The Legal Environment of Business: A Critical Thinking Approach

Transcription

538
PART THREE
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Public Law and the Legal Environment of Business
As these sections have been interpreted since 1969, employers are allowed
to communicate to employees their general views on unions or their specific
views on a particular union, even to the point of predicting the impact that unionization would have on the company, so long as these statements do not amount
to threats of reprisals or promises of benefits. To keep within these bounds, an
employer must carefully phrase any predictions and be sure they are based on
objective facts; in essence, the consequences that the employer predicts must be
outside the control of the employer. Threats of reprisals that constitute unfair labor practices include threats to close a plant if the employees organize, threats
to discharge union sympathizers, and threats to discontinue present employee
benefits, such as coffee breaks or employee discounts. An example of a promise of benefits that would be an unfair labor practice is the announcement of a
new employee profit-sharing plan a few days before the election.
No-solicitation rules may also constitute an employer unfair labor practice
because they interfere with communications among employees. To exercise their
Section 7 rights, employees must be able to communicate with one another.
Businesspeople must understand what types of organizing behavior can lawfully be prohibited and what prohibitions would constitute unfair labor practices.
Understandably, employers do not want employees to use work time or company property to organize, and, in general, they may prohibit union solicitation
and the distribution of literature during work time. During nonwork time, such
as lunch and coffee breaks, employers may prohibit organizing activity on company property only for legitimate safety or efficiency reasons and only if the restraint is not manifestly intended to thwart organizing efforts. The burden of
proof is on the employer to demonstrate these safety or efficiency concerns. The
following case illustrates an employer’s engaging in unfair labor practices during an organizing campaign.
CASE
21-1
Progressive Electric, Inc. v. National Labor Relations Board
United States Court of Appeals for the District of Columbia Circuit
453 F.3d 538 (2006)
P
rogressive is a nonunion electrical contractor. Progressive, seeking to fill job openings, advertised in the local
paper. David Cousins responded to the advertisement in
order to unionize Progressive. During the application
process, Cousins did not reveal his union affiliation. He
was hired. Around the same time, Charles Randall, a member of an out-of-town union, also responded to the advertisement and was hired. His past union affiliation was
apparent on his résumé and he initiated a discussion of it
at his job interview with Randy Neeman, Progressive’s
president. Randall started work and he agreed to help the
union in its organizational efforts.
On April 8, Don Hildreth, a Progressive foreman, made
disparaging comments to Cousins and another employee
about Randall. On April 26, Randall walked off a job site
and announced that he was on strike because he was not
being paid union wages.
On May 1, Neeman held a company meeting. Just before it began, Neeman informed Randall that when Randall
had walked off the job five days earlier it was not a “strike”
but instead a “voluntary quit.” Shortly thereafter, Neeman
addressed the remaining employees, making comments
the union perceived as threatening to employees.
The union filed an unfair labor practice charge with the
NLRB. The NLRB’s general counsel issued a complaint alleging violations of Section 8(a)1 of the act. The ALJ found
that Progressive had committed unfair labor practices by
threatening employees with plant closure (on April 8,
1996) and job loss (on May 1, 1996). The NLRB affirmed,
and Progressive appealed.
Judge Brown
Our role here is a limited one, as the Board’s factual findings are “conclusive”if “supported by substantial evidence
on the record considered as a whole.” In making that determination, “we ask only whether on this record it would
have been possible for a reasonable jury to reach the
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Board’s conclusion[s], giving substantial deference to the
inferences drawn by the [Board] from the facts.” So long as
the Board’s findings are reasonable, we will not substitute
our own judgment even if we would have come to a different conclusion in the first instance.
III
Under Section 8(a)(1), it is an unfair labor practice “to interfere with, restrain, or coerce employees in the exercise
of the rights guaranteed” in Section 7, to wit: “the right to
self-organization, to form, join, or assist labor organizations, to bargain collectively through representatives of
their own choosing, and to engage in other concerted activities for the purpose of collective bargaining or other
mutual aid or protection.” An employer’s statement violates Section 8(a)(1) if, “considering the totality of the circumstances, the statement has a reasonable tendency to
coerce or to interfere with those rights.”
While “an employer is free to communicate to his employees any of his general views about unionism or any of
his specific views about a particular union,” such communications must not “contain a ‘threat of reprisal or force or
promise of benefit.’” As relevant to the present case, Section 8(a)(1) prohibits coercive statements that threaten
employees with job loss or plant closure in retaliation for
protected union activities. We “must recognize the Board’s
competence in the first instance to judge the impact of utterances made in the context of the employer-employee
relationship.”
䉬
Laws Governing Labor–Management Relations
539
A
Progressive first challenges the Board’s finding that, at the
company meeting on May 1, 1996, Neeman unlawfully coerced employees by threatening their jobs, in violation of
Section 8(a)(1). . . . [S]hortly after informing Randall he no
longer had a job at Progressive, Neeman told the remaining
employees assembled for the meeting that Randall’s actions were going to “cost all you guys your jobs . . . and
that’s why we have to put a stop to it.” Neeman went on to
offer his thoughts about that “dirty word . . . UNION,”sprinkling in various colorful epithets; his hostility was palpable
throughout the meeting.
We are persuaded that there is substantial evidence for
the Board to reasonably discern impermissible coercion.
Employees, having heard such statements in this context,
on the heels of Randall’s termination, could reasonably perceive a direct connection between union activities and job
loss.
B
Progressive next challenges the finding that it violated Section 8(a)(1) by virtue of Hildreth’s April 8, 1996 statements
threatening facility closure. Progressive’s . . . gambit—that
Hildreth’s statements did not violate the Act because they
were simply an opinion protected by Section 8(c), 29
U.S.C. § 158(c)—is not properly before us, having not been
raised before the Board.
Affirmed in favor of the National Labor Relations Board.
CRITICAL THINKING ABOUT THE LAW
1.
Is there ambiguity in the phrase “cost all you guys your jobs . . . and that’s why we have to put a stop to it”?
Would the ambiguity be more evident had Randall not recently lost his job?
Clue: Look at the first sentence below Section A of the court’s decision.
2.
Why is the court unwilling to consider the question of whether Hildreth’s statements were a protected expression
of opinion?
Clue: Take a look at the rationale in Section B.
It is not always easy to predict when employer conduct is going to be found
unlawful, because in many cases the court is trying to strike a balance between
the employer’s private property rights and the employees’ rights to communicate
with one another during an organizing campaign. For example, it is not unlawful
for an employer to refuse to allow workers to post organizing notices on a company bulletin board on which employees have previously been allowed to post
only “for sale” cards. Only when an employer has opened up bulletin boards for
all employee postings and then disallows postings related to organizing have
courts found a violation of the NLRA.
Nonemployee organizers have fewer rights than employee organizers. As
long as they have some way to communicate with employees (and they do in
almost all cases now, because they are entitled to the Excelsior list of names and
addresses of employees), nonemployee organizers may be prohibited from
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entering the employer’s property, including private parking lots. The courts have
held that in the case of nonemployee organizers, the employer’s private property rights will be protected.
labor–management
committee A forum in which
workers communicate directly
with upper management. May
be illegal under the NLRA if the
committee has an impact on
working conditions, unless all
workers in a bargaining unit or
a plant participate or the
employees on the committee
are carrying out a traditional
management function.
Domination or Support of Labor Organizing. In addition to the NLRA’s allencompassing Section 8(a)(1), other subsections of 8(a) set forth specific behaviors that constitute unfair labor practices; a violation of any of these subsections is
simultaneously a violation of Section 8(a)(1). For example, under Section 8(a)(2),
an employer cannot dominate, support, or interfere with a labor organization.
Thus, in response to an organizing campaign by one union, the employer cannot
aid some of its employees in contacting a different union to compete for the right
to represent the workers at that plant. Nor can the employer play any role in establishing or operating any committee or other organization designed to represent
or aid employees in their dealings with the employer over wages, rates of pay, or
other terms and conditions of employment.
The employer must also be careful about voluntarily recognizing a union
claiming to represent a majority of the employees. If the employer recognizes a
union that does not represent the majority of employees, that is a violation of
Section 8(a)(2), even if the employer was acting in good faith.
A union dominated by an employer will be disestablished; that is, it may
never again represent those employees. A union unlawfully supported by an employer will be decertified; that is, it will not be able to represent the employees
until it has been certified as a result of a new representation election monitored
by the NLRB.
One of the major concerns facing labor relations specialists at present is
the impact of Section 8 on some of the more cooperative labor–management
programs that employers are trying to put in place. Many commentators from
both business and academia have cited the traditional adversarial relationship
between labor and management as being at least partially responsible for productivity problems in many industries.9 Consequently, U.S. management has
been experimenting with programs to increase cooperation between labor and
management. There is strong evidence that these programs do boost productivity.10 Many of them, however, have been found to constitute unfair labor
practices.
Labor–management committees are one such program. They provide a
forum in which workers can communicate directly with upper management.
Worker participants on these committees are either elected by their fellow workers or appointed by management. They usually serve for a limited time, such as
six months, to ensure maximum participation.
Under a literal interpretation of the NLRA, most participatory committees
would appear to constitute labor organizations. In fact, in the leading U.S.
Supreme Court case on this issue, NLRB v. Cabot Carbon Co.,11 the Court found
that “employee committees” established by the employer to allow employees to
discuss with managers such issues as safety, increased efficiency, and grievances
at nonunion plants and departments are labor organizations. Numerous decisions
since Cabot have followed this strict interpretation. The dilemma for management
is that these committees are rather useless unless they are allowed to discuss issues that have an impact on working conditions, but having such discussions
makes them illegal employer-dominated labor organizations under the NLRA.
There are narrow exceptions to the strict interpretation the Supreme Court
set forth in Cabot. The first applies when all of the workers in a bargaining unit
9
C. Farrell and M. J. Mandell, “Industrial Policy,” Business Week 70, 75 (Apr. 6, 1992); B. Childs,
“United Motors: An American Success Story,” Labor Law Journal 40: 453 (1989).
10
B. Childs, “United Motors: An American Success Story,” Labor Law Journal 40: 453 (1989).
11
360 U.S. 203 (1959).
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541
or plant participate in the program. In that situation, the committee does not
“represent” the employees because it comprises all the employees; if it does not
represent employees, it cannot be a labor organization and, hence, cannot be
construed as an employer-dominated union.
The second exception involves a situation in which employees carry out a
traditional management function. In such cases, the employee group no longer
“deals with” management because it is performing the delegated function itself.
Remember, even if a labor–management committee is found to constitute a
labor organization, to be unlawful, the committee must be dominated or supported by the employer. The traditional test12 asks whether the committee is
structurally independent of management. Most participatory committees have
some minimal association with management that would render them unfair under this strict test. Again, however, some circuit courts are using two factors to
minimize the impact of this holding on participatory programs. First, the court
asks whether the employers had good motives in establishing the plan. Second,
the court asks whether the employees are satisfied with it.
Applying this two-part analysis, the court may then distinguish illegal domination and support from legal cooperation.13 In the case in which this two-part
test was initially set forth, the court focused on the NLRA’s goal, which is to protect employee free choice, and said that employees should be free to enter into
cooperative arrangements with their employers as long as the employer does not
try to use the plan to interfere with free choice.
Discrimination Based on Union Activity. An employer that discriminates
against employees because of their union activity is in violation of Section 8(a)(3).
An ambiguous situation arises when a marginal employee who is also an organizer
for a union is fired. The NLRB will have to determine whether the firing was motivated by the employee’s poor performance or by the employee’s union activity.
Discharge of even the most strident union activist is legal as long as the primary
motivation for the firing was poor performance rather than union activity. In such
cases, courts look at such factors as how others who engaged in similar misconduct
have been treated by the employer.
Firing is the ultimate form of discrimination, but other forms of discrimination, such as reducing break time and unfavorable treatment in job and overtime
assignments, also constitute violations of Section 8(a)(3). The following case examines a situation in which employers allegedly fired a number of employees
for their union activity.
CASE
21-2
Gaetano & Associates, Inc. v. National Labor Relations Board
United States Court of Appeals for the Second Circuit
2006 U.S. App. LEXIS 12436 (2006)
G
aetano & Associates Inc. (the Company) is the owner
and developer of properties in New York City. The
Company is its own general contractor and tries to perform as much of the construction work as possible. As
part of two joint renovation projects in New York, the
Company hired a number of carpenters. Representatives
of the Carpenters’ Union began organizing efforts in early
12
13
April 2003. The Company was aware of the union organizing
activity even before a petition for an election was filed by
either union.
A union representative called the Company on April 16,
2003, and spoke to William Gaetano, the owner, stating
that his union represented the carpenters. This was followed up by a letter dated April 16 advising that the union
This test was established in NLRB v. Newport News Shipbuilding & Drydock Co., 308 U.S. 241 (1939).
Chicago Rawhide v. NLRB, 221 F.2d 165 (7th Cir. 1955).
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claimed to represent a majority of the carpenters employed by the Company. Also on April 16, 2003, the Carpenters’ Union filed a petition for an election. The NLRB’s
regional office immediately faxed a copy of this petition,
along with a notice that a representation hearing would
take place on April 25, 2003.
At the end of the working day on April 16, 2003, the
owner laid off a large number of the carpenters. On the
same day, the Company began replacing some of the fired
employees. Furthermore, after the April 16 layoff, the
Company entered into two subcontracts to install windows and sheetrock. With two minor exceptions, the subcontracted work could easily have been performed by the
fired carpenters. The workers and the union brought
charges against the Company. The ALJ found in favor of
the carpenters, and the NLRB affirmed.
En Banc
Our review of NLRB orders is limited. “We must enforce
the Board’s order where its legal conclusions are reasonably based, and its factual findings are supported by substantial evidence on the record as a whole.” . . . Moreover,
we accept an ALJ’s credibility determinations, as adopted
by the NLRB, unless the testimony is “incredible or flatly
contradicted by undisputed documentary testimony.”
Mass Lay-Offs
The ALJ found, and the Board agreed, that the Company’s
April 16, 2003 mass lay-off of carpenters was motivated by
anti-union animus and that the company would not have
made the same decision absent the concerted activity and
thus that the Company had violated NLRA § 8(a)(1) and (3).
Contrary to the Company’s argument, temporal proximity
can be a sufficient basis from which to infer anti-union animus as a matter of law. Here, the lay-off occurred at the end
of the day on April 16, 2003, in the middle of the workweek
on the same day that union representative Byron Schuler
called the Company to inform it that its carpenters sought to
be represented by his union and the NLRB faxed the Company the union’s petition for a representation election. Immediately after laying off a significant number of its
carpenters on April 16, 2003, the Company hired two carpenters to work at the main site and hired three more carpenters to work at that site a week later. The ALJ credited
the testimony of a number of employees that at least 20 percent of rough carpentry remained at the time of the lay-off.
The testimony is neither so incredible as to defy the laws of
nature nor contradicted by documentary evidence, and
therefore we do not disturb the ALJ’s finding.
The Company argues further that the Board erred in
finding it liable for an unfair labor practice under the twopart test of Wright Line, . . . because its actions were taken
for economic reasons. It relies on cases in which we found,
on the basis of testimony and corroborating documentary
evidence, substantial support for the employer’s proffered
business justification for lay-offs that occurred in close temporal proximity to protected activity. The Company’s
reliance is misplaced, however, because it has failed to produce any documentation supporting its proffered economic justifications, and the ALJ found the testimony of
the Company’s principals inconsistent with its actions in
hiring additional carpenters in April and May. In these circumstances, we find no error in the Board’s rejection of
the Company’s affirmative defense.
Anti-Union Animus in Sub-Contracting
The Company next contends that the Board erred in finding that anti-union animus was a substantially motivating
factor in the Company’s decision to sub-contract the window installation and related work because it relied on circumstantial evidence and the fact that the Company had
committed other unfair labor practices. We disagree.
First, there is no prohibition on the Board’s consideration of circumstantial evidence. Second, the Board only
noted the existence of other unfair labor practices in concluding that the circumstances of the outsourcing gave rise
to an inference of anti-union animus. There is substantial
evidence supporting the Board’s conclusion; namely, that
the Company’s decision to subcontract the window installation was a departure from its policy, adopted in 1998, to
use its employees to perform as much of the construction
work as possible; that the Company knew of the employees’ union activity; and that the Company’s numerous unfair labor practices in response to the union campaign gave
rise to the inference that the decision to subcontract soon
after the employees engaged in protected activity was motivated by anti-union animus.
Affirmed in favor of NLRB.
UNFAIR LABOR PRACTICES BY EMPLOYEES
Unfair labor practices by employees are less common in organizing campaigns
than unfair labor practices by employers, perhaps because when a union is
trying to gain representational status, it generally does not have enough
power to engage in such practices. The sections of the NLRA most applicable
to unions during the organizing period are 8(b)(1), which prohibits restraint
or coercion of employees in the exercise of their Section 7 rights; 8(b)(2),
which prohibits forcing the employer to discriminate, encourage, or discourage union activity; and 8(b)(7), which prohibits picketing for recognition
when another union has been certified or when the picketing union has lost
an election within the past year.
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LINKING LAW AND BUSINESS
Management
In your management class, you may have discussed several different approaches to management. One type is the
behavioral approach, which emphasizes an increase in productivity based on a better understanding of people.
Proponents of this approach believe that a better understanding of human behavior by the managers, while
adapting an organization to its workers, will lead to greater organizational success. The behavioral approach to
management highlights the human relations movement, which places a strong emphasis on the people-oriented
aspects of a firm. The human relations movement involves the observation of relations among people in organizations to determine the relational impact on a firm’s success. By developing a better understanding of human
behavior, managers become equipped to engage in healthier relations with their employees. Therefore, the overall efficiency of the organization may increase. As already mentioned in this section, adversarial relations between
a company’s management and employees may, in contrast, lead to productivity problems. Programs such as quality circles, autonomous and semiautonomous work groups, and labor–management committees are several
means of enhancing organizational productivity by improving employer–employee relations. Thus, a lawful use
of these programs may result in better relational interactions with employers and employees, which could boost
organizational productivity.
Source: Adapted from S. Certo, Modern Management (Upper Saddle River, NJ: Prentice Hall, 2000), 32–33. Reproduced
by permission.
ORGANIZING THE APPROPRIATE UNIT
The purpose of all organizing activity is for the union to gain the right to be the
exclusive representative of employees in negotiations with the employer over
wages, hours, and terms and conditions of employment. Because the potential
power of the union clashes with the employer’s desire to maintain control over
the workplace, organizational campaigns can become very heated. In any organizing campaign, the first step for the union is to gain the support of a substantial number of the members (generally 30 percent) of an appropriate
bargaining unit so that a board-run election may be ordered.
As mentioned previously, an important question in this initial stage is:
What is the appropriate bargaining unit? The appropriate unit, as defined
by the NLRA, is one that can “ensure the employees the fullest freedom in exercising the rights guaranteed by the Act.” In making such a determination, the
regional director of the NLRB examines a number of alternatives. An entire
plant may be an appropriate unit; so may a single department of highly skilled
employees; and so may all the employees of a single employer located at more
than one facility (e.g., all employees of a group of retail stores located in a metropolitan area).
In determining whether a proposed bargaining unit is appropriate, the
NLRB considers primarily whether there is a mutuality of interest among the
proposed members of the unit. All proposed members should have similar
skills, wages, hours, and working conditions, for only then is it possible for a
union to look out for the interests of all members. Other factors considered include the desires of the employees, the extent of organization, and the history
of collective bargaining of the employer and of the industry in which the employer operates. In the following case decision in 2004, the NLRB considered
whether graduate students are an appropriate bargaining unit. Notice that unlike the other cases in this chapter, the text of this case is the NLRB decision
rather than a court decision.
appropriate bargaining unit
May be an entire plant, a
single department, or all
employees of a single
employer, as long as there is a
mutuality of interest among the
proposed members of the unit.
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CASE
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21-3
Brown University and International Union, United Automobile,
Aerospace and Agricultural Implement Workers of America,
UAW, AFL-CIO, Petitioner
National Labor Relations Board Case
1-RC-21368 (July 13, 2004)
O
n November 16, 2001, a regional director issued a decision determining that 450 teaching assistants, research
assistants, and proctors at Brown University were employees within the meaning of Section 2(3) of the NLRA and
constitute an appropriate unit for collective bargaining.
Brown University filed a request for review with the NLRB.
In an earlier case involving New York University (NYU), the
board concluded that graduate student assistants are employees under Section 2(3) of the act and, therefore, are to
be extended the right to engage in collective bargaining.
Here, the board revisits the issue.
Decision on Review
and Order by Chairman
Battista and Members
Liebman, Schaumber,
Walsh, and Meisburg
In Adelphi University, 195 NLRB 639 (1972), the Board
held that graduate student assistants are primarily students
and should be excluded from a unit of regular faculty. In
Leland Stanford, 214 NLRB 621 (1974), the Board went
further. It held that graduate student assistants “are not employees within the meaning of Section 2(3) of the Act.”
The common thread in both opinions is that these individuals are students, not employees. The Board found that the
research assistants were not statutory employees because,
like the graduate students in Adelphi, supra, they were
“primarily students.” In support of this conclusion, the
Board cited to the following: (1) the research assistants
were graduate students enrolled in the Stanford physics department as Ph.D. candidates; (2) they were required to
perform research to obtain their degree; (3) they received
academic credit for their research work; and (4) while they
received a stipend from Stanford, the amount was not dependent on the nature or intrinsic value of the services performed or the skill or function of the recipient, but instead
was determined by the goal of providing the graduate students with financial support. For over 25 years, the Board
adhered to the Leland Stanford principle.
The Supreme Court has recognized that principles developed for use in the industrial setting cannot be “imposed blindly on the academic world.” NLRB v. Yeshiva
University, 444 U.S. 672, 680–681 (1980), citing Syracuse
University, 204 NLRB 641, 643 (1973). While graduate
programs may differ somewhat in their details, the concerns raised . . . here forcefully illustrate the problem of
attempting to force the student–university relationship
into the traditional employer–employee framework. It is
clear to us that graduate student assistants, including those
at Brown, are primarily students and have a primarily educational, not economic, relationship with their university.
Accordingly, we overrule NYU and return to the pre-NYU
Board precedent.
The [NLRA] was premised on the view that there is a
fundamental conflict between the interests of the employers and employees engaged in collective bargaining under
its auspices and that “‘[t]he parties . . . proceed from contrary and to an extent antagonistic viewpoints and concepts of self-interest.’”
[T]he damage caused to the nation’s commerce by the
inequality of bargaining power between employees and
employers was one of the central problems addressed by
the Act. A central policy of the Act is that the protection
of the right of employees to organize and bargain collectively restores equality of bargaining power between employers and employees and safeguards commerce from the
harm caused by labor disputes. The vision of a fundamentally economic relationship between employers and employees is inescapable.
The Board’s long-standing rule that it will not assert jurisdiction over relationships that are “primarily educational” is consistent with these principles. We emphasize
the simple, undisputed fact that all the petitioned-for individuals are students and must first be enrolled at Brown to
be awarded a TA, RA, or proctorship. Even students who
have finished their coursework and are writing their dissertation must be enrolled to receive these awards. Further, students serving as graduate student assistants spend
only a limited number of hours performing their duties,
and it is beyond dispute that their principal time commitment at Brown is focused on obtaining a degree and, thus,
being a student. Also, as shown below, their service as a
graduate student assistant is part and parcel of the core
elements of the Ph.D. degree. Because they are first and
foremost students, and their status as a graduate student assistant is contingent on their continued enrollment as students, we find that they are primarily students.
We also emphasize that the money received by the TAs,
RAs, and proctors is the same as that received by fellows.
Thus, the money is not “consideration for work.” It is
financial aid to a student.
Besides the purely academic dimension to this relationship is the financial support provided to graduate student
assistants because they are students. Attendance at Brown
is quite expensive. Brown recognizes the need for financial
support to meet the costs of a graduate education. This
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assistance, however, is provided only to students and only
for the period during which they are enrolled as students.
Further, the vast majority of students receive funding.
Thus, in light of the status of graduate student assistants
as students, the role of graduate student assistantships in
graduate education, the graduate student assistants’ relationship with the faculty, and the financial support they receive to attend Brown, we conclude that the overall
relationship between the graduate student assistants and
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545
Brown is primarily an educational one, rather than an economic one.
Consistent with long-standing Board precedent, and for
the reasons set forth in this decision, we declare the federal law to be that graduate student assistants are not employees within the meaning of Section 2(3) of the Act.
The Regional Director’s Decision and Direction of
Election is reversed, and the petition is dismissed.
The appropriateness of the proposed bargaining unit is the first issue that the
staff of the regional office determines when it receives a petition for a representation election. Once that issue has been resolved, employer and union representatives try to reach an agreement on such matters as the time and place of
the election, standards for eligibility to vote, rules of conduct during the election,
and the means for handling challenges to the outcome of the election. If the parties cannot reach an agreement, the NLRB regional director determines these
matters and orders an election.
If the union obtains signed authorization cards from more than 50 percent
of the appropriate employee unit, it may ask the employer to recognize the
union on the basis of this showing of majority support alone. Realizing that it is
futile to try to prevent the union from representing its employees, the employer
may decide that it would ultimately be beneficial to recognize the union and begin the bargaining process on an amicable note. Such behavior is risky, however,
because it may constitute a violation of Section 8(a)(1), which prohibits employers from interfering with employees’ Section 7 right of free choice. In other
cases, the employer may wish to avoid the risk of violating Section 8(a)(2), which
prohibits employer-dominated unions and may, therefore, request that the union
file a petition for certification. Having a board-run election to ensure that there
indeed is majority support protects the employer.
If a union receives a majority of the votes and the election results are not
challenged, the board will certify the union as the exclusive bargaining representative of the employees of that unit. If two or more unions are seeking to
represent employees, and neither one of the unions nor “no union” receives a
majority of the votes, there will be a runoff election between the choices that
got the first and second greatest number of votes. Once a valid representation
election has been held and there has been either a certification of a representative union or a majority vote for no union, there cannot be another election
for one year. Nor can there be an election during the term of a collective bargaining agreement, unless either the union is defunct or there is such a division in the ranks of the union that it is unable or unwilling to represent the
employees.
The Collective Bargaining Process
Shortly after a union has been certified, or recognized, the collective bargaining
process begins. Both the employer and the bargaining unit representative are required by the NLRA to bargain collectively in good faith with respect to wages, hours,
and other terms and conditions of employment. Note that the requirement is only
to bargain in good faith, not to reach an agreement. The board has no power to order the parties to accept any contract provision; it can only order them to bargain.
To a great extent, good-faith bargaining is defined procedurally. Under
Section 8(d), the parties must (1) meet at reasonable times and confer in good
faith; (2) sign a written agreement if one is reached; (3) when intent on terminating or modifying an existing contract, give 60 days’ notice to the other party with
an offer to confer over proposals, and give 30 days’ notice to the federal or state
good-faith bargaining
Following procedural
standards laid out in Section 8
of the NLRA; failure to bargain
in good faith, by either the
employer or the union, is an
unfair labor practice.
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mediation services in the event of a pending dispute over the new agreement; and
(4) neither strike nor engage in a lockout during the 60-day notice period.
Failure of the employer to bargain in good faith is an unfair labor practice under Section 8(a)(5). Employers violate this section not only by disregarding proper
procedural standards but also by assuming a take-it-or-leave-it attitude. Hence, if
the employer takes a position and says it will alter that position only if new information shows its proposal to contain incorrect assumptions, this is not good-faith
bargaining. Employers who refuse to provide the union with relevant information
that it requests and needs in order to responsibly represent the employees in the
bargaining process are also engaging in an unfair labor practice. Relevant information includes job descriptions, time-study data, financial data supporting a company claim that it is unable to meet union demands, and competitive wage data to
support a company claim that the union is demanding noncompetitive wage rates.
Taking unilateral action on a matter subject to bargaining is also an unfair employer labor practice under Section 8(a)(5). One example is giving employees a
raise or additional benefits during the term of a collective bargaining agreement
without first consulting the union. This behavior would have the effect of undermining the union as a bargaining representative and, thus, would be unlawful.
Because bargaining is meant to secure benefits for employees, there are
fewer cases of union refusals to bargain, but failure of a union to bargain in good
faith is a violation of Section 8(b)(3). Thus, unions may not violate any of the
procedural requirements already delineated, nor may they refuse to sign a contract after an agreement has been reached or insist on bargaining for clauses that
fall outside the scope of mandatory bargaining.
SUBJECTS OF BARGAINING
mandatory subjects
of collective bargaining
Subjects over which the
parties must bargain, including
rates of pay, wages, hours of
employment, and other terms
and conditions of employment.
permissive subjects of
collective bargaining
Subjects that are not primarily
about conditions of
employment and, therefore,
need not be bargained over.
All subjects of bargaining are either mandatory or permissive. Many people
mistakenly assume that wages are the only real issue that unions bargain over. As
Table 21-6 illustrates, unions have been successful in negotiating higher wages for
workers in most professions. The scope of bargaining items, however, is much more
expansive than merely wages. Mandatory subjects of collective bargaining are
those over which the parties must bargain: rates of pay, wages, hours of employment, and other terms and conditions of employment. Failure to bargain over these
subjects constitutes an unfair labor practice. All other bargaining subjects are
permissive and need not be bargained over. Management decisions concerning the
commitment of capital and the basic scope of the enterprise, for instance, are not
primarily about conditions of employment and, thus, are not mandatory. Inclusion
of a permissive subject in the bargaining process in one year, even if that results in
its inclusion in a collective bargaining agreement, does not make that subject an issue
TABLE 21-6 UNION AND NONUNION EARNINGS BY OCCUPATION, 2006
Occupation
Union Earnings ($)
Nonunion Earnings ($)
1,116
1,036
702
768
1,009
786
1,139
983
435
613
657
578
Management, professional, and related occupations
Professional and related occupations
Service occupations
Sales and office occupations
Natural resources, construction, and maintenance occupations
Production, transportation, and material moving occupations
Note: These numbers are median weekly earnings for full-time wage and salary workers.
Source: Adapted from http://www.aflcio.org/joinaunion/why/uniondifference/uniondiff5.cfm.
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of mandatory bargaining in any future contract. The only subjects that cannot be included in the bargaining process are illegal terms, such as a contract clause that
would require unlawful discrimination by the employer.
Unions have traditionally tried to expand the scope of mandatory items.
Mandatory items concerning wages include piece rates, shift differentials, incentives, severance pay, holiday pay, vacation pay, profit sharing, stock option
plans, and hours (including overtime provisions). Mandatory items concerning
conditions of employment include layoff and recall provision, seniority systems,
promotion policies, no-strike and no-lockout clauses, grievance procedures, and
work rules. In a case that generated a lot of interest, the U.S. Supreme Court held
that even changes in prices offered in a company cafeteria were subject to
mandatory bargaining.14
Strikes, Boycotts, and Picketing
In 2009, five major work stoppages occurred.15 Major work stoppages may occur
through worker-initiated strikes or employer-initiated lockouts. These 5 major
work stoppages idled 13,000 workers and led to 124,000 idle workdays.16 The prudent businessperson needs to understand the NLRA as it applies not only to labor
organizing and collective bargaining, but also to three other common occurrences
in the labor–management relations context: strikes, picketing, and boycotts.
COMPARATIVE LAW CORNER
Unions in Sweden
In the United States, we generally consider labor unions to be something of the past. The United States’ big push
to unionize came in the early 1900s, in response to worker abuse and health and safety issues. Some people see
unions as unnecessary today, given the laws that protect workers’ rights. Now, 12.3 percent of U.S. workers are
unionized.a The U.S. view of unions, however, is not prevalent around the world. Sweden has very high union
membership; approximately 80 percent of the workforce is unionized.
Swedish trade unions are very powerful in collective bargaining. For example, Sweden does not have a national minimum wage, but their workers are well compensated and get regular pay increases to account for inflation. Their trade unions, through collective bargaining, set a guiding wage for different business sectors.
Although the company-level contracts have primacy, most workers do not have to settle for a wage below the
guiding wage, because they know that they can get a higher wage at another company.
Despite the high union concentration, Sweden has one of the lowest strike rates in Europe, about 10 strikes
of any kind per year, whereas the United States records about 20 “major stoppages” a year. Perhaps, because
unions are such a force in Sweden, there is a much bigger push for cooperation between unions and business
during collective bargaining.
Labor unions in Sweden are set up a little differently than in the United States. Swedish unions do not have
minimum membership requirements or registration requirements. Consequently, there are fewer barriers to
union membership. A union is simply a group of workers who wish to associate in order to protect workers’
rights. They must create bylaws and a board of directors to carry out their aim of protecting workers’ rights. The
few legal requirements regarding unions make it much easier for Swedes to join unions. There is also less antipathy toward workers’ unionizing in Sweden, compared to the United States. Unions are so widespread in
Sweden that it is not unusual or unexpected for workers to want to join a union.
a
Union Members Summary, http://www.bls.gov/news.release/union2.nr0.htm.
