and legality.

Contracts arise out of agreements that are purely mental; hence a contract really exists in the mind. This mental condition is shown by actions, by oral or written words, and rarely, by silence or inaction.

In interpreting a contract, a court tries to determine the intent of the parties from words and actions considered in their entirety.


Contracts can be classified in several different ways.


An express contract is stated in words, written or oral, or partly written and partly oral. The express contract is overtly, consciously, and specifically arrived at.

There are two types of implied contracts: those implied in fact and those implied in law.

The existence and the terms of an implied-in-fact contract are manifested by conduct, rather than words. The proof of the contract lies in the conduct of the parties; a reasonable person aware of this conduct, including words, if any, would infer that a contract exists.

An implied-in-law or quasi contract is created by operation of law (i.e., a court implies a contract) in order to avoid unjust enrichment of one party at the expense of another. There is no agreement, no meeting of the minds; one party has rendered a benefit to another under such circumstances that fairness and equity require compensation.

Example: A Quasi Contract

Stanley Samaritan, M.D., renders assistance to an unconscious person on a city sidewalk. When the patient recovers, he receives a bill for these services.

Since the patient received and benefitted from the services, he may be required to pay on grounds of quasi contract.

The amount of compensation due under a quasi contract is the current market price (called quantum meruit, “as much as he/she earned”), not a special price or even the performer’s usual rate. In the example above, Dr. Samaritan is entitled to the ordinary rate of pay of a general physician rendering these services, even if Samaritan is a specialist ordinarily receiving thousands of dollars for his work.



A bilateral contract is based on an exchange of promises—a promise for a promise.

Example: A Bilateral Contract

Roommate Robert offers to make for Lodger Louise a deluxe grilled cheese sandwich in return for Louise’s promise to clean the kitchen after she eats the sandwich. Louise agrees to those terms. There is an exchange of Robert’s promise (to make the sandwich) for Louise’s promise (to clean the kitchen).

A unilateral contract involves a promise by one party and an act by the other. If, however, the person receiving the offer promises to act before doing so, the contract may become bilateral.

Example: A Unilateral Contract

If a homeowner offers a man $25.00 to mow her lawn, this is an offer to make a unilateral contract. The offer is a promise (to pay $25.00) in exchange for the performance of an act (mowing the lawn).


An executed contract is one that has been fully performed by both parties; all promises have been fulfilled.

In an executory contract something remains to be done by one or both parties.


A valid contract meets all legal requirements and can be enforced by either party.

An unenforceable contract does not meet one or more legal requirements and cannot be enforced by either party. Examples are promises to make a gift (no consideration), promises made in jest (no contractual intent), agreements that fail to meet Statute of Frauds requirements, and past breaches of contract now beyond the statute of limitations.

A void contract has no validity and cannot be enforced by either party. Examples are illegal agreements made under threat of physical force.

A voidable contract is binding on only one of the parties. The other party has the option to withdraw from the contract or enforce it. Examples are contracts made by minors and contracts made under mental duress.


Contracts may be classified by type of formation (express or implied), performance (unilateral or bilateral, executed or executory), or enforceability (valid or unenforceable, void, or voidable).


The word “negotiation” is derived from the Latin negotium, meaning “business” or, literally, “the absence of leisure.” Since a contract (except a quasi contract) arises out of an agreement, and an agreement is a meeting of the minds, it is clear that most minds meet through the transaction of business, or through negotiation.


  1. Negotiations begin with discussion or exchange of comments to determine mutual interest in making a deal.

  2. Mutual interest is clarified and refined in terms of both parties’ basic objectives, such as description of goods to be sold, work to be performed, and price for goods or services.

  3. The contract subject is defined, with a price agreed upon.

  4. The deal is now worked out in detail (e.g., method of payment, guarantees, delivery place, and date).

  5. The contract is formally accepted—a written agreement is prepared and executed, or the parties shake hands or otherwise express an intention to be bound.

Implied contracts are far more informal in their negotiation than are express contracts. Implied contracts may arise entirely from actions, but these actions must be so clear that no reasonable person (member of a jury, for example) would doubt the existence of a meeting of the minds. In the case of an implied contract, the performer is entitled to receive his/her current rate of pay for services rendered, since it is implied that the other party should have expected to pay that price. Under a quasi contract, as mentioned previously, the compensation is quantum meruit, the current market rate.

Express contracts are usually formal; certainly the fact that the contract exists is more formally expressed.

The express contract is often revealed through words of contract: “agree,” “agreement,” “promise,” “offer,” “accept,” or even the very word “contract.”

Most legal writers treat the negotiation of an express contract as though it invariably transpires through a formal offer and the acceptance of that offer. As a matter of fact, however, it may be difficult to say which party extends the offer (is the offeror) and which accepts the offer (is the offeree).

Example: Negotiation as Flirtation

Brown: “I like your car.”

Jones: “Yes, Smith offered me $5,000 for it last week.”

Brown: “That sounds like a good price. You should have sold it.”

Jones: “I would not take less than $7,000.”

Brown: “I would give you $6,000.”

Jones: “It’s yours for $6,200.”

Brown: “Sold.”

If the transaction is concluded at this point, most courts would construe the agreement as an express contract, even without contract words. In reality, it makes no legal difference that the offer and acceptance are not formally stated, or that the offeror or offeree cannot be identified or separated.

The Uniform Commercial Code defines an “agreement” as the bargain of the parties. This bargain is always derived from mutual assent, proved by outward actions or by spoken or written words. Subjective intent, not manifested by words or action, counts for little or nothing in a court of law.


Most contracts are reached through negotiation, which may be formal or informal. Once there is a meeting of the minds on the fundamentals (an agreement), the parties are bound and neither party may withdraw without consent of the other.


Each of the four essential requirements—capacity of the parties, mutual agreement or assent, consideration, and legality—must be met in the formation of a valid contract.


Under the law, only a person who is legally competent has the power to make a binding contract and can be held to any promises contained therein. Persons who may be considered to be legally incompetent include minors, insane persons, and, sometimes under specified circumstances, intoxicated persons. This subject is discussed in detail in Chapter 6.


The mutual assent of the parties to a contract is manifested in two legal concepts, the offer and the acceptance.


The simplest way to form an express contract begins with a formal offer. This offer is transmitted directly to the offeree by acts or by words, whether spoken or written, through any medium whatsoever.

Requirements of an Offer

  1. It must indicate a clear intent to make a contract.

  2. It must be sufficiently definite so that a court can determine the actual intent of the parties.

  3. It must be communicated to the other party.

The offer should contain the fundamental ingredients of the contract; then acceptance by the offeree will bind the deal. In communicating the offer, use of the word “offer” helps, but is not necessary, to show intent to make a contract. Even if the word “offer” is used, circumstances, actions, or other words may indicate that there is no real intent to enter into a valid contract. “Offers” made in obvious jest or under great emotional stress, for example, do not possess the requisite intent.


Things generally not offers are: opinions, plans, requests for bids, circulars, price quotations, invitations to deal, social invitations, price lists, preliminary negotiations, and statements of future intent (“I plan to sell my stock”). Similarly, general advertisements, agreements to agree, catalogs, brochures, and announcements are usually not offers because:

(a) they are not sufficiently definite,

(b) they are not communicated to a specific person or persons, or

(c) the circumstances of publication indicate lack of contractual intent.

Advertisements are usually considered to be “invitations to deal,” that is, invitations to the public to make offers to the advertiser.

In the following circumstances, however, an advertisement can be construed to be an offer: it is so specific to an identified or identifiable person or group that contractual intent can be inferred.

Example: An Advertisement Construed to Be an Offer

A store places an ad in a newspaper that reads: “The first person in our store on Washington’s Birthday will receive $100 toward the purchase of an appliance.”

Courts would probably hold this to be an offer because it is addressed to an identifiable individual, not the general public. Therefore the first person in the store on the holiday named would be entitled to receive $100 toward his/her appliance.

Businesses generally should uphold advertisements as a matter of ethics and of maintaining goodwill (sustaining short-term losses rather than a long-term diminution of business because of fewer “repeat” customers). Businesses also often must honor their advertisements in order to comply with consumer protection laws (e.g., laws against “bait and switch” tactics). Egregious cases could even subject a business to fraud claims and possible punitive damages.


Although an offer must state the essential terms of the proposed contract, modern common law, as well as the Uniform Commercial Code, assumes that many unstated terms may be understood by the parties, may be implied, or may be matters of common sense. With respect to the sale of goods, Article 2 of the Uniform Commercial Code specifically provides that one or more terms (including even the proposed price) may be left open so long as there is a clear intention to make a contract. Under the present common law also, if the offeror offers to sell his hat for $20, it is implied, or understood, (a) that the price is payable in cash, and (b) that delivery is to occur, and payment to be made, with reasonable promptness.


If an offer does not specify a period of time during which it is to remain open, it expires after the passage of a reasonable time. What constitutes a reasonable time depends on the implied intention of the offeror as shown by the property or goods offered, customs of the trade or business, and the like. An offer to sell or buy perishable goods, such as fresh fruit or vegetables, or goods having an unstable or fluctuating market, such as stock or other securities, is generally held not to remain open as long as an offer to sell or buy real estate, a far more stable item.

When the time during which the offer is to remain open is specified, that time then becomes the expiration date. An offer may expire at an earlier time than stated, however, because of rejection, counteroffer, or the death or incompetency of either offeror or offeree.


Fundamental Principle of Contract Law

An offer may be withdrawn at any time before it is accepted.

An offer is like an outstretched hand—it may be pulled back at any time before it is clasped by the outstretched hand of the offeree. Even a firm offer, that is, one expressly stated to remain open for a specified time, may generally be withdrawn. Thus a person who makes a firm offer to sell his hat for $20 and promises to leave the offer open for one week may withdraw the offer immediately, or any time before acceptance. If not accepted within one week, the offer will have expired.

There are four exceptions to the easy right to withdrawal.

Option contracts: The option contract (usually referred to as an “option”) commits the offeror to keep his/her offer open in return for a specified price. In other words, the offeror makes a contract to hold the offer open for some specified period, and is paid a consideration for this agreement.

Example: An Option Contract

An offeror offers to sell a farm for $100,000, agrees to hold this offer open for 7 days, and is paid $100 for this agreement to be held open.

In this example, if the offeror withdraws the offer by selling the farm to some other person within the 7-day period, this would be a breach of contract. The offeree (also called the “optionee”) has no obligation to buy; he has paid $100 for the right to accept the offer within the 7-day period. If he does not buy, his $100 is not refunded; if he does buy, the $100 is not credited to the purchase price unless the option contract expressly so provides.

An option is an excellent legal device to provide the opportunity to think a proposition over, investigate a deal, or raise money to go through with the deal.

Unilateral contracts: Since a unilateral contract depends on the performance of an act by the offeree, some courts consider that the offer can be revoked unless there has been substantial performance. According to this view, in the homeowner could revoke the contract even though the youngster had already mowed half the lawn. Other courts, however, hold that the offer cannot be revoked once the offeree has clearly commenced to perform; the commencement is treated as consideration.

The Uniform Commercial Code exception: Section 2-205 of the Uniform Commercial Code provides that a merchant’s firm written offer to buy or sell goods cannot be revoked during the term specified in the offer, or, if no time is specified, for a reasonable period (but in either case the period of irrevocability shall not exceed 3 months).

Promissory estoppel: if the offeree reasonably relies on the offer’s being held open, and will suffer injustice if it is revoked, then the offer is deemed irrevocable.


An offer must meet three requirements: it must be communicated, it must indicate a clear intent to make a contract, and it must be definite. However, many terms may be left unstated or may be implied or understood by the parties.

An advertisement is not an offer unless it is addressed specifically to an identified or identifiable person or group.

An offer lasts for the period of time stated or, if no time is stated, for a reasonable time. It may also expire by reason of rejection, counteroffer, or the death or incompetency of one of the parties.

Generally, an offer may be withdrawn at any time before it is accepted. There are four exceptions: option contracts, the UCC exception stated in Section 2-205, promissory estoppel, and, according to some courts, unilateral contracts if clear commencement to perform has occurred.


Acceptance of the offer clinches the contract. However, the acceptance must meet certain standards.

First, the acceptance must be clear and unqualified; an “acceptance” that modifies the offer or attempts to get a better deal is treated in the law as a counteroffer, that is, a rejection of the original offer and the making of a new offer. Thus, if an offeror offers to sell his hat for $20, and the offeree says, “I can’t pay $20, but I will give you $12,” the offeree becomes the offeror for $12. If the original offeror rejects the $12 offer, the original offer is “dead” and cannot be revived by the original offeree.

Second, the offeree must accept in any manner required by the offer. If the offer states, “I must have your answer by 1 P.M. on December 1,” then failure to have the answer in the hands of the offeror by that time is fatal to the contract.


Prior to the Uniform Commercial Code, the common law gave special status to acceptance by the same medium as was used to transmit the offer. Thus, if the offer was mailed, the acceptance was good upon being placed with the mail carrier or in the post office—effective, as a matter of fact, more speedily than if made by wire, in which case the acceptance had to be received to bind the contract. According to UCC 2-206(1)(a), however, acceptance in any manner or by any medium, so long as reasonable and meeting the requirements of the offer (if any), is as effective as any other method.


We have defined a unilateral contract as a promise in exchange for an act. Thus an order for 100,000 steel widgets to be shipped for a price of $100,000 is unilateral: upon delivery of the widgets the contract will have been made. Under UCC 2-206(1)(b), an offer to buy goods to be shipped may be accepted either by performance (shipment of the goods) or by a promise to act; the latter effectively converts a unilateral offer to a bilateral contract, something the common law would not permit.

Since some courts, as well as the Uniform Commercial Code, Section 2-206(2), take the view that failure by the offeree to notify the offeror of acceptance of the order or offer gives the offeror the right to withdraw, good business dictates that the offeree of a unilateral offer transmit an acceptance before commencing to act, particularly when fulfillment of the contract will be expensive and laborious. Equitable principles of fair play may operate in many courts to favor an innocent party who has acted in good faith in reliance upon the unilateral offer and has clearly begun to do the requested act before the offer was withdrawn. Of course, substantially performing or completing the requested act constitutes acceptance in all courts.


Generally, silence is not acceptance, nor can the offeror impose a duty upon the offeree to speak. This principle is found not just in American law, but also in international law. Article 18(1) of the Convention on Contracts for the International Sale of Goods (the CISG, discussed in later chapters) states, “Silence or inactivity does not in itself amount to acceptance.”

“If I do not hear from you, I will assume that you have accepted my offer” does not operate to impose a duty of any kind on the offeree. Indeed, if such a statement, in writing or otherwise, accompanies goods that have not been ordered, no duty arises to pay, even if the goods are not returned and are consumed. There is no implied-in-fact contract because the circumstances do not give rise to the inference of an agreement; there is no quasi contract because there is no unjust enrichment.

There are, however, certain circumstances under which silence may give rise to acceptance.

  1. If the offeror observes the offeree acting in response to the offer, and says nothing, there may be a contract.

  2. The parties may mutually agree that silence will constitute acceptance by the recipient of goods that are shipped to him/her (record and book clubs use this approach).

  3. If the parties, by previous dealings, have considered silence to be acceptance, the silent party must reject the offer if he/she wishes to change the customary practice.

Good business (if not good law) indicates that a written rejection should be sent to the offeror when silence could be reasonably considered ambiguous or the outcome doubtful.


The acceptance of an offer should be clear and unconditional. A conditional acceptance is treated as a counteroffer, and is a new offer and, hence, a rejection.

Some courts hold that a unilateral offer is accepted by a clear commencement to perform the act requested. Since the offeror may withdraw his/her offer (and promise), however, the offeree should confirm acceptance and thereby bind the contract as a bilateral contract.

Silence does not constitute acceptance unless (1) the offeror, observing the offeree acting in response to the offer, says nothing; (2) the parties mutually agree that silence means acceptance; or (3) in previous dealings, the parties have considered silence to be acceptance.


Mutual assent may be lacking for a variety of reasons, including mistake, misrepresentation, duress, and undue influence. This topic is discussed in detail in Chapter 5.


Consideration is any lawful alteration of responsibilities that is given in exchange for the other person’s consideration (“his/her lawful alteration of responsibilities”). Consideration is based on the idea of quid pro quo (“something for something”): some action, forbearance, or promise. In almost all contracts, consideration is required for enforceability.

It is not necessary that the thing promised be affirmative; it may be refraining from acting or promising not to act (his/her lawful alteration of responsibilities). A promise made to give $1,000 to a friend if she does not smoke (a negative unilateral contract) is mutual and binding.

A contract cannot be one-sided; it exists only if there is a promise or an action (or nonaction) on each side.

Comparative Law: Consideration

The Civil Law tradition does not require an exchange of consideration. A contract, in Civil Law (e.g., in Germany) requires only offer, acceptance, and mutual consent about the contract’s essential content. (That is somewhat like the older common law of centuries past, in which consideration was not yet an essential element of contracts.)


Usually a court will not evaluate the adequacy of consideration. In other words, if two parties make a deal, it will not be struck down because the court feels that the consideration is inadequate or unequal. Indeed, if a person contracts to buy a pencil or a piece of ordinary paper for $500, the agreement is enforceable, provided, of course, that there is intent to make a contract, the parties are competent, and there is no fraud or violation of other contract principles.

However, the agreement to pay a small amount of money in return for a larger amount of money is not enforceable; this is merely an agreement to make a gift of the difference. Thus, if a person were to agree to accept $10 for a $100 debt immediately due, the agreement would be to make a gift of $90. Usually a promise to make a gift is not consideration.

Suppose, however, that a property owner agrees to pay a contractor $150,000 to build a house in accordance with specifications. Suppose further that a dispute arises over the price after an agreement that the contract is to be modified by certain changes. The owner pays $145,000 “as full payment,” which the contractor accepts. If there had been no dispute, the contractor could recover the remaining $5,000 since he received no consideration for this “gift”; here, however, since for $5,000 the owner gave up her disputed claim, the contract is considered real, and the benefits mutual.

  1. Adequacy of consideration is not an issue for the court unless (a) there was no consideration at all, or (b) in equity cases, there was grossly inadequate consideration.

  2. Adequacy of consideration always can be part of the evidence that assent may not have been genuine (e.g., a party was defrauded, under duress, etc.)

  3. IRS Issues: While adequacy of consideration is generally unimportant in determining whether a valid contract exists, agencies, such as the Internal Revenue Service, will look at the value of a so-called bargained-exchange when the “contract” at issue has tax implications. For example, even if a contract is okay under the law of contracts, it does not mean that the IRS will accept it for purposes of permitting one to take a tax benefit for business losses or other deductions or credits. The IRS is likely to look at the real, objective value of a “deal.”


Consideration entails a bargained for exchange: a “legal detriment” (or benefit), not necessarily an economic or material loss or benefit but any lawful alteration of responsibilities (e.g., giving up one’s right to sue) can be consideration.

There are a number of reasons why consideration may be absent.


The mutual promises must be real. An illusory promise is not an actual promise; the promiser offers to do something only if he/she “wishes” or “needs” to.

Example: Illusory Promises

An employment agreement whereby the employee agrees to work for one year at a salary of $25,000, provided the employer has need of her services, is not a contract because the employer has no real obligation.

Commodity agreements to buy all of one’s requirements, or to sell all of one’s output, may be illusory if no requirement or output has been established, typically through past usage or production. Thus, if a homeowner heats his house with gas and expects to convert to fuel oil, the agreement to buy all of his fuel oil requirements from a particular supplier may be considered illusory, since no requirement for fuel oil has been established.


An agreement to do one’s duty is not consideration. If a person already has a contract, an additional agreement to perform this same contract is lacking in consideration. An airline pilot who promises to land the plane safely for a frightened passenger who offers him $1,000 cannot claim the reward; he is already contractually obligated to land the plane safely. For the same reason, a sheriff is usually not entitled to a reward for capturing a wanted criminal—he is merely doing his duty, for which he is being paid.

Exceptions to the Preexisting Duties Rule

  1. Modified duties of both parties; and

  2. Rescission and a new contract meant to cancel the old contract.

UCC 2-209(1) states, “An agreement modifying a contract within this Article needs no consideration to be binding.” However, under UCC 1-203, every contract imposes an obligation of good faith. Thus, modifications must also be in good faith. This means no “low-balling,” in which a party enters into a contract and then seeks the modifications that the party had all along intended (e.g., insisting on a higher price than the “low-ball” amount).


A moral obligation (what a person ought to do) has no legal substance; it is not measurable and not commercial. Under this heading are agreements to pay the obligations of others or agreements to provide for relatives. In addition, love and affection, as such, will not support a contract, although they may be of the highest moral nature.

Ordinarily, there is no consideration in such cases. However, some courts have recognized one or more special situations in which a moral obligation may be consideration: (1) it arises from a preexisting legal liability acknowledged by a new promise; (2) a party obtained a benefit or suffered a legal detriment; and (3) the agreement supported by moral consideration has been wholly or partially executed.


Past consideration is something that was performed without expectation of obtaining something in return from the other party. If the latter party should afterward promise some compensation for the benefit received, the traditional rule is that this promise would not be enforceable because it was not bargained for in the current transaction.

Example: Past Consideration

Susanna Swimmer rescues drowning Larry Landlubber, who thereupon promises to give Susanna $500 for her courageous act. Under the common law’s traditional interpretatation, Larry’s promise is not contractually binding because the act for which it was made—Susanna’s rescue of Larry—has already been completed.

A Minority View

In a minority of states, including Colorado, Idaho, Louisiana, Maryland, Missouri, New York, Oregon, and South Dakota, the traditional rule against past consideration has been relaxed: a promise based on past consideration is enforceable if (a) the promise is based on a material benefit (typically, but not exclusively, economic) that the promisee had previously provided to the promisor, and (b) the benefit triggered a duty (even if only a moral duty) to pay compensation. Of course, the key question is what type of past benefits actually triggers such a duty. Some states holding to this minority approach have a fairly broad interpretation of what would qualify as a trigger, while a few states (e.g., New Jersey, Washington) may, for their exceptions to the traditional “no past consideration” rule, narrowly limit those exceptions to benefits related to providing a mortgage or conveying real estate.


Sometimes a contract is barred (no longer subject to legal action) by the statute of limitations. Periods of limitations vary from state to state but generally run from 3 to 6 years, except for sales contracts under the Uniform Commercial Code (4 years). An agreement to pay made years later, after the original obligation to pay is no longer binding, results, however, in a valid contract. No new consideration is needed; the old consideration is revived by the new promise to pay. Thus the law has arbitrarily created an exception to the “illusion” principle since concepts of fair play and equity do not favor the statute.


Consideration is found by the courts in rather vague contracts calling for the purchase of one’s requirements or for the sale of a manufacturer’s output. Frequently, a manufacturer will agree to buy all of his requirements for a material from a specified source, or he may agree to sell all of his output of a certain product to a single customer. Even though the quantity to be bought or sold is not specified, these contracts are good under modern case law, as well as under the Uniform Commercial Code, unless one side acts in bad faith or attempts to take advantage of the other by padding or understating the requirements or output.

Requirements and output contracts should be accompanied by an estimate of the quantities to be bought or sold. In most cases the facility buying or selling should have a record of needs or production so that contractual intent can be ascertained in the event of a dispute. If there is no such record, the contract could be “illusory,” that is, no obligation to buy or sell could be demonstrated.


Consideration may also be found where there is total reliance on the promise of another. This reliance gives rise to estoppel, which is a holdover from equity principles and appears in modern law in a number of different contexts. The word generally describes a situation in which a person, by reason of his/her actions, cannot assert certain legal defenses that are in contradiction of these actions.

Promissory estoppel occurs when a promise is made without any consideration, but the promisee, relying upon the gratuitous promise, takes certain action, or fails to take action, to his detriment. It is not sufficient that the gratuitous promise be made carelessly or thoughtlessly; the promisor should know, or reasonably expect, that the promisee will act in reliance. Unjustified reliance on a promise does not give rise to promissory estoppel.

Example: Promissory Estoppel

The promise to make a charitable contribution to a church, followed by expenditures or actions taken by the church in reliance upon the promise, would create a binding contract. Reliance should be expected and is surely reasonable, even though this simple promise to make a gift would ordinarily be unenforceable as lacking consideration.


Consideration means “something for something”—one party promises to do something, or refrain from doing it, and the other party promises to give something of value in return.

The mutual promises must be real, not illusory.

A promise to do what one is already bound to do (one’s duty) or to carry out a moral obligation is not consideration.

Usually the court is not concerned with the adequacy of consideration. An exception occurs when a small amount of money is given for a larger amount.

Past consideration is something that was done without expectation of receiving something in return. A subsequent promise of compensation for a benefit received in the past is not binding.

Promissory estoppel, a holdover from equity law, requires that a person who has made a gratuitous promise be held to it when the promisee, to his/her detriment, justifiably relied upon the promise.


Contracts that are in violation of common or statutory law or are against public policy are generally held to be illegal. This topic is discussed in Chapter 6.


Under the early English common law, consideration was not required for a contract. To be binding, a contract had to be in writing and under seal. The seal was placed on the contract in heated wax, either on the signature or at the place of execution. Later, as wax seals fell into disuse, the word “Seal,” Locus Sigilli (Place of the Seal), or the abbreviation “L.S.” was substituted. Such “sealed” contracts did not require consideration, and the laws of many states extended the period of limitation for these agreements. Modern court cases, as well as the Uniform Commercial Code, have abolished the seal as a consideration substitute, but many states still permit seals to extend limitation periods. However, a notary seal, corporate seal, or personal seal (including “Seal” and “L.S.”), is still required for certain formal documents (e.g., deeds to real estate).



  1. In what sense is it incorrect to refer to a written document as a contract?

  2. How would you go about proving (a) an express contract, (b) an implied-in-fact contract, (c) a quasi contract?

  3. Why is a lawsuit based on an implied contract more likely to produce greater damages and a larger verdict than one based on a quasi contract?

  4. How can a unilateral offeree convert the contract into a bilateral contract? When should he/she do so?

  5. When is an advertisement an offer?

  6. What are the four exceptions to the rule that an offer can be withdrawn at any time before it is accepted?

  7. What is the effect of a conditional acceptance?

  8. What is the meaning of the term “adequacy of consideration”?

  9. What does it mean to say that a contract must have “consideration”?

  10. What is the consideration for the promise in a unilateral contract?




bilateral contract




executed contract

executory contract

express contract

implied-in-fact contract



option contract

past consideration

promissory estoppel

quasi contract


statute of limitations

unenforceable contract

unilateral contract

valid contract

void contract

voidable contract


  1. You enter an expensive restaurant and are seated by the hostess. A waiter brings you plates, knives and forks, napkins and other “setups” for dinner, including bread and butter, which you partly consume. When you read the menu, you realize that the prices far exceed what you can afford, and you then make it clear that you do not intend to order a meal. What kind of contract (obligation) do you have, if any?

  2. In Problem 1, you read the menu and place an order. Nothing is said about agreement to pay. Is there a contract?

  3. In Problem 1, there is fine print at the bottom of the menu: “15% gratuity, $25.00 cover charge.” What is the effect, assuming that you order dinner but do not see the fine print?

  4. You receive a letter from the General Moose Company containing an offer and concluding: “… and we will pay you for your services $50,000 for your first year.” You respond by saying, “I like your offer, and would accept for $55,000.” You hear nothing in response, so after 10 days you write and say, “I accept your offer of $50,000.” Is there a contract? Suppose you hear nothing in response to this second letter. What is the result?

  5. If a farmer agrees, in writing, to pay his wife $100 a month to keep farm accounts and perform farm chores “as you have always done,” is this an enforceable contract?



  1. A contract is a mental condition expressed in a written document. The written document is only evidence of the mental condition.

  2. (a) An express contract should be easy to prove since it is stated in words and generally in contract language.

(b) An implied-in-fact contract is implied by the facts of the case. These facts include proof of the circumstances, actions of the parties, and their words, if any. All of these together should lead a “reasonable person” to believe that there was an agreement.

(c) A quasi, or implied-in-law, contract involves proof of unjust enrichment, that is, proof of a benefit to an individual under circumstances requiring payment for the benefit. A quasi contract generally does not include benefits imposed upon someone who may or may not want them.

  1. The implied contract is for the usual charge for services rendered, whereas the quasi contract is for the going price for such services in the marketplace. On the assumption that usual charges are higher than those in the marketplace, the implied contract is preferable.

  2. If the offer is to buy goods that are to be shipped, the unilateral offeree can say, “I accept your offer and hereby agree to perform the requested services.” This should be done before the offeree expends money and effort.

  3. An advertisement is an offer only when definite and made very specifically to an identifiable person or group of persons.

  4. The option contract, promissory estoppel, the unilateral contract after substantial performance has taken place, and the UCC exception relating to a merchant’s firm agreement to hold his offer open for the period specified or, if no time is specified, for a reasonable period (in either case, no more than 3 months).

  5. A conditional acceptance is a counteroffer and a rejection of the original offer.

  6. “Adequacy of consideration” relates to the value of the consideration or to its weight when compared with the consideration offered by the other party to the contract. Ordinarily, courts do not test the value or weight of consideration.

  7. All contracts require “something for something,” that is, a contract cannot be a “one-way street.” There must be consideration on both sides.

  8. In a unilateral contract, the consideration for the promise is the performance of the requested action.


  1. There is a quasi contract for the food that you have consumed; the value of this food should be a subject of some discussion. Also, it could be argued that there is an implied unilateral contract for the price of a dinner, since you may have entered the restaurant knowing the kind of establishment it purported to be. However, a unilateral offer can be withdrawn before it is accepted if no substantial performance has occurred. Some courts, however, hold that clear commencement to perform constitutes acceptance.

  2. Yes. Ordering food from the menu creates an implied-in-fact contract to pay the menu price.

  3. In case of conflict between fine print and express contract language that contradicts the fine print, the fine print would be ignored. In this case the fine print is uncontradicted and becomes part of the contract. If the fine print is illegible or hidden in some manner, it could be argued that it is not part of the agreement and therefore not a part of the contract obligation. The fact that you did not see the fine print does not excuse your obligation if a “reasonable man” would have seen it.

  4. Your response would probably be viewed as a counteroffer and a rejection of the General Moose offer. Consequently, your subsequent letter attempting to accept the rejected offer does not create a contract for the job in the $50,000 offer. However, failure of the original offeror to respond may lead a reasonable person to believe that General Moose has accepted the second reply. Usually, silence is not an acceptance, but there are exceptions to this rule, one of which relates to circumstances creating a duty to speak. Such a duty may arise when the first party opened the transaction by the original offer, and General Moose should now make some kind of response. This question should provoke discussion both pro and con.

  5. If a person agrees to do what she already has a duty to do, there is no consideration for the agreement. Whether the wife has a duty to keep accounts and perform chores is the central question in this case. The fact that she has always done so without being paid, or as part of her wifely responsibilities, suggests that such a duty exists, and the new contract is not enforceable.




material mistake a mistake that goes to the very heart of the agreement

fraud intentional misrepresentation of a material fact, made knowingly, with intent to defraud, that is justifiably relied upon by the other party and causes injury to him/her

undue influence taking advantage of another by reason of a position of trust in a close or confidential relationship

duress coercion, either physical or mental, that deprives a person of free will

unconscionability gross unfairness brought about by the superior position of one of the parties to the contract

As explained in Chapter 4, a contract is a legally enforceable meeting of the minds—a mental condition. This mental condition is manifested by words—oral or written—by actions, or by both words and actions. This chapter is concerned with situations where there is not really an agreement, even though words or actions seem to prove otherwise.

A meeting of the minds—mutual assent or agreement—is a necessary element of a contract. Without it, the contract may be void or voidable.

There are six reasons why mutual assent may be lacking: mistake, fraud, innocent misrepresentation, undue influence, duress, and unconscionability.


The most frequent circumstance barring a real meeting of the minds is mistake.


A mistake concerning an incidental or trivial detail or insignificant matter will not affect the fact of agreement so long as there is agreement on the basic or material features of the transaction.

What is “incidental” or “trivial,” and what is “material” or “basic”?

A basic or material mistake generally goes right to the heart of the matter; indeed it usually pertains to the existence or nature of the subject matter. If, for example, the parties agree that one will sell and the other buy a horse that, unknown to them, has died, the mistake is material and there is no contract.

In the preceding example, the parties believe that they know the facts—there is a live horse to be bought and sold—but both parties are mistaken. However, if the facts are not known and both buyer and seller take their chances, each believing that he/she has some advantage, there will be a contract. Purchase of land or chattels that prove to be more valuable, or less valuable, than anticipated by either party fall within this category. Such a contract is based, not on a common fallacy, but on judgments about value. Such differing judgments and opinions about the bargain are present in practically all contracts, are considered incidental mistakes, and do not affect the validity of the contract.


In general, there is no binding contract if a material mistake or fallacy is mutual. The contract is binding, however, if only one party is mistaken, that is, if the mistake is unilateral, except when the other party knows, or should have known, of the mistake.

Basic Philosophy of the Unilateral Mistake Principle

A person should not be allowed to benefit from his/her own ignorance or carelessness.

Persons who carelessly fail to read what they sign, fail to observe defects that are readily apparent, or fail to examine that which is displayed before them should not be able to claim lack of agreement in order to abandon contracts they do not like. In other words, a unilateral mistake usually does not provide the mistaken party with grounds for rescinding the contract.1

But this result does not apply if the nonmistaken party either caused the mistake or knows of or suspects the mistake. Thus, if the buyer believes that a property contains 100 acres when in reality it contains only 65 acres, the seller should correct the buyer’s misapprehension, if the seller is aware of it, even though the buyer might be able to discover the exact acreage without assistance from the seller. In such a case of palpable unilateral mistake, the contract may be voidable. (Also, if the effect of a mistake is to make an agreement unconscionable (extremely unfair), then the agreement may be voidable.)

In the earlier common law, the principle of caveat emptor (“let the buyer beware”) required buyers to inspect fully and carefully. Failure to do so was at their peril. Modern law, influenced by the equity concepts of fairness and the consumer-friendly provisions of the UCC, is more generous to unobservant or careless buyers and imposes on sellers a higher duty of speaking out. Indeed, it is sometimes argued that the law now enforces caveat venditor (“let the seller beware”). Mere failure by the seller to speak, in cases where he should have spoken, may permit the negligent, unobservant buyer to withdraw from the contract.

An agreement made as a result of a mutual mistake regarding a material fact can be made void by either party in the equitable action of rescission (cancellation). (Rescission is unavailable, though, to a person who expressly takes the risk of a mistake—e.g., someone who buys an item “as is.”) In this action, the supposed contract is rescinded, and the parties are restored to the respective positions existing before the agreement was formed, that is, any monies paid are returned and any goods delivered are restored to the original owner. Thus we say that all such contracts are voidable—they can be made void by the action of rescission.

Example: Rescission Due to Mutual Mistake of Fact

Sheila Steinway agrees to sell a painting generally thought to be a genuine Rembrandt to Angus Artlover for $2 million. Later a panel of experts determines that the painting was done by a pupil of Rembrandt, not by the master himself. The contract is voidable because of a mutual mistake of fact.


A material mistake usually pertains to a fact, not to a matter of value or opinion.

In general, mutual mistake of a material fact is grounds to cancel a contract. Unilateral mistake by one party, however, is not grounds for cancellation unless the other party knew about the mistake and said nothing.

A voidable contract may be rescinded. Unless rescission occurs, the contract remains in effect.


If a person enters into a contract as a result of the intentional misrepresentation or deceit of the other party to the contract, there is no meeting of the minds, no agreement, and hence no legal obligation. In most cases of mistake, both parties are innocent of wrongdoing—the minds simply did not meet. In the case of fraud, however, the minds not only do not meet, but one party is guilty of deceptive, dishonest conduct.


Five Requirements for a Finding of Fraud

(all five must be present)

(1) Misrepresentation of a material fact,

(2) made knowingly,

(3) with intent to defraud,

(4) justifiably relied upon,

(5) causing injury to the other party.


To prove a case of fraud, the misrepresentation must concern a material (important) fact.

Examples: Misrepresentations of Material Facts

  1. A painting is by a specified artist.

  2. An air conditioner will adequately cool a certain-size room.

  3. An automobile will pass state inspection.

  4. Turkey poults are healthy and free from disease.

Matters pertaining to value and matters asserted as opinion are generally not factual in nature and are not grounds for fraud.

As stated concerning incidental mistakes, the parties to a contract usually have different perceptions of the value of the chattel, land, or other object being bought or sold. Moreover, it is customary for the seller to “huff and puff” and to exaggerate the value of his/her goods, and many buyers, in turn, seek to diminish or deprecate the value of the goods in order to lower the price. Opinions are, of course, statements of judgment, not of fact, and do not constitute grounds for fraud.

There is, however, one major exception to this principle: an “opinion” by an expert—for example, a physician, an accountant, a lawyer, an engineer, a financial advisor—or one claiming to be an expert may be the basis for fraud. The law treats the expert as a master of the facts; his/her judgments are to be relied on as skilled—and factual.


The party misrepresenting the material fact must do so knowingly.

Scienter is the legal word for “guilty knowledge.” Nonlawyers frequently believe that they can claim ignorance of the falsity of a statement and thus defeat a claim for fraud. However, scienter goes beyond actual knowledge—it includes careless indifference to the truth, a lack of belief by the declarer in his/her statements. Whether scienter is present is a question for a properly instructed jury, and juries can be cynical about persons who “unintentionally” lie to gain an advantage.


The misrepresentation of a material fact must be made with intent to defraud. Obviously, every defrauding party will claim he/she had no intention to deceive, that the falsehood was innocent and not willful. Unfortunately for such persons, the intent to defraud is presumed if the false statement is made knowingly—if scienter is present.


The party to whom the misrepresentation was made must rely on it. This requirement is of the greatest importance. If the seller lies, knowingly and intentionally, and the buyer recognizes (or should recognize) the lie, but buys anyway, there is no fraud. Thus, if the salesman says, “This pesticide will kill beetles on roses,” but the container has a clear statement that the product will kill aphids and slugs but not beetles, an argument can be made that there is no reliance. (Some recent cases, however, have held that reliance is justified under these circumstances, and hence there may be fraud.)

A Warning to Liars! One cannot lie, thinking that a lack of justifiable reliance will prevent one’s liability for fraud; the court may determine that reliance was reasonable. Although potential plaintiffs should investigate the facts (be careful), potential defendants must understand that the modern trend is not to presume that cheated people should have found out about a lie. As caveat emptor (“buyer beware”) has become a less important legal doctrine, so an assertion of unreasonable reliance has become more circumscribed.


The party to whom the misrepresentation was made must have suffered injury as a result. Frequently, however, the false statement or concealment does not cause injury. In this case, there is no fraud.

Example: Misrepresentation That Does Not Cause Injury

Sam, the seller, tells Bill, the buyer, that Sam is the original and only owner of the 1985 Mustang Bill is purchasing. In fact, Sam bought the Mustang from his next-door neighbor.

In this case the car is in excellent condition, and there is doubt that any injury will result from the falsehood. Hence, there would be no basis for a claim of fraud.

As a matter of fact, many misrepresentations, although intentional and deceptive, are not bases of fraud, particularly if they pertain to other matters than the use intended of the goods by the buyer.


In the case of fraud, the defrauded party can rescind the contract. However, he/she has an alternative remedy: to affirm the contract and bring an action in tort to recover damages for the deceit. For example, if a seller misrepresents the expired mileage of a second-hand automobile by turning back the odometer, the buyer may rescind the contract. Alternatively, she may keep the automobile and recover damages for the lessened value of the automobile.

Fraud is a grave offense in the eyes of the law. In any case where it can be proved, the victim has a real advantage over the perpetrator. Our analysis of business torts and crimes (Chapter 19) points out that not only is fraud a tort, it is also a crime. If the fraud is particularly aggravated, malicious, or oppressive, it can give rise to punitive damages (see Chapter 8).

Failure to keep up with common professional, industrial, or other business practices could become a legal problem—perhaps fraud or unconscionability. Assume that those practices represent a consensus on the ethical standards for a particular field—that they are not simply seen as aspirational (a goal) but instead are viewed as the lowest common denominator of behavior (required conduct). Therefore, typically through court decisions but also possibly through legislation or regulation, these ethical standards may be incorporated into public policy and thus into law. This process transforms “mere” custom or ethics that were optional (e.g., something that a businessperson may like to do, but may decided he/she cannot afford to do so) to obligatory (no longer simply a choice).


Fraud is intentional misrepresentation of a material fact, made knowingly, with intent to defraud, that is justifiably relied upon by the other party and causes injury to him/her.

A defrauded party has two choices: (1) rescind the contract and get back any consideration paid, or (2) retain the goods or value obtained and sue in tort for damages (the lessened value because of the fraud).


Misrepresentation that lacks element 2 (knowing) and element 3 (intent to defraud) will result in a contract voidable by the innocent party.

Unlike fraud, however, innocent misrepresentation is not a tort and does not give rise to a claim for damages. The only remedy available to the plaintiff is rescission of the contract.

Example: Innocent Misrepresentation

Alice bought a rug for $1,000 at auction and was given a certificate stating that the rug was a genuine Aubusson. Shortly thereafter, Alice sold the rug, as an Aubusson, to Betty, whose insurance agent called in an appraiser. The expert pronounced the rug a fake worth at most $200.

Since Alice had been assured that the rug was an Aubusson and had innocently misrepresented it as such, with no intent to defraud, Betty could not win damages. The contract, however, could be rescinded; Betty returned the rug and Alice refunded the money.


Undue influence occurs when one party takes advantage of another by reason of a superior position in a close or confidential relationship.

A contract entered into as a result of undue influence, although having the form and shape of an agreement, is not enforceable over the objection of the victim.

There are many confidential relationships that may give rise to undue influence, in which the dominant party exercises control over the dominated person’s will for the former’s benefit. Attorney and client, doctor and patient, clergyman and parishioner, trustee and beneficiary, principal and agent, husband and wife (or wife and husband), guardian and ward—these are examples of such relationships. In each case, the person occupying a superior position, that is, one of trust, should be acting in the interest of the other person; hence any contract that is in reality for the former’s benefit, and not for the latter’s, is presumed to be tainted with undue influence and therefore voidable.

Examples: Undue Influence

A client wins a large judgment in a lawsuit and then lends a portion of the award to her attorney.

A dying patient deeds over valuable property to his doctor.

A husband, hospitalized because of a serious illness, signs insurance releases for the sole benefit of his wife, and upon her advice.

All these transactions would be suspect.

To overcome suspicion, the party in a position of trust should make full disclosure of his private interest and potential gain (in writing or before independent witnesses) to the other party, and if possible should assist him/her in obtaining independent advice concerning any proposed contract or gift.

When a transaction may have occurred because of undue influence, we are concerned about use of excessive pressure by the dominant person (e.g., the professional over his/her patient or client), and we recognize the susceptibility of the subservient person. If strong enough, any one of these characteristics of “overpersuasion” may prove undue influence took place, or—even if one factor is not overwhelming—the combination of these factors may have a cumulative effect indicating undue influence:

  1. Discussion of the transaction at an unusual place or time.

  2. Consummation of the transaction in an unusual place.

  3. Insistent demand that the business be finished at once.

  4. Extreme emphasis on the untoward consequences of delay.

  5. The use of multiple persuaders (e.g., several people) by the dominant side.

  6. Absence of third-party advisers to the servient party.

  7. Statements that there is no time to consult with advisers.


A contract that is in valid form and to all appearances is an agreement may be voided because of duress.

Duress is coercion, either physical or mental, that deprives a person of free will and leaves that person with no reasonable alternative other than to accept the contract terms as imposed on him/her.

A contract made at gunpoint or under other compelling physical force is simply void. No mental condition of agreement ever existed.

The more typical case of duress arises out of mental coercion. A contract made under mental coercion is voidable. Such coercion may come about by threats—a kind of blackmail. However, the threat must be improper or wrongful. A threat to sue in civil court on a just debt, thereby inducing a promise to pay, is not duress.

Five kinds of threats are generally considered duress in contract law:

  1. Threat of physical violence or harm to the individual or to his/her family or property.

  2. Threat of criminal prosecution.

  3. Threat of a lawsuit, but only if the threat is made with actual knowledge that the suit would be without any basis.

  4. Threat of personal or family social disgrace.

  5. Threat of economic loss if the party claiming duress can show that the loss may occur because of actions of the one accused of coercion. Note: It is not wrong to threaten suit to recover a valid debt or even a supposedly valid debt.


A contract in valid form may be voided because of gross inequality in the respective positions of the parties during the contract process. “Unconscionable” describes special situations in which an overbearing party in a superior position (e.g., a merchant) imposes outrageously unfair terms on some other party (e.g., a consumer) through fine print and “fast talk.” (UCC 2-302 covers unconscionable sales contracts.) An adhesion contract, for example, often is unconscionable because it is a standardized agreement tendered to a consumer on a “take it or leave it” basis, leaving him/her no opportunity to bargain or to obtain the desired goods or services without signing the printed form.

Unconscionability is not an “easy out” from contract obligations. The burden of proof is high; the law imposes a heavy duty to resist such high-handed, aggressive tactics before entering into the contract. Moreover, even if a court finds part of the contract to be unconscionable, the court may enforce the rest of the contract; the court even may choose to enforce the unconscionable clause, but limit its application so as to avoid an unconscionable result. UCC 2-302 thereby grants judges wide-ranging remedial discretion.

Courts often describe two categories of unconscionability, procedural and substantive. Procedural unconscionability concerns contract formation. It may be present when there is inequality in bargaining power (generally, a very high degree of inequality) or unfair surprise caused by to “hidden” terms in a contract that is lengthy, confusing, or both. Substantive unconscionability concerns the fairness of a contract; it may exist when there is an unjustified and overly harsh allocation of risks or costs or a great price disparity (e.g., a contract price three to four times higher than fair market value).

Other countries may be more energetic in intervening to protect parties from a supposedly unfair contract. For example, Germany’s closest equivalent to the UCC, its Law on General Business Terms (the German acronym is AGBG), prohibits any clause that violates good faith by imposing an “unfair burden” on the other party. It forbids certain contract terms quite common in U.S. commercial contracts, such as (1) a bargained-for disclaimer that the parties are not liable for lost profits as a result of problems that arise and (2) clauses that give the seller the right to increase prices, except in limited circumstances. In general, the AGBG does not look favorably on enforcing boilerplate terms in a contract “imposed” by a large firm on a smaller firm. German judges even may void contracts they deem to be for unusually long periods of obligation.



  1. Explain the circumstances under which it may be possible to rescind a contract because of unilateral mistake.

  2. Name a situation in which an opinion statement would give rise to rescission of a contract.

  3. How have the old equity doctrines influenced the law of contract mistake?

  4. How does the penalty for contract fraud differ from the right of recission in cases of simple mutual mistake?

  5. Can a person’s careless statements give rise to fraud when the person does not know for a fact that he/she is lying?

  6. Name four confidential relationships where undue influence could exist.

  7. When does duress cause a contract to be (a) void or (b) voidable?

  8. Define “unconscionable contract.”


adhesion contract

caveat emptor

caveat venditor



innocent misrepresentation

intentional misrepresentation

material mistake

mutual mistake




undue influence

unilateral mistake


  1. Fred Farmer is the owner of a 100-acre farm near a large city. Consider the following two situations:

(a) An employee of the State Roads Department tells a friend, Lester Listener, that the state plans a major road relocation through Fred’s property, including a cloverleaf and commercial interchange on the property. Lester persuades Fred to sign an option contract to sell him the farm for $125,000, a fair price for farm land.

(b) Lester knows that XYZ Chemical Company is seeking a plant site near the city, and he gets an option contract from Fred, as before, for $125,000.

If Lester says nothing to Fred about the plans outlined in (a) and (b), in either case is there mistake? Fraud?

  1. Bruce Brown is seriously ill. While heavily sedated, he is persuaded by his wife Betty to sign some “papers” so she can pay the hospital bills. These “papers” include a bill of sale on Bruce’s cabin cruiser. Actually, the hospital bill is amply covered by insurance, and Betty sells the boat to purchase expensive jewelry for herself. Is Betty’s action lawful?

  2. Marian Merchant discovers that her bookkeeper has embezzled $50,000 while working in Marian’s store. Marian agrees not to report this theft if the bookkeeper will sign a 3-year, interest-free promissory note. Is the note valid?

  3. Nellie Naive is an elderly, naturalized American citizen with a marginal knowledge of English and a meager education. She owns a boarding house but is having trouble making ends meet. One of her boarders, Sam Slick, a traveling salesman, is aware of her difficulties. He offers to lend her $10,000 “on her home” if she will sign a “paper.” The “paper” turns out to be a deed, and Nellie now seeks to have an equity court set aside the conveyance. Should she be successful?



  1. Generally speaking, a unilateral mistake does not provide ground for rescinding a contract. The major exception covers situations where the other party is aware of the mistake and should have spoken up. In today’s consumer-minded world, the unilaterally mistaken party has a substantial chance of rescinding the contract if (a) he/she could not easily have learned the facts, and (b) the other party had full control of the situation.

  2. In a case involving fraud, an opinion given by a professional, such as an attorney or a physician, is a statement of fact giving rise to grounds for rescission. In addition, you should consider that opinions given by tradespeople, such as plumbers, electricians, and hairdressers (in cases concerning shampoos or brushes), will be given greater weight and should be discussed.

  3. The equity concept of fairness controls the law of contract mistake. The old idea of caveat emptor favored an unscrupulous seller. The modern law tries to “balance the equities,” so that neither side should be able to take unreasonable advantage of the other. This is basic equity law.

  4. Contract fraud permits the defrauded party either to keep the contract and receive damages in tort (perhaps even punitive damages) or to rescind the contract; simple mutual mistake permits only the right of rescission.

  5. Merely careless statements can give rise to fraud if they are made recklessly. The law does not protect those who show disregard for the truth, whether the disregard is shown by outright lying or lack of interest in presenting the facts accurately.

  6. Undue influence can exist in the relationship of husband/wife, minister/parishioner, lawyer/client, doctor/patient, parent/child, trustee/beneficiary, political office holder/constituent and others involving trust and potential conflict of interest.

  7. (a) Duress causes a contract to be void if it is the result of a physical threat, such as pointing a gun. (b) A contract is voidable when it is the result of mental coercion.

  8. “Unconscionable” means grossly unfair. Gross unfairness occurs generally when one party is in an advantageous position in relation to the other party, because of either superior knowledge and power, or the inferior knowledge and power of the other. Disparities in skill, education, professional background, and economic status would be factors in determining unconscionability.


  1. (a) This is an example of unilateral mistake on the part of Fred, where such mistake is known to the other party. Therefore Fred would have the right to rescind the contract. An argument could also be made that fraud exists since Lester has inside information that a judge or jury might hold he has a duty to share with Fred.

(b) There is neither mistake nor fraud in this situation. XYZ Chemical Company may or may not be interested in Fred’s property according to the statement of facts, and therefore Lester’s failure to disclose this information is not nondisclosure of a material fact.

  1. This is an example of undue influence practiced by a wife upon a husband. Betty is acting in her own self-interest while leading her ill husband to believe that she is acting either for him or for both parties.

  2. The bookkeeper can rescind the obligation. The promise not to report a crime as consideration for a contract is duress. (The promise not to sue generally would be okay.)

  3. This is a prime example of an unconscionable contract that will be set aside in an equity court. The one-sided nature of the bargain, combined with the lack of equality between the parties, is the essential characteristic of unconscionability. In addition, it could be argued that this is a case of fraud (check each of the five fraud elements) or even of undue influence (is there a relation of trust?).

1 To undermine further any potential claims of overlooking the terms in a contract, the document should be in an easily read font and type size, and any significant nonadjacent terms (e.g., conditions found on the reverse side of the page or in an addendum) should be boldly identified with a phrase such as, “This contract is subject to terms and conditions in Addendum A.” Key terms should be accompanied by blanks for the parities to sign their initials indicating clear assent to those contract terms specifically.




capacity a legally defined level of mental ability sufficient to reach an agreement

insanity mental impairment sufficient to prevent one from appreciating the nature of an agreement or the consequences of his/her actions

public policy concepts of prevailing morality used by courts to determine the legality or illegality of contracts

Preceding chapters have dealt with consideration and mutual assent, two of the four elements necessary for a valid contract. In this chapter we consider the other two: capacity of the parties and legality of subject matter.


The technical requirement of capacity arises out of common sense. Capacity is a legally defined level of mental ability sufficient to reach an agreement. If one (or both) of the parties has a mind so immature or childish, so befuddled by mental illness or disease, or so stupefied by alcohol or other drugs that it cannot form an intent or know what is going on, the party (or parties) thus lacking capacity may opt to disavow their agreement.

Three categories of people may lack capacity to make a contract: minors, insane persons, and intoxicated persons.


In most states both parties must be at least 18 years old to make a legally binding agreement; a few states set the minimum age at 21.


A person who deals with a minor does so at his/her peril. The adult party to the contract is bound by the bargain; the minor is not.

If one of the parties is under the age of 18—is a minor—that party has the right to declare the contract void. Disaffirmance is the cancellation or rejection of a contract made during one’s minority. Disaffirmance may consist of returning goods bought (if they still exist or have not been consumed), in whatever condition they then may be, or of some other express or implied action of cancellation or rejection made known to the adult party. This action must occur during minority or within some reasonable period after the minor reaches 18.

If the minor has sold the goods in question to an innocent third party, that party will have acquired a good title with respect to third parties, but the minor can also disaffirm the contract and recover the goods. As for the original contract, if the minor still has the goods in his/her possession at the time of disaffirmance, most courts hold that the minor must return the goods to the other party; if the goods are damaged, these courts hold that the damaged goods must be returned.

In a departure from the traditional rule that the adult party, in effect, takes all of the risk when contracting with a minor, some states now require that the minor reimburse the other party for the use or depreciation of its property.

State law often prevents minors from disaffirming transactions such as marital agreements, child support obligations, educational loans, duties concerning financial transactions (e.g., bank accounts, stock and bond transfers), life and health insurance policies, transportation contracts, court-approved contracts (e.g., to employ a child actor), and medical care or psychological counseling. In most states, emancipation (termination of a parent’s right to control a child, e.g., because of the minor’s marriage or full-time employment) does not, by itself, give a minor the capacity to contract.


General Rule:

A minor is responsible for his torts down to a very tender age; however, a parent is not responsible for the torts of a minor child.

Some state courts hold that a minor who represents him/herself to be an adult is estopped from disaffirming the contract that he/she made with the other party. Other courts, while allowing disaffirmance would permit the other party to sue the minor for fraud. Damages would be the loss sustained by the adult because of the minor’s disaffirmance. Of course, if the minor is of such obvious youth that the adult party could not reasonably have relied on his/her misrepresentation of age, there would be no estoppel or fraud (see Chapter 5).

Caution: Some courts, albeit decreasing in number, do not follow the estoppel or fraud principle set out above since they see it as a subterfuge for circumventing principles of law designed to protect minors.


Necessaries are items required to sustain existence, such as food, shelter, clothing, medical services, and some types of schooling (e.g., vocational training). A car may or may not be a necessary, depending on the minor’s circumstances and intended use of the car. Indeed, the concept of “necessary” is flexible and may be defined in accordance with circumstances and the minor’s station in life.

A minor is legally liable for necessaries that he/she has used or consumed and that were provided by another person at the minor’s request.

This liability is based on the quasi-contract (unjust enrichment) principle since a minor does not have the mental ability to make an express or implied-in-fact contract. Since the obligation is based on a quasi contract, the liability is for the reasonable value of the goods, which may or may not be the agreed-upon value. Moreover, a quasi contract does not exist if the minor is living at home under the care of a parent or guardian.

Note that the unjust enrichment is for goods used or consumed. This principle does not apply to an executory contract (an exchange of promises not yet performed).

Example: Contract for Necessaries

If a 17-year-old enters into a 6-month lease agreement, at an exorbitant rental of $1,000 per month, and if she occupies the premises for 3 months, she would be responsible for the 3 months of actual usage but at a reasonable rental.

The express contract of lease is not relevant to the quasi-contractual obligation and is not binding on the minor. Of course, the minor has no liability for the unexpired 3-month remaining period in the lease.


Once a minor reaches the age of 18, he/she may accept the contract, and thus ratify it ab initio (from the beginning). Such ratification may be express or implied—an understanding of the kind required to have made a contract in the first place.

The courts sometimes differ on what actions constitute implied ratification. In general, however, making payments when due, continuing to enjoy the benefits of the agreement, or other clear, unambiguous action within the scope of the contract usually implies acceptance.


By “insanity” the law does not necessarily mean insanity in the medical or extreme sense. Any temporary, oppressive condition affecting the mind and the ability to understand may amount to legal insanity, particularly if this condition is apparent to the other party.

A person who enters into a contract while unable to appreciate the nature of the agreement or the consequences of his/her actions may, upon recovery, declare the contract void. Such a person is in the same position as the minor (the contract is voidable) with one exception: If the sane party acted in good faith, upon disaffirmance of the contract the mentally impaired party must restore whatever he/she received.

If a person is “insane” in the medical sense and has been adjudicated insane (declared insane, upon medical evidence in a court of law), his/her agreements are void ab initio and of no effect. Such a person cannot contract for anything, and a guardian handles his affairs.


For intoxication by drugs or alcohol to operate as a defense to a claim based on contract, the intoxication must (a) be such as to deprive the subject of the ability to understand the nature of his/her agreement, and (b) be apparent to the other party. If these two conditions are present, the contract is voidable, but the person under disability must restore the other party to the status quo by returning any goods or other consideration received. (A court may declare a person who cannot control his/her appetite for alcohol a “habitual drunkard,” and he/she is therefore without any capacity, similar to a person who has been adjudicated insane.)


A minor, a person under the age of 18, lacks capacity to make a contract. Therefore a minor can cancel a contract at any time during minority and for a reasonable period of time after his/her eighteenth birthday. A minor is, however, responsible for necessaries consumed.

Although minors cannot be held to their contracts, they are responsible for their torts (down to a tender age), including frauds. Consequently, some courts hold a minor responsible for losses to the adult party to a contract because of the misrepresentation of age (fraud).

If a minor accepts the contract after reaching the age of 18, he/she is then bound by it because of ratification.

Insanity is grounds for cancellation of a contract. If, however, the “insane” person has not been adjudicated insane and if the other party acted in good faith, the mentally impaired party must restore value received if he/she wishes to cancel.

A contract made by a person so intoxicated by alcohol or drugs that he/she did not understand the nature of the agreement is voidable if the intoxication was apparent to the other party.


If the subject matter of an agreement is not legal, the agreement is not enforceable in court. The illegal agreement is considered void. Generally, neither party can obtain court assistance for any aspect of a void agreement.

There are two reasons why a contract’s subject matter may be illegal: statute and public policy. Statutes are legislative acts; public policy is a judicial determination of prevailing morality.

In Chapter 1 we explored the close relationship between law and morality. We shall now see how law as statute and law as morality (“public policy”) play identical roles in the law of contracts.


Criminal statutes such as those dealing with murder or arson, and the criminal provisions of the antitrust laws, prohibit certain conduct. Any contract in furtherance of such activity (e.g., a wife’s contract with a hired killer to murder her husband) would have no legal effect and be unenforceable.

In addition there are other statutes—for example, statutes requiring professionals or tradesmen to be licensed, statutes prohibiting betting or wagering, “blue laws” prohibiting purchases on Sundays, usury laws prohibiting exorbitant interest—that indirectly affect a contract and may render it unenforceable. Thus a person who is not a lawyer cannot enforce an agreement to be compensated for legal advice, and a faith healer cannot recover in contract for medical advice. For the same reason, an unlicensed person cannot collect in contract for a real estate commission, nor can an unlicensed contractor collect for home improvements in states where a license is required. Because these licenses are regulatory measures mainly meant to protect the public from unqualified practitioners (e.g., in medicine, law, accounting), the service recipient need not uphold his end of the bargain. However, revenue licenses (intended to tax licensees, not prescribe practice standards for them) can be enforced.

Betting and wagering contracts are generally illegal except where such activities are permitted by statute. (Insuring of risks is permissible, and is discussed in Chapter 21.) Public attitudes (prevailing morality) in these areas of the law, however, are influencing statute law, so that many gambling activities, such as the bingo games conducted by churches or charities, are now lawful where only recently prohibited. Similarly, blue laws, prohibitions of trading contracts on Sunday, seem to be yielding to a more liberal morality in many states. However, one should be aware that Sunday sales of nonnecessity items are illegal in many states and contracts to pay consideration for such transactions may not be enforceable.

Usury is an unlawful rate of interest. Ceilings, set by statute, vary from state to state. A usurious contract is thus void, or enforceable only as to principal, or enforceable as to principal plus interest up to the legal rate. (The standard varies from state to state, and according to the type of contract involved.) “Interest” is usually defined as a charge for the use of money and does not extend to carrying charges or finance charges related to the sale of goods.


In this second ground for illegality of subject matter, general morality again gives rise to public policy, but this illegality is judicially declared in cases before the courts.


Before the enactment of any antitrust laws, the common law found agreements that unreasonably restrained trade to be illegal. Typical of such agreements were those unduly restricting a person in the pursuit of his/her livelihood.

Example: Agreements Restricting Persons in Pursuit of Their Livelihoods

If a chemist agreed that, after any termination of her employment by a chemical manufacturer, she would not work for any other chemical manufacturer for an unlimited period of time, this agreement not to be employed would be found unduly restrictive and unenforceable.

If a barber sold his business and the agreement of sale provided that the seller would not thereafter work as a barber at any place in the state, such an agreement might be found unduly restrictive and unenforceable.

In determining the illegality of such restrictions (covenants), the courts consider the legitimate interests of the party that the agreement seeks to protect as well as the negative effect on the party being restricted. If, in the examples above, there is a likelihood that the chemist may know technology and trade secrets useful to a competitor, or that the barber may be planning to work in a nearby shop, a court may be sympathetic to a restriction upon her/his activity. Conversely, an undue hardship on the chemist or barber may cause the court to refuse enforcement of the restriction.

In all cases, however, the parties should refrain from total restriction—a person should be able to continue to make a living by practicing a trade, profession, or skill. Thus the restriction should be limited as to time (e.g., 2 or 3 years), place (miles or a region), and specialty (e.g., organic chemist, woman’s hair stylist). Otherwise, it may be vulnerable to attack as unreasonable.

A covenant not to compete must be ancillary to some other legitimate agreement, such as employment, sale of a business, partnership, or franchise contract. Some limit—by time, place, and subject matter—should be placed on a covenant not to compete.

How do courts treat non-compete clauses if they are unreasonably broad?

  1. Throw out entirely.

  2. Winnow down to a reasonable level; make reasonable, e.g., in time, in geographic scope.

  3. Blue-Pencil Doctrine—judicial removal of parts of the clause, but enforcement of the rest.

The second and third approaches have been criticized for encouraging the drafters of non-compete clauses to make the clauses overbroad: such clauses may have an in terrorem effect (severely discouraging competition), yet still be enforceable, to a lesser extent, if challenged in court.


Many agreements contain exculpatory clauses, that is, provisions that disclaim liability for negligence or other actions. Thus a sign in a restaurant may warn customers that the restaurant has no responsibility for lost coats or a sign in a parking garage may deny liability for damages to vehicles. Exculpatory clauses are not against public policy per se, and disclaimers such as those in the restaurant or parking garage may genuinely warn the public or another party to a contract that one uses the premises at his/her own risk.

If, however, the parties are not in equal bargaining positions, or if the exculpatory clause attempts to excuse a party from his/her own negligence, such a clause may be against public policy and be illegal and unenforceable.

Such unequal bargaining positions are held, for example, by individual travelers with respect to public carriers, whose exculpatory clauses on tickets and claim checks may be found to be contrary to public policy and thus unenforceable.

In the case of the restaurant or parking garage mentioned above, the public has other options for obtaining the services offered and may refuse to be subjected to the risk implied by the disclaimer or denial of liability.

Courts in California and other states have found six criteria necessary to deem an exculpatory clause against public policy and thus unconscionable:

  1. It concerns a business of a type generally thought suitable for public regulation.

  2. The party seeking exculpation is engaged in performing a service of great importance to the public, which is often a matter of practical necessity for some members of the public.

  3. The party holds him/herself out as willing to perform this service for any member of the public who seeks it, or at least any member coming within certain established services.

  4. As a result of the essential nature of the service, in the economic setting of the transaction, the party invoking exculpation possesses a decisive advantage of bargaining strength against any member of the public who seeks his/her services.

  5. In exercising a superior bargaining power the party confronts the public with a standardized adhesion contract of exculpation, and makes no provision whereby a purchaser may pay additional fees and obtain protection against negligence.

  6. Finally, as a result of the transaction, the person or property of the purchase is placed under the seller’s control, subject to the risk of carelessness by the seller.


Some other types of contracts that are contrary to public policy and therefore illegal are those that would

• Obstruct justice.

• Corrupt public officials.

• Impair public morality.

• Offend public concepts of decency.

• Discriminate because of race, religion, color, or national origin in the sale or rental of property or the use of public facilities.


As a general rule, a court of law will not admit into evidence any matter pertaining to an illegal agreement. Such agreements are not actionable and do not even have legal existence except as possible evidence of a crime or tort.

Exceptions to this general rule are primarily equitable in nature: the innocent public, the disadvantaged party, a repentant party, a party not as guilty of wrongful intent as the other party—all may be permitted to sue on the illegal agreement, and in many cases may obtain restitution and return of the status quo.


An agreement may be illegal because it violates a statute.

An agreement may also be illegal because it violates public policy, that is, it is contrary to general morality as declared by a court of law. Two examples of such illegality are contracts in restraint of trade and contracts between parties not in equal bargaining positions that contain exculpatory clauses.



  1. State how the term “capacity” applies to minors, insane persons, and sometimes users of alcohol or drugs.

  2. Discuss the pros and cons of permitting a suit against a minor for fraud if he misrepresents his age.

  3. Name a specific instance in which contract law attempts to protect general morality.

  4. Why is an intoxicated person not given the same right to disaffirm his/her contract that a minor is given?

  5. Does the warning on cigarette packages that “Smoking by Pregnant Women May Result in Fetal Injury …” operate as an exculpatory clause to the cigarette company?

  6. If an action (e.g., murder) is a crime by reason of a statute, will it usually also be a crime by reason of public policy?


ab initio

blue laws



exculpatory clause





public policy



  1. Just after his seventeenth birthday, Murdock Minor signs a contract with Scholarship Books, Inc., for a correspondence course in geology. The cost of this course is $1,000, payable in 20 monthly installments of $50.00 each. There are 20 units, each completed monthly. Murdock completes 14 units and makes monthly payments promptly. In the fifteenth month, he seeks to rescind the contract. Can he do so?

  2. Fran Flighty, the 17-year-old daughter of wealthy parents, is visiting an aunt in Honolulu. While there, she signs a contract with the ABC Dancing School whereby she is to be taught “all sophisticated modern dances for young and old alike” in “12 easy lessons.” Fran takes no lessons, makes no payments, and seeks to rescind the contract when the ABC Company threatens to sue.

(a) What will be the result?

(b) What would happen if she took the lessons and refused to pay just after her eighteenth birthday?

  1. Dan Diver is a 22-year-old student at Ambiance Air Academy in Smalltown, Any State. He joins a parachute diving club to “experience the exhilaration of diving” and to “engage in the world’s most exciting sport,” according to a contract he signs with the club, Live-Long Divers, Inc. The contract also contains an exculpatory clause releasing the club for damages due to any reason whatsoever, “including negligence by the Club.” While descending via parachute on his first jump, Dan collides with electric power lines and is seriously injured. Would the exculpatory clause excuse Live-Long Divers, Inc., if it should be found negligent?



  1. The term “capacity” relates to the ability of one mind to meet another mind. This ability may not yet be developed in a minor and may be clouded or confused by insanity or alcohol/drug use.

  2. A reason for permitting such a suit is that fraud is a tort, and minors are responsible for this kind of tort if all other requirements of fraud are met. A reason not to permit such a suit is that it indirectly permits the adult party to obtain the same benefits he/she would have received for the minor’s breach of contract.

  3. Public policy is “grounded” in common morality. Thus, an agreement contrary to public policy is simply one that is contrary to general morality. Restraint of trade is contrary to fairness and good morals. The same is true of an excessively broad exculpatory clause, as well as other illegality.

  4. An intoxicated person becomes intoxicated by reason of his/her own freedom of action and is not within a class of persons whom society seeks to protect. Thus, unless the intoxication is evident to the other party, he/she is bound by a contract made while intoxicated.

  5. Cigarette companies have attempted to use the Surgeon General’s warning as an exculpatory clause. However, such a clause does not excuse harm caused by their gross negligence, recklessness, or active, intentional misconduct (e.g., fraud).

  6. Actions made criminal by statute are usually contrary to prevailing morality and, hence, contrary to public policy. Murder, arson, robbery, and so forth are contrary to public policy. Some crimes—speeding, failure to file income tax returns, failure to register securities being offered to the public—arguably are criminal only because they are in violation of a statute.


  1. No. Murdock has ratified the contract by continuing to take the course and making payments after his eighteenth birthday.

  2. (a) This contract by a minor is not enforceable as an express or implied-in-fact contract. The dance studio might argue that it is a contract for necessaries and that there is a liability in quasi contract. However, since the lessons were never taken and no benefit has been received, there is no such liability.

(b) If Fran had taken the lessons, she might be required to pay in quasi contract if the lessons could be considered necessaries. Whether “sophisticated modern dancing” lessons are “necessary” for the teen-age daughter of wealthy parents is a jury question.

  1. Dan Diver does not have to take parachute diving lessons, and even if he did he could choose some other club—thus the parties are in equal bargaining positions. However, the clause should not operate to excuse the club from its own negligence, even though Dan proceeded to take the lessons at his own risk.