14
Ford Motor Co. v. National Labor Relations Board, 441 U.S. 488 (1979).
Major Work Stoppages Summary, http://www.bls.gov/news.release/wkstp.nr0.htm.
16
Id.
15
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STRIKES
strike A temporary, concerted
withdrawal of labor.
economic strike A nonviolent
work stoppage for the purpose
of obtaining better terms and
conditions of employment
under a collective bargaining
agreement.
unfair labor practice strike
A nonviolent work stoppage
for the purpose of protesting
an employer’s commission of
an unfair labor practice.
A strike, simply defined, is a temporary, concerted withdrawal of labor. It is the
ultimate weapon used by employees to secure recognition or to gain favorable
terms in the collective bargaining process because it can be so costly to employers. For example, in 2007 into 2008, television and film writers went on a
100-day strike in an attempt to receive pay raises. The strike caused a loss of approximately $250 billion to the Los Angeles economy.
Not all strikes, however, are legal, and employees engaging in certain types
of legal strikes may still lose their jobs as a consequence of striking. The type of
strike that one is engaged in is determined both by the purpose of the strike and
by the methods used by the strikers.
Lawful Strikes. A lawful economic strike is a nonviolent work stoppage for
the purpose of obtaining better terms and conditions of employment under a
collective bargaining agreement. Because this type of strike is a protected activity, strikers are entitled to return to their jobs once the strike is over. Employers are, however, allowed to fill economic strikers’ jobs while the strike
is taking place, and if permanent replacements are hired, strikers are not entitled to return to their jobs. This ability of the employer to replace economic
strikers permanently tends to make the strike a less potent weapon than it at
first appears.
Because of the ability of the employer to permanently replace workers
engaged in an economic strike if they first hire permanent replacement workers,
unions have fought to try to get Congress to pass legislation prohibiting the use
of permanent replacement workers. Workers did achieve a minor victory in 1995,
when President Clinton issued an executive order prohibiting federal contractors
with government contracts worth over $100,000 from hiring permanent replacements for strikers. If any such firm does hire replacement workers, the labor secretary is to notify the head of any agencies that have contracts with such firms,
and the contracts are to be terminated and no contracts are to be made with said
firms in the future.
Even if replaced, however, economic strikers still are entitled to vote in representational elections at their former place of employment within one year of
their replacement or until they find “regular and substantially similar employment” elsewhere, whichever comes first. Any permanently replaced economic
striker is also entitled to be rehired when any job vacancies arise at the former
place of employment.
Employees may also lawfully engage in a strike over employer unfair labor
practices. An unfair labor practice strike is a nonviolent work stoppage in
protest against an employer’s committing an unfair labor practice. Employees
engaged in such a strike are entitled to return to their jobs at the end of the
strike. If the employer fires such strikers, they will be able to sue for reinstatement and back pay for the time during which they were unlawfully prohibited
from working.
Unlawful Strikes. Strikes are unlawful when either their means or their purpose
is unlawful. Strikes with unlawful means include (1) sit-down strikes, wherein
employees remain on the job but cease working; (2) partial strikes, wherein only
some of the workers leave their jobs; and (3) wildcat strikes, which are strikes
that are not authorized by the parent union and are frequently in violation of the
collective bargaining agreement. Strikes that include acts of violence or blockading of exits or entrances of a plant are also strikes with unlawful means.
Strikes with an unlawful purpose include jurisdictional strikes, which are
work stoppages for the purpose of forcing an employer to resolve a dispute
between two unions. Jurisdictional strikes are most common in the construction
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industry, where two unions often disagree over which trade (and, thus, which
union’s members) is entitled to do a particular type of work on a given project.
Also unlawful are a number of strikes that fall into the category of secondary strikes. A secondary strike occurs when the unionized workers of one employer go on strike to force their employer to exert pressure on another
employer with which the union has a dispute.
When employees engage in a strike with unlawful means or an unlawful
purpose, they are not legally protected and, therefore, may be discharged by
their employer. For example, in 2003, the NLRB decided that a strike by an
employer’s security guards was not protected because the union failed to
take reasonable precautions to protect the employer’s operations from foreseeable dangers resulting from security guards’ work stoppage. Because the
strike was not protected, the employer’s termination of the security guards
was lawful.17
BOYCOTTS
A boycott is a refusal to deal with, purchase goods from, or work for a business. Like a strike, it is a means used to prohibit a company from carrying on its
business so that it will accede to union demands. Primary boycotts are legal; that
is, a union may boycott an employer with which the union is directly engaged
in a labor dispute.
Secondary boycotts, like secondary strikes, are illegal. A secondary boycott
occurs when unionized employees who have a labor dispute with their employer
boycott another employer to force it to cease doing business with their employer.
One type of secondary boycott is legal under the NLRA in the construction
and garment industries. That is the “hot cargo agreement,” an agreement between the union and the employer that union members need not handle
nonunion goods and that the employer will not deal with nonunion employers.
This type of secondary boycott, however, is considered an unfair labor practice
under Section 8(b) in all other industries.
boycott A refusal to deal with,
purchase goods from, or work
for a business.
secondary boycott A boycott
against one employer to force
it to cease doing business with
another employer with which
the union has a dispute.
PICKETING
Picketing is the stationing of individuals outside an employer’s place of business for the purpose of informing passersby of the facts of a labor dispute. Picketing usually accompanies a strike, but it may occur alone, especially when
employees want to continue to work in order to draw a paycheck.
Just as there are numerous types of strikes and boycotts, there are multiple
types of picketing with different degrees of protection. Informational picketing,
designed to truthfully inform the public of a labor dispute between an employer
and employees, is protected. This protection may be lost, however, if the picketing has the effect of stopping deliveries and services to the employer. Picketing
designed to secure a stoppage of service to the employer is called signal picketing
and is not protected.
Jurisdictional picketing, like jurisdictional strikes, occurs when two unions
are in dispute over which union’s workers are entitled to do a particular job. If one
union pickets because work was assigned to the other union’s members, this
action is unlawful; jurisdictional disputes are resolved by the NLRB under an expedited procedure, so there is no need to take coercive action against the employer.
17
NLRB, Sixty-Eighth Annual Report of the NLRB for Fiscal Year Ended September 30, 2003, 23;
available at www.nlrb.gov/nlrb/shared_files/brochures.
picketing The stationing of
individuals outside an
employer’s place of business
to inform passersby of the fact
of a labor dispute.
informational picketing
Picketing designed to truthfully
inform the public of a labor
dispute.
jurisdictional picketing
Picketing by one union to
protest an assignment of jobs
to another union’s members.
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organizational
(recognitional) picketing
Picketing designed to force the
employer to recognize and
bargain with an uncertified
union.
The other union or the employer may secure an injunction to preserve the status
quo until the board resolves the dispute.
Organizational or recognitional picketing, which is designed to force
the employer to recognize and bargain with an uncertified union, is illegal
when (1) another union has already been recognized as the exclusive representative of the employees, and the employer and employees are operating
under a valid collective bargaining agreement negotiated by that union;
(2) there has been a valid representation election within the past year; or
(3) the union has been picketing for longer than 30 days without filing a petition for a representation election.
When (1) and (2) are not applicable, a union may picket for up to 30 days
while attempting to secure signed authorization cards from more than 30 percent
of the employees. Once the appropriate signatures have been obtained, the union
may then file its petition for recognition and continue picketing to inform the public of the company’s refusal to recognize the union.
Picketing, like striking, may be illegal because of its means. Violent picketing is, of course, unlawful. So is massed picketing, though this type of unlawful
activity is somewhat more difficult to define. It is said to exist when the pickets
are so massed (physically arranged) as to be coercive or to block entrances and
exits. In cases interpreting this term, the courts have tended to find unlawful
massed picketing when there have been so many picketers before a gateway to
a plant that free entry or exit is made difficult or almost impossible.
Global Dimensions
of Labor–Management Relations
Many U.S. corporations have moved their operations overseas to obtain cheaper
labor costs. Our laws permit this, and a corporation’s foreign operations are not
subject to U.S. labor laws; however, most countries have labor laws of their own
to which U.S. companies are subject. Likewise, foreign companies with plants in
the United States must comply with our labor laws.
Many scholars argue that it would be desirable to have uniform labor laws
across the world, or at least among all the industrialized nations. Their reasons
differ. Some believe that there are certain inherent rights of workers that should
be protected regardless of where they live and work. Others believe that uniformity would make it easier for multinationals that have a presence in many
countries because then their labor practices could be uniform throughout all
their operations.
The likelihood of a worldwide uniform labor law is almost nonexistent,
because different countries’ leaders have very different philosophies about the
purpose of labor law. There are a few similarities, however, among most
countries’ labor laws. For example, in almost all countries a worker has the
right to refuse to perform unsafe work.18
The International Labor Organization (ILO), to which 174 nations now
send government, management, and labor delegates, has attempted to create
some uniformity among the labor laws of member nations. The ILO formulates
conventions and recommendations for labor legislation that can be adopted by
all countries. These include minimum specifications and often provisions for
national or traditional variations on those basics. Enforcement procedures are
generally left to the individual nations.19 The ILO has promulgated 182
18
19
M. Lennards, “The Right to Refuse Unsafe Work,” Comparative Labor Law Journal 4: 217 (1981).
International Labor Organization (ILO), The ILO: What It Is, What It Does (Feb. 10, 2000).
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conventions and 190 recommendations; there have been over 6,600 ratifications of these.20 Although there are still more differences than similarities in labor laws from country to country, the ILO has stimulated some harmonization
of those laws.
SUMMARY
The NLRA is the primary piece of legislation governing labor–management relations. Section 7 of the NLRA sets forth the rights of employees, and Section 8(a)
identifies specific employer behaviors, called unfair labor practices, that are
prohibited. Employee unfair labor practices are set out in Section 8(b). The
Landrum–Griffith Act was passed to ensure proper internal governance of labor
organizations.
The administrative agency responsible for oversight and enforcement of the
NLRA is the National Labor Relations Board. The board is primarily responsible
for ensuring that organizing campaigns are conducted fairly and that neither employers nor employees commit unfair labor practices.
Prospects for a worldwide uniform labor law are negligible, but the ILO
is attempting to create some harmony among the labor laws of member
nations.
REVIEW QUESTIONS
21-1 Explain why some people support unions
whereas others oppose them.
21-2 Explain the relationship between Section 7
and Section 8 of the NLRA.
21-3 Explain why someone would argue that the
existence of Section 8(a)(1) really makes
Sections 8(a)2–5 unnecessary.
21-4 Describe the roles of the NLRA and its general
counsel.
21-5 What is the difference between violating a
board rule and committing an unfair labor
practice?
21-6 What advice would you give to an employer
that wants to adopt some form of employee
participation program but is concerned about
the legality of such programs?
REVIEW PROBLEMS
21-7 A national union wanted to organize the employees of Dexter Thread Mills. The company parking lot
was adjacent to a public highway, separated from the
highway by a 10-foot-wide grassy public easement. The
union sought to distribute handbills in the parking lot;
the company sought to exclude the union from the lot.
Was the union allowed to distribute the handbills on the
company lot?
20
Id.
21-8 Otis Elevator was acquired by United Technologies (UT) in 1975. A review of Otis’s operations
showed its technology to be outdated. The company’s
products were poorly engineered and were losing
money. Its production and research facilities were scattered across the United States with many duplications
of work. Research, in particular, was done at two separate New Jersey facilities, one of which was extremely
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outdated. UT did all of its research at a major research
and development center in Connecticut; some research
for Otis was also done there. UT decided to transfer
Otis research from the two New Jersey locations to an
expanded facility in Connecticut in order to strengthen
the overall research effort and to allow Otis to redesign
its product. The union representing Otis employees alleged that UT had engaged in an unfair labor practice
by refusing to bargain with the union over its decision
to relocate the work. Was UT’s refusal to bargain over
this decision a violation of Section 8(a)(5)?
21-9 The clerks at Raley’s were represented by the
Independent Drug Clerks Association (IDCA). When
the Retail Clerks Union (Retail Clerks) began a
campaign to oust IDCA, Raley’s maintained a neutral
posture. Retail Clerks picketed the store in July. Could
Raley’s obtain an injunction prohibiting the picketing?
21-10 The workers at the Big R Restaurant were trying unsuccessfully to negotiate a new contract. On
Monday, all of the busboys called in sick. On Tuesday,
all the cooks called in sick. On Wednesday, all the
waitresses called in sick. Was there anything unlawful
about the employees’ behavior? If so, what recourse
does the employer have?
21-11 Ajax Manufacturing Company was unionized in
1998 and was operating under a contract negotiated at
the beginning of that year. Several new workers were
hired near the end of the year, and they thought a
stronger union was needed. They began picketing
the employer to recognize a different union as the
representative of the workers, or at least to have a decertification election. Is their picketing legal? Why or
why not?
CASE PROBLEMS
21-12 Honeyville Grain processes and distributes food
products, and it employs truck drivers to deliver its
products. Local 166 of the International Brotherhood of
Teamsters, AFL-CIO, petitioned the NLRB for an election in a unit of Honeyville’s full-time and part-time
truck drivers. The Board conducted a secret-ballot election. All 32 eligible voters cast ballots: 23 voted in favor
of the union, 7 voted against the union, and 2 ballots
were challenged. Honeyville, however, objected to
comments made in a meeting held at the union’s office
5 days before the election, which 20 to 25 of the drivers
attended. Union agents made disparaging comments
about Honeyville management’s Mormon religious
views, and asserted that the owners gave money to the
Mormon Church instead of sharing it with the workers.
The religious remarks were made at 1 of about 10 union
meetings held prior to the election.
A regional director of the Board investigated
Honeyville’s objections to the election. After the hearing,
the hearing officer recommended that the Board overrule
the objection about the religious remarks and certify the
union. The Board adopted the recommendations and
certified the union as the exclusive collective bargaining
representative for Honeyville’s drivers. After the certification, Honeyville refused to bargain with the union. The
union filed charges with the Board. The Board’s general
counsel then issued a complaint alleging that Honeyville
had refused to bargain collectively with the union, in
violation of Sections 8(a)(1) and (5) of the NLRA.
Honeyville filed an answer, reasserting its objections to
the certification. The Board concluded that Honeyville
violated the act by its admitted refusal to bargain with
the union. Honeyville petitioned for review. Was
Honeyville legally allowed to refuse to acknowledge the
union certification because of the potentially inflammatory religious comments? Honeyville Grain, Inc. v.
NLRB, 444 F.3d 1269 (10th Cir. 2006).
21-13 On the night of February 28, Local 94 called a
strike and some of its members began picketing the
New York Post’s printing facility in the Bronx, New York.
For some time during that night, certain Newspaper and
Mail Deliverers’ Union’s (NMDU) drivers refused to leave
the facility and deliver newspapers. The NMDU claimed
that the drivers acted out of concern for their safety. It
had been reported that before midnight on February 28,
a bottle had been thrown from a highway overpass at the
windshield of a New York Post truck driven by an NMDU
member, shortly after it had left the facility. The bottle
shattered the windshield, causing the truck to return to
the facility. The NMDU claimed that its drivers believed
the bottle had been thrown by a member of Local 94 or
someone else sympathetic to that union’s strike, and that
they refused to drive their trucks out of genuine fear for
their own safety.
The Post contended that the drivers’ work stoppage was unrelated to this incident and was actually a
sympathy strike with Local 94. The Post, invoking a
no-strike provision in the parties’ collective bargaining
agreement, sought to enjoin the NMDU from any further work stoppages for the duration of its negotiations with Local 94, because it believed that the threat
of a sympathy strike by the NMDU gave Local 94 an
unfair degree of leverage with which to negotiate.
CHAPTER 21
After hearing arguments from both sides, the arbitrator issued a “status quo order,” directing the NMDU
drivers to return to work on the condition that the
Post help to ensure their safety by assigning two drivers
per truck for the remainder of that morning. The
NMDU claimed that the drivers returned to work after
having the ruling explained to them and being assured
that members of Local 94 would not take any actions
against them. The Post claimed that the drivers returned to work only after the Post agreed to further
negotiations with Local 94. The Post sought an injunction barring NMDU from engaging in any work stoppage for the duration of the negotiations underway
between the Post and Local 94. Did NMDU’s actions
constitute a sympathy strike? Can the Post prevent
NMDU from further strikes? Why? NYP Holdings, Inc.
v. NMDU of NY & Vicinity, 485 F. Supp. 2d 416 (2007),
reconsidered and affirmed 492 F. Supp. 2d 338 (2007).
21-14 The union was attempting to organize the Aladdin Hotel and Casino in Las Vegas. One afternoon,
when a human resources manager overheard an organizer asking hotel workers to sign union cards during the lunch break in the employee dining room, the
manager interrupted the conversation and told workers that they should make sure they understood all
the facts before signing the cards. A discussion about
unionization of approximately eight minutes’ duration then took place. The union filed a complaint
with the NLRB alleging that management was engaging in illegal surveillance in violation of the NLRA.
The ALJ ruled in favor of the union and the company
appealed. What do you believe the court held on appeal? Why? Local Joint Executive Board of Las Vegas
v. NLRB, 515 F.3d 942 2008 WL 216935 (9th Cir.
2008).
21-15 Sacred Heart is an acute care hospital in
Spokane, Washington. The Washington State Nurses
Association (WSNA) is a union that represents approximately 1,200 registered nurses employed at Sacred
Heart. In the fall of 2003, WSNA and Sacred Heart began negotiations for a new collective bargaining agreement (CBA) to replace the then-existing agreement, set
to expire in January 2004.
During the negotiations, nurses at Sacred Heart
wore a number of union buttons without incident.
The buttons read: “Together Everyone Achieves
More”; “WSNA SHMC RNs Remember 98”; “Staffing
Crisis-Nursing Shortage-Medical Errors-Real Solutions”;
and “RNs Demand Safe Staffing.” Several months after
the nurses began wearing these buttons, the hospital
issued a memorandum banning the nurses from wearing the “RNs Demand Safe Staffing” buttons. The hospital stated that it was concerned about the potential
for patients to interpret buttons incorrectly and fear
that they would receive inadequate treatment. The
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553
hospital claimed that its ban was designed to minimize
or eliminate the negative impact on patients.
Shortly after the memorandum was issued, WSNA
filed an unfair labor practice charge with the NLRB.
There was an evidentiary hearing and the ALJ issued a
decision concluding that Sacred Heart had engaged in
an unfair labor practice by enforcing the button prohibition. Shortly thereafter, a divided three-member
panel of the Board reversed, finding that Sacred Heart
had demonstrated that the message would disturb
patients. Given your understanding of the NLRA, did
Sacred Heart commit an unfair labor practice? Why or
why not? Washington State Nurses Association v.
NLRB, 526 F.3d 577 (8th Cir. 2008).
21-16 In June 2000, two agents of the American
Postal Workers Union entered the Postal Service’s bulk
mail center to solicit drivers employed by Mail Contractors of America (MCOA), a company that hauls
mail by truck for the postal service. The two agents,
neither of whom was employed by the postal service,
went to a lounge to solicit membership from drivers.
Johnson, a postal service employee, joined the two
agents in the lounge. Upon finding the three men talking, a supervisor, after consulting with a manager, instructed them to leave the bulk mail center, which
they did. The supervisor and the manager acted pursuant to the postal service’s southeast area office policy: the office policy was to remain neutral, neither
hindering nor helping union organization, as well as to
prohibit all solicitations. The union filed an unfair labor practice charge. Did the postal service commit an
unfair labor practice? What reasons did the NLRB give
for its conclusion? American Postal Worker’s Union v.
NLRB, 370 F.3d 25 (D.C. Cir. 2004).
21-17 The Venetian is a luxury hotel and casino in
Las Vegas. When the Venetian was constructed, Las
Vegas Boulevard was expanded by one lane to accommodate the increased traffic. To complete the expansion, it was necessary to remove the existing sidewalk.
The Venetian agreed to construct a new sidewalk on
its property. When construction began, a temporary
sidewalk was constructed where the Venetian would
later construct the permanent sidewalk.
Although the Venetian had not yet begun hiring
staff, it had assembled an employment package for
employees that would be superior to the union’s.
Local 226 of the Culinary Workers Union and Local
165 of the Bartenders Union planned to hold a rally
on the temporary walkway protesting the fact, that unlike the casino that had previously stood on the property, the Venetian did not have a union contract.
The demonstration took place on March 1,
1999. More than 1,000 demonstrators, many wearing
T-shirts, buttons, and pins with union messages,
marched on the walkway. The demonstrators
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repeatedly chanted slogans, including, “Venetian no,
Union yes,” “Hey, hey, ho, ho, Union busting[’]s got to
go,” and “Who owns the sidewalk? Union sidewalk.”
Other protestors carried picket signs analogizing
union rights to civil rights. Some even made speeches
about the labor dispute between the union and the
Venetian.
During the protest, the Venetian played a recording indicating that the protestors were allegedly trespassing on private property. The Venetian also asked
the police to issue criminal citations to the demonstrators. Security guards for the Venetian also told the
demonstration’s leader that he was being placed under
“citizen’s arrest.” Did the Venetian’s actions constitute
an unfair labor practice by interfering with the union’s
right to picket? Why or why not? Venetian Casino
Resort, LLC v. NLRB, 484 F.3d 601 (D.C. Cir. 2007).
21-18 ITS operates a container terminal through
which imports and exports pass continuously.
Through its membership in the Pacific Maritime Association (PMA), the company indirectly employs longshoremen represented by local unions affiliated with
the International Longshore and Warehouse Union
(ILWU). ITS directly employs its office clerical workers, a bargaining unit represented by the Office
Clerical Unit (the union) of ILWU. The company also
employs a single “payroll and billing representative.”
When ITS hired Deanna Tartaglia as the payroll and
billing representative, the union was not authorized to
bargain on her behalf. The union presented ITS with a
letter demanding recognition as the bargaining representative of a single-employee unit consisting of
Tartaglia. ITS rejected the demand and refused to recognize the union as Tartaglia’s bargaining representative.
Two union representatives and Tartaglia immediately responded by picketing. No other ITS employees
joined the picket line, but many ILWU-affiliated employees ceased working. The work stoppage, having
brought the terminal to a halt, prompted ITS to request expedited arbitration with ILWU through the
PMA. Within a few hours, the arbitrator concluded
that the picket line was not bona fide and ruled in the
company’s favor, allowing ITS to refuse to pay employees who honored the picket line. Although not subject to the arbitration, the union and Tartaglia ended
the picket line following the ruling. Because her actions triggered delays and a loss of revenue for ITS, it
fired Tartaglia.
The union filed an unfair labor practice charge
against ITS for Tartaglia’s termination. An ALJ found
that ITS had committed an unfair labor practice by discharging Tartaglia for picketing. The NLRB adopted
the ALJ’s ruling, which held on two alternative
grounds that Tartaglia had engaged in protected activity. ITS petitioned for review of the Board’s decision.
Did the court determine that Tartaglia’s actions were
protected? Why? International Transportation Service, Inc. v. NLRB, 449 F.3d 160 (D.C. Cir. 2006).
THINKING CRITICALLY ABOUT RELEVANT LEGAL ISSUES
Despite the claim that a strike is the “ultimate
weapon” for workers, strikes are never in the interest
of workers. Strikes are an outdated tool that cannot
work now, and were never all that effective. It does
not make sense for workers to rush to an ineffective
extreme and go on strike. If workers stopped to think
about their interests, they would realize that strikes do
not help them achieve their goals.
The point of engaging in a strike is for workers to
put pressure on their employers to get an economic
benefit from their actions. If the workers are on strike
because they want more money, how can deliberately
missing work help them reach their goals? If the workers’ claim is that they need more money, missing work,
and thus losing out on pay, does not seem like it will
accomplish the workers’ goal. Even if the workers
manage to get a raise by striking, the raise would have
to account for what the workers “need,” in addition to
making up for the lost wages during the strike. It
seems very unlikely that any strike will be effective
enough to make up for lost wages during the strike.
Accordingly, the strike will not serve the interest of
the workers. If the strike is for some other sort of benefits, the gained benefits would still have to offset the
lost wages to be rational, and once again the likelihood of the benefits accounting for the lost work, plus
the benefits originally sought, seems highly unlikely.
Not only is it illogical to strike to get money or
benefits, but strikes are also very risky for workers.
Employers can temporarily replace workers during
strikes. With a substitute workforce, the employer will
not necessarily feel pressure from the strike. What replacements mean is that the workers on strike do not
get paid, and the work still gets done, so the employer
does not have incentive to give in to the striking
workers’ demands. In addition, the employer can
CHAPTER 21
simply hire permanent replacements. Permanent replacements mean that after the strike, the striking
workers are not entitled to get their old jobs back.
Clearly, it is not in the interest of workers to strike for
economic reasons, and end up losing their jobs because of it. The risk is too high to make strikes in the
interest of the workers. Even if the employer negotiates with the workers because of the strike, the whole
process is likely to foster resentment, which will not
create a good working environment for anyone, further making strikes not in the interest of workers.
Another reason strikes are not in the interest of
workers is that strikes are likely to breed contempt for
the workers, as opposed to creating sympathy. Strikes
do not affect just the workers and employer. Rather,
others are harmed by strikes. For example, in 2005,
when New York City transit workers went on strike,
the masses of people who rely on public transportation in New York City were forced to walk, take taxis,
or find other means of transport about the island. In
addition, other workers who rely upon the products
or services produced by the striking workers have
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555
their work affected. As the other workers who are not
involved in the strike feel the effects of the strike, they
are more likely to resent the striking workers than
they are to put pressure on the strikers’ employer to
end the strike. Being despised is typically not in anyone’s interest.
1. How would you word the issue and conclusion of
this essay?
2. Is relevant information missing from the argument?
Clue: What would you like to know before deciding whether the author is correct?
3. Does the argument contain significant ambiguity?
Clue: What word or phrases could have multiple
meanings, where changing the meaning either
strengthens or weakens the argument?
4. Write an essay that someone who holds an opinion
opposite to that of the essay author might write.
Clue: What other ethical norms could influence
an opinion about this issue?
ASSIGNMENT ON THE INTERNET
You have learned about many laws and regulations
that govern labor–management relations. Many of
those laws and regulations are used in each of the
NLRB’s decisions. Visit the NLRB’s Web site that contains recent decisions (www.nlrb.gov/research/
decisions/board_decisions/index.aspx) and read
at least two decisions.
What information from this chapter helps you better understand the decisions? What reasons were
given for the decisions? When reading, pay careful attention to how the Board interpreted or resolved ambiguity in the law. Finally, what ethical norms support
the decisions?
ON THE INTERNET
www.nlrb.gov This site is the home page of the NLRB.
www.aflcio.org Find out about the AFL-CIO at this site.
www.albany.edu/history/LaborAudio This site contains a number of audio recordings, many historical, detailing firsthand accounts of labor and industrial history in the United States.
http://ctb.ku.edu/en/tablecontents/sub_section_main_1265.htm Contains information on why groups
strike, as well as the steps typically taken to organize an effective strike.
www.dol.gov The home page for the Department of Labor provides a wealth of useful information and links.
This is a good place to begin research in areas of employment law, especially the Bureau of Labor Statistics.
www.gklaw.com/publication.cfm?publication_id⫽552 This site contains information regarding a 2006 NLRB
decision that attempts to define who counts as a supervisor. In addition, the Web site contains links to useful
information for business managers regarding labor topics.
556
PART THREE
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FOR FUTURE READING
Arthurs, Harry. “Reconciling Differences Differently:
Reflections on Labor Law and Worker Voice after Collective Bargaining.” Comparative Labor Law & Policy
Journal 28 (2007): 155.
Dray, Phillip. There is Power in a Union: The Epic
Story of Labor in America. Doubleday, 2010.
Cote, Marc. “Getting Dooced: Employee Blogs and
Employer Blogging Policies under the National Labor
Relations Act.” Washington Law Review 82 (2007): 121.
Gould, IV, William B. “Labor Law Beyond U.S. Borders:
Does What Happens Outside of America Stay Outside
of America?” Stanford Law and Policy Review 21
(2011):401.
LaJeunesse, Jr., Raymond J. “The Controversial “CardCheck” Bill, Stalled in the United States Congress, Presents Serious Legal and Policy Issues,” Texas Review of
Law and Politics 14 (2010): 209.
Mishler, Paul C. “Trade Unions in the United States and
the Crisis in Values: Towards a New Labor Movement.”
Notre Dam Journal of Law, Ethics, & Public Policy 20
(2006): 861.
22
Employment Discrimination
䊏 THE EMPLOYMENT-AT-WILL DOCTRINE
䊏 CONSTITUTIONAL PROVISIONS
䊏 THE CIVIL RIGHTS ACTS OF 1866 AND 1871
䊏 THE EQUAL PAY ACT OF 1963
䊏 THE CIVIL RIGHTS ACT OF 1964, AS AMENDED (TITLE VII),
AND THE CIVIL RIGHTS ACT OF 1991
䊏 THE AGE DISCRIMINATION IN EMPLOYMENT ACT OF 1967
䊏 THE REHABILITATION ACT OF 1973
䊏 THE AMERICANS WITH DISABILITIES ACT OF 1991
䊏 AFFIRMATIVE ACTION
䊏 GLOBAL DIMENSIONS OF EMPLOYMENT DISCRIMINATION
LEGISLATION
eing an employer was so much easier 100 years ago. Managers could use
almost any criteria for hiring, promoting, and firing employees. Today, employers’ decision-making powers are restricted by both federal and state
laws, many of which are discussed in this chapter.
The right of the employer to terminate an employment relationship was originally governed almost exclusively by the employment-at-will doctrine, discussed
in the first section of this chapter. The second section discusses the constitutional
provisions that affect an employer’s ability to hire and fire workers.
The following six sections discuss each of the major pieces of federal legislation designed to prohibit discrimination in employment; these acts are discussed
in the order of their enactment. The ninth section discusses the increasingly controversial subject of affirmative action. Global dimensions of employment discrimination are discussed in the final section.
B
You will soon be a businessperson and may be responsible for hiring, promoting, and firing people. When you do hold
this position, you will need to be aware of federal and state laws that prohibit discrimination in employment. Why do
you think the government has prohibited discrimination in employment? What ethical norm does the government
emphasize by prohibiting discrimination in employment? The government seems to emphasize justice, in the sense
that it wants all human beings to be treated equally, regardless of class, race, gender, age, and so on. Reading the
557
558
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following case example and answering the critical thinking questions will sharpen your thinking about laws prohibiting employment discrimination.
Tom, Jonathan, and Bob were hired to work as executive secretaries at a major corporation. The other secretaries
for the corporation were surprised that three men were hired as secretaries, because no man had ever before been
hired as a secretary at this corporation. All secretaries were required to type 20 five-page reports each day in addition
to completing work for their respective departments. After the male secretaries had been working at the corporation
for approximately one month, they received pay raises. None of the female secretaries received raises. When the women
asked the manager why the male secretaries had received raises, the manager claimed that the men were performing
extra duties and consequently received raises.
1.
The manager claimed that the men received raises because they were performing extra duties. Can you identify
any potential problems in the manager’s response?
Clue: What words or phrases are ambiguous in the manager’s response?
2.
The female secretaries decided to bring a suit against the corporation. They claimed that they did not receive
raises because of their gender. Pretend that you are a lawyer and the female secretaries have come to you with
their complaint. After talking with the secretaries, you realize that you need some additional information. What
additional information might be helpful in this case?
Clue: The female secretaries claimed that the male secretaries received raises because they are male. Can you
think of any alternative reasons why the men might have received raises?
3.
You discover only one case regarding equal pay that was decided in your district. In this case, both men and
women performed hard labor in a factory, but only men received offers to work during the third shift. Those
employees who worked the third shift received an additional $30 per hour. The women in this factory
claimed that they were not asked to work the third shift because of their gender. The factory argued that
the women who worked at the factory were not physically strong enough to endure the work of the third
shift. The court ruled in favor of the women. Do you think that you should use this case as an analogy? Why
or why not?
Clue: How are the two cases similar? How are they different?
The Employment-at-Will Doctrine
employment-at-will doctrine
A contract of employment for
an indeterminate term is
terminable at will by either the
employer or the employee; the
traditional American rule
governing employer–employee
relations.
In all industrial democracies except the United States, workers are protected by
law from unjust termination. The traditional “American rule” of employment—
the employment-at-will doctrine—has been that a contract of employment for
an indeterminate term is terminable at will by either party. Thus, an employee
who did not have a contract for a specific length of time could be terminated at
any time, for any reason.
This doctrine has been justified by the right of the employer to control its
property and on the ground that it is fair because both employer and employee
have the equal right to terminate the relationship. Some question the latter justification because the employer can almost always replace a terminated employee, whereas it is not equally easy for the employee to find a new job. Thus,
the employment-at-will doctrine places the employer in a position to treat employees arbitrarily.
The doctrine has been slowly restricted by state and federal legislation, as
well as by changes in the common law. One of the first laws to restrict the
employer’s right to freely terminate employees was the National Labor Relations
Act (discussed in Chapter 21), which has reduced the number of employees
covered by the employment-at-will doctrine. This reduction has occurred
because the act gives employees the right to enter into collective bargaining
agreements, which usually restrict the employer’s ability to terminate employees except for “just cause.” Employees covered by these agreements are thus
no longer “at-will” employees.
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The doctrine has also been restricted by common-law and state statutory exceptions, which fall into three categories: implied contract, violations of public
policy, and implied covenant of good faith and fair dealing. In some states, the
courts find that an implied contract may arise from statements made by the employer in advertising the position or in an employment manual. For example,
sometimes a company provides an employment manual delineating the grounds
for termination but not containing any provision for termination “at will.” Under
such circumstances, if the court finds that the employee reasonably relied on the
manual, the court will not apply the employment-at-will doctrine and will allow
termination only for the reasons stated in the manual. Thirty-seven states and the
District of Columbia recognize this exception.
The public policy exception prohibits terminations that contravene established public policy. “Public policy” varies from state to state, but some of the
terminations commonly deemed unlawful include dismissals based on actions
“in the public interest,” such as participation in environmental or consumer protection activities, and dismissals resulting from whistleblowing. Many states have
also cut away at the employment-at-will doctrine with laws that specifically prohibit the termination of employees in retaliation for such diverse activities as
serving jury duty, doing military service, filing for or testifying at hearings for
worker’s compensation claims, whistleblowing, and refusing to take lie-detector
tests. A total of 43 states accept the public policy exception.
Eleven states recognize the implied covenant of good faith and fair dealing exception. This theory holds that every employment contract, even an unwritten one, contains an implicit understanding that the parties will deal fairly
with one another. Because there is no clear agreement on what constitutes “fair
treatment” of an employee, this theory is not often used.
Many federal laws also restrict the employment-at-will doctrine. Employees
cannot be fired for filing a complaint, testifying, or causing a hearing to be instituted regarding the payment of the minimum wage, equal pay, or overtime.
Pursuit of a discrimination claim is likewise statutorily protected.
The doctrine of employment-at-will, however, still exists and is strongly adhered to in many states. So, although the doctrine is being cut back, and business managers of the future therefore cannot rely on its continued availability, it
may be a long time before the doctrine is no longer applicable. As its applicability varies from state to state, however, familiarity with the parameters of the
doctrine in one’s own state is extremely important. Table 22-1 breaks down
which states accept each of the three major exceptions.
559
public policy exception An
exception to the employmentat-will doctrine that makes it
unlawful to dismiss an
employee for taking certain
actions in the public interest.
implied covenant of good
faith and fair dealing An
exception to the employmentat-will doctrine, based on the
theory that every employment
contract, even an unwritten
one, contains the implicit
understanding that the parties
will deal fairly with each other.
TABLE 22-1 EXCEPTIONS TO EMPLOYMENT-AT-WILL DOCTRINE
Public Policy Exception
Implied Contract Exception
Good Faith and Fair Dealing Exception
Alaska, Arizona, Arkansas, California,
Colorado, Connecticut, Delaware, District
of Columbia, Hawaii, Idaho, Illinois,
Indiana, Iowa, Kansas, Kentucky,
Maryland, Massachusetts, Michigan,
Minnesota, Mississippi, Missouri, Montana,
Nevada, New Hampshire, New Jersey,
New Mexico, North Carolina, North
Dakota, Ohio, Oklahoma, Oregon,
Pennsylvania, South Carolina, South
Dakota, Tennessee, Texas, Utah, Vermont,
Virginia, Washington, West Virginia,
Wisconsin, Wyoming
Alabama, Alaska, Arizona,
Arkansas, California, Colorado,
Connecticut, District of Columbia,
Hawaii, Idaho, Illinois, Iowa,
Kansas, Kentucky, Maine, Maryland,
Michigan, Minnesota, Mississippi,
Nebraska, Nevada, New Hampshire,
New Jersey, New Mexico, New
York, North Dakota, Ohio,
Oklahoma, Oregon, South Carolina,
South Dakota, Tennessee, Utah,
Vermont, Washington, West
Virginia, Wisconsin, Wyoming
Alabama, Alaska, Arizona, California,
Delaware, Idaho, Massachusetts, Montana,
Nevada, Utah, Wyoming
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TABLE 22-2 FEDERAL STATUTES PROHIBITING DISCRIMINATION IN EMPLOYMENT
Law
Prohibited Conduct
Remedies
Civil Rights Acts of 1866
and 1871, codified as 42
U.S.C. §§ 1981 and 1982
Equal Pay Act of 1963
Discrimination on the basis of race and
ethnicity
Compensatory damages, including several years of
back pay, punitive damages, attorney’s fees, court
costs, and court orders
Back pay, liquidated damages equivalent to back pay
(if defendant was not acting in good faith), attorney’s
fees, and court costs
Back pay for up to two years, remedial seniority,
compensatory damages, punitive damages (may be
limited due to class), attorney’s fees, court costs, and
court orders for whatever actions are appropriate,
including reinstatement and affirmative action
Back pay, liquidated damages equal to back pay (if
defendant acted willfully), attorney’s fees, court costs,
and appropriate court orders including reinstatement
Back pay, attorney’s fees, court costs, and court
orders for appropriate affirmative action
Wage discrimination on the basis of sex
Civil Rights Acts of 1964
(Title VII) and 1991
Discrimination in terms and conditions of
employment on the basis of race, color,
religion, sex, or national origin
Age Discrimination in
Employment Act of 1969
Discrimination in terms and conditions of
employment on the basis of age when the
affected individual is age 40 or older
Discrimination by government or
governmental contractor on the basis of a
handicap
Discrimination in employment on the
basis of a disability
Rehabilitation Act of 1973
Americans with Disabilities
Act of 1991
Hiring, promotion, reinstatement, back pay,
reasonable accommodation, compensatory damages,
and punitive damages
Constitutional Provisions
Civil Rights Act of 1866
Statute guaranteeing that all
persons in the United States
have the same right to make
and enforce contracts and
have the full and equal benefit
of the law.
The beginnings of antidiscrimination law can be traced back to three constitutional provisions: the Fifth Amendment, which states that no person may
be deprived of life, liberty, or property without due process of law; the Thirteenth Amendment, which abolished slavery; and the Fourteenth Amendment, which granted former slaves all the rights and privileges of citizenship
and guaranteed the equal protection of the law to all persons. These provisions alone, however, were not sufficient to prohibit the unequal treatment
of citizens on the basis of their race, sex, age, religion, and national origin.
Congress needed to enact major legislation to bring about a reduction in
discrimination. These laws, referred to as civil rights laws and antidiscrimination laws, are summarized in Table 22-2 and discussed in detail in the
following sections.
The first major civil rights act was passed immediately after the Civil War: the
Civil Rights Act of 1866 (42 U.S.C. Section 1981). This act was designed to effectuate the Thirteenth Amendment and guarantees that all persons in the United
States have the same right to make and enforce contracts and have full and equal
benefit of the law. The Civil Rights Act of 1871 (42 U.S.C. Section 1982) prohibited discrimination by state and local governments. Initially used only when
there was state action, today these acts are also used against purely private discrimination, especially in employment.
Civil Rights Act of 1871
Statute that prohibits
discrimination by state and
local governments.
The Civil Rights Acts of 1866 and 1871
APPLICABILITY OF THE ACTS
Initially, the civil rights acts were interpreted very narrowly to prohibit discrimination based only on race. For several years, circuit courts of appeals were split
as to how race is defined. In June 1986, the U.S. Supreme Court resolved that
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561
issue by holding that both an Arabic and a Jewish individual were protected by
the Civil Rights Act of 1866. Justice White, writing the majority opinion in Saint
Francis College et al. v. Majid Ghaidan Al-Khazraji,1 said that it was clear from
the legislative history that the act was intended to protect from discrimination
“identifiable classes of persons who are subjected to intentional discrimination
solely because of their ancestry or ethnic characteristics, even if those individuals would be considered part of the Caucasian race today.” Thus, today these
laws have a broader application.
Remedies. The acts themselves do not have specific provisions for remedies.
A wide variety of both legal remedies (money damages) and equitable remedies
(court orders) have been awarded under these statutes. The courts are free under these acts to award compensatory damages, that is, damages designed to
make the plaintiff “whole” again, which may amount to several years of back
pay. The courts may also award punitive damages, an amount intended to penalize the defendant for wrongful conduct. Finally, the courts may require the
defendant to pay the plaintiff’s attorney’s fees.
Procedural Limitation. Unlike most antidiscrimination laws, the Civil Rights
Acts of 1866 and 1871 do not require the plaintiff to first attempt to resolve the
discrimination problem through any administrative procedures. The plaintiff simply files the action in federal district court within the time limit prescribed by the
state statute of limitations, requesting a jury trial if one is desired. Often a claim
under the 1866 or 1871 Civil Rights Act will be added to a claim under another
antidiscrimination statute.
The Equal Pay Act of 1963
The next major piece of federal legislation to address the problem of discrimination was the Equal Pay Act of 1963, an amendment to the Fair Labor Standards Act. Enacted at a time when the average wages of women were less than
60 percent of those of men, the act was designed with a very narrow focus: to
prevent wage discrimination based on sex within a business establishment. It
was primarily designed to remedy the situations in which women, working
alongside men or replacing men, were being paid lower wages for doing substantially the same job.
As stated in 29 U.S.C. Section 206(d)(1), the act prohibits any employer from
discriminating within any “establishment”
between employees on the basis of sex by paying wages to employees in such
establishment at a rate less than the rate at which he pays wages to employees
of the opposite sex . . . for equal work on jobs the performance of which
requires equal skill, effort, and responsibility, and which are performed
under similar working conditions, except where payment is made pursuant to
(i) a seniority system; (ii) a merit system; (iii) a system which measures
earnings by quantity or quality of production; or (iv) differential based on
any factor other than sex.
In the typical Equal Pay Act case, the burden of proof is initially on the plaintiff to show that the defendant-employer pays unequal wages to men and
women for doing equal work at the same establishment. Two questions necessarily arise: What is equal work? What is an establishment?
1
483 U.S. 1011 (1987). The accompanying case, filed by a Jewish plaintiff, was Shaare Tefila
Congregation et al. v. John William Cobb et al., 481 U.S. 615 (1987).
Equal Pay Act of 1963 Statute
that prohibits wage
discrimination based on sex.
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EQUAL WORK
The courts have interpreted equal to mean substantially the same in terms of all
four factors listed in the act: skill, effort, responsibility, and working conditions. If
the employer varies the actual job duties affecting any one of those factors, there is
no violation of the act. For example, if jobs are equal in skill and working conditions, but one requires greater effort, whereas the other requires greater responsibility, the jobs are not equal. Obviously, a sophisticated employer could easily vary
at least one duty and then pay men and women different wages or salaries.
Skill is defined as experience, education, training, and ability required to
do the job. Effort refers to physical or mental exertion needed for performance
of the job. Responsibility is measured by the economic and social consequences
that would result from a failure of the employee to perform the job duties in
question. Similar working conditions refers to the safety hazards, physical surroundings, and hours of employment. An employer, however, is entitled to pay
a shift premium to employees working different shifts, as long as the employer
does not use sex as a basis for determining who is entitled to work the higherpaying shifts.
Extra Duties. Sometimes, employers try to justify pay inequities on the ground
that employees of one sex are given extra duties that justify their extra pay. The
courts scrutinize these duties very closely. The duties are sufficient to preclude
a finding of equal work only if:
1. the duties are actually performed by those receiving the extra pay;
2. the duties regularly constitute a significant portion of the employee’s job;
3. the duties are substantial, as opposed to inconsequential;
4. additional duties of a comparable nature are not imposed on workers of the
opposite sex; and
5. the extra duties are commensurate with the pay differential.
In some jurisdictions, the additional duties must also be available on a nondiscriminatory basis.
Establishments. One business location is obviously an establishment, but if an
employer has several locations, they may all be considered part of the same
establishment on the basis of an analysis of the company’s labor relations policy.
The greater the degree of centralized authority for hiring, firing, wage setting,
and other human resource matters, the more likely the courts are to find multiple locations to be a single establishment. The more freedom each facility has to
determine its own human resource policies, the more likely it is that a court will
find it to be independent of other facilities.
DEFENSES
Once an employee establishes that an employer is paying different wages to employees of different sexes doing substantially equal work, there are certain defenses the employer can raise. These are, in essence, legal justifications for
paying unequal wages to men and women.
The first defense that an employer may use is that the pay differential is
based on one of the four statutory exceptions found in the Bennet Amendment
to the Equal Pay Act. If the wage differential is based on one of these four factors, the differential is justified and the employer is not in violation of the act.
The four factors are:
1. A bona fide seniority system
2. A bona fide merit system
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563
3. A pay system based on quality or quantity of output
4. Factors other than sex
The first three factors are fairly straightforward. Seniority-, merit-, and
productivity-based wage systems must be enacted in good faith and must be
applied to both men and women. As minimal evidence of good faith, any
such system should be written down.
The fourth factor presents greater problems. Circumstances such as greater
availability of females and their willingness to work for lower wages do not constitute “factors other than sex.”
One frequently litigated factor is training programs. A training program that
requires trainees to rotate through jobs that are normally paid lower wages will
be upheld as long as it is a bona fide training program and not a sham for paying members of one sex higher wages for doing the same job. The court will
look at each case individually, but factors that would lead to a training program’s
being found bona fide include a written description of the training program that
is available to employees, nondiscriminatory access to the program for members
of both sexes, and demonstrated awareness of the availability of the program by
employees of both sexes.
REMEDIES
An employer found to have violated the act cannot remedy the violation by reducing the higher-paid workers’ wages or by transferring those of one sex to another job so that they are no longer doing equal work.
A person who has been subjected to an Equal Pay Act violation may bring
a private action under Section 16(b) of the act and recover back pay in the
amount of the differential paid to members of the opposite sex. If the employer
had not been acting in good faith in paying the discriminatory wage rates, the
court will also award the plaintiff damages in an additional amount equal to
the back pay. A successful plaintiff is also entitled to attorney’s fees.
The Civil Rights Act of 1964, as Amended
(Title VII), and the Civil Rights Act of 1991
The year after it passed the Equal Pay Act, Congress passed the Civil Rights
Act of 1964. Title VII of this act is the most common basis for lawsuits
premised on discrimination, because it covers a broader area of potential
claimants than does either of the previously discussed statutes. Title VII prohibits employers from (1) hiring, firing, or otherwise discriminating in terms
and conditions of employment and (2) segregating employees in a manner
that would affect their employment opportunities on the basis of their race,
color, religion, sex, or national origin. These five categories are known as
protected classes.
It is important that today’s business manager be familiar with Title VII, because the number of claims filed under the act is significant. According to the
EEOC, the total number of charges filed in 2009 was 93,277.2 That number is
lower than the 95,402 claims filed in 2008, but we would want to see more years
of declining claims being filed before determining that there is a significant
downward trend occurring.
2
EEOC, Charge Statistics, FY 1997 – 2009, http://www.eeoc.gov/eeoc/statistics/enforcement/
charges.cfm.
Title VII Statute that prohibits
discrimination in hiring, firing,
or other terms and conditions
of employment on the basis of
race, color, religion, sex, or
national origin.
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APPLICABILITY OF THE ACT
Employers covered by Title VII include only those who have 15 or more employees, that year or last, for 20 consecutive weeks and are engaged in a business that affects interstate commerce. In 1994, the term employer was broadened
to include the U.S. government, corporations owned by the government, and
agencies of the District of Columbia. The act also covers Indian tribes, private
clubs, unions, and employment agencies.
In addition to prohibiting discrimination by covered employers, unions, and employment agencies, the act also imposes recordkeeping and reporting requirements
on these parties. Covered parties must maintain all records regarding employment
opportunities for at least six months. Such records include job applications, notices
for job openings, and records of layoffs. If an employment discrimination charge is
filed against an employer, such records must be kept until the case is concluded.
EEO-1 forms (forms containing information concerning the number of minorities in
various job classifications) must be filed annually with the Equal Employment
Opportunity Commission (EEOC) by employers of more than 100 workers. A copy
of this form is shown in Exhibit 22-1. Finally, each covered employer must display
a summary of the relevant portions of Title VII where the employees can see it. The
notice must be printed in a language that the employees can read.
PROOF IN EMPLOYMENT DISCRIMINATION CASES
The burden of proof in a discrimination case is initially on the plaintiff. He or
she attempts to establish discrimination in one of three ways: (1) disparate treatment, (2) disparate impact, or (3) harassment.
disparate treatment Occurs
when the employer treats one
employee less favorably than
another because of that
employee’s color, race,
religion, sex, or national origin.
disparate impact Occurs
when the employer’s facially
neutral policy or practice has a
discriminatory effect on
employees who belong to a
protected class.
Disparate Treatment. Disparate treatment occurs when one individual
is treated less favorably than another because of color, race, religion, sex, or national origin. The key in such cases is proving the employer’s unlawful
discriminatory motive. This process is referred to as building a prima facie case.
The plaintiff must establish the following set of facts: (1) The plaintiff is
within one of the protected classes; (2) he or she applied for a job for which the
employer was seeking applicants for hire or promotion; (3) the plaintiff possessed the minimum qualifications to perform that job; (4) the plaintiff was
denied the job or promotion; and (5) the employer continued to look for someone to fill the position.
Once the plaintiff establishes these facts, the burden shifts to the defendant
to articulate legitimate and nondiscriminatory business reasons for rejecting the
plaintiff. Such reasons for a failure to promote, for instance, might include a
poor work record or excessive absenteeism. If the employer meets this burden, the plaintiff must then demonstrate that the reasons the defendant offered
were just a pretext for a real discriminatory motive. In other words, the alleged
reason was not the real reason; it was just put forth because it sounded good.
One way in which the plaintiff can demonstrate pretext is by showing that the
criteria used to reject the plaintiff were not applied to others in the same situation. Introducing past discriminatory policies would also be relevant, as
would statistics showing a general practice of discrimination by the defendant.
At the pretext stage, the issue of proving an employer’s intent to discriminate
appears first and is usually the key to the plaintiff’s winning or losing the case.
Exhibit 22-2 shows how the burden of proof shifts in a disparate treatment case.
Disparate Impact. As complex as disparate treatment cases are, disparate
impact cases are even more difficult to establish. Disparate impact cases
arise when a plaintiff attempts to establish that an employer’s facially neutral
employment policy or practice has a discriminatory effect or impact on a
EQUAL EMPLOYMENT OPPORTUNITY
•
•
Joint Reporting
Committee
Equal Employment
Opportunity Commission
1 OF
Office of Federal
Contract Compliance Programs (Labor)
EMPLOYER INFORMATION REPORT EEO-1
1994
1
RETURN COMPLETED REPORT TO:
THE JOINT REPORTING COMMITTEE
P.O. BOX 779
NORFOLK,VA 23501
PHONE: (804) 461-1213
Section A—TYPE OF REPORT
Refer to instructions for number and types of reports to be filed.
1. Indicate by marking in the appropriate box the type of reporting unit for which this copy of the form is submitted (MARK ONLY ONE BOX).
(1)
Multi-establishment Employer:
(2)
Consolidated Report (Required)
(3)
Headquarters Unit Report (Required)
(4)
Individual Establishment Report (Submit one for each establishment with 50 or more employees)
(5)
Special Report
Single-establishment Employer Report
2. Total number of reports being filed by this Company (Answers on Consolidated Report only)
OFFICE
USE
ONLY
Section B—COMPANY IDENTIFICATION (To be answered by all employers)
1. Parent Company
a. Name of parent company (owns or controls establishment in item 2) omit if same as label
a.
Address (Number and street)
b.
State
City or town
ZIP code
c.
2. Establishment for which this report is filed. (Omit if same as label)
a. Name of establishment
d.
Address (Number and street)
City or town
County
State
ZIP code
e.
f.
b. Employer identification No. (IRS 9-DIGIT TAX NUMBER)
c. Was an EEO-1 report filed for this establishment last year?
Yes
No
Section C—EMPLOYERS WHO ARE REQUIRED TO FILE (To be answered by all employers)
Yes
Yes
No
No
1. Does the entire company have at least 100 employees in the payroll period for which you are reporting?
2. Is your company affiliated through common ownership and/or centralized management with other entities in an enterprise
with a total employment of 100 or more?
Yes
No
3.
Does the company or any of its establishments (a) have 50 or more employees AND (b) is not exempt as provided by
41 CFR 60-1.5. AND either (1) is a prime government contractor or first-tier subcontactor, and has a contract,
subcontract, or purchase order amounting to $50,000 or more, or (2) serves as a depository of Government funds in
any amount or is a financial institution which is an issuing and paying agent for U.S. Savings Bonds and Savings Notes?
If the response to question C-3 is yes, please enter your Dun and Bradstreet identification number (if you have one):
NOTE: If the answer is yes to questions 1, 2, or 3, complete the entire form, otherwise skip to Section G.
NSN 7540-00-180-6384
EXHIBIT 22-1
(Continued)
EEO-1 FORM
565
100 Page 2
Section D—EMPLOYMENT DATA
Employment at this establishment—Report all permanent full-time and part-time employees including apprentices and on-the-job trainees unless specifically
excluded as set forth in the instructions. Enter the appropriate figures on all lines and in all columns. Blank spaces will be considered as zeros.
NUMBER OF EMPLOYEES
OVERALL
TOTALS
(SUM OF
COL. B
THRU K)
A
JOB
CATEGORIES
Officials and
Managers
1
Professionals
2
Technicians
3
Sales Workers
4
Office and
Clerical
Craft Workers
(Skilled)
Operatives
(Semi-Skilled)
Laborers
(Unskilled)
5
WHITE
(NOT OF
HISPANIC
ORIGIN)
B
MALE
HISPANIC
BLACK
(NOT OF
HISPANIC
ORIGIN)
C
D
ASIAN OR
PACIFIC
ISLANDER
E
AMERICAN
INDIAN OR
ALASKAN
NATIVE
F
WHITE
(NOT OF
HISPANIC
ORIGIN)
G
FEMALE
HISPANIC
BLACK
(NOT OF
HISPANIC
ORIGIN)
H
I
ASIAN OR
PACIFIC
ISLANDER
J
AMERICAN
INDIAN OR
ALASKAN
NATIVE
K
6
7
8
Service Workers
9
TOTAL
10
Total employment
reported in previous
EEO—1 report
11
NOTE: Omit questions 1 and 2 on the Consolidated Report.
1. Date(s) of payroll period used:
2. Does this establishment employ apprentices:
1
Yes
2
No
Section E—ESTABLISHMENT INFORMATION (Omit on the Consolidated Report)
1. What is the major activity of this establishment? (Be specific, i.e., manufacturing steel castings, retail grocer, wholesale plumbing supplies,
title insurance, etc.) Include the specific type of product or type of service provided, as well as the principal business or industrial activity.
OFFICE
USE
ONLY
Section F—REMARKS
Use this item to give any identification data appearing on last report which differs from that given above, explain major
changes in composition or reporting units and other pertinent information.
Check
One
1
2
Section G—CERTIFICATION (See instructions G)
All reports are accurate and were prepared in accordance with the instructions (check on consolidated only).
This report is accurate and was prepared in accordance with the instructions.
Name of Certifying Official
Title
Name of person to contact regarding
this report (Type or print)
Address (Number and Street)
Title
City and State
Signature
ZIP Code
Date
Telephone Number (Including
Area Code)
All reports and information obtained from individual reports will be kept confidential as required by Section 709(e) of Title VII.
WILLFULLY FALSE STATEMENTS ON THIS REPORT ARE PUNISHABLE BY LAW, U.S. CODE, TITLE 18, SECTION 1001.
EXHIBIT 22-1
CONTINUED
566
Extension
CHAPTER 22
The plaintiff proves a
prima facie case
The plaintiff proves that
defendant’s “reason”
was just a pretext
Burden of proof shifts
䉬
The defendant proves a legitimate,
nondiscriminatory reason for
rejecting plaintiff
567
EXHIBIT 22-2
THE SHIFTING BURDEN
OF PROOF IN A DISPARATE
TREATMENT CASE
Burden of proof shifts back
protected class. In other words, a requirement of the policy or practice applies
to everyone equally, but, in application, it disproportionately limits employment opportunities for a particular protected class.
To establish a case of discrimination based on disparate impact, the plaintiff
must first establish statistically that the rule disproportionately restricts employment
opportunities for a protected class. The burden of proof then shifts to the defendant to demonstrate that the practice or policy is a business necessity. The plaintiff, at this point, can still recover by proving that the “necessity” was promulgated
as a pretext for discrimination.
The first two steps for proving a prima facie case of disparate impact were laid
out in Griggs v. Duke Power Co.3 In that case, the employer-defendant required all
applicants to have a high-school diploma and a successful score on a professionally recognized intelligence test for all jobs except that of laborer. By establishing
these criteria, the employer proposed to upgrade the quality of its workforce.
The plaintiff demonstrated the discriminatory impact by showing that 34 percent of the white males in the state had high-school diplomas, whereas only
12 percent of the black males did, and by introducing evidence from an EEOC study
showing that 58 percent of the whites, compared with 6 percent of the blacks, had
passed tests similar to the one given by the defendant. The defendant could show
no business-related justification for either employment policy, so the plaintiff was
successful. Not all employees of Duke Power needed to be smart or have highschool diplomas. After all, when does a student in high school learn how to install
power lines or repair company vehicles? A high IQ or a high-school or college
diploma may be necessary for some jobs, but not for all jobs at Duke Power.
Harassment. The third way to prove discrimination is to demonstrate harassment. Harassment is a relatively new basis for a discrimination claim; it first developed in the context of discrimination based on sex and then evolved to
become applicable to other protected classes.
The definition of sexual harassment stated in the EEOC Guidelines and accepted by the U.S. Supreme Court is “unwelcome sexual advances, requests for
sexual favors, and other verbal or physical conduct of a sexual nature,” which
implicitly or explicitly make submission a term or condition of employment;
make employment decisions related to the individual dependent on submission
to or rejection of such conduct, or have the purpose or effect of creating an intimidating, hostile, or offensive environment.
The courts have recognized two distinct forms of sexual harassment. The first,
quid pro quo, occurs when a supervisor makes sexual demands on someone of
the opposite sex, and this demand is reasonably perceived as a term or condition
of employment. The basis for this rule is that similar demands would not be made
by the supervisor on someone of the same sex.
The second form of sexual harassment involves the creation of a hostile environment. Case 22-1 demonstrates the standards used by the U.S. Supreme
Court to determine whether an employer’s conduct has indeed created a hostile
work environment.
3
401 U.S. 424 (1971).
sexual harassment
Unwelcome sexual advances,
requests for sexual favors, and
other verbal or physical
conduct of a sexual nature,
which explicitly or implicitly
makes submission a term or
condition of employment or
creates an intimidating, hostile,
or offensive environment.
568
PART THREE
CASE
䉬
22-1
Teresa Harris v. Forklift Systems, Inc.
United States Supreme Court
510 U.S. 17 (1994)
P
laintiff Harris was a manager for Defendant Forklift Systems, Inc. During her tenure at Forklift Systems, Plaintiff Harris was repeatedly insulted by defendant’s president
and, because of her gender, subjected to sexual innuendos.
Numerous times, in front of others, the president told
Harris, “You’re just a woman, what do you know?”He sometimes asked Harris and other female employees to remove
coins from his pockets and made suggestive comments
about their clothes. He suggested to Harris in front of
others that they negotiate her salary at the Holiday Inn.
When Harris complained, he said he would stop, but he did
not; so she quit and filed an action against the defendant for
creating an abusive work environment based on her sex.
The district court found in favor of the defendant,
holding that some of the comments were offensive to the
reasonable woman but were not so serious as to severely
affect Harris’s psychological well-being or to interfere
with her work performance. The court of appeals
affirmed. Plaintiff Harris appealed to the U.S. Supreme
Court.
Justice O’Connor
In this case we consider the definition of a discriminatorily
“abusive work environment” (a “hostile work environment”) under Title VII.
Title VII of the Civil Rights Act of 1964 makes it “an
unlawful employment practice for an employer . . . to
discriminate against any individual with respect to his
compensation, terms, conditions, or privileges of
employment, because of such individual’s race, color,
religion, sex, or national origin.” . . . [T]his language “is
not limited to ‘economic’ or ‘tangible’ discrimination.
The phrase ‘terms, conditions, or privileges of employment’ evinces a congressional intent ‘to strike at the
entire spectrum of disparate treatment of men and
women’ in employment,” which includes requiring people to work in a discriminatorily hostile or abusive environment. When the workplace is permeated with
“discriminatory intimidation, ridicule, and insult,” that is
“sufficiently severe or pervasive to alter the conditions
of the victim’s employment and create an abusive working environment.”
This standard, which we reaffirm today, takes a middle path between making actionable any conduct that is
merely offensive and requiring the conduct to cause a
tangible psychological injury. As we pointed out in
Meritor, “mere utterance of an ‘epithet which engenders
offensive feelings in a employee,’ does not sufficiently affect conditions of employment to implicate Title VII.
Conduct that is not severe or pervasive enough to create
an objectively hostile or abusive work environment’—an
environment that a reasonable person would find hostile
or abusive”—is beyond Title VII’s purview. Likewise, if
the victim does not subjectively perceive the environment to be abusive, the conduct has not actually altered
the conditions of the victim’s employment, and there is
no Title VII violation.
But Title VII comes into play before the harassing
conduct leads to a nervous breakdown. A discriminatorily abusive work environment, even one that does not
seriously affect employees’ psychological well-being, can
and often will detract from employees’ job performance,
discourage employees from remaining on the job, or
keep them from advancing in their careers. Moreover,
even without regard to these tangible effects, the very
fact that the discriminatory conduct was so severe or
pervasive that it created a work environment abusive to
employees because of their race, gender, religion, or national origin offends Title VII’s broad rule of workplace
equality. The appalling conduct alleged in Meritor, and
the reference in that case to environments “so heavily
polluted with discrimination as to destroy completely
the emotional and psychological stability of minority
group workers,” merely present some especially egregious examples of harassment. They do not mark the
boundary of what is actionable.
We therefore believe the District Court erred in relying
on whether the conduct “seriously affected plaintiff’s psychological well-being” or led her to “suffer injury.” Such an
inquiry may needlessly focus the fact-finder’s attention on
concrete psychological harm, an element Title VII does
not require. Certainly Title VII bars conduct that would seriously affect a reasonable person’s psychological wellbeing, but the statute is not limited to such conduct. So
long as the environment would reasonably be perceived,
and is perceived, as hostile or abusive, there is no need for
it also to be psychologically injurious.
This is not, and by its nature cannot be, a mathematically precise test. But we can say that whether an environment is “hostile” or “abusive” can be determined only by
looking at all the circumstances. These may include the
frequency of the discriminatory conduct; its severity;
whether it is physically threatening or humiliating, or a
mere offensive utterance; and whether it unreasonably interferes with an employee’s work performance. The effect
on the employee’s psychological well-being is, of course,
relevant to determining whether the plaintiff actually
found the environment abusive. But while psychological
harm, like any other relevant factor, may be taken into account, no single factor is required.
Reversed and remanded in favor of Plaintiff, Harris.
CHAPTER 22
䉬
569
As has previously been touched upon, the judiciary most often operates in relationship to shades of gray and not to
the black and white between which those shades lie. The Court’s decision in Case 22-1, in large part dependent on its
determination of a definition, illustrates this point.
The Court’s primary test was to decide what constitutes an “abusive work environment,” the second type of sexual harassment actionable under Title VII. Deciding on such a definition is not as easy as going to a legal dictionary and
looking up “abusive work environment.” The Court had to interpret the meaning of such an environment, and important to this interpretation were legal precedent, ambiguity, and primary ethical norms.
Hence, the questions that follow will aid in thinking critically about these factors influential in the Court’s interpretation.
1.
What ambiguous language did the Court leave undefined in Case 22-1?
Clue: To find this answer, look at the Court’s definition of an “objectively hostile work environment.” As always, remember that ambiguities, most often, are adjectives.
2.
In her discussion of the Meritor Savings Bank precedent, Justice O’Connor made it clear that the district court
misinterpreted the Meritor decision in rendering its decision. Contrary to the district court’s decision, the existence of which key fact was not necessary for the Court to find the defendant guilty of sexual harassment?
Clue: Revisit the paragraph discussing the district court’s dismissal of Harris’s claim. On what basis was this
dismissal made? This is the key fact the existence of which the Supreme Court found unnecessary for judgment
in favor of the plaintiff.
Since Meritor, conflicting lower-court decisions have created confusion
in the area of sexual harassment. It appeared that in a quid pro quo case, a
company was liable regardless of its knowledge, but in a hostile environment
case, a company could not be held liable without direct knowledge of the situation. Another question was whether there could be recovery when only empty
threats were made.