Statute of Frauds the statutory requirement that certain agreements must be evinced by a memorandum in writing

Parol evidence evidence concerning a written agreement that is not part of the writing

privity the requirement that a person be one of the parties to a contract in order to have a legal interest in the contract

Up to this point we have emphasized the mental nature of contracts—in fact, we have stated that written and oral words are mere evidence of the mental condition comprising the contract. However, some contracts require more than a provable mental condition.


In 1677, the British Parliament passed “An Act for the Prevention of Frauds and Perjuries,” generally referred to as the Statute of Frauds. This act was designed to prevent the perpetration of frauds arising out of purely oral agreements. It required that there be specified evidence in writing (called a “memorandum”) about certain kinds of contracts that the Parliament considered particularly subject to perjury, abuse, and frauds.

When the various states adopted the common law of England in 1776, this common law included the English statute law then in effect, including the Statute of Frauds. All 50 states, to this very day, follow the old English Statute of Frauds as part of their common law, and in addition follow the Uniform Commercial Code statute of frauds provision relating to sales contracts. The British, however, have repealed the original Statute of Frauds.

The Statute of Frauds has two features: (1) it covers certain categories of contracts, and (2) it requires that there be a written memorandum about contracts within these stated categories.


The Statute of Frauds relates to six kinds of contracts that require written evidence:

  1. A contract calling for the sale of land or an interest therein.

  2. A contract not to be performed within one year.

  3. A contract to sell goods for $500 or more (UCC 2-201) or to lease goods for total payments (excluding payments for options to renew or buy) of $1,000 or more (UCC 2A-201).

  4. A promise by one person to pay the debt of another.

  5. A promise made in consideration of marriage.

  6. A promise by the executor or administrator of an estate to pay a debt of the estate out of his/her own funds.

The meanings of specific words and phrases in contracts within these six categories are, of course, subject to judicial interpretation.

A brief explanation of each of these various contract categories follows.

  1. A contract for the sale of land or an interest in land. This category covers real estate contracts, mortgages, life estates, leases, and easements (rights of way and the like), as well as buildings, growing crops, trees, and other property attached more or less permanently to real estate. There is one important exception to the written evidence requirement: most states, by statute, provide that an oral lease for one year or less is valid.

  2. A contract not to be performed within one year. If it is possible for a contract to be performed within a year, a memorandum is not necessary.

A contract made January 1 for 2 years must have a written memorandum; a contract made January 1 for 1 year may be oral since the contract can be performed within a year. A contract to do work “for life” may also be oral, since the law acknowledges that a person may die within a year and thus fully perform the contract. Similarly, a contract for 5 years terminable at any time upon 90 days prior notice (or some other notice provision of 1 year or less) is a valid oral agreement.1 Finally, under UCC 8-113, sales of securities may be oral regardless of whether the one-year rule could apply—i.e., no statute of frauds extends to securities sales even when such sales could not be performed within one year of being agreed upon.

  1. A contract to sell goods for $500 or more (UCC 2-201) or to lease goods for $1,000 or more (UCC 2A-201). UCC 2-201(3)(c) and 2A-201(4)(c) make it clear that the statutes cover only fully executory (unperformed) contracts. Once the goods have been delivered, the money can be recovered on an oral agreement; likewise, if the money has been paid, the goods can be demanded, again on an oral contract.

  2. A promise by one person to pay the debt of another. This provision generally relates to contracts of guaranty, and is sometimes called the “suretyship provision.” The contract; of guaranty actually involves two contracts: (1) X is indebted to Y on a contract; and (2) as part of a separate contract between A and Y (with consideration going from each party to the other), A assures Y that, if X does not pay, A will pay. It is this second contract, a guarantee of one person’s performance by another person, that is subject to the Statute of Frauds. Such contracts are generally not enforceable if oral.

  3. and 6. A Promise made in consideration of marriage and executors’ contracts. These two categories are somewhat archaic and narrowly technical. The category relating to marriage was not intended to be applicable to the promise to marry, that is, it does not involve an engagement to marry, which itself is not a legally binding contract. Rather, it was intended to involve dowry—the agreement of a woman (or her father) to pay consideration (money or land) to the intended husband. Although dowry agreements are not common in the United States, prenuptial (or antenuptial) agreements are covered by the Statute of Frauds since such agreements usually involve a division of property upon death or separation and are made in consideration of marriage.

The executors’ contract relates to the promises of administrators or executors (sometimes called “personal representatives”) to pay the estates’ debts from their own pockets. This promise is like the agreement to pay the debts of another, and the memorandum in writing is required.


Caution: It is misleading to say that the Statute of Frauds requires that certain contracts be in writing.

The Statute of Frauds requires, not that the entire contract be reduced to a written document, but only that there be some written evidence of the agreement. Several documents, letters, or notations may be read together as a memorandum if all clearly pertain to the disputed transaction.

The memorandum in writing must meet the following minimum requirements:

  1. It must identify all the essential parts of the transaction. (This requirement is satisfied if only the quantity of goods is referred to in a sales contract subject to exceptions made by the Uniform Commercial Code.)

  2. It must have been signed by the party being charged (sued) in case of a dispute.

  3. It must identify the other party to the agreement.

The contents of item 1 may vary from circumstance to circumstance, but usually a description of the price or consideration, as well as the nature or identification of the items being sold or the work to be done, is required. Note in items 2 and 3 that, although both parties must be identified, both parties do not have to sign; only the party against whom suit is being brought or against whom the claim is being made must have signed. Many legal writers and courts are critical of this one-sided requirement, since only one party (the signer) may be sued, not the other party. Moreover, in this rule, as well as most other rules of law pertaining to signing, any signing is sufficient: initials, a stamped or typed signature, a nickname, and the like.

Since the common law favors the enforceability of agreements, the Statute of Frauds is strictly applied; that is, if possible, a court will permit an agreement to stand if there is reasonable evidence that the written memorandum is adequate (or, in some cases, if a party asserting the statute has admitted there was in fact a contract, e.g., under UCC 2-201(3)(b), an admitted oral sales contract is enforceable up to the quantity of goods admitted). Moreover, the statute of frauds will not bar enforcement of a contract for specially-made goods, even though it is a sale for $500 or more and lacks the necessary written evidence. UCC 2-201(3)(a) states that such a contract is enforceable “if the goods are to be specially manufactured for the buyer and are not suitable for sale to others in the ordinary course of the seller’s business and the seller, before notice of repudiation is received and under circumstances which reasonably indicate that the goods are for the buyer, has made either a substantial beginning of their manufacture or commitments for their procurement.”


The Uniform Electronic Transaction Act of 1999 (UETA), a model state law enacted in 47 states (all but Illinois, New York, and Washington, although even those states have electronic commerce, authentication, or signature laws), and the federal Electronic Signatures in Global and National Commerce Act of 2000 (ESIGN) both try to bolster enforcement of electronic contracts. They are procedural statutes that defer to existing substantive law but remove any barriers in those substantive laws that are based upon the method of transaction. For example, UETA permits notary publics to act electronically, thus eliminating stamp or seal requirements.

The UETA strives to eliminate obstacles that the Statute of Frauds might impose by stating four basic principles, at §7: (a) A record or signature may not be denied legal effect solely because it is in electronic form; (b) A contract may not be denied legal effect solely because an electronic record was used in its formation; (c) If a law requires a record to be in writing, an electronic record satisfies the law; and (d) If a law requires a signature, an electronic signature satisfies the law. Pursuant to these principles, electronic records and signatures (e.g., with passwords, digital formats, website click-through processes, or other technologies) may take the place of traditional paper and ink. “The medium in which a record, signature, or contract is created, presented or retained does not affect its legal significance,” UETA §7, comment 1. ESIGN likewise counters any Statute of Frauds defense. Under UETA or ESIGN, people can buy insurance, open bank or brokerage accounts, buy securities or mutual funds, get a new mortgage, or take other online actions without signing a piece of paper.

UETA and ESIGN do not mandate the use of electronic records or signatures and thus apply only if the parties agree to conduct transactions by electronic means. The documents offered electronically to consumers must be transmitted “in a manner that reasonably demonstrates that the consumer can access information in the electronic form,” the Federal Trade Commission has held.

If a law outside the UETA requires a person to provide, send, or deliver information in writing to another, that information may be communicated in an electronic record that the recipient is able to retain. To be effective, the electronic record must follow any formatting, type size, or other requirements imposed by the law requiring the information. If, however, the law explicitly requires that the information be communicated by a specific method (e.g., registered U.S. mail), that method must be used. (The UETA even provides that, in a legal proceeding, evidence of a record or signature may not be excluded solely because it is in electronic form, UETA §13.)

ESIGN protects customers in the following six ways. (1) A customer cannot be forced to use an e-signature—the company has to offer the option of a paper contract, although it can charge extra for it. (2) A customer must be told how to withdraw his/her consent for an electronic account and have notices sent by mail, instead. (3) E-signature deals have to be confirmed by computer to prove that the customer understood the rules. (4) All notices about an account will arrive by e-mail so that the company also has to confirm that the customer’s system can open the electronic envelopes. (5) The electronic contract is to be saved via a method that renders the document unalterable. (6) Critical notices (e.g., utility shutoffs, evictions, foreclosure notices, terminations of health insurance, and most product recalls) must still be sent via the U.S. mail.

Neither UETA nor ESIGN applies to the writing requirements for UCC articles 3 through 9 (every article but 2 and 2A) and/or for the creation of wills, codicils, or testamentary trusts. Because the UETA and ESIGN are similar, it usually does not matter which law applies. Also, ESIGN specifically provides that if a state has enacted UETA, then UETA rather than ESIGN governs the exceptions to the state’s Statute of Frauds.


The Statute of Frauds relates only to executory contracts. Once an oral agreement has been carried out by both parties, the court will not nullify the performed agreement. Moreover, if the oral agreement has been partly or fully performed by one party, a quasi-contract action may be brought for the value of benefits rendered.

With regard to real estate contracts subject to the Statute of Frauds, an oral contract may be enforceable by the buyer even without the memorandum in writing if he/she has paid some or all of the purchase price and has taken possession of the property.

Practical advice:

Regardless of whether the Statute of Frauds applies, put agreements in writing.

  1. While writing, one often thinks of things that should be covered.

  2. The writing process helps to clarify terms, hence making the contract better.

  3. The written document serves as (a) evidence that there was a contract, and (b) evidence of the agreement terms. Memories fade, but written evidence remains.


The parol evidence rule prohibits either of the parties from contradicting or invalidating a fully written contract by means of evidence prior or contemporaneous to the contract and external to the contract. If the parties have reduced their agreement to writing, why should they be permitted to introduce other evidence contrary to their own written understanding?

Although the word “parol” is derived from a Latin word meaning “oral,” the rule prohibits any outside (extrinsic) evidence that contradicts or alters the written agreement. Great care should be used, however, in attempting to apply this broadly stated rule, because (1) there are many exceptions and (2) judges often are reluctant to exclude evidence of clear understandings freely assented to by both parties.

Here is a four-part test for deciding whether to apply the parol evidence rule:

  1. Have parties reduced their contract to a written document (put it in writing)?

if yes, then

  1. Is the contract “integrated” (a final expression of all contract terms)? This is sometimes also referred to as “merging” the terms into a written document.2 An example of an integration or merger clause (which makes the contract “integrated” or “merged”) is the following:

“This agreement contains and constitutes the parties’ entire agreement and supersedes all prior agreements, contracts, and understandings, whether written or otherwise, between the parties relating to the subject matter hereof.”

if yes, then

  1. Is the proposed evidence to be introduced at court as evidence of a prior or contemporaneous agreement?

if yes, then

  1. Does the evidence conflict with or substantially add to the terms of the integrated contract?

If the answer is “yes” to all four questions, then the parol evidence rule bars the introduction of that evidence. If there is a “no” to any of the questions, the inquiry stops and the determination is that the parol evidence rule does not apply.

The following types of evidence are considered exceptions to (or simply are not covered by) the parol evidence rule, and therefore may be introduced concerning matter outside the written contract:

  1. Evidence explaining, clarifying, or elaborating upon the agreement.

  2. Evidence concerning later dealings between the parties, particularly if there was mutual consideration, or reliance by either party, with respect to such dealings.

  3. Evidence tending to prove that the parties did not intend the writing to be a contract, or that the transaction was signed under duress or tainted by fraud, or that other factors would render the agreement void ab initio.

  4. Evidence completing an incomplete written agreement.

  5. Evidence that a condition was to occur before the contract was to be enforced, and that condition did not happen.

  6. For a sale of goods, explanatory or supplemental evidence of a custom (trade usage) or of the parties’ prior repeated actions (course of dealing, course of performance) in similar situations (UCC 2-202).

Because parties have limited time and resources, they often decide to, or simply feel compelled to, not gather all of the relevant information for their decision making. Instead, they only bargain over a small portion (what they consider the key clauses) of a large, complex, and formulaic contract. The economic and public policy premise behind the parol evidence rule thus is undermined because a long, written agreement contains many terms the parties did not discuss and that even the attorneys may have spent very little time reviewing. If a party has otherwise reasonable notions of what the contract involves, but some “buried,” non-negotiated point conflicts with these notions, the rule tells judges to bar evidence of those notions. Perhaps the best example of the parol evidence rule’s potential to exclude evidence is the complex approach it takes to alleged fraudulent inducement of the agreement. Evidence of the inducement, if it varies from terms in the written agreement, is not admissible. Moreover, the promisee must reasonably have relied on the promisor’s promises to perform, with those promises having been false when made. In other words, the promisor not only failed to perform his promise, but also—when he made his promise to perform—already knew that he would or could not perform. Statements that turn out to be merely unfulfilled promises or statements of future events cannot form the basis for a claim of fraud, and thus there is no exception to the parol evidence rule based on alleged fraud. Also, if the false promise does not concern something other than the written terms of the document but instead contradicts terms in that document, the falsehood is inadmissible. Note, however, that according to some state courts, a party is not bound by its signed statement that it (a) received no representations of fact outside the scope of the written agreement, and (b) only relied on representations of fact within the contract. Other courts have honored such clauses and thus barred parties who sign such statements from introducing evidence in conflict with those disclaimers of reliance on extra-contractual representations, particularly if the signing party is “sophisticated” (e.g., an experienced, knowledgeable businessperson, or one represented by counsel).


The Statute of Frauds requires that there be written evidence (called a “memorandum”) for certain kinds of contracts: a contract for the sale of land or an interest in land, a contract not to be performed within a year, a provision by one person to pay the debts of another, a promise made in consideration of marriage, an executor’s promise to pay a debt of the estate from his/her own funds. In addition, the Uniform Commercial Code requires written evidence for a contract for the sale of goods for $500 or more.

The memorandum in writing does not have to be a fully written contract, but it must (1) include all the essential parts of the transaction, (2) have been signed by the party being sued, and (3) identify the other party to the agreement.

The parol evidence rule prohibits extrinsic (outside) evidence that contradicts or alters a written agreement. Exceptions to the rule, however, are broad and numerous.


Privity is the old common law requirement that for a person to have a legal interest or right in a contract he/she must be a party to the contract.

Exceptions to the Privity Doctrine

Modern common law has grafted two very important exceptions onto the privity doctrine: first, one party to the contract can assign his/her rights to someone else; second, sometimes an outside party intended to benefit by the contract may sue on the contract in order to obtain his/her benefit.


Each party to a contract enjoys a right but is also burdened with a duty. If A agrees to sell his hat to B for $20 and B agrees to buy A’s hat for $20, A has a right (to receive $20) and A also has a duty (to deliver the hat); B has a right (to receive the hat) and B also has a duty (to deliver the $20).

Rights are freely assignable. Thus A could assign his right to receive the $20 to C; B could assign his right to receive the hat to D.

Example: Assignment of Rights

Smith gives Thompson an option contract to purchase his property, known as Blackacre, for $100,000. Thompson can freely assign the option (the right to buy Blackacre) to Sanders, and Sanders can show up at the place of sale and purchase the property in the place of Thompson.

Whenever rights are assigned, the party to whom they are assigned (called the assignee) is simply substituted for the person making the assignment (called the assignor). In the example above, Thompson is the assignor, and Sanders is the assignee. This substitution of parties gives the assignee precisely the same rights and duties as the assignor, that is, the assignee is said “to stand in the shoes of the assignor.”

This “standing in the shoes” principle is one of the most important rules of contract law and of commercial law generally.

Suppose that one purchases a boat and signs a contract of sale calling for making certain payments. If the seller of the boat assigns to any third party, such as a bank, the right to receive the payments under the contract, the assignee is substituted for the seller (assignor). If a dispute arises, any defense (breach of contract, defects in the boat, or other claim of any kind) is good against the assignee to the same extent as against the seller (assignor).


The right to receive personal services cannot be freely assigned. Thus, if Employee X agrees to perform clerical services in Y’s store, and Y sells her store to Z, Z cannot claim the services of Employee X even though Y may have attempted to assign this employment agreement to Z.

Also, the right to purchase goods on credit generally cannot be assigned because it is based on a credit rating of the original party.


The contract may expressly forbid assignment by one or by both parties. A milder prohibition may require that the person wanting to assign must obtain the consent of the other party. To this requirement of consent is sometimes added the phrase “which consent shall not unreasonably be withheld.”

In case of doubt, if you do not want your contract assigned, place a prohibition in the contract, or require consent of both parties for an assignment.


Whether duties to be performed under a contract can be delegated to someone else must be examined on a case-by-case basis. Routine duties, that is, duties that do not require any personal skill or reliability, can be delegated. On the other hand, if the performing party was chosen because of talent, skill, reputation, standing, credit, or the like, such a performing party cannot assign or delegate the duty to perform to some other party. The person contracting to receive this performance is entitled to the work of this skilled or highly regarded person, be he/she a lawyer, doctor, engineer, artist, musician, actor, cabinetmaker, electrician, or other such person; this performer cannot delegate his/her duties to another.

A delivery service, messenger service, meter reader, storekeeper, or other party may perform routine duties that can be delegated, but a provision can be made in the contract prohibiting delegation.


A novation is an agreement among the two contracting parties and a third party whereby all parties agree that this third party shall perform the duties of one of the original parties to the contract. For example, if a patient agrees that a new doctor may assume the duties of a prior doctor under an original contract, and the new doctor accepts the delegation of these duties, this three-way agreement is a novation and the first doctor is relieved of the obligation.


The rights of an assignee in a contract constitute one exception to the privity requirement; the other exception is the right of a third-party beneficiary in a contract. A third-party beneficiary is a person for whose benefit a contract is made but who is not an actual party to the contract. Two categories of such beneficiaries can bring suit on a contract even though they are not parties to the contract: the creditor beneficiary and the donee beneficiary.

A creditor beneficiary is a person who is owed the performance of a contract. If X owes Y $1,000, which X agrees to pay by having Z pave Y’s driveway, Y is the creditor beneficiary of the paving contract between X and Z. Y can sue Z to compel him to perform the paving agreement between Z and X. Of course, if Z cannot or does not perform, Y can still sue X for the $1,000 original debt.

Business Law, 6th edition (Business Review Series) (7)

A common third-party creditor beneficiary is a bank holding, say, a mortgage of M that is assumed by a new party, A. Under the assumption contract, A agrees with M that she will take over (pay) M’s mortgage. The bank is the creditor beneficiary of this assumption agreement and may bring suit against A even though the bank is not in privity with M and A on their contract. Of course, the bank may also sue the original mortgagor, M, if A does not pay.

Business Law, 6th edition (Business Review Series) (8)

A donee beneficiary is the recipient, by gift, of a contractual performance agreed to by two other parties. Thus, if Mr. Smith makes a contract with an insurance company whereby Mrs. Smith will be given certain benefits upon the death of Mr. Smith, Mrs. Smith is a third-party donee beneficiary who can bring suit directly on Mr. Smith’s contract with the company if payment is refused upon the death of Mr. Smith.

Beneficiaries of contracts other than creditor or donee beneficiaries cannot sue on the contracts of other parties. These “incidental” beneficiaries do not have a substantial interest in the contract. Although such a person may show a benefit under the contract, the contract was not made expressly for him/her or for his/her benefit. Thus, if a landlord were to employ security guards for an apartment complex and through the negligence of these guards a tenant’s apartment was burglarized, the tenant would have no cause for action (under the lease) against the guards.


Privity is the requirement that a person must be a party to the contract to bring suit on the contract. There are two major exceptions: the assignment of rights and third-party beneficiaries.

Most rights can be assigned, but as a rule certain others (e.g., the right to receive personal services) cannot.

Routine duties can be delegated, but duties requiring personal skill or reliability generally cannot.

Novation is a three-party agreement permitting one of the parties to be excused and another person to take his/her place.

There are two important types of third-party beneficiaries: creditor beneficiaries and donee beneficiaries.



  1. Does the Statute of Frauds require that certain contracts be in writing?

  2. Is an agreement to work for a person for the lifetime of that person subject to the Statute of Frauds?

  3. What is the meaning of the sentence “The assignee stands in the shoes of the assignor”?

  4. Would the right to enter another person’s property and pick fruit from fruit trees be subject to the Statute of Frauds?

  5. Explain why an incidental beneficiary cannot sue on contracts to which he/she is a party.




creditor beneficiary

donee beneficiary



“incidental” beneficiary


parol evidence


Statute of Frauds

third-party beneficiary



  1. Evan Eager telephoned the Ardent Cosmetic Company asking for a job as manager of sales. Ardent had advertised this job in a trade publication, stating, in part, as follows: “Exciting opportunity for sales manager with leading cosmetics manufacturer. $99,000 per year; 2 years to make good.”

The president of Ardent, Amy Ardent, agreed on the telephone to employ Evan, and he reported for duty the following Monday. Amy also wrote Evan, stating, “Glad you saw our ad in Cosmetics World; welcome aboard!”

Amy fires Evan after 6 months, and he sues for 18 months’ compensation. What will be the result?

  1. Guana Fertilizer Company made a written contract with Rufus Rural to mine phosphate from the “Rural farm in Boise County, Idaho.” The contract required Guana to pay a royalty of $35 per ton for all mineable phosphate taken from the property.

(a) Discuss whether parol evidence can be introduced for each of the following purposes: (1) to describe the location of the farm; (2) to define phosphate; (3) to state the depth to which Guana must dig to remove phosphate subject to the royalty.

(b) Decide whether the royalty can be paid in Guana Company stock as opposed to cash.

  1. Irene Instructor made an agreement to teach at a well-known university for a period of one year for a salary of $80,000 per year.

(a) Discuss (1) Irene’s right to delegate her teaching position to her friend, Smith, a highly qualified and respected teacher in the same field; (2) The university’s right to assign this contract to a nearby university.

(b) Discuss Irene’s right to assign her salary to a bank as collateral for a large farm.



  1. The Statute of Frauds requires that there be written evidence of certain contracts. This written evidence is a so-called memorandum, not a full contract.

  2. No. It is possible for this contract to be performed within one year.

  3. The sentence simply means that the assignee has exactly the same rights as did the assignor. The other party to the contract does not have a better or worse position because the contract has been assigned.

  4. Yes. Since the fruit is attached to trees, which are in turn attached to the real estate, and since the right to enter property is a right affecting real estate, a memorandum should be prepared as evidence of the agreement.

  5. An incidental beneficiary’s benefit is too indirect and too remote. When persons make a contract, they should not have to expect that any person in the world can bring suit on their private agreement.


  1. This 2-year contract is covered by the Statute of Frauds. There is probably a good memorandum, since the ad contains the basic terms of the contract and Amy’s letter is a signed document that can be read with the ad, thus meeting the requirements of the Statute of Frauds.

  2. (a) Items (1), (2), and (3) are definable in court by parol evidence, since they do not contradict the terms of the contract. (b) Since the use of a dollar value suggests cash or the equivalent, Guana stock does not meet these requirements and would, therefore, contradict the writing.

  3. (a) (1) The teaching position cannot be delegated, since teaching is a personal service and substitution is not permitted. (2) The same answer is true of the right to receive the teaching skill, since again the relationship between the employer and the employee is personal. (b) Irene can assign her salary, however, since this is the mere right to receive money.

1 This possibility test states that if the terms of the contract do not require completion to occur more than one year after the contract was entered into and if it is at all possible for the contract to be completed within that first year, then the contract does not fall under the Statute of Frauds. However, a minority of states, including Alabama and Florida, require that more contracts evince a writing than does this possibility test. Instead of just looking for possibilities of performance within a year, however remote, this minority approach is as follows: (1) When a contract does not provide any agreed upon time period, the court is to examine the contract’s purpose and the surrounding circumstances to decide whether the parties must have intended for the contract period to extend longer than a year; (2) If it clearly appears that a longer period was intended, although less than a year was possible, then the contract (under this minority approach) must meet the Statute of Frauds. If there is no reasonable possibility of completing the contract within a year, this minority view is that the Statute of Frauds applies.

2 Partial integration occurs when contracting parties reduce some provisions of their contract to written form and leave other parts unwritten. If the parties meant to leave the latter items to oral expression only, these unwritten provisions may be proven by parol evidence consistent with (e.g., merely adding to, not contradicting) the written portion of the contract.




discharge termination or completion of the contract

condition a fundamental requirement that must be met by one party before the other party has an obligation under the contract

damages the compensation owed to the nonbreaching party to recover any financial loss or injury caused by a breach of contract


Discharge is a general legal term describing the termination or completion of a contract. This word is much broader than “performance,” which denotes only one of several ways in which a contract is brought to an end.


When a contract is performed by both parties, it is said to be discharged by performance. By “performance” is meant substantial performance, not necessarily performance to the very last detail. To determine whether the essential parts of the contract have been performed, one must usually look at the main provisions of the contract; if these have been achieved, the contract has been substantially performed. Thus, if a contract to build a house and to grade and prepare the lot and lawn is fulfilled except for grading the lot, the contract is “performed,” but the cost of completing the work can be subtracted from the agreed-upon price. On the other hand, if the contract is not substantially performed, that is, if the house itself is not completed, the contractor can recover, not on his unperformed express contract, but only in quasi contract for the quantum meruit (“going market value”; see Chapter 4) of his limited performance. Of course, the contractor is responsible for his unperformed express contract. Moreover, in many states, a contractor who willfully departs from the contract cannot recover even in quantum meruit.

Tender of Performance: occurs when a party tenders (presents) an unconditional offer to perform, and the party is truly ready, willing, and able to perform. If the other party rejects the tender, it is as if the first party performed.


Conditions are events whose occurrence or nonoccurrence changes, limits, precludes, gives rise to, or terminates a contractual obligation. Conditions are distinguished from promises. There is breach of contract liability for broken promises, but with non-completed conditions, there simply is no contract (rather than a breached contract).

There are a number of ways to classify conditions: by formation, there are (1) express conditions and (2) implied conditions; by timing, there are (1) conditions precedent, (2) conditions concurrent, and (3) conditions subsequent.


Express conditions are conditions that the contracting parties deliberately create as such in making the contract. Usually, such phrases as “under the following conditions,” “on condition that,” “of the essence,” and “subject to” are used to describe the agreed-upon essentials of the contract. In making a contract, each party should carefully state as essentials or conditions the things that must be done in order to call forth his/her obligation to perform.


Most contracts, whether oral or written, contain implied conditions, some implied in fact or by the nature of the agreement, others implied by law (constructive).

Example: Implied Condition

If Arnold agrees to sell his hat to Bert for $25, it may be implied that the hat to be sold is the hat Arnold is wearing. This would be a condition implied in fact. The law implies that the $25 is to be cash and not a check.

The conditions set out in the example are implied from the nature of the transaction even though they are not expressly or consciously stated by the parties.


Time of performance is usually not an implied condition; if one of the parties strictly requires performance at a certain time, express words of condition should be used. Thus, if a contract to have a house built for A provides “completion to be on or before September 1,” failure to add such a phrase as “time being of the essence,” or other words of condition, will require A to accept late completion, that is, September 20 or even October, as substantial performance. On the other hand, in the sale of highly perishable goods or of stocks and bonds having rapidly fluctuating values, time of performance could be implied as a condition because of the unusual or peculiar circumstances.

If time of performance is not specifically stated, courts will ordinarily enforce a contract, and find performance timely, as long as the contract’s terms are performed in any reasonable time frame.


Satisfactory performance may be called for in the contract. Whether satisfaction is guaranteed as a condition depends on whether the “satisfaction” called for is subjective (a matter of personal taste) or whether the “satisfaction” can be objectively proved. If the satisfaction is subjective, the performer is saying, in effect, “I guarantee that the contract will be completed to your taste,” and satisfaction is a condition. Thus, an agreement by painter P to paint C’s portrait “to the satisfaction of C” sets up a subjective condition that must be met by P before C is obligated to pay under the contract.

On the other hand, an agreement by B to build a club basement for H “as per plans and specifications attached hereto, to the satisfaction of H,” sets up an objective satisfaction for H. In other words, if the plans and specifications are complied with, H cannot unreasonably claim that he is not satisfied. In this case, satisfaction is not a matter of taste, and not a condition.


A condition precedent is one that must be complied with, or must occur, before the other party becomes obligated for his/her performance.

Example: A Condition Precedent

Tom agrees to buy certain property for commercial purposes, provided that Sheila, the seller, obtains proper zoning by an agreed-upon date. The zoning must be obtained before Tom becomes obligated.

Conditions concurrent require that performance by both parties take place at the same time. Most conditions fall within the concurrent category: the deed will be delivered when the price is paid or tendered, or the bank will make a mortgage loan when the buyer presents proof of credit.

A condition subsequent may abolish liability or obligation: for example, a clause that the seller will be liable for defective goods provided that the buyer gives notice within 30 days of delivery that the goods are defective. Failure to give such notice absolves the seller of any obligation for the defective goods.


If one party to a contract fails in a material way to perform, the other party has no obligation on the contract—the contract is discharged by breach. Bear in mind, however, that if the contract is substantially performed it is not materially breached. Also, remember that, even when the contract is not substantially performed, the nonbreaching party is responsible for value received (quantum meruit) in quasi contract. This value received may be subtracted from damages recovered from the breaching party.


Unless the UCC’s perfect tender rule applies, only a material breach, or under Civil Law a “fundamental breach,” permits the nonbreaching party to cancel the contract. However, CISG Article 49(1) lets a nonbreaching party (“N”) issue a Nachfrist notice (taken from German law), which notifies the other, breaching party (“B”) that B has been given an additional specific period of time to comply with the N-B contract. If B still fails to comply, N may void the contract because it now has been fundamentally breached. The Nachfrist notice thus lets the innocent (nonbreaching) party do more than just sue for damages. It permits the innocent party to declare a breach to be a fundamental breach that, if not corrected, gives the innocent party the right not to have to perform anymore.

Nachfrist Notice: Example

Anna Agro Machinery (AAM) of Jacksonville, Florida, makes mechanized harvesters and agrees to sell eight to a buyer, Svensson Farm Cooperative (“Svensson”) of Goteborg, Sweden. The order calls for the harvesters to be painted blue and gold, Sweden’s colors. Svensson learns that the harvesters to be delivered were being painted orange and blue instead. A Nachfrist notice demanding that AAM obey the contract specifications (here, a possible “minor” breach) within a specific time period would establish for Svensson a right to terminate the contract for a “fundamental breach” under Article 49(1) of the CISG, if AAM does not comply.


If one of the parties to a contract clearly states or implies that he/she cannot or will not perform as agreed, the other party does not have to sit idly by and await the due date of performance before declaring the contract breached and therefore discharged. Such a statement of nonperformance creates an anticipatory breach. Anticipatory breach may be implied by some clear, unambiguous action on the part of one of the parties: sale of goods under contract to the other party to some other person; failure to commence construction of a residence within several days or weeks of the date of completion.

When breach appears probable, but is not certain, the innocent party should demand assurance from the other party that the contract will be performed. For sales contracts, if no assurance is given within a reasonable time (no more than 30 days), repudiation has occurred. UCC 2-609.

Basic Principle of Anticipatory Breach

An anticipatory breach occurs if one party to a contract clearly states or implies that he/she cannot or will not perform as agreed, even though the time of performance has not yet arrived.



Since a contract comes into being by mutual agreement, it can be ended at any time by mutual agreement or mutual rescission. Mutual rescission is a contract to end a contract. If the contract is wholly executory, the mutual rescission requires no additional consideration.

Parties may orally agree to end a written agreement, regardless of the formality with which the written contract was made. Indeed, most courts hold that a written agreement providing “This contract shall not be modified except in writing, duly executed by a corporate officer of each of the parties hereto” may nevertheless be orally cancelled provided that the parties effecting the cancellation have the authority to do so.


Accord and satisfaction discharge a contract in that the parties agree to substitute a new performance in place of, and in satisfaction of, an existing obligation. An essential element is acceptance of the new performance, frequently the doing of an act, as full satisfaction for an obligation to pay money. The accord is the agreement to accept the substitution; the performance of the accord is the satisfaction.

Example: Accord and Satisfaction

Arthur owes Beth $1,000, which he cannot pay. Arthur agrees to repair the roof on Beth’s house in lieu of paying the $1,000. The agreement to accept the repair is the accord; performance of the repair is the satisfaction.

Acceptance of a new performance in satisfaction of an existing obligation discharges the old obligation and operates as an accord and satisfaction.


If there is an unliquidated debt (e.g., a partly or totally contested bill), with a colorable (real) dispute, then payment of part of the alleged debt with a conspicuous statement that payment is “in full,” usually discharges the debtor from any remaining amounts allegedly owed.

But what if the debtor cannot prove that, within a reasonable time before the creditor tried to collect on (receive payment from) the check, the creditor knew the check was tendered as a payment in full? Then, under UCC 3-311, the creditor’s claim for the remainder of the amount supposedly owed is not discharged (despite the cashing/depositing of a “payment in full” instrument), if

  1. the creditor is an organization, and the debtor was informed reasonably prior to his/her tendering the instrument that all communications about disputed debts, including attempted “payments in full,” are to be sent to a designated person, office, or place; and the instrument or accompanying communication was not received by the designated person, office, or place; or

  2. the creditor is an individual or (assuming no payment went to the organization’s designated person, office, or place) is an organization and the creditor proves that, within 90 days after payment of the alleged “payment in full” instrument, the creditor tendered to the debtor repayment of the amount that the creditor received on that instrument.


Another type of discharge of contract by agreement of the parties is a release. A release is an agreement by one party to excuse the other party from performance of his contract. If A and B have a contract, and A is unable to perform or is in breach of contract, he may obtain a release from B by the payment of consideration, usually money, although anything of value will support the discharge. A release is valuable protection when a person has, or may have, breached a contract and wishes to avoid any possibility of suit.

In the case of claimed breaches by both parties, with claims and counterclaims by the contracting parties, mutual releases should be obtained in order to ensure the full discharge of the contract by both parties.


Section 1-107 of the Uniform Commercial Code provides that “Any claim or right arising out of an alleged breach can be discharged in whole or in part without consideration by a written waiver or renunciation signed and delivered by the aggrieved party.” A waiver is the voluntary relinquishment of a party’s rights in a contract. A waiver may result in acceptance of defective or incomplete performance.

One should be careful, therefore, to object to incomplete performance and to serve notice that one’s rights are not being waived when additional time is granted for performance or a defaulting party is afforded an opportunity for correction.


Four categories of occurrences will operate to discharge a contract as a matter of law: subsequent illegality, impossibility, bankruptcy, and the statute of limitations.


Subsequent illegality is a rather narrow category of discharge. The principle applies to contracts that are legal when made, but become illegal by the subsequent passage of a statute. The example usually given pertains to alcoholic beverages; contracts to buy and sell become illegal by reason of the passage of prohibition laws.

Generally, legislation making certain acts or conditions illegal contains a grandfather clause, an exemption for conditions or circumstances (including contracts) existing before the legislation was enacted. Typical of such clauses are those found in zoning statutes: uses in existence before enactment of a law may continue thereafter as “nonconforming” uses even though contrary to the new statute.

A very real, but also narrow, subsequent illegality occurs with the declaration of war. Statutes making “trading with the enemy” illegal would nullify any executory contract requiring commerce with the enemy or even with a neutral if the “enemy” could be shown to benefit. There is a distinction, however, between executed and executory contracts: if the enemy had delivered goods or licensed patent rights (an executed contract as to him) but money was owing or not yet paid (an executory contract as to the buyer or licensee), payment would be suspended until the cessation of hostilities. After the war was over, the former “enemy” could collect!


If performance becomes “impossible,” the contract is discharged by operation of law. There are a number of occurrences that may render performance impossible:

• In a personal service contract (e.g., services of a professional such as a lawyer or teacher), the death or incapacitating illness of the performer.

• Destruction of the subject matter of the contract (the property or goods being bought or sold).

• A law or administrative act of government (such as environmental controls prohibiting disposal of wastes or regulating the chemical or toxic content in goods to be manufactured and sold under a contract) that makes performance illegal.

• Acts of God (natural occurrences such as floods or hurricanes that render performance impossible).

“Acts of God” are frequently addressed in contract provisions called force majeure clauses. These clauses may excuse nonperformance (or permit delayed performance) because of a force majeure, that is, a superior force operating beyond the control of either party to the contract. Such clauses are highly desirable in contracts where performance is vulnerable to natural occurrences or to strikes, inability to obtain raw materials, or other outside “supervening” interferences. Reliance on the general legal principles of impossibility may not suffice, in that simple discharge of contract by the affected party would leave the other party in an unprotected, precarious position. It is best to define in the contract the force majeure occurrence in question and to anticipate possible delays and necessary make-up work, the need to purchase elsewhere, and other events occurring because of superior force intervention.

Some courts follow the principle of strict impossibility: the only impossibility excusing performance is absolute factual impossibility—the contract could not be performed at any cost by anyone under any circumstance. Other courts follow a rule of commercial impracticability, that is, if the contract cannot be performed except at excessive and unreasonable cost, the party subject to such cost is excused under the doctrine of impossibility. Courts following the impracticability rule require, however, that some unforeseen contingency occurred, that such contingency was not bargained for in the agreement, and that custom or usage in the business or trade of the contracting parties did not require that one of the parties assume the risk of the contingency.

Example: Commercial Impracticability

An excavator agrees to excavate a cellar under an existing building for a specified price. Upon commencing work, the excavator finds that underground springs at the site disproportionately multiply the anticipated costs. Even though it might be possible to do the job at enormous loss, many courts would excuse the contractor from performance on the grounds of economic impracticability, or impossibility.

The Uniform Commercial Code (see Section 2-615) also adopts the rule of commercial impracticability with regard to sales contracts.


The Bankruptcy Act provides that certain contracts are discharged by compliance with the act (see Chapter 13). After a proceeding in a bankruptcy court, the debtor is released from all contractual obligations to his/her creditors.


The statute of limitations was discussed in Chapter 4. It should be emphasized that, if the promise to perform is renewed in writing following the period of limitation, the contract obligation is revived.


“Discharge” means termination or completion of a contract.

A contract may be discharged by substantial performance of the obligation (i.e., it may be “performed” even though minor aspects have not yet been completed). The performing party may bring suit on the contract, but the court will deduct the cost of completion.

A contract may be discharged by meeting the fundamental conditions of the agreement. These conditions may either be agreed to in the contract specifically as conditions or be implied. It is important in making a contract to use words of condition to describe the things that are fundamental to the parties.

A contract may be discharged by breach if one party fails in a material way to perform his/her obligations.

If a contract is not working out to the satisfaction of both parties, it can be ended by agreement. In mutual rescission, this agreement may be written or oral: the only requirement is that there be a meeting of the minds to cancel.

In accord and satisfaction, the parties agree to substitute a new performance in place of, and in satisfaction of, the existing obligation. When one party has failed to perform a contract, or if there is dissatisfaction with his/her performance and fear of a suit by the other party, it is recommended that a release be obtained as protection from a later lawsuit. In a waiver one party voluntarily relinquishes his/her rights in a contract.

A contract may be discharged by operation of law. Four kinds of occurrences will operate to discharge a contract as a matter of law: subsequent illegality, impossibility, bankruptcy, and the statute of limitations.

Since the meaning of “impossibility” is subject to argument (e.g., strict impossibility versus commercial impracticality), it is helpful to put into a contract a force majeure clause, which defines impossibilities that may occur during the life of the contract and states the consequences for the person claiming the impossibility. Generally, force majeure clauses relate to things beyond the control of the parties to the contract.


The word damages refers to the compensation due the nonbreaching party to recover any financial loss or injury caused by a breach of contract. Damages are an essential ingredient in every contract case in a court of law.

Essential Elements of Plaintiff’s Case in a Contract Action

  1. Proof of the existence of a contract.

  2. Proof that the contract was breached by the defendant.

  3. Proof that, as a result of defendant’s breach, the plaintiff has been injured or damaged.

Whether the contract action is brought by the plaintiff pro se (acting as his own lawyer) in a small claims court, or is a multimillion dollar suit between giant corporations in federal court, these three elements of proof are required.

Sometimes the injury or damage to the plaintiff is negligible, that is, the financial loss to the complaining party is so small as to be practically immeasurable. In that case, the plaintiff will receive only nominal damages ($1 or some other token amount), or plaintiff’s case may be dismissed altogether for lack of proof of injury. De minimis non curat lex (“the law does not concern itself with trifles”), frequently abbreviated simply as de minimis, is an important principle of the law and should be carefully considered before a person goes to court to avenge some perceived violation of principle, hurt feelings, or embarrassment.


If there has been a material breach of contract and this breach has caused measurable damages to the plaintiff, the court will try to compensate the plaintiff by awarding a sum of money sufficient to make him/her “whole.” This sum of money is called compensatory damages. In Hammurabi’s Code, society compensated the injured party by permitting him to injure the other party in the same manner; modern law places a money value on the injury and takes that money from the wrongdoer as compensation to the injured party.

Example: Compensatory Damages

Smith agreed to sell a new automobile, model X, to Jones for $30,000. If Smith fails or refuses to sell that automobile to Jones, or for any reason cannot deliver, and if Jones must pay $32,000 to some other seller for model X, the injury to Jones is $2,000, and that amount of money from Smith will make him “whole,” or will compensate him.

Three principles operate to limit compensatory damages.

Limitations on the Ability to Be Legally Compensated for Damages

  1. Damages must be proved to a reasonable certainty.

  2. Defendant is liable only for damages that were reasonably foreseeable at the time the contract was made or at the time the breach occurred.

  3. Plaintiff must use every reasonable effort to mitigate, that is, avoid or minimize, the damages.

Because of these three principles, proof of damages may be the most difficult part of the contract case.


The first principle, certainty, eliminates speculative losses. Suppose, for example, that ABC Contractors, Inc. has a contract with Glass Manufacturing Company to build and have operative a glass factory by February 1, time being of the essence. Suppose that the factory is not completed on time, and the Glass Company claims that it would have made profits of over $1 million during the period of delay in completion. These profits are generally considered too speculative to support an award of damages.


The second principle, foreseeability of damage when the contract was made or breached, is a reasonable guide for a party about to breach his/her contract: What will it cost to breach? This question can be answered only in terms of foreseen consequences. Suppose, for example, that a manufacturing company has a breakdown in its operations. It orders certain machinery parts from X Machine Company, such parts to be delivered in 24 hours. If the Machine Company is 3 days late in delivering the machine parts, the manufacturing company would have no basis for lost profits during the 3-day period if loss of these profits would not have been reasonably foreseeable by X Machine Company at the time of the breach.


The requirement of mitigation is the third limitation on compensatory damages. Mitigation means reduction to a minimum. It is the requirement that the injured party use reasonable efforts to minimize his/her loss. If the plaintiff fails to mitigate damages, such failure may operate as a partial or complete bar to his/her ability to recover in a breach of contract suit.

Suppose a tenant has a valuable piano under a leaking roof in a rented apartment. If the tenant has the opportunity to move the piano from the leaking area, failure to do so will defeat a contract case (for damages to the piano) against the landlord for breach of the lease provision requiring the roof to be kept in good repair.

Examples: Mitigation Requirement

  1. The duty of a wrongfully fired employee to find comparable employment at the best salary possible.

  2. The duty of a landlord to find a new tenant to replace a tenant who broke her lease by moving before the end of the lease period.

Of course, the mitigating plaintiff is entitled to compensation for the cost of mitigation. The fired employee is entitled to reasonable moving expenses to his new job; both the fired employee and the landlord whose tenant moved are entitled to reasonable advertising expenses. These direct costs of mitigation which can reasonably be anticipated by the parties are called incidental damages and are generally allowed to plaintiffs as part of their loss.


Consequential damages are also allowed as part of the compensatory damages if the breaching party knew or had reason to know that losses would result from the breach. These indirect damages can include injury and lost profits caused by faulty performance if the principles of foreseeability and certainty are met. If, for example, an automobile with defective brakes is delivered to a buyer pursuant to a contract, injuries to that buyer and other persons caused by this defect may be the responsibility of the seller. Lost profits may be allowed if the breaching party knew or should have known that the other party expected such profits at the time the contract was made.

However, consequential damages are examined carefully under both the certainty and foreseeability tests; their inclusion in a specific case is usually a matter for the fact finder jury (or, if a bench trial, the judge) to decide. For some special types of contracts where the nature and purpose of the agreement make reasonably foreseeable the mental anguish or anxiety associated with a breach, courts have awarded damages related to psychological or economic distress. Such special types of contracts have included insurance policies, funeral arrangements, transportation, hotel stays, weddings, plastic surgery, and other “personal” contracts.1


The question of damages is not always a simple one. It is a good idea, therefore, to consider the inclusion of a damage clause in the contract itself as part of the meeting of the minds. It is perfectly acceptable to insert a provision that the performing party shall (or shall not) be responsible for damages. A clause creating responsibility may be preceded by a statement that the parties understand and agree that profits in certain amounts are expected and are dependent on timely completion of performance.

Clauses specifying the dollar amount due upon breach are called liquidated damage clauses. When these clauses reflect reasonable efforts by the parties to calculate damages, they are enforced by the courts, particularly if the subject matter is such as to make the actual assessment of damages difficult. However, if the clause is found to be a penalty (i.e., an unreasonable or arbitrary amount) for nonperformance or breach, it is not judicially enforceable.

Comparative Law: America, Brazil, and Foreseeability

In the United States, the foreseeability rule limits the award of damages to those damages that were predictable.

In Brazil, on the other hand, the foreseeability rule differentiates a total breach from mere tardiness (a delay but not an outright, absolute breach). For mere delay, liability awards are only for the recovery of foreseeable losses, whereas for the total breach Brazilian law permits the additional recovery of even unforeseeable losses. Generally, the Civil Law is more forgiving about late performance than is U.S. contract law.


Punitive damages (to punish), sometimes called exemplary damages (to serve as an example), are recoverable in tort cases as punishment for the outrageous, malicious, and oppressive conduct of the defendant. Generally the amount of such damages is a matter for the jury, which may consider not only the oppressiveness or maliciousness of the conduct, but also the wealth (or lack of wealth) of the defendant, since wealth is a factor in assessing the degree of punishment.

A distinct majority of the states do not allow punitive damages for breach of contract.2 However, when a breach of contract is accompanied by a separate, independent tort (e.g., fraud), this tort (a tort is a private wrong against a person or his/her property; see Chapter 19) may give rise to punitive damages. (This is the rule formulated in RESTATEMENT (SECOND) OF CONTRACTS § 335 (1981).) Also, actions that breach a contract may be considered tortious (constitute a tort), too, in which case the suit may have both contract and tort counts, the latter seeking punitive damages such as for intentional wrongdoing—e.g., battery, defamation, invasion of privacy, conversion, and intentional infliction of emotional distress.3 Only a few state courts have conceptualized a willful breach of contract, such as a deliberate, completely unprovoked failure to pay money due, as itself justifying punitive damages. Indeed, most courts remain adamant that for punitive damages to be in play, something else must be present—a tort, a special fiduciary relationship—something besides just a deal “gone bad,” no matter how outrageous one side’s breach may seem.

Example: A Suit with Both Contract and Tort Counts

Under a contract to deliver goods to the plaintiff’s pier by barge, the defendant’s barge captain strikes the pier and destroys it. The suit may be both in contract (failure to perform) and tort (reckless destruction of property). If the captain acted maliciously (out of spite) or otherwise intentionally and wrongfully (e.g., becoming intoxicated), punitive damages may also be recovered.



In Chapter 1, the equity courts first established in England by the Norman kings were discussed. Certain extraordinary relief requiring the power of the king, such as specific performance of contract or injunction, were reserved to the king’s equity court; money damages were available in the regular English law courts. This division exists to this day as a matter of technical procedure; however, as in the old law, equity is used only as a matter of last resort. If damages will suffice, the plaintiff must seek them in a regular court of law.

Basic Principle of Law

Specific performance of a contract will not be granted if a money award of damages will make the plaintiff “whole.”

Suppose X has agreed to sell a new smartphone, model Z, to A for $350. If X refuses to perform her contract of sale, A cannot obtain specific performance in an equity suit. A must buy model Z for the best obtainable price and sue X for the difference in damages.

Two Kinds of Cases in Which Equity Can Be Counted on for Relief

  1. The subject matter of the contract is unique (not available in the marketplace).

  2. There is a contract for the conveyance of real estate.

Since real estate is, in a sense, unique, the two categories can really be considered as one.

Suppose that, in the example of the new automobile, the car, instead of being new model Z, were an irreplaceable antique. Equity would then grant relief in specific performance. The same result would apply to parcels of ground, houses, and other items of realty: either buyer or seller can order specific performance in equity.

There is one kind of contract in which specific performance is not available: a personal service contract for the work of either a laborer or a professional. These personal service contracts are not enforceable in equity. Courts cannot supervise work to be done; moreover, they cannot be a party to involuntary servitude—a jail term for contempt of court arising out of breach of contract would be a giant step backward in modern law.


Injunction is a second form of relief available in equity in certain situations. An injunction is a court order to a person or party to do, or refrain from doing, a specific thing. The equity court order may prohibit a breach of contract that has not yet occurred if the prospective breach threatens “irreparable injury.” For example, in an employment contract in which a person agrees not to work for a competitor in a specific area for a specific period of time after termination of employment, injunction may be obtained to block the person from violation of his/her agreement. In such a case, great injury may result if the employee works for a competitor even briefly, since the new employer may have full access to the first employer’s business secrets through this breach of contract.


If a judge can determine what the parties truly intended, but a written contract does not reflect the parties’ intent, the judge may reform the contract. A reformation thus states the actual agreement of the parties. When reformation is impractical or the law of mistake otherwise prevents the “rewriting” of a contract, the judge may order a rescission. This equitable remedy means that the contract is canceled (rescinded).


The law does not concern itself with trifles, and litigation for abstract principles that have no financial implication should be avoided. An award of money damages is the general goal of contract litigation.

The courts will award compensation for damages only if (1) damages can be proved with reasonable certainty, (2) they were reasonably foreseeable when the contract was made, and (3) the plaintiff used every reasonable effort to mitigate damages.

To receive consequential damages for injury or lost profits, the principles of foreseeability and certainty must be met.

A liquidated damage clause should be considered as a provision in every contract. This is an attempt to specify the anticipated dollar loss should the contract be breached. If the amount is unreasonable, it is not enforceable.

Punitive damages are not generally available in a suit involving a simple breach of contract, since they represent a tort remedy. If, however, there is a tort aspect (e.g., fraud) to the contract suit, punitive damages may be claimed.

Equity actions—specific performance and injunction—are extraordinary relief and will not be allowed if money damages will make the plaintiff “whole.” Specific performance may be obtained when the subject matter of the contract is unique or it is impossible to have satisfaction without the contract actually being performed. Injunction should be considered where “irreparable” damages will occur in the absence of a court order requiring performance.



  1. What is the difference between the words “discharge” and “performance”?

  2. State the four broad categories for the ways in which a contract can be discharged.

  3. In a contract what words and phrases create express conditions?

  4. When does the law consider “satisfaction” to be objective and not a matter of taste? What difference does this distinction make in setting up a “condition”?

  5. How can a contract be breached before the date of performance arises?

  6. When should one obtain a release?

  7. Discuss the legal significance of the word “impracticable.”

  8. Is an “act of God” the same as a force majeure?

  9. Is a contract obligation “wiped out” (erased) by the passage of time provided in the statute of limitations?

  10. What are the three essential elements to a contract case in court? Which is most difficult to prove?

  11. What limits are placed on compensatory damages?

  12. When are consequential damages not allowed?

  13. What prevents the parties, by mutual agreement, from placing any desired dollar amount of damages in their contract as the definition of liquidated damages if the contract is breached?

  14. Why does the court permit a jury to hear about a defendant’s wealth in a case involving punitive damages?

  15. Name two equity remedies available in some breach of contract cases.


accord and satisfaction

anticipatory breach

breach compensatory damages


conditions concurrent

conditions precedent

conditions subsequent

consequential damages


de minimis


exemplary damages

express conditions

force majeure


grandfather clause

implied conditions

incidental damages


liquidated damages


mutual rescission

Nachfrist notice

punitive damages




specific performance



  1. In a contract dated February 15, Wright agreed to build a drugstore on a lot owned by Peoples, near Washington, D.C. The drugstore was to be completed and ready for occupancy by January 1 of the following year. In September, a hurricane struck the Washington area and flooded the work site, where excavations had just been commenced. No further work was done, and Wright walked off the job. On December 1, Peoples declared Wright to be in breach of contract and employed Turner to complete the job. What damages are available to Wright and Peoples, respectively?

  2. Assume that plaintiff P and defendant D had a contract, with P to perform specified services in return for D’s payment. P claims that he has performed the required services, but D refuses to pay P anything. P sues D. What damages award can P receive if:

(a) P substantially, but not fully, performed the services?

(b) P’s performance of the contract had barely begun and D received only a small benefit?

  1. Gunther, a German national, was the owner of a valuable patent covering dehydrated food processing filed in the U.S. Patent Office. In July 1936, he made a contract with Samson whereby Samson received exclusive rights to manufacture, market, and sell foodstuffs in the United States in accordance with the patent. Samson agreed to pay Gunther a royalty of 12% on all foodstuffs made and sold in accordance with the patent. Samson’s payments were duly made until late December 1941, at which time Samson ceased these payments for “patriotic reasons” (war between the United States and Germany, commencing December 1941 and ending May 1945). In July 1946, Gunther sued for an “accounting” (statement of sales and amounts due) and for back royalties. What would be the result?

  2. Willis, a senior at Charlestown University, rented a room from Thomas by oral lease for a period of 10 months to expire June 1. On January 1, Willis moved from the room without notice to Thomas, but left the room occupied by Goldman, also a student. Thomas accepted Goldman’s personal check for the January rent, but Goldman moved out on February 1. Thomas now seeks rent from Willis for the months of February, March, April, and May. Can he collect?

  3. Singleton was transferred from employment in Dayton, Ohio, to Atlanta, Georgia. In June, he purchased an old house in Atlanta and made a contract with “We Fix It” to have the house ready for occupancy by September 1, “time being of the essence.” The contract contained a “liquidated damage” clause providing for damages to Singleton in the amount of $100 per day for each day, after September 1, required for completion. The house was not ready until October 10. Is this damage clause enforceable if (a) the price of the work was agreed to be $10,000 and (b) Singleton had a family that included two teenage children, and (c) the fair rental value of the house was $400 per month?



  1. “Discharge” refers to any of the ways in which a contract may be completed or ended; “performance” is one way to discharge.

  2. The four categories for discharge are performance, breach, agreement of the parties, and operation of law.

  3. “Condition,” “of the essence,” “subject to,” and equivalent words or phrases.

  4. “Satisfaction” is considered to be objective if the contract contains a definition of performance, such as a reference to plans and specifications, or if performance is determined by ascertainable criteria. If satisfaction can be objectively proven, it is not a condition.

  5. Anticipatory breach may occur before the date of performance arrives, if one party signifies or implies that he/she cannot or will not perform.

  6. A release should always be obtained if there could reasonably be a question of performance of one’s contract.

  7. Many courts consider that a contract performance is “impossible” if it is commercially “impracticable.” However, some unforeseen contingency must occur that was not bargained for and that custom or usage in the trade or business does not require one to assume.

  8. Force majeure (superior force) is broader than “act of God” (natural forces), although it includes acts of God. Force majeure applies to any third force or action beyond the control or power of the contracting parties.

  9. The statute of limitations does not “wipe out” (erase) the contractual obligation. This obligation may be revived by renewal of the promise.

  10. These three elements are (1) that there was a contract, (2) that defendant breached it, and (3) that as a result of the breach, plaintiff was damaged. Depending on the nature of the case, difficulty of proof varies. An implied-in-fact contract is sometimes hard to prove; where performance is complicated, breach may be difficult to show; damages are difficult to prove when bills were not rendered or accounts not kept.

  11. The limits are (1) reasonable certainty, (2) reasonable foreseeability, (3) mitigation of damage.

  12. Consequential damages are not allowed if they were not reasonably foreseeable.

  13. The parties cannot agree upon an unreasonable, unconscionable amount of damages under the guise of “liquidated” damages. To be enforceable, the agreed-upon damages should be related in some way to the expected or anticipated loss that would occur upon breach.

  14. In order to assess an appropriate amount for such damages. A person of great wealth is not punished by a money damage award against him/her to the same extent as is a person of more modest means who is subject to the same award.

  15. Specific performance of contract, and injunction to prevent breach of contract.


  1. Peoples is entitled to a completed drugstore for the same price as agreed upon by Wright. This “make whole” principle governs this case. Wright is entitled to the value of the work performed in quasi contract, but this amount would no doubt be absorbed by People’s greater damages. The September storm, an act of God, could be force majeure, excusing late performance, but Wright gave no notice—he merely walked off the job. Employment of Turner should have occurred early in order to mitigate damages; leaving the work unattended and uncompleted would conflict with the mitigation requirement. Compensatory damages are probably too uncertain; however, incidental damages caused by getting a new contractor to complete the work may well be allowable.

  2. (a) Because the contract has been substantially, but not fully, performed, P is entitled to the contract amount minus the cost of completion.

(b) Because performance of the contract has barely begun, P cannot recover on the express contract; P may be entitled, however, to the fair value of the work performed based on quasi contract.

  1. Gunther is entitled to the “accounting” and to back royalties during the war years. Samson’s obligations were only suspended during this time (World War II).

  2. Thomas is required to mitigate damages by finding a new tenant comparable to Willis, if possible. He found this tenant when he accepted Goldman and Goldman’s rent for January—probably a novation. Willis has no further obligation on the oral lease.

  3. Is $100 a day liquidated damages, or is it an unenforceable penalty? This $4,000 penalty for 40 days amounts to nearly half the price of the work. It is also too large when compared with the fair rental value of the house ($400 per month). In all events, there should have been a ceiling (e.g., $1,000) on the $100 per day penalty; moreover, it should have been tied to some other ascertainable dollar cost—rental of two hotel rooms, for example. Conclusion: This damage clause is an unenforceable penalty.

1 Many civil law nations permit a broad form of compensation—often termed “moral damages”—intended to cover not just outrageous contract-related misconduct, but sometimes extending to a broader class of almost any purposeful breach. That makes for potential damage awards that would not be available in common law jurisdictions and also some civil law nations.

2 Canada has been more receptive to punitive damages claims in the contract context. The Canadian courts have awarded punitive damages for contract breaches in commercial (e.g., franchising) or other contexts without even expecting a related tort claim by the plaintiff. Criteria for possibly awarding punitive damages due to a breach tend to be that the breaching defendant:

  1. carried out a planned and deliberate breach

  2. had illegitimate intentions and motives

  3. knew its actions were wrong

  4. concealed or tried to conceal the misconduct

  5. persistently, over a long time period, engaged in the wrongdoing

  6. profited from the misconduct

  7. knew that the misconduct violated and harmed interests of the plaintiff that were irreplaceable or deeply personal (e.g., the plaintiff’s professional reputation)

3 These and other torts are discussed in Chapter 19.




chattel an item of personal property; a movable piece of property

merchant one who deals in goods or has knowledge or skill with regard to goods

sale transfer of title to goods for a consideration or price

This chapter deals specifically with sales contracts and Article 2 of the Uniform Commercial Code. It serves also as a review of Chapters 4 through 8 on general contract principles. A comparison of the law of sales with the common law of contracts will be helpful in understanding both.


Article 2 of the UCC deals specifically with contracts for the sale of personal property or movables, that is, chattels (goods). Much of Article 2 retains common law principles and restates or expands upon the general law of contracts. Sometimes, the Article fills niches and advances legal positions not found in the common law. Also, just as the common law pervades much of Article 2, so too have courts returned the favor, with interpretations of Article 2 affecting the general law of contracts. Judges and legal commentators have tended to extend the code’s principles to contracts generally, not just sales contracts.



Article 2 imposes higher standards of conduct on merchants than on nonmerchants. Section 2-104(1) defines a merchant as one “who deals in goods of the kind or otherwise by his occupation holds himself out as having knowledge or skill peculiar to the practices or goods involved in the transaction.…”

A number of provisions of the code implement the higher standards for merchants. For example:

(a) Section 2-103(1)(b): Every contract imposes on the parties an obligation of “good faith.” “Good faith” in the case of a merchant means both “honesty” and the observance of “reasonable commercial standards of fair dealing in the trade.”

(b) Section 2-201(2): A written confirmation from one merchant to the other of an oral agreement satisfies the Statute of Frauds unless the recipient, within 10 days, objects in writing.

(c) Section 2-205: A written firm offer of a merchant to buy or sell goods is irrevocable even without consideration, for up to 3 months.

(d) Section 2-207(2): Between merchants, an acceptance may vary the offer, without being treated as a rejection, unless (i) the offer prohibits such varying, (ii) the proposed terms materially alter the offer, or (iii) the offeror objects within a reasonable time. Section 207(1) provides that, as to nonmerchants, an acceptance with new terms is an acceptance of the offer as made, not a rejection. The new terms are treated as proposals for additions to the contract unless the offeree specifies, as a condition, that they must be part of the agreement. This section attempts to solve a “battle of forms” in which each party tries to bind the other to his/her version of the contract by a last communication containing such a version. How can merchants avoid the “battle of the forms”? Merchants should limit acceptance to the terms of the offer or should closely monitor the form of all “acceptances.”

(e) Sections 2-312 and 2-314n (or 2A-211 and 2A-212): These provide for implied warranties of title, non-infringement, and merchantability by merchants.


Under the UCC, an agreement for the sale of goods for $500 or more is subject to the Statute of Frauds. The requirement that the principal terms of the agreement be stated is satisfied if there is “some writing sufficient to indicate that a contract for sale has been made between the parties,” but the contract is not enforceable for any quantity of goods beyond that shown in the writing. A reference to price is not required.


In general, more relaxed, flexible rules are permitted in the creation of sales contracts to carry out the intent of the parties. For example, the common law requires agreement on price before a contract can be said to have been formed. Under the code, a contract for the sale of goods may be silent about price, permitting the parties to set as a price whatever is “reasonable” at the time of delivery of goods. A clause permitting either party to fix the price is enforceable under the code, requiring the party setting the price to act in good faith.


To interpret a contract a jury or court tries to determine the intention of the parties. Article 2 of the code sets out certain criteria for determining the meaning of a sales contract. These principles, while usually developed from concepts in the common law of contracts, sometimes reject common law formalism and require judges and juries to consider a transaction’s commercial context. Under the UCC, the parties’ intent is shown by (a) “the course of performance accepted or acquiesced in without objection” [Section 2-208(1)] and (b) “a sequence of previous conduct between the parties … as establishing a common basis of understanding for interpreting their expressions and other conduct,” and (c) “practice or method of dealing … in a place, vocation or trade.…” These rules of interpretation, although specifically for sales contracts, are widely used by the courts to determine the meaning of any contract.

Caution: As stated previously, Article 2 of the code is limited to sales of personal property (movables or chattels). It does not cover sales of real estate, nor does it apply to contracts for services or for employment. If personal property is conveyed along with real estate, or if the contract calls for both services and sales (such as supplying and installing automobile parts, or supplying blood for a blood transfusion), the courts attempt to determine whether the predominant factor, or primary purpose, of the contract is to supply services (not covered by the code) or goods (covered by the code). This primary purpose, of course, is shown by the intent of the parties, the nature of the transaction, the terms of the contract, and the like. Thus the sale of a residence, including furniture and lawn equipment, would not be covered by the code; a blood transfusion has been held by some courts to be covered by the code, although other courts disagree. However, a vaccination is generally considered a sale of vaccine and hence a transaction under the code!


The principal ways in which the UCC changes sales contracts are as follows:

  1. For merchants the code provides that

(a) higher standards of conduct must prevail;

(b) written confirmation of an oral agreement may satisfy the Statute of Frauds;

(c) a firm offer to buy or sell goods may be irrevocable;

(d) an acceptance may vary an offer without being considered a rejection;

(e) implied warranties of merchantability and ownership are established.

  1. The code establishes a Statute of Frauds for the sale of goods for $500 or more.

  2. The code provides for more flexible rules in determining the existence of a sales contract.

  3. The code lays down specific criteria for determining the meaning of a sales contract; these criteria are less technical and rely on performance, past conduct, and custom.

  4. The sales contract changes in the UCC have influenced courts with regard to the conduct of sellers (courts have become buyer oriented) and the interpretation of contracts generally.


Although international trade has taken place since there were first “nations,” the emergence of multinational and global business enterprises is a twentieth-century phenomenon. As early as the 1930s, the political, legal, and business leaders of many nations saw the need for, and began to develop, uniform laws to cover contracts for the international sale of goods. The ultimate result of this important legal development was the 1980 Vienna Convention on Contracts for the International Sale of Goods, or CISG. Nearly ninety countries, including most important trading nations, have ratified the CISG. (Key nonsignatories include India, Indonesia, Saudi Arabia, South Africa, and the United Kingdom.) The CISG, as a compromise between the common law/UCC system and the Civil Law system, has been used by courts and other authorities as evidence of international custom.

The United States ratified the CISG in 1987. It thereby became the governing law for most international sales transactions carried out by U.S. firms.

The CISG applies only to contracts between business entities located in two different countries, both of which have ratified the CISG. The application of CISG provisions is not mandatory, however, because any U.S. company dealing with a firm located in another signatory country can, by agreement, provide that another law, and not the CISG, will apply. The specific language used in such a provision must be as follows:

The provisions of the Uniform Commercial Code as adopted by the state of ________ [e.g., Florida], and not the Convention on Contracts for the International Sale of Goods, apply.

The CISG does not apply to domestic sales (e.g., between parties both from the same country), to noncommercial sales (consumer sales of goods bought for family, household, or personal use), or to the sale of services. In situations in which an international contract calls for both services and goods, if the sale of goods outweighs the sale of services then the CISG applies. In these respects, the CISG is very similar to the Uniform Commercial Code.

Like the UCC for domestic sales, the CISG generally controls only when the parties to an international transaction have failed to specify in writing the precise terms of the contract. That is when the CISG fills in the terms for the parties. Here are some specific contract law resolutions under the CISG that differ from domestic American law.


The CISG’s firm offer rule does not, as the UCC does, require a signed writing (except in those nations that specifically require written contracting). Further, the creation of a CISG firm offer is more casually established than under the UCC. CISG Article 16(2) states, “An offer cannot be revoked: (a) if it indicates, whether by stating a fixed time for acceptance or otherwise, that it is irrevocable; or, (b) if it was reasonable for the offeree to rely on the offer as being irrevocable and the offeree has acted in reliance on the offer.” Additionally, the CISG does not limit firm offers to a three-month maximum, as the UCC does.

Note that (1) the CISG does not limit firm offers to a three month-maximum, as the UCC does; and (2) under the French Civil Code and the French Code of Commerce rules, anyone can make a firm offer, not just merchants.


The mirror image rule has been followed in many nations (e.g., under both the common law tradition of Great Britain and the Civil Law of France). It is, in effect, the law under CISG Article 19(3), which defines “additional or different terms” (material terms) between an offer and an acceptance in such broad, sweeping language—covering, among other things, anything related to price, payment, quality and quantity of goods, place and time of delivery, liability, and settlement of disputes. Thus, almost all offer/acceptance differences appear to be material alterations and mean that no contract was formed.

The offeror could ignore the significance of a contrary response and act as if a contract has been formed. Thus the offeror may have “accepted” the offeree’s proposed terms. The offeror’s conduct—by not objecting (not even orally) to the reply’s discrepancies could lead, under CISG Article 19(2), to a contract, with the terms those of the so-called acceptance rather than the offer. Moreover, trade usage, course of performance, and industry standards are clearly important under the CISG. Article 9 of the CISG says, “(1) The parties are bound by any usage to which they have agreed and by any practices which they have established between themselves; (2) the parties are considered, unless otherwise agreed, to have impliedly made applicable to their contract or its formation a usage of which the parties knew or ought to have known and which in international trade is widely known to, and regularly observed by, parties to contracts of the type involved in the particular trade concerned.”

Still, CISG Article 19(1) states that any reply to an offer purporting to be an acceptance but containing “additions, limitations or other modifications” is a rejection and a counteroffer (not an acceptance). Also, CISG Article 19(2) states, “However, a reply to an offer which purports to be an acceptance but contains additional or different terms which do not materially alter the terms of the offer constitutes an acceptance, unless the offeror, without undue delay, objects orally to the discrepancy or dispatches a notice to that effect.” If there is no objection, the terms of the contract are “the terms of the offer with the modifications contained in the acceptance.”


There is no CISG Statute of Frauds. The international practice of oral contracting is lawful under CISG Article 11, which states, “A contract of sale need not be concluded in or evidenced by writing and is not subject to any other requirement as to form. It may be proved by any means, including witnesses.” This means that CISG-covered sales contracts need no writing to be enforceable (except for those signatory states that, under CISG Article 96, exempted themselves from the provision). Eight CISG nations (Argentina, Armenia, Belarus, Chile, Hungary, Paraguay, Russia, and Ukraine) specifically reserve the right to demand writing for sales contracts. Therefore, an American business contracting with, for example, a business located in Argentina or Russia (both of which opted to retain a writing requirement) would still be governed by a writing requirement in regard to purely executory contracts.