For example, in Jones v. Clinton,4 the district court judge threw out Jones’s
sexual harassment case against the president because Jones had no clear and tangible job detriment (necessary to establish a quid pro quo case), and she was not
subject to a hostile environment when the totality of the circumstances was
viewed. Even if the allegations were true, the contacts did not constitute “the kind
of pervasive, intimidating, abusive conduct”5 necessary for a hostile environment.
The U.S. Supreme Court attempted to clarify these issues in Ellerth v.
Burlington.6 Ellerth was subjected to a litany of dirty jokes and sexual innuendos from her boss. He propositioned her and threatened to make her life miserable if she refused him. She refused him without reprisals and was even
promoted. She did not complain about harassment but quit after a year because
she could not stand the threats and innuendos.
In a decision that offered something to both plaintiffs and defendants, the
high court ruled that
an employer is subject to vicarious liability to a victimized employee for
an actionable hostile environment created by a supervisor with immediate
(or successively higher) authority over the employee. When no tangible
employment action is taken, a defending employer may raise an affirmative
defense to liability [by showing that] (a) the employer exercised reasonable
4
No. LR-C-94-290 (E.D. Ark. 1998).
Id.
6
118 S. Ct. 2275 (1998).
5
570
PART THREE
䉬
care to prevent and correct promptly any sexually harassing behavior,
and (b) the plaintiff employee unreasonably failed to take advantage
of any preventive or corrective opportunities provided by the employer
or to avoid harm otherwise. No affirmative defense is available,
however, when the supervisor’s harassment culminates in a tangible
employment action.7
The Court then remanded the case to the lower court for a new trial.
Under limited circumstances, employers may be held liable for harassment
of their employees by nonemployees: If an employer knows that a customer is
harassing an employee but does nothing to remedy the situation, the employer
may be liable. For example, in Lockhard v. Pizza Hut Inc.,8 the franchise was
held liable when the company failed to take any steps to stop the harassment of
a waitress by two male customers.
Same-Sex Harassment. Initially, same-sex harassment did not constitute sexual harassment. In the first appellate case on this issue, a male employee sued
his employer for sexual harassment, alleging that on several occasions his male
supervisor had approached him from behind and grabbed his crotch.9 The
court of appeals affirmed the trial court’s dismissal of the claim on the ground
that no prima facie case had been established. The court said that Title VII addressed gender discrimination, and harassment by a male supervisor of a male
employee did not constitute sexual harassment, regardless of the sexual overtones of the harassment.
However, the circuit courts soon became split on whether one could be sexually harassed by a person of the same sex. The U.S. Supreme Court finally rendered a definitive answer to that issue in the case of Joseph Oncale v. Sundowner
Offshore Services,10 with its holding that “nothing in Title VII necessarily bars a
claim of discrimination ‘because of . . . sex’ merely because the plaintiff and the
defendant are of the same sex.”11 As long as the discrimination was because of
the victim’s sex, it was actionable.
Hostile Environment Extended. Hostile environment cases have also been
used in cases of discrimination based on religion, race, and even age.12 For example, in one case,13 Hispanic and black corrections workers demonstrated that
a hostile work environment existed by proving that they had been subjected to
continuing verbal abuse and racial harassment by coworkers and that the county
sheriff’s department had done nothing to prevent the abuse. The white employees had continually used racial epithets and posted racially offensive materials
on bulletin boards, such as a picture of a black man with a noose around his
neck, cartoons favorably portraying the Ku Klux Klan, and a “black officers’
study guide” consisting of children’s puzzles. White officers once dressed a Hispanic inmate in a straw hat, sheet, and sign that said “spic.” Such activities were
found by the court to constitute a hostile work environment.
STATUTORY DEFENSES
The three most important defenses available to defendants in Title VII cases are
bona fide occupational qualification (BFOQ), merit, and seniority. These defenses
are raised by the defendant after the plaintiff has established a prima facie case
7
Id.
162 F.3d 1062 (10th Cir. 1998).
9
Garcia v. Elf Atochem, 28 F.3d 466 (5th Cir. 1994).
10
118 S. Ct. 998 (1998).
11
Id.
12
Crawford v. Medina General Hospital, 96 F.3d 830 (6th Cir. 1996).
13
Snell v. Suffolk County, 782 F.2d 1094 (1986).
8
CHAPTER 22
䉬
571
of discrimination based on disparate treatment, disparate impact, or a pattern or
practice of discrimination.
Bona Fide Occupational Qualification. The BFOQ defense allows an employer to discriminate in hiring on the basis of sex, religion, or national origin when such a characteristic is necessary to performance of the job. Race
or color cannot be a BFOQ. Such necessity must be based on actual qualifications, not on stereotypes about one group’s abilities. Being a male cannot
be a BFOQ for a job because it is a dirty or “strenuous” job, although there
may be a valid requirement that an applicant be able to lift a certain amount
of weight if such lifting is a part of the job. A BFOQ does not arise because
an employer’s customers would prefer to be served by someone of a particular gender or national origin; nor does inconvenience to the employer, such
as having to provide two sets of restroom facilities, make a classification
a BFOQ.
Merit. Most merit claims involve the use of tests. Using a professionally developed ability test, which is not designed, intended, or used to discriminate, is
legal. Such tests may have an adverse impact on a class, but do not violate the
act as long as they are manifestly related to job performance. The Uniform
Guidelines on Employee Selection Procedures (UGESP) have, since 1978, contained the policy of all governmental agencies charged with enforcing civil
rights, and they provide guidance to employers and other interested persons
about when ability tests are valid and job related. Under these guidelines, tests
must be validated in accordance with standards established by the American
Psychological Association.
Acceptable validation includes: (1) criterion-related validity, which is the
statistical relationship between test scores and objective criteria of job performance; (2) content validity, which isolates some skill used on the job and
directly tests that skill; and (3) construct validity, wherein a psychological trait
needed to perform the job is measured. A test that required a secretary to type
and take shorthand would be content valid. A test of patience for a teacher
would be construct valid.
Sexual Harassment in France
The French deal with the problem of sexual harassment in employment very differently than Americans do. In
the United States, sexual harassment is a civil offense and can receive compensatory and punitive damages. In
France, sexual harassment is instead part of the criminal code. Part of this difference has to do with a difference
in the definitions of sexual harassment. The United States recognizes both quid pro quo and hostile work environment sexual harassment, whereas the French recognize only quid pro quo. Sexual harassment in France is
defined as “[t]he fact of harassing anyone using orders, threats or constraint, in order to obtain favors of a sexual
nature, by a person abusing the authority that functions confer on him. . . .” With this definition, it makes sense
that the French consider sexual harassment a criminal offense. The French do not recognize the idea of a hostile
work environment, and it is considered somewhat normal for male employees to comment on the attractiveness
of female employees at work.
The French sexual harassment law also differs significantly from American law in its method of enforcement. Women in France are responsible for filing their own claims with the court, and the punishment their
harasser can receive is limited to one year in jail or paying a fine. Also, French companies are not seen as
responsible for the behavior of their employees, so if a supervisor sexually harasses a female subordinate, the
woman cannot claim damages from the company. Her charges will be filed only against the supervisor who
sexually harassed her.
572
PART THREE
䉬
Seniority Systems. A final statutory defense, available under Section 703(h), is
a bona fide seniority system. A seniority system, in which employees are given
preferential treatment based on their length of service, may perpetuate discrimination that occurred in the past. Nonetheless, such systems are considered bona
fide, and thus are not unlawful if (1) the system applies equally to all persons;
(2) the seniority units follow industry practices; (3) the seniority system did not
have its genesis in discrimination; and (4) the system is maintained free of any
illegal discriminatory purpose.
Mixed Motives. One problem with discrimination cases is proving that the
plaintiff’s membership in a protected class is the reason for unfair treatment. In
the 1991 act, Congress addressed the concept of a “mixed motives” case, that is,
a case in which the plaintiff proves that being a member of a protected class was
one reason for the unfair treatment, but the defendant also proves that it also
had a legal reason. If the court determines that the defendant had mixed motives, the verdict is for the plaintiff, but the court decides whether the plaintiff is
entitled to damages based on the weight of the two motives. Case 22-2 shows
how the Supreme Court ruled on a mixed-motives case.
CASE
22-2
Desert Palace, Inc., dba Caesar’s Palace Hotel & Casino
v. Catharina Costa
Supreme Court of the United States
539 U.S. 90 (2003)
C
atharina Costa worked as a warehouse employee and
heavy equipment operator for Caesar’s Palace Hotel &
Casino (Desert Palace, Inc.) in Las Vegas. Costa, the only
woman in this job as well as in her local Teamsters bargaining unit, was involved in a number of disputes at work
that resulted in disciplinary action. Finally, she had an altercation with a fellow worker, Herbert Gerber. Both employees were disciplined, but Gerber received only a
five-day suspension, because he had a clean record,
whereas Costa was terminated. Costa sued Desert Palace,
asserting sex discrimination and sexual harassment under
Title VII. The district court dismissed the sexual harassment claim but allowed the sex discrimination claim to go
to trial.
At trial, Costa presented evidence that she was singled
out for “intense ‘stalking’” by one of her supervisors, received harsher discipline than male workers for the same
conduct, and received less-favorable treatment than the
male workers in assignment of overtime, and also that
supervisors “stacked” her disciplinary record and used and
tolerated sex-based slurs against her. The district court gave
two important jury instructions before the jurors made
their decision. The jury was instructed that Costa must
prove, by a preponderance of the evidence, that she
suffered adverse work conditions and that her sex was the
motivating factor in the imposition of those work conditions. The jury was also instructed that if the employer was
motivated by sex, as well as some lawful reason, Costa
was entitled to the verdict, but the jury was to decide if
she was entitled to damages. Costa would be entitled to
damages unless Desert Palace proved by a preponderance
of the evidence that she would have been treated the same
regardless of her sex.
The district court found for Costa and Desert Palace appealed. The court of appeals initially vacated and remanded,
finding the mixed-motive instruction inappropriate, but after
hearing the case en banc, it reinstated the district court’s verdict. Desert Palace appealed to the Supreme Court.
Justice Thomas
The question before us in this case is whether a plaintiff must
present direct evidence of discrimination in order to obtain
a mixed-motive instruction under Title VII of the Civil Rights
Act of 1964, as amended by the Civil Rights Act of 1991
(1991 Act). We hold that direct evidence is not required.
I
In Price Waterhouse v. Hopkins, the Court considered
whether an employment decision is made “because of”
sex in a “mixed-motive” case, i.e., where both legitimate
and illegitimate reasons motivated the decision. The
Court concluded that, an employer could “avoid a finding
of liability . . . by proving that it would have made the
same decision even if it had not allowed gender to play
such a role.” The Court was divided, however, over the
predicate question of when the burden of proof may be
shifted to an employer to prove the affirmative defense.
Two years after Price Waterhouse, Congress passed the
1991 Act. In particular, § 107 of the 1991 Act, which is at
CHAPTER 22
issue in this case, “responded”to Price Waterhouse by “setting forth standards applicable in ‘mixed motive’ cases” in
two new statutory provisions. The first establishes an alternative for proving that an “unlawful employment practice” has occurred:
“Except as otherwise provided in this subchapter, an
unlawful employment practice is established when
the complaining party demonstrates that race, color,
religion, sex, or national origin was a motivating factor for any employment practice, even though other
factors also motivated the practice.”
The second provides that, with respect to “a claim in
which an individual proves a violation under section
2000e-2(m),” the employer has a limited affirmative defense that does not absolve it of liability, but restricts the
remedies available to a plaintiff. The available remedies include only declaratory relief, certain types of injunctive relief, and attorney’s fees and costs. In order to avail itself of
the affirmative defense, the employer must “demonstrate
that [it] would have taken the same action in the absence
of the impermissible motivating factor.”
Since the passage of the 1991 Act, the Courts of Appeals have divided over whether a plaintiff must prove by
direct evidence that an impermissible consideration was a
“motivating factor” in an adverse employment action.
II
Our precedents make clear that the starting point for our
analysis is the statutory text. And where, as here, the
words of the statute are unambiguous, the “judicial inquiry
is complete.” Section 2000e-2(m) unambiguously states
that a plaintiff need only “demonstrate” that an employer
used a forbidden consideration with respect to “any employment practice.” On its face, the statute does not mention, much less require, that a plaintiff make a heightened
showing through direct evidence.
Moreover, Congress explicitly defined the term “demonstrates” in the 1991 Act, leaving little doubt that no special
evidentiary showing is required. Title VII defines the term
“demonstrates” as to “meet the burdens of production and
persuasion.” If Congress intended the term “demonstrates”
to require that the “burdens of production and persuasion”
be met by direct evidence or some other heightened showing, it could have made that intent clear by including language to that effect in § 2000e(m). Its failure to do so is
significant, for Congress has been unequivocal when imposing heightened proof requirements in other circumstances, including in other provisions of Title 42.
In addition, Title VII’s silence with respect to the type
of evidence required in mixed-motive cases also suggests
that we should not depart from the “conventional rule of
䉬
573
civil litigation [that] generally applies in Title VII cases.”
That rule requires a plaintiff to prove his case “by a preponderance of the evidence,” using “direct or circumstantial evidence.” We have often acknowledged the utility of
circumstantial evidence in discrimination cases. The reason for treating circumstantial and direct evidence alike is
both clear and deep-rooted: “Circumstantial evidence is
not only sufficient, but may also be more certain, satisfying
and persuasive than direct evidence.”
The adequacy of circumstantial evidence also extends
beyond civil cases; we have never questioned the sufficiency of circumstantial evidence in support of a criminal
conviction, even though proof beyond a reasonable doubt
is required. And juries are routinely instructed that “the
law makes no distinction between the weight or value to
be given to either direct or circumstantial evidence.” It is
not surprising, therefore, that neither petitioner nor its amici curiae can point to any other circumstance in which we
have restricted a litigant to the presentation of direct evidence absent some affirmative directive in a statute.
Finally, the use of the term “demonstrates” in other
provisions of Title VII tends to show further that § 2000e2(m) does not incorporate a direct evidence requirement.
For instance, § 2000e-5(g)(2)(B) requires an employer to
“demonstrate that [it] would have taken the same action
in the absence of the impermissible motivating factor” in
order to take advantage of the partial affirmative defense.
Due to the similarity in structure between that provision
and § 2000e-2(m), it would be logical to assume that the
term “demonstrates” would carry the same meaning with
respect to both provisions. But when pressed at oral
argument about whether direct evidence is required
before the partial affirmative defense can be invoked,
petitioner did not “agree that . . . the defendant or the
employer has any heightened standard” to satisfy. Absent
some congressional indication to the contrary, we decline
to give the same term in the same Act a different meaning depending on whether the rights of the plaintiff or
the defendant are at issue.
For the reasons stated above, we agree with the Court
of Appeals that no heightened showing is required under
§ 2000e-2(m) n3.
In order to obtain an instruction under § 2000e-2(m), a
plaintiff need only present sufficient evidence for a reasonable jury to conclude, by a preponderance of the evidence, that “race, color, religion, sex, or national origin
was a motivating factor for any employment practice.” Because direct evidence of discrimination is not required in
mixed-motive cases, the Court of Appeals correctly concluded that the District Court did not abuse its discretion
in giving a mixed-motive instruction to the jury.
Affirmed, in favor of the Respondent, Catharina Costa.
PROTECTED CLASSES
Five classes are protected under Title VII. Unique problems have arisen with regard to each of these classes.
Race and Color. A primary goal of Title VII was to remedy the discrimination in
employment to which blacks had long been subjected. The act, however, also
574
PART THREE
䉬
contains a proviso stating that nothing in the act requires that preferential treatment
based on an imbalance between their representation in the employer’s workplace
and their representation in the population at large be given to any protected class.
This proviso paved the way for questions about “reverse discrimination,” or discrimination against whites, as a result of employers’ attempts to create a racially balanced workforce. (This issue is discussed later in the section on affirmative action.)
National Origin. The act prohibits discrimination based on national origin, not on
alienage (citizenship of a country other than the United States). Thus, an employer
can refuse to hire non–U.S. citizens. This prohibition applies even to owners of foreign corporations who have established firms in the United States. In the absence
of a treaty between the United States and the foreign state authorizing such conduct, a corporation cannot discriminate in favor of those born in a foreign state.
Since the terrorist attack on the World Trade Center on September 11, 2001,
there has been a significant increase in charges based on national origin by individuals who are, or are perceived as being, Arab or South Asian. Many of these
claims are combined with claims of discrimination based on religion. Many are
based on harassment. For example, two California auto dealers agreed to pay
seven Afghan workers $550,000 to settle their complaint of harassment based on
national origin and religion. The workers alleged that they were called everything from “camel jockeys” to “bin Laden’s gang.” One of the women with an
Arabic name was asked to call herself by an American name, like Sara.14
During fiscal year 2006, the EEOC received 8,327 charges of national-origin
discrimination, and resolved 8,181, recovering $21.2 million for the charging parties. In 2007, the number of such charges increased by 2 percent to 9,369. In
2009, the number of charges filed with the EEOC was 11,134, with 9,644 resolved
for a total recovery of $25.7 million.15
Religion. Under Title VII, employers cannot discriminate against employees on
the basis of religion. Although an exception has been made allowing religious
corporations, associations, and societies to discriminate in their employment practices on the basis of religion, they may not discriminate on the basis of any other
protected class. In fiscal year 2006, the EEOC received 2,541 charges of religious
discrimination, and resolved 2,387 such charges, recovering $5.7 million.16 In
2010, the number of charges increased to 3,790, with 3,782 being resolved, generating $10 million for claimants.17
Employers are required to make reasonable accommodation to their employees’
religious needs, as long as such accommodation does not place an undue hardship
on the employer or other employees. For example, an employer has a dress code
that prohibits clerical workers visible to the public from wearing hats or scarves.
A Muslim worker requests that she be granted an exemption from the dress code so
that she may wear the hijab (head scarf) in conformance with her Muslim beliefs.
Her exemption would be a reasonable accommodation. Flexible scheduling, voluntary substitutions or swaps, job reassignments, and lateral transfers are other examples of reasonable accommodations to an employee’s religious beliefs. Courts will
examine the requested accommodation very carefully to ensure that it does not place
an undue burden on the workplace. For example, the reasonableness of accommodating an employee’s request to not work on Saturday would depend on the
availability of other workers who would willingly work on Saturdays.
14
Bob Egelko, “Two Auto Dealers Agree to Settle Suit with Afghan Workers,” San Francisco
Chronicle, B7 (Apr. 7, 2004).
15
EEOC, National Origin Based Charges FY 1997–2009, retrieved December 31, 2010 from http://
www.eeoc.gov/eeoc/statistics/enforcement/origin.cfm
16
EEOC, “Religious Discrimination”; retrieved March 12, 2008, from www.eeoc.gov/stats/
religion.html.
17
EEOC, “Religious Discrimination”; retrieved January 12, 2011, from http://www.eeoc.gov/eeoc/
statistics/enforcement/religion.cfm.
CHAPTER 22
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As mentioned previously, since September 11, 2001, the number of charges
of religious discrimination by individuals who are, or are perceived to be, Muslim
or Sikh has increased. From September 11, 2000, to September 11, 2001, 323
charges based on “religion-Muslim” were filed with the EEOC. The following
year, 706 similar charges were filed. In 2003, the EEOC settled one of the largest
workplace discrimination suits against Muslims. In that case, four Muslim
Pakistani machine operators alleged that their employer, Stockton Steel, routinely gave them the worst jobs, ridiculed their daily prayers, and called them
“camel jockey” and “raghead.” The four workers shared a $1.1 million settlement.18 At the time of the settlement, then EEOC Commissioner Steven Miller
expressed hope that such cases would sensitize employers to issues of religious
and ethnic discrimination.19 Since the 9/11 attacks, the EEOC has been attempting to reach out to Arab and Muslim groups to explain what illegal discrimination is and what actions they can take to enforce their rights.
In 2007, Bilan Nur, a Muslim woman won an award of $287,000 for religious
discrimination. Nur had requested permission to wear a head covering during
the holiday of Ramadan, a deviation from her employer’s dress code. Her employer, Alamo Rent-a-Car, refused to allow her to wear the head scarf in front of
customers while she worked at the front counter. Nur wore the head scarf while
at the front counter in violation of the dress code. Alamo sent Nur home several
times and eventually fired her for wearing the head scarf. The EEOC brought a
case against Alamo on behalf of Nur, and her award included $21,640 in back
pay, $16,000 in compensatory damages, and $250,000 in punitive damages.20
The EEOC stated that it hoped the large punitive damages would send a message to employers that religious discrimination would not be tolerated.21
Sex. Under Title VII, sex is interpreted as referring only to gender and not to
preferences. Hence, homosexuals and transsexuals are not protected under the
act. It would, however, be sex discrimination to fire male homosexuals while
retaining female homosexuals.
As noted earlier, sexual harassment is addressed by Title VII’s prohibition against
discrimination based on sex. Although sexual harassment cases were not filed in
large numbers immediately after the passage of Title VII, there has been a tremendous increase in the number of such cases filed since law professor Anita Hill captivated the nation in late 1991 by testifying before Congress about the harassment to
which she was subjected by U.S. Supreme Court nominee Clarence Thomas. According to the EEOC, 9,953 sexual harassment complaints were filed in the year ending in October 1992, an increase of 2,564 over the previous year. In fiscal year 2009,
12,696 sexual harassment complaints were filed, but in 2010, claims fell to 11,717.
Not all the sexual harassment charges are filed by women; in 2010, 16.4 percent of
those charges were filed by males.22
These sex discrimination cases can be quite costly. For example, in 2004, it
cost Morgan Stanley $54 million to settle a sex discrimination case brought by
67 female officers and women eligible for officer promotions.23 The women had
alleged workplace discrimination in promotions, assignments, and compensation, along with a hostile work environment. Although management admitted no
18
Marjorie Valbrun, “U.S. Battles Bias against Arabs and Muslims in the Workplace,” The Asian
Wall Street Journal, A6 (Apr. 14, 2003).
19
Id.
20
Kevin D. Kelly, “Jury Awards $287,000 to Muslim Employee Denied a Religious Accommodation”; retrieved March 12, 2008, from www.lexology.com/library/detail.aspx?g⫽43ea1ef7-353c4134-b6e5-fe408356149a&l⫽6G99TH2.
21
Id.
22
EEOC, “Sexual Harassment”; retrieved December 31,2010, from http://www.eeoc.gov/eeoc/
statistics/enforcement/sexual_harassment.cfm.
23
“EEOC and Morgan Stanley Announce Settlement of Sex Discrimination Lawsuit.” EEOC Press
Release, July 12, 2004; retrieved March 19, 2008, from www.eeoc.gov/press/7-12-04.html.
575
576
PART THREE
䉬
EXHIBIT 22-3
1. Senior management must make clear its position that sexual harassment in any form
will not be tolerated.
2. Have an explicit written policy on sexual harassment that is widely disseminated in the
workplace and given to every new employee.
3. Make sure employees know what is, and is not, sexual harassment.
4. Provide a gender-neutral training program on sexual harassment for all employees.
5. Establish an efficient system for investigating charges of sexual harassment and
punishing violators.
6. Make sure that complaints are to be filed with a neutral party, not with the employee’s
supervisor.
7. Thoroughly investigate and resolve every complaint, punishing every violation appropriately. If no violation is found, explain to the complainant why there was no violation.
TIPS FOR AVOIDING
SEXUAL HARASSMENT
CHARGES
Source: Adapted from
K. Swisher, “Corporations
Are Seeing the Light on
Harassment,” Washington
Post National Weekly Edition,
February 14–20, 1994, 21.
guilt, it also agreed to set up mechanisms to prevent sex discrimination. Thus, it
is increasingly important that businesspersons be able to recognize sexual
harassment and to prevent its occurrence in the workplace. Exhibit 22-3 provides
some suggestions on how managers can avoid liability for sexual harassment.
Pregnancy Discrimination Act. After a U.S. Supreme Court ruling that discrimination on the basis of pregnancy was not discrimination on the basis of sex
under Title VII,24 Congress amended the law by passing the Pregnancy Discrimination Act (PDA), which specifies that discrimination based on pregnancy is sex
discrimination and that pregnancy must be treated the same as any other disability, except that abortions for any purpose other than saving the mother’s life
may be excluded from the company’s medical benefits. The U.S. Supreme Court
has concluded that Congress intended the PDA to be “a floor beneath which
pregnancy disability benefits may not drop—not a ceiling above which they may
not rise.”25 Consequently, the high court held that a California statute requiring
unpaid maternity leave for pregnant women and reinstatement after the birth of
the child was constitutional because the intent of the law was to make women
in the workplace equal, not to give them favored treatment.26
In the summer of 2001, the PDA became the basis for the first ruling on
the employment discrimination issue of gender equity in drug coverage. In a
class action lawsuit against Bartell Drug Company, a Seattle judge ruled that
the drugstore chain discriminated against women when it excluded prescription contraceptives from its employee health plan.27 Granting summary judgment to the plaintiff, the judge said, “Male and female employees have
different sex-based disability and health care needs, and the law is no longer
blind to the fact that only women can get pregnant, bear children, or use prescription contraception.”28
ENFORCEMENT PROCEDURES
Enforcement of Title VII is a very complicated procedure and is full of pitfalls.
Failure to follow the proper procedures within the appropriate time framework
may result in the plaintiff’s losing her or his right to file a lawsuit under Title VII.
An overview of these procedures is provided in Exhibit 22-4.
24
General Electric Co. v. Gilbert, 429 U.S. 125 (1976).
California Federal Savings & Loan Association et al. v. Department of Fair Employment &
Housing et al., 479 U.S. 272 (1987).
26
Id.
27
Erickson v. Bartell Drug Co., 141 F. Supp. 2d 1266 (W.D. Wash. 2001).
28
Id.
25
CHAPTER 22
䉬
EXHIBIT 22-4
Does the state have an
agency responsible for
enforcing fair employment
laws?
Yes
ANATOMY
OF A TITLE VII CASE
No
File charge with appropriate
state agency within time
limits prescribed by state
law, not more than 180 days.
File charge with federal
EEOC within 180 days of
discriminatory act.
State agency may remedy the
problem; if not, must file
charge with federal EEOC
within 300 days of
discriminatory act or within 60
days of receipt of notice that
state agency has disposed of
matter.
EEOC attempts conciliation; if
successful, matter resolved. If
unsuccessful, EEOC must
decide whether to pursue the
matter any further.
Yes
EEOC files suit in
federal district court.
No
EEOC informs plaintiff of rights
and issues right-to-sue letter. If
180 days have lapsed since
charge filed and EEOC has not
acted, plaintiff may request
letter.
Plaintiff files suit in federal
district court.
The Charge. The first step in initiation of an action under Title VII is the
aggrieved party’s filing a charge with the state agency responsible for enforcing
fair employment laws (a state EEOC) or, if no such agency exists, with the federal
EEOC. A charge is a sworn statement that set out the name of the charging party,
the name(s) of the defendant(s), and the nature of the discriminatory act. In
states that do not have state EEOCs, the aggrieved party must file the charge with
the federal EEOC within 180 days of the alleged discriminatory act. In states that
do have such agencies, the charge must be filed either with the federal EEOC
within 180 days of the discriminatory act or with the appropriate state agency
within the time limits prescribed by local law, which cannot be more than
180 days. If initially filed with the local agency, the charge must be filed with
the federal EEOC within 300 days of the discriminatory act or within 60 days of
receipt of notice that the state agency has disposed of the matter, whichever
comes first. Exhibit 22-5 shows a typical charge.
Conciliation and Filing Suit. Once the EEOC receives the charge, it must
notify the alleged violator of the charge within 10 days. After such notification,
the EEOC investigates the matter in an attempt to ascertain whether there is “reasonable cause” to believe that a violation has occurred. If the EEOC does find
such reasonable cause, it attempts to eliminate the discriminatory practice
through conciliation. If unsuccessful, the EEOC may file suit against the alleged
discriminator in federal district court.
If the EEOC decides not to sue, it notifies the plaintiff of his or her right to
file an action and issues the plaintiff a right-to-sue letter. The plaintiff must have
this letter in order to file a private action. The letter may be requested at any time
577
AGENCY
CHARGE OF DISCRIMINATION
x
x
This form is affected by the Privacy Act of 1974; See Privacy Act Statement before completing this form.
CHARGE NUMBER
FEPA
EEOC
OHIO CIVIL RIGHTS COMMISSION
and EEOC
State or local Agency, if any
Name (Indicate Mr., Ms., Mrs.)
Home Telephone (Include Area Code)
(419) 863-4125
Ms. Nellie Baldwin
STREET ADDRESS
DATE OF BIRTH
CITY, STATE AND ZIP CODE
826 Potter Road
Toledo, Ohio 43602
11/10/56
NAMED IS THE EMPLOYER, LABOR ORGANIZATION, EMPLOYMENT AGENCY APPRENTICESHIP COMMITTEE, STATE OR LOCAL GOVERNMENT AGENCY WHO DISCRIMINATED AGAINST ME (If more than one list below.)
Name
NUMBER OF EMPLOYEES, MEMBERS
Mancum Manufacturers
TELEPHONE (Include Area Code)
+15
STREET ADDRESS
(419) 693-8296
896 Lewis Ave .
COUNTY
Toledo, Ohio 43605
Name
Lucas
TELEPHONE NUMBER (Include Area Code)
STREET ADDRESS
COUNTY
CAUSE OF DISCRIMINATION BASED ON (Check appropriate boxes)
RACE
X
COLOR
RETALIATION
AGE
SEX
Female
DATE DISCRIMINATION TOOK PLACE
RELIGION
DISABILITY
NATIONAL ORIGIN
OTHER (Specify)
/ /
02/ 05/ 93
CONTINUING ACTION
THE PARTICULARS ARE (If additional space is needed, attach extra sheet(s)):
1.
2.
3.
4.
5.
6.
I was employed by Canfield for 2 years as a machine operator general.
An opening for machine operator specialist, a higher position, was posted.
I applied for the position along with 4 other males and 2 females.
All applicants took a dexterity test.
I received the highest score on the test, but a male who scored second highest was promoted.
I was told that the posted job was “better suited for a male”, but that with my test score I would be first in line when a
more appropriate opening arose.
CXM/IFL:bd
X
I also want this charge filed with the EEOC.
Notary - (When necessary for State and Local Requirements)
I will advise the agencies if I change my address or telephone number and I will cooperate
fully with them in the processing of my charge in accordance with their procedures.
I swear or affirm that I have read the above charge and that it is true to the best
of my knowledge, information and belief.
I declare under penalty of perjury that the foregoing is true and correct.
SIGNATURE OF COMPLAINANT
SUBSCRIBED AND SWORN TO BEFORE ME THIS DATE
Date
EEOC TEST FORM 5 (09/01/91)
Charging Party (Signature)
(Day, month, and year)
EXHIBIT 22-5
A TYPICAL CHARGE OF DISCRIMINATION FILED WITH THE EEOC
578
CHAPTER 22
䉬
after 180 days have elapsed since the filing of the charge. As long as the requisite time period has passed, the EEOC will issue the right-to-sue letter regardless
of whether the EEOC members find a reasonable basis to believe that the
defendant engaged in discriminatory behavior.
REMEDIES
The plaintiff bringing a Title VII action can seek both equitable and legal remedies. The courts have broad discretion to order “such affirmative action as may
be appropriate.”29 Under this broad guideline, courts have ordered parties to engage in diverse activities ranging from publicizing their commitment to minority
hiring to establishing special training programs for minorities.
In general, a successful plaintiff is able to recover back pay for up to two
years from the time of the discriminatory act. Back pay is the difference between
the amount of pay received after the discriminatory act and the amount of pay
that would have been received had there been no discrimination. For example,
if two years before the case came to trial the defendant refused a promotion to
a plaintiff on the basis of her sex, and the job for which she was rejected paid
$100 more per week than her current job, she would be entitled to recover back
pay in the amount of $100 multiplied by 104. (If the salary rose at regular increments, these are also included.) The same basic calculations are used when
plaintiffs were not hired because of discrimination. Such plaintiffs are entitled to
the back wages that they would have received minus any actual earnings during that time. Defendants may also exclude wages for any period during which
the plaintiff would have been unable to work.
That same plaintiff may also receive remedial seniority dating back to the
time when the plaintiff was discriminated against.
The most significant impact of the 1991 Civil Rights Act resulted from its
changes to the availability of compensatory and punitive damages. Under the new
act, plaintiffs discriminated against because of race, and also those discriminated
against on the basis of sex, disability, religion, or national origin, may recover
both compensatory damages, including those for pain and suffering, and punitive damages. In cases based on discrimination other than race, however, punitive damages are capped at $300,000 for employers of more than 500 employees,
$100,000 for firms with 101 to 200 employees, and $50,000 for firms with 100 or
fewer employees.