Three common law nations that still have the Statute of Frauds—Australia, Canada, and the United States—did not opt out of the CISG oral contracting rules when they ratified the CISG. The effect is that the domestic Australian, Canadian, and U.S. sales law (e.g., in the United Sates, it is UCC §2-201) has a Statute of Frauds, whereas these nations’ international sales law (the CISG) does not.


The CISG has no parol evidence rule. Parol evidence is admissible. This is in accord with the Civil Law tradition, which while sometimes requiring the introduction of a written agreement for cases involving contracts above a certain monetary amount (in effect, something akin to the U.S. Statute of Frauds), once that written evidence is presented then witnesses’ testimony or any other evidence is allowed.


Before sales transactions can be fully understood, it is necessary to understand nonsales transactions. The law sets up three important categories of nonsales: bailments, leases, and gifts.


A bailment is a transfer of possession, care and/or control of personal property by the owner or possessor (bailor) to another (bailee) for a limited time for a special purpose. Bailments include temporary conveyance of goods for storage, repair, cleaning, and other such transfers of possession of chattels without transfer of title or ownership. There is a detailed discussion of bailments in Chapter 20.


A lease is a transfer of rights of possession by the owner (lessor) of real or personal property to another (lessee) for that person’s use during a period of time for an agreed-upon consideration (rent). First proposed in 1987, UCC Article 2A applies many general UCC principles (course of dealings, trade usages, etc.) to the leasing of goods and has been adopted by every state except Louisiana.


A gift is a transfer of title by the owner of goods (donor) to another person (donee) without consideration. Whereas an executory (promised) gift is not an enforceable agreement, a fully executed (completed) gift will not be legally disturbed. An executed gift requires (a) delivery, (b) donor’s intent to make a gift, and (c) donee’s acceptance.


Both the code (Section 2-106) and the common law agree that a sale of goods is the transfer of title from a seller to a buyer for a consideration known as the price.

Sometimes, however, the UCC and the common law of contracts differ. For example, in some states, the statute of limitations for a breach of a sales contract (four years under the UCC) and for other types of breaches of contract may be different time periods; in such a case, whether a transaction involves goods, and is thus a sale, could make the difference in whether a lawsuit can proceed.

Under UCC Section 2–102, “goods” are tangible, moveable, personal property (e.g., motor vehicles, ships, animals, mobile or modular homes, machinery, etc.). Services, real estate, and intellectual property are not goods and therefore are not governed by UCC Article 2. For example, bailments or loans of an item, book publication contracts, commission contracts, construction contracts, security or financing agreements generally, and equipment installation or maintenance agreements are not goods.

Example: The sale of a business ordinarily encompasses transfers of equipment, furniture, and other moveables (perhaps inventory), which are goods. But it also often includes, among other things, customer accounts, goodwill, and real property (nongoods). For such “mixed” transactions (involving both goods and nongoods), the courts try to find what the predominant purpose is: does it provide goods or services? In other words, which of the two dominates, while—conversely—which is merely incidental to the main transaction?

GOODS OR SERVICES? (the usual classification)


carpeting (although installed) computer software programs or systems (although intellectual property is involved)

concert tickets

film (including processing)

granite blocks (to be put into buildings)

jet aircraft (even though there is training of flight and maintenance personnel)

prescription drugs

rare coins

shrubs, sod, and trees (even if planted as part of a landscaping contract; but once planted they become part of the real estate)


alarm systems

architectural work or building construction

caskets (part of funeral services)

blood (from an individual to a blood bank)

herbicide spraying

hog confinement (pig pen) drains

lockers (including installation)

steel for a bridge

swimming pools (construction)

tanks and power-washes

tour tickets or tickets for amusement rides

waste-disposal systems

wedding photos (including photographic services)

The Special Case of Utilities

Public utility transmission of natural gas and water is usually held to be goods; likewise for electricity that has passed the home meter and been measured. However, electricity is usually deemed a service when transmitted by high voltage wires before being converted into usable electric currents.


One of the cornerstone principles of the common law is that a seller can transfer only the title (rights) that he/she has. If the seller has no title (e.g., a thief) or has a defective title (e.g., subject to mortgage or lien) he/she transfers merely these limited rights, even though the parties may call the transaction a “sale.”

The code, however, recognizes three exceptions to the common law, three circumstances in which a buyer may obtain a better title than the seller has had:

  1. A person with a voidable title (i.e., title received by a buyer subject to cancellation by the seller) can pass a good title to a bona fide purchaser (a purchaser who has no knowledge of defect).

  2. A person who in good faith buys goods from a retailer in the regular course of the retailer’s business will get a good title even though the retailer has transferred a prior interest to others.

  3. A person who in good faith buys goods from a dealer in such goods obtains a good title even though the goods in question may have been entrusted to the dealer by others.

In the first circumstance the seller’s right to cancel under the code generally occurs because of some kind of fraud practiced by the buyer: giving a bad check, for example, or making some false representation. The buyer, thus in possession and with color (appearance) of title, can transfer title to a good-faith purchaser. The original seller who trusted the original buyer can sue only the buyer with whom he/she dealt.

The other two code exceptions to the common law rule against a buyer acquiring a good title from a seller having a less than perfect title involve dealers in goods. In the first, the dealer may have previously sold or committed the goods to another person, for example, on “layaway”; in the second, the goods were entrusted to the dealer or merchant for a special purpose—e.g., repair or storage (as in a bailment)—and the bona fide purchaser reasonably believes the dealer or merchant to be the rightful owner. In both of these dealer situations, the real owner’s only remedy is against the dealer, not against the innocent buyer from the dealer.


Before the widespread adoption of the Uniform Commercial Code, the risk of loss of goods in the process of being sold and delivered hinged on the answer to the question, “Who had title at the time of loss?” Thus, if goods were lost during the process of delivery, that is, on the high seas, or were stolen from a warehouse, or were damaged while in rail cars, legal questions of title at the moment of loss or damage determined the liability for repair or replacement.

Under the code, buyer and seller are expected to deal with the problem of potential loss, before or in the course of delivery, by contract provisions. If there are no contract provisions, the code establishes general principles for determining risk of loss, depending on whether the contract of sale and delivery is a “shipment contract” or a “destination contract” (Section 2-509).


A shipment contract passes the risk of loss to the buyer when the seller delivers the goods to a carrier. The carrier is deemed the agent (representative; see Chapter 14) of the buyer in any situation in which the contract does not include a requirement for the seller to deliver the goods to a specified destination.

Frequently, the use of certain shipping phrases creates a shipment contract:

  1. FOB (free on board), sometimes with “point of origin,” “seller’s plant,” or “manufacturing facility,” together with the statement of FOB point, imposes the risk and cost of loss on the buyer at the FOB point, including the cost of shipment and loading at that point, the seller’s factory. However, FOB car or vessel (statement of a different FOB point) requires the seller to load the goods into the buyer’s carriage facilities.

  2. FAS (free alongside ship) requires the seller to deliver the goods at his/her expense and risk to a specified ship and port. For example, “FAS White Star, Baltimore, Maryland” would require the seller to deliver the goods to the dock alongside the White Star in Baltimore. Cost of loading onto the ship is for the account of the buyer.

  3. CIF (cost, insurance, and freight) means that the price of the goods includes the cost of shipping and insuring the goods to the buyer’s delivery point. These costs are thus passed to the seller.

  4. C & F (cost and freight) means the same as CIF without the insurance obligation falling on the seller.


A destination contract passes the risk of loss to the buyer when the goods are delivered to the specified destination. The following terms create destination contracts:

  1. FOB destination: See item 1.

  2. Ex-ship: This term does not require that the contract name a specific vessel; risk and expense of loss are borne by the seller until the goods have actually been unloaded from the ship.

  3. No arrival, no sale (UCC, Sections 2-324; 2-613): If the goods do not arrive, there is no contract; and neither buyer nor seller has an obligation to the other unless the seller has caused the nonarrival. If the goods arrive damaged or in violation of the contract, the seller is responsible.


Sometimes it is difficult or impossible to ascertain whether the contract is a shipment or a destination contract and there may be no terms in the contract providing for risk of loss. Section 2-509(3) provides that, if the seller is a merchant, he/she bears the risk of loss until delivery to the buyer; if the seller is not a merchant, risk of loss passes to the buyer when the goods are tendered for delivery, that is, become available to the buyer. This is another example of the higher duty imposed by the code on merchants.

Occasionally, contracts call for delivery of goods held by a person other than the seller or buyer. If the agreement does not describe the movement of these goods, then the buyer takes the risk of loss once he has the power to possess the goods (e.g., receives a document of title).

Lastly, for breaches: (1) if goods are nonconforming and unaccepted, the risk of loss stays with or reverts to the seller; and (2) if there are identifiable, conforming goods, a buyer who repudiates the contract is liable for a commercially reasonable time for any uninsured loss or damage.


On occasion, a seller may deliver goods to a buyer for the buyer’s inspection and approval (on trial) or for the buyer’s resale (consignment), title remaining in the seller (consignor) and subject to the terms of a contract between the parties. Until approval (approval may be express, implied, or conveyed by silence after the passage of a contractually specified period of time), risk of loss remains in the seller. However, if the goods are delivered on consignment, risk of loss passes to the consignee (person receiving delivery) and this person may convey title freely to others.

Consigned goods may be seized or possessed by the consignee’s creditors. The consignor may protect his/her interest in the goods by placing the public on notice of the consignor’s ownership through proper filing of a notice of a security interest under the code, or placing a sign or other clearly visible statement of ownership where the goods are held for sale.


Performance of the sales contract is governed by Part 5 of Article 2 of the Uniform Commercial Code. Before the provisions of Part 5 are discussed, it will be helpful to review both the common law of contracts and some other provisions of the code that touch on the question of performance.

As always, the performance obligations of parties to a contract are to be found, if possible, in the contract itself. At the beginning of this chapter we discussed the code requirement of “good faith”—“honesty” and, in the case of a merchant, observance of standards of “fair dealing” applicable to his/her trade. In truth, the code did not create the requirements of “good faith,” “honesty,” or “fair dealing”; they were, and are, part of the common law.

Unless specific provisions of the code affect or define the performance obligations of the parties, questions of performance are determined by the contract itself or by the general law of contracts.


Section 2-507(1) of the UCC requires that the seller of goods “tender” their delivery as a condition of the buyer’s duties to accept them and, unless otherwise agreed, to pay for them. Section 2-511(1) requires that, unless otherwise agreed, the buyer’s “tender” of payment is a condition to the seller’s duty to “tender and complete delivery of the goods.”

The word “tender” is a legal term with specific meaning as defined by the code and the common law. As used here, “tender” means merely “to proffer” or “make available.”


Although the code sections may seem to create an impasse as to whether the seller or the buyer makes the first tender, in practice an impasse rarely occurs. In most contracts, whether shipment contracts or delivery contracts, including FOB place of shipment or buyer’s plant and FAS seller’s or buyer’s port, the first move must be made by the seller: he/she must tender (make available) the goods to the buyer unless the contract specifically requires that the buyer tender payment, or part payment, before the seller’s tender is made.


Under the common law of contracts, substantial performance of a contract is considered performance. The code changes this rule with regard to the seller’s obligation to tender conforming goods; the goods must be made available strictly in conformity with the contract (the perfect tender rule). Substantial performance will not suffice. Section 2-601 of the code provides that, if the tender of delivery or if the goods “fail in any respect to conform to the contract,” the buyer may do one of three things: (a) reject all the goods, (b) accept all, or (c) accept conforming goods and reject the rest. The buyer must pay for all accepted goods.

Other aspects of the seller’s tender are also governed by the code, but these are generally mere codifications (statutory enactments) of the common law. The seller must hold the goods for the buyer for a reasonable time; the goods must be tendered within a reasonable time; if the contract does not specify or imply an obligation to deliver to a specified place, the place of tender is the seller’s place of business. Here, also, such terms as “FOB,” “FAS,” “CIF,” “C & F,” and “No arrival, no sale,” discussed earlier in this chapter, also apply.


In the absence of contract provisions to the contrary, once the seller has made the goods available to the buyer, the buyer must tender payment before taking possession. Section 2-511 provides that “payment” is sufficient if in accordance with the ordinary course of business. This permits payment by check; if the seller requires cash, the buyer must be given a reasonable period of time within which to procure it. Of course, if the check is dishonored, the buyer’s title to the goods is voidable and the goods may be repossessed by the seller.


Section 2-513 of the UCC provides that the buyer has the right to inspect the goods before payment or acceptance. Cost of inspection must be borne by the buyer unless the goods do not conform to the contract; then these expenses—and the risk of loss—revert to the seller. A C.O.D. delivery does not provide the buyer with the right of inspection before payment of the price [Section 2-513(3)(a)].


The contract itself is the best guide to determine the performance obligations of the parties to a contract.

In the absence of express provisions in the contract, the seller has an obligation to tender (make available) the goods; the buyer is obligated to tender payment. Generally, the first move must be made by the seller. The code requires perfect tender (absolute compliance with the contract) by the seller.

The buyer generally has the right to inspect the goods before accepting or paying for them. Ordinarily the buyer may pay for the goods by check; if cash is required, he/she is entitled to a reasonable period of time to obtain it.



Section 1-106(1) of the code provides that the remedies provided for shall “be liberally administered to the end that the aggrieved party shall be put in as good a position as if the other party had fully performed.…” This code provision is a statutory confirmation of the general contract rule for damages (see Chapter 8). The expression “liberally administered” requires the courts to lean over backward in complying with the “make whole” principle in attempting to assess damages.

The code (Section 2-718) provides for liquidated damage clauses in sales contracts (if not unconscionable, penal, or excessive), as does the general law. Section 2-719 permits the parties to exclude or limit consequential damages (e.g., lost profits). However, such a limitation is considered prima facie unconscionable in the sale of consumer goods (where it would protect the merchant), but not so in the sale of commercial goods (sold to a merchant or in the course of trade).

There is one other important general provision in the code concerning remedies: the statute of limitations for a sales contract (period within which suit must be filed) is 4 years from date of breach (Section 2-725). The code goes on to state that the contract may provide for a shorter period down to 1 year, but may not extend the period beyond 4 years. Limitations for other kinds of contracts vary from state to state.


A buyer may breach a sales contract by (i) wrongfully refusing to accept the goods, (ii) wrongfully returning the goods, (iii) failing to pay for the goods when payment is due or (iv) expressing an unwillingness to go forward with the contract.

The code is quite detailed as to a seller’s remedies (right to be made whole) upon the occurrence of a breach. Among other things, the seller may cancel the contract and hold up delivery, resell the goods to another buyer and recover damages for any difference in price (see Section 2-706 for this procedure), or recover damages for nonacceptance or repudiation. These rights are cumulative (the seller does not have to choose one to the exclusion of others). As stated, unless limited by contract, the seller is entitled to consequential and incidental damages.


A seller may breach a sales contract by (i) failing to deliver the goods as agreed, (ii) delivering goods that do not conform to the contract, or (iii) expressing an unwillingness to go forward with the contract.

As in the case of the seller’s remedies, the code is detailed as to the buyer’s remedies upon breach by the seller. The buyer (Section 2-712) may buy other goods (known as “covering”) and recover damages for any difference in price plus additional expenses, recover damages based on the difference between the contract price and the current market price (Section 2-713), recover damages for goods that do not comply with the contract, or obtain specific performance if the goods are unique.

The reader should compare the provisions of the code for breach of sales contracts with the general common law provisions already discussed. The code does not attempt to rewrite the law: it attempts to improve where appropriate and possible, and to make uniform.


The UCC applies the “make whole” principle to damages incurred by buyer or seller when a sales contract is breached. The statute of limitations is set at 4 years after date of breach, but may by contract be reduced to a shorter term (no less than 1 year).



  1. Why is there a special article in the Uniform Commercial Code dealing with sales contracts but not an article dealing with contracts in general?

  2. Give some examples of the higher standard of dealing imposed on merchants by the code.

  3. Name two legal transactions that transfer possession, but not title.

  4. How does the UCC permit a possessor of property to convey a better title than the possessor himself/herself has?

  5. Does the UCC rely entirely on contract terms in determining risk of loss during the process of sale and delivery of goods?

  6. How does the perfect tender rule change the common law rule of performance?

  7. Ordinarily, which tender much occur first: the seller’s tender of the goods, or the buyer’s tender of payment?

  8. What does the UCC’s “make whole” principle confirm?


Article 2







destination contract









method of dealing

perfect tender rule

prima facie case


shipment contract


voidable title


  1. Anderson, purchasing manager for Fast Kolor Paint Company, mailed a purchase order to AB Can Corporation for 100,000 cans. The order form contained 17 printed conditions on its reverse side. The third condition stated: “Buyer may reject any defective goods within 30 days of delivery.” AB Can sent a letter confirming the order, but the letter stated: “Any objection to goods shipped must be made in writing within 5 days of receipt of goods.” Anderson sought to object to 10,000 of the cans, as defective, on the seventh day after receipt. What would be the result?

  2. AG Gas Wells, Inc. and Trans-American Pipelines Company enter into a contract whereby AG agrees to sell natural gas to Trans-American. The price is to be set by AG based on “the average price then being obtained by gas producers in the state of Oklahoma for sales of gas in interstate commerce.” If all essentials other than price are established in the contract, is the contract binding as to price?

  3. Smith takes an overcoat to XYZ Dry Cleaners to be dry cleaned. He inadvertently left a $200 gold piece in one of the pockets. XYZ sells this coin to Gould, a coin collector. Can Smith recover the coin from Gould?



  1. Sales contracts involve both consumers and merchants, categories with high levels of visibility and concern in the law of business. Also, there is a greater need for uniformity of law in these categories.

  2. Merchants must observe not only rules of honesty, but also reasonable standards of fair dealing in their trade; they are subject to an implied warranty of merchantability; their contracts are interpreted in accordance with methods of doing business in their trade; they have a high standard of duty to make disclosures to uneducated and untrained buyers; they may be subject to strict liability in tort; they have limited ability to disclaim liability for consequential damages in their sales contracts.

  3. Bailment and lease.

  4. A person with a voidable title can pass a good title to a bona fide purchaser; a purchaser from a retailer who had previously sold an interest in the goods to some other person can acquire a good title; a purchaser may get a good title from a dealer in goods even though the dealer is holding the goods for someone else.

  5. If the contract terms are clear about risk of loss, these terms control. If the contract contains no provision, the seller bears the risk until delivery of goods to the buyer.

  6. The common law rule of performance considers “substantial” performance as an acceptable performance. The perfect tender rule requires absolute compliance with the contract before the tender is considered to have been performed.

  7. Ordinarily, the seller’s tender of goods is to occur before the buyer’s tender of payment.

  8. UCC Section 1-106(1) confirms for sales contracts the common law of contracts principle that, in general, the remedies for breach are to be “liberally administered” to make the aggrieved (non-breaching) party whole: “put in as good a position as if the other party [the breaching party] had fully performed.”


  1. This is a “battle of forms” question. If Anderson objected to the 5-day notice-of-defect provision in the seller’s letter of confirmation, he should have promptly notified the seller. Failure to object sets up the 5-day requirement as part of the contract, and the buyer cannot object after this period of time since the proposed term did not “materially vary the offer.”

  2. An agreement permitting one of the parties to set the price is enforceable if that party acts in good faith. The gas producer must make a genuine effort, and document this effort, to determine an average price being charged for interstate gas sales in the state of Oklahoma.

  3. Smith cannot recover the coin from Gould, a bona fide purchaser, from a party in possession with a voidable title. Smith can, however, sue XYZ Dry Cleaners for the value of the coin.





commercial paper in its broadest sense, documents used to facilitate the transfer of money or credit

negotiable instrument a type of commercial paper; a written, signed, unconditional promise or order to pay a fixed amount of money to order or bearer either on demand or at a definite time

negotiation the process by which both possession of, and title to, an instrument are transferred from one party to another, with the transferee becoming a holder

holder a person who possesses a negotiable instrument issued, drawn, or indorsed to that person or his/her order or to bearer

The term “commercial paper” encompasses a variety of documents used to facilitate the exchange of money, including extensions of credit. There are two important types of commercial paper: a promise to pay money (e.g., the promissory note and the certificate of deposit) and an order to pay money (e.g., the draft and the check).

Chapters 10 through 12 will discuss the major forms of commercial paper and the uniform law governing those forms.


The development and use of commercial paper resulted from, and in turn helped to accelerate, the growth of trade. As the words themselves suggest, only after the development of commerce did people need commercial paper. Once it became impracticable to pay always in cash or commodities, society needed a money substitute that would have the ready acceptability of cash, but would entail much less risk of loss or theft. Various types of commercial paper, including the check, have met these requirements.

Commercial paper, though, is not merely a substitute for cash. It can also serve as a means of extending credit. The borrower agrees in writing to repay his/her loan, and that document (e.g., a promissory note), like a simple money-substitute document (e.g., a check), is a special type of commercial paper: the negotiable instrument.

Negotiable instruments are constantly being used by businesses and consumers. One such instrument, the check, is clearly the most common form of commercial paper (excluding money itself), and millions of checks are written every day.


In England, negotiable instruments law was part of a field of law known as the law merchant, which was first developed and enforced in special merchant courts. Based on the customs among merchants, this law’s major concern was to aid the growth of trade.

The merchant courts were abolished in 1756. By then, the law merchant had been incorporated into the common law but remained incomplete and chaotic. Lord Mansfield, Chief Justice of the King’s Bench from 1756 to 1788, extended the commercial law and refined the terms and rights of parties under that law.

Relying on Mansfield’s work, the British Parliament formally codified the negotiable instruments law by enacting the Bills of Exchange Act in 1882. Many American lawyers, judges, and bankers realized that the United States needed a similar codification, and by 1924 all of the states had enacted a set of proposed uniform laws termed the “Negotiable Instruments Law.”

By the late 1940s, changes in commercial practice, as well as divergent interpretations by state courts, led to the belief that negotiable instruments law had to be reformed and made truly “uniform.”


Negotiable instruments law is part of the Uniform Commercial Code, specifically Article 3 (Negotiable Instruments) and Article 4 (Bank Deposits and Collections). These articles, like the overall code, do not represent a brand-new approach to an old subject; rather they attempt to simplify, clarify, and make uniform the nation’s commercial law. The process is ongoing. Indeed, a 1990 revised form of Article 3 has been adopted by 49 states (all but New York).1 Almost all of the law stated in Chapters 10–12 applies to either the original or revised article, but the discussion and UCC references concern revised Article 3.

Although some negotiable documents, such as documents of title and investment securities, are covered in other articles of the UCC, Articles 3 and 4 concern the two fundamental, omnipresent forms of commercial paper: promises to pay money and orders to pay money. As mentioned earlier, promissory notes and bank certificates of deposit are examples of promises to pay money. An order to pay money is called a draft. By far the most common type of draft is the check, which is an order directed to a bank.


Section 3-104(a) of the Uniform Commercial Code states the requirements for negotiability. To be negotiable, an instrument must

(a) be written;

(b) be signed by the maker or drawer;

(c) contain an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the instrument; and no other undertaking or instruction given by the maker or drawer, except as authorized by Article 3;

(d) be payable on demand or at a definite time; and

(e) be payable to order or to bearer.

An instrument that meets all of these requirements except the last one (i.e., it is not payable to order or to bearer) is treated like a negotiable instrument if it is otherwise a check (e.g., payable on demand and drawn on a bank) (UCC 3-104(c)(f)).

The five requirements given above are strictly construed. Ambiguities are resolved in favor of nonnegotiability; and, if an instrument is plainly nonnegotiable, the parties to that instrument cannot agree to make it negotiable.

Section 3-104(a) negotiability is thus restricted to drafts, checks, certificates of deposit, and notes. Section 3-102(a) states that funds transfers (Article 4A) and money are not governed by Article 3. While other forms of commercial paper, including investment securities, may be negotiable instruments under Article 3, any conflicting rule in the Federal Reserve System or in Articles 4 (Bank Deposits and Collections), Revised Article 8 (Investment Securities), or Revised Article 9 (Secured Transactions) prevails over Article 3 for those instruments (UCC 3-102).


A “signature” is any symbol that a party executes or adopts in order to authenticate a writing [UCC 1-201(39)]. It need not be handwritten, but must be on the instrument itself [UCC 3-401].

The law presumes that a signature is authentic and authorized, that is, made with the actual, implied, or apparent consent of the person who is to be bound by the signature [UCC 3-308(a)]. In some cases, even an unauthorized signature is treated as if it were authorized (UCC 3-403); for instance, if the person whose signature is unauthorized knew about it but failed to inform innocent parties who reasonably believed that the signature was authorized. UCC 3-403(a).


The term “unconditional” generally means that the promise or order is not limited or changed by a clause or any other item contained within or incorporated into the instrument. Conditions include tying payment to the occurrence of an event or to the performance of an agreement.


Numerous statements can be placed on an instrument without destroying its negotiability. Such statements, which are not deemed to be conditions on the promise or order to pay, include mentioning

(a) the transactions or agreements that gave rise to the instrument;

(b) the instrument’s consideration;

(c) a separate writing;

(d) that the obligor waives the benefit of laws (e.g., on debt collection) intended for his benefit;

(e) that rights concerning collateral, acceleration, or prepayment are in a separate writing;

(f) that the instrument is secured (but inclusion of the security agreement or mortgage in the instrument itself will make it conditional);

(g) that a confession of judgment is authorized upon default.

These statements are covered in UCC 3-104(a) and 3-106.


Under UCC 3-106(a), two types of statements make an instrument conditional, and thus nonnegotiable:

  1. An express condition on payment.

  2. A statement that the instrument is subject to or governed by another agreement.

Any instrument that is not a check can be rendered nonnegotiable by issuing it with a conspicuous statement that it is “Not Negotiable.” UCC 3-104.


To constitute a fixed amount, the amount must be expressly stated or readily verifiable from the terms of the instrument. An amount is “fixed” even if it includes a specified interest rate, installment payments, particular discounts or additions, collection costs, attorney’s fees, or other charges.

The term “money” encompasses all means of exchange authorized by some government as part of its currency. Therefore, an instrument payable in dinars, euros, or some other foreign currency can be negotiable (UCC 3-107).


To be negotiable, an instrument must be payable either on demand or at a definite time (UCC 3-108).


A negotiable instrument that does not state a time for payment, states that it is payable on demand, or at sight, or otherwise indicates that it is payable at the will of the holder is a demand instrument (e.g., a check) (UCC 3-108). It becomes due (is to be paid) simply upon being presented for payment.


A “definite time” instrument may be payable

at a fixed date or dates;

at a fixed period after sight (presentment) or acceptance;

at a time which was readily ascertainable when the instrument was issued;

at a fixed or readily ascertainable time subject to (i) prepayment, (ii) acceleration (advancing the date of payment to a sooner, definite time), (iii) extension (postponing the date of payment) at the holder’s option, or (iv) extension to a further definite time if by the maker or acceptor or if automatic (upon or after a specified act or event).

The payment time cannot be based on a special act or event that is uncertain as to time of occurrence, even though the act is certain to happen some time. Thus an instrument is nonnegotiable if it is payable on Mr. X’s death; although death is a certainty, when Mr. X’s death will occur is uncertain.


“To order” includes instruments that state:

(i) pay to the order of A (an identified person) and (ii) pay to A or his/her order.

“To bearer” includes instruments that do not state a payee, and instruments that state

(a) pay bearer;

(b) pay to the order of bearer;

(c) pay A or bearer; and

(d) pay cash or to the order of cash.

A person can indorse an instrument in such a way as to convert it from order to bearer paper, or vice versa.


Negotiable instruments may be postdated, antedated, or undated (UCC 3-113), and need not state the place where the instrument is drawn or payable (UCC 3-111). The dates on instruments are presumed correct.

Rules of agency (see Chapter 14) are applicable. Thus authorized agents may complete an instrument (UCC 3-115).

If it is unclear whether a negotiable instrument is a draft or a note, the holder may treat it as either (UCC 3-104(e)).

When there are disputes as to the terms of an instrument, the following rules govern:

  1. Handwriting prevails over typewriting and print.

  2. Typewriting prevails over print.

  3. Words prevail over numbers.

  4. An unspecified rate of interest is treated as being the same as the judgment rate (interest rate earned on unpaid judgments) for the place where the instrument is paid. Unless stated differently in the instrument, interest runs from the date of the instrument or, if undated, from the issue date. (UCC 3-112, 3-113, and 3-114).

Two or more persons may sign in the same role (e.g., as comakers or codrawers). Unless otherwise specified, each such person is fully responsible for any liability charged to that “role,” be it maker, drawer, or whatever.

That an instrument is nonnegotiable does not mean it is worthless. It still may evince a valid, enforceable contract.



The note, often called a promissory note, is a two-party instrument in which one person (the maker) makes an unconditional, written promise to pay another person (the payee), or a person specified by the payee, a fixed amount of money either on demand or at a particular time in the future.

Business Law, 6th edition (Business Review Series) (9)

Jim Jones is the maker, and Matthew Klein is the payee.

Issued by a financial institution (e.g., a bank) as an acknowledgment that the institution has received a particular sum of money, the certificate of deposit is the institution’s note to pay the depositor that sum of money, plus a stated rate of interest.


A draft is a three-party instrument in which one person (the drawer) orders a second person (the drawee) to pay a fixed amount of money to a third person (the payee), or another person specified by the payee, either on demand or at a particular time in the future.

Business Law, 6th edition (Business Review Series) (10)

Thompson is the drawer, Erstwhile is the drawee, and Pseudo is the payee.


A check is a special type of draft in which the drawee is always a bank and the instrument is payable on demand.

Business Law, 6th edition (Business Review Series) (11)

Mary Merchant is the payee, Bob Buyer is the drawer, and Name of Bank is the drawee.

A check drawn by a bank upon itself is a cashier’s check. The traveler’s check is likewise a check in which the financial institution is both drawer and drawee, but with the payee/holder required to sign a specimen signature on the instrument when it is issued and then sign it again when cashing it. Certified checks are checks that have been “accepted” by the drawee bank, that is, the bank certifies that there is money in the drawer’s account to cover the check.


A note originates with two parties:

  1. The maker, who promises to pay.

  2. The payee (depositor), who will be paid by the maker.

All drafts start with three parties:

  1. The drawer, roughly comparable to the note’s maker.

  2. The drawee, the party ordered by the drawer to make payment.

  3. The payee, essentially equivalent to the note’s payee.

Whereas the maker of a note simply promises to pay, more or less directly, the payee, the drawer of a draft states that a third-party, the drawee, will actually pay the payee. The drawee pays with funds from an account the drawer maintains with the drawee.

Both notes and drafts may have additional parties known as indorsers. Although indorsements come in different forms, they all have a common feature: the signature of the indorser.


A note has two initial parties: a maker and a payee. A draft has three initial parties: a drawer, a drawee, and a payee. Both notes and drafts may have additional parties who are indorsers.


Negotiable instruments are frequently preferred over nonnegotiable types of commercial paper or ordinary contracts. The major reason for this preference is that, in exchange for greater formal requirements, the negotiable instrument conveys to its holder rights superior to those of someone trying to enforce an ordinary contract (e.g., a nonnegotiable instrument). Also, rights, duties, and liabilities of the parties are generally clearer under Article 3 of the UCC than under the common law of contracts.

In the ordinary contract, consideration must be proved. With a negotiable instrument, consideration is presumed unless evidence to the contrary is introduced. Even if the other party proves that there was no consideration, the holder’s case will generally not be affected if he/she is deemed to be a holder in due course (HIDC) defined in Chapter 11. Whereas past consideration (e.g., a preexisting debt) is not usually an enforceable basis for ordinary contracts, it is sufficient for negotiable instruments. Most important, the assignee of an ordinary contract is subject to personal defenses (see Chapter 11), but a HIDC generally is not (i.e., many defenses ordinarily available under contract law are not as readily available against some holders).


Negotiable instruments are often easier to enforce than ordinary contracts because (1) consideration is presumed, (2) past consideration is sufficient, (3) a HIDC usually need give no consideration, and (4) a HIDC is generally not subject to personal defenses.



In the “ordinary” contract, one party may be able to assign to someone else his/her rights under the contract (e.g., the right to receive money or goods). The party to the contract is called the assignor, and the person to whom the assignor assigns his/her contractual rights is the assignee. Although not usually a party to the original contract, the assignee “steps into the shoes of the assignor” and not only gains all of the assignor’s contractual rights, but also is subject to all of the contractual defenses to which the assignor was subject.

Example: Rights and Risks of an Assignee

Otto’s Outerware Outlet (OOO) contracts with Brenda’s Bikini Boutique (BBB); OOO is to supply BBB with 25 specially designed “OOO-La-La outfits” at $40 per outfit. If OOO later assigns to a third party, Inga, its rights under the OOO-BBB contract, then Inga has whatever rights OOO had at the time of the assignment. Inga would be entitled to receive $1,000 from BBB if the 25 outfits were delivered to BBB in proper condition and on time. The money would properly belong to Inga because OOO had performed as promised, was thus entitled to the money from BBB, and had assigned to Inga the right to receive the money from BBB.

But what if OOO failed to conform to the terms of the contract, perhaps by not delivering the outfits or by delivering cheap imitations of the “OOO-La-La” line? Then Inga would be subject to BBB’s defense against payment to OOO.

The assignee takes a risk, particularly if he/she cannot verify the rights and defenses that are being assumed. For this reason, the potential assignee may request a “premium” (high or extra payments) for taking assignments, and may instead insist on taking a negotiable instrument whenever possible.


For commercial paper to be readily accepted as a safe substitute for cash, the potential “acceptor” must be confident that the commercial paper does not entail many of the risks assumed by the assignee of an ordinary contract.

A holder possesses an instrument passing to him/her via an unbroken chain of negotiation, if transferred (see below) and (1) issued, drawn or indorsed to him/her or to his/her order, or (2) payable to bearer. To qualify as a holder in due course (HIDC), the holder must have good title to an instrument for which he/she paid value, against which the holder had no notice of any claims or defenses, and which the holder acquired in good faith. See Chapter 11 for a detailed discussion of the holder in due course.

Example: Advantages of a HIDC

If Hollis is the HIDC of a check issued by Baker Co. to pay for an industrial appliance sold by Smith, then Hollis is not subject to Baker’s claim against the seller for breach of warranty or for fraud inducing the sale. These are personal defenses against payment on the instrument, which the buyer, Baker, cannot assert against a HIDC. However, these defenses can be used against Smith and any assignee of Smith.


A holder possesses an instrument passing to him/her via an unbroken chain of negotiation (if transferred) and issued, drawn, or indorsed to the holder or to his/her order, or payable to bearer. If the instrument is negotiable, and the holder is a HIDC, then the HIDC generally can defeat personal defenses that would work against an assignee.


The inherent value of negotiable paper rests largely on the easy, relatively safe manner in which possession of such paper and title to it can be transferred. The transfer process is called negotiation. The negotiable instrument is “negotiated” (transferred) to a holder.

Bearer paper, such as checks made out to “Cash” or indorsed in blank (the holder’s name is signed on the back without any accompanying instruction, such as “Pay to the order of X” or “For deposit only”), can be negotiated merely by a change in possession, that is, by “delivery.” Holders of such instruments may not be the lawful owners; for instance, a thief may take bearer paper.

Order paper negotiation, on the other hand, requires not only delivery but also the proper indorsement(s).

An instrument payable to the order of Joe Smith is not negotiated to Barbara Brown until delivered to her with Joe Smith’s indorsement. Without the indorsement, Barbara (and anyone else who acquires the instrument from her) is a mere transferee.

To have rights under an instrument (e.g., obtain payment), a mere transferee (someone to whom the instrument was transferred, but to whom there was no effective negotiation) must prove that the instrument is valid and that he/she has title to it. There are no presumptions in favor of the transferee’s claim.

A holder, though, benefits from negotiation. Opposing parties have the burden of proving that the holder is not entitled to payment.


A holder is not necessarily the “owner” of an instrument. A holder can obtain payment on an instrument, however, unless the opposing party proves a defense to payment. Mere transferees, though, must prove their right to payment.



Written on a negotiable instrument by or on behalf of the holder, an indorsement is the signature of the holder, with or without additional or qualifying words, so that title to the instrument and the holder’s property interest in the instrument are transferred to a new holder. An instrument may be indorsed on its front or back, or on an allonge (a paper physically attached to, and made a part of, the instrument). When the role of a signatory is ambiguous, his/her signature is treated as an indorsement. Moreover, if a name is misspelled in the instrument, the indorsement may be made in either the correct name, the name as misspelled, or both. (Dual indorsement can be demanded by the person taking the instrument.)


There are several different types of indorsements.

Blank (general) indorsements specify no particular indorsee; a mere signature constitutes a blank indorsement. The effect is to make the instrument payable to bearer. UCC 3-205(b).

Special indorsements specify the person to whom, or to whose order, the instrument is payable. Such an indorsement makes the instrument order paper. UCC 3-205(a).

Example: Special Indorsement

John Smith, the payee of a check, specifically indorses the check to Mary Jones by writing on the instrument “Pay to the order of Mary Jones [signed] John Smith.”

John Smith could simply indorse “Pay Mary Jones,” and it would still be a special indorsement. It renders the instrument order paper (to Mary Jones), even though the front of a negotiable instrument should not be made out that way (see UCC 3-104(a)(1).

An instrument may have any number and combination of blank and special indorsements. The last (most recent) indorsement determines whether the instrument is bearer or order paper.

A third type of indorsement is the restrictive indorsement. There are four main types of restrictive indorsements:

  1. Those that are conditional. Indorsements can contain conditions that would destroy negotiability if they were in the instrument itself. However, despite its negotiability, no holder (except a bank handling or paying instruments in the normal course of collection) has any right to enforce the conditionally indorsed instrument until the condition is met. UCC 3-206.

Example: Conditional Indorsement

John James, the payee of a check, indorses it as follows:

“Pay Jane Jones when she delivers 250 shares of Blue Chip Stock to me [signed] John James.”

John then delivers the check to Jane, who in return promises to transfer the stock to John. Jane could negotiate the check to another holder. However, until she met the condition, most subsequent holders could not enforce payment.

  1. Those that attempt to prohibit further transfer of the instrument. Like a conditional indorsement, an indorsement prohibiting further transfer has no effect on the instrument’s negotiability. An example is: “Pay to the order of Joe Doe only.” In effect, the UCC [Section 3-206(a)] converts such an indorsement to “Pay to the order of Joe Doe.”

  2. Those that include the words “for collection,” “for deposit only,” “pay any bank,” or similar expressions. Like conditional indorsements, those made to facilitate deposits or collections have no effect on negotiability. However, the holder who first receives such an indorsed instrument must obey that indorsement, although subsequent holders need not. “Pay any bank” also means that only a bank may be a holder of the instrument unless it is specially indorsed by the bank or returned to the indorser. UCC 3-206(c).

  3. Those that state that they are for the benefit or use of the indorser or another person. An example of this type of indorsement is: “Pay X in trust for Y.” The instrument’s first new holder must take any money transferred to him/her via the instrument and apply the money in accord with the indorsement. Subsequent holders have no such constraints unless they know that the terms of the indorsement were violated. UCC 3-206(d).

Regardless of type, the indorsement can have a disclaimer. Such an indorsement places subsequent holders on notice that the indorser disclaims liability on the instrument if it is not paid. The most frequent disclaimer is the phrase “without recourse” (a qualified indorsement ).



  1. Name two purposes of commercial paper.

  2. (a) Name the parties to a note.(b) Name the parties to a draft.

  3. (a) What article of the UCC covers the law of negotiable instruments?

(b) What article of the UCC covers the law of bank deposits and collections?

  1. How is a check different from other drafts?

  2. State the differences in the role of consideration when one attempts to enforce a negotiable instrument rather than an ordinary contract.

  3. What advantage does a holder-in-due-course have over the assignee of a contract?

  4. Which usually requires greater formality (adherence to specific requirements for proper formation): a negotiable instrument or an ordinary contract?

  5. What are the requirements for an instrument to be negotiable?

  6. True or false?

(a) Ambiguities are to be resolved in favor of negotiability.

(b) By agreement of the parties, a nonnegotiable instrument can become negotiable.

  1. What types of statements may affect the amount due under an instrument, but do not leave the instrument without a fixed amount?

  2. What types of statements do not make a promise or order conditional?

  3. True or false?

(a) An instrument “payable upon drawer’s death” is negotiable.

(b) Agents may complete an instrument for their principals (e.g., employers).

(c) Dates and signatures on an instrument are presumed correct.

  1. In disputes about the terms of an instrument, which usually takes precedence?

(a) Handwriting or typing

(b) Typing or print

(c) Handwriting or print

(d) Words or numerals

  1. How are negotiable instruments negotiated?

  2. What is the effect of a blank (general) indorsement?





bearer paper

blank (general) indorsement

certificate of deposit


commercial paper






holder in due course



negotiable instrument



order paper


promissory note

restrictive indorsement

special indorsement

UCC Articles 3 & 4


  1. Weaver, who had an account at Boris’s Bank & Trust, borrowed money from Porter. In an attempt to repay Porter, Weaver sent him to Boris, Sr., President of Boris’s, with this writing:

Business Law, 6th edition (Business Review Series) (12)

Is this a negotiable instrument?


Business Law, 6th edition (Business Review Series) (13)

Is this a negotiable instrument?

  1. (a) Miss O’Hara obtains a loan of $300 from Mr. Butler, to whom she dates and signs a written “I owe you” (IOU) for $300.00. Soon thereafter, Butler expresses to O’Hara his resolute apathy as to her future whereabouts and seeks recovery of the $300 from O’Hara. Is the IOU a negotiable instrument? Is the IOU crucial, merely helpful, irrelevant, or in fact harmful to his case?

(b) Suppose Butler, in order to get some cash quickly, discounts his IOU from O’Hara and transfers it to Mr. Dashing Silkes for the sum of $200, with Butler placing his “indorsement” on the back of the IOU. May Silkes collect from O’Hara on the IOU?


Business Law, 6th edition (Business Review Series) (14)

Is this a negotiable instrument? If so, what type?

  1. A promissory note states that one year from the instrument’s date the maker will pay the amount set out in the note “with interest at the current rate.” Is this a negotiable instrument? If so, what type?

  2. (a) Jerry Joker makes a note payable to Kid Kooke “five days after Nate Nerd’s first kiss.” Is the note negotiable?

(b) What if Kid gets tired of waiting and plants one, that is, a kiss, on Nate?

  1. An instrument from A to the order of C is handed by C to B.

(a) What should B request from C?

(b) What may B do if he is afraid that A may not be good for the money and a subsequent holder may seek the money from B, instead?



  1. Extension of credit, money substitute.

  2. (a) Maker, payee.—(b) Drawer, drawee, payee.

  3. (a) Article 3.—(b) Article 4.

  4. The drawee of a check is always a bank, and a check, unlike some drafts, is payable on demand.

  5. Ordinary contract: consideration must be proved; past consideration generally insufficient.

Negotiable instrument: consideration presumed; consideration unnecessary for holder-in-due-course; past consideration sufficient.

  1. A holder-in-due-course is usually not subject to personal defenses, as an assignee is.

  2. The negotiable instrument. Some special contracts (e.g., land transactions) must meet formal requirements to be enforceable. Generally, though, contracts do not require such formality.

  3. It must be (1) in writing, (2) signed by the maker or drawer, (3) an unconditional promise or order to pay a fixed amount of money, (4) without any other undertaking or instruction, except as permitted by UCC Article 3, (5) payable on demand or at a definite time, and (6) payable to order or to bearer.

  4. (a) False. (b) False.

  5. Specified interest rate, stated installments, collection costs, attorney’s fees, particular discounts or additions.

  6. Statements that mention: the underlying transaction or agreement; the instrument’s consideration; a separate writing; that the obligor waives the benefit of laws intended for his protection; that rights concerning collateral, acceleration, or prepayment are in a separate writing; that the instrument is secured; that upon default a confessed judgment is permitted.

  7. (a) False. (b) True. (c) True.

  8. (a) Handwriting. (b) Typing. (c) Handwriting. (d) Words.

  9. Bearer instrument: by delivery
    Order instrument: by delivery and proper indorsement.

  10. It makes the instrument bearer paper.


  1. No. The instrument does not contain a promise to pay or an order to pay. It merely says that Weaver would be very appreciative.

  2. Yes. Although it is not to bearer or to order (it should read: Pay to the order of Wallace Wimpy), the instrument is otherwise negotiable. Under UCC 3-104(c), it is treated as negotiable because it is otherwise a check (payable on demand and drawn on a bank—the Bank of Mayflower).

  3. (a) The IOU should be helpful. Although not a negotiable instrument, it is evidence of a loan to O’Hara from Butler.

(b) Perhaps. Silkes is, at best, an assignee of Butler’s rights and duties under Butler’s contract with O’Hara (the IOU). Silkes is subject to personal defenses O’Hara may have had against Butler.

  1. Yes. A type of note known as a certificate of deposit.

  2. No. A “current” interest rate is unclear. Thus there is no sum certain. (If the interest rate were not specified at all, then the judgment rate could be used, so as to render a fixed amount.)

  3. (a) No. It is not payable at a definite time.

(b) The note is still not a negotiable instrument. The happening of an uncertain event does not convert an indefinite as to time (hence nonnegotiable) instrument into a negotiable instrument. However, such a triggering event could make enforceable the contract that may underlie the nonnegotiable instrument.

  1. (a) An indorsement.

(b) When B cashes the instrument, he should indorse it “without recourse.”

1 UCC Articles 3 and 4 were updated in 2002 to include rules for new technologies and practices in payment systems, but only eleven states have adopted these 2002 amendments. Of course, that does not mean that there are no answers, but simply that there may not be uniformity. Instead, when commercial disputes arise for which the UCC has no provisions, the courts have fashioned their own, often varying approaches, such as for nonpaper payments not yet governed by a UCC Article 3 or 4 revision.




holder in due course (HIDC) a holder who takes an authentic-appearing negotiable instrument (1) for value, (2) in good faith, and (3) without notice that it is overdue, has been dishonored, or has certain defenses or claims against it

“real” (“universal”) defenses defenses to the enforcement of an instrument that are good against anyone, including HIDCs

personal (limited) defenses any defenses not “real” defenses; generally, insufficient against HIDCs

dishonor to refuse to pay (or accept for later payment) an instrument

discharge the removal of parties’ liability on an instrument, usually by payment

The holder in due course (HIDC) of a negotiable instrument is not generally subject to claims or personal defenses that could be raised by the original parties to the instrument. This protection from claims or defenses is the central tenet of negotiable instruments law.

In Chapter 10 you learned what negotiable instruments are and how their title and possession can be transferred (negotiated). This chapter mainly concerns HIDCs, other holders, defenses, and liability among parties. In essence, it covers what happens when something goes wrong.


A holder, you have learned, possesses a negotiable instrument drawn, issued, or indorsed to the holder or his/her order or to bearer. The holder in due course (HIDC) is a special type of holder, one who takes possession and title free of most personal defenses that could be raised against the HIDC’s transferor.

Payees can be HIDCs. However, in the vast majority of cases, the payee was directly involved in the transaction that caused the instrument to be issued (e.g., the payee sold goods or services to the maker or drawer). So the payee very likely would have had notice of any claim or defense against his/her being paid by the maker or drawer, and the payee would not be a HIDC (UCC 3-302(a)(2)(v) & (vi)).


For a holder to be a negotiable instrument’s HIDC:

(1) the instrument when issued or negotiated to the holder must not bear evidence of forgery or alteration or other irregularities or incompleteness calling into question the instrument’s authenticity; and (2) the holder must take the instrument (i) for value, (ii) in good faith, and (iii–vi) without notice that it is overdue, has been dishonored or altered, contains an unauthorized signature, or has certain defenses or claims against it (UCC 3-302(a)).



A holder takes an instrument for “value” to the extent that (1) the agreed-upon consideration has been performed, or (2) he/she acquires a security interest or lien on the instrument (UCC 3-303(a)(1-2)). “Value” does not arise, however, from security interests or liens obtained via legal proceedings, such as deficiency judgments. (For more on security interests or liens, see Chapter 13.)

Example: Taking for Value

Carrie is to pay Bart $500 in order to receive a check from Anne to Bart in the same amount. If Carrie pays Bart $500, then Carrie can be a HIDC for the full amount of the check. If Carrie gives less than $500, however, then she can be a HIDC for only that amount for which she actually gave value to Bart. It does not matter what consideration, if any, passed between prior parties, such as Anne and Bart.

Although an executory promise (to do something in the future) is generally good consideration for contracts, including those under the UCC, it does not constitute the “value” necessary to make a HIDC.


There is also HIDC “value” when a person takes an instrument as security or payment for a preexisting claim, whether or not that claim is due (UCC 3-303(a)(3)). If Baker claimed that Connor owed him money, an instrument from Connor to pay Baker’s claim would be for “value.” HIDC “value” also occurs when, in order to take an instrument, a person gives a negotiable instrument or makes an irrevocable commitment to a third party (UCC 3-303(a)(4-5)). For instance, Smith gives “value” by giving Jones a check in return for taking Jones’s promissory note.

The following are not HIDC “value”: (1) gifts, (2) inheritances, (3) unperformed promises (except binding ones to third parties), (4) purchases pursuant to legal proceedings such as foreclosures, and (5) bulk transfers not made in the ordinary course of business.


A person takes an instrument in good faith if he/she acts honestly [UCC 1-201(19)]. The test is subjective: Did the holder actually believe that the instrument was regular (genuine, authorized, and conforming with the law)? It is usually irrelevant that a reasonable person (the “objective” test) might have acted differently.

Obvious defenses may, though, lead to a presumption against subjective good faith. In addition to the size of any discount from the instrument’s face amount, courts will look at the parties’ relationship, the instrument’s appearance, the time remaining before the due date, and the time and place of the instrument’s transfer.


Most disputes about HIDC status concern alleged notice of a claim or defense; whether “value” was given is generally easy to determine, and good faith is usually assumed.

“Notice” includes both what the holder actually knew and what he/she should have known from all of the facts and circumstances [UCC 1-201(25)]. Under this objective test, obvious forgeries, alterations, or blanks in material terms are themselves sufficient to suggest potential claims or defenses to the instrument; hence nothing else is necessary to show notice. In most other cases, the court will have to look beyond the instrument itself to determine notice.

UCC 3-302(a)(2) covers the defects about which a holder, in order to be a HIDC, must not have had notice.

  1. The instrument is overdue. For time instruments (those with a specific due date), “overdue” means that some or all of the amount of the instrument remains unpaid after the due date. Unless the holder knows that acceleration has occurred, there is no notice of an overdue instrument merely because an installment note or draft contains an acceleration clause.

For demand instruments, “overdue” means either that a demand for payment has been made, yet money remains due, or that the instrument has been outstanding for an unreasonable period of time (more than 30 days, presumably, for certified checks; longer for other instruments).

  1. The instrument has been dishonored. To dishonor an instrument is to refuse payment on, or acceptance of, the instrument. For drafts the dishonoring is generally by the drawee, while for notes it is usually by the maker.

  2. There are defenses against, or claims to, the instrument. Aside from obvious forgeries or alterations (UCC 3-302(a)(1)), notice of claims or defenses arises from awareness that the obligations of one or more parties are voidable or that the parties have been discharged.

Merely filing a document or recording it (e.g., in the land records, with a governmental agency or the like) does not provide notice to a holder (UCC 3-302(b)). Courts look beyond such “constructive” (legally implied) notice to determine whether the holder actually knew or should have known about that defense or claim.

Example: Notice of a Defense

If Gary Gullible pays Skippy Skunk $10,000 in cash to obtain a check payable to Skippy in the amount of $11,000 and with the words “trustee for Molly Minor” written in bold face in the memorandum section of the check, Gary may be deemed to have notice of a defense to payment. The words in the memorandum section seem to indicate that payment is intended to be for the benefit of Molly Minor, but from the $1,000 discount and the fact that payment is in cash a person could reasonably infer that Skippy will keep the money for himself.

Without the discount or the cash payment, Gary probably could argue successfully that he neither knew nor should have known that Skippy was violating his duties as Molly’s trustee. See UCC 3-307 (Notice of Breach of Fiduciary Duty).

Notice of a Claim or Defense?(UCC 3-302(a)(2), 3-305 & 3-306)

Generally YesGenerally No 1. Instrument Itself:

a. Incorrect indorsements

b. Material omissions

c. Important alterations

a. Antedated or postdated

b. Originally incomplete and later completed

  1. Knowledge of Facts:

a. Party’s obligation void or voidable

b. Obligor has a claim in recoupment against the payee (e.g., the payee failed to deliver conforming goods to the instrument’s obligor)

c. Obligor has a contract defense against the person trying to enforce the instrument

d. Obligor is discharged (e.g., in bankruptcy)

e. Transferor’s title defective because of fraud, illegality, theft, etc.

f. Unauthorized signature and/or completion of the instrument

g. Default on any other instrument that is part of a series with this instrument

a. Parties to the instrument include accommodation parties or fiduciaries (trustees)

b. Instrument issued or negotiated for an executory promise

c. Instrument accompanied by separate agreement

d. Default in interest payments on this instrument

e. Default on another instrument [except (g) in left column]

Notice is effective only if received early enough to give a potential holder time to respond. UCC 3-302(f)

Example: Inadequate (Untimely) Notice

If Company X’s branch manager in one store receives notice 30 seconds before Company X’s branch manager in another store accepts the instrument in question, Company X may still be a HIDC. Notice was not timely.

Obviously, later notice cannot serve to undo HIDC status; however, it can limit such status to cover only the amount already given for an instrument. Thus the HIDC is not an HIDC for subsequent, postnotice value provided on that instrument.

Lastly, in most cases no connection need exist between (a) whatever deprives a person of HIDC status, and (b) the defense or claim being asserted against the would-be HIDC.

Example: Personal Defenses Against Holder Need Not Be Related to the Notice That Deprived Holder of HIDC Status

If holder Harry takes a note that Harry knows or should know has been dishonored, maker Mike can assert personal defenses against Harry not necessarily related to the reasons for dishonoring the note. In other words, “A miss is as good as a mile”; if Polly Smith is not a HIDC, it does not matter how close she came to being one—she is subject to the same personal defenses as are other mere holders.



Non-HIDCs usually take whatever rights their transferors had. Thus a transferee who is not a HIDC (e.g., a donee—there is no “value”; the instrument is a gift), but who takes the instrument from a HIDC, acquires all the rights of a HIDC [UCC 3-203(b)]. This shelter rule furthers the transferability of instruments and the benefits of HIDC status; HIDCs and potential transferees know that the latter will acquire HIDC status.

Example: The Shelter Rule

Maker is induced by Payee’s fraud to issue Payee a promissory note. Payee negotiates the note to Course, who takes it for value, in good faith and without notice that it is overdue, has been dishonored, or has defenses or claims to it. After the note becomes obviously overdue, Course negotiates it to Safehaven.

Although Safehaven is clearly not a HIDC (he has notice that the note is overdue), Course was. Therefore Safehaven takes all the HIDC rights that Course had, and Safehaven is free of Maker’s personal defense (fraudulent inducement).

The shelter rule covers anyone who can trace his/her title back to a HIDC. Thus, in the preceding example, once Course takes the instrument, all subsequent transferees, no matter how far down the line, also have HIDC rights.


Transferees cannot use the shelter rule if they participated in fraud or illegality affecting the instrument (UCC 3-203(b)). It would be unseemly to let a party acquire HIDC status by “laundering” an instrument through one or more transferees and then reacquiring it. In the preceding example, the fraudulent Payee cannot become a HIDC no matter how far down the chain of title he reacquires the instrument; Course’s and the subsequent transferees’ HIDC right will not pass to Payee.


A holder has all of the rights of an assignee. A HIDC is a holder who takes a negotiable instrument for value, in good faith, and without notice that it is overdue, has been dishonored, or has defenses or claims against it. Although a mere holder is subject to all defenses, the HIDC is free of personal defenses raised by a party with whom the HIDC has not dealt.

HIDC “value” includes presently performed or past consideration, most security interests or liens, negotiable instruments, and irrevocable commitments to third persons. Gifts, inheritances, mere promises, purchases pursuant to legal proceedings, and most bulk transfers do not constitute HIDC “value.”

HIDC “good faith” is tested subjectively: Did the holder believe that the instrument was regular (genuine, authorized, and conforming with law)? The “without notice” issue is measured objectively: besides the holder’s actual knowledge, notice also arises whenever a reasonable person would have known. Notice of specific claims or defenses is outlined in UCC 3-302(a), 3-305, and 3-306.

Once HIDC status has occurred, it is not removed by later notice. Personal defenses raised against a holder need not be the same as the defense or other factor that deprived the holder of HIDC status.

The shelter rule extends HIDC benefits to all transferees in the chain of title after a HIDC. The exceptions are transferees who (1) were parties to fraud or illegality affecting the instrument, or (2) as prior holders, had notice of a claim or defense to the instrument.


The key to understanding the HIDC’s special status is to distinguish between “real” defenses, which work against even HIDCs, and personal defenses, which do not.


These include:

  1. Fraud in the execution (factum). Before signing an instrument, the maker, drawer, or indorser is led to believe (with no reasonable opportunity to discover otherwise) that he/she is signing something else, not an instrument.

  2. Forgery (writing another person’s name as if that person had done so) or an unauthorized signature (a signature indicating that the signer has authority to bind another person when such is not the case) wholly inoperative for passing title, unless the person whose name is signed ratifies the signature (consents or acquiesces to it) or is estopped to deny it (conducts him-/herself in such a way that another party reasonably assumes that the signature is authorized, and then relies on this assumption). However, a good-faith, paying transferee always has the right to enforce the instrument against the actual forger.

  3. Other defenses sufficient (under other law) to nullify the obligor’s duty, namely duress, illegality, or incapacity.

  4. The obligor’s infancy, to the extent it is a defense to a simple contract.

  5. Discharge of the instrument, if the holder became a HIDC with actual notice of the discharge.

  6. Discharge of the obligor in an insolvency proceeding (e.g., a bankruptcy discharge).

  7. The obligor has a claim for recoupment (compensation in the same matter that the instrument concerned), if the claim is against the holder.

  8. Material (important) alteration of the instrument, giving the instrument a different legal effect (e.g., one or more of its terms changes the liability, duties, and/or rights of one or more parties to the instrument). (Nonmaterial alterations, e.g., crossing an uncrossed “t” or changing the date of a note without any effect on its maturity, are not even personal defenses.) The HIDC can still enforce the instrument’s terms as they existed before alteration. Also, as with forgeries or unauthorized signatures, a party can ratify or be estopped to deny an alteration.

Example: Material Alteration as a “Real” Defense

If Cora Careless signs a check for $10 and a transferee erases the period and otherwise changes the amount to $1,000, Cora may have a real defense against a HIDC for all but the original $10. The HIDC’s hopes for collecting the additional $990 would depend upon estopping Cora—showing that she carelessly left large gaps in her writing or in some other manner made it easy for someone else to change the amount without being detected.


These include the following:

  1. Lack or failure of consideration.

  2. Fraud in the inducement. The maker, drawer, or indorser knows that he/she is signing an instrument for x amount; the fraud concerns misrepresentation about the consideration or other matters. If fraud in the execution (factum) could reasonably have been discovered, it is treated as merely a personal defense, like fraud in the inducement.

  3. Ordinary contract defenses, such as another party’s breach of contract (nonperformance, failure to pay, or the like).

  4. Undue influence, mistake, slight duress, infancy (in some states), illegality, incapacity, or other defenses rendering the contract voidable.

  5. Payment violating a restrictive indorsement (e.g., a prior transferee’s cashing a check indorsed “for deposit only”).

  6. Breach of warranty when a draft was accepted (UCC 3-417(b)).

  7. Modification of the obligation by a separate agreement.

  8. Conditional issuance of an instrument.

  9. Nondelivery of unauthorized delivery of an instrument.

  10. Failure to countersign a traveler’s check.

  11. Acquisition of lost or stolen bearer instruments.

Example: Acquisition of a Stolen Instrument

Thad Thief picks the pockets of Abner Obtuse and discovers among his ill-gotten gains a bearer check, which Thad indorses to the order of Harry Holder. The theft operates as a personal defense; Abner’s title remains good against all but a HIDC or someone taking possession of the check under the HIDC shelter rule. There can be a holder, and even a HIDC, because the bearer paper does not require Abner’s forged signature.

  1. Unauthorized completion of an instrument. Because the UCC generally permits authorized persons to complete instruments on behalf of others, the burden of paying for unauthorized completions is placed on the person who might have been more careful, rather than the HIDC.

Example: Unauthorized Completion of an Instrument

If Barry Bumbler signs a blank check and then loses it, with the finder filling in x amount, a HIDC could collect x from Barry. Of course, if Barry’s signature were forged or the check’s material terms were altered, the defense would be “real.”

  1. An obligor’s claim for recoupment against someone other than the holder.


HIDC status encourages the use of negotiable instruments, which are almost as transferable as money, yet safer. To paraphrase words Lord Mansfield used, the negotiable instrument is a “courier” not bogged down with any luggage. This is especially the case for a HIDC.


UCC 3-302(g) subordinates HIDC status to any laws favoring consumer protection and other public policy concerns. With that in mind, some state legislatures and courts have reduced or eliminated the HIDC’s right to collect from consumers who have personal defenses. Another approach is simply to eliminate HIDC status in certain situations, such as for finance companies closely tied to sellers of consumer products.

So, if Connie Consumer buys a refrigerator from Manny’s Manufacturers, the usual law of commercial paper would allow a HIDC to enforce payment from Connie on her check to Manny; it would not matter that Manny is not entitled to payment from Connie because of numerous problems with the refrigerator. Although Connie would not be protected against the HIDC under the UCCC (the instrument was a check), a state court or agency applying other consumer protection principles may seek to shield Connie from being compelled to pay a HIDC.


To make consumer protection more uniform, as well as to cover states which had failed to act, the Federal Trade Commission (FTC) in 1976 adopted a rule requiring that a consumer credit agreement include the following statement in very bold type.



The notice is required not just when sellers themselves extend credit. If a party other than the seller lends the money needed for a consumer purchase, the loan documents must contain the same bold-type statement (without the words “pursuant hereto or”) if the lender is affiliated with the seller by common control, contract, or business arrangement or if the seller otherwise referred the consumer to the lender.

The net effect is to bar HIDC status. UCC 3-106(d) expressly provides that statements required by legislation or regulation, such as the above FTC-mandated Notice, do not make a promise or order conditional (hence, non-negotiable) but do preclude the possibility of a HIDC. Thus, a debtor’s/consumer’s defenses and claims against the seller can be asserted against all subsequent holders.

Of course, if the bold-type statement is missing, the holder could become a full-fledged HIDC. However, that situation is extremely unlikely; those who violate the FTC rule are subject to such severe fines that compliance is usually assured.


Heretofore, we have assumed that a person being sued on an instrument is liable unless he/she can successfully assert a defense. We now directly consider liability.

In the absence of a defense, liability may be based on the underlying contract, on a breach of warranty, or on the instrument itself. A third type of liability, warranty liability, is discussed later in this chapter.

UCC 3-401(a) provides that no one is liable on the instrument unless it contains his/her signature or the signature of an authorized agent.


The parties to an instrument are either primarily or secondarily liable. Primary parties are drawers (for unaccepted drafts), makers, and acceptors (usually drawees), while secondary parties are indorsers.

The primary party must pay on an instrument (1) as it existed when drafted by the drawer or maker or accepted by the drawee, or (2) for an incomplete instrument, as it was ultimately completed (if the completion was authorized). A secondary party usually can assume that the primary party will pay on the instrument.

If the primary party has not paid, the secondary party has an obligation to pay, provided that (1) the person seeking payment first demanded payment from the primary party, and (2) the secondary party received notice that the primary party dishonored (refused to pay) the instrument.

The indorser’s secondary liability is for the amount stated at the time of his/her indorsement. This contractual liability can be avoided by signing with the words “without recourse.” The indorsement is then “qualified.” The indorser is saying, “I make no guarantee that the primary party will pay; if he does not, I will not pay, either.” (When multiple, unqualified indorsements are on an instrument, the indorsers are generally liable to one another in the order in which they indorse (i.e., each indorser is liable to the subsequent indorser); that chronological order is presumably the order in which signatures appear on the instrument.)

Aside from these contractual liabilities (which can be qualified), secondary parties also may face liability on warranties.


Three main types of liability problems involve negligent persons, impostors or fictitious payees, and signers lacking capacity or authority.


Under UCC 3-406(a), any person whose negligence substantially contributes to the alteration of an instrument or the making of a forged signature is precluded from asserting such alteration or signature against anyone who pays the instrument in good faith or takes it for value or for collection. UCC 3-406 defines negligence in the same way as is done for the common law tort of negligence: failure to exercise ordinary care. It further provides that if the party asserting a 3-406 preclusion also was negligent, then the loss is apportioned between those negligent persons according to the comparative negligence standards found in tort law.

Remember: To preclude a claim because of UCC 3-406 negligence, the negligence must be significant (“substantially contributes”), not just remotely responsible.

Examples of UCC 3-406 negligence include the following:

  1. Upon receiving notice that forgeries are occurring, failure to act to prevent more forgeries.

  2. Negligence in controlling access to, and use of, a signature stamp.

  3. Drawer’s failure to include a corporate designation (e.g., Co., Corp., Inc.) after a corporate name.

  4. Delivery of an instrument to the wrong person.

  5. Failure to audit corporate books.


UCC 3-404 and 3-405 say that indorsements in the payee’s name are effective for negotiation purposes under the following circumstances:

  1. An imposter induced the drawer or maker to issue the instrument to the imposter or his/her accomplice. (This usually involves bona fide payees, with an imposter obtaining the instrument directly from the drawer or maker.)

  2. The payee was never intended to have an interest in the instrument, and an agent of the maker or drawer supplied the latter with the payee’s name or simply signed the instrument on the maker’s or drawer’s behalf. (This generally entails “fictitious payees”—made-up accounts actually controlled by dishonest employees.)

  3. An employee of the drawer or maker takes the instrument and forges the payee’s indorsement; or the employee takes instruments naming the employer as the payee, indorses those instruments in the employer’s name and/or has them deposited (with or without indorsement) in an account under the employer’s name, but actually used by the employee personally. The key factor is that the employer entrusted this employee with one or more responsibilities involving the issuing, receiving, indorsing, processing, or otherwise handling of the instrument.

With negotiation effective, there can be holders and even HIDCs down the chain of title. Thus the duped drawer, maker, or employer-payee cannot raise the personal defense of fradulent inducement against someone shielded with HIDC status. (Of course, for what it is worth, the drawer, maker, or employer-payee could proceed against the person(s) who duped him/her.)

UCC 3-404’s and 3-405’s underlying policy is plain: it encourages the ready transfer of instruments, and it discourages carelessness by makers, drawers, and employer-payees.


Negotiation is effective even though it may be subject to rescission because of incapacity, illegality, duress, fraud, mistake, or break of duty (UCC 3-202). Furthermore, negotiation cannot be rescinded against a HIDC if the problem amounts to merely a personal defense, not a “real” defense. Like UCC 3-404, the UCC 3-202 provision is to be distinguished from blatantly unauthorized signatures (forgeries), which simply do not constitute negotiation and thus cannot create holders, let alone HIDCs.


By way of review and example, let us look at two liability problems involving forgery: (1) the drawer’s forged signature, and (2) the indorser’s forged signature. Then we will examine a hypothetical case involving rescission.

Example: Drawer’s Forged Signature

Ira Innocent loses a check that he has not yet written. Fanny Forger finds the check. She fills it out, making it payable to the order of Paula Payee for $2,000, and signing Ira’s name as drawer. Fanny, using her fake identification cards as Paula Payee, obtains payment from Tammy Transferee, who takes it for value, in good faith, and without notice of the forgery.

May Tammy recover from Fanny? Yes. An unauthorized signature still operates as the signature of the unauthorized signer [UCC 3-403(a)]. Fanny is also liable for breach of warranties.

May Tammy recover from Ira? Probably not. Ira’s signature would be necessary to make the check negotiable and to make him liable on the instrument. Since Ira did not ratify the signature, it remains unauthorized and, having failed to receive a duly negotiated instrument, Tammy is not a holder, let alone a HIDC. Only if Ira was negligent and if this negligence “substantially contributed” to what Fanny did, could Tammy recover from Ira (UCC 3-406). To make such a case, Tammy would need more facts.

Incidentally, Tammy cannot force the drawee bank to pay her on the instrument unless the bank has accepted (certified) it (UCC 3-408).

Example: Forged Indorsement

Mary Maker issues a note to the order of Pam Payee for $3,000. Donald Devious steals the check, forges Pam’s blank indorsement, and then himself indorses “without recourse” and to the order of Trudy Transferee. Trudy takes it for value, in good faith, and without notice of the forgery. She in turn gives an unqualified indorsement to Troy Transferee, the note being a gift to Troy.

May Troy recover from Donald Devious? Yes. It does not matter that Donald himself indorsed “without recourse.” Donald’s forgery of Pam’s signature leaves him accountable as if he were Pam (UCC 3-403(a). Furthermore, Donald is liable for breach of warranties.

May Troy recover from Trudy? Yes, if Troy indorses the instrument and the primary party (Mary Maker) refuses to pay. Aside from any breach of warranties, Trudy is secondarily liable on the instrument because she failed to qualify her indorsement.

May Troy recover from Mary or Pam? No. As in the preceding example, Trudy is not a holder, let alone a HIDC. (The note was “order paper” to Pam, not properly negotiated by Pam.) Thus Troy (a non-HIDC for the same reason as Trudy and also because of the fact that he did not “take for value”) cannot acquire HIDC rights under the shelter rule. Furthermore, there is no indication that either Mary or Pam acted negligently and thus permitted Donald to steal the check and forge Pam’s signature (i.e., no recourse under UCC 3-406).

May Pam require Mary to issue another note? Yes, UCC 3-309 gives her that right, although a court might require security indemnifying Mary from loss by possibly having to pay twice. (Such a possibility is more a concern for drawers than makers; under UCC 4-401, a drawer can require the drawee to recredit the drawer’s account for the payment of a forged instrument.)

Example: An Instrument Subject to a Defense: Rescission

Ignatius Insane issues a note to the order of Pat Payee. Pat knows that Ignatius is insane. The note is then indorsed without qualification by Pat and given to Arnie. In turn, Arnie indorses “without recourse” to Sue, who pays value in good faith and without notice of Ignatius’s condition or any other defense or claim. By the time that Sue transfers the note to Sam, it has, on its face, become overdue.

Can Sam collect from Ignatius? It depends on whether Ignatius’s insanity is a “real” defense (sufficient to nullify obligor Ignatius’ duty). If it is merely a personal defense, then Sam wins, for he took possession from a HIDC, Sue, and thus acquired rights under the shelter rule. Sam acquired Sue’s rights even though he could not himself become a HIDC. (The note was, by the time he took it, obviously overdue.)

Can Sam collect from Pat? Yes, if the primary party, Ignatius, refuses to pay. Pat is secondarily liable; her indorsement was unqualified.

Can Sam collect from Arnie? No, unless Arnie breached a warranty. On the instrument itself, Arnie qualified his indorsement.

What about rescission (cancellation) in order to discharge the instrument? If Ignatius or his guardian rescinded at any time before the formation of a HIDC, then Ignatius probably would be free from paying (UCC 3-306). But what if, after hearing about the rescission, a holder went ahead and transferred the instrument? The holder’s actions appear to be in bad faith, and he would probably have to reimburse Ignatius for any amount Ignatius has to pay to a subsequent HIDC.


Negotiable instruments are often issued or transferred as part of an underlying contract (e.g., a sale of goods or services). The law governing such matters is the law of contracts, discussed in preceding chapters.

A second type of contractual liability, which we have just finished examining, is based on the negotiable instrument itself. In this case, a signer to the instrument is either primarily or secondarily liable. By signing, having someone else sign on his/her behalf, or ratifying a signature, the primary or secondary party has, in the absence of a qualified signature, made a type of contract to pay according to the instrument’s terms.

There is another basis for liability: warranties. Any person who obtains payment or acceptance of an instrument, or who transfers an instrument and receives consideration, makes warranties. Under these, like other warranties (e.g., sales warranties under UCC 2-312, 2-313, 2-314, and 2-315), a party may be liable for damages if they are breached. (Note: HIDCs ordinarily can enforce payment on an instrument despite the presence of alleged warranties.)

Some warranties are imposed on both the person who obtains payment or acceptance [in negotiable instruments law, acceptance is “the drawee’s signed engagement to pay a draft as presented” (UCC 3-409(a)] and all prior transferors. There are three such presentment warranties, which are given only to the person who in good faith pays or accepts the instrument (UCC 3-417):

  1. That the person is entitled to enforce the draft (obtain the draft’s payment or acceptance) or is authorized to act for someone else so entitled. This warranty is given to makers and to drawees of either unaccepted or accepted (certified) drafts. UCC 2-403(1).

  2. That the person has no knowledge that the drawer’s signature is unauthorized. The warranty only, in effect, protects drawees of unaccepted drafts. UCC 2-403(2)-(3).

  3. That the instrument has not been altered. This warranty only protects drawees of unaccepted drafts. UCC 2-403(2)-(3).

These presentment warranties are given only to the person who in good faith pays or accepts the instrument (usually, the drawee). UCC 3-417.

The other warranties are warranties on transfer. They are made by any person who transfers an instrument and receives consideration. This group includes sales agents or brokers, unless they have disclosed that they are acting solely on behalf of someone else. If they make such a disclosure, then they warrant only their good faith and authority.

The five warranties on transfer are as follows:

  1. That the transferor is entitled to enforce the instrument.

  2. That all signatures are authentic and authorized.

  3. That the instrument has not been altered.

  4. That the instrument is not subject to a defense or claim in recoupment which can be asserted against the transferor.

  5. That the transferor has no knowledge of any insolvency proceeding commenced with respect to the maker, the acceptor, or (for an unaccepted instrument) the drawer.

These transfer warranties are given to the immediate transferee and, if the transfer is by indorsement, any subsequent holder who takes the instrument in good faith. UCC 3-416. This means, in effect, that a remote holder can sue the indorser-warrantor directly without having to sue intermediate transferors also.

Neither the presentment warranties nor the transfer warranties can be disclaimed with respect to checks. UCC 3-416(c) & 3-417(e). Moreover, within 30 days after having reason to know about a breach, the claimant must notify the warrantor about the alleged breach or else lose its right to damages caused by that delay in notification. UCC 3-416(c) & 3-417(e). Generally, damages are the difference between the instrument’s value had the warranty not been breached and the instrument’s actual worth because of the breach. That difference usually translates into damages equaling the face amount of the instrument, with both UCC 3-416(b) and UCC 3-417(b)(d) also permitting an award for expenses and loss of interest resulting from a breach.


Article 3, in addition to providing specifically for warranty liability and contractual liability on the instrument, also provides that a person may be sued for the tort of conversion (UCC 3-420). (For further discussion of conversion, see Chapter 4.) Also, as already discussed, negligence may preclude a person from recovering on, or maintaining a defense on, an instrument (UCC 3-406).

Aside from possible remedies or legal theories outside of Article 3 (e.g., recovery on the underlying contract), there is one other major form of liability: that of accommodation parties or guarantors.


An accommodation party signs an instrument in some capacity (e.g., maker, drawer, indorser, or acceptor) to lend his/her credit status to another party to the instrument. (Generally, an indorsement not in the instrument’s chain of title is an accommodation indorsement.) The accommodation party is essentially a surety for the accommodated party; therefore, without first seeking recourse from the accommodated party, subsequent holders for value can enforce the instrument against the accommodation party, who can assert only the defenses available to the accommodated party as well as general surety defenses. (For more on sureties, see Chapter 13.) Of course, the accommodated party has no right to enforce payment from the accommodation party. That right is held by other parties to the instrument.


Indorsement with the words “payment guaranteed” or their equivalent converts an indorser’s secondary liability to primary liability. The holder may proceed directly against the indorser (guarantor) once the instrument falls due and is unpaid.

Another type of guarantor, though, is not liable until it is clear that proceeding against the primary party (maker or acceptor) is useless. Such a guarantor has indorsed with the words “collection guaranteed” or their equivalent. UCC 3-419(d).

If the words of guarantee do not specify their nature, they are deemed to guarantee payment, not just collection.

Example: Guarantor

If Guarantor Smith does not want to be primarily liable for a note signed by Dead-Beat Dingham, Smith should plainly indicate that the guarantee extends simply to collection.


Secondary parties (indorsers) can avoid potential liabilities on an instrument (except for warranties) by indorsing “without recourse.”

If a person’s negligence substantially contributes to a material alteration or an unauthorized signature, that person cannot use the alteration or signature as a defense against a HIDC or anyone else who in good faith pays for the instrument. Although a drawer or maker issues an instrument to an impostor or fictitious payee, the negotiation remains effective; usually, the drawer’s or maker’s only recourse is against the imposter or other persons who got him/her to issue the instrument.

Presentment warranties cover title, signature authorization, and lack of alteration. Transfer warranties cover these areas as well as (1) lack of good defenses and (2) absence of knowledge about the insolvency of the maker, acceptor, or (for an unaccepted instrument) drawer.


A party’s liability to pay an instrument may be discharged (terminated). Discharge usually arises by payment or other satisfaction. See UCC 3-602. However, some or all of the parties may be discharged of their liabilities by any of these other methods:

  1. Tender of payment (even if unaccepted). UCC 3-603.

  2. Cancellation. UCC 3-604.

  3. Impairment of reimbursement rights. UCC 3-605(c-f).

  4. Fraudulent alterations. UCC 3-407(b).

  5. Check certification or other acceptance of a draft. UCC 3-414(c).

  6. Reacquisition of an instrument by a former holder. UCC 3-207.

  7. Unexcused delay (e.g., more than 30 days) in presentment. UCC 3-415(e).

  8. Unexcused delay (generally, more than 30 days) in notice of dishonor. UCC 3-503.

  9. Acceptance varying a draft. UCC 3-410(c).

  10. Any agreement or act that discharges a simple contract to pay money. UCC 3-601(a).

Discharge is generally effective against all parties except a HIDC who lacked notice of the discharge when he/she took the instrument. UCC 3-302(b).



  1. Define a HIDC.

  2. (a) Name three characteristics of an instrument that usually indicate notice of a claim or defense.

(b) Name two that do not.

  1. (a) Name at least three facts that, if known by the would-be HIDC, usually indicate notice of a claim or defense.

(b) Name at least three that do not.

  1. Name at least five “real” defenses and seven personal defenses.

  2. Which type of defense works even against a HIDC?

  3. In regard to consumer protection versus the HIDC concept, one approach reduces the HIDC’s power to evade personal defenses, while another approach makes it more difficult for someone to become a HIDC. Which approach has been followed by many state legislatures? By the FTC?

  4. Name at least three types of negligence that can so substantially contribute to unauthorized alterations or signatures that they preclude recovery against persons paying in good faith.

  5. (a) State the three main types of liability between parties to a negotiable instrument.

(b) What tort is expressly listed as a remedy (e.g., for wrongful payment of an instrument) in UCC 3-420?

  1. Name the areas covered by the three presentment warranties.

  2. Name the areas covered by the five transfer warranties.


accommodation party




good faith


holder in due course (HIDC)

personal defenses

presentment warranty

primary party

“real” defenses

secondary party

shelter rule

unauthorized signature

warranty on transfer


  1. Jim pays Joan $50 for a check in the amount of $75. Can Jim be a HIDC? If so, for what amount?

  2. Fred Fraud owes Helen Holder $500. Fred fraudulently induces Tom Taken to buy a worthless stereo system for $500. Helen knows nothing about Fred’s misdeeds but is told that, if she releases Fred from his debt to her, Fred will have Tom issue a check to her for $500. Two weeks later, Helen takes the check to the bank. By then, however, Tom has discovered Fred’s fraud. Tom asserts that payment may be refused because:

(a) Helen is a payee, not a HIDC.

(b) Helen did not act in good faith.

(c) Tom can successfully raise Fred’s fraud against Helen.

(d) The check was overdue.

Discuss the merits of each reason.

  1. Paul Payee indorses a negotiable instrument “to the order of Julia Jumper,” who takes the instrument for value, in good faith, and without notice of claims or defenses to it. The instrument is not overdue, nor has it ever been dishonored, when Julia indorses it and gives it to Debbie Dole. Apparently, however, Paul still has not performed the services for which the instrument was issued. Now the issuer refuses to pay Debbie. Discuss.

  2. What is meant by the statement, “A negotiable instrument is a courier without any luggage?”

  3. Having performed services for Poe Credit, you are concerned about the check that you received as payment: Is Poe really “good for the money”? You owe Jane an amount somewhat less than the face value of Poe’s check. Jane is willing to take the check as complete payment of the debt. She seems to be impressed by the amount of Poe’s check, while you are more concerned about whether one can really collect on the check. In indorsing the check to Jane, what can you do to protect yourself if Jane or a subsequent transferee has trouble collecting?

  4. M issues a note payable to P’s order. C steals the note, forges P’s indorsement, and sells the note to X. M pays X. On the assumption that M has to pay P for conversion (UCC 3-420), may M recover from other parties?

  5. In Problem 3, what warranties, if any, have been breached?

  6. John drafts a check on Bank Y, payable to the order of Pat. For money, Pat negotiates the check to Viola. Pat has been declared insolvent in a federal bankruptcy court. What warranties, if any, have been breached?



  1. A holder who has taken a negotiable instrument for value, in good faith, and without notice that it is overdue, has been dishonored, or has defenses or claims against it.

  2. (a) Incorrect indorsements, material omissions, important alterations.

(b) Antedated or postdated, originally incomplete and later completed.

  1. (a) Party’s obligation void or voidable, parties discharged, defective title, unauthorized completion of instrument, default in principal payments or on series instruments.

(b) Parties include fiduciaries or accommodation parties, instrument issued or negotiated for an executory promise, existence of separate agreements, default on interest payments or on different instruments.

  1. “Real” defenses: fraud in the execution (factum), forgeries and unauthorized signatures, defenses nullifying the obligor’s duty, infancy (sometimes), the obligor’s claim in recoupment against the holder, a bankruptcy discharge of the obligor, other discharges of the instrument that the holder had actual notice of when he became a HIDC, and material alterations.

Personal defenses: lack or failure of consideration, fraud in the inducement, ordinary contract defenses, breach of warranty when a draft was accepted, modification of the obligation by a separate agreement, conditional issuance of an instrument, defenses rendering a contract voidable, payment violating a restrictive indorsement, acquisition of lost or stolen bearer paper, nondelivery or unauthorized delivery of an instrument, unauthorized completions, some “real” defenses in which the party asserting the defense was negligent.

  1. “Real” defenses. Only in cases of consumer protection does a personal defense have any likelihood of defeating a HIDC.

  2. The first approach. The second approach.

  3. Doing nothing to stop known forgeries, negligence as to signature stamps, failure to include a corporate designation when appropriate, delivery of instrument to wrong person, failure to audit.

  4. (a) The underlying contract, contractual liability on the instrument, warranty liability.

(b) Conversion.

  1. Title, signature authorization, lack of material alteration.

  2. Same as answer 9, plus: lack of good defenses and absence of knowledge about insolvency of makers, acceptors, or (sometimes) drawers.


  1. Yes, if Jim meets the remaining HIDC requirements. If Jim had agreed to pay Joan more than $50 for the check, he can be a HIDC only to the extent that he has furnished consideration (here, $50). However, if $50 was the agreed-upon consideration, then Jim has fully met the “taking for value” element and—if he meets the other HIDC requirements—is fully a HIDC.

  2. (a) Poor reasoning—payees can also be HIDCs.

(b) Wrong—under the subjective test, it appears that Helen acted in good faith.

(c) If indeed Helen “dealt” with Tom, then Tom’s personal defense (fraudulent inducement) can be raised against Helen even if Helen is a HIDC.

(d) Wrong—only 2 weeks old, check not overdue.

  1. Debbie took the instrument from a HIDC, Julia. Nothing indicates that Debbie is an exception to the shelter rule. Therefore Debbie should be able to enforce the instrument against the issuer, who has raised only a personal defense.

  2. Unlike ordinary contracts, negotiable instruments are not necessarily weighed down with the assignee’s potential liabilities or other baggage. If properly drafted and negotiated, a negotiable instrument may be free of these personal claims or defenses, because a HIDC will take it. Moreover, the shelter rule will then protect most subsequent transferees.

  3. You can seek to have the drawee bank accept the instrument. If it does accept, you then have a bank with primary liability ahead of your secondary liability as an indorser. (But at that point you might as well seek to collect the money from the check, rather than just sell it at a discount to Jane.)

If Poe’s instrument were a note, not a check, you could seek to disclaim your transfer warranties. You should still indorse the check with the words “without recourse” to eliminate your potential contractual liability as an indorser, but—unlike former Article 3—such an indorsement no longer disclaims any of the transfer warranties.

  1. Yes, M may recover on the presentment warranty (breach as to title) from X and/or C.

  2. Payee has breached the transfer warranty that there is no defense of any party good against him.

  3. None. Pat is not a maker, acceptor, or drawer; thus the insolvency proceeding against him is not of the type to which a transfer warranty could extend.




overdraft a check for more than the amount in the customer’s account

stop-payment order an order, oral or written, by a depositor directing his/her bank not to honor a specified check

You have already learned that a check is a special type of draft: one drawn on a bank and payable on demand. For most purposes, it is treated like any other draft under UCC Article 3. However, questions may arise concerning the processing of checks or the bank/customer relationship. These matters are governed by Article 4 of the Uniform Commercial Code.

The purposes of Article 4 are the same as for the rest of the UCC: rendering fair results to individual parties and also assisting the overall goal of efficient commerce. Although conflict between Article 4 and Article 3 is quite unlikely, Article 4 is given priority in such a situation.


When someone deposits money in a checking account, the bank acquires title to the deposited money. In effect, the account-holder is the bank’s creditor, and the bank is the account-holder’s debtor. If the bank becomes insolvent, the customer is only a general creditor, not a secured party with specific property he/she can seize to pay his/her account. (This usually does not matter, however, because in most cases the account is insured by the Federal Deposit Insurance Corporation.) Chapter 13 discusses the concepts of creditor and secured party in much greater detail.

Because the bank owes money to the customer, it is subject to garnishment by the customer’s creditors. (For information on garnishment, see Chapter 13.) Likewise, because the customer does not actually “own” the bank funds, he/she cannot assign the funds. All a customer can do is order the bank to make payment (by writing a check: “Pay to the order of …”). Since the order is not an immediate “assignment,” a customer may die, issue a stop-payment order, or otherwise undermine the order before it takes effect; and, unless the check is certified, the holder has no recourse against the nonpaying bank. (The holder would instead sue the drawer and/or indorsers.)


The bank’s primary duty to its customer is to honor his/her checks when the customer has sufficient funds on deposit. Banks are thus liable to their customers for wrongful dishonor. If the wrongful dishonor was a mistake (i.e., not intentional), the customer’s recovery is limited to his/her actual damages, which are, however, liberally defined as including harm to credit or reputation, arrest for writing bad checks, or other proved, consequential damages.

Note that dishonor must be wrongful. For instance, banks are not liable for refusing to pay on insufficient funds or on improper or missing indorsements.

A second duty of the bank is to maintain customer signature cards and to be familiar with the depositor’s authorized signature, so that forgeries can be detected before any payment is made.

Rules under the federal Expedited Funds Availability Act (1988) limit the maximum length of holds a financial institution may place on the funds from local and non-local checks deposited at the institution. The Act also requires disclosure of hold policies and of the specific hold placed on a deposit.


The first duty of the customer is to maintain sufficient funds in an account to cover the checks that he/she expects to write. In addition, under section 4-406, the customer has a second important duty.

As mentioned above, banks are supposed to maintain customer signature cards and thus be able to verify the authenticity of a customer’s signature, whether as drawer or indorser. As a practical matter, however, the enormously high volume of checks frequently renders it impossible for a busy bank to examine the authenticity of every check in every account. Therefore, while the drawee bank is charged with knowing its drawer’s signature and with otherwise avoiding payment on altered or forged instruments or indorsements, the customer is also expected to do his/her part in preventing or correcting unauthorized transactions.

Section 4-406 of the Uniform Commercial Code requires that the customer promptly review his/her bank statements and any other documents (e.g., canceled checks) sent by the bank. Generally, if failure to do so results in his/her not discovering and reporting an alteration or unauthorized signature, the customer is precluded from asserting a claim against the bank in the following situations:

  1. The bank suffered a loss because of the customer’s failure to discover and report.

  2. The bank paid in good faith and without notice of the type of problem (fraud by the same wrongdoer) that the customer should have discovered by the time payment was made.

Example: Failure of Customer to Review Bank Statement

If Customer Carol had reviewed the bank statements sent to her by Big Bank, she could have told Big Bank about a check forged by Fanny Fraud. Carol is thus precluded from having her account recredited if prompt reporting to Big Bank would have spared the bank a loss (item 1 above).

More important, if Fanny Fraud continues to practice her deceit, Carol is barred from asserting against Big Bank these later forgeries by Fanny; simply put, Carol’s diligence could have prevented these later problems because she would have put Big Bank on notice (item 2 above).

Preclusion under 4-406, as well as preclusion under 3-406 (drawer’s negligence) and 3-404 (impostor/fictitious payee), is discussed in Chapter 11. However, note that, as under Sections 3-404 and 3-406, the bank cannot take full advantage of 4-406 unless the bank itself was not negligent. If the bank, also, failed to exercise ordinary care (here, in paying an item), and that failure substantially contributed to the loss, then the loss is apportioned between the customer and the bank under a comparative negligence approach.

Customers who review their bank statements and are not otherwise negligent are entitled to have their accounts recredited not only for checks bearing their own forged signatures, but also for checks containing other persons’ forged indorsements.

Example: Bank Customer Rights

Agnes writes a check for $700 “to the order of Tim.” Chris forges Tim’s indorsement and cashes the check. So long as Agnes is not precluded by her own failure to inspect or other negligence, she is entitled to have the bank recredit her account for the $700. The bank failed to carry out Agnes’s order to pay “to the order of Tim.”

Besides going after Chris, Agnes’s bank can recover its loss from the bank that cashed the check; The cashing bank breached its warranty that there were no forged indorsements. (Warranties were discussed in Chapter 11.) For a forged drawer’s signature, though, the drawee bank can recover only from the forger unless others were negligent or actually knew that the signature was unauthorized. Again, the drawee bank is charged with knowing its drawer’s signature.


The drawer’s bank is the primary agent in the collection process, that is, the sequence of events through which a check goes before final settlement. Article 4 of the UCC sets forth specific rules governing the payment of checks:

  1. The bank need not (but may) pay overdrafts (checks for more than the amount in the customer’s account). If the bank has specifically agreed to pay overdrafts, then it must do so.

  2. The bank can charge the customer’s account for the full amount that it pays on an overdraft.

  3. The bank can refuse to pay stale checks (uncertified checks drawn more than 6 months before presentation for payment).

  4. In the check-collection process, a bank may supply necessary indorsements for a customer, except when the missing indorsement is that of the payee and the check expressly requires the payee to sign.

  5. If a customer dies or is adjudged (declared by a court) to be incompetent, the bank may continue to honor his/her checks (pay them from the customer’s account) until it receives notice of the death or incompetence and has had a reasonable opportunity to respond. Even with notice, the bank may pay or accept checks during the first 10 days after death (unless it receives a stop-payment order from someone claiming an interest in the decedent’s account).

  6. The customer can order the bank not to pay a particular check, provided that the bank has enough time to act on the stop-payment order. Such orders can be either oral orders effective for 14 days or written orders (including written confirmations of oral orders) that last 6 months. The written order can be renewed for additional 6-month periods if the customer, in writing, so requests. If the bank fails to comply with a stop-payment order, it is liable to the customer for his/her actual losses.

These rules, as well as other Article 4 requirements, are not absolute. A bank and its customer may, by their contract, alter these rules. The only unchangeable terms are these: a bank’s responsibility for its lack of good faith or ordinary care (dishonesty or negligence), and the measure of damages resulting from such lack of good faith or ordinary care. Indeed, so long as the terms are not plainly unreasonable, the bank and its customer may even state in their agreement the standards by which bank responsibility is to be decided.


Initially, a check is only as good as the credit of the drawer. To ensure payment, a payee or subsequent holder should have the check certified (accepted). Certification prevents the drawee bank from denying liability; the certified check is the bank’s guarantee that sufficient funds (presumably from the drawer’s account) have been set aside to cover the check.

The drawee bank is not required to certify a check. Refusal to certify is not dishonor; the bank merely refuses to agree in advance to cover a check.

Once the check is certified, the drawer and all indorsers prior to certification are released from liability on the check. If, when payment is later sought, the drawee bank discovers that there was not in fact a “hold” on sufficient funds in the drawer’s account, the drawee must make up the difference. Furthermore, the bank can never revoke certification against someone with HIDC rights or any other good-faith holder who changed position in reliance on the certification. It is thus easy to see why banks are generally very cautious about certifying checks. As is the case for cashier’s checks (where the account-holder has the bank issue a check to a particular payee, the bank being both drawer and drawee), the bank tends to subtract the amount of the check from the customer’s account immediately.


If the drawer was negligent (e.g., left unreasonably large spaces in writing the check), then Section 3-406 may completely bar bank liability for payment if the check was altered (generally, the amount was increased). If the drawer was not negligent, however, then these are the general rules:

  1. The bank bears a loss to the extent of the raised amount.

  2. The bank may charge the drawer’s account for the original amount of the check.

  3. The bank may recover from the person who presented the check for payment (warranty liability).

For certified checks, the crucial question on alterations is “when?” Alterations before certification are deemed to have been accepted by the certifying bank, whereas alterations after certification could not, of course, have been accepted by the bank when it certified the check. Therefore, unless the drawee bank negligently goes ahead and pays the altered amount, the drawee bank ordinarily will be liable only for the check as it stood when certified unless there is a HIDC subsequent to the alteration. To avoid such a scenario—having to pay the HIDC the altered (i.e., raised) amount—accepting banks can, while certifying a check, state the amount certified; that limits the acceptor’s liability to the stated amount, no matter what happens thereafter (UCC 3-413(b).


UCC 4-401:
Charge Against Account Bank may charge customer for every properly payable item even if an overdraft. UCC 4-402:
Wrongful Dishonor Bank is liable to customer for wrongful dishonor. Unless more than just a bank “mistake,” damages are limited to damages actually proved, but can include consequential damages (e.g., loss of credit, arrest and prosecution). UCC 4-403:
Stop-Payment Orders Bank is liable for payment over a timely stop-payment order. Oral orders bind for 14 days, but can be confirmed (and extended) by putting the order in writing. Written orders last for 6 months and are renewable. UCC 4-404:
Stale Checks Bank has no duty to pay uncertified checks more than 6 months old, but may in good faith pay them. UCC 4-405:
Death or Incompetence Bank may pay checks as long as it does not know of customer’s death or incompetence. Despite knowledge, bank can honor or certify checks in first 10 days after customer’s death (unless a stop-payment order is issued by a person claiming an interest in the dead customer’s account). UCC 4-406:
Customer’s Duty to Examine Bank Statements Customer must examine account statements and notify bank of unauthorized signatures or alter-ations. Bank exercising reasonable care is not liable to customer if (a) customer’s failure to examine and report results in banks loss or (b) customer fails to examine and report within a reasonable time period (no more than 30 days) after receiving the bank statement and there were continuing unauthorized signatures or alterations by the same wrongdoer. UCC 4-406(f):
Statute of Limitations More than one year after receiving relevant bank statement, customer is precluded from asserting against bank unauthorized customer signatures or alterations. The statute bars claims against even a negligent bank. ELECTRONIC FUNDS TRANSFER ACT

Most banks have sought to substitute, when possible, electronic communications for a time- and paper-consuming check-collection process. Electronic funds transfer (EFT) is practically instantaneous. No checks are needed, with payment being by electronic signal. The most common methods of EFT are automated teller machines, paycheck direct deposits/withdrawals, pay-by-phone systems, and point-of-sale terminals (e.g., direct transfers from consumers’ accounts to store accounts).

Between 1990 and 1996, every state adopted a new UCC Article, 4A, which governs fund transfers between the bank accounts of large, highly sophisticated businesses. Much more comprehensive in scope (covering consumer EFT) and applicable in all states, is the federal Electronic Funds Transfer Act of 1978. This act, in combination with its implementing law, Federal Reserve Board Regulation E, details some of the rights and duties of financial institutions (hereinafter, “banks”) and their consumer-customers:

  1. Limits are placed on customer liability for charges on a lost or stolen bank card (e.g., a “debit card” used to transfer funds directly from the customer’s bank account to the account of a merchant from whom the customer makes a purchase). The limits, though, increase or even disappear entirely if the customer fails to tell the bank about the loss or theft.

  2. Banks must furnish receipts for computer terminal (e.g., ATM) transactions, but not for telephone transfers. Also, banks cannot distribute unsolicited EFT access devices (e.g., debit cards).

  3. Banks must furnish a statement for each month that an electronic funds transfer occurs. Such statements have to show amounts, dates, names of retailers, locations of terminals used, and any fees. An address and telephone number for customer inquiries and error notices must also be included.

  4. The customer must discover any errors on the monthly statement and notify his/her bank within 60 days. If the bank takes longer than 10 days to investigate, it must, for the time being, credit the disputed amount to the customer’s account. (Obviously, if there was no error, the bank gets this money back.)

  5. Information about rights and duties under the act must be given to customers opening an EFT account. Among the many items covered must be error-resolution procedures as well as the conditions under which a customer can revoke authorization for preauthorized electronic funds transfers.

Several federal agencies are empowered to enforce the Electronic Funds Transfer Act. Customers can sue for violations of the act. They may recover their actual damages as well as statutory penalties. There are also criminal provisions.



  1. Are checks assignments?

  2. Are banks subject to garnishment by a customer’s creditors? Why?

  3. Give at least three proper reasons for dishonoring a check.

  4. State the two ways of making stop-payment orders and the length of time for which each is effective.

  5. What Article 4 legal requirements can a bank and its customers not change via the bank/customer contract?

  6. When can certification of a check be required?

  7. (a) What does Section 4-406 require of bank customers?

(b) If the customer fails to meet the 4-406 requirements, what can happen to him/her?

  1. What is the statute of limitations for a customer’s claim against his/her bank on unauthorized customer signatures or alterations?

  2. Name at least four areas covered by the Electronic Funds Transfer Act.



certified check

Electronic Funds Transfer Act

Expedited Funds Availability Act

Federal Reserve Board Regulation E


stale check

stop-payment order

UCC Articles 4 & 4A

wrongful dishonor


  1. Horace Holder presents a check to Big Bank. The check was drawn by Big Bank account-holder Cory Careless to the order of Horace for the amount of $900, and it contains all of the proper signatures. Big Bank pays it, although Cory’s account contains only $750. Cory says that Big Bank should not have paid Horace.

(a) Is Cory correct?

(b) What may the bank do in regard to Cory and to Horace?

  1. Assume that Big Bank refused to honor the check, and Cory therefore lost a major business contract. Could Cory win a lawsuit against Big Bank?

  2. Sharon Survivor’s uncle has just died, leaving Sharon as his next of kin. Sharon believes that her uncle wrote several “crazy” checks in the last few days of his life. She is concerned that her uncle’s bank will honor these checks. What should she do?

  3. Gary Greedy wants to bring a certified check to his meeting with Robert Reelistate. However, Gary feels that he needs every last cent of interest he can get from his account. Are these conflicting goals?

  4. During a 3-month period, Boris Baddie forges Dudley Dewgood’s signature on several checks, makes Dudley’s supposed checks payable to Boris, and then cashes them. Dudley takes each month’s bank statement and simply puts it in a box. Six months later, Dudley discovers Boris’s fraud.

(a) May Dudley recover from the bank?

(b) What if the checks were themselves inartfully drawn copies, not the ones actually sent by the bank to its customers?



  1. No.

  2. Yes. In essence, the bank is a debtor of the customer/account-holder.

  3. Insufficient funds, improper or missing indorsement, unauthorized drawer’s signature, stale check (over 6 months old).

  4. Written and oral. Written last 6 months and can be renewed. Oral last 14 days, but can be confirmed in writing (and thus extended to 6 months).

  5. The bank’s responsibility for its lack of good faith or ordinary care (dishonesty or negligence) and the measure of damages resulting from such dishonesty or negligence.

  6. Generally, never. It is the bank’s option whether to certify.

  7. (a) That the customers promptly examine bank statements and report any unauthorized signatures or alterations.

(b) The customer can be precluded from recovering for unauthorized signatures and alterations that he/she could have discovered, unless the bank was itself negligent.

  1. One year after receiving relevant bank statements.

  2. Customer liability limits on lost or stolen bank cards, receipts for transactions, monthly statements, customer examination of monthly statements, bank investigation of alleged errors, information about the act for new customers.


  1. (a) No. Banks generally have the option to pay overdrafts.

(b) Big Bank may seek reimbursement from Cory for the remaining $150 (plus perhaps a penalty). It may charge Cory’s account directly, assuming that more money is deposited.

As for Horace, once Big Bank honored the check, its only recourse against him would be claims arising under Article 3. However, Horace may well be a HIDC.

  1. Not ordinarily. However, checking account arrangements can specifically provide for the payment of overdrafts. If Cory had such a contract with Big Bank, then he could hold the bank liable.

  2. Sharon should immediately contact the bank to inform it of her uncle’s death and her status as next of kin. She should also demand that it stop payment on any checks in her uncle’s account and thus give the estate time to determine the propriety of the “crazy” checks.

  3. Probably. When a check is certified, the bank usually withdraws the amount from the account immediately. Unless Gary’s bank has some other arrangement (or somehow continues to credit interest until the certified check is actually cashed), Gary will lose further interest on the amount of the check once he has the check certified. Of course, with ordinary checks, interest earnings are unaffected until the check is collected.

  4. (a) Unless the bank was itself negligent, Dudley certainly cannot recover for checks drafted toward the end of the 3-month period; by that time, if Dudley had examined his bank statements, he could have detected the fraud and put the bank on notice in order to prevent further forgeries. Even for the earlier checks, Dudley cannot recover if his prompt review of the bank statements would have left the bank able to prevent a loss (e.g., by getting the money back from Boris or some other party to the instrument).

(b) If the bank was negligent, as in this case, Dudley’s failure to examine does not matter. The bank’s cashing of inartfully drawn copies constitutes the type of bank negligence that eliminates 4-406 preclusion of Dudley’s claim.




surety a person who has expressly or implicitly agreed to be liable for another’s debts even if the creditor has not exhausted all remedies for collection

guarantor a person who has expressly or implicitly agreed to be liable for another person’s debts if the creditor cannot collect directly from the debtor

bankruptcy a legal procedure for settling the debts of individuals or business entities that are unable to pay debts as they become due. The debtor’s business may be reorganized; a set payment may be arranged, or the debtor’s nonexempt assets may be liquidated and distributed to creditors. Proper completion of the bankruptcy procedures leaves the debtor free from liability on some or all of the remaining debts.

secured transaction any transaction involving a security interest, which generally is an interest in the debtor’s personal property (or fixtures). The security interest is held by the secured party (the creditor) as a means to ensure payment or performance of the debtor’s obligation.

History has not been kind to debtors. In various places and at various times, debtors have faced prison, slavery, torture, dismemberment, and/or death because they were unable to pay in full their creditors. For good measure, a debtor’s relatives were often punished.

Under modern law, the creditor is not the only one with rights. In fact, the emphasis on consumer protection and on giving people a “second chance” (or more) has led to creditors’ complaints that debtors now receive too much protection. However, the law generally reflects society’s choices; as long as society cannot definitively decide the relative worths of competing values, neither can the law. In the meantime, both creditors and debtors have many rights or remedies available through statutes, the law of contracts, and the common law.


There are several major debt-collection mechanisms. A creditor may:

  1. Place a lien upon the debtor’s property. When real estate owner Red receives services or materials intended to repair or improve his premises, a mechanic’s lien on the real estate may develop if Red does not fully pay his bill. A lien is an encumbrance upon Red’s property—if the lien remains unpaid, the security held by the creditor can be sold to satisfy the debt (lien). In Red’s case, the real property itself is security; after following the mechanic’s lien procedures outlined in the relevant state statutes, including a filing of notice, the lien holder may foreclose (force a sale).

Other liens include artisan’s liens and hotelkeeper’s liens, both of which involve personal property. As long as the lien holder retains possession of the debtor’s personal property, he/she may have a lien on that property for unpaid services or for unpaid repairs, improvements, or care of the debtor’s property.

  1. Obtain a prejudgment attachment. A prejudgment attachment entails a court-ordered seizure of the debtor’s property before the creditor’s claim and the debtor’s defenses have been fully adjudicated. It is designed to prevent the waste or removal of assets pending the completion of a lawsuit. Obviously, this remedy carries the potential for abuse, including deprivation of property based on claims that the “debtor” later successfully refutes; therefore Fourteenth Amendment due process considerations limit the scope and use of prejudgment attachments.

Generally, the creditor must strictly comply with the state statutes governing such attachments. For instance, the creditor must file an affidavit, as well as post a bond covering court costs, loss of use of the property, and the value of the property itself. Seized property is not sold immediately, but remains under the sheriff’s control until a judgment is entered.

  1. Take a security interest in the debtor’s property. See the sections on secured transactions later in this chapter.

  2. Recover the debt before or during the course of a bulk transfer. A bulk transfer occurs when (1) a business sells or otherwise disposes of a substantial portion (e.g., more than half) of its materials, supplies, merchandise, or other inventory, (2) this sale or other disposal does not occur “in the ordinary course of business,” and (3) the buyer ordinarily knew or should have known that the transferor (e.g., the seller) would not continue to operate the same or a similar business after the transfer. See UCC Revised Article 6, at 6-102(1)(c)(ii). Services and the operations of nonretail manufacturers are usually excluded from coverage under bulk transfer laws, such as UCC Revised Article 6, adopted by about seven states (the original Article 6 has been repealed by every state that adopted it). These laws require the would-be transferor of goods to list both its creditors and the property to be transferred, and that the would-be transferee notify the creditors of the proposed transfer, tell creditors whether debts will be fully paid, and provide other information.

Creditors then have time before the transfer (e.g., 10 days under Revised Article 6) to take the steps necessary to protect their rights (e.g., levying of execution on property, suing for an injunction on the sale). If these procedures have not been followed, the creditors have time after learning about the bulk transfer to file suit and/or to levy against the transferred property (e.g., six months under Revised Article 6).

  1. Proceed against property fraudulently conveyed to a third party. Just as improper bulk transfers may be set aside, so the law does not permit other transfers by debtors trying to avoid debt payment by selling or giving away their assets. Such a transfer is termed a fraudulent conveyance.

  2. Seek payment from a surety or guarantor, who has expressly or implicitly agreed to be liable for another person’s debts. A surety is primarily liable—the creditor need not exhaust all of his/her remedies against the debtor before holding the surety liable. A guarantor is secondarily or collaterally liable—the creditor can seek payment from the guarantor only after first trying to obtain relief directly from the debtor. Suretyships need not be in writing, but usually are. All guaranty agreements, though, fall under the Statute of Frauds requirement of a written contract.

Some guaranty agreements are general (applying to all creditors who agree). Others are special; they apply only to a named creditor and are usually not assignable.

Performance bonds and fidelity bonds are examples of suretyship contracts. Performance bonds cover the costs of a party’s failure to meet the terms of a contract, such as one for construction of a building. Fidelity bonds protect against losses from the dishonest acts of employees or others. In either instance, payments under the bond cover the costs or losses up to a maximum amount stated in the bond.

Both sureties and guarantors “step into the shoes of the debtor,” and may thus raise any claim or defense that the debtor might have advanced, except infancy, bankruptcy, and—in some cases—the statute of limitations. Two other major defenses for sureties or guarantors are that (1) the debtor tendered payment; (2) the debtor’s obligations were materially altered without the consent of the surety or guarantor.

Upon paying the creditor, most sureties and guarantors are entitled to reimbursement, if possible, from the debtor. This right is sometimes referred to as subrogation. In subrogation (also frequently invoked by insurance companies that have paid a claim), the surety or guarantor is substituted for the original creditor, thus acquiring the latter’s right to collect from the debtor.

  1. Foreclose on real property. If a loan is secured by real property, there is a mortgage agreement between creditor (mortgagee) and debtor (mortgagor). Upon mortgagor’s default, mortgagee may initiate foreclosure procedures.

A few states permit the mortgagee to acquire absolute, immediate title to the foreclosed property (“strict foreclosure”) or to take immediate possession and then gain title after a waiting period. Most states allow foreclosure and sale to occur pursuant to terms within the mortgage agreement. The customary method of foreclosure, though, is a judicial sale; after proper notice, the sheriff or other court official takes control of the property and sells it. As with forced sales arising from liens, writs of execution, or otherwise, the sales proceeds are applied first toward the costs of the foreclosure (advertising, court filing fees, etc.) and then toward payment of the debt. Any surplus goes to the debtor. In most states (California is one exception), if the proceeds do not cover the debt, the mortgagee can obtain a “deficiency judgment” against the mortgagor for the remaining amount owed and then collect from other, nonexempt property owned by the mortgagor.

From the time of default until the foreclosure sale, the mortgagor has a right, called equity of redemption, to redeem (recover) the property by fully paying the debt, plus the foreclosure costs to date and any interest. Most states also allow mortgagors to redeem within a brief, specified time after the sale (“statutory period of redemption”); this type of redemption serves to cancel the sale, but usually requires the debtor to cover yet another set of costs, namely, the nonrefundable expenses incurred in the sale.

  1. Obtain a writ of execution and/or a garnishment. After obtaining a judgment in a lawsuit on a debt, an unpaid creditor (“judgment creditor”) may request a prompt accounting of the judgment debtor’s assets. The defendant’s failure to provide information can lead to a finding of contempt of court and—ultimately—jail. The creditor may seek a court order that (a) a sheriff or other authorized official seize and sell the debtor’s nonexempt property (writ of execution); (b) third parties holding property of (owing money to) the debtor send to the judgment creditor the nonexempt portion of that property (garnishment). After costs have been paid, the proceeds go to the creditor until the judgment debt is satisfied. For garnishment, common third parties are employers (who hold wages due) and banks (who hold checking or savings accounts).

  2. When there are two or more creditors, accept a composition and/or extension agreement or an assignment to a trustee. In the first situation, the debtor and creditors agree that each creditor will receive a certain percentage (less than 100%) of the amount owed (the composition) and/or extend the payment period (the extension). The debtor’s full compliance constitutes a discharge, that is, a release from obligation, of the entire debt. In the second situation, the debtor transfers to a trustee the title to some or most of the debtor’s property. The trustee in turn sells or otherwise disposes of that property for cash and then distributes the proceeds pro rata among the creditors. A creditor accepting such payment discharges the entire debt owed to him/her.

In Grupo Mexicano de Desarrollo SA v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999), the U.S. Supreme Court ruled that while a U.S. plaintiff’s contract claim for damages was being decided, a U.S. court could not grant a preliminary injunction barring a failing Mexican defendant company from using its only assets to pay its local creditors. The decision could mean that by the time certain investors find out they have prevailed in a legal claim, there may be no assets left with which to pay them. So the message to American investors in foreign businesses is that when a default occurs and the assets are abroad, these investors cannot expect American courts to intervene.


Both state and federal laws provide certain measures of protection for debtors.


State law exempts certain types of property from being seized and sold to satisfy debts. Most states provide for a homestead exemption. When a home is sold to pay a judgment, a specific amount may be retained by the debtor, free of the judgment debt. Although mortgages are not subject to this exemption, it is generally meant to provide a debtor with sufficient funds to protect his/her family and find another home.

Example: Homestead Exemption

X owns a house with a $150,000 mortgage on it, and Y has a judgment against X for $45,000. If the mortgage agreement antedates the judgment, proceeds from the sale of the house must go first to pay the mortgagee, not Y.

If the state homestead exemption is $25,000, and X’s house sells for $195,000, the mortgagee receives $150,000, X then gets $25,000 (the exemption), and Y takes the remaining $20,000. Y can, of course, collect the remainder of the debt from other nonexempt property that X may own.

Exemption statutes also cover personal property. Most states protect up to a specified dollar value for household furnishings, clothes, personal possessions, motor vehicles, livestock, pets, and veterans’ pensions.


A provision in the federal Consumer Credit Protection Act (commonly known as the Truth-in-Lending Act) bars employers from terminating an employee because of garnishment for any single debt, regardless of the number of levies made or collection proceedings instituted. The law limits garnishments in any week to the lesser of either (1) 25% of that week’s disposable earnings, or (2) the amount by which that week’s disposable earnings exceed 30 times the federal minimum hourly wage. (Disposable earnings are net income after withholding for federal and state income taxes and social security.) Federal garnishment restrictions do not apply to federal or state tax debts, and some bankruptcy orders. Moreover, up to 50% of disposable earnings may be garnished to pay court orders for alimony or child support (up to 60% if the worker is not supporting another spouse or child), with another 5% subject to garnishment for support payments over 12 weeks in arrears. The federal law permits states to substitute, in effect, an even larger exemption of disposable earnings; many states have done so. Some even permit judges to set a higher exemption rate so as to prevent undue hardship. Finally, five states outright prohibit garnishment of wages. Florida bars such garnishment from the head of family (a wage earner providing a spouse or child more than half of his/her support).1 North Carolina, Pennsylvania, South Carolina, and Texas forbid garnishment except in special circumstances such as for unpaid taxes or child support (not ordinary debt collection).


Many regulatory agencies, both federal and state, conduct investigations, promulgate rules, punish violators, and otherwise deal with unfair and deceptive trade practices and consumer fraud. The federal agencies include the Federal Trade Commission, the Federal Communications Commission, the Food and Drug Administration, the Department of Housing and Urban Development, the Securities and Exchange Commission, and the Postal Service. Regulated practices include advertising, labeling and packaging, pricing, sales practices, and warranties. Also, state attorneys general and state departments of consumer affairs seek to protect consumers through enforcement of various state labeling laws, privacy acts, deceptive sales practices statutes, and warranty provisions (e.g., “lemon laws”).

The following deceptive practices often violate federal law:

Deceptive comparisons—an inaccurate advertisement in which the defendant makes false statements about either the quality or the price of its own product/service as compared to a competitor’s products/services. The federal Lanham Act prohibits such false statements if they are likely to cause damage to businesses or individuals.

Bait and Switch—a low price is advertised to bait the customer into the store. The salesperson then tries to switch the customer to another, more expensive item. It is unlawful bait-and-switch advertising if the store refuses to show the advertised item, fails to have adequate quantities of it available, fails to promise or deliver the advertised item within a reasonable time, or discourages employees from selling the item.

Deceptive Testimonials and Endorsements—when advertisements are intended to make consumers feel that someone other than the seller believes in a product’s or service’s benefits, FTC guidelines require that the endorser be a user of the product or service. If the advertisement claims that the endorser has superior expertise in making a judgment about the product/service, the endorser must, in fact, have the experience or training that qualifies him/her as an expert.

Five other federal laws are:

  1. The FTC Door-to-Door Sales Rule (1973). It singles out for special treatment door-to-door sales because of their potential for high pressure tactics placing consumers on the spot. A seller must give consumers a notice of their right to cancel a sale within three days after the sale takes place.

  2. Interstate Land Sales Full Disclosure Act (1968). This statute regulates the sale of unseen land in order to cut down on the seller’s opportunities for fraud by mandating full disclosure of relevant information.

  3. Mail Fraud Statutes. They specify criminal penalties for using the mail to engage in a fraudulent enterprise. The statutes also provide civil penalties, such as intercepting fraudulent mail, returning all mail, and seizing some types of mail.

  4. Mail-Order House Regulations. Because consumers have less ability to check out completely what they are getting from a mail-order house (as compared to purchases made in stores), these purchases are regulated. One type of sale is the “negative option plan” (offered, for example, by book and CD clubs). These plans must disclose all their terms, must send members a notice of intent to send the product in enough time for the member to accept it or reject it, and must include a rejection form for use by the club member.

  5. The Telemarketing and Consumer Fraud and Abuse Prevention Act (1994). This act empowers the FTC and the state attorneys general to enforce this law, and 1995 FTC regulations, against such practices as falsely claiming a government affiliation, or an ability to improve a consumer’s credit record or to assist him in obtaining loans, goods, or cash. Fines are potentially as high as $10,000 for each violation. Financial institutions, telecommunications carriers, airlines, insurers, franchisors, on-line services, people regulated by the SEC, and not-for-profit organizations are exempt. The 1995 FTC regulations require several disclosures by telemarketers. The caller must identify himself/herself and the product offered. The recipient must be informed the call is for sales purposes; misrepresentation is prohibited. The product’s total cost and special contractual terms must be disclosed. Calls may be made only after 8:00 A.M. and before 9:00 P.M. Many state telemarketing laws are more stringent.

Numerous federal consumer protection statutes apply to the debtor/creditor relationship.

  1. The Truth-in-Lending Act (1968) states that a lender, or a seller who is extending credit, must comprehensively disclose credit terms, including finance charges. The act covers all transactions in which the creditor, during the ordinary course of business, makes a loan or extends credit in an amount less than $25,000; the loan or credit must go to an individual or individuals and must concern real or personal property used for personal, family, household, or agricultural purposes.

  2. The Fair Credit Billing Act (1974) (an amendment to the Truth-in-Lending Act) requires the prompt posting of payments and a notice of prospective finance charges on new purchases, prohibits credit card issuers from forbidding merchants to offer cash discounts, and provides procedures for disputes about credit statements, billings, or purchases.

  3. The Fair Debt Collection Practices Act (1977) prohibits certain abusive practices by debt collectors. It applies mainly to collection agencies, but also to others, such as attorneys who regularly engage in consumer-debt collection activity (Heintz v. Jenkins, 514 U.S. 291 (1995)). The Act does not restrict the initial creditor (the one who originally extended the credit to the defaulting debtor), but only future assignees of that creditor.

  4. The Fair Credit Reporting Act (1970) (part of the Truth-in-Lending Act) provides for debtors’ access to credit reports and sets forth procedures for correcting misinformation or otherwise protecting a consumer’s credit reputation.

  5. The Fair Credit and Charge Card Disclosure Act (1988) requires fuller disclosure of terms and conditions in credit-card and charge-card applications and solicitations.

  6. The Equal Credit Opportunity Act (1976) prohibits discrimination in the extending of credit.

  7. Credit card rules in the Truth-in-Lending Act (a) limit the liability of a cardholder to $50 per card upon notifying the creditor about a lost or stolen card, and (b) prohibit outright billing a consumer for unauthorized charges (e.g., on a card never accepted by the consumer).

  8. The 2009 Credit Card Accountability, Responsibility and Disclosure Act (“Credit CARD Act”) applies only to consumer credit cards (not commercial or business credit cards). It does not limit interest rates. The Credit CARD Act requires that credit card agreements be in plain English and at least 12-point font, prohibits companies from giving credit cards to someone under age 21 unless that person proves he/she has the means to pay the debt or a parent or guardian co-signs, declares that on each billing statement credit card companies must notify cardholders how long a series of minimum payments would take to pay off the balance (or how much must be paid each month to pay off the balance, including interest, in three years), and mandates that any payments above the minimum amount be applied to balances with higher interest rates first. The Credit CARD Act further states that if a cardholder cancels a card, he or she can pay off existing balances at the existing payment schedule and interest rate. The law also provides that a customer has to be more than 60 days behind on a payment before the credit card company increases the rate on an existing balance. Even then, the lender must restore the previous, lower rate if the cardholder pays the minimum balance on time for six months. Companies have to give notice and an explanation 45 days before increasing a customer’s interest rate on any new extensions of credit (e.g., on purchases or cash advances).

The Credit CARD Act limits the scope of the universal default rule, which makes a consumer’s single default (one late payment on any credit card the consumer holds) grounds for all of his/her credit card companies’ raising rates on his cards. Before the Act, the universal default rule often applied retroactively to raise the rate on existing credit card balances. With the Credit CARD Act the universal default rule can only reach future balances—a higher interest rate only coming into effect for newer credit.

Violators of the Credit CARD act may face criminal prosecution and civil remedies.

  1. The Home Equity Loan Consumer Protection Act (1988) prohibits lenders from changing the terms of a loan after the contract has been signed; it requires fuller disclosure in home equity loans of interest rate formulas and repayment terms.

  2. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) increases the powers and supervisory breadth of the reorganized and streamlined U.S. government agencies regulating banking. Along these lines, a core reform is a new federal agency, the Consumer Financial Protection Bureau (CFPB), which has broad authority to regulate consumer financial products and services, perhaps especially through the heightened use of a mandatory disclosure regime about credit terms and consumer risks. The CFPB has rule-making powers overseeing banks, debt counseling firms, payday lenders, and others. The CFPB could ban financial products it considers unsafe or confusing to consumers. Theoretically, it could block credit card companies from charging rates above a particular rate.

Dodd-Frank has two major provisions affecting consumer financial protection:

a. Title X of Dodd-Frank (called the Consumer Financial Protection Act of 2010) is supposed to prevent hidden fees and charges, increase disclosures to consumers, and abolish deceptive or abusive loan practices. Lenders must use plain language so that consumers can understand the risks, benefits, and costs of consumer financial products and services. Among some of the specific laws are—

(1) a minimum credit or debit card transaction amount, such as at a gas station, can be no more than $10; and only the Federal Reserve Board can raise that minimum.

(2) the Federal Reserve Board can limit the fees on debit card transactions charged by large banks (but this does not apply to credit card issuers such as Visa, American Express, or MasterCard).

(3) any lender that, because of a would-be borrower’s credit score, denies a credit application (e.g., for a mortgage, a car loan, or a store credit card) must, for free, tell the applicant his/her score.

b. Title XIV of Dodd-Frank (called the Mortgage Reform and Anti-Predatory Lending Act of 2010) is meant to eliminate many abusive mortgage loan practices while requiring disclosures from mortgage lenders. The act—

(1) mandates that mortgage originators and lenders verify a prospective borrower’s income, assets, credit history, employment status, debt-to-income ratio, and other factors relevant to the lender’s decision for or against extending credit.

(2) makes lenders undertake a reasonable, good faith determination whether a credit applicant can afford to repay the loan for which he/she applied. Among other things, assets and income must be documented. In a foreclosure action that the lender brings against a borrower, the borrower may—as a defense barring any recovery of money from the borrower—assert that the lender did not meet these “due diligence” or other Dodd-Frank standards.

(3) gives borrowers the right to sue lenders for engaging in predatory and deceptive practices as well as for violating this Act.

(4) requires banks to hold onto at least 5% of the loans they make (not sell them to investors).

Auto dealers making car loans and banks with less than $10 billion in assets are exempt from Dodd-Frank oversight. These dealers remain subject to Federal Trade Commission oversight.

In addition to these federal measures, the states have their own laws and regulations, which may set maximum interest rates (usury laws) or otherwise protect consumers who have been extended credit. For example, eleven states have adopted some form of the Uniform Consumer Credit Code (UCCC), which establishes maximum interest rates and requires a full disclosure of facts to buyers on credit in almost any situation. The UCCC is an attempt to systemize the law; it thus serves to replace particular laws on such matters as usury, credit advertising, small loans, retail installment sales, and service, delinquency, or deferral charges. Perhaps most important, the UCCC forbids (1) multiple agreements in order to obtain higher interest rates, (2) “balloon” payments more than twice as large as the average payment, (3) assignments of a debtor’s wages, and (4) in most cases, judgments for money beyond that obtained by repossessing goods purchased on credit. Criminal as well as civil penalties are provided.


Lenders increasingly have been sued by debtors and others for damages allegedly resulting from lender misconduct in revoking credit, foreclosing on security, administering a loan, refusing to extend credit, or even for extending credit. Liability theories include: breach of contract, fraud, excessive control (e.g., interference with the debtor’s contractual relations with others), negligence, economic duress (which may make a loan settlement voidable), breach of fiduciary duties or implied duties of good faith and fair dealing, and even statutory bases such as state consumer fraud legislation and federal environmental, bankruptcy, securities, RICO, and tax laws.


State law exempts some property from seizure to satisfy debts. After the proceeds on the sale of a home have paid the mortgage, most states exempt a specific amount of the remaining proceeds. For personal property, state law tends to exempt up to a specified dollar value for household furnishings, clothes, personal possessions, motor vehicles, livestock, pets, and veterans’ benefits.

The federal Consumer Credit Protection Act (known as the “Truth-in-Lending-Act”) limits garnishment to 25% of disposable earnings or even less in the case of low-income wage earners; state law may further limit garnishment. Numerous federal and state statutes regulate creditor practices, prohibit abuses, provide dispute-resolution mechanisms, or otherwise protect debtors.


Bankruptcy is a method for settling the debts of individuals or business entities that are unable to pay debts as they become due. Under court supervision, all or most of the debtor’s assets are used to pay his/her creditors, with creditors of equal status (priority) each receiving the same proportion of the amounts owed to them. Once the liquidation, reorganization, or adjustment plan is judicially approved and then properly completed, the bankruptcy serves to relieve the debtor from all or most of his/her debts even though these debts have not been fully paid.

The U.S. Constitution, Article I, Section 8, empowers Congress to make “uniform laws on the subject of bankruptcies throughout the United States.” Congress has structured a system of federal bankruptcy courts, with judges appointed to 14-year terms and serving the same or similar geographic areas as do federal district court judges. Appeals go either to the U.S. District Court or (as some U.S. circuits provide) to a bankruptcy appellate panel consisting of bankruptcy judges from within the circuit.

Although matters of state law may arise during a bankruptcy proceeding, the essential issues in the bankruptcy itself are governed by federal law as stated in the Bankruptcy Code and interpreted in federal court opinions. For instance, while orders about legal fees and costs in conjunction with a divorce case are matters of state law, it is up to the federal bankruptcy court to decide whether, under federal law, these orders are, in effect, part of a debtor’s obligation to pay alimony or child support and thus cannot be discharged in bankruptcy.


The Bankruptcy Code provides for three main alternatives: proceedings under Chapter 7 (Liquidation), Chapter 11 (Business Reorganization), or Chapter 13 (Adjustment of an Individual’s Debts). A fourth type of proceeding, to adjust the debts of a municipal corporation, is available under Chapter 9 when authorized by the state where the municipal corporation is located. (Both family farming and family fishermen business reorganizations are governed by Bankruptcy Code Chapter 12.)

Under any of these four alternatives, the debtor may file a voluntary petition for bankruptcy, although individuals can file for Chapter 7 or 13 only upon completion of a short Credit Counseling course (about 15–90 minutes long).2 Creditors may initiate only a Chapter 7 or a Chapter 11 proceeding; this is done by filing an involuntary petition, with the goal being to preserve the debtors’ assets and to ensure fair treatment for every creditor.

Any creditor, either individually or joined by other creditors, may file an involuntary petition when the debtor has fewer than 12 creditors. However, when the number of creditors is 12 or more, at least 3 of the creditors must sign the petition. In all cases, the involuntary petition must meet these two requirements:

  1. The debtor must owe at least $13,475 in unsecured claims to the petitioning creditors (the ones who have signed the petition).

  2. The creditors must allege either that a custodian for the debtor’s property has been appointed in the prior 120 days or that the debtor has generally not been paying debts that are due.

A filing under any of the four chapters creates an “estate” consisting of all of the debtor’s property, with an automatic stay preventing creditors, other than those owed alimony or child support, from collecting debts or foreclosing on collateral. (Secured creditors may petition the bankruptcy court for relief from the stay.)


In a Chapter 7 case, the bankruptcy court appoints a trustee to take charge of the estate. The trustee sells (“liquidates”) the debtor’s nonexempt property, and the proceeds are then distributed to the creditors according to their priorities under law—for example, taxes are usually paid before general creditors are paid.

A Chapter 7 discharge covers debts, including judgments, arising before the bankruptcy order granting the discharge. Just as a bankruptcy petition operates temporarily to prevent most creditors from trying to collect their debts pending the bankruptcy proceedings, the discharge makes this prevention permanent.

Because Chapter 7 discharges cover only individuals, business entities such as corporations and partnerships remain technically liable for their debts. However, the lack of discharge does not matter unless the entity later acquires assets. The effect is to prevent the resurrection of that same entity (e.g., as a “shell” business) after a Chapter 7 liquidation. (Under Chapter 11, a type of discharge is granted.)

Some businesses, though, are simply denied the right to file for bankruptcy. Railroads, banks, savings and loan associations, credit unions, insurance companies, and other financial institutions are regulated in all matters, including insolvency, by administrative agencies, not the Bankruptcy Code. However, railroads are permitted to file for a Chapter 11 reorganization.


Chapter 11 is mainly intended to allow ongoing businesses to restructure their debts. Before restructuring occurs, a court-appointed trustee or examiner conducts an investigation, files reports with the court, and may submit a reorganization plan (if the debtor has not) or (instead) recommend conversion to a Chapter 7 liquidation. Also, a “small business”—one with total debts under $2,490,925—can use a simpler, fast-track Chapter 11 process.

Whether for an individual proprietorship, a small firm, or a large corporation, successful reorganization requires a detailed plan covering all aspects of the organization’s business operation and its assets and debts. Then the plan must be accepted by the bankruptcy judge and by two-thirds in amount, and more than half in number, of the claims in any particular class of creditors. Each creditor must receive at least as much as the creditor would be entitled to obtain under Chapter 7 liquidation.


Chapter 13 is available only to individuals with regular sources of income, unsecured debts not exceeding $383,175 (to increase in 2016 and every three years thereafter), and secured debts of no more than $1,149,525 (to increase in 2016 and every three years thereafter). Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), Chapter 7 (with its more generous discharge of debtors) ordinarily is unavailable to debtors who earn more than the median income in their state;3 these debtors must instead use Chapter 13 if they can pay their creditors, altogether, at least $7,475 over five years.

The debtor files a payment plan, with payments beginning no more than 30 days after the bankruptcy petition is filed and continuing for up to 5 years. Payments are made to a court-appointed trustee, who begins paying creditors after the court approves the plan. Upon completion of the plan, and even for “hardship” cases in which plan payments are incomplete, a Chapter 13 discharge (comparable to, but in some ways broader than, a Chapter 7 discharge) is granted.

Usually about one fourth of the debtor’s disposable earnings goes to his/her creditors, although the specific amount is somewhat dependent on the debtor’s level of income and family responsibilities. As in Chapter 11, payments cannot be any less than a creditor would receive under Chapter 7 liquidation. At any time, the debtor or the court may turn the case into a Chapter 7 proceeding.


A debtor must file a financial statement (including income and expenses) and must list assets, creditors (with addresses and amounts owed), and exempt property. Under BAPCPA, an attorney representing a debtor in bankruptcy must conduct a thorough investigation to determine whether the information provided in the debtor’s petition and schedules (statements about the debtor’s financial position) is accurate. The attorney provides a certification, under penalty of perjury, for the information in the petition and can be fined and otherwise penalized for any discrepancies.

Exemptions under federal law include the following (with dollar figures to rise in 2016 and every three years thereafter):

  1. Equity in a home and burial plot up to $22,975.

  2. Interest in one motor vehicle up to $3,675.

  3. Trade or business items up to $2,300.

  4. Professionally prescribed health aids.

  5. Unmatured life insurance contracts (other than credit life insurance).

  6. Federal and state benefits such as social security, local public assistance, and veterans’, disability and unemployment benefits.

  7. An interest in jewelry not to exceed $1,550.

  8. Alimony and child support, as reasonably necessary for support of the debtor or his/her dependents.

  9. Certain pensions, stock bonuses, profit-sharing plan payments, annuities, and other such plans to the extent needed for support.

  10. An interest in household furnishings or goods, clothes, books, appliances, animals, crops, musical instruments, or other items of a personal, family, or household nature (up to $575 for any one item, with the total not exceeding $12,250).

  11. Criminal victim restitution payments, lost earnings payments, wrongful death benefits, life insurance payments to a dependent beneficiary, and—up to $22,975—personal injury payment.

  12. Retirement funds that are in a fund or account that is exempt from federal taxation, and some individual retirement accounts with the aggregate amount exempted limited to $1,245,475.

  13. Accrued interest or dividends of up to $12,250 in life insurance policies.

  14. Some contributions to education and college savings accounts made more than one year before bankruptcy.

  15. Any other property worth altogether (a) no more than $1,225, plus (b) up to $11,500 of the unused portion, if any, of the homestead exemption (item 1, above).

States are permitted to substitute their own exemptions for these federal exemptions, and most have done so. The rest of the states permit debtors to choose between the relevant state or federal exemptions. Bankruptcy law reforms in 2005 restrict a state’s homestead exemption to $155,675 (adjustable for inflation in 2016 and every three years thereafter) if the person in bankruptcy bought his/her residence less than 40 months before filing. Also, that same homestead cap applies if the bankruptcy court finds that the debtor was convicted for a felony demonstrating that the bankruptcy filing was an abuse of the bankruptcy laws or if the debtor owes a debt arising from a violation of federal or state securities laws, fiduciary fraud, racketeering, or crimes or intentional torts that caused serious injury or death in the preceding five years. A debtor’s discharge may be delayed while the debtor is involved in a proceeding (e.g., a criminal charge) that might lead to this homestead exemption cap.


The trustee acquires title to all of the debtor’s property (“the estate”) and administers the estate by collecting and liquidating assets as well as deciding claims. The trustee may sue, accept or reject executory contracts, revoke unperfected property transfers, and negate preferential or fraudulent transfers.

Preferential transfers favor one creditor over others (i.e., the favored creditor gets more than he/she would under the Bankruptcy Code). Such transfers are prohibited when they concern preexisting debts and are made during the 90-day period before the bankruptcy petition is filed.

Creditors with liens on or security interests in the debtor’s property may sell or otherwise dispose of the property in order to collect the debt secured by that property. If a sale generates more than is owed, the excess goes into the debtor’s estate. If, after disposition of the secured property, the debtor still owes money, the creditor becomes an unsecured, general creditor for the remaining amount owed (category 11, immediately below).

The trustee distributes the debtor’s estate (pays costs, claims, or other expenses) in this order:

  1. Alimony, child support, and property distribution (domestic support) obligations.

  2. Costs of administering, collecting, and maintaining the estate, including attorneys’ fees and, usually, taxes and even penalties. BABCPA adds as part of this administrative expenses category “the value of any goods received by a debtor within 20 days before the petition date in which the goods have been sold to the debtor in the ordinary course of the debtor’s business.” (BAPCPA further protects sellers as follows: Sellers may reclaim goods sold in the ordinary course of business and on credit to a debtor who received the goods while insolvent. To do that, the seller must demand reclamation in writing no later than 45 days after the debtor received the goods or, if a petition for bankruptcy was filed during those 45 days, within 20 days after that filing.)

  3. For involuntary petitions under Chapter 11, credit extended or taxes incurred in the ordinary course of business during the “gap”—the period after the bankruptcy petition was filed but before a trustee was appointed or an order for relief was made.

  4. Unsecured claims up to $12,475 per employee for wages (including vacation, severance, and sick pay) earned 180 or fewer days before the bankruptcy petition was filed or the business ceased, whichever was first.

  5. Unsecured claims up to $12,475 per employee for contributions to employee benefit plans arising from services rendered 180 or fewer days before the bankruptcy petition was filed. (However, the combined priority of 4 and 5 (wages and pension contributions) is limited, altogether, to $12,475 per person.)

  6. Claims up to $6,150 of farmers and fishermen against debtors owning or operating facilities for storing grain or processing fish.

  7. Consumer claims up to $2,775 for deposits with or prepayments to the debtor for undelivered property or unperformed services.

  8. Some taxes and penalties due—unsecured claims for unpaid income and gross receipts taxes incurred in the three years preceding the bankruptcy petition and for unpaid property taxes incurred within one year of the petition.

  9. Unsecured claims based on the debtor’s commitment to the Federal Deposit Insurance Corporation (FDIC) or other such regulatory agency (e.g., to maintain the capital of an insured bank).

  10. Claims for liability based on death or personal injury resulting from operation of a motor vehicle where the operator was unlawfully intoxicated from alcohol, drugs, or other substances.

  11. Claims of general creditors (almost all other unsecured debts). Those parts of claims that exceed the money or time limits in categories 4, 5, 6 or 7 above fall within this category.

(As with other figures in the bankruptcy laws, these amounts (categories 4–7, above), will automatically be adjusted for inflation in 2016 and every three years thereafter.)



Six types of debts are considered to be too important to be discharged by bankruptcy:

  1. Alimony, child support, and debts in the nature of support, ordinarily also including marital settlement agreements or divorce decree property distributions.

  2. Certain loans owed to a pension, profit-sharing, stock bonus, or other plan.

  3. Some government fines and penalties.

  4. Taxes and related fines owed for the 3 years before bankruptcy.

  5. Amounts the debtor borrowed to pay federal taxes.

  6. Student loans, unless payment imposes an undue hardship on the debtor or his/her dependents.4

The main reason for not discharging a debt may be the debtor’s misconduct. These other nondischargeable debts are as follows:

  1. Intentional tort claims.

  2. Judgments and consent decrees based on drunk driving (or flying or operating a boat while intoxicated).

  3. Claims to money or property obtained by fraud, false pretense, embezzlement, larceny, or misuse of funds (including compensatory or punitive damages for fraud).

  4. Criminal restitution obligations.

  5. Claims not listed in the bankruptcy petition.

  6. Debts exceeding $650 for luxury goods/services purchased from one creditor within 90 days before the bankruptcy filing.

  7. Certain cash advances exceeding $925 within 70 days before the filing.

  8. A debt (e.g., marital) whose discharge results in a benefit to the debtor outweighing any detriment to the debtor’s child, spouse, or ex-spouse.

Moreover, if in a prior bankruptcy action the debtor was denied a discharge of a particular claim (for reasons other than the 8-year waiting requirement between bankruptcy discharges), he/she cannot later get a discharge on that claim. (Nor, as discussed earlier, can the debtor use a fraudulent or preferential transfer to avoid his/her responsibilities or favor certain creditors.)


Overall bankruptcy discharge may be denied in these cases:

  1. The debtor has: (a) in writing waived his/her right to a discharge; (b) destroyed, concealed, or transferred his/her property and/or records in order to hinder or defraud a creditor; (c) unjustifiably failed to maintain records from which his/her financial status could be determined; (d) not adequately explained a supposed loss of assets; (e) committed a bankruptcy “scam” or other such crime (e.g., lied about his/her financial position when obtaining credit); (f) refused to obey a bankruptcy court order to answer the court’s questions or to appear at scheduled bankruptcy meetings or hearings; or (g) failed to complete a required Credit Education course.

  2. A bankruptcy court granted the debtor a Chapter 7 discharge or Chapter 11 relief within 8 years of the filing of his/her present petition (just six years after Chapter 13 discharges, and no bar applies when the prior proceeding was a good-faith Chapter 13 plan paying at least 70% of unsecured claims).

  3. A prior bankruptcy petition was dismissed 180 days before the present petition was filed.

  4. A Chapter 7 discharge by a consumer debtor would be a “substantial abuse” of the system.

In most, if not all of these cases, the debtor’s nonexempt assets are still distributed to creditors; but, instead of receiving a discharge, the debtor remains liable for the unpaid portion of his/her debts.