Attorney’s fees are ordinarily awarded to a successful plaintiff in Title VII
cases. They are denied only when special circumstances would render the award
unjust. In those rare instances in which the courts determine that the plaintiff’s
action was frivolous, unreasonable, or without foundation, the courts may use
their discretion to award attorney’s fees to the prevailing defendant.
LILLY LEDBETTER FAIR PAY ACT OF 2009
In many cases, determining when a cause of action accrued can play a vital role
in disposition of the case. Prior to 2007, the EEOC supported the position that
every time an individual received a paycheck of a discriminatory amount, a new
discriminatory compensation action arose. After every paycheck, an individual
had 180 days to file a claim. In 2007, the Supreme Court decided, in Ledbetter v.
Goodyear Tire & Rubber Co.,30 that a compensation discrimination charge must
be filed within 180 days of a discriminatory pay-setting decision. In other words,
after an individual received the first discriminatory paycheck, she or he had
29
30
§ 706(a).
550 U.S. 618 (2007).
579
580
PART THREE
䉬
Management
Perhaps you learned in your organizational behavior or management class about biculturalism. This term refers
to instances in which individuals of a particular racial or ethnic minority class have been socialized in two
cultures—the dominant culture and the individual’s ethnic or racial culture. Living in two cultures often increases
stress, which is referred to as bicultural stress. Two general characteristics of bicultural stress are: (1) role
conflict—the conflict that exists when an individual fills two competing roles due to her or his dual cultural membership; and (2) role overload—the excess expectations that result from living in two cultures. The intensity of
these problems tends to increase for women of color, because of the negative dynamics directed toward both
women and minorities. Hiring minorities can pose adaptation problems in the workplace for some managers.
Accustomed to the cultural norms of the majority, some managers may be insensitive to the bicultural stress with
which minorities are often burdened. Additionally, managers may not realize that employees usually do not set
aside their values and lifestyle preferences while at work. Therefore, it is important for managers to recognize
differences and respond in ways that increase productivity without discriminating. This shift in management philosophy may include diversity training for managers and other employees to help them to raise behavioral awareness, recognize biases and stereotypes, avoid assumptions, and modify policies. Therefore, an acute sensitivity
to differences in the workplace may result in a friendlier environment where productivity is increased.
Sources: S. Certo, Modern Management (Upper Saddle River, NJ: Prentice Hall, 2000), 534–35, 544; S. Robbins,
Organizational Behavior (Upper Saddle River, NJ: Prentice Hall, 2001), 13–14.
180 days to file a claim; subsequent paychecks no longer gave rise to new causes
of action. Two years after the Court’s decision in Ledbetter, President Obama
signed the Lilly Ledbetter Fair Pay Act of 2009. That act, which explicitly recognizes the importance of protecting individuals who are victims of wage discrimination, restores the pre-Ledbetter policy that each paycheck gives rise to a new
cause of action.
The Age Discrimination
in Employment Act of 1967
Age Discrimination in
Employment Act of 1967
(ADEA) Statute that prohibits
employers from refusing to
hire, discharging, or
discriminating against people
in terms or conditions of
employment on the basis of
age.
Our society does not revere age. Older employees detract from a firm’s “youthful” image, and are expensive. They have accumulated raises over the years and
thus earn more than younger employees. They have pension benefits, which the
employer will have to pay when they retire. They are sometimes viewed as rigid
and unwilling to learn new technology. Thus, it is understandable that firms may
attempt to discriminate against older employees. The Age Discrimination in
Employment Act of 1967 (ADEA) was enacted to prohibit employers from
refusing to hire, discharging, or discriminating in terms and conditions of
employment on the basis of age. The language describing the prohibited
conduct is virtually the same as that of Title VII, except that a person’s being
age 40 or older is the prohibited basis for discrimination.
Although the motivation for the ADEA was to prevent the unfair treatment
of older people in the workplace, after the legislation had been in place for several years, some began to question whether the law also prohibited giving older
workers more favorable treatment. In 2004, the U.S. Supreme Court decided that
issue in General Dynamics Land Systems, Inc. v. Dennis Cline et al.31 In General
Dynamics, present and former employees of General Dynamics brought suit
31
540 U.S. 581 (2004).
CHAPTER 22
䉬
under the ADEA. General Dynamics had instituted a policy effectively eliminating a retiree health insurance benefits program for workers under the age of 50.
Those employees who were 50 or older at the time the policy was enacted would
still be eligible for benefits, but others would not. The Supreme Court held that
discrimination against “the relatively young” was beyond the scope of the protection offered by the ADEA. According to the Court’s interpretation, the ADEA
was designed to protect a “relatively old worker from discrimination that works
to the advantage of the relatively young.”32 General Dynamics’ policy did not
violate the ADEA.
As the U.S. economy started a downward turn in late 2000, which continued
through 2001, age discrimination claims began to increase. Charges of age
discrimination filed with the EEOC rose from roughly 14,000 filed in fiscal year
1999 to 16,000 in 2000, and have continued to increase through fiscal year 2010,
when the agency received 23,264 charges of age discrimination and secured
$93.6 million in benefits for aggrieved individuals.33
APPLICABILITY OF THE STATUTE
The ADEA applies to employers having 20 or more employees in an industry that
affects interstate commerce. It also applies to employment agencies and to
unions that have at least 25 members or operate a hiring hall. As a result of a
Supreme Court ruling in Kimel v. Florida Board of Regents,34 however, the act
does not apply to state employers.
PROVING AGE DISCRIMINATION
Discrimination under the ADEA may be proved in the same ways that discrimination is proved under Title VII: by the plaintiff’s showing disparate treatment
or disparate impact. Most of the ADEA cases today involve termination. To prove
a prima facie case of age discrimination involving a termination, the plaintiff
must establish facts sufficient to create a reasonable inference that age was a
determining factor in the termination. The plaintiff raises this inference by showing that he or she (1) belongs to the statutorily protected age group (age 40 or
older); (2) was qualified for the position held; and (3) was terminated under circumstances giving rise to an inference of discrimination.
Until 1996, the plaintiff also had to demonstrate that he or she was replaced
by someone outside the protected class. In O’Conner v. Consolidated Caterers
Corp.,35 however, the U.S. Supreme Court held that replacement by someone
outside the protected class was not a necessity as long as there was evidence
that the termination was based on age.
If the plaintiff establishes these three facts, the burden of proof then shifts to
the defendant to prove that there was a legitimate, nondiscriminatory reason for
the discharge. If the employer meets this standard, the plaintiff may recover only
if he or she can show by a preponderance of the evidence that the employer’s
alleged legitimate reason is really a pretext for a discriminatory reason.
Initially, circuit courts were split on the evidentiary standard to which an
age discrimination plaintiff must be held. Some courts have relied only on a pretext standard, as described earlier, whereas others have required a plaintiff to
show direct, not just inferential, proof of discrimination (known as “pretext
32
Id.
EEOC, Age Discrimination in Employment Charges FY 1997–2009, retrieved June 27, 2010, from
http://www.eeoc.gov/eeoc/statistics/enforcement/adea.cfm.
34
120 S. Ct. 631 (2001).
35
529 U.S. 62 (2000).
33
581
582
PART THREE
䉬
plus”).36 To resolve this circuit court confusion, the Supreme Court agreed to
hear the case, Reeves v. Sanderson Plumbing Products, Inc.,37 a case filed by a
former employee that raised issues of age discrimination under the ADEA. The
Supreme Court held that when a plaintiff establishes a prima facie case of age
discrimination and subsequently provides sufficient evidence of pretext by the
employer, a trier of fact can find unlawful discrimination without additional, independent evidence of discrimination. Therefore, “pretext plus” is no longer
necessary. Case 22-3 demonstrates how the courts have applied the pretext
standard.
CASE
22-3
Jones v. National American University
Eighth Circuit Court of Appeals
2010 WL 2508602
K
athy Jones had been an employee at National American
University (NAU) since 1998, when she was hired as a
part-time corporate liaison at the university’s Rapid City,
South Dakota, campus. Later that year, Jones became a fulltime admissions representative. In 2004, the director of admissions position at the Rapid City campus became
available. Jones, then age 56, applied for the position. NAU
formed a four-person committee to make the hiring decision. Individuals who had recently been denied a position
as vice president of admissions for the university’s online
program were notified of the opening.
After receiving initial applications, the applicant pool
was narrowed to six of the prior vice-president candidates
and Jones. After phone interviews, the pool was narrowed
to two of the former applicants and Jones. Each candidate
attended an in-person interview. The position was offered
to both of the prior vice-president candidates, both of
whom rejected it. Jones was never offered the position,
but was asked to serve as interim director until a candidate
could be found. As part of her interim director duties,
Jones helped to interview candidates for admissions positions. Following the interview of a 50-year old candidate,
one of the members of the hiring committee said, “I’m not
sure we want a grandpa working with our high school students.” Jones never reported this comment. The open
directorial position was eventually offered to a 34-year old
candidate for an admissions representative position. Jones
resigned and filed discrimination charges with the EEOC.
After trial, the jury found that NAU had discriminated
against Jones and that its conduct had been willful. The
district court denied NAU’s motion for judgment as matter
of law and its motion for a new trial. Judgment was entered
for $35,130 in damages, as well as attorney’s fees and costs.
NAU appealed.
36
37
Judge Murphy
NAU does not contest that Jones satisfied her burden of
presenting a prima facie claim of age discrimination. Instead the university asserts that after it rebutted Jones’
prima facie case by providing a legitimate, nondiscriminatory reason for the failure to promote—specifically Jones’
lack of management experience—she failed to establish
that NAU’s proffered reason was pretext.
An employee can prove that her employer’s articulated justification for an adverse employment action is
pretext “either directly by persuading the court that a discriminatory reason more likely motivated the employer
or indirectly by showing that the employer’s proffered
explanation is unworthy of credence.” Pretext may be
shown with evidence that “the employer’s reason for the
[adverse employment decision] has changed substantially
over time.”
Viewing the evidence in the light most favorable to
Jones, we conclude that she presented sufficient evidence
for the jury to conclude that NAU’s proffered reason for the
failure to promote was a pretext for age discrimination.
Jones presented evidence that between the time of its
EEOC charge response and the trial, NAU shifted its reasons for failure to promote her to the director position.
NAU’s response to the EEOC charge provided that throughout her employment, “Ms. Jones struggled with her performance. She consistently received moderate to low
scores on her semiannual reviews. . . . She has consistently
mediocre performance.” By contrast, at trial NAU asserted
that its primary reason for not promoting Jones was her
lack of managerial and marketing experience. The university did not present evidence at trial that Jones was deficient in her performance.
28 M. Coyle, “How to Judge Age Bias,” National Law Journal A10 (Mar. 20, 2000).
530 S. Ct. 2097 (2000).
CHAPTER 22
Jones also presented evidence to dispute each of NAU’s
proffered reasons for their failure to promote her to the director position. She established that she was the only candidate considered who had the three years recruiting
experience listed as required in one job posting, and preferred in the other. She also presented evidence that Beck
lacked the extensive management experience that the hiring committee asserted had been their primary qualification. She presented evidence that she had received
consistently positive reviews and performance awards,
and that she had a good relationship with her colleagues.
Finally, Jones testified about the two age-related comments
made by Buckles: (1) that he wasn’t sure he wanted a
“grandpa”working with the college kids, and (2) that Beck
was a better long-term choice for the director position
while Jones would have been the better short-term choice.
Given the benefit of all reasonable inferences from the
evidence, Jones presented sufficient evidence at trial for
the jury to determine that NAU’s proffered reasons for the
failure to promote were pretext for intentional age discrimination.
NAU alternatively argues that it is entitled to judgment
as a matter of law under what it terms “the honest belief
䉬
583
doctrine.” See Scroggins v. Univ. of Minn., 221 F.3d 1042,
1045 (8th Cir.2000); McNary v. Schreiber Foods, Inc.,
535 F.3d 765, 769-70 (8th Cir.2008). Relying on Scroggins
and McNary, NAU asserts that “what ultimately matters is
whether NAU’s hiring committee established its honest
belief in the nondiscriminatory facts that led to its decision.” NAU’s reliance on these cases is misplaced. In both
Scroggins and McNary, the employer prevailed in a discrimination claim because the employee plaintiff failed to
present any evidence to contradict the employer’s asserted reason for the adverse employment decision. Thus,
the employee failed to present evidence showing that the
employer’s proffered reason was mere pretext for discrimination. See Scroggins, 221 F.3d at 1045 (concluding
that the employee had presented “no evidence suggesting
anything other than the [employer’s] honest belief”);
McNary, 535 F.3d at 770 (same). By contrast, Jones has
presented evidence sufficient to support a jury finding
that NAU’s alleged “honest belief” was pretext. The district court properly denied judgment as a matter of law to
the university.
Affirmed in favor of Plaintiff, Jones.
So much about legal reasoning depends on taking a close look at analogies. No set of facts is ever exactly like another.
When citing precedents, however, each party hopes that the facts in certain cases are similar enough in significant ways
to cause the courts to select their cited cases as the more relevant ones in each case.
The questions here focus on the quality of the precedent cited by the defendant in Case 22-3.
1.
What about Scroggins v. University of Minnesota and McNary v. Schreiber Foods, Inc. led to their being cited as
authority by the defendant?
Clue: Who won in Scroggins and McNary and why?
2.
What caused Judge Murphy to reject the analogy of Scroggins and McNary as binding in Case 22-3?
Clue: Check her discussion of Scroggins and McNary to find how she distinguished Scroggins and McNary from
the Reeves case.
STATUTORY DEFENSES
Bona Fide Occupational Qualification. A number of statutory defenses are
available to an employer in an age discrimination case. The first is the bona fide
occupational qualification, which requires the defendant to establish that he or
she must hire employees of only a certain age to safely and efficiently operate
the business in question. The courts generally scrutinize very carefully any
attempt to demonstrate that age is a BFOQ.
One example of an employer’s successful use of this defense is Hodgson v.
Greyhound Lines, Inc.,38 wherein the employer refused to hire applicants aged
35 or older. Greyhound demonstrated that its safest drivers were those between
the ages of 50 and 55, with 16 to 20 years of experience driving for Greyhound.
38
499 F.2d 859 (7th Cir. 1974).
584
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Greyhound argued that this combination of age and experience could never
be reached by those who were hired at age 35 or older. Therefore, to ensure
the safest drivers, it should be allowed to hire only applicants younger than 35.
The court accepted the employer’s rationale. Although safety considerations
are important, to use them in establishing age as a BFOQ, the employer must
indeed prove, as did the defendant in the Greyhound case, that safety is related
to age.
Other Defenses. As under Title VII, decisions premised on the operation of a
bona fide seniority system are not unlawfully discriminatory despite any discriminatory impact. Likewise, employment decisions may also be based on “reasonable factors other than age.”
executive exemption
Exemption to the ADEA that
allows mandatory retirement
of executives at age 65.
Executive Exemption. Additionally, termination of an older employee may be
legal because of the executive exemption. Under this exemption, an individual may be mandatorily retired after age 65 if (1) he or she has been employed
as a bona fide executive for at least two years immediately before retirement,
and (2) on retirement, he or she is entitled to nonforfeitable annual retirement
benefits of at least $44,000.
After-Acquired Evidence of Employee Misconduct. An important issue, not
just for the ADEA but also for other employment discrimination claims, is
whether an employer can use evidence of an employee’s misconduct discovered
after a charge has been brought to defeat that charge. In McKennon v. Nashville
Banner,39 a unanimous Supreme Court decided that issue in a manner that
pleased lawyers who represented both businesses and plaintiffs.
In Nashville Banner, the plaintiff had feared being fired by the company because of age, so she copied confidential documents to use (if needed) in her subsequent lawsuit. She was, in fact, fired, and filed a discrimination claim. The
employer subsequently discovered that she had copied the documents and argued that her ADEA action should be dismissed because she would have been
fired anyway had the firm known that she had copied the documents. The circuit court held that she deserved to be fired because of her misconduct, and
therefore she could not sue for discrimination.
The Supreme Court overruled the circuit court and held that after-acquired
knowledge of misconduct will not bar a discrimination action. The Supreme
Court did not, however, believe that such conduct should be totally irrelevant.
If the defendant can prove that the misconduct was actually substantial enough
to have warranted termination of the employee, then reinstatement will not be
required. The amount of back pay required will also be reduced. The employee’s back pay will be calculated from the date of the unlawful discharge
until the date that the evidence of misconduct was discovered. Thus, the afteracquired evidence may be used to reduce, but not completely bar, an action for
discrimination.
Enforcement of ADEA is similar to the enforcement of Title VII. The victim of
age discrimination may file a charge with the appropriate state agency or with
the EEOC within 180 days of the act. If a charge has been filed with the state
agency, an EEOC charge must be filed within 300 days of the discrimination or
within 30 days of receiving notice of the termination of state proceedings,
whichever comes first. The charge must identify the defendant and specify the
nature of the discriminatory act. On receipt of a charge, the EEOC must notify
39
513 U.S. 352 (1995).
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585
the accused and attempt to conciliate the matter. If conciliation fails, the EEOC
may then bring a civil action against the violator.
A party who does not plan to file a private action may choose to file a
charge with the EEOC only; if a party wishes to file a private civil action, complaints must be filed with both the appropriate state agency and the EEOC. If
these complaints are filed within the appropriate time limits, a party then has
three years from the date of the discriminatory act within which to file a private
action under ADEA, assuming that the alleged discriminatory act was willful. If
the alleged discrimination is purportedly unwillful, the party has two years
within which he or she must file the private action. The party, however, must
wait 60 days from the date of the filing of the complaints with both the EEOC
and the state agency before filing the lawsuit. If the EEOC or the state agency
files an action on the matter during that time, the plaintiff is precluded from
filing suit.
REMEDIES UNDER ADEA
A successful ADEA plaintiff is entitled to back pay for up to two years. In
addition, in a private action, a plaintiff may be able to recover liquidated
damages in an amount equal to the back pay recovered if the plaintiff can
prove that the employer acted willfully. Willfully means that the employer was
substantially aware of the possibility that it was in violation of the ADEA but
did not attempt to ascertain the legality of its actions. If liquidated damages are
not granted, the plaintiff is generally entitled to interest on the back pay; interest is not awarded when liquidated damages have been granted. Compensatory
damages for items such as mental distress from the discrimination are occasionally, but rarely, awarded by a few courts. Likewise, punitive damages are
rarely awarded.
The Rehabilitation Act of 1973
In 1973, Congress broadened the class of individuals protected against discrimination to include the handicapped by passing the Rehabilitation Act of 1973,
an act designed to protect the handicapped from discrimination in employment
and to help them secure rehabilitation, training, access to public buildings, and
all benefits of covered programs that might otherwise be denied them because
of their handicap. It also requires that covered employers have a qualified
affirmative action program for hiring and promoting the handicapped. A
handicapped individual, for purposes of the act, is defined as one who has a
“physical or mental impairment, which substantially limits one or more of such
person’s major life activities,”40 or who has a record of such impairment. Even
people who are falsely regarded as having such impairment are protected. The
major provisions of this act are outlined in Table 22-3.
This act applies only to the federal government and employers that have
contracts with the federal government, so its impact is relatively limited. However, in 1991, the Americans with Disabilities Act (ADA) was passed, which
extends similar prohibitions against discrimination to private-sector employers
who do not have federal contracts. Because of its broader impact, the ADA is
discussed in greater detail in the next section; bear in mind that the principles
discussed with respect to the ADA apply to the Rehabilitation Act as well.
It is important to remember that neither the Rehabilitation Act nor the ADA
requires any employer to hire an unqualified individual. The acts require only
40
31 U.S.C. § 706(b).
Rehabilitation Act of 1973
Prohibits discrimination in
employment against otherwise
qualified persons who have a
handicap. Applies only to the
federal government, employers
who have contracts with the
federal government, and
parties who administer
programs that receive federal
financial assistance.
586
PART THREE
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TABLE 22-3 SUMMARY OF MAJOR PROVISIONS OF THE REHABILITATION ACT
Section
Potential Defendant
Prohibited Conduct
Required Conduct
501
Federal departments
and agencies
502
Federal agencies entering into
contracts with private employers for
property or services and the private
employers entering into these
contracts
Parties who administer
programs receiving federal
assistance
Cannot discriminate against
otherwise qualified workers because
of a handicap
Private party with government
contract cannot discriminate against
otherwise qualified workers because
of a handicap
Prepare and implement an
affirmative action plan for hiring
and promoting the handicapped
Contracts must contain clause
requiring private employer to take
affirmative action in hiring and
promoting the handicapped and to
not discriminate against them
504
Discrimination by those
administering programs is
prohibited
the hiring of an individual with a disability who, with reasonable accommodation for his or her disability, can perform the job at the minimum level of productivity that would be expected of an individual with no disability. Nor does
this act or the ADA prohibit an employer from terminating an employee whose
disability does in fact prevent him or her from doing the job.
The Americans with Disabilities Act of 1991
Act of 1991 (ADA) Statute
requiring that employers make
reasonable accommodations
to the known disabilities of an
otherwise qualified job
applicant or employee with a
disability, unless the necessary
accommodation would impose
an undue burden on the
employer’s business.
Like the Rehabilitation Act, the Americans with Disabilities Act of 1991 (ADA)
is intended to prevent employers from discriminating against employees and
applicants with disabilities by requiring employers to make reasonable accommodations to the known physical or mental disabilities of an otherwise qualified
person with a disability, unless the necessary accommodation would impose an
undue burden on the employer’s business.
The ADA now covers all employers of 15 persons or more, which includes
approximately 660,000 businesses, so its impact has the potential to be significant. Some fear that because of Amendments to the ADA passed in 2008 and described below, the impact of the act may become even more significant.
COVERED INDIVIDUALS
The definition of an individual with a disability, for purposes of the act, is
essentially the same as the definition of a handicapped individual in the
Rehabilitation Act. A disability is “(1) a physical or mental impairment which
substantially limits one or more of the major life activities of such individual,
(2) a record of such impairment, or (3) being regarded as having such an
impairment.”41 A wide variety of impairments are captured under such a definition. Individuals suffering from diseases such as cancer, epilepsy, and heart
disease are included, as are those who are blind or deaf. Those who are infected with the human immunodeficiency virus (HIV), but who are not yet
symptomatic, are covered,42 as are those whose past records may harm them.
For example, persons who suffer from alcoholism but are not currently drinking, or who are former drug addicts, are protected. However, an employee
who is currently a substance abuser and whose abuse would affect job performance is not protected.
41
42
42 U.S.C. § 12102(2).
1998 WL 332958.
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Initially, both the EEOC and the U.S. Supreme Court interpreted both the
“substantial impairment” requirement fairly strictly, and considered a fairly limited number of activities to be “major life activities.” But in 2008, Congress
decided that the rulings of the Supreme Court and the EEOC were too restrictive
and not in keeping with the spirit of the ADA, and passed the Americans with
Disabilities Act Amendments of 2008 (ADAAA) to remedy the situation.
The ADAAA now provides that “major life activities include, but are not
limited to, caring for oneself, performing manual tasks, seeing, hearing, eating,
sleeping, walking, standing, lifting, bending, speaking, breathing, learning,
reading, concentrating, thinking, communicating and working.” The ADAAA
also added as a major life activity “the operation of a major bodily function,
including, but not limited to, functions of the immune system, normal cell
growth, digestive, bowel, bladder, neurological, brain, respiratory, circulatory,
endocrine, and reproductive functions.” thereby expanding the number of
people who could potentially be protected under the act.
One other change by the ADAAA that could increase the number of
claimants is its overturning previous interpretation of the act that held that when
determining whether a person was disabled, mitigating actions were taken into
account. Thus, a person who was hard of hearing but who could hear when
wearing his hearing aids, was not considered disabled. The ADAAA now prohibits the use of mitigating measures in evaluating whether a person has a disability, except for the use of glasses or corrective lenses if they fully correct the
vision problem.
Initially, we did not see a huge spike in claims. The law took effect January
1, 2009, and the EEOC reported 21,451 claims filed in FY 2009, which is an increase of almost 2,000 claims over the 19,453 claims filed in 2008, the same as
the increase in the number of claims between 2007 and 2008, when there was
no change in the law. However, in FY 2010, the number of disability claims rose
more significantly to 25,165 claims, an increase of almost 4,000 claims, whereas
in the prior three years, the increases were around 2,000 claims.43
Employers often find it difficult to know how the ADA applies to those who
have mental disabilities. Under the ADA, employers are not only forbidden from
discriminating against persons with mental disabilities, but also must make reasonable accommodations for them unless such accommodations could cause undue hardship. Typical accommodations include providing a private office,
flexible work schedule, restructured job, or time off for treatment.
Another type of disability that employers must be aware of is an intellectual
disability. According to the EEOC, roughly 1 percent of Americans have an intellectual disability, and only about 31 percent of these individuals are employed,
even though a much greater percentage would like to work.
An individual is considered to have an intellectual disability when (1) the
person’s intellectual functioning level (IQ) is below 70–75; (2) the person has significant limitations in adaptive skill areas as expressed in conceptual, social, and
practical adaptive skills; and (3) the disability originated before the age of 18.
“Adaptive skill areas” refers to basic skills needed for everyday life, and includes
communication, self-care, home living, social skills, leisure, health and safety,
self-direction, functional academics (reading, writing, basic math), and work.
A major difficulty employers face under the ADA is ensuring that they do not
violate the law during the interview process. The EEOC issued guidelines to help
employers comply with the law. The guidelines emphasize that employers’ questions must be designed to focus on whether a potential employee can do the
job, not on the disability, but it is often difficult to know when a question violates
43
EEOC, Americans with Disabilities Act of 1990 (ADA) Charges; retrieved January 1, 2011 from
http://www.eeoc.gov/eeoc/statistics/enforcement/ada-charges.cfm.
587
588
PART THREE
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EXHIBIT 22-6
You May Ask
• Can you perform the functions
of this job (essential and/or
marginal), with or without reasonable accommodations?
• Can you meet the attendance
requirements of this job?
• Do you illegally use drugs?
Have you used illegal drugs in
the past two years?
• Do you have a cold? How did
you break your leg?
• How much do you weigh? Do
you regularly eat three meals
a day?
INTERVIEWING POTENTIAL
EMPLOYEES WITHOUT
VIOLATING ADA
Source: Adapted from EEOC’s
“Enforcement Guidance on
Pre-Employment Disability—
Related Inquiries and Medical
Examinations Under the
Act” (EEOC, 1998).
Do Not Ask
• Do you have a disability that
would interfere with your ability
to perform the job?
• How many days were you sick
last year?
• What prescription drugs are
you currently taking?
• Do you have AIDS? Do you
have asthma?
• How much alcohol do you
drink each week? Have you
ever been treated for alcohol
problems?
the act. Exhibit 22-6 provides examples of acceptable and unacceptable questions, drawn from the EEOC’s guidelines.
It is well worth the prudent employer’s time to study these guidelines,
because the liability for violating the rules for job interviews can be substantial.
For example, one job applicant who was asked about his disability during an interview was awarded $15,000 in compensatory damages and $30,000 in punitive
damages.44 The plaintiff was partially disfigured, partially deaf, and partially blind
as a result of two brain tumor operations. The plaintiff brought up the disability
himself to explain a gap in his work record, but the interviewers told him they
felt uncomfortable with his disability and asked him to make them feel more comfortable by describing the condition and its treatment. They also asked whether
managers or customers had a problem with him because of his disability.
The ADA is enforced by the EEOC in the same way that Title VII is enforced. To
bring a successful claim under the ADA, the plaintiff must show that he or she
(1) had a disability, (2) was otherwise qualified for the job, and (3) was excluded
from the job solely because of that disability.
REMEDIES
affirmative action plans
Programs adopted by
employers to increase the
representation of women and
minorities in their workforces.
reverse discrimination
Discrimination in favor of
members of groups that have
been previously discriminated
against; claim usually raised by
white males.
Remedies are likewise similar to those available under Title VII. A successful
plaintiff may recover reinstatement, back pay, and injunctive relief. In cases of
intentional discrimination, limited compensatory and punitive damages are also
available. An employer who has repeatedly violated the act may be subject to
fines of up to $100,000.
Affirmative Action
One of the most controversial workplace issues of the past two decades has been
the legitimacy of affirmative action plans. Ever since employers began to try
to create balanced workforces by focusing on increasing their employment of
minorities, there have been cries that such actions constitute reverse discrimination, which is a violation of the Equal Protection Clause of the Fourteenth
Amendment.
44
EEOC v. Community Coffee Co., No. H-94-1061 (S.D. Tex. 1995).
CHAPTER 22
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589
TECHNOLOGY AND THE LEGAL ENVIRONMENT
The Internet as a Public
Accommodation?
As e-commerce and the use of the Internet become
more common, the courts are likely to begin to treat
the Internet as a public accommodation, meaning that
it would be subject to the ADA, which states that
“[n]o individual shall be discriminated against on the
basis of disability in the full and equal enjoyment of
the goods, services, facilities, privileges, advantages,
or accommodations of any place of public accommodation by any person who owns, leases to, or operates
a place of public accommodation.”
No one yet knows the full implications of treating
the Internet as a public accommodation, but a lawsuit
filed by the National Federation of the Blind (NFB)
against America Online (AOL) may help give us an
idea of what some disabled individuals would expect.
In November 1999, the NFB sued AOL, alleging
that the company’s software does not work with
other software required to translate computer signals into braille or synthesized speech. By failing to
remove communication barriers presented by its
designs, and thus denying the blind independent
access to its service, AOL is alleged to be violating
the ADA.
In July 2000, AOL and the NFB reached an agreement. NFB suspended the lawsuit against AOL, and
AOL promised to have appropriate software by April
2001. The lawsuit was subsequently dropped. Regulations tacked on to Section 508 of the Rehabilitation
Act, which went into effect in December 2000, also assisted the blind. Under these regulations, federal agencies must construct and design their Web sites using
applications and technologies to make site information available to all users.
Many of the significant cases challenging affirmative action plans have arisen
in contexts other than private employment. Other areas in which these programs
have been challenged include school admissions policies and government policies
to set aside contracts for minority businesses. Table 22-4 summarizes the major affirmative action cases. A close reading of the cases reveals the increasing scrutiny
that the courts have come to apply to affirmative action policies, and it now appears that any affirmative action plan that can withstand constitutional muster must
(1) attempt to remedy past discrimination, (2) not use quotas or preferences, and
(3) end or change once it has met its goal of remedying past discrimination. This
standard was set forth by the Supreme Court in Adarand Constructors, Inc. v.
Pena, a case challenging a federal affirmative action program (see Table 22-4).
In 1997, many interested observers hoped the U.S. Supreme Court would
hand down a definitive decision regarding affirmative action cases in the employment setting, as the high court agreed to hear the case of Taxman v. Board
of Education described in Table 22-4. The parties, however, settled the case before it went to trial.
The next major affirmative action case arose in the area of university admissions. In Grutter v. Bollinger,45 admissions policies of the University of Michigan
Law School were challenged by Grutter, a white Michigan resident with a 3.8 GPA
and 161 LSAT score, who was denied admission. The school followed an official
admissions policy seeking to achieve student body diversity through compliance
with University of California v. Bakke. Focusing on students’ academic abilities,
coupled with a flexible assessment of their talents, experiences, and potential, the
policy required admissions officials to evaluate each applicant based on all the
information available in the file, including a personal statement, letters of recommendation, an essay describing how the applicant would contribute to law school
life and diversity, and the applicant’s undergraduate grade point average (GPA)
and Law School Admissions Test (LSAT) score. Additionally, officials were required to look beyond grades and scores to so-called “soft” variables, such as
45
288 F.3d 732 (6th Cir. 2002), aff’d, 539 U.S. 306 (2003).
TABLE 22-4 MAJOR REVERSE DISCRIMINATION CASES
Case
Alleged Discriminatory Action
Outcome
Regents of the University of
California v. Bakke, 438 U.S. 265
(1978)
The school’s special admissions policy
reserved 16 out of the 100 available
seats for minority applicants. Bakke was
denied admission while minorities with
lower test scores were admitted.
United Steelworkers v. Weber, 443
U.S. 193 (1979)
The employer and union entered into a
voluntary agreement that half the
openings in a skilled craft training
program would go to blacks until the
rough proportion of blacks in the
program was equal to that of blacks in
the labor force. A white male who
would have been admitted to the
training program absent the plan
challenged the plan.
County affirmative action plan
authorized agency to consider
applicant’s sex as a relevant factor when
making promotion decisions for job
classifications in which women have
traditionally been underrepresented.
Although race could be one of a number of
factors considered by a school in passing on
applications, this special admissions policy
was illegal because a classification that
benefits victims of a victimized group at the
expense of innocent individuals is
constitutional only where proof of past
discrimination exists.
The Court said it was clear that Congress did
not intend to wholly prohibit private and
voluntary affirmative action. To be valid,
such plans must not unnecessarily trammel
the rights of whites, should be temporary in
nature, and should be customized to solve
the past proven pattern of discrimination.
Johnson v. Santa Clara County
Transportation Agency, 480 U.S.