A discharge does not affect the liability of a codebtor, a surety, or a guarantor. Moreover, within one year of a discharge the bankruptcy court may revoke its discharge decree because of evidence that the debtor committed fraud or lied during the bankruptcy proceedings.

Debtors may reaffirm a dischargeable debt; such a reaffirmation agreement, though, must be in writing and contain a statement to the effect that the debtor knows of his/her right to rescind the reaffirmation before discharge or within 60 days, whichever is later. The reaffirmation agreement must be filed in bankruptcy court, along with an affidavit by the debtor’s attorney that the agreement would impose no undue hardship on the debtor or a dependent of the debtor, and that the debtor was fully informed of his/her rights and entered into the agreement voluntarily. If the debtor was not represented by counsel, a reaffirmation agreement usually requires the bankruptcy court’s approval; it must find that the reaffirmation does not impose undue hardship on the debtor and is in the debtor’s best interest.

Of course, a debtor may simply volunteer to repay a discharged debt. Such payments cannot be compelled, however, in the absence of a binding reaffirmation.

BAPCPA modifies former section 304 of the Bankruptcy Code concerning cross-border insolvency procedures (for cases where the debtor has insolvency proceedings pending in more than one country). The act is based on the Model Law on Cross Border Insolvency, which had been prepared by the United Nations Commission on International Trade Law. For these concurrent procedures, the act is intended to reconcile differences and keep one country from ruling in ways that render the other countries’ procedures moot. To take advantage of this act (Chapter 15 of the Bankruptcy Code), the debtor must file “a petition seeking recognition of a foreign proceeding by a foreign representative.”


The test for bankruptcy is: Can the debtor pay debts as they become due?

The Constitution empowers Congress to make uniform laws on bankruptcy. Thus bankruptcy is governed by federal law, with a system of U.S. bankruptcy courts.

The Bankruptcy Code has three main alternatives: Chapter 7 (Liquidation), Chapter 11 (Business Reorganization), and Chapter 13 (Adjustment of an Individual’s Debts). Petitions for bankruptcy may be voluntary (filed by the debtor) for all three chapters or involuntary (filed by creditors) for Chapters 7 and 11.

The Bankruptcy Code exempts certain property, or amounts of property, from being used to satisfy creditors’ claims.

A court-appointed trustee administers the debtor’s property (“the estate”) and distributes the debtor’s nonexempt property according to the priority of claims outlined in the Bankruptcy Code.

The Bankruptcy Code prohibits the discharge of certain debts and also allows the bankruptcy judge to deny discharges because of the debtor’s misconduct.

Discharges do not remove the liability of codebtors, sureties, or guarantors; and a debtor may, in writing, reaffirm a discharged debt.


A secured transaction is any transaction in which a debtor gives a creditor a security interest in personal property or fixtures.


Revised UCC Article 9, promulgated in 1999 and since adopted by all 50 states, governs secured transactions (as did the UCC’s original Article 9). In a typical case, the debtor has borrowed money (often a purchase on credit), with the creditor expecting the debtor’s performance (e.g., payments) in compliance with the terms of the loan. As additional protection of his/her right to repayment, the creditor requires that the debtor give a security interest in personal property; if the debtor fails to perform, the secured creditor can use that personal property (known as collateral) as a substitute for, or a means to collect, the debtor’s performance.

Security interests are commonly given in the very property for which a business or consumer has borrowed money (received financing) in order to buy. Secured credit thus permits a consumer or business to make large-scale purchases while assuring the sellers and lenders that they can obtain complete, or at least partial, payment from the secured property if necessary.


The oldest and simplest type of secured transaction is a pledge; there the debtor provides the creditor with physical possession of some of the debtor’s property. This collateral may consist of tangible items, such as jewelry or machinery, or intangible personal property, such as stocks. If the debtor defaults, the creditor sells or uses the collateral to satisfy the debt.

Example: Pledge

Ellen Extravagant owes a credit card company $500. She borrows the money from Paul Pawnbroker and leaves a diamond ring worth $800 with Paul as collateral.

One obvious problem with a pledge is that the debtor frequently will not or cannot turn over possession of his/her property. In fact, a pledge contradicts the underlying purpose of many credit transactions, that is, to help the debtor acquire and use property, not merely buy property (on credit) and then pledge away its possession.


Because of problems with the pledge, the law has long permitted the use of security devices that do not require transfer of possession. Such devices include chattel mortgages, trust receipts, and assignments of accounts receivables; the UCC now labels all of these security interests.


The following types of property can be collateral (i.e., property subject to a security interest):

• Consigned goods (including equipment and inventory).

• Documents evincing rights (e.g., accounts, payment intangibles, promissory notes, chattel paper, securities created by a government debtor, health insurance receivables, deposit accounts, guarantees, and letters of credit).

• Proceeds from a security interest.

• Most other personal property or fixtures (e.g., items subject to agricultural liens, collection on a commercial tort claim, and property liens that establish a right to payment).

Excluded interests include those involving wages, landlord’s liens, most assignments, and papers or notes for the sale of a business.

Even “after-acquired property” (personal property acquired by the debtor after the security agreement was executed) may be collateral, although UCC 9-204(b) bars such collateral for commercial tort claims and sets limits on after-acquired interests in consumer goods (only permitted for accessions or for property acquired within 10 days after the secured party gave value). Collateral may even secure future credit, not just past or present loans (UCC 9-323).



To make the security interest effective between the debtor and creditor, the interest must “attach” to the secured property (the collateral). The three requirements of an attachment are as follows:

  1. A written agreement sets forth a security interest, describes the collateral, and is signed by the debtor.

  2. Value is given by the secured party to the debtor.

  3. The debtor has rights in the collateral.

“Value” arises from commitments to extend credit, from consideration sufficient for a contract, or from preexisting consideration. When the secured party obtains possession of the collateral (a pledge), no written agreement is necessary.


To make the security interest effective against third parties, it must be “perfected.” Perfection gives the secured party priority over other parties seeking to attach or otherwise use the collateral. In short, if C perfects a security interest in D’s equipment, most third-party creditors will not be permitted to seize and sell that equipment in order to satisfy D’s debts to them.

The method for obtaining a perfection depends on the type of collateral. The four methods are possession, control, attachment, and the filing of a financing statement.

  1. Possession constitutes perfection for pledges. It is a method for perfecting an interest in goods, instruments (e.g., promissory notes), certificated securities (e.g., stocks and bonds), tangible chattel paper, money, and negotiable documents of title (e.g., warehouse receipts, bills of lading).

  2. Control is the only way to perfect a security interest in a letter of credit or in a deposit account (UCC 9-314). Such control exists only if: (a) the secured creditor is the depositary bank where the account is maintained, (b) the debtor, secured creditor, and depositary bank have agreed that the bank will follow the creditor’s instructions without the debtor’s further consent, or (c) the creditor becomes the depositary bank’s customer concerning the account.

  3. Automatic perfection (perfection by attachment) usually involves a purchase-money security interest (PMSI) in consumer goods other than fixtures or motor vehicles. Section 9-103 of the UCC defines a PMSI as a security interest that is: (a) held by the seller of the collateral in order to secure all or part of the sales price, or (b) held by a person lending money or otherwise giving value that the debtor uses to acquire or use the collateral.

Without automatic perfection, filing offices would be swamped with financing statements concerning PMSIs in consumer goods. Most authorities believe that such increased filing would provide little added protection to other creditors, and might only confuse matters.

The other typical instance of automatic perfection involves assignments of accounts or contract rights that do not, alone or with other assignments to the same assignee, amount to a “significant part” of the assignor’s outstanding accounts of contract rights.

  1. The fourth and most preferred method of obtaining perfection is to file a financing statement. Such a statement must contain the debtor’s signature, the names of both the debtor and the secured party, and a description of the collateral (UCC 9-502 and 9-504). Filing is necessary for perfection if possession is not the required method for perfection: if the secured party does not in fact have possession; and if the transaction does not involve automatic perfection (usually via a consumer PMSI).

The secured party has the duty of filing the financing statement. Section 9-501 of the UCC provides that for fixture filings and other realty-based collateral, the creditor must file in the office where one would record a mortgage on real estate. For every other filing, besides transmitting utilities, the creditor must file centrally in the office that the state designates as official keeper of the state’s UCC files (UCC 9-501(a)(2)). Filings can be electronic.

A person in doubt as to whether he/she needs to file a financing statement should—to be safe—file one.

Do not confuse the financing statement with the security agreement. The former cannot replace the latter. Indeed, the financing statement simply furnishes the minimal information needed to put other parties on notice of a security interest. (In some cases, the security agreement itself may be filed as the financing statement.) To obtain further information, the debtor or secured party may have to be contacted directly.

A proper filing will be good for 5 years, unless it indicates a shorter maturity date. Continuations may be filed in order to extend the financing statement for another 5 years. The number of such extensions is unlimited, and the secured party need not obtain the debtor’s signature.

When a Debtor Moves to Another State, or Is Succeeded Through a Merger

Perfection by filing continues for four months after a debtor changes his/her jurisdiction. Under a 2010 amendment to Article 9 that all states have enacted, this perfection is extended to collateral: (1) in a debtor’s post-move after-acquired property; or (2) that a debtor’s successor through merger acquired either before or within four months after the merger.



A default on a debt is not defined in UCC Article 9. The parties usually state in their security agreement the conditions that will constitute a default. The typical default is failure to make timely payments on the loan. Another type of default may be to breach a warranty that no liens or other security interests cover the same collateral as that relied on in the security agreement.


Before default, the parties have certain rights or duties, unless specified differently in the security agreement.

The secured party:

(a) may release or assign all or part of the collateral;

(b) may file an extension or amendment of a financing statement, although the latter also requires the debtor’s signature;

(c) if in possession of the collateral, must use reasonable care to preserve it.

The debtor:

(a) may periodically request and receive from the secured party a written statement as to the current amount of the unpaid debt, and perhaps a full listing of the collateral;

(b) bears the risk of loss or damage to the collateral;

(c) must pay for all reasonable expenses incurred in taking care of the collateral.


Upon default, the secured party may sue on the underlying obligation or enforce the security interest directly. These remedies are not exclusive, and can be cumulative if need be [UCC 9-601(c)].

UCC Section 9-609 states the secured party’s right to take possession after default, unless prohibited by the security agreement itself. Although the secured party may take possession without a court order, such conduct must not lead to a breach of the peace (UCC 9-609(b)(2)). As is the case before default, the secured party has to exercise reasonable care over any collateral it now possesses.

As an alternative, a secured party may require the debtor to assemble the collateral at a place designated by the secured party. In fact, the secured party may choose not to remove collateral equipment, but simply to make it unusable and then dispose of it (e.g., sell it) on the debtor’s premises.


The debtor may, via a recorded signed statement (or the failure to object to a notice from the secured party), agree to the secured party’s retention of collateral in partial or full satisfaction of the debtor’s obligation (UCC 9-620 and 9-621). However, if the debtor has paid over 60% of the price or the loan for collateral that consists of consumer goods, the secured party must sell the collateral within 90 days unless the secured party and the debtor otherwise agree (UCC 9-620). Also, for consumer transactions, a secured party may not accept collateral in partial satisfaction of the secured debt. It must be a full satisfaction (UCC 9-620(g)).

For collateral other than consumer goods, the secured party must also notify other secured parties who have given written notice of an interest in the collateral (UCC 9-610). If within 20 days a person entitled to notification (e.g., the debtor or another secured party) objects to the secured party’s retention of the goods, a sale must take place. Otherwise, the secured party may keep the collateral (UCC 9-620).


Sale of collateral may be by any method so long as it is “commercially reasonable.” It is not enough to show that a different type of sale could have produced a better price; for example, the sale is “commercially reasonable” if it was conducted in the usual manner for a recognized market in the goods, or if it obtained the current market price, or if it conformed to the practices of merchants selling the same type of property.

The debtor, of course, has a right to redeem the collateral before the sale by fully paying the debt, plus the additional expenses incurred by the secured party (UCC 9-623). Moreover, another secured party may, in effect, substitute his/her payment for that of the debtor so as to secure the collateral. Once sold, the purchaser takes the collateral free of claims by the debtor or by secured parties.

Upon sale, the proceeds are distributed in this order to pay:

(a) reasonable expenses related to possessing, preserving, and selling the collateral, including attorney’s fees;

(b) the debt owed to the secured party;

(c) claims of other secured parties who gave written notice of an interest in the collateral.

The surplus, if any, goes to the debtor.

As with other debt-collection mechanisms, if the sale does not give the secured party all that he/she is owed, then the secured party (unless barred by the security agreement itself) usually retains a right to collect the deficiency by other means. (The exceptions involve accounts or chattel paper, in which a deficiency is nonrecoverable unless the security agreement specifically provides otherwise.)


Once the debtor’s obligations are satisfied, he/she may require that the secured party file a termination statement wherever a financing statement was filed. For financing statements concerning consumer goods (a rarity because of automatic perfection), the termination statement is mandatory even if the former debtor does not demand it. Failure to file (or, for nonconsumer transactions, at least send a termination statement to the debtor) subjects the secured party to fines and also liability to the debtor for any resulting losses (UCC 9-625). Also, the debtor or some other person can then proceed to file the termination statement without the secured party’s permission (UCC 9-509(d)(2)).


Obviously, one major purpose of the secured transaction is to ensure that the secured party can use the collateral to collect the debt before other creditors may do so. Thus one creditor has priority over another creditor (who has an interest in the same collateral and/or is owed money by the same debtor).

For Article 9 priority rules to apply, at least one party must be a secured party. UCC 9-201 states the basic premise, “Except as otherwise provided in the Uniform Commercial Code, a security agreement is effective according to its terms between the parties, against purchasers of the collateral, and against creditors.” So, a secured party wins the priority dispute unless a UCC rule (e.g., in Article 9) decides that it loses.

The following table shows the major priority controversies and their usual outcomes.

Business Law, 6th edition (Business Review Series) (15)

Business Law, 6th edition (Business Review Series) (16)

Business Law, 6th edition (Business Review Series) (17)


UCC Article 9 governs secured transactions. A security interest may be taken in almost any type of personal property.

To make the security interest effective between the debtor and the creditor, it must “attach” to the secured property (collateral). Attachment requires (1) a written agreement stating a security interest, describing the collateral, and signed by the debtor; (2) value from the secured party to the debtor; and (3) rights of the debtor in the collateral.

To make the security interest work against third parties, it must be “perfected,” depending on the type of collateral, by possession, control, attachment, or—most commonly—the filing of a financing statement. Upon default, the secured party may sue on the underlying obligation or enforce the security interest directly; these remedies can be cumulative.

In some cases, the secured party may keep the collateral as satisfaction of the defaulting debtor’s obligations. In all defaults, the secured party may sell the collateral by any “commercially reasonable” method, with the debtor having a right to redeem up to the time of sale. Proceeds are distributed first to cover expenses, then to pay (1) the secured debt, (2) other secured parties, and (3) if any money remains, the debtor.

Satisfaction of the debtor’s obligation is evinced by the secured party’s filing of a termination statement.

The order in which creditors are paid follows an established system of priorities, in which the first to perfect a security interest usually takes precedence.



  1. Name ten lawful methods for collecting debts.

  2. Name five or more types of personal property that may be at least partly exempted from debt-collection enforcement.

  3. (a) Name at least five federal statutes that regulate creditor practices, prohibit abuses, provide dispute-resolution mechanisms, or otherwise protect debtors.

(b) Would you include the UCCC in your list?

  1. Which law, federal or state, governs bankruptcy proceedings?

  2. Under the Bankruptcy Code, what is the test for insolvency (the “bankruptcy test”)?

  3. Name the three main chapters of the Bankruptcy Code, the type of relief under each chapter, and the party that may ask for that relief.

  4. Name at least four types of assets (property) totally exempt from being liquidated or otherwise disposed of to help pay claims against a bankrupt debtor.

  5. Name at least four types of nondischargeable debts and state the main other reason a debt might not be dischargeable.

  6. Does a bankruptcy discharge affect the liability of a codebtor, surety, or guarantor?

  7. What is the simplest type of secured transaction?

  8. Name four types of property that can be subject to a security interest.

  9. (a) What are the requirements for an attachment?

(b) What does an attachment accomplish?

  1. (a) What are the four methods for making a security interest “perfect”?

(b) What does perfection accomplish?

  1. Upon default, what may a secured party do with the collateral?

  2. What is the general rule governing priority between two conflicting security holders?






Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

bulk transfer





equity of redemption

financing statement



fraudulent conveyance garnishment


homestead exemption

judicial sale

lender liability





prejudgment attachment priority

purchase money security interest

reaffirmation agreement secured transaction

security interest



termination statement



writ of execution


  1. Sure-Thing Surety has entered into suretyships with the following debtors. Coincidentally, in each case the creditor is Wanda Wealthy.

(1) Dirk Debtor owes $10,000 on a loan. Payments are in default. Dirk is 15 years old.

(2) Daphne Delinquent purchased a number of items on credit. Wanda demands payment. Daphne says a check is in the mail.

(3) Ollie Obligor persuaded Wanda to extend the duration of his loan, in return for Ollie’s agreeing to pay a higher interest rate. Ollie now defaults.

(4) Karen Komitted goes bankrupt. She receives a discharge of her debt to Wanda.

(a) For each case, state whether, on the limited facts given, Wanda can obtain payment directly from Sure-Thing Surety.

(b) What additional two defenses might be raised if Sure-Thing were a guarantor, not a surety?

  1. Harry Homeowner owes $120,000 on a mortgage for a house, owned solely by Harry and lived in by the entire Homeowner family. Harry also owes $5,000 to unsecured creditor A, as well as $3,000 to creditor B, the latter debt being secured by a perfected security interest in Harry’s sailboat. Harry is in default on all three debts. The house would sell for $178,000 with costs of sale being $7,000. The state homestead exemption is $25,000.

(a) If the mortgagee conducts a foreclosure sale, what will happen to the sales proceeds?

(b) If Harry files for bankruptcy, what will happen to the boat and the home, and what will be the distribution of proceeds?

  1. Betty’s Boutique (BB) has filed for a Chapter 7 liquidation. BB’s creditors are as follows:

Corporation A: $7,000 claim for business deliveries (similar to previous deliveries) occurring between time of bankruptcy petition and appointment of trustee.

Ms. B and Mr. C: Deposits of $400 and $3,775, respectively, for purchases of consumer goods not yet provided.

State D: Unpaid taxes of $10,000 for the past 2 years.

Workers E, F, and G: $3,800, $5,000, and $13,475, respectively, owed for the last 2 months of work as BB’s employees.

Secured creditor H: $5,000 owed on a car loan (perfected security interest in the car).

Unsecured creditors J and K: $8,000 owed to each.

(a) Assume that the proceeds, after costs, from a sale of BB’s car are $3,000. Assume that the liquidated value of the estate is $61,450 with costs of administration, collection, and maintenance being $10,000. State the distribution to each creditor.

(b) If BB proposes a Chapter 11 reorganization, name one creditor whose lone objection would not render the plan inoperative. How much must that creditor receive under the plan?

  1. Delia Debtor purchased an automobile on credit. May her creditor take priority over a previously perfected security holder who took a security interest in Delia’s present and after-acquired motor vehicles?

  2. A lends money to B. As collateral, A takes possession of stocks and promissory notes owed to B. B subsequently receives a business loan from C, with a security agreement (and properly filed financing statement) specifying a security interest in (among other things) B’s stocks, promissory notes, and other documents. Who has priority as to the stocks and promissory notes, A or C?

  3. (a) Don Debtor is lent money by Bob Bucks, who takes an unperfected security interest in a number of items, including the computer Don has owned for 3 years. If Telly’s Shop (TS) obtains a lien for repairs on Don’s computer, does Bob or TS have priority?

(b) What if Bob now perfects his security interest?

  1. Joe, for money lent to Kay, receives a signed agreement stating a security interest and describing the collateral (Kay’s accounts receivable). Kay already has a judgment against her in favor of A. She also already owes money to B, although no collateral or security interest is in effect. After Joe lends Kay the money and takes her security agreement, C also lends Kay money and gets her to sign a security agreement almost identical to the one with Joe (it, too, covers Kay’s accounts receivable). C follows up by filing, in the correct location(s), a financing statement containing Kay’s signature, the full names and addresses of Kay and Joe, and a description of Kay’s accounts receivable.

In each of the following, who has priority?

(a) Joe or A (b) Joe or B (c) Joe or C

  1. (a) Mary has a perfected security interest in Nancy’s inventory of 100 widgets. Nancy regularly sells widgets, and soon sells 8 widgets to Opal. Opal knows about Mary’s security interest, but knows nothing that would indicate the sale to her violates that security interest. If Nancy defaults, can Mary enforce her security interest against the 8 widgets that Opal bought?

(b) Assume that the widgets are consumer goods. Further assume that Mary has a PMSI perfected by attachment, not filing. If Nancy is not ordinarily in the business of selling widgets, can Walter, a widget purchaser, be free of Mary’s security interest?



  1. Lien (mechanic’s, artisan’s, or hotelkeeper’s), prejudgment attachment, use of security interests, preventing or setting aside bulk transfers or fraudulent conveyances, payment from sureties or guarantors, mortgage foreclosure, writ of execution, garnishment, composition and/or extension agreement, and assignment to a trustee.

  2. Homes, household furnishings, clothes, personal possessions, livestock, pets, and veterans’ pensions.

  3. (a) The Dodd-Frank Act, the Consumer Credit Protection Act (Truth-in-Lending Act), the Fair Credit Billing Act and Fair Credit Reporting Act (both part of the Truth-in-Lending Act), the Fair Debt Collection Practices Act, and the Equal Credit Opportunity Act.

(b) The Uniform Consumer Credit Code (UCCC) is not a federal statute, but has been passed by some states.

  1. Federal.

  2. Inability to pay debts as they become due.

  3. Chapter 7, Liquidation (straight bankruptcy), voluntary or involuntary (debtors or creditors); Chapter 11, Reorganization of a Business, voluntary or involuntary (debtors or creditors); Chapter 13, Readjustment of an Individual’s Debts, voluntary (debtors).

  4. Criminal victim restitution payments, prescribed health aids, unmatured life insurance policies, alimony and child support, pensions and annuities, and federal and state benefits such as social security, disability, and unemployment benefits.

  5. Alimony, child support, some government fines and penalties, taxes owed for the 3 years before bankruptcy, student loans received within 7 years of bankruptcy. The other main reason is the debtor’s misconduct.

  6. No.

  7. A pledge.

  8. Almost any type of personal property: goods (including equipment and inventory), documents evincing rights (e.g., commercial paper, securities, bills of lading), accounts receivable, after-acquired property.

  9. (a) Requirements are that (1) a written agreement sets forth a security interest, describes the collateral, and is signed by the debtor; (2) value passes from the secured party to the debtor; and (3) the debtor has rights in the collateral.

(b) It makes the security interest effective between the secured party and the debtor.

  1. (a) Possession, control, attachment, and the filing of a financing statement.

(b) It makes the security interest effective against most third parties.

  1. Either (1) take it in satisfaction of the debtor’s obligation (although the debtor or another secured party may prevent such action), or (2) sell the collateral and apply the proceeds toward payment of the debtor’s obligation.

  2. The first to perfect has priority.


  1. (a) (1) Yes. Dirk’s infancy is not a defense for Sure-Thing.

(2) Perhaps. It depends on whether Daphne has indeed mailed a check. If Daphne has tendered payment, then Wanda’s claim against Sure-Thing would be reduced (by the amount of a partial payment from Daphne) or eliminated (if the payment was complete or otherwise settled the debt).

(3) No. Ollie’s obligations were materially altered (higher interest rate, longer loan) without the consent of Sure-Thing.

(4) Yes. Karen’s bankruptcy is not a defense for Sure-Thing.

(b) Guaranty agreements must be in writing, and the creditor must first try to obtain relief from the debtor. Neither is necessary for a suretyship.

  1. (a) First, $7,000 to pay the foreclosure costs; second, $120,000 to the mortgagee; third, the remainder to Harry. There is no indication that creditor A or B has obtained a judgment or otherwise acquired a right to some of the remaining proceeds. If the creditors had, they would take only after Harry exercised his homestead exemption.

(b) The boat and home will be liquidated.

Proceeds from the home sale will be applied first to costs of sale and second to the mortgagee, with Harry then being entitled to the state homestead exemption of up to $25,000. (Unless precluded by state law, Harry could instead choose the federal list of exemptions; although the federal homestead exemption is only $22,975, other exemptions may make the federal list altogether better than the overall state exemptions.)

Proceeds from the boat sale will go first to sales costs and then to B. If there is a deficiency, B will become an unsecured creditor for the remainder. If there is a surplus, that goes into the estate.

In summation, the mortgagee and house sales costs will be paid in full. Of the remaining $51,000 either $25,000 (state) or $22,975 (federal) will be kept by Harry. The rest goes to the estate, for distribution according to priority of claims. As an unsecured creditor, A is at the bottom of the priority list. B is in the same position as A with respect to any deficiency after the sale of the boat.

  1. (a) The easiest way to answer this problem is to proceed in order of priority, from top claims down to the lowly “general creditors.” Also, note that H would receive $3,000 from the car sale and become a general creditor for the remaining $2,000 owed.

Payments, in order of priority, would be as follows:

  1. Costs of $10,000 for administering the estate.

  2. Corporation A: $7,000.

  3. Workers E, F, and G: $3,800, $5,000, and $12,475, respectively. (For his/her remaining $1,000, G becomes a general creditor.)

  4. Ms. B and Mr. C: $400 and $2,775 respectively. (For his remaining $1,000, C becomes a general creditor.)

  5. State D: $10,000.

General creditors and amounts of claim would be as follows: C, $1,000; G, $1,000; H, $2,000; J, $8,000; K, $8,000; (total $20,000).

Liquidated value $61,450 minus total amounts in categories 1–5 ($51,450) equals $10,000. Because the amount left in the estate is $10,000, whereas the general creditors’ claims total $20,000, each general creditor will be paid half of his/her claim. Thus C and G each get $500 to add to the $2,775 and $12,475, respectively, already received; H gets $1,000 in addition to the $3,000 received from the sale of his/her collateral (BB’s car); and J and K get $4,000 apiece.

(b) Worker E or Worker F, with that worker receiving $3,800 or $5,000, respectively. If both object, than the plan would not have the necessary majority approval and two-thirds in amount approval of the employee creditors. (If either E or F voted with Worker G to approve the plan, then the other worker’s objection would not scuttle the plan.)

  1. Yes, if the creditor perfects before or within 10 days after Delia, the debtor, takes possession of the automobile.

  2. A. Here possession generally constitutes perfection. Even if C’s actions constituted perfection, A’s perfection by possession has occurred before C’s attempted perfection by filing; thus A wins under the general “first to perfect” rule.

  3. (a) TS. Lien creditors prevail over unperfected security holders, except for some PMSIs. Because Don had owned the computer for 3 years, clearly his loan from Bob did not enable Don to purchase the typewriter (so not a PMSI).

(b) Bob has priority, at least inasmuch as his security interest concerns a loan made before or within 45 days after Telly’s lien.

  1. (a) Joe. Unperfected security holders have priority over unlevied judgment creditors.

(b) Joe. Unperfected security holders have priority over unsecured creditors.

(c) C. Unperfected security holders lose to subsequent perfected security holders [UCC 9-322(a)].

  1. (a) No. UCC 9-320(a) provides that a purchaser of goods in the ordinary course of business prevails over a perfected security holder.

(b) Yes. Walter’s ownership would not be subject to Mary’s PMSI if Walter gave value to Nancy, he bought before Mary filed a financing statement covering the goods, he did not know about Mary’s security interest, and he used the widgets for personal, family, or household purposes [UCC 9-320(b)]. Mary’s prior filing of a financing statement, although not needed to perfect a PMSI in consumer goods, would prevent this type of outcome: Walter could not then take the 8 widgets “free and clear” of Mary’s security interest.

1 To get a court order barring garnishment, the Florida head-of-family debtor must file an affidavit attesting to his/her earning $750 or less per week or, if he/she makes more than the $750 threshold, that he/she has not agreed in writing to garnishment.

2 Also, these individuals must take a credit education (personal financial management) course before receiving a bankruptcy discharge.

3 There are some accommodations for active-duty service members and those with serious medical conditions.

4 The BAPCPA eliminated the prior law’s provision allowing a student loan to be discharged once seven years have passed from the start of that loan’s repayment period. It also eliminated the distinctive treatment of privately financed student loans, which no longer may be easier to discharge than other student loans.





agency a legal relationship whereby one person acts for another

agent a person authorized to act for another (principal)

principal the person for whom an agent acts and from whom the agent derives authority

independent contractor a person hired to undertake a contractually defined result (not an employee and usually not an agent)


Agency is of fundamental importance to all business. An agency is a legal relationship in which one person represents another and is authorized to act for him/her. The person who acts is the agent; the person for whom the agent acts is the principal.

Agency law consists of all the rules, recognized and enforced by society, whereby one person acts for another. Without the body of agency law, every person would have to act directly for him-/herself and could not send a representative, a salesman, or a messenger. Since corporations can act only vicariously through employees, officers, and agents, corporations could not function at all and would cease to exist.

Without the ability of a principal to act through an agent, business would be severely crippled.

By and large, agency law is state common law. Neither federal law nor the Uniform Commercial Code deals expressly with the subject of agency.


  1. Agency may include employment. An agent may or may not be the principal’s employee. It depends on whether the agent meets this definition of “employee”: under the control and supervision of his/her employer, who determines not only what is to be done, but also how it is to be done and other details of performance. Conversely, the Restatement (Second) of Agency (1959) holds that employees always are agents. Some courts and commentators have disagreed—stating that certain types of employees have no power to represent the employer and thus are not agents.

  2. Agency includes and may be created by a power of attorney. In its broadest sense, the word “attorney” denotes a representative or agent. An attorney-at-law is a legal representative, employed to represent a client in lawsuits and other legal matters. An attorney in fact may represent another person as an agent for general or special purposes other than legal ones. An attorney in fact is named as representative or agent in a power of attorney, a written document setting out the appointment of the attorney. The appointment may be general, that is, for broad agency purposes (“to do any act for me”), or special (“to sell my real estate known as “Blackacre”) for named and limited purposes.

  3. Agency generally does not include independent contractors. An independent contractor is hired to achieve a purpose, to do a job, to undertake a contractually defined result. How the contractor achieves the end result and what tools and techniques are used are his/her responsibility. (Only if the independent contractor is a representative does he constitute an agent.)

The tort or contractual responsibility of a principal for the acts of his/her agent moves from very great when the agent is an employee to far less in the case of an independent contractor.

  1. Personal service obligations cannot be performed by an agent. As discussed in Chapter 7, a number of personal service obligations cannot be delegated to another. These nondelegable obligations require the special skill of a designated person who cannot send a representative (agent) to act in his/her place. Thus, without the approval of the benefitted third party, a doctor or lawyer, for example, cannot name an agent to act in his/her place. Similarly, a member of a corporation’s board of directors, charged with the personal responsibility of a fiduciary (trustee), cannot act through an agent but must discharge his/her board duties in person. What can be delegated to an agent or subagent? Administrative, clerical, or mechanical duties—almost anything in which the delegating party’s special skills or judgment are not involved.

  2. It is very important to distinguish between employees (who often are agents) and independent contractors (who rarely are agents). There are advantages to using independent contractors instead of employees: no tort liability under respondeat superior, less administrative burdens, as much as 40% less in benefit expenses (e.g., no social security tax, no unemployment tax), avoidance of worker discipline and performance evaluations, reduced exposure to potential discrimination or other wrongful treatment liabilities, and far less regulation as to labor, workers’ compensation, OSHA and many other laws. Disadvantages include: less control over a worker’s performance and over his use of the hirer’s proprietary information, potential liability beyond workers’ compensation levels, the possibility that misclassification will result in penalties costing far more than simply classifying, initially, someone as an employee.

Is he/she really an independent contractor? Look at the parties’ actions and circumstances, not just what the parties say (e.g., their written agreement), but what is actually done. Is the hired person really “independent”? Does the hirer only determine ultimate goals, while the hired person decides how to do the job?

There are many tests for whether someone is an employee or an independent contractor, with different standards found at many different administrative agencies, such as the NLRB, the Labor Department (for FLSA purposes), the Social Security Administration, and the Internal Revenue Service. The common law approach is to look at how much the hirer has a “right to control” the hired person. The “economic realities” test uses numerous factors, often focusing on this very important question: does the worker depend on the hirer’s business for the opportunity to render service (employee) or does the worker depend on his own business (independent contractor)? Some factors to consider are: (1) degree of skill (employees often receive training from their employer, while independent contractors already have expertise—a specialized or skilled occupation); (2) level of supervision (little or none for independent contractors, who usually exercise some judgment and initiative); (3) who supplies the tools, materials, and equipment (an independent contractor tends to supply his own); (4) is the work part of the hirer’s regular business (e.g., waiters and waitresses at a restaurant are employees), or it is part of a distinct enterprise (e.g., caterers for a business that normally does not dispense food very likely are independent contractors); (5) the opportunity for profits/losses (e.g., franchisees are usually not employees); (6) the method of calculating payment for the work (by time worked—a regular salary or an hourly wage—is more for employees, while by the job—e.g., payment upon completion—is more for independent contractors); (7) the setting, time, place, and manner of performing the work (usually determined by the independent contractor or by employers, not employees); (8) the permanency and exclusivity of the work relationship (the more there is, the more likely the relationship is one of employment); (9) the providing of annual or sick leave of medical, retirement benefits, and of employer-paid social security taxes (more such payments indicate employment); and (10) the parties’ intent, such as evidenced in a written agreement, concerning employee or independent contractor status. It is a balancing test. Misclassification of an employee as an independent contractor can result in administrative penalties and suits against the employer.



The agency relationship is always consensual. It usually is created by contract, oral or written. Sometimes, though, the contract element of consideration is lacking. For example, the power of attorney creates a consensual, but often noncontractual agency. The attorney in fact makes no promise to act, nor does the power granted necessarily provide for his/her payment or compensation. In some states, the power of attorney to sell real estate must be in writing, signed by the principal.

When an agency is not contractual, either party can terminate it at any time without liability to the other for failure to continue performance of the agency. However, there is responsibility for tasks completed, undertaken, or underway. Even if there is no contract, the parties are bound by all of the general duties and responsibilities of principal and agent.


Implied contracts of agency may be judicially determined because the words or actions of the parties would lead others to believe that an agency existed, that one party was acting for another. This is the test for implied contracts, generally. Indeed, because of the way persons act, third parties may depend upon there being an agency relationship even though the parties, as between themselves, may deny the existence of an agency.


Even though there was no agency when an “agent” performed a valid act ostensibly on behalf of another person, that person may ratify the act by accepting its results after the fact. There is no ratification unless the party that supposedly ratified: (1) was in existence when the “agent” acted, (2) had full knowledge of all material facts before it ratified, and (3) ratified the entire act of a would-be agent, not simply the favorable parts.

Example: Implied Contract by Ratification of an Unauthorized Act

Tara Tenant employs an interior decorator to install draperies and rugs in a residence owned by Larry Landlord. Larry will be responsible on the contract by ratification if he accepts the benefits of the work knowing of the transaction and knowing that the decorator expects to be compensated.

Since the ratification can be express or implied, in order to avoid responsibility Larry should repudiate the action as soon as he learns of it.


Estoppel is conduct by one person that causes another person, reasonably relying on this conduct, to act to his/her detriment or to change his/her position. A would-be agent’s actions alone do not create agency by estoppel. Although most scenarios involve actions or words of the supposed agent that convey to others the false impression he/she is an agent, that apparent agent cannot give himself apparent authority; instead, he/she acquires apparent authority from his/her purported principal if the “principal,” by his/her conduct (acts or omissions) leads another to reasonably believe that the “agent” is in fact authorized to act on the purported principal’s behalf. The third party’s reliance on the appearance of authority binds the purported principal, who is estopped (precluded) from denying the agent’s authority.

Example: Connie Customer enters the Tech Store and pays cash for an item that she is told will be in stock later that day. Connie receives a Tech Store receipt and “IOU” from Sally, the apparent salesperson wearing a Tech Store shirt. Sally is not actually a store agent or employee, but rather just took the shirt and invoice book from the back of the store, where they had been lying near an unattended sales register. The Tech Store’s careless supervision—allowing Sally to take the shirt and the invoice book and to then operate in the store as a fake salesperson—estops Tech Store from liability to Connie for Sally’s actions.


There are a few special situations in which one person, for example, a parent, is responsible for the necessities of another, a child. In such a case, the parent may be responsible as a principal for a contract made by the child for his/her necessities (e.g., for medical treatment when away from home). The contract, of course, must be reasonable, and the provider of the service will be liable to the parent (principal) for failure to perform the contract with proper care.


Agency can be created by contract (express or implied, oral or written), by ratification (assent is given either to an act done by someone who had no previous authority to act or to an act that exceeded the authority granted to an agent), by estoppel (a person allows another to act for him/her to such an extent that a third party reasonably believes that an agency relationship exists), or necessity (a person acts for another in an emergency situation without express authority to do so).



When the agent is appointed by contract, the terms of the contract determine the duties of each party to the other. However, the duties of an agent may be modified by express agreement. In the absence of specific terms or modifications by contract, these duties are as described in this section.

The law considers that an agent acts in a fiduciary capacity to his/her principal. The obligations of a fiduciary are very strict; failure of the fiduciary to account for monies collected for his/her principal, commingling of such monies with the fiduciary’s own, or appropriation of the principal’s property to the fiduciary’s own use may be not only a breach of the agency contract, but also a criminal act (embezzlement, larceny after trust).

In keeping with this high degree of fidelity, the following duties are required of the agent (unless modified by contract):

  1. Duty to obey instructions. This duty is self-evident; it involves no more than might be expected from any contract obligation. Bear in mind, however, that the agent may be undertaking duties of the highest and most complex nature: buying and selling, entering into contracts, and the like, all as an alter ego (other self) for the principal. The agent is personally liable to the principal if he/she (a) causes the principal to become responsible for unauthorized contracts, (b) improperly delegates his/her duties to another, or (c) commits torts for which his/her principal may be responsible.

  2. Duty to act with skill. An agent undertakes to act with the degree of skill ordinarily expected from others undertaking such employment. A business agent, a stockbroker, a manufacturer’s representative—all undertake their agencies with the understanding that they will perform with skill. Any case for breach of contract requires proof (a) of the proper standard of care or skill and (b) of failure of the agent’s performance to rise to that level.

  3. Duty to avoid conflict of interest (duty of loyalty). An agent who is acting for a principal cannot act for him-/herself with respect to the same matter. An agent buying property for a principal cannot purchase property in which he/she has some personal or private interest; an agent selling the principal’s goods cannot sell to him-/herself or to friends or relatives at a special or lower price. An attorney cannot act for conflicting parties in a lawsuit, or represent conflicting interests in any business transaction. On occasion a conflict, or possibility of conflict, can be resolved by full disclosure of all facts to both principals, followed by their fully informed consent to such double representation.

The disclosure of conflict or possible conflict must be complete, and the consent of the principal must be given with realization of all consequences.

  1. Duty to protect confidential information. Obviously, the principal must be free to disclose all necessary information to his/her agent, including trade secrets and proprietary information. The agent must protect this property from the general public, third persons, and the principal’s competitors. Also, such proprietary and confidential information must be restored to the principal upon termination of the agency.

  2. Duty to notify. Since the agent is, in some respects, an extension of the principal, he/she is, by this extension, the eyes and ears of the principal. Consequently, the agent must notify the principal of all information that is or may be useful to the principal in evaluating the matter at hand. In this way, the principal can make further choices with respect to his/her business and continue to give the agent proper guidance.

  3. Duty to account. The contract of agency will specify times and manner of accounting. In all cases, the agent must maintain “an open book” for the principal so that the principal may assess the progress of the work. At termination of the agency, all property must be accounted for and all income turned over to the principal in accord with the agency agreement. Commingling of funds is a violation of the agent’s duty of fidelity.

Failure to account and breach of the relation of trust may be criminal.


The duties of the principal to the agent are governed by the contract of agency. The primary duty is to compensate the agent for his/her services. If the contract is implied, the compensation is the agent’s fee as understood, or generally understood. If there is no contract, express or implied, the agent is entitled to compensation in quasi contract calculated at the reasonable value (quantum meruit) of the services performed. If, however, the agent agreed to perform the agency gratuitously, no compensation is due.

The principal must (1) pay all expenses the agent reasonably incurred in furtherance of the principal’s business, and (2) inform the agent of dangerous risks the principal has reason to know exist. If the agent is an employee, he/she is entitled to a place to work and to the equipment, supplies, and accessories necessary to perform the employment.


An agent is a trustee, and this trust relation requires a high degree of loyalty. The law implies a number of duties of performance, but these may be modified by contract.

The primary duty of the principal to the agent is to compensate the agent according to the terms of the agency agreement or, if no agreement exists, at the reasonable value of the services performed.



Concerning the principal’s business, the agent is an extension of the principal, an alter ego. Thus, when an agent is acting within the authority granted by the principal, he/she can bind the principal to the deal; otherwise, creation of agents (representatives) would serve no purpose, would make no sense. Justinian’s code stated it this way: Qui facet per alium, facet per se, that is, “Who acts through another, acts himself.”

The principal is bound contractually if the agent has either the actual authority to make a contract for the principal or has the apparent authority to do so.

Actual authority is either express (based on oral or written words to the agent) or implied (inferred from words or conduct manifested by the principal to the agent).

Implied authority to make contracts for the principal is a common sense fulfillment of the agent’s job, a going forward with the purposes of the principal’s business. If the agent can buy goods, manage real estate, or set up a branch office, he/she has the implied authority to make contracts to achieve these purposes. Remember that almost every business transaction involves a contract, and the authority to transact the principal’s business usually carries with it the authority to make contracts in furtherance of that business.

Apparent authority, unlike implied authority, arises out of actions or conduct of the principal which causes a third party to reasonably believe that the agent has the authority to make contracts for the principal. Lawyers and judges sometimes say that an agent is “clothed” with apparent authority, that is, the principal has “dressed” the agent in such a way as to lead others to rely on his/her authority. If the agent is given an office, a title, and a staff, third parties may reasonably believe the agent can bind his/her employer or principal. Indeed, any trappings or other evidence of agency may create apparent authority. An officer’s position within a corporation provides apparent authority (termed authority by position) if, although the officer had no actual authority in that particular situation, a third person reasonably assumes the officer’s authority is consistent with his/her holding that corporate office.

Actually, unknown to the third party, there may be a private order or memo to the agent that he/she is not to bind the principal, that the agent has no authority. The third party’s reasonable, albeit false, understanding that the presumed agent can bind the principal is sufficient to establish apparent authority (e.g., bind the principal to the agent’s contracts with the third party).

If a corporation permits an office manager to exercise general supervision over office employees, the office manager may have apparent authority to discipline these employees or to increase their compensation, even though secret or confidential limitations may have been placed upon this authority.



A principal is directly responsible for his/her agent’s torts under any of the following circumstances:

  1. The principal gave the agent improper orders or instructions that caused the tort to occur.

  2. The agent was improperly or negligently chosen or employed.

  3. The principal failed properly to supervise or oversee the work when he/she had a duty to do so.

This direct liability of the principal for tort does not derive from the agency relation. Rather, it is the very act of the principal that is negligent.

Examples: Direct Liability of the Principal

An agent hired by the principal to drive the principal’s bus has a record of drunken and negligent driving.

A company car to be driven by an agent has defective brakes.

An agent is given chemical pesticides with improper instructions for application to the fruit trees of a third person.


Even though the principal has committed no act of negligence, the agent’s negligence is imputed (charged) to the principal if the agent is acting for the principal in the scope of his/her employment. This liability is founded on the common law doctrine of respondeat superior: “Let the superior respond.”

The key requirement of indirect liability, respondeat superior, is that the agent be acting in the scope of his/her employment. The expression “scope of employment” is a technical legal phrase, and the concept must meet four tests:

Tests for Respondeat Superior (set forth at common law and in the Restatement (Second) of Agency, § 229)

  1. The conduct must be of the kind the agent was employed to perform.1

  2. The conduct must occur at the authorized place and time of employment.

  3. The conduct must be motivated, at least in part, by service to the principal (rather than the agent’s self-interest).

  4. The use or means employed by the agent could have been anticipated by the principal.

If a night club bouncer evicts a drunken patron with such force as to cause death, the club owner is indirectly liable under the doctrine of respondeat superior. If, however, an elevator operator pulls a knife from his/her jacket and seeks to carve up a passenger, this tort would not be imputed to the building owner, the principal, under the doctrine of respondeat superior since the first, third, and fourth tests above are not met. (However, the negligent employment of this operator might give rise to direct tort responsibility.) Moreover, under the aided-in-the-agency-relation doctrine, an employer can be vicariously liable for a tort that an employee commits outside the scope of employment if the authority of the employer made it possible for the employee to commit the tort. For example, this may be grounds for holding an employer liable for sexual assaults or harassment that an employee committed, although the employer had not known, at the time, about such misconduct.


Is commuting to or from work something for which an employee’s negligence can be the basis of the employer’s liability? The employer is not vicariously liable because the employee is not then within the employer’s control.

Different facts may lead to a different result: If an employee/agent is already at work (e.g., at a conference, for his/her employer, in another city), then going to or from a worksite (e.g., from the hotel where the employee is staying) may be seen as travel within the employer’s control; all 24 hours may be, in effect, “during the workday,” with the employer potentially vicariously liable.

The principal is responsible for such torts as fraud and misrepresentation since they clearly meet the respondeat superior tests. Note that liability for fraud and misrepresentation is present notwithstanding the fact that the agent has no authority to misrepresent the product he/she is selling.

The vicarious responsibility of the principal arises out of the fact that the agent is an extension of the principal. The agent was chosen by the principal; and it is the action of making the choice, holding the agent out to the public as the transactor of the principal’s business, that creates liability for the principal.


An independent contractor does not act under the supervision and control of the person who hired him/her. The contractor is chosen to accomplish a result by his/her own means. Consequently, the doctrine of respondeat superior does not apply to the torts of an independent contractor.

It is not always possible, however, to avoid liability by delegating work to an independent contractor. Under the law of torts, strict liability is imposed in regard to certain “ultrahazardous activities,” such as blasting and the transport of volatile chemicals or wild animals. Responsibility for mishaps arising from such activities cannot be delegated to an independent contractor.

The person hiring the independent contractor may be directly responsible, however, if the contractor is negligently chosen, or if other conditions of direct liability are present.



If a third party knows, or should know, that the agent is acting for a principal and if the third party knows the identity of this principal, the principal is a disclosed principal.

If these conditions are met, the agent has no personal responsibility for a contract made on behalf of this principal.

The fact of the agency and the identity of the principal are usually disclosed in any contract with a third party. If the contract is between P, the principal, and T. P., the third party, A, the agent who negotiates the contract and signs P’s name, is obviously the agent. Nevertheless, some word of agency should be used when A signs; such words as “by” or “for” or “agent for,” or, if A signs in her employment capacity, “President,” “Sales Manager,” or “Secretary”—all of these indicate the representative capacity and bind the principal, not the agent.

Failure to identify the principal and to use agency words upon signing may create personal liability for the agent. Thus, for corporations, limited liability companies (LLCs), and any other entities with distinct legal status apart from their owners-managers, persons acting on behalf of those entities must make clear the capacity in which they are acting. For example, all stationery used by LLC managers should include the LLC’s name and its status as an LLC. As with corporate officers, LLC managers/members should execute contracts as follows: NAME OF ENTITY By: Name and Title of Signatory.

Even if a principal is disclosed, however, the agent may have personal liability if, in fact, he/she had no authority. Obviously, if agent A merely claims to act for principal P, but P has not given her authority or clothed her with any appearance of authority, A is on her own and is bound by the contract, not P. Indeed, such a case gives rise to a tort by A (fraud and misrepresentation) and possibly a crime.

On the other hand, if A, the agent, frequently acts for P and has the apparent authority to do so, but in fact P has either not given authority or has withdrawn it, both A and P may be liable to the third party. If the third party sues P and recovers, P may in turn recover from A, who had no authority in fact. In all cases where an agent discloses a principal, the agent is deemed to make an implied warranty that he/she has the authority to make a contract for that principal.


In this case the third party knows that the agent is acting for a principal but does not know the identity of the principal. This partially disclosed principal situation occurs when a principal wishes privacy or seeks for financial reasons to conceal his/her identity. For example, a wealthy developer, seeking to accumulate a large commercial tract of land from a number of small landowners, may send his agent to obtain contracts with these owners. The fact of the agency is disclosed but not the name or identity of the principal. In such a situation the agent is liable on the contract. If the principal’s identity can be determined and the agent cannot satisfy the contract, the principal may be liable on the contract also.


If neither the fact of agency nor the identity of the principal is disclosed (undisclosed principal), the agent is liable on the contract since the third party was led to believe that the agent was the real party on the contract.

An agent may recover from the undisclosed or partially disclosed principal for any costs it incurred as an agent, including a third party’s breach of contract claims. If the third party learns of the agency, he/she, too, may recover directly from the principal, not just the agent.


An agent who commits a tort, whether acting within the scope of his/her employment or not, is personally liable for the tort. If the agent is acting within the scope of employment, both he/she and the principal are simultaneously liable for the tort. In cases of such joint and several liability, the injured party may sue either principal or agent, or both. Of course, the victim may not have a double recovery, and any recovery from one party is deducted from the recovery from the other. The agent, the party who actually committed the tort, is liable to indemnify the principal for the latter’s loss to third parties because of the agent’s tort.

Example: Joint and Several Liability

Charlie Careless, a truck driver for the XYZ Hauling Co., while hauling a load of goods for the company, negligently runs over a child riding her bicycle. Both the principal (XYZ Hauling Co.) and the agent (Charlie Careless) are liable to the child for the tort. Technically, Charlie is liable to XYZ Hauling Co. for any judgment obtained by the child or her parents.


If a principal directs, approves, or participates in a crime of his/her agent, the principal is criminally liable, as is the agent. An employer whose employees are violating criminal statutes in furtherance of their employment may be liable if the employer knows, or should know, of the criminal acts. Employees who violate pollution laws or antitrust laws create criminal liability both for themselves and for their employers if the employers fail adequately to supervise their job performance or negligently delegate work that the employees perform in a criminal manner.

Scienter (a Latin word used in law to mean a broadly construed form of knowledge—what one knows or should know) is imputed to the employer if the employer fails to learn what he/she has a duty to know.


The agent may have actual authority or apparent authority to make contracts for the principal. Actual authority is either express or implied. Apparent authority arises from a signal to a third party that the agent is clothed with authority to bind the principal in contract.

The principal has direct or indirect responsibility for the torts of an agent. Direct responsibility involves a negligent act of the principal him-/herself, including negligence in the choice of agents. Indirect responsibility arises from torts committed by the agent while acting within the scope of his/her employment.

The agent has no personal responsibility for contracts made for his/her principal if the principal is fully disclosed, provided, of course, the agent has authority to make the contract. If the principal is undisclosed or partially disclosed, the agent is responsible (and, once discovered, the principal is, also).

An employer who knows, or should know, of criminal acts by his/her employees is jointly responsible with the employees for these acts.



The parties may terminate the agency by any act that would terminate a simple contract. If the agency was created for a specified time or for a specified purpose, it terminates upon the passage of that time or the accomplishment of that purpose. If no time is specified, the agency is terminated by the passage of a reasonable time.

The agency can also be terminated by mutual rescission, by revocation of authority by the principal, or by renunciation by the agent. Both revocation and renunciation are achieved by a simple communication, oral or written, manifesting withdrawal of consent. (Remember that agency is consensual; in the absence of a contractual obligation to continue the agency, the consent may be freely withdrawn by either party.)

To assure that there is no lingering apparent authority, the principal generally must give actual notice of termination to third persons who previously dealt with the agent; for other third parties, the former agent’s apparent authority may arise only if there was not even constructive notice of the termination (e.g., an announcement in a trade publication that the agency had ceased would suffice as notice to these third parties, whether they actually read it or not.)


The agency relation is terminated by any of the following:

  1. The death or permanent incapacity of either the principal or the agent.

  2. The bankruptcy of either party.

  3. Frustration of the purpose of the agency. This frustration may occur because of the destruction of the subject matter (e.g., fire damage or loss to goods or property being bought or sold), changes in business conditions, or changes in the value of property being bought or sold.

  4. Subsequent illegality of the business or of the business venture. This would occur, for example, if the business were prohibited, or if the agent were required to have a license which he/she could not reasonably obtain, or if the property were rezoned so as to prevent the legal operation of the business.

  5. Impossibility of performance by either principal or agent. This is an example of termination of a contract by impossibility.

  6. Material breach of the agency contract by either principal or agent.


An agency may be terminated by acts of the parties (any act that would terminate a simple contract) or by operation of law (e.g., either party’s death, permanent incapacity, bankruptcy, or material breach of the agency).


The European Union (EU) Commercial Agents Directive automatically applies some terms and protections to commercial sales agents in the EU regardless of what the agent’s agreement with the manufacturer states. The directive provides for mandatory compensation or indemnity upon the sales agency’s termination. When a commercial agent carries out activity in the territory of an EU member state, the directive applies no matter what law the parties may have selected in their agreement’s choice-of-law clause. So, American businesses with sales agents in Europe need to understand this directive.



  1. Why would corporations be unable to function without agency law?

  2. What is the difference between an employee and an agent?

  3. How does an attorney in fact differ from an attorney-at-law?

  4. Is the agency relationship always created by contract?

  5. Why is an independent contractor usually not an agent?

  6. Give examples of obligations that cannot be delegated to an agent.

  7. Can a person further his/her own goals and objectives while acting for a principal?

  8. How does the term alter ego play a part in the agency relation?

  9. What is meant by “commingling” of funds?

  10. Does insanity of the principal make a power of attorney void?

  11. Why do lawyers and judges say that an agent may be “clothed” with apparent authority?

  12. Explain the difference between the principal’s direct and indirect liability for his/her agent’s torts.

  13. When can the hirer of an independent contractor be liable for the contractor’s tort?

  14. What does the expression “partially disclosed principal” mean?


actual authority



alter ego

apparent authority

attorney at law

attorney in fact


disclosed principal


EU Commercial Agents Directive


implied authority

independent contractor

joint and several liability

lingering apparent authority


partially disclosed principal

power of attorney



respondeat superior


undisclosed principal


  1. XYZ Oil Company, a corporation that owned and operated a number of gasoline filling stations in northern California, hired Tom’s Tank Company to dig up and replace underground tanks at one of its stations in San Francisco. While this work was being done, Cora Endicott, a customer, fell into the open and unprotected hole and was severely injured. The hole was left open and unattended by Sam Jones, an employee of Tom’s Tank Company, who was drunk at the time. Cora sues both XYZ Oil and Tom’s Tank in tort. What will be the result?

  2. Jim Mason, a janitor at the Celestial Trade Center in Dallas, Texas, ordered 500 cartons of paper products from MX Toilet Supply Company. Celestial Trade Center duly paid the invoice rendered for this merchandise. A year later, Jim ordered 1000 cartons of goods from the same supplier. Celestial Trade Center refused to pay this bill, citing a memorandum to Jim after the last order forbidding him to order supplies. What would be the result?

  3. Seedy Apartments employed Melvin Malefactor as a painter for the interior of its apartments in Kansas City. Unknown to Seedy, Melvin had been convicted of assault 3 years previously and of indecent exposure 17 years ago. Seedy checked Melvin’s references and found that he was an excellent painter on his last two jobs. Three weeks after his employment, Melvin raped a tenant while painting her apartment. Is Seedy liable for this tort?

  4. Pollutant Company operates a large manufacturing facility in Factory City, Anywhere. Stuart Smedley, its plant manager, has caused sulfuric acid from the manufacturing operations to be dumped into an adjacent river for years. Is Pollutant (a) criminally liable for this violation of the environmental laws, and (b) liable in tort to downstream property owners whose wells have been contaminated by the acid?



  1. A corporation has no “arms and legs” of its own. It can act only through agents.

  2. “Agent” is a broader term than “employee” and includes representatives of various kinds. An employee is an agent who is under stricter control and supervision than other agents; indeed, some authorities find that certain types of employees are not agents at all.

  3. The word “attorney” designates a representative. An attorney in fact represents his/her principal for general or special purposes other than legal purposes; an attorney-at-law represents his/her principal for legal purposes only.

  4. No. The agency relationship is consensual. The element of consideration is not present in every case.

  5. An independent contractor usually is not a representative, but is employed to achieve a specific purpose or to do a specific job.

  6. Obligations that require relationships of personal trust, skill, or confidence cannot be delegated to some other person. These can be performed only by the principal.

  7. The principal’s purpose must always come first; therefore any person who also helps him-/herself while helping the principal is open to a charge of conflict of interest. If agents believe that they can accomplish their own personal ends as well as the goals of their principals, they should advise the principals in advance and obtain their approval.

  8. The term “alter ego,” meaning “other person,” describes the agency relationship in that the agent serves as an alternate person for a principal and acts in his/her place.

  9. “Commingling” of funds refers to mixing of the agent’s funds with those of the principal. Agency law prohibits such a mixing since the agent’s creditors might attempt to reach this money; moreover, the agent may be spending the principal’s money on personal obligations—an action that is a breach of the agent’s duties and probably criminal.

  10. As a rule, insanity of the principal voids a power of attorney. Under the law in many states, however, the power may contain an express provision permitting it to survive insanity or incompetence of the principal.

  11. Apparent authority is a kind of outward appearance causing others to believe that the agent can make a contract for the principal. The word “clothed” is appropriate to express this outward appearance.

  12. Direct responsibility of the principal arises out of personal participation in the negligent act, that is, his/her own negligence is involved, instead of or in addition to the agent’s negligence. Indirect liability arises from negligence of the agent, which is charged or imputed to the principal.

  13. When the hirer of an independent contractor has a direct (but not indirect) responsibility for a negligent action of the contractor. If, for example, a contractor is improperly chosen or erroneously instructed, his/her hirer may be liable.

  14. “Partially disclosed principal” refers to the situation where a third party knows that the agent is acting on behalf of some other person, but does not know the identity of that person.


  1. Tom’s Tank Company is an independent contractor, hired to do a job, not to represent XYZ Oil Company. Unless there was some kind of direct negligence by XYZ Oil Company, XYZ has no responsibility for the tort. Sam is an agent for his employer, Tom’s Tank Company, and his employer is liable for this tort, which was committed in the scope of Sam’s employment. Of course, Sam is personally responsible also, but is probably without funds to pay a judgment.

  2. Since Celestial Trade Center has paid at least one previous bill arising out of its employee’s contract, MX Toilet Supply Company is entitled to rely on the “apparent authority” of Jim, the employee. The private memorandum between master and servant does not negate the appearance that has already been created.

  3. Seedy is liable for the tort since it is directly responsible for its negligent employment of Melvin. However, a good argument can be made that the reference check of previous employers was the only precaution Seedy should have been required to take in hiring a painter. The counterargument is that an employer should check police records before exposing apartment house tenants to strangers.

  4. (a) Pollutant is liable for criminal acts committed by its plant manager in furtherance of his employment if the company knows or should know of these actions. The company has a duty to supervise, and it would appear that failure to do so may have permitted the wrongdoing.

(b) As to the tort liability, Stuart is clearly acting within the scope of his authority as plant manager, and consequently Pollutant is responsible for this tort, which is inflicted on persons whose existence is known and the harm to whom can be foreseen.

1 Even when the conduct was unauthorized, the principal can still be held accountable if the conduct would have been authorized had there been time to seek such authorization. Also, even if the conduct was unusual and thus not commonly performed by the principal’s agents, the principal may be held accountable if the agent’s response is seen as a common or at least reasonable response to that unusual situation.




sole proprietorship the simplest form of business, in which a sole owner and his/her business are not legally distinct entities, the owner being personally liable for business debts

partnership the association of two or more persons who have expressly or implicitly agreed to carry on, as co-owners, a business for profit

general partnership a partnership in which there are no limited partners, and each partner has managerial power and unlimited liability for partnership debts

limited partnership a partnership conforming to statutory requirements and having one or more general partners and one or more limited partners

corporation an artificial being created by operation of law, with an existence distinct from the shareholders who own it

franchise a contractual arrangement in which the owner (franchisor) of a trademark, trade name, copyright, patent, trade secret, or some form of business operation, process, or system permits others (franchisees), for a fee, to use said property, operation, process, or system in furnishing goods or services.

limited liability company a business format that is a hybrid of the corporation and the partnership; it is taxed as a partnership but has the limited liability of a corporation.


There are three basic types of business organizations:

  1. The sole proprietorship, the simplest form. The sole owner and his/her business are not legally distinct entities. The owner has unlimited liability for debts of the business.

  2. The partnership. Two or more individuals are the owners, having expressly or implicitly agreed to establish and run a business for profit. The two types of partnership, general and limited, are discussed in this chapter.

  3. The corporation. A distinct legal entity having an existence separate from its shareholder owners is created, usually, under state law. For tax purposes, a business entity is deemed a corporation rather than a partnership only if the entity has at least three of the following four traits: limited liability, centralized management, continuity of life, and free transferability of interests.
    Corporations are discussed in detail in Chapters 16, 17, and 18.

There are many subtypes: limited partnerships, general partnerships, S corporations, close corporations, professional corporations, nonprofit corporations and general corporations, to name a few. Even organizational forms not strictly classified as either partnerships or corporations—for instance, syndicates, business trusts, associations, limited liability companies, joint ventures, and cooperatives—rely on partnership and/or corporate law for most, if not all, of their governing principles. Because one of the forms, the limited liability company, has risen in prominence, it is included in the comparative chart that follows.

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For businesses owned by more than one person, the major types of organizations are partnerships and corporations. The decision as to which organizational form to use depends on numerous factors, such as costs, relationships among owners, desirability of linking ownership and direct management, need to limit potential individual liability, raising of capital, size of the business, and (often most important) tax consequences.

A general partnership should require fewer legal formalities and afford a more direct tie between ownership and management. However, individual liability is unlimited, and duration is less assured (more dependent on continued good relations among all owners).

A corporation can increase both the number of owners and (usually) its capital without drastically affecting management, the duration is more definite (can be perpetual), and ownership interests are more easily transferred. Disadvantages for corporations include “double taxation,” greater formal requirements and costs, and greater potential for separation and estrangement of persons into either owners or management, but not both.



Partnerships1 are one of the oldest forms of business. Laws on partnerships can be found in Hammurabi’s code as well as in early Hebrew and Roman texts. Although corporations, a more recent phenomenon, are the prevailing form among medium-sized and larger American businesses, and corporate law now involves an extensive body of statutes and case law, the law of partnerships remains very important. Without a knowledge of partnership law, a businessperson may be unable to decide intelligently what organizational form to use for a new, expanding, or recently acquired business. Moreover, a businessperson will encounter partnerships in many of his/her personal and business activities and certainly should know something about their creation, structure, operations, and liabilities.


Unlike corporations, partnerships usually require no special formalities in order to be created. All that is needed is a partnership agreement.

Like most other contracts, the partnership agreement can be express or implied, and no writing is necessary except for contractual matters generally covered by the statute of frauds. Thus, for example, a partnership agreement that permits partners to transfer real estate, or that has a set term exceeding one year, must be written to be enforceable, at least with respect to these matters.

From a practical point of view, a written document is usually the best way to assure that partners, from the outset, understand the nature of their agreement. The absence of such writing probably increases the chances of disputes between partners; in many cases, it makes disputes harder to settle.


Some typical provisions in an express partnership agreement include the following:

  1. The partnership’s name.

  2. A description of the partnership’s business.

  3. A listing of the present partners.

  4. A statement of the contributions made and/or to be made by the present partners.

  5. A means of determining what constitutes partnership expenses rather than personal expenses.

  6. A method for dividing profits and losses (otherwise, the assumption is that partners share profits and losses equally).

  7. A statement of the general powers of individual partners and the limitations on their authority.

  8. For the partnership itself, required and prohibited acts.

  9. A system for quickly managing routine matters while bringing more serious issues before a management committee and/or the full partnership.

  10. Allocations of salaries and/or drawing accounts among partners.

  11. Treatment of a partner’s outside business interests.

  12. Conditions on an individual’s withdrawal from or addition to the partnership, and rules for such withdrawal or additions, including due to death or disability.

  13. Methods of transferring a partnership interest.

  14. The procedure for amending the agreement.

  15. The partnership’s term of duration.

  16. The closing out or selling of the business upon the partnership’s dissolution.

  17. Access to books and records.

  18. Management of employees.

  19. Accounting methods.

  20. Form of management.

  21. Arbitration of disputes.

  22. The rights of continuing and departing partners.


Is there an implied agreement? The key issue is: Did the alleged partners intend to be co-owners of a business?

Example: Implied Agreement of Partnership

If Jones, Smith, and Gray jointly own property, contribute money to run a business on the property, decide how to conduct the business, and share the profits or losses from the business, a court would probably decide that Jones, Smith, and Gray have formed a partnership. In reaching this decision, the court would look to three factors:

  1. Joint ownership of a business.

  2. Sharing of profits or losses.

  3. Equal management rights.

Generally, there must be some evidence of all three factors. That A and B merely own property together and receive rent for it will usually be insufficient. Likewise, the mere fact that C’s payments to D are pegged at a percentage of C’s business profits does not mean that C and D are partners. In each case, at least one of the three crucial factors is missing. (Note that installment payments on loans, as well as interest payments, wages, rents, annuities, or money from the sale of business goodwill do not constitute profits.)

The Uniform Partnership Act of 1914, as amended, once was the law in every state but Louisiana. It has been replaced in 37 states by a new Uniform Partnership Act of 1997 (UPA), which in turn has been amended several times since 1997, including as recently as 2013. These uniform laws furnish guidance on partnership issues (including whether a partnership exists) when there is no partnership agreement or the agreement does not cover the issues in question. Thus, the UPA permits partners to fashion their own rules, bound only by the law of contracts and little else (except for limited partnerships).


Although almost all partnerships are based on consent, there is one important exception: the partnership by estoppel. When a person represents, or allows someone else to represent, that that person is a partner when in fact he/she is not, the law estops (prevents) that person from denying that he/she is a partner with respect to third persons who reasonably relied on the misrepresentation and were thereby injured. The partnership to which the “partner” allegedly belonged may be fictitious, or it may be a real partnership, but one in which he/she is not a partner. In either event, the alleged partner is liable to the third persons.

Example: Partnership by Estoppel

Suppose that Sam Slick tells Big Bank that he is a partner with Rick Rich, and Big Bank thus extends credit to Sam because of Rick’s good reputation and extreme wealth. If Rick knew about Slick’s falsehood but did nothing, then most courts would treat Rick as a partner for purposes of Sam’s dealings with Big Bank; therefore Big Bank could come to “partner” Rick for money owed.

Of course, this partnership by estoppel works only for third parties such as Big Bank; between Sam and Rick themselves, no partnership rights exist. Rick may have to pay Big Bank, but—since he owes Sam no duty (as a partner) to contribute toward the loan payments—Rick can seek complete reimbursement from Sam for any money Rick paid to Big Bank.


Partnerships are created by express or implied agreement. Oral agreements are permitted, although written agreements are pre-ferable. For implied partnerships, the court generally must find: (1) joint ownership of a business, (2) sharing of profits or losses, and (3) equal management rights.

The typical partnership agreement usually covers many subjects (e.g., the partnership’s name, type of business, individual partner contributions, division of profits and losses, and authority of partners). The Uniform Partnership Act (UPA) provides guidance on partnership issues not covered by the partnership agreement.

Partnership by estoppel occurs when a person misrepresents or allows someone else to misrepresent that he/she is a partner in a fictitious or a real partnership. The alleged partner is liable to third persons who reasonably relied on the misrepresentation. Between the purported partners themselves, though, no partnership rights exist.



Each partner has both a right and a duty to help manage the partnership (UPA Section 18). Unless the agreement provides otherwise, each partner has one vote, with ordinary business decisions being decided by majority vote. (As in most voting arrangements, a proposal does not pass if there is a tie vote; however, especially for small partnerships, for example, two partners, the partnership agreement may make special provisions for resolving a deadlock.) Certain, very important actions usually require unanimous consent:

  1. Amending the partnership agreement.

  2. Changing the essential nature of the partnership’s business.

  3. Altering the partnership’s capital structure (e.g., partnership contributions).

  4. Adding an entirely new line of business.

  5. Admitting new partners.

  6. Confessing judgment (admitting partnership liability on a debt and agreeing to have a court judgment entered against the partnership on that debt).

  7. Submitting to arbitration.

  8. Transferring the partnership’s goodwill.

  9. Placing partnership assets in a trust or assignment for the benefit of creditors.

  10. Paying or assuming the individual debt of a partner.

  11. Conveying or mortgaging property, unless that is the usual business of the partnership.

  12. Serving as a surety or guarantor (unless that is the partnership’s ordinary business).

  13. Any act not apparently for the carrying on of partnership business in the usual way.

  14. Any other act that renders impossible the continuation of the partnership’s business.


Other important UPA rules are as follows:

  1. Each partner must work only on behalf of the partnership, except perhaps for noncompetitive activities that do not infringe on the partnership’s time.

  2. Although partners are entitled to profits (and to reimbursement/indemnification for personal expenses or liabilities incurred on behalf of the partnership), they are not generally paid a salary for partnership work, except for services in winding up the affairs of a dissolved partnership.

  3. Each partner may examine and make copies of some or all of the partnership’s records, which should be maintained at the partnership’s main place of business.

  4. Each partner has a duty to produce, and a right to receive, complete information on all aspects of the partnership’s business.

  5. Partners are entitled to an accounting of partnership assets (including profits) and liabilities whenever partners are excluded from the business or from the partnership records (perhaps in violation of item 3, above), whenever profits or other benefits have been wrongfully withheld or diverted, or whenever else such accounting would be “just and reasonable.”