616 (1987)
Adarand Constructors, Inc. v.
Pena, 515 U.S. 200 (1995)
Plaintiff submitted the lowest bid for a
government contract, but the contract
was awarded to a Hispanic firm
submitting a higher bid. The job was
sent to the Hispanic firm in accordance
with a government program giving 5
percent of all highway construction
projects to disadvantaged construction
firms.
Hopwood v. State of Texas, 84 F.3d
720 (5th Cir. 1996)
Two white law school applicants were
denied admission to the University of
Texas Law School because of the
school’s affirmative action program.
That program allowed admissions
officials to take racial and other factors
into account when admitting students.
The Board of Education wanted to
eliminate one teaching position at
Piscataway High School. A black female
and white female had the same seniority
and qualifications. Because minority
teachers were underrepresented in the
school, the board chose to lay off the
white teacher to promote racial
diversity.
Taxman v. Board of Education of
the Township of Piscataway, 91
F.3d 1547 (3d Cir. 1996)
590
The Court held that the plan represented a
moderate, flexible, case-by-case approach to
gradually effecting improvement of the
representation of women and minorities in
traditionally underrepresented positions. The
Court emphasized that the agency had
identified a conspicuous imbalance in
representation; that no slots were set aside
for women or minorities; and that no quotas
were established. Race or sex could just be
one of several factors considered.
In a landmark decision, the Supreme Court
held that any federal, state, or local
affirmative action program that uses racial or
ethnic classifications as a basis for making
decisions is subject to strict scrutiny by the
courts. This level of scrutiny can be met only
when (1) the program attempts to remedy
past discrimination, (2) does not use quotas
or preferences, and (3) will be ended or
changed once it has met its goal of
remedying past discrimination.
The Court of Appeals for the Fifth Circuit
held that the program violated the equal
protection clause because it discriminated in
favor of minorities. The U.S. Supreme Court
refused to hear the case.
Taxman challenged the policy as violative of
Title VII. The trial court granted summary
judgment in her favor. The circuit court of
appeals affirmed, awarding her complete
back pay. The defendants appealed to the
U.S. Supreme Court, but the case was settled
prior to the hearing before the high court.
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591
TABLE 22-4 CONTINUED
Case
Alleged Discriminatory Action
Outcome
Jennifer Johnson v. Board of
Regents of the University of
Georgia, 263 F.3d 1234; 2001
WL 967756 (11th Cir. 2001)
The University of Georgia had an
admissions policy that awarded a fixed
numerical bonus to nonwhite and male
applicants that it did not give to white
and female applicants. The three
plaintiffs, white females who were
denied admission to the University of
Georgia, filed an action arguing that the
use of race violated the Equal Protection
Clause, among other claims.
The district court found in favor of the
plaintiffs and entered summary judgment in
their favor. The defendants appealed on the
issue of preferential treatment based on race.
The circuit court said it did not need to
address the issue of whether student body
diversity is a sufficiently compelling interest
to withstand the strict scrutiny that the court
must apply to government decision making
based on race. Even if it were a compelling
interest, a policy that mechanically awards an
arbitrary diversity bonus to every nonwhite
applicant at a decisive stage in admissions,
and severely limits the range of other factors
relevant to diversity that may be considered
at the stage, is not narrowly tailored to
achieve that interest. The policy, therefore,
violates the Equal Protection Clause of the
Fourteenth Amendment.
After a 15-day bench trial, the federal
district court found that Michigan’s use of
race as a factor in admissions decisions was
unlawful. The Sixth Circuit Court of
Appeals reversed, finding the use of race to
be narrowly tailored because it was used
only as a potential plus factor. The U.S.
Supreme Court affirmed, agreeing that the
Equal Protection Clause does not prohibit
the narrowly tailored use of race in
admissions decisions to further a
compelling interest in obtaining the
educational benefits that flow from a
diverse student body.
In an opinion written by Chief Justice
Roberts, the Court held that the policy was
not narrowly tailored. However, on the
issue of diversity as a compelling state
interest, the Court was intensely divided.
Ultimately, the plurality opinion provides
little guidance as to whether the Court
would hold that diversity is a compelling
state interest in secondary education.
Grutter v. Bollinger, 288 F.3d 732
(6th Cir. 2002), aff’d, 539
U.S. 306 (2003)
A white female was denied admission
to the University of Michigan Law
School despite a 3.8 GPA and a 161
LSAT score. She argued that the
school’s admissions policy, which
focused on applicants’ academic ability
coupled with a flexible assessment of
their talents, experience, and potential
to contribute to the learning
environment as well as the life and
diversity of the law school, resulted in
her being discriminated against on the
basis of race.
Parents Involved in Community
Schools v. Seattle School District
No. 1, 551 U.S. 701 (2007)
Parents in Louisville and Seattle filed
suit arguing that the secondary
schools’ admissions plans used race as
a factor in violation of the Equal
Protection Clause. The schools
voluntarily adopted policies designed
to assign students to schools so as to
counteract segregated housing
patterns. The students were classified
as “white” or “nonwhite” and then race
was used as a tiebreaker when
students were being assigned to
oversubscribed schools.
recommenders’ enthusiasm, the quality of the undergraduate institution and the
applicant’s essay, and the areas and difficulty of undergraduate course selection.
The policy did not define diversity solely in terms of racial and ethnic status and
did not restrict the types of diversity contributions eligible for “substantial weight,”
but it did reaffirm the law school’s commitment to diversity with special reference
to the inclusion of African American, Hispanic, and Native American students, who
otherwise might not be represented in the student body in meaningful numbers.
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By enrolling a “critical mass” of underrepresented minority students, the policy
sought to ensure their ability to contribute to the law school’s character and to the
legal profession.
Grutter alleged that she was rejected because the law school used race as a
“predominant” factor, giving applicants belonging to certain minority groups a significantly greater chance of admission than students with similar credentials from
disfavored racial groups; and that respondents had no compelling interest to justify that use of race. The district court found the law school’s use of race as an
admissions factor unlawful. On appeal, the Sixth Circuit reversed, holding that
Justice Powell’s opinion in Bakke was binding precedent establishing diversity as
a compelling state interest and that the law school’s use of race was narrowly
tailored because race was merely a “potential ‘plus’ factor” and because the law
school’s program was virtually identical to the Harvard admissions program
described approvingly by Justice Powell and appended to his Bakke opinion.
The U.S. Supreme Court upheld Michigan’s policy, stating: “All government
racial classifications must be analyzed by a reviewing court under strict scrutiny. But
not all such uses are invalidated by strict scrutiny. . . . Race-based action necessary
to further a compelling governmental interest does not violate the Equal Protection
Clause so long as it is narrowly tailored to further that interest.”46 The Court reaffirmed Justice Powell’s view that student body diversity is a compelling state interest that can justify using race in university admissions, and deferred to the law
school’s educational judgment that diversity is essential to its educational mission.
The Court recognized that attaining a diverse student body was at the heart
of the law school’s proper institutional mission, and noted that its “good faith”
is “presumed,” absent “a showing to the contrary.” The Justices noted that enrolling a “critical mass” of minority students simply to assure some specified percentage of a particular group merely because of its race or ethnic origin would
be patently unconstitutional, but the law school justified its critical-mass concept
by reference to the substantial, important, and laudable educational benefits that
diversity is designed to produce, including cross-racial understanding and the
breaking down of racial stereotypes. The justices also noted that the law school’s
position was bolstered by numerous expert studies and reports showing that
such diversity promotes learning outcomes and better prepares students for an
increasingly diverse workforce, for society and for the legal profession.
In the high court’s eyes, the law school’s admissions program was a narrowly
tailored plan, which meant that it “did not insulate each category with certain
desired qualifications from competition with all other applicants.” Instead, it considered race or ethnicity only as a “‘plus’ in a particular applicant’s file,” and was
flexible enough to ensure that each applicant was evaluated as an individual and
not in a way that made race or ethnicity the defining feature of the application.
Finally, the policy was limited in time.
This case has provided some guidance to those in higher education, but the
Supreme Court’s most recent ruling on affirmative action has muddied the
waters. While still recognizing Grutter as valid in higher education, in Parents
Involved in Community Schools v. Seattle School District No. 1, the Court found
that assigning K–12 students in such a way as to keep the schools racially diverse may not fall under the Grutter precedent, because it did not demonstrate
a benefit gained by forcing diversity on schools. The most important lesson for
employers to draw from these cases is that any policy based on race will need
to adhere very closely to carefully set guidelines, especially in showing the
necessity of using race to get a specific benefit.
While school districts and universities look to these court cases for guidance,
employers have the guidance of the EEOC to look to when setting up affirmative
46
Id.
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593
action policies. The EEOC has issued guidelines in an attempt to help employers set
up valid affirmative action plans. According to these guidelines, Title VII is not violated if (1) the employer has a reasonable basis for determining that an affirmative
action plan is appropriate, and (2) the affirmative action plan is reasonable. Quotas,
however, are specifically outlawed by the 1991 Civil Rights Act amendments.
Global Dimensions of Employment
Discrimination Legislation
With many U.S. firms having operations overseas, the question of the extent to
which U.S. laws prohibiting discrimination apply to foreign countries naturally
arises. The Civil Rights Act of 1991 extended the protections of Title VII and the
ADA to U.S. citizens working abroad for U.S. employers. Amendments to the ADEA
in 1984 had already extended that act’s protection in a similar manner. The provisions of these acts also apply to foreign corporations controlled by a U.S. employer.
It is not always easy to determine whether a multinational corporation will be
considered “American” enough to be covered by these acts. According to guidelines issued by the EEOC in October 1993, the EEOC will initially look at where
the company is incorporated, but will often have to look at other factors as well.
These other factors must also be considered when the employer is not incorporated, as, for example, in the case of an accounting partnership. Some of these additional factors include the company’s principal place of business, the nationality
of the controlling shareholders, and the nationality and location of management.
No one factor is considered determinative, and the greater the number of factors
linking the employer to the United States, the more likely the employer is to be
considered “American” for purposes of being covered by Title VII and the ADEA.
In determining whether a foreign corporation is controlled by a U.S. employer, the EEOC again looks at a broad range of factors. Some such factors include the interrelation of operations, common management, centralized labor
relations, and common ownership or financial control over the two entities.
However, a corporation that is clearly a foreign corporation and is not controlled
by a U.S. entity is not subject to U.S. equal employment laws. An employer may
also violate the ADA and Title VII if compliance with either law would constitute
an illegal action in the foreign country in which the corporation is operating.
Management
Affirmative action plans promote greater diversity in workplaces. Despite the controversial issues related to these
programs, diversity itself can be advantageous to organizations. In your management class, you probably discussed some of the advantages of diversity. First, group decisions that include contributions from diverse employees are advantageous because a greater assortment of ideas for dealing with work issues may have gone into
those decisions. Second, diversity may also enhance a firm’s credibility with its customers, in the sense that the
firm is portrayed and perceived as more able to identify with customers of various backgrounds. Third, diversity
can encourage greater creativity and innovation in organizations. Fourth, diversity also tends to promote a more
flexible organizational structure that is beneficial when a firm is faced with a need to change. Therefore, diversity, if properly managed, could be beneficial to a firm.
Sources: S. Certo, Modern Management (Upper Saddle River, NJ: Prentice Hall, 2000), 529–30; S. Robbins, Organizational
Behavior (Upper Saddle River, NJ: Prentice Hall, 2001), 14.
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SUMMARY
During the early years of our nation’s history, the employment-at-will doctrine governed the employment relationship. Under this doctrine, an employee without a contract for a set period of time could be fired at anytime, for any reason. The doctrine
has been gradually eroded, and most states today recognize at least one of three exceptions to the employment-at-will doctrine: the public policy exception, the implied
contract exception, and implied covenant of good faith and fair dealing exception.
Civil rights laws have also eroded the employer’s ability to hire and fire at
will. This chapter examined those laws in the order in which they were enacted.
The Civil Rights Act of 1866 prohibits employers from discriminating against
individuals because of their race.
The Equal Pay Act of 1963 prohibits employers from paying male and female
employees doing the same job different wages because of their sex.
Title VII prohibits employers from discriminating in terms and conditions of
employment on the basis of race, color, national origin, religion, and sex. This
act was amended by the PDA, which essentially requires employers to not discriminate against pregnant women and to treat pregnancy like any other temporary disability. Title VII was also amended by the Civil Rights Act of 1991,
which expanded the remedies available under Title VII.
The ADEA prohibits discrimination based on age against persons aged 40 or
over. Enforcement of the ADEA is similar to enforcement of Title VII.
The Rehabilitation Act requires federal agencies, those who have contracts
with the federal government, and those receiving any type of federal funds to
not discriminate against persons with handicaps. The ADA extended the basic
protections of the Rehabilitation Act to private employers, requiring them to reasonably accommodate persons with disabilities.
Employers locating overseas must remember that they can no longer avoid
Title VII and the ADEA simply by leaving the country. U.S. corporations operating in foreign nations, as well as foreign companies controlled by U.S. corporations, must follow the Title VII requirements.
REVIEW QUESTIONS
22-1 Explain the employment-at-will doctrine and
why some people would prefer the complete
abolition of this doctrine, whereas others
feel saddened by its gradual demise.
22-2 Explain why each of the following sets of jobs
would or would not be considered equal under the Equal Pay Act:
a. Male stewards and female stewardesses on
continental air flights
b. Male checkers of narcotics and female
checkers of nonnarcotic drugs at a pharmacy
c. Male tailors and female seamstresses
22-3 Explain the following aspects of the Equal
Pay Act:
a. Its purpose
b. The remedies available under the act
c. The defenses available to employers
22-4 Explain the following aspects of Title VII:
a. Its purpose
b. The remedies available under the act
c. The defenses available to employers
22-5 Explain two significant ways in which the Civil
Rights Act of 1991 has changed the application of Title VII.
22-6 What constitutes “reasonable accommodation”
under the Rehabilitation Act and the ADA?
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595
REVIEW PROBLEMS
22-7 The City of Los Angeles provided equal
monthly retirement benefits for men and women of
the same age, seniority, and salary. The benefits were
partially paid for by employee contribution and partially by employer contributions. Because women, on
the average, live longer than men, the city required
women to make contributions to the retirement fund
that were 14.84 percent higher than those made by
men. Was this a violation of the Civil Rights Act?
22-8 JoAnn, Ann, and Bryon were all laboratory analysts, performing standardized chemical tests on various materials. JoAnn was hired first, with no previous
experience, and was trained on the job by the supervisor. She later trained Ann. When Bryon was hired, he
was trained by the supervisor with the assistance of
the two women. All initially worked the same shift
and received the same pay. Then Bryon received a
5-cent-per-hour raise and was to work a swing shift
every other two weeks. Was his higher wage a violation of the Equal Pay Act?
22-9 Administrators of an Ohio Christian school refused to renew a teacher’s contract after she became
pregnant, on the basis of its belief that “a mother’s
place is in the home.” When she filed sex discrimination charges under the state civil rights statute, she
was fired. Was this termination unlawful?
22-10 Ellen’s immediate supervisor repeatedly
required her to have “closed door” meetings with him,
in violation of company policy. As a consequence,
rumors began to spread that the two were having an
office romance, although the meetings in fact involved
her boss’s trying to convince Ellen to loan him money,
again in violation of company policy. When Ellen
asked her immediate supervisor to try to stop the
rumors, he said he found them somewhat amusing
and refused to do anything to stop them. As a consequence of the rumors, she began to be treated as an
“outcast” by her coworkers and received low evaluations from other supervisors in the areas of “integrity”
and “interpersonal relations.” She was passed over for
two promotions for which she had applied. She filed
an action against her employer on the ground that
her supervisor had created a hostile environment by
his refusal to stop the rumors. Do you believe she has
a valid claim under Title VII? Why or why not? Are
there any other causes of action she might raise?
22-11 A U.S. citizen was working at a multinational
company’s Zaire facility. The employer was incorporated in the state of Louisiana. When the employee was
terminated, allegedly because of his age, he sought
recovery under the federal ADEA and also the Louisiana
Age Discrimination in Employment law. The employer
argued that its overseas operations were not subject to
the federal ADEA. Was the employer correct?
22-12 Davis, D’Elea, and Sims were former heroin
or narcotics addicts. Davis and Sims were told by the
city director that they could not be hired by the city
because of their former habit. D’Elea was rejected
from a city CETA program because of his former habit.
The three sued the city, alleging that drug addiction
was a handicap under the Rehabilitation Act of 1973
and that the city’s refusal to hire them was therefore
unlawful under this act. Were they correct in their
contention?
CASE PROBLEMS
22-13 Ahmet Yigit Demirelli worked as a call representative for Convergys Customer Management Group,
Inc. Demirelli suffered from a rare condition commonly known as brittle bone disease and had to be in
a wheelchair. Convergys terminated Demirelli’s employment after he had worked there for about a year
because of excessive tardiness. Demirelli claimed that
his “tardies” stemmed from his inability to park in one
of the two handicapped van-accessible spots, because
whenever he arrived at work in the morning or after
his lunch break, they were occupied. Even when he
tried to arrive at work early, the spots were occupied.
Additionally, when returning from lunch, Demirelli
had difficulty finding an empty call cubicle in which to
work, because he had to wheel through all the rows to
see empty cubicles, rather than being able to look over
the top of a whole row as the other employees did.
Demirelli attempted to suggest accommodations
that could be made to fix his tardies situation. He suggested reserving a cubicle for him (which his first supervisor had done), or allowing him a few extra
minutes to return from lunch. When he was terminated, Demirelli made a claim with the EEOC that Convergys had violated the ADA by not providing him
with reasonable accommodations for his disability.
The EEOC filed suit against Convergys. The district
court found for the EEOC and Demirelli. Convergys
appealed, arguing that the accommodations that
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PART THREE
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Demirelli had suggested were unreasonable and that
Convergys was not in violation of the ADA. How do
you think the court of appeals ruled and why? EEOC v.
Convergys Customer Management Group, 491 F.3d
790 (8th Cir. 2007).
22-14 Plaintiff Donna McGullum was hired by Cedar
Graphics in 1996, and worked in the production
department. On September 22, 1999, she complained
of sexual harassment, alleging that she “was regularly
exposed to sexual comments, sexually explicit matters, sexual jokes, hostile and vulgar language, sexual
innuendos and gross behaviors, primarily by male
coworkers, including management,” despite her continual complaints to management. She was asked to
climb a ladder to retrieve a file and told that no one
would look up her skirt. Another coworker once said,
“Boing, boing, look at that—right through the denim,”
a “reference to the fact that [McGullam’s] hardened
nipples were visible even through [her] denim
jumper.” On September 22, 1999, after her complaint
about harassment, she was transferred to the estimation department of the company, which she said at the
time was “on the other side of the building—hopefully
far enough away from the hostility, harassment and
threats of violence.”
On September 11, 2000, she was terminated, and
on July 3, 2001, she filed a Title VII, hostile work environment claim with the appropriate agency. The only
incident of harassment that she claimed occurred after
the transfer in 1999 was that on the opposite side of
her cubicle there was a salesman who had numerous
conversations with his buddies, during which he made
frequent comments about women such as referring to
them as “chickies.” On one occasion, he said, in reference to a woman he went out with, that “it wouldn’t
be worth it if there wasn’t a sleepover.” The defendant
filed a motion for summary judgment, which the district court granted on grounds that could be described
as procedural. Looking at the requirements of the
statute, explain why the motion was dismissed and
whether you believe the dismissal was upheld on
appeal. McGullam v. Cedar Graphics, Inc., Docket
No. 08-4661 (2d Cir. 2010); available at http://
caselaw.lp.findlaw.com/data2/circs/2nd/084661p.pdf?
DCMP⫽NWL-pro_labor.
22-15 Plaintiffs Francis X. Hogan and Michael
Springstun were police sergeants in the City of Hollywood. Plaintiff Springstun was hired by the City of
Hollywood Police Department in 1980 and became a
sergeant in 1993. Plaintiff Hogan began working for
the city in 1976 and was promoted to sergeant in 1984.
When the plaintiffs were 49 and 48, they were passed
over for a promotion in favor of an individual who was
40. In 2002, when the men were 51 and 50, they were
passed over again when a promotion was given to a
41-year-old instead. The plaintiffs filed complaints
with the Florida Human Relations Commission for age
discrimination and eventually filed suit for the same.
The trial court submitted the case to the jury, which
found in favor of the plaintiffs. The city appealed,
arguing that the men who were given the promotions
were not substantially younger than the plaintiffs. How
do you think the court of appeals, based on Supreme
Court precedent, decided the appeal? City of Hollywood v. Hogan, 986 So. 2d 634 (Fla. Ct. App. 2008).
22-16 Katharine Richardson was hired by Friendly’s
Ice Cream Corporation (Friendly’s) as an assistant manager of its Ellsworth, Maine, store in 2000. Between
2000 and 2006, Richardson performed both administrative and manual tasks as a part of her job. In January
of 2006, Richardson began to experience severe pain
in her right shoulder. The pain was caused by the
manual tasks that she had been performing at work.
The company sent Richardson to see a physician, who
diagnosed Richardson with shoulder impingement
syndrome. The physician recommended that
Richardson stop doing the manual tasks she had been
doing at Friendly’s. Richardson continued to work until
September of 2006, when she took a leave of absence
to undergo shoulder surgery. After the surgery, physicians indicated that Richardson would still be unable to
perform manual tasks at Friendly’s. When Richardson
did not recover as quickly as anticipated, the company
terminated her employment, explaining that she was
disabled and had exceeded the leave guaranteed her
by the Family and Medical Leave Act. Friendly’s moved
for and won summary judgment after the close of
discovery. Richardson appealed, arguing that she was
discharged because of her disability. Friendly’s argued
that Richardson was no longer qualified for the position because she could not perform the essential functions of the position with or without reasonable
accommodation. What was the essential function of
Richardson’s position? How do you think the appellate
court ruled? Richardson v. Friendly Ice Cream Corp.,
594 F.3d 69 (1st Cir. 2010).
22-17 Bradley Baker was hired by Home Depot
in March of 2001 as a full-time sales associate in the
floor and wall department of Home Depot’s store in
Auburn, Massachusetts. Baker worked a flexible schedule that included evenings, weekends, and on any day
of the week that his services were required. During
the course of his employment, Baker attended church
services and premarital counseling at the Gospel
Fellowship Church in Belmont, New York. As a result
of the counseling sessions, Baker became fully aware
of the importance of the Sabbath. Shortly thereafter,
Baker relocated with his new wife and was offered a
job at another Home Depot store in Henrietta,
New York. At the time of his interview, he told the
CHAPTER 22
store manager that he was able to work any day other
than Sunday because of his religious convictions.
Baker was told that there was no problem with his not
working Sundays and was given the position.
For roughly a year, the store accommodated
Baker’s request. Subsequently, a new manager was
hired who did not agree that Baker should be allowed
to take Sundays off of work. Ultimately, Baker was
given the choice between coming in on Sundays when
scheduled or becoming a part-time employee and losing his benefits. When Baker refused to go part-time
and did not show up for scheduled Sunday shifts, his
employment was terminated. Baker filed suit alleging
religious employment discrimination pursuant to Title
VII of the Civil Rights Act of 1964. The district court
found that Home Depot’s offer to Baker of a work
schedule excluding Sunday mornings constituted a reasonable accommodation. Baker appealed. Do you think
Baker was discriminated against under Title VII? How
do you think the court of appeals ruled and why?
Baker v. The Home Depot, 445 F.3d 541 (2d Cir. 2006).
22-18 Stephen Grindle worked as a driver and dock
worker for Watkins Motor Lines. A majority of his time
was spent loading, unloading, and arranging freight,
which required a wide range of movement. Grindle
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597
weighed 450 lbs. in November of 1995 and injured
himself when a ladder he was climbing broke. Several
months later, he requested time off to recover from a
lingering knee injury from the accident. The leave was
granted with the knowledge that he would be terminated if he stayed on leave longer than 180 days and
that he would need a return-to-work release signed by
a doctor and a physical to return to work.
Grindle was unable to get a complete release
signed by his doctor and at his physical, the industrial
clinic doctor determined that Grindle would be unable
to perform his job functions because of his weight and
limited range of movement. Grindle was placed on
safety hold and was unable to return to work in 180
days, so he was terminated. Grindle filed a complaint
of discrimination under the ADA with the EEOC. The
EEOC filed suit against Watkins on Grindle’s behalf,
alleging that by firing Grindle for his obesity, the company had violated the ADA. The district court found
that nonphysiologically caused obesity is not a disability under the ADA and granted summary judgment for
Watkins. Grindle appealed. What rationale did the appellate court give for its decision to affirm or reject the
grant of summary judgment? EEOC v. Watkins Motor
Lines, Inc., 463 F.3d 436 (6th Cir. 2006).
Currently, one of the biggest issues surrounding discrimination is whether sexual orientation should be a
protected characteristic, along with age, race, color,
gender, national origin, religion, and pregnancy. Proponents of this legislation often present the issue as
one of fairness. All of these other groups get protection, so we also deserve protection, they plead. Supporters point out that gay people can be legally fired
for being gay in more than 30 states, suggesting that
being legally fired for a characteristic is inherently
unfair.
Unfortunately, the supporters of this legislation
do not understand the at-will doctrine of employment that is standard (with some exceptions) in the
United States. Unless an employee is part of a collective bargaining agreement, or under contract, an
employer can fire an employee for anything at anytime (with some exceptions, such as discrimination
laws and whistleblower laws). Employees under collective bargaining agreements and contracts must be
fired for “just cause”—meaning there has to be a
good reason, such as sleeping on the job, for firing
the employee. Anybody else can be fired for just
about anything.
Supporters of adding sexual orientation to the list
of protected characteristics do not seem to recognize
that there are hundreds of unprotected characteristics.
Employers can fire employees for coming to work
with purple hair, even if the purple hair would have no
effect on employee productivity. Many proponents of
this legislation argue that being gay is not a choice, just
like race or gender, so it should be protected. There
are many characteristics about which people have no
choice, which are not protected. In every state, at-will
employees can be fired for having annoying voices.
Unless the voice is a consequence of that employee’s
race or gender (such as finding that Latino voices or
female voices are annoying), having an annoying voice
is an unprotected and unchosen characteristic.
Moreover, if sexual orientation is added to the list
of protected characteristics, it would essentially take
away the rights of an already protected characteristic—
religion. Many Americans object to homosexuality on
religious grounds. Forcing a religious employer to
violate his religious principles by forcing him to hire
homosexual employees is discrimination against religious employers! It just wouldn’t be fair to give sexual
orientation protected status.
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PART THREE
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1. How would you frame the issue and the conclusion of this essay?
3. How appropriate are the analogies used in this
argument?
2. The writer gives several reasons to support her
conclusion. Identify the reasons and describe the
reasoning.
Clue: The reasoning is the logic that ties the reasons to the conclusion—ask yourself: “How does
saying ‘I like cake’ lead to ‘Let’s go get cake’”?
4. Write a short essay approaching the issue from a
viewpoint different from the author’s.
Clue: What analogies could you use in making
your case?
Affirmative action remains a contentious issue in areas
of employment, school admissions, and government
policies. Yet, many companies use a form of affirmative action to create a diverse workforce. Using the
Internet, find a company with an affirmative action
policy and review the policy.
Using the test set forth in Adarand Constructors,
Inc. v. Pena and EEOC guidelines, determine whether
the affirmative action policy would withstand a legal
challenge. Why or why not? Also make a list of information not available to you on the company’s Web site
that would assist you in better determining the legality
of its affirmative action policy.
ON THE INTERNET
public.findlaw.com/employment_employee/faq.html This site provides answers to questions an employer
or employee might have about the kinds of questions employers may ask during the hiring process.
www.eeoc.gov The home page of the U.S. Equal Employment Opportunity Commission provides numerous links
to helpful information, including statistics, laws, regulations, and how to file a charge.
http://www.ada.gov/ The ADA home page provides numerous resources for employers trying to comply with
the ADA.
aad.english.ucsb.edu This site is a useful resource for research on affirmative action.
www.law.cornell.edu/topics/employment_discrimination.html Here is a page that will give you information
about discrimination law, as well as allow you to search for statutes and cases related to employment discrimination.
www.dol.gov/asp/programs/guide.htm This Department of Labor Web site provides labor policy information
and an employment law guide.
www.discriminationattorney.com This site contains information about discrimination laws, exemplary cases,
and articles for use by employers and employees.
http://www.ohchr.org/EN/Issues/Discrimination/Pages/discrimination.aspx This United Nations Web
site gives information on all of the international treaties and conventions concerning discrimination.
FOR FUTURE READING
American Bar Association. Guide to Workplace Law
(2nd ed.). New York: Random House Reference, 2006.
Byrd, Robert C., and John D. Knopf. “Do Disability
Laws Impair Firm Performance?,” American Business
Law Journal 47 (2010):145.
Christiansen, Linda. “Can a Plaintiff Win These Days: An
Examination of Recent Sexual-Harassment Cases: Clark
County School District v. Breeden; Lack v. Wal-Mart
Stores, Inc.; Barrett v. Applied Radiant Energy Corp.”
Employment and Labor Law Quarterly 3 (2006): 1.
CHAPTER 22
Corbett, William R. “The Ugly Truth about Appearance Discrimination and the Beauty of Our Employment Discrimination Law.” Duke Journal of Gender,
Law & Policy 14 (2007): 153.
King, Nancy J., Sukanya Pillay, and Gail A. Lasprogata.
“Workplace Privacy and Discrimination Issues Related
to Genetic Data: A Comparative Law Study of the European Union and the United States.” American Business
Law Journal 43 (2006): 79.
Lacy, D. Aaron. “You Are Not Quite as Old as You
Think: Making the Case for Reverse Age
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599
Discrimination under the ADEA.” Berkeley Journal of
Employment and Labor Law 26 (2005): 363.
Prenkert, Jamie Darin, and Julie Magrid Manning.
“A Hobson’s Choice Model for Religious Accommodation.” American Business Law Journal 43
(2006): 467.
Sperino, Sandra F. “A Modern Theory of Direct
Corporate Liability for Title VII” Alabama Law
Review 61 (2010): 773.
23
Environmental Law
䊏 ALTERNATIVE APPROACHES TO ENVIRONMENTAL
PROTECTION
䊏 THE ENVIRONMENTAL PROTECTION AGENCY
䊏 THE NATIONAL ENVIRONMENTAL POLICY ACT OF 1970
䊏 REGULATING WATER QUALITY
䊏 REGULATING AIR QUALITY
䊏 REGULATING HAZARDOUS WASTE AND TOXIC
SUBSTANCES
䊏 THE POLLUTION PREVENTION ACT OF 1990
䊏 GLOBAL DIMENSIONS OF ENVIRONMENTAL REGULATION
s previous chapters have demonstrated, this country has often turned to
the government to solve problems created by business enterprises. Early
in the history of our nation, people recognized that certain problems, such
as monopolization and labor strife, were national in scope and required a
national solution.
Unfortunately, we did not exercise the same degree of foresight in thinking
about protecting our physical environment. We looked at our smokestack industries with pride and saw them as symbols of our great productivity and technological advances. People did not fully appreciate that the billowing smoke was
making the air less healthful to breathe and that the industrial sewage dumped
into rivers was killing or contaminating many forms of aquatic life. The demands
placed on nature to serve as a garbage disposal grew ever greater.
Some people eventually started to realize that pollution was a negative
externality. It was a cost of the product not paid for by the manufacturers in their
costs of production or by consumers in the purchase price. Rather, its costs were
being imposed on the community, as community members were forced to
breathe dirty air and to fish and swim in impure water. People who had the misfortune of living in industrialized areas were paying even higher costs than were
people in rural areas through pollution-related diseases and discomfort. Not only
were these costs being borne by those who did not use or manufacture the products whose production caused the pollution, but also, in many cases, these costs
were higher than the cost of preventing the pollution in the first place.
During the late 1960s, environmental problems became a major national concern, which led to the enactment of legislation to protect the environment and
clean up existing problems. This chapter first examines alternatives to the regulatory approach for solving pollution problems and examines the primary agency
responsible for enforcing environmental laws, the Environmental Protection
Agency. Next we discuss the primary direct regulations designed to protect the
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environment, followed by an overview of the Pollution Prevention Act of 1990.
The global dimensions of environmental protection are discussed last.
Alternative Approaches
to Environmental Protection
TORT LAW
Torts are injuries to one’s person or property. Pollution injures citizens and their
property. Our first attempts to regulate pollution were through the use of tort
law, in particular, through the use of the tort of nuisance. A nuisance is an
unreasonable interference with someone else’s use and enjoyment of his or her
land. If a factory were emitting black particles that settled on a person’s property every day, depositing a layer of dirt on everything in the vicinity, that person might bring an action based on nuisance. He or she would be asking the
court to enjoin the emission of the particulates. Before the tort of nuisance was
used in attempts to stop pollution, an injunction was always granted when a nuisance was found. Nuisance, therefore, would appear to be the perfect solution
to the problem of pollution. The following classic case, however, demonstrates
why actions brought claiming the tort of nuisance are ineffective.
CASE
nuisance An unreasonable
interference with someone
else’s use and enjoyment of
his or her land.
23-1
Boomer et al. v. Atlantic Cement Co.
New York State Court of Appeals
257 N.E.2d 870 (1970)
D
efendant Atlantic Cement Company operated a large
cement plant that emitted considerable amounts of
dirt and smoke into the air. These emissions, combined
with vibrations from the plant, caused damage to the plaintiffs, Boomer and other owners of property located close
to the plant. The plaintiffs brought a nuisance action
against the defendant, seeking an injunction. The trial
court ruled in favor of the defendants; it found a nuisance
but denied plaintiffs the injunction they sought. The plaintiffs appealed to the intermediate appellate court, and the
judgment of the trial court was affirmed in favor of the
defendant. The plaintiffs then appealed to the state’s highest appellate court.
Judge Bergan
[T]here is now before the court private litigation in which
individual property owners have sought specific relief
from a single plant operation. The threshold question
raised on this appeal is whether the court should resolve
the litigation between the parties now before it as equitably as seems possible, or whether, seeking promotion of
the general public welfare, it should channel private litigation into broad public objectives.
A court performs its essential function when it decides the
rights of parties before it. Its decision of private controversies
may sometimes greatly affect public issues. Large questions of
law are often resolved by the manner in which private litigation is decided. It is a rare exercise of judicial power to use a
decision in private litigation as a purposeful mechanism to
achieve direct public objectives greatly beyond the rights and
interests before the court.
Effective control of air pollution is a problem presently
far from solution even with the full public and financial
powers of government. In large measure adequate technical procedures are yet to be developed and some that
appear possible may be economically impracticable.
It seems apparent that the amelioration of air pollution
will depend on technical research in great depth, on a carefully balanced consideration of the economic impact of
close regulation, and on the actual effect on public health.
It is likely to require massive public expenditure and to demand more than any local community can accomplish and
to depend on regional and interstate controls.
A court should not try to do this on its own as a byproduct of private litigation and it seems manifest that the
judicial establishment is neither equipped in the limited
nature of any judgment it can pronounce nor prepared to
lay down and implement an effective policy for the elimination of air pollution. This is an area beyond the circumference of one private lawsuit. It is a direct responsibility
for government and should not thus be undertaken as an
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incident to solving a dispute between property owners
and a single cement plant—one of many—in the Hudson
River Valley.
The cement-making operations of defendant have been
found by the Court at Special Term to have damaged the
nearby properties of plaintiffs in these two actions. That
court accordingly found defendant maintained a nuisance
and this has been affirmed at the Appellate Division. The
total damage to plaintiffs’ properties is, however, relatively
small in comparison with the value of defendant’s operation and with the consequences of the injunction which
plaintiffs seek.
The ground for the denial of injunction, notwithstanding the finding both that there is a nuisance and that plaintiffs have been damaged substantially, is the large disparity
in economic consequences of the nuisance and of the
injunction.
[T]o grant the injunction unless defendant pays plaintiffs
such permanent damages as may be fixed by the court seems
to do justice between the contending parties. All of the attributions of economic loss to the properties on which plaintiffs’ complaints are based will have been redressed.
The nuisance complained of by these plaintiffs may
have other public or private consequences, but these
particular parties are the only ones who have sought remedies and the judgment proposed will fully redress them.
The limitation of relief granted is a limitation only within
the four corners of these actions and does not foreclose
public health or other public agencies from seeking proper
relief in a proper court.
It seems reasonable to think that the risk of being required to pay permanent damages to injured property
owners by cement plant owners would itself be a reasonably effective spur to research for improved techniques to
minimize nuisance.
The damage base here suggested is consistent with the
general rule in those nuisance cases where damages are allowed. “Where a nuisance is of such a permanent and unabatable character that a single recovery can be had,
including the whole damage past and future resulting
therefrom, there can be but one recovery.” It has been said
that permanent damages are allowed where the loss recoverable would obviously be small compared with the
cost of removal of the nuisance.
Thus, it seems fair to both sides to grant permanent damages to plaintiffs which will terminate this private litigation.
Reversed in favor of Plaintiff, Boomer.
In Case 23-1, the New York Court of Appeals became the third court to find the Atlantic Cement Company guilty of committing a nuisance against the plaintiff Boomer. At the same time, the state’s highest court also became the third court
not to grant an injunction to halt the cement company’s pollution.
At first glance, the finding of the court and its subsequent decision seem to contradict one another. A closer look
at the case, however, reveals that Judge Bergan, in delivering the decision, qualified when a nuisance warrants an injunction. The questions that follow will help you identify this qualification and determine the primary ethical norm to
which such a qualification is tied.
1.
To demonstrate your ability to follow legal reasoning, in your own words, run down the court’s reasoning for its
decision.
Clue: Do not be too narrow here. You want to identify (1) why the court granted damages to the plaintiff and
(2) why the court did not order an injunction.
2.
The court argued that granting the plaintiff monetary damages should promote more environmentally friendly
practices on the part of businesses, because they would develop technologies to avoid having to pay damages.
What assumption did the court make in this reasoning?
Clue: Reread the court’s reasoning. This assumption is related to the quantitative relationship between the
damages imposed on businesses for polluting and the economic benefits of polluting for businesses.
In Boomer, the plaintiffs technically “won” the case because they were
granted a greater remedy than the lower courts had granted; they were granted
an injunction in the event that the defendant failed to pay permanent damages
within a set period of time. They did not, however, achieve their objective, which
was to eliminate the nuisance through receipt of an injunction, the traditional
remedy in a nuisance action. Thus, in Boomer v. Atlantic Cement Co., the court
decided that before it would apply the traditional nuisance remedy to stop the
pollution, it would weigh the harms resulting from the injunction against the
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benefits. Because of a lack of scientific knowledge, judges at that time did not
see the true costs that the polluting behavior was imposing on the community.
Thus, a major problem with using nuisance laws to stop pollution is that the
courts will not necessarily use their authority to issue an injunction to stop the
polluting behavior even when they find that a nuisance exists. Nuisance actions
can be and are used, but they are used primarily as a way for plaintiffs injured
by pollution to recover damages for their losses.
Negligence, an Alternative Tort Solution. Negligence is also used at times in
the fight against pollution. Plaintiffs must establish the elements of negligence as
described in Chapter 12: duty, breach of duty, causation, and damage. Negligence would most often be used in a case in which a defendant’s polluting
behavior harmed a plaintiff. For example, if a defendant buried hazardous waste
in the ground and the waste seeped down into the water table, contaminating
the plaintiff’s well water and injuring the plaintiff, the plaintiff might bring a negligence action.
Negligence actions involving hazardous materials are often difficult to prosecute successfully, primarily because many of the pollutants do not cause immediate harm. By the time the harm occurs, it is often difficult to link the damage
to the defendant’s release of the material, making the element of causation
extremely difficult to prove. The availability of defenses such as contributory or
comparative negligence, as well as assumption of the risk, helps weaken the effectiveness of this tort. It also shares with nuisance the attribute of being reactive rather than preventing pollution in the first place.
The primary method of controlling pollution today is through direct regulation. Before we discuss the regulatory approach, though, some additional alternatives to regulation should be considered.
GOVERNMENT SUBSIDIES APPROACH
One such approach is the use of government subsidies. Under a subsidy system,
the government pays polluters to reduce their emissions. Some subsidies that
could be used are tax breaks, low-interest loans, and grants for the purchase and
installation of pollution-control devices. The primary problem with this approach
is that when a subsidy is for less than 100 percent of the cost, the firm that limits its pollutants must still pay the difference between the actual cost and the subsidy, a cost not borne by its competitors.
EMISSION CHARGES APPROACH
Another approach is simply to charge the polluter a flat fee on every unit of pollutant discharged. Each rational polluter would theoretically reduce pollution to
the point at which the cost of reducing one more unit of pollutant is greater than
the emission fee. The larger the fee for each unit, the greater the motivation of
firms to reduce their emissions. Difficulties in monitoring every discharge of the
pollutant and in calculating the amount that should be assessed for each unit of
the various pollutants are major problems with this approach. A final problem
with this approach is that it may amount to licensing a continuing wrong. Some
firms might simply pay the charges and continue to emit pollutants that would
be difficult to clean up even with the fees collected.
MARKETABLE DISCHARGE PERMITS APPROACH
Discharge permits provide a similar approach to pollution control. The government would sell permits for the discharge of various pollutants. These pollutants
could be discharged only if the polluter had the appropriate permit. Polluters
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would be encouraged to reduce their emissions because this reduction would
enable them to sell their permits. This approach is currently being attempted on
a limited scale to reduce emissions of one significant air pollutant, sulfur.
From the perspective of people wishing to reduce the total amount of pollution emitted into the environment, the primary advantage that this system offers
over a system of charges is that the government actually limits the total amount
of pollution through the permits; no permits will be issued once a certain amount
of emissions has been authorized. To reduce pollution, the government can simply reduce the number of permits that it issues. Again, however, there is the problem of monitoring the pollution sources.
DIRECT REGULATION APPROACH
technology-forcing
standards Standards of
pollution control set primarily
on the basis of health
considerations, with the
assumption that once
regulators have set the
standards, industry will be
forced to develop the
technology needed to meet
them.
technology-driven standards
Standards that take account of
existing levels of technology
and require the best control
system possible given the
limits of that technology.
Direct regulation is the primary device currently used for environmental protection. During the late 1970s, a comprehensive set of regulations designed to protect the environment and specifically to improve air and water quality was
adopted. These regulations established specific limits on the amount of pollutants that could be discharged.
One issue that must be determined when direct regulations are to be used is
whether the standards set by the regulations are “technology forcing” or “technology driven.” So-called technology-forcing standards are set primarily on
the basis of health considerations, with the assumption that once standards have
been established, the industries will be forced to develop the technology needed
to meet the standards. Technology-driven standards, in contrast, try to achieve
the greatest improvements possible with existing levels of technology. Most of the
early environmental regulations in this country were technology forcing. In some
instances, this approach was highly successful, and impressive technological
gains were made. In other instances, sufficient technology had not yet been developed, and we were unable to meet some rather lofty goals.
Environmental regulations are enforced primarily by administrative agencies.
The judiciary is available as a last resort to ensure that these agencies fulfill their
obligations under the law. Because the administrative agencies are staffed by
presidential appointment, the attitude of the chief executive has a substantial impact on an agency’s behavior. Under different administrations, federal environmental regulations have been enforced with varying degrees of vigor.
The remainder of this chapter focuses primarily on direct regulation as a
means of protecting the environment, because, despite some minor changes in
some of the environmental laws, direct regulation is still the primary means of
protecting the environment. We will first examine the Environmental Protection
Agency, which has primary responsibility for enforcing the direct regulations.
The Environmental Protection Agency
Environmental Protection
Agency (EPA) The federal
agency charged with the
responsibility for conducting
an integrated, coordinated
attack on all forms of pollution
of the environment.
Like other areas of administrative law, environmental law is primarily made up
of regulations passed by a federal agency operating under the guidance of congressional mandates. The primary agency responsible for passage and enforcement of these regulations is the Environmental Protection Agency (EPA)
headed today by Lisa P. Jackson.
The EPA is one of the largest federal agencies, having approximately 17,000
employees as of the year 2007. The agency was created by executive order in
1972 to mount an integrated, coordinated attack on pollution in the areas of air,
water, solid waste, pesticides, radiation, and toxic substances—a rather substantial mandate for any agency! The reason for placing control of all types of environmental problems within one agency was to ensure that the attack on pollution
would be integrated. In other words, Congress wanted to be certain that we
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would not have a regulation reducing air pollution that simply led to increased
water pollution. Unfortunately, such integration did not occur. Within the agency,
separate offices were established for each of the areas of pollution, and there was
very little interaction among them.
Recognizing the inefficiency of the EPA’s organizational structure, in 1993,
then-EPA administrator Carol Browner took one of the first major steps toward
trying to make the agency one with a truly integrated focus. She moved all enforcement actions from the various program offices into one main enforcement
office, the Office of Compliance, which has as its primary focus “providing industry with coherent information about compliance requirements.” The office is
divided into groups of regulators that focus on separate sectors of the economy:
energy and transportation, agriculture, and manufacturing. Browner also created
a new Office of Regulatory Enforcement to take on the tough responsibility of
deciding which polluters would be taken to court.1
One area of special concern to business managers, especially since 1990, has
been the EPA’s use of criminal sanctions, including incarceration, to enforce environmental laws. These cases are not actually tried by the EPA; rather, they are
passed on by the EPA to the Justice Department with a recommendation for
prosecution.
Since 1994, the agency has been operating under a policy statement issued to
guide its special agents in their enforcement activities. Under this policy, the agents
are to look for “significant environmental harm” and “culpable conduct.” To satisfy
the second criterion, the EPA looks for a “history of repeated violations,” “concealment of misconduct,” “falsification of required records,” “tampering with monitoring or control equipment,” and “failing to obtain required licenses or permits.”2
By issuing this policy, the EPA is trying to put firms on notice as to when
their conduct is clearly unacceptable and may subject them to criminal liability.
The policy also reflects the EPA’s intent to target the worst violators and make
examples of them, hoping that such prosecutions will have a deterrent effect.
The EPA’s Final Policy on Penalty Reductions encourages firms to engage in
environmental self-auditing. If a firm can demonstrate that it discovered a violation and moved to correct it, the EPA will seek to reduce the penalty for the violation. Of course, the firm that engages in a self-audit, discovers a violation, and
chooses not to change the harmful practice is setting itself up as a candidate for
criminal prosecution. See Exhibit 23-1 for the elements of a successful environmental auditing program.
EXHIBIT 23-1
• Explicit senior management support for environmental auditing and the willingness to
follow up on the findings
• An environmental auditing function independent of audited activities
• Adequate auditor training and staffing
• An explicit audit program, with objectives, scope, resources, and frequency
• A process that collects, analyzes, interprets, and documents information sufficient to
achieve audit objectives
• A process that includes specific procedures to promptly prepare candid, clear, and
appropriate written reports on audit findings, corrective actions, and schedules for
implementation
• A process that includes quality assurance procedures to verify the accuracy and thoroughness of such audits
1
P. Wallach and D. Levin, “Using Government’s Guidance to Structure Compliance Plan,”
National Law Journal, S10 (Aug. 30, 1993).
2
E. Devaney, The Exercise of Investigative Discretion (American Law Institute, 1995).
ELEMENTS
OF A SUCCESSFUL
AUDITING PROGRAM
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Pollution Controls in Japan
Japan’s first pollution legislation was passed in 1970, protecting air, water, and other areas. Instead of using a system like that of the United States, in which a national agency (the EPA) performs checks and assessments, Japan
addressed the problem from inside the industries themselves.
Japan’s solution was to require certain industries to have personnel specifically in charge of making sure the
company was following environmental laws. Any company in one of the following industries is covered under
this regulation: manufacturing, electric power supply, gas supply, or heat supply, which has facilities that generate soot, dust, noise, polluted water, or vibration. Larger companies are required to have three levels of pollutions
control personnel. At the highest level is the pollution control supervisor, who supervises and manages the work
relating to control of pollution in factories. A higher-level manager, such as the factory manager, is suitable and
may fulfill this role. Below the supervisor is the senior pollution control manager, who assists the pollution control supervisor and directs the pollution control managers. At the lowest level are the pollution control managers,
who actually do the inspections and make sure everything is up to environmental standards in their facility type.
The National Environmental Policy Act of 1970
Environmental Impact
Statement (EIS) A statement
that must be prepared for
every major federal activity
that would significantly affect
the quality of the human
environment.
One of the first major environmental laws passed in this nation set forth our
country’s policy for protecting the environment. This act, the National Environmental Policy Act of 1970 (NEPA), is regarded by many as the country’s most
influential piece of environmental legislation.
NEPA is also viewed as an extremely powerful piece of legislation, because
its primary purpose and effect have been to reform the process by which regulatory agencies make decisions. Title II of the NEPA requires the preparation of
an Environmental Impact Statement (EIS) for every major legislative proposal or agency action that would have a significant impact on the quality of the
human environment. A substantial number of these statements are filed every
year, and are the basis of a significant amount of litigation.
THRESHOLD CONSIDERATIONS
An EIS is required when three elements are present. First, the action in question
must be federal, such as the grant of a license, the making of a loan, or the lease
of property by a federal agency. Second, the proposed activity must be major,
that is, requiring a substantial commitment of resources. Finally, the proposed
activity must have a significant impact on the human environment.
CONTENT OF THE EIS
Once an agency has determined that an EIS is necessary, it must gather the
information necessary to prepare the document. The NEPA requires that an EIS
include a detailed statement of
1. the environmental impact of the proposed action;
2. any adverse environmental effects that cannot be avoided should the proposal be implemented;
3. alternatives to the proposed action;
4. the relationship between local short-term uses of the human environment
and the maintenance and enhancement of long-term productivity; and
5. any irreversible and irretrievable commitments of resources that would be
involved in the proposed activity should it be implemented.
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A continuing problem under the act, however, is interpreting what is meant
by environmental impacts. Clearly, they extend beyond the immediate effects
on the natural environment; in some cases, they have been held to include
noise, increased traffic and congestion, the overburdening of public facilities
such as sewage and mass transportation systems, increased crime, increased
availability of illegal drugs, and (in a small number of cases) damage to the psychological health of those affected by the agency action. Other cases, however,
have not allowed all such damages. For example, the loss of business profits resulting from a proposed agency action has not been considered an environmental impact.
The following case illustrates how difficult it sometimes is for the court to
determine what is a significant environmental impact that requires the filing of
an EIS.
CASE
23-2
TOMAC v. Gale Norton
United States Court of Appeals for the District of Columbia
433 F.3d 852 (2006)
T
he Pokagon Band of Potawatomi Indians purchased
land that would house a 110,000 square-foot gaming facility, 5 or 6 restaurants, a variety of gift shops, a child care
facility, a 200-room first-class hotel, and a surface parking
lot and parking garage. Before proceeding with the
project, the Bureau of Indian Affairs (BIA) was required under NEPA to assess the potential environmental impacts of
the gaming resort. If, based on the environmental assessment (EA), the agency finds that an EIS is not necessary, the
Bureau may issue a “Finding of No Significant Impact”
(FONSI), which “fulfills the documentation requirements
established by the CEQ regulations.”
The BIA issued a FONSI for the trust acquisition. The
Bureau explained that implementation of the proposed actions with corresponding mitigation measures “will have
no significant impact on the quality of the human environment” within the meaning of NEPA. Thus, an EIS was not
warranted. BIA subsequently issued a “Notice of Intent to
Take Land into Trust.” Subsequently, the Taxpayers of
Michigan Against Casinos (TOMAC) filed a complaint
against the Department of the Interior. TOMAC alleged
that the secretary’s trust acquisition decision violated
NEPA, because the gaming and recreation complex would
significantly affect the area surrounding the site.
The district court concluded that BIA sought out and
properly considered the available data, thereby fulfilling its
responsibility under NEPA. The district court granted
summary judgment in favor of BIA. TOMAC appealed.
Judge Edwards
A. Environmental Assessments
The court’s role in reviewing an agency’s decision not to issue an EIS is a “limited” one, designed primarily to ensure
“that no arguably significant consequences have been
ignored.” The evaluation of the “‘impact’ of those consequences on the quality of the human environment, . . . is
‘left to the judgment of the agency.’” This court will overturn an agency’s decision to issue a FONSI—and therefore
not to prepare an EIS—only “if the decision was arbitrary,
capricious, or an abuse of discretion.” When examining a
FONSI, our job is to determine whether the agency: (1) has
“accurately identified the relevant environmental concern,” (2) has taken a “hard look” at the problem in preparing its EA, (3) is able to make a convincing case for its
finding of no significant impact, and (4) has shown that
even if there is an impact of true significance, an EIS is unnecessary because “changes or safeguards in the project
sufficiently reduce the impact to a minimum.”
Size of the Project and Report
In contending that an EIS is in order, TOMAC first argues that
the sheer magnitude of the proposed gaming resort, as well
as the length and complexity of the resulting EA, indicates
that an EIS is necessary. In terms of the project’s size, TOMAC
avers that the anticipated arrival of 4.5 million visitors a year
to a rural community of less than 5,000 residents suggests
that BIA should produce an EIS. Similarly, TOMAC claims that
because BIA spent four-and-a-half years and generated almost
900 pages of data and analysis examining the potential environmental impacts of the proposed gaming resort, it is clear
that an EIS is needed. These claims miss their mark.
TOMAC offers no support for the proposition that an
EIS is required when a project reaches a certain size. The
relevant benchmark is whether the federal action “significantly affects the quality of the human environment.”Large
federal projects may, on the average, be more likely to meet
this threshold. But there is no categorical rule that sizable
federal undertakings always have a significant effect on the
quality of the human environment.
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Similarly, the significant time and effort BIA has spent
preparing its EA does not alone prove that an EIS is obligatory. TOMAC relies on the CEQ guidelines, which advise
that an EA should be no more than 10–15 pages in length.
This guideline is not a binding regulation, however. The
simple point here is that the length of an EA has no bearing on the necessity of an EIS. “What ultimately determines
whether an EIS rather than an EA is required is the scope
of the project itself, not the length of the agency’s report.”
The opposite regime would create perverse incentives for
agencies, as it would only serve to “encourage agencies to
produce bare-bones EA’s.”
Cumulative Impacts
TOMAC next asserts that BIA’s EA Supplement ignores the
“cumulative impacts” of the gaming resort. NEPA’s implementing regulations require an agency to evaluate “cumulative impacts” along with the direct and indirect impacts
of a proposed action. A “cumulative impact”is “the impact
on the environment which results from the incremental
impact of the action when added to other past, present,
and reasonably foreseeable future actions regardless of
what agency . . . undertakes such other actions.” We have
held that a “meaningful cumulative impact analysis must
identify” five things: “(1) the area in which the effects of
the proposed project will be felt; (2) the impacts that are
expected in that area from the proposed project; (3) other
actions—past, present, and proposed, and reasonably
foreseeable—that have had or are expected to have impacts in the same area; (4) the impacts or expected impacts from these other actions; and (5) the overall impact
that can be expected if the individual impacts are allowed
to accumulate.” In other words, the agency “cannot treat
the identified environmental concern in a vacuum.”
Appellant appears to misunderstand the function of
a cumulative impacts analysis. TOMAC construes the
requirement to mean that BIA was required to consider
the “cumulative impact of all the casino’s expected
impacts when added together.” This is not correct. The
“cumulative” impacts to which the regulation refers are
those outside of the project in question; it is a measurement of the effect of the current project along with any
other past, present, or likely future actions in the same
geographic area.
The Bureau discusses one identifiable “future action” in
its EA Supplement—the potential for new business development on a particular parcel of land as a result of the
casino. It found that the zoning ordinances of the local governments, as well as taps to the sewer and water system,
were sufficient to account for the “cumulative impact.”BIA
concluded its cumulative impacts statement by declaring
that “no past, present, or reasonably foreseeable future actions are known or anticipated which might produce a significant cumulative impact when considered with the
added incremental impact of the Project.”
Other than the potential for development on the one
parcel of land, the Bureau notes that no projects are
“known or anticipated” to combine to produce a significant negative impact on the environment. And TOMAC
points to nothing to suggest that BIA overlooked anything.
Therefore, we find that BIA’s cumulative impacts analysis is
sufficient for purposes of NEPA.
Affirmed in favor of Norton (Department of the Interior,
Bureau of Indian Affairs).
1.
Reasons or facts by themselves do not necessarily lead to one and only one decision. In this case, for instance,
could you make the case that the court strains to find on behalf of Norton?
Clue: Review the reasoning under the section “Size of the Project and Report.” Could that same evidence have
been used to overturn the original decision?
2.
Is “cumulative impacts” ambiguous? In other words, is it reasonable to wonder just what that term means in this
instance?
Clue: Read the second paragraph under “Cumulative Impacts.”
Another problem regarding the scope of the EIS pertains to the requirement of
a detailed statement of alternatives to the proposed actions. What alternatives must
be discussed, and how detailed must the discussion be? In general, any reasonable
alternatives, including taking no action, must be discussed. The more likely the alternative is to be implemented, the more detailed the statement must be.
EFFECTIVENESS OF THE EIS PROCESS
The EIS requirement has clearly changed the process of agency decision making, but many wonder whether the requirement has improved the quality of that
decision making.
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Now that the reader is familiar with this umbrella environmental act, we
will examine some of the specific laws designed to protect various aspects of
the environment. The focus will initially be on protecting the quality of the
nation’s water.
Regulating Water Quality
Water pollution is controlled today primarily by two pieces of legislation: the
Federal Water Pollution Control Act (FWPCA; also called the Clean Water Act)
and the Safe Drinking Water Act (SDWA). The first concentrates on the quality of
water in our waterways; the second ensures that the water we drink is not harmful to our health. (Some people say that the former law protects the environment
from humans, whereas the latter protects humans from the environment!)
THE FEDERAL WATER POLLUTION CONTROL ACT
When Congress passed the 1972 amendments to the FWPCA, it established two
goals: (1) “fishable” and “swimmable” waters by 1983 and (2) the total elimination
of pollutant discharges into navigable waters by 1985. These goals were to be
achieved through a system of permits and effluent discharge limitations. Obviously, these goals were not attained. Many argue that no one really expected their
attainment. They did, however, set a high goal toward which we could aspire.
Point-Source Effluent Limitations. One of the primary tools for meeting the
goals of the 1972 FWPCA amendments was the establishment and enforcement
of point-source effluent limitations. Point sources are distinct places from
which pollutants can be discharged into water. Factories, refineries, and sewage
treatment facilities are a few examples of point sources. Effluents are the outflows from a specific source. Effluent limitations, therefore, are the maximum
allowable amounts of pollutants that can be discharged from a source within a
given time period. Different limitations were established for different pollutants.
Under the National Pollutant Discharge Elimination System (NPDES), every
point source that discharges pollutants must obtain a discharge permit from the
EPA or from the state if the state has an EPA-approved plan at least as strict as
the federal standards. The permits specify the types and amounts of effluent discharges allowed. The discharger is required to continually monitor its discharges
and report any excess discharges to either the state or federal EPA. Discharges
without a permit or in amounts in excess of those allowed by the permit may
result in the imposition of criminal penalties. Enforcement of the act is left primarily to the states when those states have an approved program for regulation.
The act, however, provides for federal monitoring, inspection, and enforcement.
Citizens may also bring suit to enforce the effluent limits.
Permissible discharge limits under the discharge system are based on technological standards. Most sources today must use the best available control technology (BACT). All new sources must meet this standard, but some existing
facilities are allowed to meet a slightly lower standard, best practicable control
technology or BPCT. The EPA issues regulations explaining which equipment
meets these standards.
THE SAFE DRINKING WATER ACT
The FWPCA ensures that the waterways are clean, but “clean” does not necessarily mean “fit to drink.” The SDWA, therefore, sets standards for drinking water
supplied by a public water supply system, which is defined by the act as a water
supply system that has at least 15 service connections or serves 25 or more
persons.
point sources Distinct places
from which pollutants are discharged into water, such as
paper mills, electric utility
plants, sewage treatment
facilities, and factories.
effluent limitations Maximum
allowable amounts of pollutants that can be discharged
from a point source within a
given time period.
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The SDWA requires the EPA to establish two levels of drinking water standards for potential drinking water contaminants. Primary standards are to protect human health, and secondary standards are to protect the aesthetic quality
of drinking water.
Primary standards are based on maximum contaminant level goals (MCLGs)
and maximum contaminant levels (MCLs) for all contaminants that have the
potential to have an adverse effect on human health. MCLGs are the levels at
which there are no potential adverse health effects. These are unenforceable,
health-based goals; they are the high standards to which we aspire. The MCLs
are the enforceable standards. They are developed from the MCLGs but also
take into account the feasibility and cost of meeting the standard. By 1991, the
EPA was to have set MCLs for 108 of the hundreds of contaminants found in
our drinking water, and MCLs for 25 more contaminants every 3 years thereafter. These goals were not met, and the 1996 amendments to the SDWA gave
the EPA more flexibility in setting standards so that the agency could focus first
on setting standards for the contaminants that posed the greatest potential
health hazards.
As the reader might guess, keeping up with the ever-increasing MCLs is a
difficult task for public drinking water suppliers. Monitoring these systems is
also a chore. Most states do monthly monitoring. Violations may be punished
by administrative fines or orders. The 1996 amendments also imposed a “right
to know” provision, requiring drinking water suppliers to provide every household with annual reports on water contaminants and the health problems they
may cause.
Regulating Air Quality
A second major environmental concern is protecting the quality of the air. To that
end, Congress enacted the Clean Air Act in 1970. Although air quality continues
to improve, the EPA estimated that in 2006 more than 60 percent of Americans
lived in areas that did not meet the ambient air quality standards for at least one
of six major conventional air pollutants: carbon monoxide, lead, nitrogen oxides,
suspended particulates, ozone, and sulfur dioxide.3
Table 23-1 illustrates some of the most common health problems caused by
these pollutants. In addition to these enumerated health problems, nitrogen
oxides and sulfur dioxide contribute to the formation of acid rain, which defaces
buildings and causes the pH levels of lakes to reach such low levels that most
plants and animals can no longer survive in them. These pollutants, frequently
referred to as criteria pollutants, have been regulated primarily through national
air quality standards.
Although the EPA is authorized to regulate air quality, environmentalists and
others do not always feel that the EPA does its job effectively. In a case heard by
TABLE 23-1
AIR POLLUTANTS
AND ASSOCIATED
HEALTH PROBLEMS
Pollutant
Associated Problems
Carbon monoxide
Lead
Nitrogen oxides
Ozone
Angina, impaired vision, poor coordination, lack of alertness
Neurological system and kidney damage
Lung and respiratory tract damage
Eye irritation, increased nasal congestion, reduction of lung function,
reduced resistance to infection
Lung and respiratory tract damage
Sulfur dioxide
3
EPA, Air Trends: Six Principal Pollutants; retrieved March 15, 2008, from www.epa.gov/
airtrends/sixpoll.html.
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the Supreme Court, the state of Massachusetts and a number of environmental
organizations challenged the EPA’s refusal to regulate greenhouse gas emissions
from motor vehicles.
CASE
23-3
Massachusetts v. Environmental Protection Agency
Supreme Court of the United States
127 S. Ct. 1438 (2007)
O
n October 20, 1999, the state of Massachusetts and
19 private organizations filed a rulemaking petition
asking the EPA to regulate “greenhouse gas emissions from
new motor vehicles under §202 of the Clean Air Act.” The
petition alleged that climate change will have serious
adverse effects on human health and the environment. In
addressing the EPA’s statutory authority, the petition stated
that the agency itself had already confirmed that it had the
power to regulate carbon dioxide.
The EPA entered an order denying the rulemaking petition on September 8, 2003. The agency gave two reasons for
its decision: (1) that, contrary to the opinions of its former
general counsels, the Clean Air Act does not authorize the
EPA to issue mandatory regulations to address global climate
change; and (2) that even if the agency had the authority to
set greenhouse gas emission standards, it would be unwise
to do so at this time. In essence, the EPA concluded that
climate change was so important that unless Congress spoke
with exacting specificity, it could not have meant the agency
to address it. Having reached that conclusion, the EPA
believed it followed that greenhouse gases could not be considered “air pollutants” within the meaning of the act. The
agency furthermore characterized any EPA regulation of
motor-vehicle emissions as a “piecemeal approach” to
climate change, and stated that such regulation would conflict with the president’s “comprehensive approach” to the
problem. The organizations and the state of Massachusetts
challenged the EPA’s refusal.
Justice Stevens
On the merits, the first question is whether . . . the Clean Air
Act authorizes EPA to regulate greenhouse gas emissions
from new motor vehicles in the event that it forms a “judgment”that such emissions contribute to climate change. We
have little trouble concluding that it does. In relevant
part, [the CAA] provides that EPA “shall by regulation prescribe . . . standards applicable to the emission of any air pollutant from any class or classes of new motor vehicles or
new motor vehicle engines, which in [the Administrator’s]
judgment cause, or contribute to, air pollution which may
reasonably be anticipated to endanger public health or welfare.”Because EPA believes that Congress did not intend it to
regulate substances that contribute to climate change, the
agency maintains that carbon dioxide is not an “air pollutant” within the meaning of the provision.
The statutory text forecloses EPA’s reading. The Clean
Air Act’s sweeping definition of “air pollutant” includes
“any air pollution agent or combination of such agents,
including any physical, chemical . . . substance or matter
which is emitted into or otherwise enters the ambient
air. . . .” On its face, the definition embraces all airborne
compounds of whatever stripe, and underscores that intent through the repeated use of the word “any.” Carbon
dioxide, methane, nitrous oxide, and hydrofluorocarbons
are without a doubt “physical [and] chemical . . . substance[s] which [are] emitted into . . . the ambient air.”