  6. Each partner must tell the entire partnership about notices to the partnership sent to him.

  7. Partners generally have a duty to maintain the confidentiality of partnership information.

  8. Each partner has a property interest in the partnership equal to (a) a proportionate share of the profits and (b) a return of capital contributions upon dissolution (partners can assign or creditors can attach that interest without dissolving the partnership itself).

  9. Partners are tenants in partnership of all partnership property; this means that each partner has full possessory rights, that the property can be used only for partnership purposes, that none of the partners can assign, have attached, or in any way transfer specific partnership property (such as equipment, real estate, or office supplies), and that a deceased partner’s rights in partnership property pass to the surviving partners, not to the deceased partner’s heirs (although his/her heirs have a right to both an accounting and compensation for the value of the deceased partner’s property interest).

Partners may also have implied authority to: hire personnel; pay partnership debts with partnership funds; buy and sell inventory; borrow money and issue commercial paper; settle claims; receive notices on behalf of the partnership. These and other implied powers depend on the nature of the partnership.


Each partner is an agent for the other partner(s). As such, he/she owes the other(s) a high, fiduciary duty of care similar to that required in any principal/agent relationship. See Chapter 14.

A partner must act in good faith for the benefit of the partnership.

A partner may not divert a partnership opportunity for personal benefit. A partnership opportunity includes any business transaction (a) necessary or related to partnership business, (b) offered to or learned about through the partnership, and (c) developed with partnership funds or facilities.

Revised UPA § 404(f) states, “A partner may lend money to and transact other business with the partnership.” While doing so, however, the partner must disclose all material facts to co-partners concerning his ownership of property, business dealings, plans, and any other actual or potential interest adverse to the partnership. Disclosure is required under any of these circumstances regardless of whether another partner requested the information. A partner who is purchasing another partner’s interest in the partnership owes a similar duty of complete disclosure.

Example: Partner as Fiduciary

When the interest of partnership PR conflicts with Polly Partner’s personal interest, Polly must remain loyal to PR’s interest. Polly must not keep pertinent information from her fellow partners, and she must account to the entire partnership for any personal gains made while using PR property or otherwise acting in her role as a partner.



Each partner also has a responsibility to third persons.

Example: Authority of a Partner to Bind Other Partners

Suppose that partner Pam transacts business with a third person, Theo, and Theo reasonably believes that Pam is engaged in ordinary partnership business. Theo is then entitled to treat the transaction as being one with the partnership itself, regardless of whether Pam had actual authority.

From this example we see that the agency concept of apparent authority applies to partnerships. (See Chapter 14.) In fact, a partner’s implied authority is usually broader than the authority of other agents. Third persons know that the partner is an “owner”/principal, not simply an employee/agent. Therefore, partners must take strong measures to prevent third parties from making reasonable but erroneous assumptions that a partnership employee or some other nonpartner is a partner. Consider these examples:

  1. Employee—Apparent Partner. Paulina, a partner in the PQR General Partnership, and one of PQR’s senior employees, Evan, are at a business convention. Paulina refers to her long friendship and many projects with Evan, who is not a partner, and calls Evan “my partner in crime.” If a third person does not know Paulina is joking, reasonably concludes that Evan is a partner, and deals with Evan because of that, then it is an apparent partnership (Evan’s actions can bind PQR as if Evan were a partner).

  2. Outsider—Apparent Partner. Pauvre applies to an investment capital firm for a debt consolidation loan and brings along her friend, Rich, a wealthy, well-known businessman. Rich tells the firm’s chief loan officer of his long friendship and past business associations with Pauvre and then says, “Pauvre’s my partner in crime.” The firm lends Pauvre the money because it assumes Rich is her partner, which he is not. Pauvre soon fails to make payments on the loan. The firm sues Pauvre and Rich as if the two were partners; the firm seeks repayment of the loan based on partnership by estoppel or apparent authority.

Under the revised UPA, apparent authority is called a purported partnership. Revised UPA § 303 permits the partnership to limit such liability by a recorded statement about the limitation on partner authority.


Aside from apparent authority, a partner’s acts may bind the partnership to a contract because he/she has (1) express actual authority stemming from the partnership agreement; (2) implied actual authority based on the partnership’s business and/or the law of partnerships; or (3) ratification by the other partners after the fact. In the last case, any unauthorized action, even one that would not bind the partnership under a theory of apparent authority, may be expressly or implicitly ratified by the entire partnership.

Note that, whereas any one of these four approaches (including apparent authority) permits a third person to hold the partnership accountable, only three of them allow the acting partner to do so. A partner with apparent, but not actual or ratified, authority not only has no rights against his/her fellow partner(s), but also may have to indemnify the partnership for binding it to an unauthorized transaction.

Express actual authority and ratification are fairly straightforward. Implied actual authority, however, requires an assessment of various criteria, based mainly on the nature of the business and any industry customs. If the partner’s activities were reasonably necessary to conduct ordinary partnership business, and if the partnership agreement did not prohibit such actions, the partner’s powers are implied. For example, a partner in a sales business generally can buy or sell goods of the type customarily traded in the business, and can make warranties on the goods. In most partnerships, a partner can hire and fire employees, pay and collect debts, and acquire personal property needed to conduct the business. However, as stated earlier, there are restrictions on implied authority—some actions require the express consent of all partners.


Because of their broad powers, partners can bind the entire partnership to admissions or other statements made during the course of ordinary partnership business. Moreover, once a partner learns of facts relevant to running the partnership or its business, these facts are imputed to the partnership as a whole. Finally, because partners are principals for each other and their employees, they are civilly liable under respondeat superior for breaches of trust and/or torts committed by a partner or employee acting within the scope of his/her authority. (Respondeat superior, though, does not apply in criminal law. Therefore a partner who has committed no wrongful acts or omissions will not be held criminally liable for another partner’s crimes.)

Whereas partners are jointly and severally liable for torts and breaches of trust (the plaintiff may sue all the partners together or any one or more of them separately), partners are jointly, but not severally, liable for contracts. Therefore any lawsuits based on a contract (including partnership debts) must be brought simultaneously against all partners.


In most ordinary business matters, a partner’s actions may bind the entire partnership. Routine partnership decisions are usually decided by majority vote, with each partner having one vote. Certain fundamental decisions usually require unanimous consent; two examples are (1) to change the essential nature of the business, and (2) to take action that renders impossible the continuation of the business.

Partners are tenants in partnership. They have duties to furnish partnership information to other partners, work on behalf of the partnership, and not compete with the partnership. They have the right to examine partnership documents, be provided complete information on the partnership’s business and finances, and retain a property interest in the partnership itself.

Partners are principals and agents for each other. Each partner must act in good faith for the benefit of the partnership.

Third persons may bind the entire partnership to the actions of a single partner if the partner had (1) express actual authority, (2) implied actual authority, or (3) apparent authority, or if the partnership otherwise ratified the partner’s actions. Apparent au-thority depends on the reasonableness of a third person’s belief in the partner’s authority. Because apparent authority in-volves unauthorized actions, the partnership may have a right to proceed against the partner for unjustifiably binding it to a transaction with a third person.


At common law, the partnership was considered simply a collection (an aggregate) of individual partners, with no separate status for the partnership itself. This aggregate approach to partnerships tended to dominate twentieth-century case law, but it has, for the most part, been displaced by the notion that the partnership is an entity, with a legal existence distinct from its individual owners (the partners). Although the original UPA of 1914 took no position on the matter, Section 201 of the 1997 UPA expressly declares the partnership to be an entity. As a practical matter, this may not be significant in that the partners usually can spell out their rights and duties in their partnership agreement.



  1. In the case of bankruptcy, liquidation proceedings may be brought in the name of the partnership and thus limited to exclusively partnership assets and liabilities, excluding the nonpartnership assets and liabilities of individual partners.

  2. Judgments against the partnership entity usually must be collected from partnership property before collection remedies are instigated against individual partners.

  3. The partnership usually can sue or be sued, have accountings performed and property owned in the partnership’s name, and enforce judgments; some states, though, will not allow such actions.

  4. Under federal income tax laws, the partnership is not separately taxed (as the corporation is), the partnership is generally considered to be an aggregate of the partners’ interests, and the individual partners are taxed on their shares of the profits. (Partnerships, though, must file informational tax forms.)

  5. Generally, partners cannot disclaim personal liability for the partnership’s acts or omissions; the partnership is not a separate entity.

  6. A partnership is not an employer of the partners (e.g., departing partners are not entitled to unemployment benefits).

  7. In many situations, the partnership itself has no power or distinct status, but must depend on the sum of individual efforts by partners.


Partnerships are terminated upon their dissolution and liquidation (winding up).


Dissolution is a change in the partners’ relationship caused when one partner ceases, generally because of death or voluntary or involuntary withdrawal, to be associated with the partnership business (UPA Section 29). There are three methods of dissolution: (1) acts of the parties, (2) operation of law, and (3) court decree.


“Acts of the parties” can dissolve the partnership by several different means:

  1. The partners agree to dissolve the partnership.

  2. The partnership’s term of duration expires, or its purpose for being formed is completed. (Either eventuality is usually covered in the partnership agreement.)

  3. A partner is expelled or withdraws voluntarily from the partnership (unless the partnership agreement provides that withdrawal does not cause a dissolution). Under the revised UPA that most states now follow, a partner can leave the partnership and not disrupt the partnership. This is called a dissociation.

When the partnership is at will (there is no set term of duration), a partner’s expulsion or good-faith withdrawal leaves neither the departing partner nor the remaining partners liable for breach of the partnership agreement. When expulsion or withdrawal occurs before the end of a specified term of duration, however, such an action is a breach if not done for good cause.

Departing partners remain liable for partnership obligations existing at the time of their departure. (A withdrawing partner who fails to notify the remaining partners of his/her withdrawal may continue to be bound as a partner for future partnership obligations.) In fact, no partner can cancel existing partnership obligations by dissolution. Of course, the remaining partners and any partnership creditor may agree not to hold a departing partner accountable for the debts to that creditor; this type of agreement is inferred when there have been past such arrangements and the creditor, knowing that a partner is leaving, has done nothing to alert the partner that he/she remains liable. As for the partnership liabilities of a new partner, they extend only to partnership debts incurred after the incoming partner joined the partnership.

Note that, although a partnership interest may be assigned or attached, such assignment or attachment does not dissolve the partnership. The assignee or attaching party may acquire rights to profits or other rights, but not the right to a voice in management (UPA Sections 27–28).


“Operation of law” arises in one of the following ways:

  1. Illegality (it would be unlawful to continue the partnership’s business or to conduct such business with one of the partners).

  2. Bankruptcy of the partnership or of a partner (most cases serve as a dissolution).

  3. A partner’s death. Note that under the revised UPA (1994 or 1997 version) there is no “new” partnership just because of membership changes, such as via resignation, retirement, disability, or death.

The partnership obligations of a dead partner pass to his estate. This rule follows the general requirement that dissolution not eliminate a partner’s partnership liabilities. However, creditors for other debts have claim to the partner’s estate before the estate pays claims from partnership creditors.


A court decree dissolving a partnership can be applied for by a partner or a third person. The partner’s grounds for dissolution [UPA Section 32(1)] are as follows:

  1. A partner is insane or otherwise incapable of participating in management.

  2. A partner has acted improperly, either by a breach of the partnership agreement, another act severely harmful to the partnership’s business, or still other conduct rendering it impracticable to continue the business with that person as a partner.

  3. The partnership’s business can be operated only at a loss.

  4. Other circumstances, such as strong personal conflicts between partners, make dissolution equitable.

The third person’s grounds are fewer: if he/she is a partner’s assignee or is the recipient (creditor) of a judicial charging order (in essence, attachment) upon a partner’s interests, then the third person may obtain a dissolution decree for a partnership at will or for a partnership whose set term or purpose of formation has been completed.


No matter how dissolution occurs (except for illegality or bankruptcy), notice of the dissolution must be given to third persons to ensure that the entire partnership is not held accountable for future obligations. Actual notice (by mail, telephone, or the like) must be extended to all partnership creditors; public (constructive) notice (via a statement in the community newspaper) is all that is needed for others who knew about the partnership. Of course, there is no duty to give notice to third persons who did not know about the partnership or (in cases of withdrawal) were unaware of the withdrawing partner’s involvement with the partnership.

Example: Importance of Giving Notice

Proper notice serves to eradicate the potential for apparent authority to bind the partnership. Although dissolution removes partner X’s actual authority to bind her partners, third person Z, who does not know about the dissolution, might see X as still having authority. Therefore, without proper notice of dissolution, X probably has the apparent authority to bind the dissolved partnership to transactions with Z.


After the partnership is dissolved, it must be liquidated. This liquidation process is often called “winding up”; the dissolved partnership retains authority to complete unfinished business and do whatever else is necessary to terminate the partnership. Winding up typically involves: (1) collection, preservation, and sale or other liquidation of partnership assets, including collection of money owed to the partnership; (2) paying or otherwise settling partnership debts; and (3) accounting to each partner for the value of his/her partnership interest.

A partner who wrongfully dissolves the partnership (e.g., by persistently breaching the partnership agreement or his fiduciary duties), cannot require winding up, has no right to participate in the winding up process, and cannot use the partnership’s name in any connection to his current business. Wrongfully dissolving partners are entitled to their share of the partnership’s values, minus their share of partnership goodwill and of damages they caused the partnership.


Once the winding up is completed, distribution of assets takes place. Distribution proceeds in this order:

  1. Payment of third-party debts.

  2. Return of a partner’s advances (loans) to the partnership.

  3. Return of each partner’s capital contribution.

  4. Distribution of remaining assets to partners in accordance with the division of profits stated in the partnership agreement (if there is no such provision, the surplus is divided equally).

Of course, among themselves, partners can always agree to alter the order of payments they are to receive.

Creditors’ Priorities in Looking for Payment from the Assets of:

A Dissolving Partnership

An Individual Partner

Higher priority: the partnership’s creditors

Higher priority: the individual partner’s creditors

Lower priority: individual partners’ creditors

Lower priority: the partnership’s creditors

These are the general approaches in nonbankruptcy cases.

Only after individual and partnership creditors are paid may partners seek contribution from another partner (payment of that partner’s partnership obligations).

A partner’s personal creditors have no claim against the personal property of other partners. Also, a partnership’s creditor must exhaust the partnership’s assets before enforcing a judgment against the separate assets of a partner.


Termination of partnerships requires dissolution and winding up.

The three methods of dissolution are acts of the parties, operation of law, and court decrees. Notice of dissolution is necessary except for cases of illegality or bankruptcy.

Winding up involves collecting the partnership assets, paying partnership debts, and accounting to each partner for his/her interest in the partnership.

Upon completion of winding up, final distribution of assets takes place. Partnership creditors generally have first priority as to payment from partnership assets, while a partner’s individual creditors have first priority as to his/her personal (nonpartnership) assets.



A limited partnership (LP) must conform to state statutory requirements, including the filing of a LP certificate. In this respect, as well as the limited liability of limited partners, the LP is similar to corporations.

Special laws on LPs have existed since the Middle Ages, and the first LP statutes in the United States were enacted during the early nineteenth century. The Uniform Limited Partnership Act of 1916 (ULPA) was replaced in 49 states by the Revised ULPA of 1976 (RULPA). (Louisiana follows neither the ULPA nor the RULPA.) Some states additionally adopted the 1985 amended version of the 1976 act. (Unless stated otherwise, this text’s references to the RULPA apply to both versions.) A new ULPA, promulgated in 2001 and so far enacted by about a third of the states (including California, Florida, and Illinois), stands apart from all previous versions. It incorporates all laws while improving flexibility and protection for partners and third parties.

Limited partnerships can conduct almost any business that could be carried on by a general (ordinary) partnership. Exceptions include banking, insurance, and most professional partnerships, such as law firms.


The key feature of a LP is that there are two distinct types of partners, general and limited. A limited partner contributes capital and receives a specified share of the LP’s profits, but does not participate in management and is not held personally liable for partnership obligations beyond the amount of his/her capital contribution. A general partner in a LP has essentially the same rights and duties as do partners (i.e., general partners) in a general partnership (GP).


The LP certificate must state the following information:

  1. The partnership’s name.

  2. Its location.

  3. The name and address of its agents for service of process.

  4. The names and addresses of its general partners.

  5. The term of duration.

Under the 1976 RULPA or the ULPA, additional information is required:

  1. A description of the LP’s business.

  2. The names and addresses of limited partners.

  3. The cash amount or description and value of initial and subsequent (if any) contributions by each partner.

  4. A description of all partners’ rights to receive distributions, including return of contributions.

  5. The method (if any) for withdrawing/changing partners and continuing the business.

Other provisions may also be included. The certificate can be amended, and it tends to resemble both a GP agreement and a corporate charter.

Because limited partners are free from any liability beyond what they have contributed to the LP, statutory requirements must be carefully followed. If an LP fails to file in the state office(s) required, third persons dealing with the partnership but having no actual notice that it is an LP will usually be permitted to treat the limited partners as if they were general partners. Moreover, an LP properly certified in its home state should register as a foreign LP in every other state where it does business. (Corporations must likewise register in other states where they do business.)

In every LP, there must be at least one general partner. As with the GP, the one or more general partners are personally liable for partnership debts. (However, in states where general partners can be corporations, the ultimate effect could be to have a LP in which no individual could be held personally liable for partnership debts in any amount above that paid into the LP. Although the general partner that happens to be a corporation has unlimited liability, if this general partner/corporation becomes insolvent, its “owners” (stockholders) are not personally liable for these corporate obligations.)

A LP likewise needs at least one limited partner. Ordinarily, there is no specified maximum number of limited partners. Since the limited partners do not participate in management, having numerous limited partners should not prove nearly as unwieldy as having large numbers of general partners, whether in a GP or a LP.


The limited partner’s exemption from personal liability depends on his/her abstinence from any role in management. Under the RULPA:

  1. The LP’s capital contribution—whether by general or limited partners—must be money, property, services, a promissory note, or another obligation (e.g., a promise of services).

  2. The limited partner’s last name must be excluded from the partnership name, which has to include, without abbreviation, the words “limited partnership.”

  3. The limited partner must not misrepresent, or allow others to misrepresent, his/her role as being anything other than that of a limited partner.

  4. The limited partner will probably have to withdraw from the LP, or at least renounce any future profits, upon learning that the partnership certificate contains false statements or that the LP was formed defectively. Good faith, substantial compliance with LP legal requirements is sufficient; a minor defect does not destroy the LP.

If any of these requirements are violated, the “limited partner” may become just as liable as a general partner. The RULPA, however, protects the limited partner if the partnership creditor seeking to hold him/her liable did not transact business with the LP while reasonably believing, based upon the limited partner’s conduct, that the limited partner was, actually, a general partner. Under the RULPA, limited partners who engage in managerial activities retain the limited liability if their participation in the control of the business is unknown to the partnership creditor. Also, the RULPA, especially the 1985 version, lists a number of “safe harbor” activities in which limited partners may engage without opening themselves to general, unlimited liability. These activities include consultation with general partners about the LP’s business, being a contractor, agent, employee or surety for the LP, attending partnership meetings, and proposing—and voting on—various fundamental or structural changes to the LP (e.g., dissolution, sale of all the LP’s assets, amending the LP agreement, admitting or removing partners).

The limited partner obviously has no right to bind the partnership, as a general partner can, but does have almost all of a general partner’s other rights. Some of the more important rights of a limited partner include suing (either individually or for the partnership), reviewing all partnership records, obtaining an accounting of partnership assets and liabilities, deciding whether to admit new partners, assigning his/her partnership interest, and participating in the dissolution process for terminations by court decree.


Dissolution and winding up generally occur for the same reasons and by the same methods for an LP as for a GP. However, the addition of a general or limited partner does not dissolve the LP, and an LP agreement may permit the LP to continue despite a general partner’s withdrawal. Also, a limited partner’s withdrawal, expulsion, or death does not dissolve the partnership. (A withdrawing partner ordinarily is entitled to receive the fair value of his/her partnership interest, including business goodwill.)

The RULPA treats all partners in a dissolving LP the same. All creditors, including limited and general partners, are paid first. Unless the LP agreement specifies otherwise, the LP next pays to both general and limited partners any accrued profit shares (unpaid distributions), then returns all partners’ contributions, and lastly, if LP assets still remain, it pays all partners in accordance with the LP’s profit-distribution scheme (if nothing is stated to the contrary, payments are proportionate to each partner’s capital contribution).


On the negative side, the LP is not as effective as the corporation in shielding “owners” from personal liability. Moreover, LP agreements and certificates tend to require formal amendment more frequently than do articles of incorporation, which can be very broadly drafted.

Two reasons for forming a LP are these:

  1. Tax laws sometimes make a LP more profitable than a corporation, which is subject to “double taxation.” Tax laws may also favor R&D (Research and Development) LPs. (However, the 1986 federal income tax reforms reflect a continuing effort to prevent the use of LPs that make little or no economic sense except as tax shelters.)

  2. A GP is in the works (and is preferred over a corporation), but (a) one or more important, potential partners are unwilling to assume unlimited liability and/or do not wish to participate in management; (b) the general partners seek a large infusion of capital without giving up actual or potential control of management. [In case (b), securing a bank loan might make more sense than forming a LP.]


The LP must meet state statutory requirements, including certificate filing. Forty-nine states have adopted the Revised Uniform Limited Partnership Act (RULPA).

Limited partnerships have at least one of each of the two types of partners: general and limited. General partners have essentially the same role in an LP as in a GP. Limited partners have almost all of the rights held by a general partner, except the right to bind the partnership to their actions. In most cases, limited partners simply contribute money, property, or services and receive a specified share of the profits; by not participating in management, the limited partner’s partnership liability is limited to his/her actual contributions to the partnership. Inappropriate management participation or other noncompliance with statutory requirements may render a “limited partner” generally liable if the partnership’s creditor reasonably believed, because of the limited partner’s conduct, that the limited partner was actually a general partner.

In distributing a dissolved LP’s assets under the RULPA, creditors are paid first, then the partners’ accrued profit shares are paid, then the partners’ contributions, and—lastly—any profits are distributed to the partners. For distribution of assets the limited and general partners are treated the same.

Tax laws or other factors favoring a partnership may make an LP preferable to a corporation.


A newer form of partnership is the registered Limited Liability Partnership (LLP). Every state authorizes some form of LLP, which is similar to a general partnership except that (1) a corporation cannot be an LLP partner, and (2) an LLP partner’s liability for another LLP partner’s acts, such as professional malpractice, is limited to the partnership’s assets. Therefore, all that the non-negligent partner can lose is his capital contribution to the partnership.

In some states, the LLP must furnish proof that it has adequate liability insurance or other assets to pay potential claims. An LLP must include the name “Registered Limited Liability Partnership” or the initials “LLP” in its name.

Each partner in an LLP has unlimited liability for his own actions, but—in most states—is protected from personal liability for the partnership’s or other partners’ acts or obligations. However, rules from state to state vary greatly for the LLP. For example, a few states (California, Nevada, New York, and Oregon) permit LLPs only for professional firms (e.g., lawyers, accountants, engineers, medical doctors, etc.). Over a dozen other states permit only LLP liability protections from negligence claims against the partnership or other partners. Thus, in this large minority of states, the LLP partners are jointly liable for breach of contract and unintentional tort claims, but are individually liable only for their own negligence or that of those directly under their control.

One still newer format used mainly for real estate businesses, such as large commercial building projects, is the limited liability limited partnership (LLLP). Permitted in over half the states, an LLLP is a type of limited partnership, with both general and limited partners, but the LLLP status affords even the general partners limited liability for the LLLP’s debts and obligations that occurred while the LLLP status was in place. Most states authorizing the LLLP mandate that any such entity identify itself as an LLLP in its name. Whether an out-of-state LLLP’s general partners have limited liability in states without an LLLP statute remains questionable. However, at least in those states with an LLLP statute, the LLLP designation of a business may protect all its partners better than would be the case even for the limited partners in LPs. The LLLP name informs third parties that there are no partners with unlimited personal liability, while for a limited partnership third persons know that general partners have no such liability shield and may reasonably believe that a limited partner is actually a general partner. In effect, the LLLP designation should estop third parties, at least in those states with an LLLP statute, from drawing such assumptions, as no LLLP partner could have unlimited personal liability.


A franchise is a contractual arrangement whereby, in return for an initial fee and recurring royalties from the franchisee, the owner (franchisor) of a trademark, trade name, copyright, patent, trade secret, or some form of business operation, process, or system permits (licenses) its franchisees to use that property, operation, process, or system in furnishing goods or services. Usually, the franchisee conducts a business in accordance with conditions and procedures prescribed by the franchisor, who in turn advertises, advises, perhaps lends capital, and/or otherwise assists the franchisees. The franchise network generally consists of a system-wide marketing plan and/or a “community of interest” between the franchisor and its franchisees.

Note that the franchise is a relationship. The parties to that relationship—the franchisor and franchisees—are business entities whose individual structures, like those of other businesses, tend to be in the form of sole proprietorships, partnerships, or corporations.

Although many commentators believe there is a higher survival rate for franchised businesses than for new, independent businesses, there are, compared with completely independent operations, many additional costs associated with franchising, such as initial fees and continuing charges (royalties). Thus, a bottom-line question for a prospective franchisee is this: “What can the franchisor do for me that I cannot do for myself?” Only if the services, trademarks, goods, and other items obtained from the franchisor cannot be lawfully produced on one’s own, and only if they are truly of long-term economic worth, should one pay the franchisor to join its network as a franchisee.


Typical advantages to franchisors are as follows:

  1. Franchisees together provide much capital, as well as entrepreneurial skills.

  2. Franchisees provide a set distribution network and (usually) greater efficiency in limiting costs and expanding sales.

  3. Franchisees absorb much of the risk of losses.

These are typical advantages to franchisees:

  1. They can start a business despite limited capital and experience.

  2. They can rely on the goodwill generated by a regionally or nationally known trade name or product.

  3. They can rely on the franchisor’s business expertise in such areas as marketing, research, and the training of personnel.

  4. They are assured access to supplies and to prices based on volume buying.

A franchise may be based on an agency relationship between franchisor (principal) and franchisee (agent). If, however, the franchisee is able to run the business with few outside controls, he/she will probably be viewed as an independent contractor. (See Chapter 14 on Agency.)


Franchises fall into three main categories:

  1. Distributorships (a manufacturer licenses dealers to sell products). Example: many gasoline or automobile dealerships.

  2. Business format systems (franchisees conduct a particular type of business under the franchisor’s trade name and customarily follow the franchisor’s standard method of operation). Example: fast-food franchises.

  3. Manufacturing or processing arrangements (the franchisor provides its franchisees with the ingredients or formula for making a product and then marketing it in accordance with the franchisor’s standards). Example: soft drink bottling franchises.


The franchise agreement, almost always prepared by the franchisor, is usually a very lengthy document covering many aspects of the prospective franchisor-franchisee relationship. It ordinarily contains these provisions, among others:

  1. The franchisee’s initial payment to the franchisor for receiving the franchise, as well as the continuing payments (royalties) throughout the term of the franchise. (Royalties are generally based on a percentage of the franchisee’s gross sales, not his/her profits; thus, a franchisee will still owe the franchisor money even if his/her business is unprofitable.)

  2. The franchisor’s control over, or specifications about, (a) the franchisee’s business site, territory (or non-exclusivity), and structure, (b) the franchisee’s training, qualifications, operational standards, financing, advertising, and purchases, (c) the franchisee’s alleged status as an independent contractor, (d) franchisor ownership of intellectual property, inspections of the franchisee’s business premises, and audits of the franchisee’s financial records, (e) franchise transfers (usually giving the franchisor final control), (f) franchisor mergers or assignments (giving the franchisor discretion to merge or sell its business and bring in a replacement franchisor), (g) arbitration, controlling law, and venue in the event of a dispute, and (h) covenants that the franchisee not compete against the franchisor or its franchises after his/her franchise is terminated.

  3. The duration of the franchise, any renewal periods, and the franchisor’s grounds for termination (usually numerous).


The franchisor usually has much more bargaining power than does the franchisee, particularly once the franchisee has joined a system and sunk its money into a franchised business. Therefore the case law on franchises recognizes the occasional need to protect franchisees. Courts will find obligations of good faith and commercial reasonableness in any franchise agreement, and they will not enforce grossly unfair (“unconscionable”) provisions.

As for statutory law, most states have passed statutes specifically designed to govern franchises. Some statutes, like the UPA for partnership agreements, set forth guidelines in the absence of provisions within the franchise agreement; and many franchise relationship statutes forbid certain franchisor practices, such as franchise termination without “good cause.” Even more state statutes do not deal with post-sale matters but rather govern the initial offer and sale of franchises, requiring franchises to file a franchise registration statement, with mandatory disclosure of pertinent facts about the franchisor.

Via a rule promulgated in 1978 and revised in 2007 (16 CFR Part 436), the Federal Trade Commission (FTC) also mandates disclosure of detailed information about the franchisor and its business. The 23 items that must be disclosed in the FTC-required Franchise Disclosure Document (“the FDD”) to a prospective franchisee include information on: (1) the franchisor and its parents, predecessors, and affiliates; (2) business experience; (3) litigation history; (4) bankruptcy; (5) initial fees; (6) other fees; (7) estimated initial investment; (8) restrictions on sources of products and services; (9) the franchisee’s obligations; (10) financing; (11) the franchisor’s assistance, advertising, computer systems, and training; (12) territories; (13) trademarks; (14) other intellectual property (namely, patents, copyrights, and proprietary information); (15) the obligation to participate in the actual operations of the franchise business; (16) restrictions on what franchisees may sell; (17) renewal, termination, transfer, and dispute resolution; (18) public figures; (19) financial performance representations; (20) outlets and franchisee information; (21) financial statements; (22) contracts; and (23) receipts.

Although there is no franchise registration with the FTC, the government can prosecute for failure to comply with the FTC’s disclosure requirements.

Federal and state laws also protect franchisees in special industries. Two examples are the Automobile Dealer’s Day in Court Act and the Petroleum Marketing Practices Act (PMPA), both federal laws governing franchise terminations and—for the PMPA—also nonrenewals. In addition, federal antitrust laws may prohibit a franchisor’s restrictions on franchisees’ sales territories, purchases, pricing structure, and dealings with others. Finally, as franchising has grown tremendously throughout the world, about 40 nations have enacted franchise-specific laws, many of which are more likely to protect franchisees in terms of territorial rights, access to franchisor know-how, mandatory contract clauses, or other rights.


Franchises are based on contractual arrangements between franchisors and franchisees. The franchisee may be an agent or an independent contractor.

Franchises involve (1) product distributorships, (2) business format systems, or (3) manufacturing or processing arrangements.

Because franchisors usually have much more bargaining power than franchisees, the courts and legislatures have provided special protections for franchisees (e.g., forbidding franchise termination without “good cause”). Good faith and commercial reasonableness are imputed in any franchise agreement, and the Federal Trade Commission, as well as many states, require the disclosure of rather detailed information about the franchisor.



  1. What are the three basic types of business organization?

  2. Compare these types of business organizations with respect to manner of creation, formality, governmental regulation, ownership, transfer of ownership, legal entity, agency, division of labor, owner’s liability, access to specialists, payment of personal debts, management, profits, changes in business formation documents, fees, multistate businesses, raising capital, income taxes, termination, and size of businesses.

  3. Name at least 16 typical provisions in a partnership agreement.

  4. To what three factors do courts look for evidence of an implied partnership?

  5. What actions generally require the partners’ unanimous consent?

  6. List some duties and rights of partners.

  7. Name the four bases for binding a partnership to a contract between third persons and a partner.

  8. Name three ways in which a partnership is a legal entity.

  9. Name the three methods of dissolution of a partnership.

  10. Give five reasons why a supposedly limited partner may be held generally liable for partnership obligations.

  11. Between general partners, limited partners, and creditors, state the basic order of distribution of assets for a LP and for a GP.

  12. State three customary provisions in a franchise agreement.

  13. Federal and state statutes, as well as court cases, have sought to furnish additional disclosures from whom (franchisors or franchisees) and protection from unfair creation and termination of franchises for whom (franchisors or franchisees)?




distribution of assets




general partner

general partnership (GP)

limited partner

limited partnership (LP)

liquidation (winding up)

partnership by estoppel

Revised Uniform Limited Partnership Act (RULPA)

sole proprietorship

tenants in partnership

Uniform Partnership Act (UPA)


  1. John wants to control a business completely, knows nobody else with whom he wishes to work, is not worried about lawsuits, and dislikes formalities, paperwork, and lawyers. What type of business organization would he probably prefer?

  2. Mary has the time and expertise to put into a new bakery, but little money. Sally has a substantial sum of money to invest, but no interest in the day-to-day operations. What type of business organization would you recommend?

  3. There are six partners in a LP: general partners A, B, C, and D, and limited partners E and F. Under the LP agreement, E and F are each entitled to 20% of the profits. E and F each contributed $20,000. A, B, C, and D are each entitled to 15% of the profits, each having contributed $2,500 and also having assumed managerial duties. C assigns his interest in money receivable from the LP to Ms. C on January 1. On February 1, E sells her partnership interest to Bank E. On March 1, G is added as a new general partner; he has made no capital contribution. On April 1, D dies. Assets and liabilities are as follows:

January 1 to February
14 $95,000 in assets, and no liabilities February 15 and thereafter
$95,000 in assets (minus a new liability—judgment of $20,000 against the LP) The LP is now dissolved. It made no profits this year, but the previous year’s profits were $60,000, which has not been divided among the partners.

Assume that the LP agreement does not alter the RULPA rules. Discuss (a) the changes in the partnership, (b) the judgment liability, and (c) distribution of the remaining $75,000.



  1. Sole proprietorships, partnerships, and corporations.

  2. See charts.

  3. Twenty-two typical partnership agreement provisions concern name, description of business, list of partners, statement of contributions, delineation of partnership and personal expenses, division of profits/losses, statement of individual partner’s powers and limits, the partnership’s required and prohibited acts, management decision systems, allocations of salaries/drawing accounts, treatment of outside business, partners’ withdrawals and additions, transfers of partnership interests, agreement amendments, term of duration, closing out access to books and records, management of employees, accounting methods, form of management, dispute arbitration, and rights of continuing and departing partners.

  4. Joint ownership, sharing of profits or losses, equal management rights.

  5. Amending partnership agreement, changing essential nature of partnership’s business, altering capital contributions, adding a new business or new partners, confessing judgment, submitting to arbitration, transferring goodwill, placing assets in trust or assignment for creditors, paying or assuming a partner’s individual debt, conveying or mortgaging property (usually), serving as surety or guarantor, and other acts unusual for the business or rendering business impossible.

  6. Duties: uncompensated work for, and noncompetition with, partnership, producing information on partnership for other partners, accounting for any personal gains while acting as partner or using partnership property, and maintaining the confidentiality of partnership information.

Rights: examination of books, receipt of information on partnership from other partners and accounting of partnership assets and liabilities, property interest in partnership, tenant in partnership, and other implied rights.

  1. Express actual authority; implied actual authority; apparent authority; ratification.

  2. Bankruptcy can be brought by partnership; judgments against partnership are first enforceable only against the partnership; in most states, it is possible to sue, having accountings, and own property in partnership’s name.

  3. Acts of parties, operation of law, and court decree.

  4. He participated in management; his last name was part of the partnership’s name; he misrepresented or allowed others to misrepresent that he was a general partner; the LP certificate contained falsehoods; the LP was defectively formed.

  5. LP: under the RULPA all creditors are repaid, then the limited and general partners are paid together, according to various priorities (unless the LP agreement states otherwise)—(a) accrued profit shares, then (b) contributions, then (c) remaining assets in accord with the LP’s profit-distribution scheme.

GP: third-party creditors are repaid, then general partners (loans, then capital contributions, then remaining assets according to the division of profits in the partnership agreement). There are no limited partners in a GP.

  1. Franchisee’s payment to franchisor; franchisor’s controls over numerous aspects of the business; franchise’s duration and ground for termination.

  2. Franchisors; franchisees.


  1. Sole proprietorship.

  2. General partnership seems inappropriate because of disparity in wealth and interests of Mary and Sally. Limited partnership might be suitable, especially since Mary’s contribution could come in the form of property other than just money (e.g., rent-free use of her house as the business location) or—under the RULPA—it could even be services or a promissory note. Mary would be the general partner, and Sally the limited partner.

However, a corporation is by no means out of the question. There the decision depends more on the tax consequences, Mary’s concerns about her unlimited liability in a partnership, and Mary’s and/or Sally’s desires as to transferability of ownership. Unless Sally’s stock was nonvoting, though, Mary would probably face a situation in which ultimate control would rest with Sally.

  1. (a) Ms. C can collect the profits due C; she just cannot participate as a general partner. If there is no agreement to the contrary, E may transfer her entire limited partner interest and status to Bank E without dissolving the partnership. G may be added as a new general partner with the other general partners’ permission. D’s death dissolves the new LP (the one with G in it).

(b) G is not personally responsible for a debt incurred before his admission, except for an amount no greater than his capital contribution, which is nothing. All of the other partners, however, would be responsible, with even the limited partners liable to the amounts of their capital contributions.

(c) After the liability of $20,000 is paid off, $75,000 remains. There appear to be no other creditors, so the next priority under the RULPA is to pay the $60,000 in accrued profits. A, B, Ms. C, and D’s estate each are entitled to 15% of the profits of $60,000, and F and Bank E are entitled to 20% each. The remaining $15,000 is distributed pro rata according to the partners’ contributions. Thus F and Bank E get most of the $15,000, but A, B, Ms. C, and D’s estate each get 5% (because each is credited for a contribution of $2,500 out of a total capital outlay of $50,000). G, of course, gets nothing because he made no capital contribution.

1 Usually, the word “partnership” without any adjective (e.g., “general” or “limited”) refers to a general partnership. That is the typical practice in law and business, and this text follows that practice. To avoid possible confusion, one should, at the outset, make clear the form of business one has, wants, or otherwise is discussing.




corporation an artificial being created by operation of law, with an existence distinct from the individuals who own and operate it

charter a formal document that creates a corporation

articles of incorporation a formal document that creates a corporation; a charter


A corporation is an artificial being created by operation of law. This artificial being, or entity, is entirely separate from its shareholders, directors, officers, and employees. This separation gives the corporation a life of its own and the responsibility and accountability to the law that are attributable to a natural person.

If all the shareholders, directors, officers, and employees of corporation A were to die simultaneously in a common accident, corporation A would continue to exist: stock ownership would pass to heirs of the deceased shareholders; these new shareholders would name new directors and hire new officers and employees.

A corporation has a totally independent existence apart from the persons who own and operate it.


Although the imperial government of Rome suppressed private societies and associations of every kind, it permitted individuals to form collegia, that is, nonprofit, membership clubs for such diverse purposes as education, fire control, and burial of members. In the late Middle Ages and early modern period (the twelfth through the sixteenth centuries) the Roman model was expanded in France and Germany to permit merchants to form trading societies and craft guilds for investment and larger business purposes.

In the 1500s the English government, followed by France and other European nations, began to grant monopolies to groups of individuals (joint-stock companies), for trading and for revenue purposes, with the Crown receiving a share of the monopoly profits. Colonization of the New World and other foreign lands was undertaken through charters to develop specified territories and operate as governments under the general supervision of the king. Trading ventures included the Massachusetts Bay Company (English), Hudson’s Bay Company (English), and East India Company (three distinct companies of the Dutch, English, and French).

During the colonization period corporate charters were granted to private individuals by special acts of the colonial legislatures. When the United States became a nation, corporations were created by grant of charter by the several states, first by legislative enactment, and later by special state agencies or commissions created for this purpose. In all of the states, corporations are created by state corporation commissions, although the management of corporations is left to internal controls within the corporate structure.

Most states now follow, to some degree, the Model Business Corporation Act (MBCA) proposed in 1950 and frequently amended since (including a completely overhauled Revised Model Business Corporation Act—RMBCA—put forth in 1984 and adopted by half the states). Still, each state’s corporation commission, by whatever name it may be called, tends to be little more than the issuer of the corporate charter at the beginning of the corporate life; in practice, the state rarely takes any interest in the actual corporate function. Nevertheless, a corporation must be a good citizen. It may be punished for its crimes, sued for its torts, and held accountable for its contracts. At all times it must be operated for the benefit of its shareholders, who are its owners.



For most legal purposes a corporation is a person. Like any citizen, it can sue and be sued, make contracts, own property, and perform other personal acts. Moreover, it can be charged with almost any crime except crimes the sole punishment for which is imprisonment.1 For most purposes, a corporation is entitled to the protections afforded citizens under the Bill of Rights except the right against self-incrimination provided for in the Fifth Amendment.


Under the provisions of applicable statutes, a corporation is created by contract with the state. The evidence of this contract is the corporation’s charter. Under modern corporation law, most state statutes provide that, as a condition to the grant of charter, the state may, by regulation or statute, unilaterally modify the terms of charters already granted. [In the case of Dartmouth College v. Woodward, 17 U.S. 518 (1819), the Supreme Court held that, without such statutory permission, a state could not modify or revoke a corporate charter without “impairing the obligation of contracts” as forbidden by Article I, Section 10, of the United States Constitution.]


If a shareholder engages in behavior beyond his/her role as an investor and acts as—declared or not—a corporate agent, he/she can be held civilly liable or even criminally responsible for his/her wrongful acts on behalf of the corporation (see Chapter 14 on Agency). This is distinct from liability for a shareholder simply because he/she owns shares of a corporation that owes debts to third parties. That type of indirect, general liability is unusual, but there are some specific exceptions to the presumption against personal liability for corporate debts. In such special circumstances, a shareholder may be liable for a narrow class of corporate debts, such as the corporation’s unpaid employment taxes or sales taxes or for unpaid workers’ compensation claims not covered by insurance. More broadly, two states—New York and Wisconsin—impose pro rata shareholder liability for the unpaid wages of their corporation’s employees.

Except for these special cases (e.g., unpaid taxes), the shareholders’ liability to a corporate creditor must meet a high standard of proof. This piercing of the corporate veil is not to be granted simply because corporate creditors would otherwise not be fully compensated. There must be more proof.

Since a corporation is a legal entity separate from its shareholders, the corporation, not the shareholders, is liable for its debts. However, the courts will disregard the corporate entity, and hold the shareholders personally liable (pierce the corporate veil) if the corporate name is used as a false front or “stalking horse” behind which the owners or operators perpetrate fraud upon creditors or others dealing with them.

The “corporate veil” may be pierced if two conditions are present:

  1. a fraudulent purpose, and

  2. operation of the corporate business as though the corporation does not exist.

Thus the principal creates a corporation and uses a corporate name; however, the principal holds no corporate meetings, keeps few corporate books or records, and disregards the corporation that he/she has created. In addition, the principal fraudulently permits or causes others to believe that he/she is, in fact, responsible for the corporate business. Usually undercapitalization is not as much an issue in contract cases—where, after all, the creditor voluntarily dealt with the corporation—as it is in tort cases.


Inadequate capitalization is the most usual argument for piercing the corporate veil, at least in tort cases. Ten additional factors perhaps favoring the piercing of the corporate veil are as follows:

  1. An absence of formalities, structures, and actions that are part of corporate existence, such as issuing stock, electing directors, and keeping corporate records.

  2. Placing funds in and taking them out of the corporation for personal rather than corporate purposes (the second most common argument: commingling).

  3. An overlap in ownership involving common officers, directors, and personnel (the subsidiary temptation).

  4. Common office space for the corporation and the individual owner(s).

  5. A common address, telephone and fax numbers, and Internet site for the corporation and the individual owner(s).

  6. Restrictions on the business discretion displayed by the allegedly dominated (subsidiary) corporation.

  7. The related entities (e.g., parent and subsidiary corporations, the individual owner and “his/her” corporation) do not deal with each other at arm’s length.

  8. The related entities are not treated as independent profit centers.

  9. Payment or the guarantee of a dominated corporation’s debts by the other person.

  10. The dominated corporation has property that the other person used as if it were his/her own property.

A Similar Approach to LLC Members’ Personal Liability for Entity Debts

Although usually LLCs are not expected to have as much legal formality as corporations do, in other respects—for LLCs—piercing the veil to hold members liable for entity debts tends to track the law of corporations.


As previously indicated, a corporation has a life of its own, independent of its shareholders and managers. Modern corporations are usually granted perpetual existence as a routine charter provision, although corporate existence may also be for a stated or limited period of time.



A promoter is the person who conceives of, organizes, and begins the corporation.

Not only is the corporation his/her “brainchild,” but also the promoter finds others who are willing to participate in the development and exploitation of the idea.

Although the promoter is not an agent of the corporation to be created, he/she occupies a fiduciary relationship (position of trust) in regard to the proposed corporation and its investors, shareholders, and creditors. Basically, this trust relation requires that the promoter make full disclosure of his/her anticipated personal gain, the nature of the business, its prospects, and the promoter’s plans with regard thereto.

In the course of forming the corporation, the promoter may incur costs, make contracts, and do other acts in furtherance of the corporation. Since the promoter is not an agent, the corporation is not automatically responsible or liable for these obligations and contracts; however, it may ratify, adopt, or accept them, provided that there is full and open disclosure by the promoter to the corporation. The promoter remains obligated with respect to such obligations or contracts unless released by the obligee or unless the corporation is substituted for him by a novation (see Chapter 7).


The persons wishing to form a corporation (the incorporators) apply to the state corporation commission with a form of the charter they want to have granted.2 Although the charter is usually prepared by an attorney, this is not necessary. A detailed discussion of the nature and content of the charter follows later in this chapter.

The certificate of incorporation is the state’s official authorization for the corporation to start doing business.


The incorporators, after receipt of the certificate of incorporation, call a meeting of the interim board of directors named in the charter to be held, at which time bylaws are adopted, officers are elected, and other necessary business is transacted. Once stock is issued and sold, the shareholders duly meet and name the regular board of directors.


A de jure corporation is one that has been formed in accordance with all of the requirements of law; a de facto corporation is one that has not been properly formed, even though the incorporators made a good-faith effort to do so. The defect in the formation of the de facto corporation is technical—there is some omission, for example, in the charter—but the certificate of incorporation is nonetheless granted.

The status of the de facto corporation can be challenged only by the state; third parties must accept it as a valid, authentic corporate entity.



A public corporation is formed to meet a governmental or public purpose. Generally, a public corporation is created for the direct function of government—town, city, or county.

Most corporations fall into the category of private corporations—corporations created for private purposes. In the context of commercial law, the word “corporation” generally connotes a private entity. Public utilities have some features of both public and private corporations.

There is an important group of corporations that might be considered “hybrids,” that is, they have features of both public and private corporations. These quasi-public corporations are public utilities—privately owned businesses created for public purposes. Although these monopolies, or partial monopolies, are strictly controlled both as to services and as to prices (rates), they are permitted a reasonable return on investment, established during the course of a regulatory rate case.


Although the federal government has the right and power to create corporations, the United States has shown great restraint in entering the incorporating field. Since the exercise of this power must be solely within the scope of legitimate constitutional authority, most federal corporations are created for narrow and specific purposes. The systems of national banks and of federal savings and loan institutions are examples of federally created corporations, all of which are federally chartered and supervised.

In general, this discussion is limited to state-chartered corporations. Note, however, that within the limits of legitimate constitutional pur-poses, the United States can readily enter this field. The prospect of federal intervention in corporate law may furnish more of a check on the offering of inducements by states to corporate management, such as through tax relief and reduced regulation, than any competition among the states. That seems especially the case for one state, Delaware, which has long dominated state corporate law. Over half of all publicly traded American corporations and about 60% of Fortune 500 companies are incorporated in Delaware.

Some Basic Features of Delaware Corporate Law

  1. Delaware places few restrictions on selling or mortgaging assets, merging businesses, or other key corporate decisions. This strong management flexibility usually extends to fighting hostile takeover attempts.

  2. Delaware provides strong indemnification rights for officers and directors.

  3. Delaware affords few (and fairly weak) dissenting shareholders’ rights.

  4. Delaware provides staggered elections for boards of directors, so that it is more difficult to take over the board in just one election.

  5. Other than when corporate officers or directors face criminal charges, Delaware law usually lets persons applying for corporate status to maintain the confidentiality of some key information about their business purpose or personnel (e.g., the names of their corporation’s top executives).

  6. Delaware has debtor-friendly courts for corporate bankruptcy cases, and a federal tax code that allows companies to file for bankruptcy in the state of their main office or in the state where they are incorporated (so, often Delaware).

  7. Delaware has an experienced, extremely capable coterie of corporate and bankruptcy law judges and lawyers.

  8. Delaware is the only state with a separate business court. The Delaware court system—the Courts of Chancery—has special recognition of corporate law needs.

  9. Delaware has relative certainty of the corporate law: a long, well-developed body of statutory, regulatory, and case law, more extensive and knowable than the law of perhaps any other state, even the largest. This confidence in having answers about the corporate law in Delaware, even if the Delaware position is not always the most management friendly, often makes Delaware the choice of risk-averse incorporators who want an answer more than they are willing to face uncertainty.

Many states join Delaware in providing similar approaches to one or more of points 1–5. But the fact that Delaware does all of the above (1–9) gives some assurance to incorporators that the state will maintain its commitment to being “corporate-friendly.”

PROFIT OR NONPROFIT; social benefit

Business law primarily concerns corporations organized for profit. However, nonprofit, charitable, or eleemosynary corporations are of great importance, even in the business world, not only because of the important tax benefits and concessions accruing to such corporations but also because of the importance of permitting these charitable groups to own property, form contracts, and otherwise engage in business without individual members having personal liability for business matters. Such corporations may be stock corporations, or membership corporations (owned by their members without issuing stock).

Since 1983, over 40 states have enacted “constituency statutes” (also known as “stakeholder statutes”) allowing directors and officers of ordinary, for-profit corporations to consider non-financial interests when making decisions. The corporation’s constituencies (persons for whom the officers and directors act) extend beyond simply the shareholders. However, there is little judicial interpretation of these statutes, and there are many interpretations of a corporate board’s more traditional duties to shareholders, so businesses find it difficult to know whether and how to consider these additional, constituency interests. Because constituency statutes do not mandate, but rather simply permit, consideration of non-financial interests, officers and directors may still face civil claims if they do not strictly adhere to the usual concept of a supreme fiduciary duty to shareholders: maximizing business profits.

In contrast with the constituency statutes’ broadening of board considerations (potentially far-reaching, but actually just permissive laws) for all corporations, a newer approach provides not for loosening corporate law generally, but rather is limited to a special corporate format. This format, the benefit corporation (“B-corp”), provides an expansive notion of corporate purposes, accountability, and transparency, and it thereby offers more possibilities for socially productive business enterprises. Starting with Maryland in 2010, most states have enacted legislation authorizing a type of corporation (the B-corp) whose purpose extends to creating a general public benefit—a positive impact on society and the environment—in addition to the earning of profits. B-corps thus can incorporate mission statements as well as community and ecological principles in their business practices.

B-corp shareholders have the power to determine whether the corporation has had a positive, significant public benefit (accountability). B-corp directors and officers must consider the effect of their decisions on all stakeholders: shareholders, employees, suppliers, customers, the community, and the environment. Also, most B-corp laws provide that changing the corporation’s control, purpose, or structure ordinarily requires a vote of at least a two-thirds majority (an even higher proportion in some states).

The B-corps must publish an annual benefit report about their social and environmental performance using a comprehensive, independent standard (similar to the Generally Accepted Accounting Principles [GAAP] for financial reports); this report is adopted by the board of directors but is not subject to audits or required to be certified. While the states do not regulate the report’s content, most state B-corp laws require the report’s delivery to all shareholders and to a public website (excluding only proprietary data), and some states call for even more transparency by requiring B-corps to submit their reports to the appropriate state department for corporations. Moreover, B-corp shareholders can sue the corporation in a “benefit enforcement proceeding,” which is designed to enforce the B-corp’s social mission (i.e., to remedy problems in the setting or meeting of socially impactful goals).3 Only shareholders and directors have a right to sue for (1) violation of or failure to pursue a general or specific public benefit; or (2) violation of a duty or standard of conduct. As with any corporation, directors and officers still have fiduciary duties, such as when deciding what are public benefits and when taking actions that contemplate non-financial interests, such as actions regarding the employees, community, and environment. Even when selling or buying goods, services, licenses, securities, real estate, or other intangibles or items, the social benefits may be embraced.


A corporation is said to be domestic in the state of its incorporation, the state of its “birth.” In respect to all other states, it is a foreign corporation. Thus, in Delaware, a Delaware corporation is a domestic corporation; in all other states it is foreign. For lawsuit purposes, a corporation’s domicile (place where it is a citizen) also includes—in addition to its state of incorporation—the state in which it has its principal place of business (so the corporation is domiciled in one or two states).

Corporations formed in foreign countries are called alien corporations.


A close corporation is a stock corporation whose shares are held by relatively few persons, frequently members of a family. Such a corporation may be operated like a partnership, sometimes with no board of directors, or with other informalities not permitted to general stock corporations for profit.

To permit such loose organization, the laws of most states limit the number of stockholders and permit restrictions on stock transfer by agreement among the shareholders or by charter provision.

S CORPORATIONS (formerly “Subchapter S” of the Internal Revenue Code)

S corporations are organized to minimize the effect of federal income taxes on small businesses, principally by doing away with corporate “double taxation.” This double taxation, as explained in Chapter 15, is taxation applied first to the corporation’s income, and second to the individual shareholders’ income in the form of earnings and dividends.

The S corporation does not pay a corporate income tax on earnings; the entire income is taxed to the shareholders, whether distributed or not.

An S corporation must be incorporated in the United States and meet a number of ownership requirements. It cannot have more than 100 shareholders, all of whom must own the same class of stock. Whereas preferred stock is not allowed, voting differences within a class of stock are permitted. Individuals, estates, charitable organizations, pension trusts, financial institutions, employee stock ownership plans, single-member LLCs (see below), and certain small business trusts can be S corporation shareholders. To determine the number of shareholders that an S corporation is deemed to have, all members of a family are treated as one shareholder. The “family” is defined very broadly—every lineal descendant (including adopted children), as well as spouses and former spouses of these descendants, tracing back to up to six generations to a common ancestor.

An S corporation can wholly own another S corporation (be the S corporation parent of an S corporation subsidiary, termed a Q-Sub, short for “Qualified Subchapter S Subsidiary”). Ordinarily, corporations, partnerships, or other non-natural persons cannot be S corporation shareholders. S corporation status is obtained by filing with the Internal Revenue Service a form signed by each shareholder. If there is no filing, then the corporation is a C corporation (under subchapter “C” of the federal tax code). In the late 1980s, there were about twice as many C corporations as S corporations; by 2015, S corporations outnumbered C corporations nearly three to one.


Because S corporations have restrictions, the limited liability company (LLC) is an alternative. A 1988 IRS ruling that, for federal tax purposes, LLCs are to be treated like partnerships has led every state to authorize the LLC. Unlike the S corporation, the LLC has no restrictions on the number or kind of owners (e.g., partnerships, corporations, nonresident aliens, and other LLCs can be LLC “members”), the class of stock, and the owning of subsidiaries; unlike general or limited partnerships, the LLC permits investors to manage the business yet not be personally liable for the business debts. The LLC thus is a partnership-corporation hybrid, with the corporate shield protecting against personal liability, but with LLC members like partners in that two of these three partnership characteristics must be present: (1) a member’s death or a decision to pull out dissolves the LLC (no perpetual existence4); (2) transfer of a membership requires the other members’ approval; and (3) the LLC is managed by all of the members (member-managed) rather than elected managers or directors (manager-managed). If the LLC does not provide otherwise in the articles of organization it files with the state or in the operating agreement that outlines the LLC’s management structure, most states provide that the LLC is member-managed (with governance like that of a general partnership). If the LLC is managed by some designated members, or nonmembers/outsiders, or a combination of members and nonmembers, then the business is manager-managed (somewhat comparable to a corporation’s management, with the inactive members being passive investors).

Although LLP (limited liability partnership) ownership is not a security, LLC membership/ownership may be. Still, LLCs can be run informally. LLCs do not have to have the corporate mechanisms of control such as boards of directors. (Unless also a close corporation, an S corporation must follow those formal structures.) But, as stated above, an LLC is limited to four corporate-like elements (the other two elements must be partnership-like), or else the alleged LLC will not be given legal status as such an entity. The four elements are: shields or limiting of the owners’ personal liability; centralized (corporate-style) management; transferable interests; and continuity of life. If a business entity has more than two of these elements, then it does not have an LLC—a court could remove the corporate protection for the LLC members, who are thereby subject to personal liability for LLC debts.

To some degree, the LLC format is replacing the S corporation format. The LLC is similar to an S corporation (e.g., as with partnerships, no double taxation; as with corporations, limited liability of members/shareholders), but, as mentioned above, has advantages over the S corporation because it is more flexible. Every state permits a limited liability company to be formed and operated with one member (Single-Member Limited Liability Companies [SMLLCs]). Also, every state permits a judgment creditor of that member to seek a court order charging the SMLLC ownership interest with a lien. A “charging order” requires the SMLLC to pay all future distributions to the judgment creditor until the judgment is fully satisfied. Since the member alone retains discretionary control over when and if such distributions will be made, the charging order is usually ineffective because the member simply accumulates distributions. Compared with partnerships or corporations, there are some potential problems with LLCs. First, although both partnerships and LLCs are not subject to federal income tax, LLCs (as are S corporations) are sometimes subject to a state income tax (e.g., in Florida and Texas), whereas partnerships are not. Second, many states, including California and Florida, do not permit licensed professionals (lawyers, accountants, physicians, dentists, engineers, architects, etc.) to form, as a business offering those professional services, the LLC. Third, an LLC may not be permitted to merge directly with a non-LLC. Therefore, the only way to effectuate a merger is for the LLC to dissolve, form a corporation, merge with the other entity, and then revert back into a LLC, with each such business format transformation tending to create tax liabilities. (Conversely, corporations generally can merge without undergoing a dissolution.)

Legal analysis, though, must be tentative: LLC law is still new. The legal principles often are uncertain both within a state and across state borders. For instance, some states tax LLCs as if they were corporations (a few states do the same for S corporations), and some states have “Series LLC” laws allowing the LLC (or sometimes other business formats) to create a series of separate assets within the LLC.

In overall structure, the Series LLC may be labeled a master LLC with separate divisions, similar to an S corporation having Q-subs. Each distinct series of assets within the Series LLC can have different managers and members, but the LLC itself may be able to pay a single state fee and one overall income tax. The IRS and some states have, in effect, approved of the tax treatment sought for Series LLC owners. However, it is still new, and whether the internal “shields” of these assets will protect one series’ owners from liability for other debts, either those of the LLC itself or of other series within the LLC, has yet to be well-established in court, nor has there been sufficient Series LLC legislation and regulation among the states.

The differences in and relative newness of each state’s LLC approach cause uncertainties and inefficiencies for LLC businesses and their advisors. Most problematic may be the continuing uncertainty from state to state as to whether and to what degree LLC members should have fiduciary duties to their fellow members. Should these standards be subject to standards the members themselves lay out, or discard, in operating agreements? What standards should be the default position when the members’ position is unclear? And should there be some standards that cannot be altered by contract? These questions are still being addressed by courts, legislators, regulators, and academic commentators. Even when fiduciary standards are present, there are significant differences between the high, sometimes seemingly self-sacrificing fiduciary duty expected of partners and the greater discretion often permitted for corporate-type fiduciaries. For LLCs spread across 50 states in a still relatively new and growing business and legal environment, a member’s duties—both type and degree (whether to treat the LLC member as if a partner or a corporate agent)—often remain uncertain. Furthermore, the limited liability extending generally from the LLC to the members may not be as strong in some states and in some situations as for corporations.

Summary of Some Comparisons Between LLCs and S Corporations

• LLC ownership (numbers and types) and operations (little or no mandatory record keeping and boards) are more flexible, with less regulation;

• S Corporation ownership is more readily transferable;

• S Corporation has a tax advantage related to avoiding employment tax. All earnings above fair market salary levels are considered a distribution of profit, not wages, and thus avoid the employment tax. The LLC’s owner usually is considered to be self-employed, so any net profits above a fair market salary are considered wages and are liable for employment taxes.


Professional corporations are created by lawyers, doctors, accountants, architects, engineers, and other professionals in order to gain corporate tax advantages for traditional partnership or proprietorship activities. These corporations, organized under state law enacted in conformity with internal revenue code requirements, are generally identified by abbreviations: P.A. (Professional Association), P.C. (Professional Corporation), or S.C. (Service Corporation).

Although it is a corporation for most purposes, the professional corporation may not be able to shield its shareholders and members from individual tort liability for professional negligence. In effect, these shareholders are treated as if partners and are thus bound to this basic principle of common law partnership: Each partner is responsible for the torts and contracts of the other partners within the scope of the partnership venture.

Most states, though, do not apply this principle to professional corporations, thereby providing greater liability protection. This majority approach leaves the individual professional within the corporation or other limited liability entities free from personal liability for the professional negligence of another member of the organization, unless the individual was, in fact, supervising that negligent member or otherwise participating in the tortious acts.



The charter (also sometimes called the articles of incorporation, or articles) is the grant of corporate existence, the birth certificate of the corporation. This formal document, executed by the state through its corporation commission, is the source of corporate authority. Also, the charter is a public document.

Although the charter may contain any number of provisions, drawn formally or informally, modern charters tend to cover only the minimum provisions required by law. The charter is more or less a “form” document; however, the required coverage may vary from state to state.

The following information is usually required in the charter:

  1. Incorporators

  2. Corporate name

  3. Corporate address and name and address of resident agent

  4. Duration

  5. Purpose

  6. Capital structure

  7. Internal organization

  8. Other permissible provisions


The incorporators are the persons who make application for the charter. Their only function is to lend their names and signatures to the incorporating documents. By so doing, they acquire no special legal liability. Generally, the only requirement is that an incorporator be old enough to make a contract, that is, at least 18 years of age. Usually, there must be at least three incorporators. Many states do not require that these incorporators be residents of the state.


Any name may be chosen for the corporation provided that:

(a) the name indicates that the entity is a corporation by inclusion of one of the following words, or by one of these words abbreviated: Company (in most states), Corporation, Incorporated, Limited, and

(b) the name is not the same as, or misleadingly similar to, the name of any other domestic corporation, or corporation doing business in the state.

In addition, many states limit, in corporate names, the use of certain words closely associated with particular types of businesses or industries. For example, a manufacturing concern would not be allowed to include in its name a word such as “insured,” “finance,” or “fiduciary.”


The corporate address is the principal address of the corporation in the state of its incorporation.

The registered agent is a person or another corporation authorized to receive service of process and other legal and official papers. The requirement that a legal agent be named is of more than passing importance: the state is concerned that persons having business with a corporation, or interested in bringing suit against it, be able to discover a way of finding the corporation in order to hold it accountable for its actions.


As stated above, the duration may be perpetual or limited to a stated period of time.


Modern statutes permit a corporation to be organized for any legal purpose, and the charter may contain merely a broad statement of purpose. Usually, however, the charter states the specific purpose for which the corporation is being formed—for example, “to operate a restaurant business”—followed by very broad grants of power and usually a statement of purpose to do any legal act.

Charters that fail to contain the “for any legal purpose” provision are nevertheless granted such broad powers as a matter of right, unless the charter contains restrictions or limitations on certain powers or rights.


Requirements concerning charter statements about capital vary from state to state. Generally, state incorporation statutes require information about the number of shares of stock of all classes that the corporation has authority to issue, the number of shares of stock of each class, the par value, and other matters concerning both equity and capital.


State statutory requirements about organization are quite minimal: usually the only requirements are a provision as to the number of directors (e.g., “not more than seven”) and the names and addresses of those who will serve as an interim board until the shareholders meet and name the first board.

Other organizational and detailed day-to-day matters are usually left for the bylaws. The relationship among officers, directors, and shareholders (the corporation’s internal affairs) is governed by the state law in which the corporation is incorporated.


The charter may include other provisions, not inconsistent with law, defining, limiting, or regulating the powers of the corporation, its directors and shareholders, or classes of shareholders. Included may be restrictions on the transferability of stock (creating a close or S corporation), requirements of a concurrence of shareholders greater than a majority for certain actions, provisions for minority shareholder representation by cumulative voting, provisions relating to preemptive rights (see Chapter 18), and other provisions that may be included in the bylaws.


Generally, the charter should be a lean, sparse document and the bylaws should be more detailed. The reason is that charter amendments must be approved by the state as well as the shareholders. Bylaws are generally adopted by the directors and may or may not be approved by the shareholders.

Bylaws contain specific provisions for the organization and operation of the corporation, including such matters as stocks, bonds, and dividends; the election, structure, and operation of the board of directors; quorum and voting requirements for shareholders’ meetings; notices, amendments, and places for meetings.

The bylaws may not contain a provision contrary to, or inconsistent with, the charter.



Modern corporations are granted very broad powers by law; indeed, in most states they can perform any act not inconsistent with law. Thus it should be assumed that for most purposes a corporation has all of the rights and powers of action accruing to a natural person.

The MBCA and RMBCA list a number of general powers for a corporation, including the power—

to sue and be sued;

to have a corporate seal, which may be altered at will;

to make and amend bylaws, not inconsistent with the articles of incorporation or with law;

to purchase, lease, and otherwise acquire real and personal property;

to sell or dispose of its property;

to purchase, own, hold, vote, or pledge stock;

to make contracts and guarantees, incur liabilities, and issue notes and bonds;

to lend money and invest and reinvest its funds;

to be a promoter, partner, member, associate, or manager of a joint venture or partnership;

to conduct its business and exercise the powers granted by law within or outside the state;

to do any act, not inconsistent with law, that furthers the business of the corporation.


Powers are sometimes limited by statute, by the corporation’s charter, by the bylaws, or by a resolution or other action of the board of directors.


A number of statutory limitations may be placed on the power of corporations. By way of example, one very common statutory limitation, a limit on the power of the corporation to make a gift, will be discussed.

All corporate property is owned by the shareholders. At the common law, no gift of this property could be made without unanimous shareholder approval. Consequently, any gift of corporate property not unanimously approved by the shareholders was illegal. This illegality is preserved in the corporate law of some states. Most states now permit corporate gifts, but place statutory limits on their nature and object. Typically, gifts may be permitted without shareholder approval provided that they are (a) reasonable in amount, (b) approved by the directors, (c) made from profits, and (d) made for charitable purposes.


Further limits and restrictions on corporate power can be placed in the charter or bylaws. These may include such restrictions as limits on the borrowing power of officers, on pensions or salaries, on the purchase of real estate, and on the sale of assets.

Other limits may be established from time to time by resolution or other specific action of the board of directors.


A corporate action beyond the charter powers of the corporation or of the person purporting to act for the corporation is ultra vires, “beyond the powers.” If the action is appropriate and lawful, it is intra vires, “within the powers.”

Because of the broad-power concepts of modern law, the ultra vires doctrine is not a problem of major consequence. However, ultra vires acts can be enjoined by shareholders in a suit against the corporation, or by a derivative suit for damages in favor of the corporation against an officer or against the board because of the unauthorized action; or the state itself may seek to block the unauthorized action (see Chapter 17), even seeking to dissolve the corporation. Of course, if a third party dealing with the corporation knew of the ultra vires nature of the corporate act, the act may be set aside. Moreover, if a proposed ultra vires act is still executory (not yet performed), the corporation may refuse to proceed with the action unless the third party can demonstrate specific injury through his/her reliance on the corporate proposal.


If a corporation wishes to “do business” in a state other than the one in which it was incorporated, it must register or qualify in that other state as a foreign corporation. Although registration or qualification may be a mere formality, the corporation must pay a fee, sometimes post a bond, and always designate a registered agent in that state to receive service of process and other legal papers.

The out-of-state corporation, having subjected itself to the laws of the state in which it seeks to do business, is vulnerable to the expense and difficulty of suit in a more remote or inconvenient location. Penalties for failure to qualify or register can be severe: loss of privilege of using state courts for the purpose of suit; a fine for every day of failure to register while doing business; and personal liability of officers, directors, and agents for actions in the foreign state.

Under the federal constitution, a state cannot restrict or regulate interstate commerce. Therefore a state cannot require registration or qualification for a foreign corporation doing an interstate business, that is, coming through on its way to another state. Indeed, cases dealing with the meaning of the phrase “doing business” abound.

It is generally held that a foreign corporation is “doing business” within a state if it:

(a) maintains sufficient contacts or ties within a state,

(b) on a continuous or regular basis,

(c) so as to make it fair and equitable that the corporation be accountable in that state for its actions.



  1. List some ways in which a corporation is treated as a person and some ways in which it is not treated as a person.

  2. Why might a democratic society be more likely to foster the corporate form of business than a totalitarian society would be?

  3. Why is it possible for corporations to function with little or no policing and supervision by the state?

  4. Discuss the ways in which a public utility is a public corporation and the ways in which it is a private corporation.

  5. What is meant by corporate “double taxation”? Explain several ways in which double taxation may be avoided.

  6. What is the meaning of the expression “pierce the corporate veil”? Is this a “moral” as well as a legal principle?

  7. Why should the charter be a “lean” (relatively simple and short) document?

  8. What is meant by the phrase “misleadingly similar to” in establishing a corporate name?

  9. What is the underlying philosophy in requiring stockholders to approve a corporate gift? Why have many states found it necessary to relax this philosophy?

  10. Why is the common law doctrine of ultra vires not as important to the modern corporation as it was in earlier times?

  11. Why is it necessary that a foreign corporation “do business” within a state in order to be subject to the registration requirements of that state?


alien corporation

articles of incorporation


certificate of incorporation


close corporation


de facto corporation

de jure corporation

domestic corporation

federal corporation

foreign corporation


intra vires

limited liability company


membership corporation

pierce the corporate veil

private corporation

professional corporation


public corporation

quasi-public corporation


S corporation

ultra vires


  1. Doctors Hacksaw, Smith, and Spurgeon operate a general medical practice as a professional corporation, known as HSS, P.C. While performing a tonsillectomy on one Samuels, Hacksaw is allegedly negligent, as a result of which Samuels is left partly paralyzed. Each of the doctors is quite wealthy, but the corporation is without substantial assets.

Advise Samuels as to whether he can expect to win a case against each of the doctors as individuals.

  1. In 1990, Soper and his two adult sons, Sam and Steve, created a corporation, Soper and Sons Electrical Company. During the first year or so, they maintained corporate bank accounts, had the name printed on trucks and stationery, and held annual stockholders’ meetings. After the elder Soper died in 1998, Sam and Steve forgot about the corporation and failed to hold meetings or otherwise follow the corporate formalities. In 2003, Sam’s allegedly negligent electrical wiring caused a disastrous fire at a local elementary school, in which several children and school personnel were injured.

Are there legal theories under which Steve and Sam can be personally liable to the injured parties?

  1. Snyder wishes to create a corporation under the name “First National Liquor Stores, Inc.” Should this name be permitted as a good corporate name over the objection of First National Food Stores, Inc.?

  2. Good Times Candy Company, an Illinois corporation, is a large manufacturer and distributor of confections and candies in the Midwest. It has never qualified or registered in the state of Iowa as a foreign corporation, although it has passed through Iowa in the course of making sales in other states. Most sales of the company and all of the sales that involve passing through Iowa are made in response to orders shipped FOB Chicago. If Good Times sells its products directly in Iowa for the 2015 Christmas season, should it register as a foreign corporation before doing so again for the 2016 Christmas season?



  1. A corporation has all of the constitutional rights of a person except protection from self-incrimination, provided for in the Fifth Amendment to the Constitution. This protection against self-incrimination has been construed to be “a human protection,” and the courts have refused to extend it to a corporate entity. Other constitutional rights, such as the protection of property rights, extend to the corporation. A corporation cannot commit a crime the only punishment for which is a jail sentence. Bear in mind, however, that the mere fact that a corporation may be guilty of a crime or liable for a tort does not protect the corporate employee, agent, or officer; these individuals may also be concurrently guilty of a crime or liable for a tort, along with their corporate employer.

  2. There are several reasons why a democratic society fosters the corporate form. First of all, the shareholders vote for directors, and the voting power is distributed among the stockholders in equal measure to their actual ownership of stock. These are democratic concepts. Also, the protection of stockholders’ property rights is in accord with democratic principles.

  3. Since corporations exist for the benefit of their shareholders, it is presumed that the shareholders will protect their interests through regular corporate procedures. Shareholder rights are discussed in the next chapter.

  4. A public utility is public in the sense that it performs a public function. Its prices are fixed by regulatory authorities. The rate of return allowed to its investors is set by regulation. Its service territories are determined by regulators. Another public aspect is its right of eminent domain or condemnation.

As a private matter, a public utility is owned by private investors; its stock may be freely traded. Within legal constraints, some of which are discussed in this chapter, the investors may make a profit. The utility’s stockholders have the usual legal rights of shareholders generally.

  1. “Double taxation” is taxation on the corporation’s profits and further taxation on these profits when they are distributed to shareholders.

The S corporation and the limited liability company provide a direct way of dealing with this problem: professional corporations permit professionals such as doctors, lawyers, and accountants to incorporate without double taxation and receive a number of tax benefits through corporate planning. Of course, in a small “mom and pop” corporation, the principals, who are usually the shareholders, may pay themselves reasonable salaries, expense monies that are not taxed to the corporation.

  1. “Piercing the corporate veil” has a moral aspect in that the shareholders are not directly responsible for corporate losses unless the corporate form is abused: the corporation is operated as a “front” for a fraudulent purpose, and the corporate business is operated as though the corporation does not exist.

  2. The charter is more difficult to amend or change than bylaws or other documents. Approval of the state corporation commission may be required, as well as that of the shareholders and directors. Therefore, most corporate charters should have no more provisions, and no more specificity in those provisions, than is necessary.

  3. Members of the public should not be misled by the name into believing that they are dealing with some other corporate entity. Many corporations spend vast sums establishing an identity or a reputation for excellence; it would not be fair to permit a new enterprise to adopt a similar name and thus benefit from the older company’s established identity or reputation.

  4. The underlying philosophy is that all corporate property belongs to the shareholders; their assets cannot be given to another without their approval.

Corporate giving may be necessary and appropriate in the modern world. There may be tax, advertising, and goodwill advantages to the corporate gift. Moreover, several shareholders, or perhaps a single shareholder, might otherwise thwart a gift giving against the wishes of a vast majority.

  1. The modern view of corporate powers is more relaxed and trusting than the earlier common law view. Most modern corporations are permitted to consummate any lawful act.

  2. A state cannot interfere with interstate commerce; hence it is necessary that the state have legitimate control over foreign corporate activity in order to prohibit it or police it in some manner. The state has legitimate interests of its own citizens to protect. If a corporation’s business is not interstate (and subject to federal control), but is performed on a continuous and regular basis within the state, it becomes accountable to the state.


  1. The creation of a professional corporation does not protect the individual doctor from professional torts. Hacksaw is personally responsible. Unless Smith or Spurgeon were personally involved with the tonsillectomy, most states would not hold them responsible for Hacksaw’s tort (although if the doctors had held themselves out as general partners each would be liable for the torts of the others). A few courts might hold both Smith and Spurgeon responsible for Hacksaw’s negligence on the theory that professional corporations do not alter the old partnership obligations of the members to each other.

  2. This question has broad implications beyond the subject matter of this chapter. However, one obvious problem, that of piercing the corporate veil, is covered in the current chapter. The veil would not be pierced in the absence of a showing of a fraudulent purpose; hence this theory is not adequate to reach the individual stockholders or principals. However, in Chapter 14 (Agency) we dealt with the personal responsibility of employee agents for their torts while undertaking company business. Under agency law, Sam and Steve may well be liable if they, or others acting under their supervision, personally committed the tort.

  3. “First National Liquor Stores, Inc.” is probably not confusing or misleadingly similar to “First National Food Stores, Inc.” Not only are the product lines different; the name “First National” is not strongly identified with any special or unusual type of business.

  4. Good Times may need to qualify in Iowa as a foreign corporation before doing an intrastate business for the second Christmas in a row. It could certainly be argued that twice is not “regular and continuous”; however, it seems that a pattern of doing business is beginning to emerge. Good corporate practice should be conservative, and doubt should be resolved in favor of complying with the registration requirement. Note that going through the state is an interstate activity and does not constitute “doing business.” Note also that an “FOB Chicago” sale causes the title to pass in Chicago; consequently, the sale did not take place in Iowa, and the seller has not entered that state on an intrastate basis.

1 If a corporation is convicted of a crime, the corporation’s penalty could be a fine, to be paid from corporate coffers, or the corporation could lose its corporate charter, or a government license, or its right to contract with the government.

2 The commission reviews a requested charter. If it complies with the law, the charter—along with a certificate of incorporation—will be issued by the appropriate state official (usually, the state’s secretary of state).

3 While LLCs generally could commence with or amend their membership agreements to incorporate provisions similar to those of the B-corp, most commentators believe that the corporate structure of the B-corp is more suited than is the LLC to the needs of institutional investors or to company insiders planning to raise outside capital (e.g., through an initial public offering).

4 The LLC’s operating agreements could provide for the LLC’s continuance in the event of a member’s death or withdrawal. However, most states require that the operating agreements set a limit to the LLC’s existence (usually 30 years). The members later may decide to continue the LLC’s existence.




shareholders the owners of the corporation through the ownership of its stock

directors persons elected by the shareholders to manage the corporation

officers persons named by the directors to operate the corporate business



The owners of the shares of stock issued by the corporation are the owners of the corporation. These shareholders elect a board of directors, who oversee the management of the corporation. The directors, in turn, name and employ the officers, who are responsible for the operation of the business.

Business Law, 6th edition (Business Review Series) (27)


Theoretically, the modern corporation has the power to accomplish any lawful purpose. For larger corporations, there usually are a number of “stakeholders” with an interest in the corporation’s well-being; employees, suppliers, customers, creditors, licensees, and the overall community are some of the main groups affected by the company’s activities. However, the corporation is owned by its shareholders and under law exists for their benefit. Corporate profits should result in shareholder gain, while corporate losses become shareholder losses.

The managers of the corporation (the board of directors) have wide discretion to determine precisely the best way to funnel corporate powers into shareholder gain (or loss), which is not necessarily measured solely in financial terms. A good corporate image created by conformity with environmental laws, charitable acts of kindness, and good neighbor policies within the larger community may foster profits and serve the shareholder. On the negative side, a corporation with uncaring and hardened management, a polluter of air and water, an enterprise that neglects its employees or imposes on their loyalty may inhibit profits and harm its shareholders.

Still, corporate management must not neglect the shareholders. While the community at large or certain charities may benefit from corporate action, such benefit must somehow contribute to the ultimate good of the corporation and therefore of the shareholders.


Shareholders may own either preferred or common stock. The classes of stock are discussed in Chapter 18.



Although the shareholders are the owners of the corporation, this ownership does not carry with it the right of management.

The primary right of the shareholder is to attend meetings of the shareholders and to vote on matters properly brought before such meetings, including the election of directors and other fundamental matters affecting the corporation and required by statute or by the charter.

In most situations, shareholders can add items to the shareholder meeting agenda or bring new issues to a vote.

Except for attending the shareholders’ meetings and casting votes in favor of directors, a shareholder cannot directly interfere with the directors or with their management of the corporation, even though he/she may own or control a majority or all of the outstanding shares.


At common law, a corporate charter was considered to be a contract between the state and the corporation, on the one hand, and between the corporation and the shareholders, on the other. Change of this contract required unanimous shareholder approval.

Under modern corporate law a change can be accomplished by a less than unanimous shareholder vote. The percentage of shares required for approval of a charter amendment varies among the states in accordance with the nature of the proposed amendment. Generally, minor changes, such as dropping the word “The” from the corporate name or changing the registered agent, do not require any shareholder approval but can be done by the directors.

Drastic changes in the nature of the corporate business, however, or changes affecting the value of the stock or voting rights may require approval of

(a) two thirds of the shares outstanding and entitled to vote, or

(b) a majority of the outstanding shares entitled to vote, or

(c) a majority of the shares present and voting,

depending on the applicable state statute.

Procedures for charter changes require that any change be first proposed by a resolution of the board of directors. Certain changes may specifically require that dissenting shareholders be given the right to sell their stock to the corporation at its appraised value.


Corporations merge when the stock of one is purchased by another; they are consolidated when a third corporation (generally created for that specific purpose) purchases the stock of both. In a merger, corporation A buys all of the stock of B; A continues to exist, but B will be dissolved or continued as a subsidiary of A. In a consolidation, corporation C buys the stock of A and B; A and/or B will be dissolved or continue as subsidiaries of C.

In a merger, approval is required in all cases by the shareholders of B, the merged corporation; approval is also required by the shareholders of A, the continuing corporation, unless that corporation already owns most of the stock of the merged corporation, or unless the surviving corporation is so much larger than the merged corporation that the acquisition of the smaller corporation will have no effect on the business of the survivor or on the value of its stock.

Example: Merger

If corporation A, with assets in excess of $50 million, merges with corporation B, with assets of $100,000, approval of the shareholders of A would not be required. The shareholders of B, however, must approve.

In most states, two thirds of the outstanding shares eligible to vote must approve a merger or consolidation.


Sale of all or substantially all of the assets of a corporation other than in the regular course of business requires shareholder approval. The meaning of the phrase “substantially all” varies from case to case, but the principal test is whether the sale affects the corporate business to the extent that the nature of the shareholders’ investment has changed.

Shareholder approval not required: The corporation owns five fertilizer plants; two are sold and the proceeds are used to repair and remodel the remaining three.

Shareholder approval required: Two of the five fertilizer plants are sold, and the proceeds are used to invest in facilities and technology for the manufacture of ice cream.

Cautious and prudent business practice dictates that the approval of the shareholders be obtained in any doubtful or borderline case.

As with consolidations and mergers, most states require that two thirds of the shares outstanding and eligible to vote approve the sale of all, or substantially all, of the assets of a corporation.


The functions described in the preceding section are carried out by the shareholders at their meetings.


Notice of both the annual meeting and of special meetings must be given to shareholders of record, that is, shareholders whose names appear on the share transfer books of the corporation at the time of notice. The notice must state the purpose of the meeting, such as amendment of the charter, sale of all or substantially all of the assets, or some other extraordinary matter.

Failure to give notice, or giving a defective notice, will void any shareholder action unless the shareholder waives his/her objection by attending the meeting without objection, or by signing a written waiver.


A quorum (usually defined by state law as a majority of shares outstanding) must be present in person or by proxy. The president or chairman of the board usually presides, and minutes are kept by the secretary of the corporation. Many states, by statute, permit shareholder action without a meeting, provided that all (in some states, a majority) of the shareholders give their consent in writing to the action or actions taken.


Most matters are decided by a majority of the votes cast. If there is more than one class of stock (see Chapter 18) and approval of all classes is required, a majority of each class is necessary. In the election of directors, each share has one vote for each director. This mode of director election is usually referred to as straight voting. If, for example, seven directors are to be elected, the holder of 100 shares may select up to seven nominees out of the pool of those nominated and vote up to 100 shares for each of them.


Cumulative voting is permitted by law, or by special provision in the corporate charter in most states. In the example just given, in cumulative voting the holder of 100 shares has a potential of 700 votes and may distribute them among seven nominees as she chooses. If this shareholder “accumulates” her votes and casts all 700 in favor of a single nominee, this nominee may very well be elected when there are, for example, a total of 100 shares present and voting.

By cumulative voting, a minority shareholder may be assured of some representation on the board of directors and a voice (albeit a minority voice) in management. The percentage of stock ownership needed to elect one director (x) under cumulative voting is seen in this formula:

x = 1/(number of directors being elected + 1)

So, if five directors are being elected, a shareholder holding 16.7% of the stock (1/(5 + 1)) could elect one director.


A proxy is a limited power of attorney whereby a shareholder names an agent or a representative (a proxy) to vote his/her shares. Several shareholders may join forces, name a proxy, and control the corporation. A proxy may be revoked at any time, as is the case with powers of attorney in general (see Chapter 14).


Most states permit shareholders to transfer their shares to a voting trustee for the limited purpose of electing directors and for voting on other matters as specified in the trust. Alternatively, shareholders may enter into a contract creating a voting agreement or stock-pooling agreement whereby they combine forces in order to gain a voice or exercise control. Such voting trusts, voting agreements, or stock-pooling arrangements are governed by the law of contracts unless state statute imposes a special restriction or limitation.



If shareholders object to certain corporate actions that may diminish the value of their stock holdings, most states give these objectors (dissenters) the right to receive the fair value of their stock from the corporation. “Fair value” may have to be determined by appraisal if it is not otherwise ascertainable.

This right of dissenters is usually provided for following two kinds of majority action: (1) consolidation or merger of the corporation, and (2) sale or transfer of all or substantially all of the corporate assets in other than the usual course of business. In addition, appraisal rights may be provided for with regard to any charter amendment that adversely affects the value of the stock or the rights of shareholders.

The appraisal procedure varies from state to state. If the stock is traded on a recognized securities exchange, the fair value is readily ascertainable. Otherwise, statutes provide for a judicial determination, or for the appointment of an appraiser by the corporation and by the dissenter, respectively, and for the two appraisers to name another one if they cannot agree.

The dissenting shareholder must follow a strict procedure in order to avail him-/herself of the appraisal right: the shareholder must file a written objection to the proposed action, must vote against the proposal (or, in some states, abstain from voting), and must make a written demand for appraisal and buy-out within some specified time.


The decision to pay dividends is within the business judgment of the board of directors. In the absence of an agreement to the contrary, however, holders of a particular class of stock have the right to share in a dividend on a parity with other holders of the same class.


Since the assets of the corporation belong to the shareholders, no substantial portion of these assets can be given away or transferred to others without shareholder approval.

Most states statutes have special procedures for shareholder approval of eleemosynary gifts from profits approved by the board. Furthermore, bonuses, stock option plans, and incentive plans not tied into contract payments for specific work performed may require shareholder approval since such payments may be judicially construed as gifts.

Conflict of interest questions involving members of the board of directors may be resolved by the shareholders. Indemnification of directors and officers, as well as all other matters pertaining to benefits and potential benefits to the corporate managers, may be subject to stockholder approval. Indeed, prudent corporate management favors obtaining shareholder approval for major, fundamental decisions vitally affecting the corporation.


Statutes in practically all states permit shareholders to inspect corporate books and records. However, this right of inspection may be limited with respect to the nature of the records sought, depending on the number (or percentage) of shares making the request and, in some states, the purpose of the request.

As a general rule, any shareholder (even one with a single share out of 100,000 shares outstanding) may inspect and copy the annual reports to shareholders, minutes of the shareholders’ meetings, the bylaws, the charter, and the list of shareholders, together with their names and addresses. In addition, some percentage, frequently the holders of 5% or 10% of the outstanding stock (along with or through their attorneys and accountants), may inspect and copy all books and records, including books of account.

Whether the broad right of inspection accorded the holders of some specified percentage of stock will be permitted without showing good cause varies from state to state. Some courts, arguing that the corporate property belongs to the shareholders, and that the state does not closely police the corporate business, permit unlimited inspection unless the corporation can demonstrate an improper motive, such as proof that these shareholders are “fronting” for a competitor or seeking to discover trade secrets. Other states take a contrary view: unless a proper purpose or motive is shown by the shareholders, inspection is not permitted.


Existing shareholders may have the right to preempt, or come ahead of, other purchasers of stock of the same class in order to protect their percentage interest in, or control of, the corporation (these preemptive rights are antidilution rights). Thus, if 100 shares of common stock are outstanding, the owner of 20 of these shares has a one-fifth interest in the corporation. If the corporation were to sell 100 additional shares to a new party or to the other four-fifth owners, the ownership of 20 shares would be diluted to a one-tenth interest. However, with a right to preempt, the owner would have the ability to maintain his one-fifth interest (by purchasing 20 of the additional 100 shares).

In most states, in the absence of a charter provision or shareholders’ agreement granting preemptive rights, shareholders do not have these rights. Even when such rights are granted, they do not attach to treasury stock (stock previously issued, but not outstanding) or to shares issued for a merger or consolidation or in noncash transactions.



Derivative suits are suits brought by one or more shareholders on behalf of the corporation and for its benefit. Since these suits are not for the benefit of the suing party, any recovery belongs to the corporation, and in such event the corporation must pay the stockholder’s reasonable attorney’s fees. A shareholder who loses the suit, on the other hand, may be required to reimburse the defendant for his/her expenses, including attorney’s fees.

Derivative suits are usually brought against individual officers or directors for waste or conflict of interest. There are certain strict requirements for such a suit. The shareholder must first demand that the directors bring the suit (demand may be excused if the shareholder can show that it would have been futile), and that demand must be refused. Some states and the Federal Rules of Civil Procedure also require that the shareholder notify other shareholders of his/her intent to bring a derivative suit in order to give them an opportunity to ratify or confirm the alleged wrongful action.


A shareholder may sue the corporation individually to protect his/her personal rights or property in the corporation. Such a suit may seek to enjoin an ultra vires act or to protect the right to inspect the books of the corporation.


Officers and directors can be successfully sued for all sorts of corporate activities in which they were engaged or for which they otherwise had some responsibility, whereas shareholders, in their role as shareholders, ordinarily have no liability for corporate actions.

Basically, the only loss that a shareholder may sustain is his/her investment in the corporation’s stock. This limitation on liability for stock ownership is one of the primary reasons for the existence of the corporate form. As Chapter 16 pointed out, however, if the shareholders themselves disregard the corporate entity, and use the corporate form for fraudulent purposes, the “corporate veil” may be pierced and the shareholders may be personally responsible for corporate obligations.


Although shareholders own the corporation, their ownership does not give them the right of direct management, a function of the board of directors. Shareholders have the right to elect directors, control major charter amendments, and approve mergers, consolidations, and the sale of all or substantially all of the corporate assets.

Shareholder functions are exercised chiefly at meetings of shareholders, either general or specially called pursuant to proper notice. A quorum of shareholders must be present, in person or by proxy. In the election of directors, straight voting is generally required, although state law or the charter may permit cumulative voting.

In addition to the right to attend meetings and to vote on directors and other corporate business, shareholders have other rights: appraisal rights if they dissent from corporate acts that may affect the value of their stock; right to share in dividends, to approve corporate gifts, and to inspect and copy the corporate books; and, if permitted by the charter, preemptive rights.

Shareholders may bring legal action by derivative suits (suits for the corporate benefit and on its behalf) or by direct suits against the corporation.



Directors are elected to hold office until the end of their term, which coincides with the next annual shareholders’ meeting at which those directors may be reelected or successors may be elected and qualify as new directors. Terms can also be staggered, so that only a fraction of the board’s terms will expire each year. For example, a board may be split into three groups, A, B, and C; the first year, the terms for group A expire and those directors are either reelected to, or replaced for, three-year terms. The following year, group B will be up for the same reelection or replacement process, and the third year it is the C group that is reelected to or replaced for three-year terms. This is done to ensure that the board at all times at least partially comprises experienced people familiar with the company. It also may make it more difficult for shareholders, even when upset over management’s performance, to radically redirect the board and thereby replace management.

The MBCA and RMBCA provide that one or more directors can be removed by the shareholders “with or without cause” unless the charter permits removal only for cause. The common law (case law) and some statute law different from the Model Acts permit removal only for cause. “Cause” includes conflicts of interest or other violations of fiduciary functions, violation of the charter or bylaws, or illegal actions.


Directors are neither employees nor agents of the shareholders; rather, they occupy a position of trust to the shareholders. This trust relation is legally described as that of a fiduciary—a position of loyalty to the corporate interest and well being, superior to the director’s self-interest or desire for personal gain.

In general, this fiduciary relationship applies to the officers, as well as the directors, of the corporation.

Four important aspects of the fiduciary relationship are as follows:

  1. Duty of loyalty. Directors and officers owe an uncompromising duty of loyalty by the directors and officers to the corporation and its shareholders. Above all, the corporate manager must make full disclosure of any personal interest in a matter involving the corporation or its business and in any doubtful case should refrain from voting upon, or taking any action regarding, any such matter. Corporate loans, bonuses, and gifts to directors and officers are prima facie colored by a conflict of interest and should have prior shareholder approval.

  2. No usurpation of corporate opportunity. Directors or officers violate their fiduciary duty if they personally avail themselves of a business opportunity that should have been reserved for the corporation.

Example: Corporate Opportunity

A director or officer of a corporation owning and operating mineral lands cannot purchase other, similar lands for his/her own private purposes without first giving the corporation the opportunity to make the purchase, or without first making a full disclosure of the private objective.

  1. No personal use of corporate assets. Obviously, a director or officer cannot use corporate property or personnel to conduct personal business or to achieve his/her own ends. Moreover, directors and officers cannot divulge company secrets or technology without breach of their fiduciary obligations.

  2. Restrictions on transactions in shares. Directors and officers cannot deal in corporate stock if they receive such stock at an unfair price or on advantageous terms. Moreover, federal statutes require certain disclosures of insider transactions affecting stock values or transpiring in interstate commerce.

Germany’s Supervisory Boards

German law requires that board members take into account employee interests, not simply represent shareholders. For any corporations with more than 2,000 employees, the workers, through their workers’ councils, appoint half the members of a company’s “supervisory board” (Aufsichstrat) and the shareholders get the other representatives. This board, similar to an American board of directors, decides who the chief executive officer is and signs off on major investment decisions. With inside and outside directors, and with employee and union representatives, the supervisory board is responsible for the appointment and oversight of a lower “management board” (the Vorstand). The latter comprises corporate officers who run the corporation. On issues where labor and management is split down the middle, the chairman, who represents management and gets two votes, breaks deadlocks.

German unions can still strike, but only after exhausting all means of peaceful conflict resolution. In exchange for the unions’ restraint, the German system grants the workers’ councils extensive power in running companies, including a say in hiring, firing, transfers, working conditions, and all major strategic decisions through their representatives on the Aufsichstrat. (Besides extensive employee membership, another German check on their board of directors is that “proxies” [voting rights], which in the United States many shareholders normally give to the board, are in Germany usually given not to the board but to the corporation’s main creditors, such as banks.)


Both directors and officers of the corporation must govern its affairs with reasonably good judgment. Among other duties, they must attend meetings, remain apprised of corporate business, and not engage in self-dealing or conflicts of interest.

The phrase “reasonably good judgment” is somewhat difficult to define, but is intended to describe a standard of care lower than that applicable to a sharp, well-trained, prudent businessperson but higher than that of a casual, disinterested outsider. Three standards are generally applied to director or officer actions to determine compliance with the business judgment rule (“BJR”):

  1. Exercise of due care—An informed decision, in consideration of what the directors or officers reasonably believe to be all the factors relevant to their decision. Therefore, directors have a “duty to monitor”: to assure, among other things, that the corporation has an adequate information and reporting system.

  2. Action in good faith—The BJR protects directors against claims for wrongful acts, but not against claims for failure to act. Inaction by directors is protected by the BJR only if it is a result of a conscious decision to refrain from acting.

  3. Reasonable belief that the action is in the corporate interest—Usually, a court will not question whether the directors’ action was wise or whether they made an error of judgment or a business mistake. Not all decisions of directors will result in benefit to the corporation. As a result, directors will be personally liable for loss to the corporation only if the elements of the BJR defense are not satisfied.

When officers and directors make a poor decision, one must ask: Was it something that, in retrospect, simply turned out to be a mistake (“20/20 hindsight” by itself does not lead to liability), or was it worse? More is needed to establish liability—damages to the corporation caused by the officers’ or directors’ gross failures.

So a claim generally is that the harm arose because the directors/officers knew or should have known that they needed help—usually, more information—yet they failed to obtain that help. An example is the important ruling of the Delaware Supreme Court, Smith v. Van Gorkom, 488 A.2d 858 (1985). The Van Gorkom court found a corporation’s directors grossly negligent because the directors rapidly approved the corporation’s being bought out and merged into an acquiring company, all without substantial inquiry or any expert advice. By failing to undertake a good faith, thorough review of and research into what the corporation was really worth, the board of directors failed to get the information needed to make an informed decision and breached the duty of care that it owed to the shareholders; protection under the business judgment rule was unavailable.

A court is understandably reluctant to substitute its wisdom or judgment for that of a director—after all, directors are chosen by the shareholders, and they are familiar with the business and with the overall corporate objectives. However, a court may be compelled to substitute its judgment for that of a director who, in effect, forfeits responsibility by breach of his/her fiduciary or loyalty duties.


Generally, the bylaws determine the number and qualifications of directors.

Except when the shareholders unanimously agree to eliminate the board, or when the corporation has fewer than 50 shareholders, a corporation must have at least one director. Otherwise, the number can reasonably be any number, but for obvious reasons should be an odd number. The board should be of such size as to function well as a committee, although many large corporations, banks, and other widely held corporate entities may have boards of 25 members or more.

In most states, any person who can make a simple contract can be a director. A director is generally not required to own stock. (Indeed, for many corporations the board functions best when it includes at least a few active “outside” directors who may bring a broader—and certainly less self-interested—perspective to board meetings than those who work for and own the business.) In the aftermath of scandals, government officials, institutional investors, public watch groups, and others have called for much greater use of outside directors and for directors to limit themselves to serve on no more than two or three boards (so as not to spread thin their task of overseeing corporate management).


At the common law, directors did not receive compensation for their services, although they were reimbursed for their expenses. Today most state statutes permit directors to set their own reasonable compensation; extraordinary compensation must be approved by the shareholders.


Since a director is a fiduciary, he/she can act only in person. In other words, a director cannot delegate his/her duties or attend board meetings by proxy.

A director can act only as a member of the board, not individually. Meetings are held at the times and places designated in the bylaws or at special times and places as indicated in the notices of meetings. It is important that a director attend director meetings, that minutes be kept of such meetings, and that the director’s vote be recorded. Poor attendance and failure to use business judgment are acts of negligence that may create personal liability to shareholders who sustain loss as a result of such negligence. (The bylaws usually establish the quorum: how many directors—typically a majority—are required to transact business.)

Most state statutes permit action without a meeting or upon telephone or other oral approval, provided that all directors consent in writing.


Although board members cannot delegate their responsibilities and duties, committees of board members may be designated to perform a number of board-type activities under the general supervision of the whole board. The executive committee, the finance committee, the audit committee, and the like may meet on a daily or weekly basis to attend to management affairs on a more intimate basis. Such committees keep agendas and minutes of business transacted for the information and ratification of the entire board where appropriate or necessary.


The decision to declare dividends, or to invest and reinvest profits, or to expand the plant or otherwise dispose of earnings and profits are matters for the board of directors, acting within the business judgment rule. In the absence of proof of negligence or bad faith, all such decisions are immune from shareholder attack.


Directors occupy a fiduciary (trust) relationship to the shareholders. This trust relationship requires an uncompromising duty of loyalty to the corporation, no usurpation of corporate opportunity, no personal use of corporate assets, no unfair dealing in the corporation’s stock, and the exercise of reasonably good judgment in managing corporate affairs.

The bylaws generally provide for the number and qualifications of directors. Most state statutes permit the directors to provide reasonable compensation for themselves. Directors must personally attend board meetings; they cannot attend by proxy.

Committees of board members may be appointed to supervise day-by-day functions, but these committees must report to the full board.

Declaration of dividends is subject to the discretion of the board, acting within the business judgment rule.


The officers are agents of the corporation. They are named and hired by the board of directors. Designation of the various offices and the duties of each office are set forth in the bylaws. As a rule, the officers are the president, one or more vice presidents, the secretary, and the treasurer. (Ordinarily, a person may hold more than one office; many states, though, require that the same person not serve as both president and secretary.)


The president is the chief executive officer (CEO) of the corporation. He/she may be a member of the board of directors and preside at meetings of the board and of the shareholders. Frequently, all or some of these functions are performed by a chairman of the board, as the bylaws determine.


The vice president usually fills the office of president in the absence of the latter. In most corporations, vice presidents are given responsibility for various line activities—manufacturing, sales, administration, and the like. Sometimes executive or senior vice presidents are designated to supervise one or more vice presidents in order to relieve undue burdens that may otherwise fall on the president. Quite often, at least one vice president is a member of the board of directors.


The secretary is in charge of the corporate books and records. As such, he/she is responsible for keeping the minutes, giving notices, and affixing the corporate seal. (The seal attests to (witnesses) the corporate validity of action and to the authority of the individual signing the document on behalf of the corporation.) Because of the need for knowledge of corporate functions and of director and officer responsibilities, many corporations, especially large ones, require that the secretary be an attorney. Other than responsibility for books and records, the secretary generally exercises no executive functions, such as executing contracts.


The treasurer is responsible for management of the corporation’s funds. The treasurer can bind the corporation by his/her checks, indorsements, and disbursements, but performs no other executive functions.

SEC rules require companies to quantify in their proxy filings the potential payments (severance packages—also known as golden parachutes) if an executive is terminated, undergoes a change in responsibilities, or is subject to a change of corporate control.


The corporation’s other employees are hired by the officers and given such duties at such compensation as is within the authority of the officers. The bylaws may designate specific duties to one or more employees.

Note: The law of agency governs the authority of these corporate agents. Chapter 14 (Agency) should be reviewed with respect to the corporation’s responsibility for contracts, torts, and crimes committed by its employees, either in its name or while acting in a representative capacity. Moreover, the general law of agency governs the personal liability of the agent for acts committed in furtherance of corporate business.


The officers are named and hired by the board of directors. The officers and their duties are prescribed by the bylaws.

Officers usually include the president (chief executive officer), one or more vice presidents (generally with responsibility for line activities), a secretary (with responsibility for maintaining books and records), and a treasurer (with responsibility for management of corporate funds). The secretary and treasurer generally do not have other executive responsibilities.


Although most corporations have perpetual existence, the law contemplates both nonjudicial and judicial dissolution.

Corporate existence is terminated by dissolution followed by (a) winding up of its affairs, and (b) liquidation of its assets.


Shareholder approval is usually required for nonjudicial dissolution, although an act of the state legislature, as well as expiration of the period of existence stated in the charter (if a period is stated), will result in nonjudicial dissolution without shareholder action. Voluntary dissolution is achieved by (a) passage of a resolution by the board of directors and (b) approval of the directors’ resolution by a majority of the shares entitled to be voted at a shareholders’ meeting called for that purpose.


There are three methods of judicial dissolution:

  1. The shareholders may petition for judicial dissolution upon their claim that the directors are hopelessly deadlocked, or that the shareholders themselves are deadlocked with regard to election of directors or to some other matter requiring shareholder approval, or that the directors are operating the corporation in an illegal or fraudulent manner.

  2. Creditors may implement court action if (a) the corporation cannot pay its debts in the usual course of business and a creditor has obtained a judgment against the corporation that the corporation cannot satisfy, or (b) the corporation has stated in writing that it cannot pay the claim of a creditor.

  3. The state itself may bring about judicial dissolution if the corporation fails to file its annual report with the secretary of state, fails to pay its annual franchise tax, abuses its corporate authority, or fails to maintain a registered agent in the state.

In the case of failure to file an annual report or pay the annual franchise tax, the secretary of state usually dissolves the corporation by administrative action. After giving the corporation notice and after the passage of a specified period of time (and generally publication of proposed dissolution), the secretary dissolves the corporation by signing a certificate of dissolution. Many, if not most, small and insignificant corporations, and corporations merely created but allowed to languish without conducting any business, are dissolved by administrative action in this manner and without penalty.


After dissolution, the board of directors liquidates the assets of the corporation and distributes the proceeds, first to creditors, second to preferred shareholders (if any), and finally to common shareholders.



  1. Can a majority shareholder, acting alone, dismiss an officer of the corporation?

  2. Should a charitable donation be considered, in all cases, a corporate gift subject to the approval of shareholders?

  3. Why are the directors of a corporation having assets of over $100 million not required to submit to their shareholders a proposed merger with a corporation having assets of less than $1 million?

  4. What advice should be given to someone who strongly objects to the consolidation of a corporation in which he owns a stock interest with another corporation?

  5. How can you determine the necessity of attending a special meeting of shareholders?

  6. What is cumulative voting?

  7. Why can a shareholder attend a shareholders’ meeting by proxy, but a director must attend in person?

  8. Can the president of a corporation conduct a telephone poll of the members of the board of directors and use the result of that poll as the basis of a board decision?

  9. Do shareholders have the right to compel the board to declare a dividend?

  10. Why should a vice president of a corporation also be a member of the board of directors?

  11. What is one relatively effective and inexpensive way to cause a corporation to be dissolved?



business judgment rule

committee consolidation

cumulative voting

derivative suits






preemptive right







vice president

voting trust


  1. You own about 1% of the outstanding stock of XY corporation. A number of shareholders believe that the management is paying a grossly exorbitant salary to Ms. X, secretary to the president of the company and believed to be his mistress. Ms. X and the president are known to take trips to Europe and other places on “corporate business” and at corporate expense. What course of action should be considered to protect your rights as a shareholder?

  2. The vice president of corporation AB, a jewelry company, attends an auction at the direction of the corporation. She is directed to bid up to $100,000 for the Omega diamond. The bidding reaches $125,000, and the vice president then buys the diamond for her own account for $126,000. Is this action proper?

  3. MM Corporation has received an order of the state department of health to cease the discharge of acid into the waters of the state. The board of directors has before it the proposal of a management team to spend over $50 million for capital equipment that will correct the effluent discharge. The company has operated at a loss for the past 2 years. Director Q and a majority of the board vote against the proposal. Later the corporation is fined $1 million for acid discharge, and shareholders ultimately bring a derivative suit against Q, claiming violation of the business judgment rule. What will be the result?



  1. A shareholder, even the owner of all of the outstanding stock, cannot directly dismiss an officer or other employee. The shareholder can only elect a board of directors that will consider his/her wishes with regard to corporate management, including the hiring and firing of officers.

  2. Charitable gifts are usually subject to state statutes and, if reasonable in amount and approved by the board of directors, do not require shareholder approval (see Chapter 16). A small or reasonable donation for a good cause may also be good business and inure to the benefit of the corporation and the shareholders. As such, it may be a proper business expense and not require submission to shareholders.

  3. The purchase of such a disproportionately small business would not affect the nature of the business of the larger corporation or the value of its stock. Shareholder approval is, therefore, not necessary.

  4. He must file a written objection to the proposed consolidation, attend the shareholders’ meeting in person or by proxy, vote “no,” and promptly demand a “buy-out” of his shares. If the stock is traded on a national exchange, the value will have been set by the board of directors as of some previously specified date. If the stock is not traded, the shareholder will proceed to have “fair value” determined by the appraisal routine.

  5. You are entitled to a notice of the meeting, which will set out its purpose and any matters to be voted upon.

  6. Cumulative voting is the right to concentrate all of your voting rights on fewer than all of the directors being elected. Thus, if you own 10,000 shares and 5 directors are being elected, you have 50,000 votes, all of which may be voted for 1 or 2 directors.

  7. A director is in a fiduciary relationship to the shareholders and cannot delegate his/her duties to a proxy or agent. Failure of the director to attend to his/her duties in person may give rise to a charge of neglect. Shareholders are exercising a right when they attend shareholder meetings and vote their shares; rights, unlike fiduciary duties, may be assigned to others by proxy.

  8. In most states, telephone action of the board is permissible if all of the directors consent in writing to the action. This consent should be given promptly and affixed to the corporate resolution pursuant to which the action is taken.

  9. Declaration of a dividend is usually regarded as a question for the board, not the shareholders. Of course, the decision is subject to the business judgment rule.

  10. Generally, a vice president should be a member of the board so that he can preside over board meetings in the absence of the president.

  11. If the corporation fails to file an annual report with the state, or fails to pay its annual franchise tax, the state may cause it to forfeit its charter by administrative action.


  1. So far, you have only hearsay and suspicion as a basis for objection to improper payments and corporate expenditures for Ms. X. Assuming that your state permits shareholders freely to inspect the corporate books but that some minimum percentage of shares is required (e.g., 5%) in order to make demand, you should join with other shareholders in order to develop the requisite percentage.
    If inspection rights are obtained without litigation (filing a petition in court), you should inspect the corporate expense records, probably with an attorney or an accountant. If waste or impropriety is discovered, you may consider a derivative suit. This, of course, will be preceded by a demand on the directors to take action to stop the waste and to cause the president to account for the misappropriation of funds. State law should be checked to determine whether other shareholders must be notified of the wrongdoing and planned lawsuit.

  2. The question is one of corporate opportunity. Has the vice president seized for herself an opportunity belonging to the corporation? Probably not; she had no authority to exceed $100,000. To have purchased the stone for a price in excess of that amount for the corporation would have violated the terms of her employment. She was impliedly authorized, therefore, to act for her own account and for her own opportunity.

  3. The shareholders would probably lose their suit against Q. If he acted in the reasonable belief that his negative vote was in the corporate interest, if he acted in good faith, and exercised due care, he acted properly. We are not told of his other options; we do not know what other competent advice he may have received. We do not know the history of the violations or the reasonableness of the corporation’s course of action.




share (of stock) a proportionate ownership interest in a corporation or in its equity

stock a term used synonymously with “share”; also, the physical evidence of share ownership, the share certificate; also, the aggregate of corporate shares

dividend a distribution of cash or stock to the shareholders

blue sky laws state laws regulating the intrastate issuance and sale of securities

Up to this point we have thought of shareholders as the ultimate source of power in the corporate structure. In this chapter we consider their role as investors. Also, we distinguish and define the various sources of corporate financing and investigate the issuance, trading, and regulation of corporate securities.



Funds to operate the corporation are derived in three principal ways:

  1. By the issuance or sale of corporate debt securities (debt).

  2. By the issuance of equity securities (equity)—e.g., via an IPO (initial public offering).

  3. Through retained earnings.


The corporation may raise money by borrowing. Unless there is a special limitation or other provision in the charter, the decision to borrow is a matter for the board of directors and does not require shareholder approval. When the corporation borrows, it becomes a debtor; the holder of the security that it issues as evidence of this debt is a creditor.

Short-term borrowing is generally accomplished by the issuance of promissory notes or other commercial paper subject to the general principles of negotiable instruments law. Debt securities are of two main types: notes and bonds.


The corporation’s notes are promissory notes subject to the Uniform Commercial Code (see Chapters 10 and 11). These notes may be secured or unsecured.


Bonds are written promises to pay a fixed sum of money at a set maturity date, with specified interest paid at stated intervals. Bonds may be secured by real or personal property. Bonds may be debentures, which are unsecured. If the corporation can redeem (pay off) the bond early, it is a callable bond. A convertible bond may be converted by its holder (at such time as he/she believes most favorable) into other securities of the corporation, such as preferred or common stock.

An indenture is a contract stating the terms under which debt securities are issued. For secured bonds, the indenture may describe, along with other contract provisions, the collateral and conditions of default. For debentures, the indenture may restrict other corporate borrowing or declaration of dividends, and place various other limitations on management in order to protect the debenture holder.


Funds to operate the corporation may be generated by the sale of shares of stock, that is, equity securities. The equity in the corporate enterprise, that is, the residual value of the assets after the payment of all debts following dissolution, belongs to the shareholders.

Equity financing may open up participation in corporate ownership (and, indirectly, management) to additional investors. Sound corporate structure attempts to maintain a fair balance between debt and equity.

There are two classes of equity stock: common shares and preferred shares.


In Chapters 16 and 17 all references to “shareholders” were to common shareholders (or stockholders). Holders of common shares participate in management control; however, these owners of the corporation are in for the “ride”—losses or gains in the value of their holdings follow the vicissitudes of the corporate enterprise. Common shareholders have a threefold interest in the corporation: (a) to vote for directors and on other fundamental matters, (b) to participate in the distribution of dividends, and (c) to share in the distribution of net assets (equity) after dissolution and liquidation.


Preferred stock may be cumulative or noncumulative, and either participating or nonparticipating.

Advantages of Owning Preferred Shares

Preferred shareholders are “preferred” to common shareholders in two respects:

  1. In the distribution of dividends. If the directors determine that a dividend is to be paid, holders of preferred shares may receive a specific percentage share of the dividend before the common stockholders are paid.

If the preferred stock is noncumulative, the preferred shareholders lose their dividend rights for years in which no dividend is declared; if the preferred stock is cumulative, unpaid dividends accumulate for years of nonpayment, and these accumulated dividends, plus current ones, are paid before common shareholders receive any dividend.

  1. In distribution upon liquidation. The preferred shareholders may also be owners of part of the equity; upon dissolution and liquidation, after the payment of debt, they may receive the first distribution of the net assets, before payment to the common stockholders, provided that such precedence is expressed in the articles of incorporation. Otherwise, the preferred shareholders participate pro rata with the holders of common stock upon liquidation. Not only does participating preferred stock receive preference when dividends are declared, but also holders of these shares may “double dip,” that is, share also in the dividend to common stock on a pro rata basis.

Participating preferred shareholders receive, first, a distribution of net assets, and then a pro rata share of what remains. Holders of non-participating preferred stock do not share in this secondary distribution of any surplus but only have the initial liquidation preference (the first distribution of net assets).

Other Aspects of Preferred Shares

  1. Redemption. The corporation may be given the right to purchase (redeem) preferred shares, even over the objection of their owners. The right of redemption by the corporation, as well as the price to be paid (the call price), is set out on the share certificate. The articles of incorporation provide for the right of redemption, if such right exists.

  2. Conversion. If the articles of incorporation so provide, the corporation may, at its option and under the terms stated, convert preferred stock into common stock or convert from one class of preferred stock to another. Shareholders may also have rights (e.g., to acquire more shares) so that their interests are not diluted.

  3. Voting rights. Generally, preferred shareholders have no voting rights. However, the articles of incorporation may give them such rights or may permit them to vote for directors in the event that the corporation fails to pay dividends.


• Authorized shares: the number of shares that the articles of incorporation permit the corporation to issue. Authorized shares may or may not be issued.

• Issued shares: authorized shares that have actually been sold to shareholders.

• Outstanding shares: the same as “issued stock,” except that some issued shares may have been repurchased by the corporation after issuance. Such repurchased stock ceases to be “outstanding.”

• Treasury shares: shares repurchased by the corporation.

• Canceled shares: shares that have been repurchased by the corporation and canceled. Such shares then cease to exist.


Stock options grant their holders the right to purchase stock, at such time and price as are specified in the option. Stock options may be granted to employees, directors, and officers as incentive payments, and to purchasers of other classes of securities as an added inducement to buy.


Retained earnings are earnings and profits not distributed to shareholders as dividends, but held back to be invested or “plowed back” into the corporate enterprise.


There are three sources of corporate funds: debt, equity, and retained earnings. Debt securities consist of notes, bonds, and debentures. Notes are short-term promissory notes. Bonds are secured long-term securities; debentures are unsecured long-term securities.

Equity securities consist of common and preferred shares. Common shareholders participate in the election of directors and in other fundamental matters; preferred shareholders may be preferred over common shareholders in regard to dividends and to distribution upon liquidation. Preferred stock may be subject to redemption and conversion into other securities.


The expectation of a dividend or distribution is one basic reason for an investor to purchase the shares of a corporation.

A distribution of cash or stock is usually referred to as a dividend; distribution of corporate assets, while also a dividend, is generally referred to as a distribution. (Stock or shares of stock are not corporate assets.)


The decision to declare a dividend or distribution is within the business judgment of the board of directors. This decision may not be “second guessed” by shareholders in the absence of director abuse or a wrong motive, such as deliberate withholding of accumulated cash without good business reasons. Once a dividend is declared by a proper resolution of the board, it is a legal debt of the corporation and is enforceable in a court of law.


The dividend may take the form of cash, other property or assets, or shares of stock. Real estate, merchandise, or other tangibles may be distributed to the shareholders.

A stock split is not a stock dividend, but merely an across-the-board aggregation of additional shares for shares already held (e.g., for every two shares one owns, an additional share is issued to that owner—someone owning 5 shares would end up with 7.5 shares). A stock split does not alter the total value of an individual stockholder’s investment.

However, a common purpose of a stock split is to reduce the per share market price in order to induce more trading and a resulting higher price per share.


If a corporation has borrowed large sums of money, creditors may have restricted (by means of “loan agreements”) its ability to declare dividends, particularly without the prior approval of the creditors. Moreover, all states prohibit the payment of a dividend or other distribution if such payment would render the corporation insolvent, that is, unable to pay its debts as they become due in the ordinary course of business. Further statutory restrictions vary among the states; most states require that dividends be paid from earned surplus. A few states (including Delaware) permit the payment of nimble dividends, that is, payment from current earnings even though there are debts outstanding from prior years.


Directors who vote in favor of an illegal dividend are jointly and severally liable for the illegal portion of the dividend, that is, the amount by which the dividend exceeds the legally permissible limit. (“Joint and several” means that each director can be held fully responsible for any payment, but whoever actually pays is entitled to then collect contributions from whichever other directors were also liable.) Directors who rely in good faith upon the financial data and statements of accountants and financial officers of the company are not liable. Only shareholders who know, or ought to know, that the dividend is illegal can be made to return it.



Stock may be paid for in cash, by check, with tangible or intangible property, or by services previously rendered. The value to be placed on noncash items (property or services) is usually considered to be a matter for the good-faith judgment of the members of the board fixing the value, although some states consider this value to be a question of fact to be determined by a jury in the event of litigation.

In some states, contracts for future services or benefits or for promissory notes (including postdated checks) are not good considerations for shares. The trend, though, has been to permit such “future consideration”; MBCA amendments (1979) and the RMBCA both allow it.


A par share has a specific dollar amount indicated on the share certificate. The par value can be any amount chosen by the board (or by the incorporators), and may or may not reflect the actual value, but the par value must be set out in the articles of incorporation.

The corporation must receive, as a minimum, the par-value price for each share it sells.

No-par shares are issued for any amount that the board assigns to such shares, arbitrarily or otherwise. Consideration received for shares in excess of the par value is capital surplus. With respect to no-par shares, the directors may arbitrarily assign a designated portion of the consideration for such shares to capital surplus, that is, surplus that may be used in the calculation of dividends. The excess of consideration over par value, or the designated portion of the consideration assigned to capital surplus in the case of no-par value, is an important factor in determining the lawfulness of a dividend.


Treasury shares (shares issued and then repurchased by the corporation) may be reissued for an amount equal to their fair value even though this amount may be less than the par or stated value.


“Discount shares” are shares issued for less than par value or stated value.

A shareholder who purchases shares at discount from the corporation is liable to the corporation for the amount of the discount.

A shareholder buying discounted shares from another shareholder is liable for the amount of the discount only if he/she knew that the shares had been originally purchased at discount.


A subscription is a promise to buy shares at a specified price. Although such a promise may be made after the corporation has been formed and is a going concern, most of the legal problems associated with subscriptions involve preincorporation subscriptions.

Since the promoters require assurance that sufficient equity capital will be raised to support the corporate venture, it is important that subscribers be bound to their promises to purchase stock that the corporation (not yet formed) will issue.

Section 6.20 of the RMBCA deals fully with share subscriptions and should be consulted as authoritative even though its provisions may not have been adopted in a specific state. This section provides that, if the corporation is yet to be organized, a subscription is irrevocable for a period of 6 months unless the subscription agreement provides otherwise or unless all subscribers consent to revocation. The section also provides that, unless the subscription agreement specifies otherwise, the price shall be paid in full at the time of the agreement or in installments at times determined by the board of directors.

Under the MBCA, RMBCA, and the other corporate law of most states, preincorporation subscription may result in a binding contract if all conditions for a contract are present. This contract may be enforced by promoters and creditors relying on it. This may be true even though the corporation is not yet formed, since the promoters and their creditors may legally enter into agreements looking toward the formation of the corporate enterprise and the creation of its underlying capital. Preincorporation share subscribers should expect that persons extending credit to the venture may seek redress from subscribers if obligations are not paid by the promoters.


A share in a corporation is a fractional interest in the ownership of the corporate entity.

The share interest may be physically represented by a share certificate (a stock certificate), or it may be uncertificated under general state corporate law or under the provisions of the MBCA.

In the modern electronic, computerized world documentary transfer is not always practicable. Revised Article 8 of the Uniform Commercial Code (promulgated in 1994 and since enacted in all 50 states) deals with investment securities and specifically recognizes that such securities may be uncertificated but states that the share or participation “may be registered upon books maintained for that purpose by or on behalf of the issuer” (Section 8-102).

The issuer of a certificated security (which, of course, includes stock or share certificates) must maintain, or cause to be maintained, books of registration of share ownership.

UCC 8-207 provides that the issuer may treat the registered owner as the person “exclusively entitled to vote, to receive notifications, and otherwise to exercise all rights and powers of an owner.” UCC 8-405 permits the owner of a lost, destroyed, or stolen certificate to obtain a new certificate if (1) the owner notifies the issuer before the issuer learns of a protected purchaser now holding the certificate and (2) the owner has posted a sufficient indemnity bond.


Article 8 of the UCC also governs the transfer and registration of investment securities. Share certificates, bonds, debentures, and corporate notes are covered by its provisions. Article 8 provides that, even though a certified security (certificate) meets the requirements of Article 3 (Negotiable Instruments), a security is nevertheless governed by the provisions of Article 8.

Securities certificates are either in registered form (registered with the issuer, usually the corporation, in a specific name) or in blank (payable to the holder). A registered certificate is transferred by delivery plus indorsement or by delivery plus the execution of a stock power (or assignment).

If a share certificate is transferred without designating a transferee by name, the certificate is a street certificate and may be further transferred by delivery only, without indorsement.

The transfer of a certificate may, however, be restricted. Restrictions may be intended to maintain voting controls, to preserve an S corporation or a close corporation, or to maintain exemption from federal or state securities laws requiring registration for public offerings. Restrictions on transfer are accomplished by a number of legal devices, such as options, rights of first refusal, and buy-and-sell agreements. UCC 8-204 requires that the restriction be noted conspicuously on the certificate or—for uncertificated securities—in the initial transaction statement, unless the transferee has actual knowledge of the restriction.


The decision to declare a dividend is within the business judgment of the board of directors. The dividend may take the form of cash or of other property or assets.

A dividend cannot be paid if the corporation is insolvent or if the payment would make the corporation insolvent. Most states require that the dividend be paid from earned surplus.

In most states, shares must be paid for in cash or other valuable present consideration, or by services previously rendered. If the shares have a par value, that value establishes a minimum price. No-par shares are issued for an amount established by the board of directors. Shares may not be sold at a discount; otherwise, the purchaser may be liable for the discount.

Share subscriptions obligate the subscriber to purchase the stock at the time of the subscription agreement or in installments as determined by the board. Promoters and creditors who rely on the subscription agreement may enforce its terms.

Share interest may be shown by a share certificate, or the share may be uncertified. Names of both certified and uncertified owners of securities are registered in books maintained by the issuer, and these persons are treated as the owners for all legal purposes.

Free transfer of securities may be restricted, but the restriction must be noted on the share certificates.


Statutory regulation of securities operates within three broad categories (although there are other important but more specifically directed statutes):

  1. The Securities Act of 1933.

  2. The Securities Exchange Act of 1934.

  3. Securities regulation within the various states.


The Securities Act of 1933, a federal “consumer protection law” for investors, requires that the public be given complete and full disclosure about new securities being offered for sale. This act is administered by the Securities and Exchange Commission (SEC), established in 1934.

Congressional investigation during the early 1930s into the stock market crash led to passage of the Securities Act of 1933. The goal of this act is twofold: (1) to assure the investor of the opportunity to make informed decisions, and (2) to protect honest enterprises seeking capital through public investment.


The Securities Act defines “security” not only as a note, stock, bond, warrant, right, debenture, stock subscription, voting trust certificate, limited partnership interest, or evidence of indebtedness, but also as an “investment contract,” or a “fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a ‘security’.” This broad statutory reach is designed to prevent circumvention of the law by the form of the document; rules of contract and statutory construction such as ejusdem generis (“of the same kind or class”) or noscitur a sociss (words are explained “by their company with other words”) require that general words and phrases be construed in their broad generality within the scope of Congressional goals and purposes. Statutes enacted to remedy widespread abuses or alleviate large societal concerns are liberally construed to achieve their legislative objectives.

In the 1946 case of Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293, the Supreme Court laid down four requirements to bring an “investment contract” within the definition of “security”: (1) an investment of money, (2) a common enterprise, (3) the expectation of profits, and (4) profits solely from the managerial efforts of persons besides the investor (i.e., a promoter or third party). In the Howey case, contracts offering investors acreage in orange groves to be cultivated and marketed by others were held to be “investment contracts” and consequently “securities” within reach of the 1933 act.

However, the Securities Act does not apply to pension funds, insurance, stock dividends, bank accounts, warranty deeds to real property, interests in joint ventures for selling real estate, or distributorships or franchises (unless the distributor or supposed franchisee has no obligation and merely reaps profits).

Although the reach of the 1933 act must be fully understood, most of the cases, both at the Securities and Exchange Commission (SEC) level and in the courts, pertain to stocks, bonds, debentures, and traditional securities.


Section 3(a) of the Securities Act exempts a number of securities (although administrative agencies other than the SEC impose regulation in some cases):

  1. Any security issued or guaranteed by the United States, by any state, by any political subdivision of any state, or by a public instrumentality of any state. Municipal bonds and industrial revenue bonds, as well as “authority” bonds and securities are excluded under this exemption.

  2. A note or draft that has a maturity date at time of issue not exceeding nine months.

  3. Securities issued by an organization operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes, and not for profit.

  4. Securities of domestic banks, savings and loan associations, building and loan associations, cooperative banks, and the like.

  5. Securities whose issuance is regulated under other federal laws.

  6. Securities issued by a receiver or trustee in bankruptcy.

  7. Any insurance or endowment policy or annuity contract issued by a regulated insurance company.

  8. Securities issued for conversion or exchange with existing shares of a security holder where no commission or other remuneration is paid or given, directly or indirectly.

  9. Securities issued for local (intrastate) investment only. This exemption applies to the local financing of an issuer having at least 80% of its gross revenues and 80% of its assets in that state. Not only must at least 80% of the offering proceeds be used in state but the offering must only be to investors in that one state. In-state purchasers cannot buy for the purpose of reselling to persons outside the state. Moreover, regardless of an investor’s original intent, SEC Rule 147 bars absolutely any out-of-state resales for at least nine months. While delivery of shares to a resident temporarily out of the state is permitted, just one sale or offer to sell to a nonresident (even a friend or relative) will vitiate the exemption status.


Registration is the heart of the 1933 act.


Registration Statement

The registration statement, filed with the SEC, contains all relevant information about the securities to be offered, the issuer and the business involved, and plans for use of the dollar proceeds of the issuance. The registration statement makes the party executing it (chief executive officer, financial officer, board of directors) liable for errors in the statement, which becomes effective on the 20th day after its filing with the SEC, although this date may be advanced by the SEC. Substantive amendments may require a recommencement of the 20-day period.

Statutory Prospectus

The statutory prospectus for potential investors is derived from the registration statement. It is a comprehensive and detailed booklet concerning the security, its issuers, the use of monies to be generated, the terms of reimbursement to the investors if minimum financing (as defined) is not obtained, the prospects of success of the venture, financial statements, and other matters, including special items that may be required by the SEC and as provided for in SEC Regulation C.

The prospectus is an informing, not a promoting, document, and is intended to enable the prospective purchaser to evaluate fully the prospects, both good and bad, of the proposed venture.

The booklet must state the following on its outside cover in boldface roman type:



Before the filing date there should be no communication with the public or potential investors concerning the planned offering, although Rule 135 of the SEC permits the publication of a limited informational notice. After the filing date, but before the effective date (i.e., during the waiting period), the securities may be offered, but not yet sold: (1) orally (in person or by telephone); (2) by certain summaries of information from the registration statement; or (3) by a tombstone advertisement that identifies the security, its price, and the party by whom orders will be executed.

During the waiting period, a preliminary prospectus, tentatively reviewed by the SEC, must accompany any written offer. This preliminary prospectus is known as a red herring prospectus because of a mandatory red-ink warning on its cover that the registration is incomplete and that the securities are not yet available for sale. Even though the SEC may finally allow the prospectus, such allowance is not a “blessing,” and the issuer is responsible for the fullness and accuracy of the document.

After the effective date, the securities, accompanied by the final prospectus, may be freely offered to investors.


Section 4 of the Securities Act exempts transactions (a) by any person other than an issuer or underwriter (or persons acting under the control of an issuer or underwriter) and (b) by an issuer that are not public offerings (private offerings). For example, without having to furnish any information, an issuer under Securities Act section 4(6) may privately offer up to $5 million in shares solely to accredited investors (i.e., statutorily defined businesses or wealthy investors).


The Securities Act is intended to cover the issuance and original distribution of securities.

The act does not cover trading transactions or transactions involving persons other than issuers and underwriters (persons dealing with the issuer as part of the plan of original distribution).

Brokers’ and dealers’ transactions are exempt to the extent that these transactions are not part of the plan of distribution.


In differentiating a public offering from a private offering, the SEC follows general guidelines permitting, as exemptions, offerings to no more than 25 persons, provided that such a small offering is not a scheme to promote a wide distribution in circumvention of the Securities Act. Also, the exemption pertains to the number of offerees and not to the number of purchasers. Thus a meeting with 40 persons to promote a small “private offering,” of whom only 3 persons actually consummate a purchase, would constitute a violation of the 1933 act.

The burden of proof is upon the issuer that any offering is not a public offering, no matter how few the offerees or how small the dollar amount of issue.


Section 3(b) of the Securities Act provides that the Securities and Exchange Commission may prescribe exemptions applicable to issues of limited dollar amounts. Section 4 of the act provides, however, that there can be no advertising or public solicitation in connection with such a dollar-exempt transaction. Furthermore, the issuer must file “such notice with the Commission as the Commission shall prescribe.”

The SEC has issued, among others, the following regulations under this section:


This regulation permits a simplified and limited registration for an issuer’s public offerings of up to $50 million of securities in any 12-month period. The seller must notify the SEC at least 20 days before the initial date of offering, furnishing general information concerning the issuer, the nature of the securities, the purpose of the issue, and a description of the arrangement (if any) to return investors’ funds if the financial objectives are not met. The seller must also distribute to potential investors an offering circular, containing essentially the same information as the notification to the SEC. Offers may be solicited, but no sales can occur until the 20-day waiting period is over.

Only privately held U.S. or Canadian corporations can offer and sell Regulation A offerings. Investment companies; businesses issuing oil, gas, or mineral rights; and firms whose owners have violated the securities laws (designated “bad boys” under SEC Rule 262) cannot rely on Regulation A.

Under the Jumpstart Our Business Startups Act (JOBS Act) of 2012, an “Emerging Growth Company” (EGC) is exempt from many securities registration requirements. The JOBS Act’s Title I (also known as “the IPO On Ramp”) provides that the EGC only needs to provide two years of audited financial statements (not the usual three years) and can follow a streamlined process with far fewer financial disclosures. The EGC can privately communicate with accredited investors to “test the waters” before actually going forward with an initial public offering (an IPO), and it can file with the SEC a confidential draft registration statement that—if the proposed IPO is withdrawn—means any confidential business information remains safeguarded from public disclosure. The EGC status expires and it must become a publicly reporting company either five years after its IPO or once the EGC has over 2,000 shareholders of record (or if over 500 of those shareholders are unaccredited). To qualify as an EGC, the company must have less than $1 billion in annual revenue (to be adjusted for inflation every five years), $1 billion in debt, and—after the IPO—$700 million in stock outstanding. It also must not have gone public more than five years earlier.

The JOBS Act permits crowdfunding, a method to raise capital from many smaller investors in which the EGC uses a website intermediary (a funding portal) registered with the SEC. The EGC can raise a maximum of $1 million during any 12-month period, with investors limited to no more than $10,000 in various crowdfunding investments (there are lesser maximum amounts for investors when their annual incomes and net worth are each under $100,000). For a company’s crowdfunded revenue under $100,000, no accountant review is required; for EGCs intending to raise between $100,000 and $500,000, a certified public accounting (CPA) firm must independently review its financial statements; and, if the EGC intends to raise over $500,000, it must have an independent audit by a CPA firm. Crowdfunding offerings are subject to the federal securities laws’ antifraud provisions.


Regulation B covers oil and gas securities. Regulation C deals with general registration requirements, registration by foreign governments, and other rules.


This regulation is intended to simplify offerings to informed, sophisticated investors and to accredited investors (Rule 501) such as national banks, insurance companies, private business development companies, investment companies, the issuer’s executive officers or directors or partners, registered broker-dealers, business entities or trusts with total assets more than $5 million, and other persons clearly defined in the regulation (e.g., individuals whose net worth exceeds $1 million or whose annual income regularly exceeds $200,000). Under Regulation D, the SEC has promulgated rules simplifying the SEC notification process for certain private offerings; these simplified rules permit filings within 15 days after the first sale.

Business Law, 6th edition (Business Review Series) (28)

Business Law, 6th edition (Business Review Series) (29)

The same private placement memorandum is required as under Rule 505 if there are any unaccredited investors. Again, investors must have the chance to ask questions and receive answers. Because, as with Rule 505, no complex offering documents are required if the sales are only to accredited investors, but—unlike Rule 505—sales are permitted in excess of $5 million, the Rule 506 exemption is the one most commonly relied upon in venture capital financings.


Rule 701 exempts offers and sales of securities by privately held companies (1) pursuant to a written compensatory benefit plan for employees, directors, general partners, trustees (if the issuer is a business trust), officers, consultants, or advisers; or (2) pursuant to a written contract relating to the compensation of such persons. To obtain this offering, consultants or advisers must render bona fide services unrelated to the offer or sale of securities in a capital-raising transaction. Issuers of these exempt Rule 701 plans must provide every plan participant and contractor with a copy of the plan/contract (no other disclosure is necessary). These exempt plans include purchase, savings, stock appreciation, option, bonus, profit-sharing, thrift incentive, and pension plans.

Rule 701 securities offerings cannot exceed, in a twelve-month period, the greater of (a) $1 million, (b) 15% of the issuer’s total assets, or (3) 15% of the outstanding securities of the type of class being offered. Once a sale brings the aggregate sales under Rule 701 to an amount above $100,000, the issuer must file a Rule 701 disclosure form with the SEC within 30 days (and annually thereafter).

Issued Rule 701 shares can, 90 or more days after the corporation went public, be sold by these securities holders to the public without any registration (an exception to the one-year holding period that is normally the minimum under Rule 144). This expanded right of resale does not apply to the corporation’s officers, directors, or 10% or greater shareholders.


SEC Rule 144 allows the purchaser to resell restricted securities only after full beneficial ownership (free from debt) for one year, and provided that information about the issuer is publicly available. The seller may thereafter sell only a limited amount of the securities in any three-month period during the next year. Rule 144A, adopted in 1990, provides further resale rights for sales to qualified institutional buyers (large-scale securities investors such as financial institutions, registered broker-dealers, and major corporations).


Section 11 of the 1933 Securities Act provides for civil liability for the following:

  1. Sale of an unregistered security required to have been registered.

  2. Sale of a registered security without delivery of a statutory prospectus.

  3. Offer of a sale before the filing (or approval) of a registration statement.

  4. Inclusion of a false statement in the registration statement.

  5. Omission of a material fact from the registration statement.

In the event of an improper offer or sale (item 1, 2, or 3 above), the purchaser’s remedy is recission of the transaction or damages. The penalty for inadequate information or a false registration statement is damages: the price the purchaser paid for the securities less the market price of the securities at the time of the lawsuit. Damages may be assessed against the issuer, the chief executive officer, the chief financial officer, the chief accounting officer, the directors, the underwriter, and the experts (auditors or lawyers) who certified the statement or rendered an opinion with regard to its sufficiency. The issuer has no defense to a civil suit other than that the purchaser knew about the misstatement or omission when it purchased the security. Other defendants may use both that defense and also a “due diligence” defense: proof by the defendant (the defendant’s burden of proof) that after a reasonable investigation the defendant had reasonable grounds to believe, and did believe, that the registration statement was true and contained no material omission. Defendant experts must not act negligently (e.g., auditors failing to comply with generally accepted auditing standards). Non-experts meet their due diligence defense for parts contributed by experts if non-experts had no reason to believe, and did not believe, that the expertised parts misstated or omitted any material fact. (Ordinarily, non-experts need not investigate the experts’ work.)

For non-user defendants, three defenses to Section 11 liability are:

  1. the misstatement proved immaterial;

  2. the investor knew about the mistake but bought anyway; or

  3. the “due diligence” defense—(i) after “reasonable investigation” the defendant reasonably believed that the registration statements were true (what is reasonable depends upon the defendant’s financial sophistication and degree of involvement in preparing the registration statement); (ii) non-experts who reasonably believe an expert need not investigate the expert’s statements.


Willful violation of the Securities Act of 1933 or of rules and regulations promulgated by the SEC pursuant to the act carries a maximum fine of $10,000 and up to 5 years’ imprisonment.


Section 12 of the Securities Act imposes broad liability for any person (1) selling securities without a registration (unless exempt); (2) selling securities before their effective date of registration; or (3) offering or selling any security (whether registered or not) by means of an oral statement or a prospectus that misstates or omits a material fact. Liability also extends to parties that solicit such securities sales and who have a financial interest in those sales. Unlike for Section 11, liability under Section 12 requires privity: the right of private legal action extends only to the immediate purchaser. The defendant may escape liability if it could not reasonably have known of the falsity or omission. Except for exempted securities transactions, purchasers are entitled to recission; as with Section 11, plaintiffs need not prove that they acted in reliance on the wrongful conduct.


The Securities Act of 1933 requires that the public be given full information about new securities being offered for sale. This information is provided by filing a registration statement with the SEC and by preparing and furnishing a statutory prospectus for all persons to whom the securities are offered.

The 1933 act does not cover:

  1. Securities exempt by statute.

  2. Exempted transactions: (a) trading transactions and (b) private offerings.

  3. Securities in issues of limited dollar amounts under SEC-defined exemptions.

The Securities Act provides for both civil and criminal penalties.


The Securities Exchange Act of 1934 is a federal statute concerned with existing securities in the marketplace. This statute established the Securities and Exchange Commission to administer federal securities laws, including the 1933 Securities Act.


There are four major goals:

  1. To regulate the securities market and securities exchanges.

  2. To make available to persons who buy and sell securities information relating to the issuers of such securities.

  3. To prevent fraud in trading in securities.

  4. To prevent the use of insider information for the private gain of a privileged few, to the detriment of outsiders.



The Securities Exchange Act created the SEC and charged it with responsibility for administering the 1933 Securities Act and other federal securities laws. It requires that all stock exchanges, over-the-counter brokers, and dealers register with the SEC. A 1990 statute, the Market Reform Act, permits the SEC to regulate trading practices and even suspend trading during periods of extreme volatility (e.g., when program trading causes the stock market to rise or fall suddenly). The 1991 Securities Enforcement Remedies and Penney Reform Act further provides the SEC with far greater powers than almost any other administrative agency: authority to impose large fines, issue cease-and-desist orders, and obtain a federal court order barring a securities defrauder from ever serving as an officer or director of a publicly held corporation.


Every issuer with a 1933 Act registration or with securities traded on a national stock exchange must be registered with the SEC. If an issuer has gross assets in excess of $10 million and at least 2,000 stockholders (or at least 500 shareholders who are not accredited investors), securities traded in the over-the-counter market must be registered with the SEC.


Registration requires disclosure of: financial and organizational information concerning the business; terms governing outstanding securities; names of underwriters and security holders with at least 10 percent of any class of registered security; and balance sheets and profit and loss statements for each of the three preceding fiscal years.


  1. Annual report. The 10-K report to the SEC includes audited financial statements for the year of filing, together with certain required information about the business, its management, and its outstanding securities.

  2. Quarterly report. The 10-Q report is a quarterly, unaudited operating statement with an updated statement covering capitalization and shareholders’ equity.

  3. “Current” report. The 8-K report is an update covering any change in the amount of securities, any default under the terms of any issue of securities, an acquisition or disposition of assets, a company bankruptcy or receivership, a change in company control or in the business’ certifying accountants or in the fiscal year calendar, amendments to or waivers of the company’s code of ethics, a temporary suspension of trading under the company’s employee benefit plans, a revaluation of assets, and details concerning any other materially important event relevant to the larger aspects of the business. It must be filed within four business days after a reported material event has occurred. Such events are so frequent that a mandatory 8-K filing is very common.

The 22 reportable 8-K events include a broad range of items affecting gains and losses. Among the major developments requiring immediate disclosure are the departure and hiring of senior executives and directors, any mergers and acquisitions, all changes in the bylaws, and transactions that have contingent liabilities that could unexpectedly affect a company’s financial condition, entry into or termination of an important agreement, the creation or increase of an off-balance sheet obligation, unregistered sales of securities, and modifications to the rights of security holders.

The reports must be filed electronically with the SEC and are immediately publicly available. A reporting company’s filing obligations are suspended if: (1) it has fewer than 300 shareholders of record (1,200 shareholders for banks or bank holding companies); or (2) it has fewer than 500 shareholders of record and less than $10 million in total assets for each of its last three fiscal years.

Foreign corporations file annual reports with the SEC on Form 20-F or, for larger Canadian companies, Form 40-F. They do not have to file quarterly reports or 8-K reports. Still, some foreign companies voluntarily file Forms 10-K, 10-Q, and 8-K, mainly to compete with domestic companies by providing a body of more detailed, more frequent, disclosure documents comparable to those furnished by their U.S. competitors.

The SEC has held that corporations do not have to disclose merger negotiations if

  1. the corporation did not make any prior disclosures about those negotiations;

  2. no other SEC rules require disclosure; and

  3. management determines that disclosure would jeopardize completion of the merger transaction.


Pursuant to Section 13(d) of the Securities Exchange Act, the SEC requires the beneficial owner of more than 5% of any class of security registered under the act to file a notification statement with the commission, with the issuer, and with each exchange on which the security is listed. The purpose of this statement is to inform potential investors of a possible attempt to take over corporate management.


The SEC has established rules for the solicitation of proxies by management, those opposing management, and other persons involved in solicitations, consents, and authorizations, directed toward holders of registered securities or of debt securities. The proxy rules establish disclosure requirements to be met before solicitation, and—before any meeting—mandate full disclosure of material facts to stockholders (including shareholder proposals). SEC Rule 14a-3 requires that the proxy statement be accompanied by the annual report if the election of directors is to come before the meeting.


A tender offer is a bidder’s public offer to buy a company’s equity securities directly from its shareholders at a specified price for a fixed time period. Opposing offers are called hostile tender offers. The Williams Act (1968) amended the Securities Exchange Act to require bidders and target companies to provide shareholders with the information needed to make an informed decision. Most states have enacted statutes tending to protect the target company from a hostile takeover.


An insider is a director, officer, or owner of 10% or more of the corporate stock of an issuer listed on a national stock exchange. Section 16(b) of the Securities Exchange Act prohibits an insider from engaging in “short-swing” trading based on inside information not available to the public. The Securities Exchange Act provides that any profit realized by the insider because of either a purchase and sale or a sale and purchase of securities within any period of less than 6 months shall be recoverable by the issuer.

For purposes of the regulations, “insider” includes not only “top management” and controlling shareholders, but may include also any employee, broker, dealer, or consultant with access to special information. It may include relatives, friends, or other “tippees” of directors, executives, or other corporate fiduciaries. The tippees’ liability arises from trading based on their receiving (and not disclosing) confidential, inside information that they knew or should have known was nonpublic and that materially affects the value of the corporation’s securities such as the planned sale of the corporation or its assets, the issuance of dividends, mineral discoveries, or know-how and technological breakthroughs. Tippees are liable for their own inside trades (profits and penalties), and tippers also are liable for their tippees’ profits. A tippee can in turn tip other persons (remote tippees), with the original tippee now also a tipper.

Under 1984 and 1988 federal statutes, persons convicted of insider trading now face substantially harsher maximum penalties: up to $1 million in fines ($2.5 million for corporations), prison sentences up to ten years, and civil penalties that, in effect, could require payments of four times the profits gained or losses avoided. SEC Rule 10b-5 permits the SEC and private parties to sue for rescission and damages those who have knowingly (with scienter) engaged in fraud and thereby gained an unfair advantage in buying or selling securities. The rule, and Securities Exchange Act Section 10(b), apply to any communications with investors. Privity of contract is unnecessary, but 10b-5 claimants must show that they relied on the defendant’s wrongful conduct and that they actually purchased or sold securities while so relying.

In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), the Supreme Court held that there is no implied private right of action for secondary, aiding and abetting liability under 10b-5. Investors instead can only sue primary violators, who directly misstated or omitted material facts. Furthermore, in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008), the Supreme Court rejected the concept of “scheme liability”—that secondary defendants, such as banks, accountants, or attorneys, can be liable for taking actions integral to a fraudulent scheme undertaken in conjunction with the primary culprit, the party that communicated directly with investors. Under the Stoneridge holding, to win its 10-b case, a plaintiff must show that it actually relied on a defendant’s deceptive acts; the alternative, presumed reliance, is only sufficient for a winning 10-b or 10b-5 case if (1) the defendant had a duty to disclose information, and it failed to do so, or (2) the defendant’s allegedly deceptive statements became public (the fraud-on-the-market doctrine). Most defrauded investors cannot show that they meet one of these presumed reliance standards, and thus they cannot successfully sue bankers, lawyers, or other third parties who did not directly mislead investors but instead worked with corporations (e.g., Enron) that did so. Moreover, in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. __ (2014), the U.S. Supreme Court held that, before a class of plaintiffs is certified in a 10-b case based on the fraud-on-the-market doctrine, the defendant has the right to present evidence about the alleged misinformation’s impact on stock prices; “event studies,” for example, may play a central role in determining whether there was a statistically significant change in the company’s stock price when the misrepresentation was made or disclosed.

Statute 10-b & Rule 10b-5: Anti-Fraud Securities Laws

Very broad in scope, these laws cover almost any type of securities transaction (anything connected to interstate commerce). To win, plaintiffs must show that the defendant had scienter (knew or should have known that there was a misrepresentation). Under 10-b or 10b-5, only actual buyers or sellers of securities have standing to sue.


Margin requirements are restrictions placed on the percentage of the value of securities that may be borrowed to purchase the securities. The term margin refers to the amount that must be paid in cash. These restrictions are created to prevent the excessive, large-scale use of credit for the purchase of, and investment in, securities. The Securities Exchange Act provides that the Board of Governors of the Federal Reserve System shall prescribe rules and regulations with respect to margins and may set lower or higher margins (up to 100%) for securities investment.


The FCPA, a 1977 amendment to the Securities Exchange Act, is discussed in this book in Chapter 28.


The Private Securities Litigation Reform Act of 1995 (PSLRA), among other things:

  1. requires plaintiffs, for cases involving securities fraud, to present in their complaint details “giving rise to a strong inference” of fraud—scienter (as the Supreme Court held in Tellabs, Inc. v. Makor Issues & Rights Ltd., 127 U.S. 2499 (2007), plaintiffs would have to put forth a “cogent inference” of the intent to deceive “at least as compelling as any opposing inference of nonfraudulent intent”);

  2. provides that any discovery is frozen pending a judicial ruling on a defendant’s motion to dismiss;

  3. substitutes proportionate liability for the old law, under which every liable party was responsible for all damages; in most circumstances, under the PSLRA, the amount for which, say, a defendant accounting or law firm could be held liable would be only a fraction of the 100% for which it might previously have been sued; and

  4. creates a “safe harbor” zone of immunity for corporate forecasts—companies are not to be liable for inaccurate “forward-looking” statements that previewed earnings and products and were accompanied by meaningful, cautionary assertions (not merely boilerplate disclaimers) identifying important factors that could cause materially different results.

Responding to an increase in securities fraud cases in state court by plaintiffs seeking to avoid PSLRA standards, Congress in 1998 enacted the Securities Litigation Uniform Standards Act (SLUSA) requiring removal of many such cases to federal court: Only state securities cases that are not class actions and do not involve more than 50 plaintiffs can be tried in state court. However, there are a few exceptions—lawsuits by states or local governments, claims based on a contract between the issues and an indenture trustee, and the Delaware carve-out. This last exception lets shareholders otherwise barred by the SLUSA bring: (1) a state law derivative suit against directors or officers, such as for breach of fiduciary duty; or (2) a suit against a corporation and its directors if (a) the suit is based on the law of the state in which the issuer is incorporated; (b) the suit involves the issuer’s communication to its shareholders about the sale of the issuer’s securities; and (c) the suit concerns specified shareholder decisions, such as a response to a tender offer or the exercise of appraisal rights (dissenters’ rights).


In 2002, Congress enacted a long and detailed statute, the Sarbanes-Oxley Act (SOX), in response to a rash of corporate scandals. The act is meant to prevent or reduce accounting fraud and thus to bolster the investing public’s confidence in the integrity of reported financial data. To accomplish those purposes, SOX requires higher levels of disclosure, better internal controls and audits, and certification of financial documents by corporate officers. Publicly traded corporations must disclose in their annual reports information about their internal controls, the composition of their audit committees (which are to have solely independent directors), and their ethics codes. Violations can lead to corporate and individual penalties, as well as the forfeiture of compensation by corporate officers.1

What Companies Are Covered under SOX?

Both in the statute itself and by mandatory SEC and stock exchange regulations, SOX requires reports and corporate governance processes from a broad class of “Reporting Issuers”—U.S. and foreign companies that:

• list their securities on U.S. stock exchanges; or

• file registration statements to offer securities to the U.S. public (even if the registration statement has not been made effective and no securities have yet been sold); or

• register their shares and thus become subject to continuing SEC reporting requirements because they have more than $10 million in assets, 500 or more shareholders worldwide and, for foreign private issuers, at least 300 shareholders resident in the United States. Note that a foreign corporation may not have listed its shares or made a public offering of those shares in the United States, but it still could meet the reporting threshold of 300 or more shareholders in the United States due to private placements to U.S. residents or U.S. residents purchasing shares in foreign markets.

Besides creating new criminal offenses, the Sarbanes-Oxley Act provides that the many enforcement powers under the Securities Exchange Act of 1934 can be used to punish violations. Most public companies must file annual certifications in which chief executive and financial officers personally vouch for the accuracy of their corporations’ financial statements. Each officer is expected to swear, “to the best of my knowledge,” that these financial reports are accurate. If the executives will not attest to the report’s accuracy, they must file a statement explaining why.


Section 906(a) mandates that both the chief executive officer and the chief financial officer certify the financial statements included in each periodic report as: (1) fully compliant with the Securities Exchange Act of 1934, and (2) fairly presenting, in all material respects, the corporation’s financial condition and operations results. SOX’s other key requirements include Section 302 (Corporate Responsibility for Financial Reports) and Section 404 (Management Assessment of Internal Controls).

Under Section 302, a corporation’s chief executive officer and chief financial officer must each certify that they have reviewed the annual and quarterly report, that the report contains no untrue statement of material fact nor omits a material fact that would make the report misleading, and that to the certifying officer the report “fairly presents” the corporation’s financial condition, results of operations, and cash flows.2 A corporation must disclose all material off-balance sheet transactions and reconcile even its pro forma filings with the corporation’s financial condition under generally accepted accounting principles. Based on the most recent evaluation, the certifying officers need to disclose to the corporation’s audit committee and external auditors any significant deficiencies in internal control and any fraud involving management or other employees with a significant role related to internal control.

The certifying officers must establish, maintain, and evaluate the effectiveness of disclosure controls and procedures, which have to be current—evaluated within 90 days of any filing date. Any significant changes in internal controls for financial reporting or in other factors affecting internal controls, or any actions taken to correct significant deficiencies and material weaknesses, need to be disclosed in their reports.

SOX’s Section 404 requires companies to include in their annual reports a self-assessment of the effectiveness of their internal control structure and procedures for financial reporting, with each registered public accounting firm that prepares or issues an audit report for the company required to attest to, and report on, that assessment. The SEC—which is charged with enforcing the act—has adopted rules implementing Section 404 and requiring ultimate compliance even by small businesses and foreign-owned companies if they are publicly traded (an EGC is exempt).


SOX states that anyone who knowingly destroys, alters, conceals, or concocts documents or files that may relate to a federal investigation or a bankruptcy filing can be imprisoned for up to 20 years. Even without that provision, the legal doctrine concerning “spoliation of evidence” permits tort suits or direct judicial action (e.g., contempt of court, fines, directing a verdict against the offending party) if someone deliberately destroys evidence that a court order or subpoena ordered preserved, or that he/she knew or should have known was going to be sought. A well-written policy that calls for deleting documents (e.g., e-mails) after given periods of time adhering to applicable document-retention laws ordinarily works fine, but businesses must have a warning system in place by which corporate lawyers can advise employees to immediately stop erasing data when a lawsuit is anticipated, a bankruptcy is being considered, or a government agency is investigating the business.

SOX recognizes the value of corporate codes of ethics, which should help businesses handle conflicts of interests, disclosures in periodic reports, regulatory compliance, and internal reporting of violations. Corporations must disclose whether they have adopted a code of ethics, and they must rapidly disclose via Internet posting or 8-K report any change in or waiver of their code of ethics for senior financial officers (e.g., accounting officers and controllers) or—per SEC rules implementing SOX—for other principal executive officers. The SEC defines the term “waiver” to include “implicit waivers”: a company’s failure to respond within a reasonable time to an officer’s material violation of a code of ethics provision.


SOX imposes restrictions on accountants, including accounting firms that perform audits and consulting services for the same client. It raises criminal penalties for securities fraud, increases corporate financial disclosure obligations, and prohibits most corporate loans to senior corporate executives or directors. The act provides for a Public Company Accounting Oversight Board (PCAOB), whose five members (including the chairperson) must have exactly two current or former certified public accountants (CPAs), with the chairperson—if a CPA—not having practiced as one for at least the previous five years. The SEC appoints the board’s chairperson and other members, and the PCAOB promulgates rules, investigates firms, and otherwise regulates firms that audit publicly traded corporations, with a focus on quality control and standards for auditors’ independence from the companies they audit.3

All regulated audit firms, both American and foreign, must register with the PCAOB. SEC rules under the Sarbanes-Oxley Act call for the partner in charge of a company’s audit, and the partner who concurs in the audit opinion, to rotate off the account after five years of service and not be allowed to return to the audit for another five years. In addition, the PCAOB can review audits in some detail, providing an additional set of eyes to determine if an auditor followed proper procedures.

The act requires lawyers to report up the corporate ladder any discovery of past or impending securities law violations, beginning with the general counsel or chief executive officer, and, if ignored, then to the corporate directors or audit board. Under SEC rules pursuant to the act, lawyers may at some point be required to have a “noisy withdrawal”: resigning from service for a client corporation and disavowing improper filings to the SEC if up-the-ladder measures fail.

Most state laws, modeled after American Bar Association recommendations, give lawyers discretion on how to handle evidence of fraud so long as they are acting in the corporation’s best interests. Furthermore, as the SEC administers it, “minimum standards of professional conduct” have been established for the thousands of lawyers who practice before the SEC.

Whistleblowing, the False Claims Act, and SOX

The False Claims Act, first enacted in 1863 but later amended, and significantly strengthened, in 1986, is meant to help identify contractors guilty of defrauding the government. The Act encourages whistleblowing because whistleblowers shed light on why something is wrong and their insights can help hold the bad actors responsible, fix problems, and achieve reforms. The Act promises to whistleblowers an award qui tam (for “acting on behalf of” the government) of 15% to 30% of the money the government recovers.

SOX also calls for whistleblowing in the context of publicly traded companies, their advisors and officers, and the investing public’s need for timely, accurate information. Both SOX and the False Claims Act protect whistleblowers from being fired, but only the False Claims Act has triple damages and gives whistleblowers a reward.


Many states regulated the intrastate sale of securities long before the 1933 Securities Act. Since these statutes were enacted to protect unsophisticated investors from unscrupulous securities salespersons often peddling “the blue sky,” these statutes, now found in every state, are sometimes referred to as “blue sky laws.”

Unlike the federal securities laws, many of these state securities statutes do more than simply require information disclosures: these states have merit registration, which means that state authorities may deny registration as unduly risky, as promising too little in return, or both (finding the issuer’s business plan and proposed issuance are not fair, just, and equitable). A Uniform Securities Act, permitting state securities registration via the same statement filed under the federal Securities Act, has been enacted in most of the states and by the District of Columbia and Puerto Rico. The blue sky laws, together with the Securities Act of 1933 and the Securities Exchange Act of 1934, completely cover the intrastate and interstate regulation of securities.


The Federal Securities Exchange Act of 1934 established the Securities and Exchange Commission and is concerned with existing securities. It provides for the regulation of stock exchanges, brokers, and dealers; the registration of traded securities; the updating of reports; and the imposition of margin requirements.

The blue sky laws are state statutes and are similar in scope and purpose to the Securities Act of 1933. They require full-disclosure registration and a statutory prospectus.

Generally, private offerings (offerings to no more than 25 persons) are not subject to registration requirements under the state securities laws.


Lawyers and accountants, acting as employees or consultants (independent contractors), are an integral part of every corporate team having responsibilities for finance and securities. These attorneys and accountants are subject to tort suits for malpractice, as well as ethics inquiries reviewing their performance under the relevant professional code of conduct. These professionals also have extraordinary liability exposure in some instances under statutory law.



Section 11 of the Securities Act of 1933, imposing civil liability upon issuers of new securities for misstatements or omissions of material fact in registration statements, specifically includes accountants and financial officers within its sweep. A complaint against an accountant or financial officer under Section 11 is sufficient if it alleges (a) that the investor purchased the security pursuant to a registration statement that (b) contained a materially defective financial statement (c) certified by the accountant or financial officer, and (d) that as a result of the material defect the plaintiff suffered damages. Under Section 11, there is no requirement that the plaintiff relied on the materially defective financial statement. The plaintiff is not required to prove negligence; the accountant has the burden of proving due diligence (lack of negligence). The 1933 act also contains a statute of limitations: suit must be brought within 1 year after the omission or error was discovered or 3 years after the securities were offered to the public.

The Securities Exchange Act of 1934 imposes civil liability on accountants who furnish false or misleading statements in reports or documents filed with the SEC. Unlike a suit based on the 1933 act, in a Securities Exchange Act suit (based on Section 18) the accountant is faced with a lawsuit from a purchaser acting in reliance on the alleged false or misleading statement. As is the case with civil suits under the 1933 act, however, the plaintiff must prove damages proximately caused by the false or misleading statement.

The accountant’s usual defense is that he/she acted in good faith and without knowledge that the information was misleading.


The 1933 Securities Act provides that any defendant, including a participating accountant, may be criminally liable for a fine of not more than $10,000 or imprisonment of not more than 5 years, or both; the 1934 Securities Exchange Act provides for a fine of up to $1 million ($2.5 million for corporations) and/or imprisonment of up to 10 years. Violations of state securities laws carry similar criminal sanctions. The SEC can prohibit anyone who has committed securities fraud from being a public company’s officer or director.


Malpractice suits against professionals (doctors, lawyers, accountants, etc.) are based on three claims:

  1. There is a professional standard of care applicable to the services rendered by the professional.

  2. The professional employed by the plaintiff failed to conform to the standard.

  3. As a direct and proximate result of this failure to conform, the plaintiff suffered compensable damages.

Proof of the applicable standard of care is generally deduced in court by the testimony of other professionals who state the standard that they consider applicable to the circumstances of the case. The defending professional, although not necessarily disagreeing with plaintiff’s experts regarding the applicable standard of care, may disagree as to whether the defendant conformed to the standard. The applicable standard, as well as defendant’s conformity to the standard, is a question of fact to be determined by a jury.

For accountants, this standard usually is GAAP (generally accepted accounting principles) or GAAS (generally accepted auditing standards). GAAP and GAAS are embodied in the rules, releases, and pronouncements of the SEC, the American Institute of Certified Public Accountants (AICPA), and the Financial Accounting Standards Board (FASB). These principles and standards are especially important because courts and legislatures usually defer to the members of the accounting profession in determining what the ordinarily prudent accountant would do. Therefore, an accountant who fails to adhere to GAAP or GAAS runs a large risk of being held culpable for any resulting harm.


In preceding chapters we discussed the foreseeability standard in determining tort and contractual responsibility for damages to secondary and remote persons. In the case of product liability, for example, a manufacturer of defective goods is responsible to all persons in the chain of distribution whom he/she could foresee as a user and hence to any party who could reasonably be expected to suffer damages.

In a leading case (Ultramares Corp. v. Touche), 174 N.E. 441 (N.Y. Ct. App. 1931), the New York Court of Appeals refused to apply the foreseeability principle to damages based on an accountant’s alleged negligence. The court limited claims for damages to persons receiving the primary benefit of the accountant’s services (the Ultramares principle). These persons would be (1) those in privity to the accountant (clients) and (2) third-party beneficiaries of the accountant’s work—persons known to the accountant, with an identified, specific purpose for using the accountant’s works and in whom the accountant acted in a way calculated to induce reliance on his/her reports; liability would not extend further, to creditors and other third parties who might incidentally rely on statements and documents certified to be correct. This narrowly construed, primary benefit test is still used by courts in a dozen states, including New York. At the other extreme, only two states, Mississippi and Wisconsin, now hold the accountant responsible to any injured party whose existence and injury he/she might reasonably have foreseen.

Of the remaining states, about ten still have no case law directly on point, and around 25 states have an approach between the strict Ultramares principle and the broad foreseeability approach. It is the standard enunciated in Restatement (Second) of Torts Section 552: if the accountant knows the nature of the transaction for which his/her work will be used, then the accountant’s potential liability extends to any class of persons the accountant knows may thus rely upon his/her work. It is unnecessary for the plaintiff to be identifiable or known to the accountant as an individual when the accountant did his/her work. The accountant simply must have known, when delivering his/her work to a client, that the work’s recipient intended to transmit the information to a person or group of persons similar to that of the plaintiff. As an official comment to Restatement Section 552 notes, potential liability does not extend to “the much larger class who might reasonably be expected sooner or later to have access to the information and foreseeably to take some action in reliance upon it.” As broadly stated in United States v. Arthur Young & Co., 465 U.S. 805 (1984), accountants must serve a broad public interest and have the duty “to preserve the integrity of the securities market.”



  1. What are some advantages and disadvantages of raising corporate capital by equity financing vis-à-vis debt financing?

  2. What is the principal difference between a bond and a debenture?

  3. In what three ways do common shareholders have an interest in the corporation?

  4. How may shareholders influence the directors’ decision to declare a dividend?

  5. What is a nimble dividend? What general dividend requirement does a nimble dividend violate?

  6. Under what theory of contract law can creditors sue subscribers to the stock of a corporation not yet formed? Does this violate the privity rule?

  7. State how a UCC section can give the corporate issuer access to information about uncertified ownership of the corporation’s shares?

  8. What are some reasons for restricting the free transfer of share certificates?

  9. Which came first, state or federal regulation of the issuance and marketing of securities?

  10. Why are the common law rules of fraud and misrepresentation insufficient to protect investors from unscrupulous securities salespersons? In any case, does the modern day rule of caveat venditor (“let the seller beware”) not afford the gullible investor sufficient legal protection?

  11. Does allowance by the SEC of a statutory prospectus constitute SEC approval of the securities described or of the prospectus?

  12. What is the underlying rationale for various exemptions to the federal securities laws?

  13. Is the term “insider” limited to a defined group?

  14. Why should accountants receive special attention for civil and criminal liability under the securities laws?

  15. Is a professional malpractice case merely a “swearing contest” between two sets of professional “experts,” with one set claiming that the defendant’s professional work did not conform to the standard of care, the other set claiming that the work did conform?



authorized shares

blue sky laws

call price

canceled shares

capital surplus

common shares


convertible bond

cumulative preferred stock


debt security

discount shares



due diligence

equity security

exempted transaction

fraud-on-the-market doctrine



issued shares

malpractice suit


merit registration

nimble dividend

noncumulative preferred stock

nonparticipating preferred stock

no-par shares


par shares

participating preferred stock

preferred shares


red herring prospectus


registration statement

retained earnings


statutory prospectus

stock option

stock split

street certificate


tender offers

tombstone advertisement

treasury shares

UCC Article 8

Ultramares principle

voting rights


  1. ABC Gulf Investment Co. owns 1000 acres of gulf-front property in Manatee County, Florida. It flies 35 persons of “substantial” means from various parts of the country to Tampa to tell them of the “opportunity of a lifetime.” The “opportunity” is the offer of a contract with ABC to buy 20-acre tracts of “prime” undeveloped land, designated on a property plat, for a price of $100,000 each, payable over 30 years. Twelve persons, including Shuster, sign contracts. If the only written information concerning the property was a promotional brochure, can Shuster void this contract on ground of illegality?

  2. Sawyer is the owner of a large, unincorporated country estate on which is located an established golf course. Approximately 100 persons regularly play golf on the course, paying semiannual dues for the privilege.
    Sawyer needs to raise $1 million to build a club house and put the course in “first-class” condition. He proposes to create a corporation and issue $1 million of $10-par-value capital stock. Each of the 100 present members signs a stock subscription agreement for 1000 shares of stock, and Sawyer enters into contracts with builders and developers for the work. Sawyer defaults on these contracts, and the contractors bring suit on the subscription agreements. What should be the result?

  3. In Problem 2, suppose that Sawyer wishes to form a corporation in Kentucky (where the golf course is situated) and sell the capital stock, all as described, to the present members, under Kentucky’s blue sky law, which has essentially the same registration and prospectus requirements as the federal Securities Act of 1933. However, the capital to be raised is $2 million of which $1 million (100,000 $10-par-value shares) will be issued to Snead, for which Sawyer will deed the country estate to the corporation.
    Discuss the following:

(a) The liability of Jones, CPA, for errors in Sawyer’s financial statements leading to an overstatement of the value of Sawyer’s estate in the amount of $300,000.

(b) The liability of Sawyer for violation of the Securities Act of 1933 if 12 of his members, residents of Ohio, resell their shares in Ohio within 6 months.



  1. Equity financing does not have to be repaid; however, ownership and control of the business enterprise must be shared with equity investors. Although issuance of debt securities may not require sharing ownership or control, the necessity of repayment may limit the scope and freedom of corporate activity.

  2. Both are long-term debt securities; however, a bond is secured, whereas a debenture is unsecured. Both bonds and debentures are subject to the terms of indenture agreements.

  3. Common shareholders may vote for directors and on other fundamental matters; they may participate in the distribution of dividends; they may share in the distribution of net assets after dissolution and liquidation.

  4. Shareholders may influence the directors’ decision to declare a dividend only through their power to elect or reject directors. Unless the directors abuse their discretion with respect to dividends, shareholders play no role in the dividend process.

  5. A nimble dividend is a dividend payable from current earnings even though there are debts outstanding from previous years. Such dividends are not permitted in most states because of the general requirement that dividends be paid only from earned surplus.

  6. The privity rule states that only a person who is a party to a contract can sue on that contract. However, there are two classes of third-party beneficiaries who can bring suit without privity: donee beneficiaries and creditor beneficiaries. If it is assumed that the subscriber could reasonably anticipate that creditors of the embryonic enterprise would extend credit in reliance on his/her promise to purchase stock, the subscriber should be legally responsible to such “creditor beneficiaries.”

  7. Section 8-102 of the Uniform Commercial Code requires that uncertificated shares be “registered upon books maintained for that purpose by or on behalf of the issuer.” The corporate issuer can access this registration.

  8. To retain voting controls within a defined group, to preserve an S corporation or a close corporation, or to maintain exemption from federal or state security laws requiring registration for public offerings.

  9. State regulation came first. The state of Kansas was the first regulator of securities, passing its underlying statute in 1911. However, many states did not enter the field of intrastate regulation until many years after the passage of the basic federal laws in 1933 and 1934.

  10. Modern law places a great burden on sellers to make full disclosures to buyers, particularly where there is a disparity of education and training between them. However, the 1933 Securities Act not only requires full disclosure of all relevant facts, but also defines the nature and extent of that disclosure. Reliance on general principles of caveat venditor would leave the parties uncertain of their rights and duties without resorting to litigation in every case.

  11. The SEC explicitly takes no position with respect to the securities or to the accuracy or adequacy of the prospectus. The SEC has no duty or responsibility to investigate the contents of the registration statement or of the prospectus, even though these documents are in complete statutory and regulatory form. Both civil and criminal liability attach to the issuer for omissions and inaccuracies in these documents. The SEC cannot lead the public to believe that such omissions and inaccuracies do not exist.

  12. The primary purpose of the federal securities laws is to protect the investing public. To the extent that an investor is sophisticated or informed, he/she requires less protection. The evils that the legislation was designed to prevent involve large-scale promotion of dubious and ill-designed plans or of schemes for the secret profit of their promoters.

  13. Although the term “insider” basically means “top management” and controlling shareholders, it extends to any party with inside knowledge or information giving him/her an unfair advantage over ordinary members of the investing public. Included are employees, consultants, and total outsiders who are “tipped off” directly or indirectly by insiders.

  14. As the compilers and preparers of financial data, accountants are in a unique position to mislead or deceive (intentionally or carelessly) not only regulators but also issuers and their managers, as well as the investing public.

  15. Almost every case in a court of law turns on the credibility of con-flicting witnesses. In Chapter 3 we learned that the strengths and weaknesses of both defendant and plaintiff are explored in pretrial discovery. If experts cannot be found to testify truthfully and conscientiously for one side or the other, litigation may not proceed to trial or the case may be settled without trial. In any event, the jury will have full opportunity to evaluate both sides as presented by opposing experts.


  1. The question presented is whether the contracts to purchase the real estate tracts are “securities” within the meaning of the Securities Act of 1933. Of the four tests laid down in the Howey case, the fourth—the expectation of profits solely from the efforts of a promoter or third party—is clearly lacking. As a matter of fact, this contract is an ordinary real estate contract. Such contracts have been treated by the courts as a mere interest in a joint venture to sell real estate. Of course, the offer to sell to 30 persons and the interstate nature of the transaction might bring the matter to the attention of the SEC. However, since the contract is not a “security,” there is no violation of law.

  2. Persons relying on the subscription agreements would be able to sue subscribers who had not paid the agreed-upon subscription price. On the assumption that the contractors know of the subscription agreements, they should be successful in their litigation.

  3. (a) On the assumption that the Kentucky blue sky law and any application of professional liability thereunder would follow the Securities Act of 1933, Jones, CPA, would be liable not only to the Kentucky authorities, but also to Sawyer and other persons with whom he had a direct contract. He may also be liable to investors who may have relied on his erroneous financial statements. Under the broader interpretation of accountant liability, he would be responsible to all persons whose injury or loss he could have foreseen. The Kentucky blue sky law would be applicable since the offering is to 100 persons and would be a public sale subject to the Securities Act.

(b) If the securities were sold to residents of Ohio who came to Kentucky to purchase these securities, the out-of-state residency would not itself cause the transaction to be an “interstate sale” unless there is a “scheme” to violate the federal statute. The facts given do not suggest such a scheme, and there would appear to be no violation of federal law in failing to file a registration statement under the 1933 act. However, the securities cannot be sold by the Ohio residents or by other purchasers outside the state of Kentucky for at least 9 months.

1 For example, if a public company engages in material noncompliance with SOX financial reporting mandates, and the company must restate its financial statements, the company’s chief executive officer and chief financial officer must reimburse the company for all bonuses, securities trading profits, incentive pay, or other compensation they made due to the noncompliance.

2 Knowing, willful violations are punishable with fines and up to 20 years in prison.

3 Auditing companies are prohibited from performing these services for those businesses that they audit: (a) bookkeeping and related services; (b) financial information systems design and implementation; (c) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (d) actuarial services; (e) internal audit outsourcing services; (f) management or human relations functions; (g) broker, dealer, investment advisor, or investment banking services; and (h) legal services or other expertise unrelated to the audit. While tax services usually are permitted, the audit company cannot help a client by taking an “aggressive interpretation” of applicable tax laws and regulations, by planning or opining on the tax consequences of a listed or confidential transaction (as defined by Treasury Department regulations), or by assisting the immediate relatives of, or the individuals themselves, who in the audited firm perform financial reporting oversight roles.





crime a public wrong, committed with intent or by negligence, for which the law provides punishment or recompense to society

tort a private wrong against a person or his/her property. Aside from certain limited circumstances, all torts arise from either an intentional, wrongful action or from a negligent action.

burden of proof the degree of proof necessary for a criminal conviction (beyond a reasonable doubt) or for a successful civil suit (preponderance of evidence)

Most court cases fall within one of three major divisions of law: crimes, torts, or contracts. This chapter focuses on crimes and torts. Although these two broad subjects are not usually as important to business as are contracts, businesspersons often also must deal with torts or crimes. Therefore, any serious student of business law must know about them.

This chapter compares crimes and torts, provides examples, and discusses defenses.


American criminal law is primarily codified law, based on statutes and regulations rather than merely on past judicial decisions. The same act or omission may be a crime under both federal law and state law. For instance, murder, a state crime, may also be a federal crime (e.g., a violation of the victim’s civil rights) and thus may be prosecuted in separate criminal cases in each of the two court systems. (Certain legal doctrines, as well as basic fairness, however, sometimes limit the use of such dual trials.)


A fundamental premise of our criminal justice system is that it is far worse to convict one innocent person than to let many guilty people go free. The procedural guarantees for alleged criminals are thus much greater than for civil defendants. Many, if not most, of these guarantees are found in the state and federal constitutions, particularly the Fourth, Fifth, Sixth, and Eighth Amendments to the U.S. Constitution. Almost all rights in those amendments have been incorporated into the Fourteenth Amendment’s due process clause, as described in Chapter 2. Thus, criminal procedure is now generally governed by nationwide standards of constitutional interpretation.

The Fourth Amendment protects against unreasonable searches and seizures and requires probable cause before a search warrant or arrest warrant is issued. Some case law exceptions to the search warrant requirement are: “hot pursuit” of a suspect, evidence in plain view or about to be destroyed, searches of arrested persons, and good faith police behavior. Also, when an arrest for a serious offense is supported by probable cause, the suspect’s being required to furnish a DNA sample is—like being fingerprinted and photographed—constitutional; the evidence can be used for that case or other, different charges against the suspect. Maryland v. King, 569 U.S. ___ (2013). On the other hand, police cannot, without a search warrant, search the data on a cell phone seized from the arrested person. Riley v. California, 573 U.S. ___ (2014).

The Fifth Amendment prohibits compulsory self-incrimination; hence people sometimes “take the fifth” rather than testify. Other provisions include a prohibition against double jeopardy (trying someone again for the same crime once he/she has been acquitted of that crime) and the federal due process clause (comparable to the Fourteenth Amendment’s state due process clause; see Chapter 2). The amendment is a constitutional basis for our presumption of a criminal defendant’s innocence.

The Sixth Amendment outlines the criminal defendant’s right (1) to a speedy and public trial by an impartial jury, (2) to know the charge against him, (3) to confront and subpoena witnesses, and (4) to have a lawyer. Under the doctrine announced in Miranda v. Arizona, 384 U.S. 436 (1966), any person about to be interrogated who “has been taken into custody or otherwise [significantly] deprived of his freedom” must be warned that (1) he has a right to remain or become silent, meet with an attorney before any questioning, and have a lawyer present during questioning; (2) anything he says can be used as evidence against him; and (3) if he wants a lawyer but cannot afford one, the state will provide one free of charge.

The Eighth Amendment prohibits excessive bail, excessive fines, and cruel and unusual punishment.

A Criminal Defendant’s Testimony: Comparative Law

There are three basic approaches to a defendant’s testifying:

  1. Some countries do not let the criminal defendant refuse to take the stand (e.g., in China, the defendant has no right to remain silent). In Germany, the defendant cannot testify as a witness and, therefore, does not enjoy the privilege against self-incrimination. Also, in France, defendants cannot prevent questions from being posed, although they can refuse to answer particular questions.

  2. Some nations protect criminal defendants against self-incrimination, but allow the judge or jury to draw an adverse inference from a defendant’s decision not to testify. In 1997, Great Britain abandoned the U.S. standard and adopted this approach—no required testimony, but prosecutors can ask the judge/jury to draw adverse inferences. Great Britain thus permits the judge or jury to presume that the nontestifying defendant had something to hide, such as guilty conduct.

  3. The U.S. approach—no required testimony and no adverse inference—is a relatively rare protection for the accused (e.g., this approach is also followed in Argentina, Canada, Israel, Italy, Morocco, and Russia).


The three classes of common law crimes are treason, felonies, and misdemeanors.

Treason against the United States, the only crime defined in the U.S. Constitution, is a comparatively rare charge.

The distinction between a felony and a misdemeanor is usually found within each state’s criminal code. Felonies are more serious crimes, punishable by imprisonment. Murder (which can carry the death penalty in most states), manslaughter, aggravated assault, arson, bribery, burglary, embezzlement, forgery, grand larceny, kidnapping, price fixing, rape, robbery, and tax evasion are felonies. Misdemeanors are generally punishable only by fines or, at most, a brief stay in the local jail. Simple assault, disorderly conduct, gambling, petty larceny, prostitution, and trespass are usually classified as misdemeanors. Certain minor offenses, such as violations of city ordinances or traffic regulations, may not even be considered misdemeanors in some jurisdictions (i.e., they are too petty to be labeled as crimes, and are often called “infractions” or “violations”).

Three other ways of categorizing crimes are these:

  1. White-collar: nonviolent crimes, perpetrated by people in positions of trust, usually against businesses or governments.
    Examples: embezzlement, mail fraud, bribery.

  2. Organized: crime by groups in the “business” of crime, such as the Mafia.

  3. Victimless: crimes that are sometimes considered to have no specific victims (just society as a whole).
    Examples: prostitution, gambling, tax evasion

Crimes can also be classified according to whom or what they are committed against: a person (e.g., assault, battery, kidnapping, manslaughter, murder, rape), the government (e.g., bribery, perjury), the general public (e.g., antitrust or environmental violations, food and drug law violations, disorderly conduct, trafficking of illegal narcotics), the home (e.g., burglary), and other property (e.g., blackmail, embezzlement, forgery, larceny).


In most cases, a crime must include both a criminal act (actus reus) and a criminal intent (mens rea).

Example: No Actus Reus

Dave Deviant thinks about assaulting Veronica Victim, but does nothing about it. No crime, not even attempted assault.

Example: No Mens Rea

Ida Innocent, through no intent, negligence, or other fault of her own, collides with Veronica Victim and kills her. No crime.

Usually, a person is presumed to intend the natural consequences of what he/she knowingly does. Moreover, in a felonious action, the doer may be deemed responsible for even unwanted results, that is, mens rea is transferable from the intended felony to the one that actually occurred.

Example: Unintended Harm

Ed Evildoer, maliciously attempting to throw a brick through Ida Innocent’s window, instead hits Ida. Ed is guilty of criminal assault and battery, although he intended a lesser, property crime.

Example: Unintended Victim

Betty Bad puts poison in Ivan Innocent’s coffee. However, Todd Toughluck drinks the coffee instead and is injured. Betty is guilty of criminal assault and battery on Todd, although she meant him no harm. Her intent to injure Ivan is transferable.

Only certain specific-intent crimes (e.g., burglary and arson) require proof of intent to commit that particular crime.

In statutory law, unlike the common law, some crimes either presuppose or do not require criminal intent; the forbidden act is a crime per se. Such laws are most commonly found in state or municipal traffic codes, food and drug purity/safety laws, and liquor or narcotics laws (e.g., proof of alcoholic beverage sales to a minor is a crime even if the seller did not intend to sell to a minor).

Note that the law distinguishes between intent and motive. Intent involves an express or implied desire to perform a particular act; it is a state of mind preceding or accompanying the act. Motive is the overall goal that prompts a person’s actions, and good or bad motives may be taken into account in assessing punishment.



A criminal case passes through several phases before trial. First, the crime is reported and investigated. Then, if there is probable cause, that is, reasonable grounds—something more than mere suspicion, to believe that a particular person committed the crime, that person can be arrested. A warrant for arrest is necessary unless the pressure of time requires immediate action (e.g., before the suspect flees).

Searches and Seizures

Routine Collection of Data

In Maryland v. King, 569 U.S. __ (2013), the Supreme Court held 5–4 that police can collect DNA through swabs of the cheek from people arrested for serious crimes and keep that data for future use (as to other crimes), even against a person who was not convicted of the crime for which the swab was taken.

Random Searches Are Okay

Generally, warrants are needed for both searches and arrests. Random or systematic searches may be okay. For example, in Illinois v. Caballes, 543 U.S. 405 (2005), the Supreme Court found it constitutional for police to use drug-sniffing dogs to check stopped cars whose drivers gave police no particular reason to suspect illegal activity.

Different National Rules for Warrants

Whereas the United States, Canada, and some other nations ordinarily require that warrants must be preceded by the approval of judicial authorities, other countries (e.g., China, Italy, South Africa) permit warrants simply to be issued by prosecutors or the police. Not in the United States but in many nations (e.g., Argentina, China, France, Israel, Russia), during the search of a dwelling, witnesses are required. Again, not in the United States but in a number of nations (e.g., Argentina, England, France), searches may not—absent special circumstances—occur at night.

Finally, criminal charges must be lodged against the defendant. Depending on the state, the charges, usually called either an indictment (by a grand jury) or an information (by a magistrate or police officer), must be based on probable cause, preponderance of evidence, or prosecutor’s evidence that supports a belief in the defendant’s guilt. (For information on extradition.)

Most cases are resolved without a trial. Prosecutors and defense counsel usually reach a plea bargain. The judge must decide whether the guilty plea was freely given and whether there was some factual basis for the plea, but judicial disapproval of an agreed-upon plea is rare.

In Padilla v. Kentucky, 559 U.S. 356 (2010), the U.S. Supreme Court held that a defense lawyer’s bad advice, which persuaded a defendant to plead guilty, amounted to ineffective assistance of counsel (and entitled the defendant to have his/her conviction overturned, with the prosecutor then deciding whether to proceed against the defendant again). In Missouri v. Frye, 566 U.S. ___ (2012), the U.S. Supreme Court held that the constitutional guarantee of a fair trial extends to pre-trial actions such as plea bargains: “defense counsel has the duty to communicate formal offers from the prosecution to accept a plea on the terms and conditions that may be favorable to the accused.” In Lafler v. Cooper, 566 U.S. 1 (2012), the Court held that defendants are entitled to a remedy when they show (1) a reasonable probability they would have accepted the plea bargain offered had they not received bad advice from their lawyer (in effect, the advice was absurd enough to violate the defendant’s Sixth Amendment right to effective assistance of counsel), and (2) the trial court would have accepted the guilty plea. In such cases, the trial court would then have the discretion to replace the stiffer sentence given after a conviction with the plea agreement, or to throw out part of the conviction and resentence accordingly, or to leave the original, stiffer sentence in place.


At trial, there is a crucial difference between criminal and civil cases in the level of proof required.

A civil plaintiff merely needs a preponderance of the evidence; the judge or jury need only find that the evidence favors the plaintiff over the defendant.

A successful criminal prosecution requires proof of guilt beyond a reasonable doubt.

Absolute proof is not mandatory; the prosecution need not eliminate all doubts—merely all reasonable doubts.

A verdict of “not guilty” does not necessarily mean that the judge or jury believes the defendant to be innocent. It is simply a finding that there was insufficient evidence to prove guilt beyond a reasonable doubt.

Comparative Law: The Presumption of Innocence

While they may not adopt a standard as rigorous as “proof beyond a reasonable doubt,” most countries accept the concept that the criminal defendant is presumed innocent and that the state must prove his/her guilt. This presumption is increasingly a fundamental concept not just in common law countries, but worldwide. For example, the European Convention on Human Rights and Fundamental Freedoms (Rome, 1950)—now adopted by almost every nation in Europe—recognizes in its Article 6(2) that “Everyone charged with a criminal offense shall be presumed innocent until proven guilty according to law.”


Criminal trial courts have numerous, complex rules about what evidence is admissible, and how it may be introduced. The rules are supposed to exclude irrelevant, unreliable, or unfairly prejudicial matters, especially in jury cases. (The system presupposes that a judge is less likely to be swayed by improper evidence.) The judge’s or jury’s verdict is to be based solely on the evidence properly brought out at trial. Otherwise proper, highly relevant evidence may be excluded because it was obtained in violation of a defendant’s constitutional rights. Criminal appeals often are decided on such so-called technical issues.


Appellate courts cannot overturn a verdict simply because they disagree with it—e.g., with how the jury weighed the evidence and decided to believe one witness more than another witness. Appeals tend to focus on problems in the trial judge’s legal rulings, the instructions to the jury, and the trial procedures, not simply in the jury’s or judge’s factual interpretations.

Ironically, the factor that studies indicate is most typically linked to an erroneous conviction—eyewitness error—is not generally something that can be challenged directly on appeal. Factual assessments, such as to witness credibility, are for the trial court judge and jury. Thus, challenges on appeal go more toward procedural defects or other legal problems that may indirectly have led to, or at least kept from scrutiny, witness errors or other such mistakes.


In both federal and state criminal cases, the most important aspects of the investigation, arrest, and trial are governed by guarantees contained in the U.S. Constitution, particularly the Fourth, Fifth, Sixth, and Eighth Amendments.

Crimes are generally classified as either felonies or misdemeanors. Felonies are the more serious crimes, with harsher punishments.

Other labels include white-collar, organized, and victimless crimes.

At common law, actus reus (criminal act) and mens rea (criminal intent) were the two necessary elements of a crime. These two concepts remain important, although some statutory offenses are crimes per se, with the mens rea requirement presumed or eliminated.

Arrests and searches must be based on probable cause, not mere suspicion. Criminal charges may have to meet an even higher standard. At trial, guilt must be proved beyond a reasonable doubt.

Rules of evidence, designed to exclude irrelevant, unreliable, or unfairly prejudicial matters, control the version of the facts presented at trial. Constitutional guarantees may necessitate further restriction of evidence.

Since the judge or jury is supposed to consider only the evidence properly introduced at trial, and since the prosecution must meet a high standard of proof, “not guilty” is not a synonym for “innocent.”


A tort is a private wrong, a trespass against a person or his/her property, for which a damages award or other judicial remedy may be sought. Most torts arise from either an intentional, wrongful action or from a negligent action. Many actions that constitute torts also constitute crimes, and most crimes involve tortious acts. Thus a single action may result in two trials: a criminal trial and a tort (civil) trial.



To constitute an intentional tort, the defendant’s act must be expressly or implicitly intended; the resulting harm need not be intended, but must have been reasonably foreseeable. Examples of intentional torts are assault and battery, false imprisonment, slander, and invasion of privacy.


In a tort case arising out of negligence, the plaintiff must show four things: (a) there was a duty imposed on the defendant in favor of the plaintiff, (b) the defendant breached (violated) that duty, (c) the breach was the proximate (natural and foreseeable) cause of the harm (causation), and (d) plaintiff suffered damages.

Example: Tort of Negligence

Suppose that a building collapses, and X thus wants to sue architect Y for negligence. To win, X must prove that (a) Y designed or was responsible for the design of the building; (b) Y had a duty to design, or review the designs of, the building in accordance with reasonable standards of her profession; (c) this duty, owed to present and future passersby, people in the building, and persons with property in or near the building, covered X; (d) the duty was breached by Y; (e) if Y had exercised due care, the building would not have collapsed; and (f) the collapse damaged X or his property.


The duty (standard of care) is that of a reasonable, prudent person acting with ordinary care and skill (the “reasonable man” standard). What would a reasonable person do in the situation faced by the defendant? This hypothetical person is given the defendant’s physical attributes, including age, but is treated as having average intelligence and temperament. However, a highly educated or skilled defendant (e.g., a person accused of professional malpractice) may be held to a standard commensurate with his/her actual knowledge and ability.

In some cases, both duty and breach are, in effect, automatically demonstrated because the defendant’s conduct constituted negligence per se. Per se means “in and of itself” or “by itself.” In the context of negligence, per se means that there has been a violation of a rule (e.g., a statute, regulation, or ordinance), and that violation, by itself, proves duty and breach. The plaintiff, to win, must be a member of the class of persons protected by the rule, and the plaintiff’s harm must be of the type that the rule was intended to prevent. Suppose that a statute requires nursing homes to install hand railings along all walkways at the home. An able-bodied young adult visitor to the nursing home is injured in a fall that would have been prevented by a railing. Under this interpretation, since the statute was not meant to protect this visitor (but to protect the elderly or otherwise inform nursing home residents), most courts would probably not invoke the negligence per se doctrine. For example, dumping hazardous waste in violation of environmental statutes or Environmental Protection Agency regulations, or speeding through a red light (violating a traffic ordinance) would be negligence per se scenarios. However, in all cases, the plaintiff would still need to show the other two elements of negligence: harm (generally of the type that the rule is intended to prevent—the “protected harm”) and causation.


Breach of duty is not enough. The plaintiff must also prove causation in fact: that the damages would not have occurred but for the defendant’s wrongful acts. An act need not be the sole or immediate cause of the damages. In fact, when two or more defendants act wrongfully, the defendants may be held jointly and/or severally liable; each defendant is liable for plaintiff’s entire damages.

The second issue in causation, proximate cause (also called legal causation), involves foreseeability. Were the plaintiff’s damages the natural and probable consequences (that is, closely and significantly connected to) of the defendant’s unreasonable acts? Although caused by the acts, the harm to the plaintiff may be so remote in time, distance, or chain of events that causation is not proximate. That is, the defendant’s legal responsibility does not extend to all consequences of his/her actions—just to the harms tied closely enough to the actions for which, as a matter of justice or social policy, the defendant should be liable.

A term referring to causation is “scope of liability,” which may encompass (1) “a continuous sequence” substantially contributing to the alleged damages, and (2) the requirement that “but for” the negligence, the injury would not have occurred. Legal or proximate cause thus deals with the presence or lack of intervening or superseding causes (sometimes requiring a direct connection between the injury and foreseeability).

Business Law, 6th edition (Business Review Series) (30)

Classic Case on Foreseeability: Palsgraf v. Long Island R.R. Company, 162 N.E. 99 (Court of Appeals of New York, 1928)

A man carrying a package was rushing to board an already moving train. Two railroad guards helped to get him aboard, and the man dropped his package, which contained fireworks. Nothing about the package would have caused someone to discern its contents. The package exploded. The shock waves caused decorative scales to fall from the station’s ceiling onto Mrs. Palsgraf, who was standing some distance from the three men and the explod-ing package. A divided court held that Mrs. Palsgraf was not a foreseeable plaintiff; hence there was no duty. This is the approach taken by most courts, but some courts and the Restatement (Third) of Torts (Scope of Liability, § 29) consider plaintiff-foreseeability to be a matter of proximate cause.

Using Experts to Prove the Case

In Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993), the U.S. Supreme Court limited the admissibility of scientific testimony. The Daubert standard is that “expert” opinions that are not scientifically reliable should be excluded, that is, kept out of the evidence admitted at trial. The court ruled that, under Federal Rule of Evidence 702, the admission or not of scientific testimony depends on (1) whether the theory or technique is generally accepted (supported in the scientific community); (2) whether it has been subjected to peer review and publication; (3) whether it can be tested (done according to proper scientific methods); and (4) whether the known or potential error rate is acceptable. In summation, Daubert holds that courts must ensure that “all scientific testimony or evidence admitted is not only relevant, but reliable.”

In Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999), the Supreme Court applied Daubert to nonscientific expert witnesses, such as engineers and other specialists. The court unanimously concluded that the Daubert holding “applies not only to testimony based on scientific knowledge, but also to testimony based on technical and other specialized knowledge,” including new technology, databases, and computer simulations. Trial judges must, the Kumho Tire court stated, “make certain that an expert, whether basing testimony upon professional studies or personal experiences, employs in the courtroom the same level of intellectual rigor that characterizes the practice of an expert in the relevant field.”


Malpractice is especially in the context of the securities laws. In essence, malpractice is the failure to adhere to professional standards. It is negligence in a professional context. Therefore, the breach of duty in a malpractice case is the failing to do what a competent, reasonable doctor, attorney, accountant, engineer (or whatever the profession be) would have done in those circumstances. The failure is measured by the standards for professionals in that field—e.g., cosmetic surgery, probate law, tax accounting—not what ordinary people (lay-people) would or could have done. As an example, note that medical malpractice could encompass not just poor diagnosis or treatment of a patient, but also the lack of a patient’s informed consent. Patient P gives his/her informed consent to a particular treatment, T, only if (1) P receives a thorough disclosure concerning T; (2) P acts voluntarily; (3) P is competent to give consent; and (4) P in fact consents to T.



When a certain type of accident occurs ordinarily because of negligence, and the defendant had exclusive control of the instrument causing the injury (e.g., an airplane that crashed, a scalpel left in a patient’s stomach), a presumption arises that the defendant was negligent. Res ipsa loquitur (“the thing speaks for itself”) shifts the onus of coming forward and explaining the occurrence to the defendant. The ultimate burden of proof (looking at the res ipsa loquitur inference and all other evidence), however, remains with the plaintiff.


Respondeat superior is the doctrine by which an employer may be liable for the tortious acts of an employee if the employee was acting in the scope of employment. Of course, regardless of respondeat superior, the employee is him/herself liable for his/her actions. This concept is discussed further in Chapter 14. Incidentally, parents generally are not liable for torts by their children.

Comparative Law: Islamic Law and Respondeat Superior

The doctrine of respondeat superior is well established in the legal systems of the United States and most Western countries. However, many predominantly Islamic countries only narrowly employ the doctrine. Islamic law, codified in the Sharia, holds to a strict principle that responsibility for human actions lies with the individual and cannot be vicariously extended to others. To find an employer liable for the acts of its employee, the Sharia looks for direct orders from the employer to its employee. Absent the employee obeying a direct order of the employer, the employee’s actions—and liability therefrom—do not extend beyond the employee to also include the employer.


Under the doctrine of strict liability, the defendant is liable for the plaintiff’s injuries despite the absence of negligence or intentional, wrongful acts. If the defendant was engaged in abnormally dangerous activities (e.g., blasting with dynamite, crop dusting, keeping wild animals), especially activities unusual for that locale, courts and legislatures have decided that he/she should bear the cost of any harm done. As in other areas of liability without fault (e.g., products liability, workmen’s compensation), the strict liability of some manufacturers or employers is a matter of public policy based on the assumption that these defendants are in a better position to shoulder the costs of injury than are potential plaintiffs.


Lawsuits involving torts are tried in civil courts and generally follow the procedures outlined in Chapter 3.

Some Congressional bills and Justice Department proposals are: make product liability laws uniform, in both federal and state courts (either for all aspects of a case or at least the punitive damages issue); establish a national statute of limitations; bar suits involving long-standing products (ones used in the workplace for many years, e.g., machines 15 years old or older); limit punitive damages; bar punitive damages for defects in a product that the Food and Drug Administration approved (so long as the manufacturers did not deceive the FDA); require arbitration or another alternate dispute resolution early in the process; permit the defenses that the victim’s alcohol/drug abuse helped to cause his/her injuries; abolish joint and several (individual) liability (presently, when two or more defendants are found liable, the plaintiff can collect the full damages award from any one of the defendants, such as the corporate defendant with the most assets) or restrict it to economic damages; and the reforms, below, at the state level.

State tort reforms, often proposed, but so far enacted in only a few states, require arbitration; set higher damages thresholds (before one can bring suit); limit or eliminate pain and suffering awards; allow suits only for personal injuries (not property damage); set shorter statute of limitations periods; cap contingency fees; and excuse wholesalers and retailers from liability if they did not cause, or help to cause, the defect.

For product liability cases, several states have taken defenses that previously were allowed only concerning negligence—e.g., comparative or contributory negligence, and assumption of risk—and now allow them for strict liability and/or breach of warranty claims. Some states have changed the causation or “unreasonably dangerous” element from foreseeable misuse to likely misuse. Thus, those states’ product liability laws no longer cover misuse of a product unless that misuse either was probable or by someone lacking capacity (e.g., a child with a toy).

(Product liability law is discussed later in this chapter.)


An intentional tort involves intended acts, not necessarily intended harm.

In negligence, duty of care is breached if the defendant failed to act as a reasonable, prudent person would have acted in the situation the defendant faced. Causation in fact exists if, but for the defendant’s wrongful acts, the damages to the plaintiff would not have occurred. However, if the plaintiff and/or his damages were unforeseeable, the defendant may successfully argue that the alleged tort lacks proximate cause.

For reasons of public policy, defendants who engage in abnormally dangerous activities are held strictly liable for harm resulting from those activities.


The following table compares these two divisions of law.



  1. A public wrong against society

  2. A private wrong against individuals or businesses

  3. “Plaintiff” (prosecutor) is the state (offended person is usually a witness)

  4. Plaintiff is an individual or a business

  5. Mostly statutory law

  6. Mostly common law

  7. Prosecutor’s burden of proof: guilty beyond a reasonable doubt

  8. Plaintiff’s burden of proof: preponder ance of the evidence

  9. Consent rarely a defense

  10. Consent usually a defense

  11. No damages are necessary.

  12. Damages must be shown.

  13. Basis for criminal guilt: an intentional act, and sometimes gross negligence or recklessness

  14. Basis for tort liability: an intentional act, negligence, or strict liability


Most torts are defined by common law precedent. Courts may (and occasionally do) define a new tort, such as infliction of emotional distress, invasion of privacy, or abusive discharge from employment—three twentieth century tort refinements. Courts and legislatures also abolish torts that no longer reflect concerns that society deems worthy of protection (e.g., alienation of affections).


Most common law torts arise out of negligence, that is, unintentional breaches of duty. Examples: poorly manufactured products, professional malpractice, traffic accidents.

In the United States, over a million tort cases are filed annually. The largest number, over 40%, involve auto accidents.



Assault: arousing in another individual the apprehension of an immediate harmful or offensive contact with his/her body. Words alone are insufficient; they must be accompanied by some act. Examples: threats while raising fists, reaching toward what seems to be a concealed weapon.

Battery: unjustified contact with someone else’s body or anything connected to it (purse, chair, cane, etc.). The contact may be direct (e.g., a slap) or due to a force put into motion by the defendant (e.g., shooting a bullet that strikes the plaintiff). It includes actions exceeding one’s authority for physical contact. Example: a masseuse suddenly shaves a customer’s head.

False arrest: detention of the plaintiff, without his/her permission, under the falsely asserted authority of the defendant. No physical barrier, force, or threat of force is necessary. Example: An insurance investigator posing as a police officer searches a person and detains him for questioning.

False imprisonment: wrongful use of force, physical barriers, or threats of force to restrain the plaintiff’s freedom of movement. Example: A merchant forcibly detains a suspected shoplifter without reasonable cause for suspicion. Most states have “merchant protection” laws against suspected shoplifters, but the merchant must have reasonable grounds for suspicion, and the confinement must also be reasonable (accomplished without excessive force, and for no longer than necessary).

Intentional infliction of mental (emotional) distress: disturbance of the plaintiff’s peace of mind by the defendant’s outrageous conduct. Although damages are not limited to bodily injury, usually some physical harm must be shown. Examples: extreme actions by bill collectors, extensive cursing and threats of future violence, continued abuse about a sensitive person’s stuttering or physical appearance, slipping a dead mouse into someone’s lunch.

Invasion of privacy: interference with a person’s right to be left alone. The right to solitude can be invaded in four different ways: (1) public disclosure of private facts (e.g., revelation of a private person’s debts or drug use; publishing information obtained from the psychiatric files of a business competitor); (2) publication of information placing a person in a false light (e.g., a large headline states, “Rape Suspect Arrested” with a photograph underneath of a man actually the subject of an article elsewhere in the newspaper); (3) intrusion upon a person’s private life (e.g., illegal searches of a home, harassment by unwanted and continual telephoning, unlawful wiretapping); or (4) unauthorized appropriation of name or likeness (e.g., picture) for commercial purposes (infringement on a person’s exclusive right of publicity—to exploit one’s own name or likeness—such as by making and selling for profit baseball cards without the permission of the ballplayers pictured). The first three must be disclosures or intrusions highly offensive to a reasonable person. For each of the four, truth is no defense.

Employers’ spying on employees: with blood, urine, and psychological tests, and with computers, telephone taps, and video cameras, employers today are probably much more likely to “invade” workers’ privacy than the government is. Employer spying is intended to maintain or improve productivity, to stem rising health-care costs, to fight pilferage and employee lying or cheating, and otherwise to reduce expenses or bolster a moral view. Tests or surveillance can show that people are smoking, drinking alcohol, taking drugs, gambling, eating fatty foods, romancing coworkers, or otherwise behaving in a manner counter to employer goals. Also, the employer’s duty to prevent harassment (notably, sexual harassment) and its obligation to protect confidential information (e.g., of shareholders’ financial interests) may necessitate the monitoring of employees’ Internet and e-mail use while on the job. “Spying” via social media (Facebook, Twitter, etc.) has become common; employers often monitor employee usage (e.g., catching them on “sick days” posting pictures of themselves at the beach) and check job applicants’ electronic footprint prior to hiring them.

The Drug-Free Workplace Act (1998) requires the federal government and private contractors supplying the federal government to establish and enforce drug-free policies. It also permits (but does not mandate) drug testing and rehabilitation services. Most states have similar statutes permitting drug testing. Urinalysis or other testing for prospective new hires is much more likely than for existing employees, who—unless in a field affecting public safety—tend to face such testing, if at all, only when there is “reasonable suspicion” or “probable cause” that substance abuse has impaired an employee’s performance. Random testing is less common but can be permitted if public safety is involved. Employers with written drug-testing policies can generally avoid invasion of privacy claims.

Federal law prohibits most use of lie-detectors (polygraph tests); and most states protect lawful behavior off of the job, such as smoking and drinking. (Exceptions involve public safety issues, such as alcohol abuse by airline pilots or truck drivers.) Other state laws, such as those protecting human rights, have been invoked by employees claiming that the employer violated their privacy rights. Also, collective bargaining agreements between a business and its workers’ labor union tend to protect employees from corporate surveillance and testing except insofar as it directly relates to job performance. But most workers are not unionized (therefore, not protected by labor contracts), and the Constitutional “right of privacy” protection extends only to governmental intrusions, not those of private business.


Abusive discharge: modification of the common law doctrine that “at will” employees (ones without a set term of employment) may be terminated for any reason. This tort occurs if a firing violates a clear mandate of public policy. Example: a firing that stems from the worker’s notifying authorities about criminal activities being carried on in the workplace.

Disparagement (trade libel): a business defamation that involves injurious falsehoods about a product or a competitor’s reputation. Example: stating falsely to customers that a competitor’s products contain carcinogens.

Infringement of copyrights, patents, trademarks, or trade names: these will be considered in the intellectual property section of Chapter 19.

Interference with contract: a tort requiring that (1) a valid contract exists between A and B; (2) C knows about the contract; (3) C intentionally causes A or B to breach the contract, or C otherwise prevents performance. Example: Interfering, Inc., persuades an employee who has another 6 months to run on her year-long employment contract with Contract Company to breach that contract and work for Interfering. Contract Company may sue Interfering for the tort (interference with contract) and sue the employee for breach of contract.

Interference with prospective economic advantage: a tort with roughly the same three requirements as interference with contract (simply substitute “prospective economic advantage” for “contract”). Example: Gary Greedy has his employees stand outside a competitor’s store to divert customers to Greedy’s shop.

Unfair competition: a tort that, in its broad sense, overlaps other torts such as infringement of intellectual property or interference with contracts or prospective economic advantage. In its more narrow application, this tort concerns trying to “pass off” goods or services upon the public as if they were the goods or services of another, more reputable business or product. Other examples: deceitful advertising injures a competitor, secret rebates or concessions, bribery of a competitor’s employees, use of a former employer’s trade secrets.

Note: Lanham Act Section 43(a) essentially creates a federal law of unfair competition, giving business competitors the right to sue a business defendant for a wide range of false, misleading, confusing, or deceptive statements or practices involving goods or services (e.g., deceptive advertising; imitating or infringing of the plaintiff’s trademarks, trade names, packages, labels, employee uniforms, and overall appearance and sales image).

In POM Wonderful LLC v. Coca-Cola Co., 573 U.S. ___ (2014), defendant Coca-Cola asserted that the Federal Food, Drug and Cosmetics Act (FDCA), an act designed to ensure the safety of food products, did not require different labeling of a fruit drink Coca-Cola marketed in competition with POM Wonderful. However, the Supreme Court held that the FDCA did not bar a private party such as POM Wonderful from suing a competitor for its allegedly inaccurate food descriptions in violation of the Lanham Act. Such suits for unfair competition due to misleading advertising and labeling serves “a distinct compensatory function”—one not in conflict with the FDCA; and, by motivating injured persons to bring claims, Lanham Act suits also “provide incentives for manufacturers to behave well.”


Conversion: unauthorized, unjustified exercise of control over another’s personal property. There are two requirements: defendant must (1) appropriate the property to his/her own use, and (2) indefinitely withhold its possession from the plaintiff and/or destroy it. A mistaken belief that one owns the property or is entitled to keep or use it is no defense. Examples: acts of arson, robbery, or embezzlement, taking someone else’s umbrella, coat, or other personal property and keeping it after discovering that fact.

Nuisance (Liability for nuisances can be based not only on intentional acts but also on negligence or strict liability): substantial interference with the individual plaintiff’s right to use and enjoy his/her property (private nuisance) or with rights common to all (public nuisance). Nuisance usually refers to wrongs arising out of the defendant’s unreasonable or unlawful use of his own property. Examples: excessive noise, fumes or smoke; storing dangerous chemicals. Private nuisance—the defendant’s watering his lawn so much that the plaintiff’s land is flooded. Public nuisance—interfering with the general right to health, safety, peace, comfort, or morals, and including, for example, pollution, brothels, and drag strips. There are “mixed” nuisances (both private and public).

Nuisances in Cyberspace and by Telephone

The CAN-SPAM (“Controlling the Assault of Non-Solicited Pornography and Marketing”) Act of 2003 prohibits false headers and deceptive subject lines in unsolicited commercial e-mail messages, which must have some form of label as well as include opt-out instructions and the sender’s physical address. The Federal Trade Commission is authorized (but not required) to establish a “do-not-e-mail” registry.1

Similarly, the Telephone Consumer Protection Act of 1991 (TCPA) outlaws autodialing to fax machines. The Junk Fax Prevention Act (2005) directs the Federal Communications Commission (FCC) to amend its TCPA rules about fax advertising. The FCC’s revised rules (1) clarify that unsolicited fax advertisements are permitted when there is an “established business relationship,” which the rules define; (2) specify the circumstances under which a person may “opt out” of any future faxes; and (3) require the senders of fax advertisements to put on the fax the specific notice and contact information needed by recipients who do want to “opt out.”

Trespass to personal property: unjustified interference with the plaintiff’s possessory interest (e.g., use) in personal property. Example: without permission, a person takes someone else’s lawnmower, cuts her own lawn with it, and then returns the machine.

Trespass to real property: unauthorized entry onto the plaintiff’s land, either by a person or by something the person caused to enter the land. This tort can also occur when presence on the plaintiff’s property becomes unauthorized, but continues. Examples: building a dam so that water backs up onto someone’s land, throwing rocks or trash onto another’s land.


Abuse of process: the use of a court process (e.g., attachment, injunction) for a purpose for which it was not intended. Example: attachment on excessive amounts of X’s property in one case so as to force X to dismiss an unrelated lawsuit.

Defamation: a false communication by the defendant to a third person (a “publication”) that harms the plaintiff’s reputation. Slander is oral; libel involves writing, broadcasting, or any other recorded medium. It is no defense that one was merely repeating what someone else wrote or stated. The media may claim in defense that the statement concerned a public official or a public figure2 and was made without malice. A plaintiff seeking to show malice must prove actual knowledge of falsity or a reckless disregard of the truth. Example: an employee tells his boss that another employee, whom he names, is a harlot, has repeatedly cheated on her income tax returns, and makes a practice of taking 3-hour lunches; the employee telling these tales knows or should know that they are false. (There tends to be immunity for a defendant Internet service provider (ISP) or others (e.g., telephone companies) who do not have, nor could they have reasonably be expected to assume, any editorial responsibilities for what is, for example, a defamatory e-mail message from an ISP customer.)

Under the doctrine of self-publication, an employer’s derogatory statement to an employee may constitute publication if the employer could foresee that the employee would be required to repeat the statement to, for example, a prospective employer. Most state courts or legislatures considering the doctrine have decided that public policy concerns favor the rejection of the doctrine.

Fraud (deceit, misrepresentation): a very important intentional tort; depends on a false, material representation of fact that the defendant either knows to be false or recklessly makes knowing that the information is incomplete. The defendant must intend that the plaintiff rely on the representation, and the plaintiff must in fact justifiably rely upon the representation and thereby be damaged. Representations are usually by words, but can be by conduct (e.g., setting back an odometer). “Material” means any representation that would influence a reasonable person in the plaintiff’s situation.

Opinions generally are not considered representations of fact, unless given by experts in their area of expertise. “Puffing” or other sales talk about the value of goods or services is usually treated as mere opinion unless a special, confidential relationship exists between buyer and seller.

Business Law, 6th edition (Business Review Series) (31)

Silence generally does not constitut