The statute is unambiguous.
EPA finally argues that it cannot regulate carbon
dioxide emissions from motor vehicles because doing so
would require it to tighten mileage standards, a job
(according to EPA) that Congress has assigned to DOT. But
that DOT sets mileage standards in no way licenses EPA to
shirk its environmental responsibilities. EPA has been
charged with protecting the public’s “health” and “welfare,” a statutory obligation wholly independent of DOT’s
mandate to promote energy efficiency. The two obligations may overlap, but there is no reason to think the two
agencies cannot both administer their obligations and yet
avoid inconsistency.
While the Congresses that drafted [the CAA] might not
have appreciated the possibility that burning fossil fuels
could lead to global warming, they did understand that
without regulatory flexibility, changing circumstances and
scientific developments would soon render the Clean Air
Act obsolete. The broad language of [the CAA] reflects an
intentional effort to confer the flexibility necessary to forestall such obsolescence. Because greenhouse gases fit well
within the Clean Air Act’s capacious definition of “air pollutant,” we hold that EPA has the statutory authority to regulate the emission of such gases from new motor vehicles.
The alternative basis for EPA’s decision—that even if it
does have statutory authority to regulate greenhouse gases,
it would be unwise to do so at this time—rests on reasoning
divorced from the statutory text. While the statute does condition the exercise of EPA’s authority on its formation of a
“judgment,”that judgment must relate to whether an air pollutant “cause[s], or contribute[s] to, air pollution which may
reasonably be anticipated to endanger public health or welfare.”Put another way, the use of the word “judgment”is not
a roving license to ignore the statutory text. It is but a direction to exercise discretion within defined statutory limits.
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If EPA makes a finding of endangerment, the Clean Air
Act requires the agency to regulate emissions of the deleterious pollutant from new motor vehicles. EPA no doubt
has significant latitude as to the manner, timing, content,
and coordination of its regulations with those of other
agencies. But once EPA has responded to a petition for rulemaking, its reasons for action or inaction must conform to
the authorizing statute. Under the clear terms of the Clean
Air Act, EPA can avoid taking further action only if it determines that greenhouse gases do not contribute to climate change or if it provides some reasonable explanation
as to why it cannot or will not exercise its discretion to determine whether they do. To the extent that this constrains
agency discretion to pursue other priorities of the Administrator or the President, this is the congressional design.
Nor can EPA avoid its statutory obligation by noting the
uncertainty surrounding various features of climate change
and concluding that it would therefore be better not to
regulate at this time. If the scientific uncertainty is so profound that it precludes EPA from making a reasoned
judgment as to whether greenhouse gases contribute to
global warming, EPA must say so. That EPA would prefer
not to regulate greenhouse gases because of some residual
uncertainty—which, contrary to Justice Scalia’s apparent
belief, is in fact all that it said. The statutory question is
whether sufficient information exists to make an endangerment finding.
In short, EPA has offered no reasoned explanation for its
refusal to decide whether greenhouse gases cause or contribute to climate change. Its action was therefore arbitrary, capricious, . . . or otherwise not in accordance with
law. We need not and do not reach the question [of]
whether on remand EPA must make an endangerment finding, or whether policy concerns can inform EPA’s actions
in the event that it makes such a finding. We hold only that
EPA must ground its reasons for action or inaction in the
statute.
Reversed in favor of Massachusetts.
THE NATIONAL AMBIENT AIR QUALITY STANDARDS
National Ambient Air Quality
Standards (NAAQS) A twotiered set of standards
developed for the chief
conventional air pollutants:
primary standards, designed
to protect public health; and
secondary standards,
designed to protect public
welfare.
state implementation plan
(SIP) A plan, required of every
state, that explains how the
state will meet federal air
pollution standards.
The National Ambient Air Quality Standards (NAAQS) provide the focal
point for air pollution control. The administrator of the EPA establishes primary
and secondary NAAQS for criteria pollutants. Primary standards are those that
the administrator determines are necessary to protect the public health, including an adequate margin of safety. Secondary standards are more stringent, as
they are the standards that would protect the public welfare (crops, buildings,
and animals) from any known or anticipated adverse effect associated with the
air pollutant for which the standard is being established. Currently, the primary
and secondary standards are the same for all criteria pollutants except sulfur
dioxide. The administrator of the EPA retains the authority to establish new primary and secondary standards if scientific evidence indicates that the present
standards are inadequate or that such standards must be set for currently unregulated pollutants.
Once each NAAQS is established, each state has nine months to establish a
state implementation plan (SIP) that explains how the state is going to ensure that the pollutants in the air within a state’s boundaries will be kept from
exceeding the NAAQS. Primary NAAQS must be achieved within three years of
the creation of a SIP, and secondary standards are to be met within a reasonable
time. The administrator of the EPA has to approve all SIPs. When a SIP is found
inadequate, the administrator has the power to amend it or send it back to the
state for revision.
In the 1990 Clean Air Act Amendments, Congress specifically addressed those
areas of the country that had not yet met the NAAQS, the so-called
nonattainment areas. Such areas are classified into five categories ranging from
“marginal” to “extreme,” depending on how far out of compliance they are. New
deadlines for meeting the primary standard for ozone were set, ranging from 5 to
20 years. Nonattainment areas also must establish or upgrade vehicle inspection
and maintenance programs.
In addition to establishing the NAAQS, the EPA administration is also
required to determine national, uniform emission standards for new motor
vehicles, as well as for new and major expansions of existing stationary
sources of pollutants. The standards for new stationary sources, established
by the New Source Review program, are to reflect the best available control
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technology, taking into account the costs of compliance. The initial emission
standards for automobiles and new stationary sources, like the NAAQS, were
not all met within the original timetables. Many of the deadlines were simply
extended. In the 1990 amendments to the Clean Air Act, Congress imposed
additional requirements on the auto makers, mandating the use of tailpipe
emissions-reduction equipment on newly manufactured vehicles, for example. In nonattainment areas, reformulated, cleaner gasolines were required
beginning in 1995.
NEW SOURCE REVIEW
As part of the 1977 Clean Air Act Amendments, Congress established the New
Source Review (NSR) program, which regulates criteria pollutants and ensures
acceptable levels of NAAQS through mandating the installation of new pollution control technology in new or modified stationary sources. In 2002, it was
estimated that the NSR regulated more than 17,000 stationary sources, such as
power plants, oil refineries, and chemical factories. Consequently, many view
the NSR as a key provision in the Clean Air Act, as it removes millions of tons of
sulfur dioxide, nitrogen oxides, and mercury from the air each year.4
The NSR program, however, can be changed, and some view proposed
changes as further rollbacks of longstanding environmental protections. One proposed change to the NSR would have allowed significant maintenance, upgrades,
and expansions to occur without requiring new pollution controls as long as the
costs of the modifications did not exceed 20 percent of the cost of the entire
“process unit.” Under this proposed rule, major utility plant changes that cost
millions of dollars and increase pollution by thousands of tons could be defined
as “routine maintenance” and, thus, be exempt from Clean Air Act protections.
Environmental groups expressed strong opposition to this proposal, arguing that
it would substantially harm the quality of the air, increase respiratory aliments
such as asthma, and cause thousands of premature deaths. In 2004, the EPA
reported that more than 100 million people in the United States breathe unhealthy
levels of particulates emitted from stationary sources. Citing the widespread health
effects of increased particulate matter in the air, environmentalist groups sued to
stop implementation of the changes. In March of 2006, the D.C. Circuit Court
sided with the environmentalists and unanimously ruled to invalidate the NSR rule
changes. However, future attempts to change the rule are still possible.
THE ACID RAIN CONTROL PROGRAM
One of the major air quality problems facing the United States, as well as other
countries, is acid rain. Roughly 75 percent of acid rain is caused by emissions
of sulfur dioxide and nitrogen oxides from the burning of fossil fuels by electric
utilities. The 1990 Clean Air Act Amendments included an innovative approach
to controlling sulfur dioxide emissions.
Under the 1990 Clean Air Act Amendments, Congress required the EPA to
establish an emissions trading program that would significantly cut sulfur dioxide emissions. Under the program, the EPA auctions a given number of sulfur
dioxide allowances each year. A holder can emit one ton of sulfur dioxide for
each allowance. Firms holding allowances would be able to use the allowances
to emit pollutants, “bank” their allowances for the next year, or sell their allowances to other firms. The purpose of the program is to reduce total emissions
in the most efficient way possible. Those firms for which emission reduction is
4
EPA, New Source Review, Report to the President (June 2002); available at www.epa.gov/nsr/
documents/nsr_report_to_president.pdf.
acid rain Precipitation with
a high acidic content (pH level
of less than 5) caused by
atmospheric pollutants.
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the cheapest will reduce their emissions extensively, whereas those for which
emission reduction is extremely expensive will find it more efficient to buy allowances. Total emissions will fall because every succeeding year the number of
allowances issued will be reduced, but the firms actually reducing their emissions will be the ones whose emissions can be reduced at the lowest cost.
On March 29, 1993, the first auction of EPA pollution allowances was held.
More than 150,000 allowances were sold, with each allowance permitting the
emission of one ton of sulfur dioxide. Prices for each allowance ranged from
$122 to $450. Utilities were given a fixed amount of allowances and could bid
for others at the auction. Some environmental groups also participated in the
auction, buying allowances to retire unused to help clean the air.
By 1995, after three years of program operation, the price of the allowances
had fallen to less than $140 per ton. In 1998, a total of 150,000 allowances were
offered for use that year at a price ranging from $115.01 to $228.92. In 2007, only
125,000 allowances were auctioned, at an average price of $444.39. By 2008, total sulfur dioxide emissions from regulated sources were down to 7.6 million
tons, exceeding the program’s long-term goal of 9.5 million tons long before the
2010 deadline. This program is often cited as a model for achieving cost-effective
pollution reduction; consequently, many people are looking at emissions trading as a possible way to meet the worldwide problem of too many harmful
greenhouse gases.5
CLIMATE CHANGE
Global climate change is the term increasingly being used by scientists and
environmentalists to refer to the process in which the Earth’s climate changes in
response to greenhouse gases and other pollutants. The phrase global climate
change is preferred to “global warming” because the process is complex and
involves many more changes than simply an increase in the Earth’s temperature.
Environmentalists and scientists argue that global climate change is a matter of
extreme concern because as the Earth’s temperature rises, a number of events are
likely to happen. First, the polar icecaps, as well as glaciers in general, will melt.
In fact, it appears that glacial loss has already begun. One report indicated that
Arctic sea ice cover had decreased in 2007 to a drastically new low: The Arctic sea
ice in 2007 was 20 percent lower than the previous low recording taken in 2005.6
The melting ice caps will release formerly frozen water, which will raise
ocean levels.7 Higher ocean water levels means that low-lying coastal areas will
begin to be flooded.8 Additionally, the release of cold, formerly frozen water will
mix with the warmer sea water, which will produce more storms. Further climate
changes could follow, and many species of animals could be in danger of
extinction from loss of habitat, change of climate, or the loss of a different
species that served as a food source.9
The existence of global climate change and the negative effects of greenhouse
gases are generally recognized by most scientists and environmentalists. Although
some (particularly in the former Bush administration) question the effects of global
climate change, not all governmental agencies are as skeptical. The National
5
EPA, EPA Allowance Auction Results; retrieved March 15, 2008, from www.epa.gov/airmarkets/
trading/2007/07summary.html.
6
“Arctic Sea Ice Cover at Record Low,” CNN, September 11, 2007; retrieved March 15, 2008, from
www.cnn.com/2007/TECH/science/09/11/arctic.ice.cover/index.html?iref⫽mpstoryview.
7
Pew Center on Global Climate Change, Global Warming Basics; retrieved March 15, 2008, from
www.pewclimate.org/global-warming-basics.
8
Id.
9
Id.
CHAPTER 23
Oceanic and Atmospheric Administration’s (NOAA) National Climatic Data Center
identified 2006 as one of the 10 hottest years since 1895. The hottest year on record
was 2005, with 2006 ranking approximately sixth.10 Although warming cannot be
attributed solely to human activity and greenhouse gases, the NOAA was able to
state, on the basis of multiple computer-based studies and models, that the warming in 2006 was primarily attributable to greenhouse gases and global climate
change.11
In 2007, 158 UN member countries held a weeklong conference in Bali to
discuss strategies for reducing greenhouse gas emissions.12 The Bali meetings,
which ended with general agreement among the 158 countries, were intended
to create a continued strategy for reducing greenhouse gases starting in 2012
when the Kyoto Protocol expires.
In 2009, the Copenhagen Agreement was reached, and contained promises
of major emitting countries to cut carbon and develop a monitoring system
to track success or failure. Industrialized countries also agreed to contribute
$30 billion in near-term climate aid while raising $100 billion annually by 2020
for vulnerable nations. However, no firm allowances were set. In 2010, countries met once more and agreed to the Cancun Agreement, which fleshed out
some of the details of the Copenhagen Agreement and bound countries to keep
temperature rise below 2 degrees Celsius above pre-industrial levels, but no
other firm commitments resulted, and parties agreed that they need to continue
working to resolve the problems that are resulting from climate change.13
Regulating Hazardous Waste
and Toxic Substances
Most of us want to enjoy the products that technology has developed; but what
price are we willing to pay for these amenities?
Until the mid-1970s, most people were content to take advantage of newly
available products without giving much thought to the by-products resulting
from their manufacture. Most businesspersons were primarily concerned about
creating new products and using new technology to increase production and
profits. Then came a growing awareness of the potential health and environmental risks posed by the waste created in the production process. In addition
to the problems created by waste, some of the new products themselves, and
their newly created chemical components, were proving to be harmful.
The potential health risks from these chemicals and wastes include a
plethora of cancers, respiratory ailments, skin diseases, and birth defects. Environmental risks include not only pollution of the air and water but also unexpected explosions and soil contamination. Species of plants and animals may be
threatened with extinction.
During the mid-1970s, Congress began to take a closer look at regulating
waste and toxic materials. One of the problems regulators face in this area,
10
Deborah Zabarenko, “Greenhouse Gases Fueled 2006 Heat,” Reuters (Aug. 28, 2007).
Randolph E. Schmid, “NOAA Blames Hot Year on Greenhouse Gases,” Associated Press
(Aug. 29, 2007).
12
Andrew Revkin, Voices on Bali and Beyond, New York Times, December 6, 2007, retrieved January 2,
2011, from http://dotearth.blogs.nytimes.com/2007/12/16/voices-on-bali-andbeyond/?scp⫽4&sq⫽bali%20climate%20conference&st⫽cse.
13
Lisa Friedman, A Near-Consensus Decision Keeps U.N. Climate Process Alive and Moving
Ahead, New York Times, December 13, 2010, retrieved January 1, 2011, from http://dotearth
.blogs.nytimes.com/2007/12/16/voices-on-bali-and-beyond/?scp⫽4&sq⫽bali%20climate%20
conference&st⫽cse http://www.nytimes.com/cwire/2010/12/13/13climatewire-a-near-consensusdecision-keeps-un-climate-p-77618.html?pagewanted⫽1&sq⫽bali%20climate%20conference&st⫽
cse&scp⫽1
11
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however, is a lack of scientific knowledge concerning the impact of many chemicals on human health. We know that exposure to many chemicals causes cancer
in laboratory animals. We are unable, however, to ascertain the impact of each increment of exposure. For example, we know that saccharin in some quantity can
cause cancer in humans, but we do not know what quantity or whether especially
sensitive persons may be affected by substantially smaller amounts. Congress has
responded to these and related problems in a variety of ways.
Four primary acts are designed to control hazardous waste and toxic substances: (1) the Resource Conservation and Recovery Act of 1976; (2) the Comprehensive Environmental Response, Compensation, and Liability Act of 1980;
(3) the Toxic Substances Control Act of 1979; and (4) the Federal Insecticide,
Fungicide, and Rodenticide Act of 1972.
THE RESOURCE CONSERVATION AND RECOVERY ACT OF 1976
The Resource Conservation and Recovery Act of 1976 (RCRA) regulates both
hazardous and nonhazardous waste, with the primary emphasis on control of
hazardous waste. The focus of the act is on the treatment, storage, and disposal
of hazardous waste (see Exhibit 23-2). The reason for this focus was the belief
that it was not necessarily the creation of waste that was the problem, but rather
the improper disposal of such waste. Also, it was hoped that making firms pay
the true costs of safe disposal would provide the financial incentive for them to
generate less waste.
manifest program A program
that attempts to see that
hazardous wastes are properly
transported to disposal
facilities licensed by the EPA
so that the agency will have an
accurate record (manifest) of
the location and amount of all
hazardous wastes.
hazardous waste Any waste
material that is ignitable,
corrosive, reactive, or toxic
when ingested or absorbed.
EXHIBIT 23-2
WHAT IS A HAZARDOUS
WASTE?
The Manifest Program. The best-known component of the RCRA is its
manifest program, which is designed to provide “cradle-to-grave” regulation
of hazardous waste. A waste may be considered hazardous and, thus, fall under
the manifest program in one of three ways. First, it may be listed by the EPA as
a hazardous waste. Second, the generator may choose to designate the waste as
hazardous. Finally, according to the RCRA, a hazardous waste may be
“garbage, refuse, or sludge or any other waste material that has any one of the
four defining characteristics: ignitability, corrosivity, reactivity, or toxicity.”
Once a waste is designated as hazardous, it falls under RCRA’s manifest program. Under this program, generators of hazardous waste must maintain records
called manifests. These manifests list the amount and type of waste produced,
how it is to be transported, and how it will ultimately be disposed of. Some wastes
cannot be disposed of in landfills at all. Others must receive chemical or biological treatment to reduce toxicity or to stabilize them before they can be deposited
in landfills. If the waste is transported to a landfill, both the transporter and the
owner of the disposal site must certify their respective sections of the manifest and
return it to the creator of the waste. The purpose of these manifests is to provide
a record of the location and amount of all hazardous wastes and to ensure that
According to the Resource Conservation and Recovery Act of 1976 (RCRA) and the
Hazardous and Solid Waste Amendments of 1984 (RCRA amendments), a hazardous waste
may be “garbage, refuse, or sludge or any other waste material” that exhibits one or more
of the following characteristics:
•
•
•
•
Ignitability
Corrosivity
Reactivity (unstable under normal conditions and capable of posing dangers)
Toxicity (harmful or fatal when ingested or absorbed)
Improperly handled, hazardous wastes can contaminate surface waters and groundwater,
release toxic vapors into the air, or cause other dangerous situations, such as explosions.
CHAPTER 23
Generator initiates
manifest
Licensed transporter receives
waste and manifest
Treatment facility receives
waste and manifest
Storage facility receives
waste and manifest
Disposal facility receives
waste and manifest
EPA or State Agency receives copy of manifest containing signatures
of all parties who handled waste after its ultimate disposition
such waste will be properly transported and disposed of. Exhibit 23-3 shows the
hazardous waste manifest trail. An electronic hazardous waste manifest trail is currently being developed to increase the safety of hazardous waste disposal.
All firms involved in the transportation and disposal of hazardous waste must
be certified by the EPA in accordance with standards established under RCRA.
Every year, approximately 12 million tons of hazardous waste are transported for
treatment, storage, or disposal.
RCRA Amendments of 1984 and 1986. Congress amended RCRA in 1984 and
1986. The primary effect of the amendments was to make landfills, or hazardous
waste dumps, a last resort for the disposal of many types of waste. Advanced
treatment, recycling, incineration, and other forms of hazardous waste treatment
are all assumed to be preferable to land disposal. Some wastes were banned
entirely from landfill disposal.
The 1986 amendment requires that companies report the amount of hazardous
chemical they release into the environment each year. From 1997 to 2001, RCRA
reported a decrease in overall chemical emissions each year, but in 2004, toxic
chemical emissions increased 5 percent over the previous year; this included a
3.4 percent increase in lead emissions and a 10 percent increase in mercury emissions. Environmental groups blame the lax standards of the Bush administration
for the increase in toxic chemicals released into the environment.14
Enforcement of RCRA. RCRA is enforced by the EPA. States, however, may set
up their own programs as long as these programs are at least as stringent as the
federal program. The EPA gives any state that has taken the responsibility for
regulating its hazardous wastes the first opportunity to prosecute violators. This
procedure is consistent with the EPA’s enforcement of other environmental laws.
If the state fails to act within 30 days, the EPA takes action to enforce the
state’s requirements. The EPA may issue informal warnings; seek temporary or
14
Juliet Eilperin, “Toxic Emissions Rising, EPA Says,” Washington Post, A-2 (Jun. 23, 2004).
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EXHIBIT 23-3
THE HAZARDOUS WASTE
MANIFEST TRAIL
Source: EPA, Environmental
Programs and Challenges: EPA
Updates (Washington, DC:
EPA, August 1988), 88.
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permanent injunctions with criminal penalties of up to $50,000 per day of violation, or civil penalties of up to $25,000 per violation, or both; or impose other
penalties that the EPA administrator finds appropriate.
THE COMPREHENSIVE ENVIRONMENTAL RESPONSE,
COMPENSATION, AND LIABILITY ACT OF 1980,
AS AMENDED BY THE SUPERFUND AMENDMENT
AND REAUTHORIZATION ACT OF 1986
Superfund A fund authorized
by CERCLA to cover the costs
of cleaning up hazardous
waste disposal sites whose
owners cannot be found or are
unwilling or unable to pay for
the cleanup.
If the manifest program is followed, waste will be disposed of properly and there
will be no more contaminated waste sites. Before RCRA was enacted, however,
there was extensive unregulated dumping. Something had to be done to take
care of cleaning up the sites created by improper disposal. Exhibit 23-4 shows
some of the risks posed by these sites.
To alleviate the problems created by improper waste disposal, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980
(CERCLA) authorized the creation of the Superfund, primarily from taxes on
corporations in industries that create significant amounts of hazardous waste.
The money in Superfund was then used by the EPA or state and local governments to cover the cost of cleaning up leaks from hazardous waste disposal sites
when their owners could not be located or were unable or unwilling to pay for
the cleanup. Superfund also provides money for emergency responses to hazardous waste spills other than oil spills. When an owner is found after a cleanup,
or was initially unwilling to pay, the EPA may sue to recover the costs of the
cleanup.
Under CERCLA, liability for cleanup extends beyond the immediate owner. Socalled potentially responsible parties who may be also held liable include (1) present owners or operators of a facility where hazardous materials are stored,
(2) owners or operators at the time the waste was deposited there, (3) the hazardous
waste generators, and (4) those who transported hazardous waste to the site.
Successful actions under CERCLA to recover costs have been less frequent
than originally hoped. The fund was intended to be self-replenishing but has not
been. Thus, CERCLA was amended in late 1986 by the Superfund Amendment
and Reauthorization Act of 1986 (SARA). These amendments provided more stringent cleanup requirements and increased Superfund’s funding to $8.5 billion, to
be generated primarily by taxes on petroleum, chemical feedstocks, imported
chemical derivatives, and a new “environmental tax” on corporations. Additional
money was to come from general revenues, recoveries, and interest.
The future of Superfund, however, remains in question. The taxes on chemical and petroleum companies used to support Superfund cleanups expired in
1995 and require reauthorization from Congress. Consequently, in 2003, the fund
was depleted of any money from the chemical or petroleum industries, shifting
EXHIBIT 23-4
ENVIRONMENTAL OR
PUBLIC HEALTH THREATS
REQUIRING SUPERFUND
EMERGENCY ACTIONS
Source: Office of Emergency
and Remedial Response
(Superfund), U.S. EPA, reprinted
in Environmental Programs and
Challenges: EPA Updates (EPA,
August 1988), 96.
•
•
•
•
•
•
•
•
•
Contaminated air
Direct contact with hazardous waste
Contaminated drinking water
Ecological damage
Fire or explosion hazard
Exposure through food web
Contaminated groundwater
Contaminated soil
Contaminated surface water
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the cleanup burden directly to the taxpayers.15 Because Superfund is no longer
funded by polluter and industry dollars, the completion of Superfund cleanups
has declined significantly, with an average of 42 completed sites a year under
President Bush, versus 79 completed sites a year under President Clinton. As of
2007, 1,569 sites were on the Superfund list, and only 320 have been removed
thus far.16 Environmentalists warn that without a renewal of the tax on chemical
and petroleum industries, Superfund will not be able to treat many of the nation’s
most polluted sites.
THE TOXIC SUBSTANCES CONTROL ACT OF 1979
Toxic substances are integral parts of some products that we use every day.
Neither RCRA nor CERCLA regulates these substances. The Toxic Substances
Control Act (TSCA) attempts to fill this regulatory gap. It attempts to ensure that
the least amount of damage will be done to human health and the environment,
while allowing the greatest possible use of these substances.
The term toxic substances has not been clearly defined by Congress. By reviewing the types of substances regulated under TSCA, however, one would
probably conclude that a toxic substance is any chemical or mixture whose
manufacture, processing, distribution, use, or disposal may present an unreasonable risk of harm to human health or the environment. This broad definition
encompasses a large number of substances. Thus, control of these substances is
a major undertaking.
The primary impact of TSCA comes from its procedure for evaluating the
environmental impact of all chemicals, except those regulated under other acts.
Under TSCA, every manufacturer of a new chemical must give the EPA a premanufacturing notice (PMN) at least 90 days before the first use of the substance
in commerce. The PMN contains data and test results showing the risk posed by
the chemical. The EPA then determines whether the substance presents an unreasonable risk to health or whether further testing is required to establish the
substance’s safety. The manufacture of the product is banned when the risk of
harm is unacceptable. If more testing is required, a manufacturer of the product
must wait until the tests have been satisfactorily completed. Otherwise, manufacturing may begin as scheduled.
toxic substance Any
chemical or mixture whose
manufacture, processing,
distribution, use, or disposal
presents an unreasonable risk
of harm to human health or the
environment.
THE FEDERAL INSECTICIDE, FUNGICIDE,
AND RODENTICIDE ACT OF 1972
One category of toxic substances that has been singled out for special regulatory
treatment is pesticides, which are defined as substances designed to prevent,
destroy, repel, or mitigate any pest or to be used as a plant regulator or a defoliant. Insecticides, fungicides, and rodenticides are all forms of pesticides.
Pesticides are obviously highly important to us. Their use results in increased
crop yields. Some pesticides kill disease-carrying insects. Others eradicate pests,
such as mosquitoes, that simply cause us discomfort. Yet, pesticides have harmful side effects; they may cause damage to all species of life. A pesticide that does
not degrade quickly may be consumed along with the crops on which it was
used, potentially harming the consumer’s health. The pesticide may get washed
15
General Accounting Office, Superfund Program: Current Status and Future Fiscal Challenges
GAO/RECD-03-850, July 2003.
16
U.S. Environmental Protection Agency, “EPA Adds Seven and Proposes 12 Sites to Superfund’s
National Priorities List” (Sept. 19, 2007); retrieved March 15, 2008, from www.epa.gov/superfund/
accomp/news/npl_091907.htm.
pesticide Any substance
designed to prevent, destroy,
repel, or mitigate any pest or to
be used as a plant regulator or
defoliant.
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into a stream to contaminate aquatic life and animals that drink from the stream.
Once the pesticide gets into the food chain, it may do inestimable harm.
In 1972, FIFRA created the registration system that is used to control pesticide use. To be sold in the United States, a pesticide must be registered and properly labeled. A pesticide will be registered when (1) its composition warrants the
claims made for it; (2) its label complies with the act; and (3) the manufacturer
provides data to demonstrate that the pesticide can perform its intended function, when used in accordance with commonly accepted practice, without presenting unreasonable risks to human health or the environment.
A pesticide with general use registration can be sold without any restrictions.
A restricted use registration will be granted if the pesticide will not cause an unreasonable risk only if its use is restricted in some manner. Typical restrictions
include allowing the pesticide to be used only by certified applicators or allowing it to be sold only during certain times of the year or only in certain regions
of the country or only in certain quantities.
Registration is good for five years, at which time the manufacturer must
apply for a new registration. If, at any time prior to the end of the registration
period, the EPA obtains evidence that a pesticide poses a risk to human health
or the environment, the agency may institute proceedings to cancel or suspend
the registration.
The EPA believes that progress under FIFRA has been significant, although
there are critics of the act. In fiscal year 2006 alone, 297 product registrations
were canceled as a result of FIFRA.17
Pesticide Tolerances in Food. Under the Federal Food, Drug, and Cosmetic
Act (FFDCA), the EPA establishes legally permissible maximum amounts of pesticide residues in processed food or in animal products such as meat or milk, as
well as on food crops such as apples or tomatoes. Before a pesticide can be registered, an applicant must obtain a tolerance for that pesticide. To obtain the tolerance, the applicant must provide evidence of the level of residue likely to
result and data to establish safe residue levels. Under the 1996 Food Quality Protection Act, a safe residue level is one at which there is a “reasonable certainty of
no harm” from exposure to the pesticide. The law also requires distribution of a
brochure on the health effects of pesticides.
The Pollution Prevention Act of 1990
Tremendous gains have been made through the laws described in the preceding sections, but it has become more costly to get increasingly smaller reductions
of pollutants. Whereas initially a $1 million expenditure on end-pipe controls
might have reduced emissions by 80 percent, today that same investment is likely
to result in only a 5 percent reduction.
Recognition of this decline in the effectiveness of direct regulation and the
consequent need to look for alternative approaches to pollution problems led to
passage of the Pollution Prevention Act of 1990, in which Congress set forth the
following policy:
Pollution should be prevented or reduced at the source whenever feasible;
pollution that cannot be prevented should be recycled in an environmentally
safe manner, whenever feasible; pollution that cannot be prevented or recycled
should be treated in an environmentally safe manner whenever feasible; and
disposal or other release into the environment should be employed only as a last
resort and should be conducted in an environmentally safe manner.
17
Environmental Protection Agency, Board of Scientific Counselors, National Center for Environmental Research (NCER) Standing Subcommittee-2007, Federal Register (Aug. 22, 2007); retrieved
March 15, 2008, from www.epa.gov/fedrgstr/EPA-PEST/2007/August/Day-22/p16560.pdf.
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The government’s role in encouraging this policy is one of providing a “carrot” as opposed to the “stick” of direct end-pipe regulations. The federal government is providing states with matching funds under the act for programs to
promote the use of source reduction techniques for business. A clearinghouse
has been established to compile the data generated by the grants and to serve
as a center for source reduction technology transfer.
BUSINESS ASPECTS OF VOLUNTARY POLLUTION PREVENTION
Despite the voluntary nature of actions under this act, pollution prevention is becoming an important concept in business today. Chemical companies, for example, are beginning to see waste as avoidable and inefficient and are looking for
ways to change their production processes to reduce the amount of waste they create. Examples abound of firms that are jumping on the pollution prevention bandwagon. For example, DuPont, America’s largest producer of chemicals, voluntarily
cut its greenhouse gas emissions by more than 50 percent from its 1991 levels.
Whether it is the increasing cost of waste disposal, a fear of stricter direct
regulations, public pressure for firms to be “greener,” or the federal government’s
new emphasis on pollution prevention, firms are changing their attitudes toward
the environment. Whether this trend toward voluntary source reduction will continue remains to be seen.
SUSTAINABLE DEVELOPMENT
Along with a shift toward pollution prevention, we have seen a shift from concern about simply being in compliance with environmental toward a concern
about sustainability or sustainable development. Sustainable development, a
term coined in 1987, refers to development that meets the needs of the current
generation without compromising the needs of future generations.
Sustainability, however, goes beyond just environmental matters. Firms talk
about maintaining their “triple bottom line,” which refers to looking not just at
profit, but at profit, people, and the planet. In other words, firms concerned
about sustainable development want to evaluate their performance in broader
terms than just making a profit; they also evaluate treating employees fairly and
reinvesting in the communities in which they live or are located, as well as minimizing the firm’s ecological impact. Triple-bottom-line accounting attempts to
describe the social and environmental impact of an organization’s activities, in a
measurable way, in relation to the firm’s economic performance, although at this
time the idea is still not well developed or widely used.
Global Dimensions
of Environmental Regulation
THE NEED FOR INTERNATIONAL COOPERATION
In most areas of regulation, the United States first enacted national legislation
and only later, if at all, considered the worldwide implications of the problem
that the law was enacted to resolve. Nevertheless, its first major piece of environmental legislation, NEPA, addressed the global nature of environmental problems. The act instructed the federal government to recognize the worldwide and
long-range character of environmental problems and, when consistent with the
foreign policy of the United States, lend appropriate support to initiatives, resolutions, and programs designed to maximize international cooperation in anticipating and preventing a decline in the quality of the world environment.
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Marketing and Management
In your marketing or management class, you may have learned about environmental sustainability, which is a management approach that focuses on sustaining the environment and still generating profits for a firm. As firms advance toward environmental sustainability, there are four levels that companies examine to gauge their progress.
The first and most basic level is pollution prevention. As already discussed in the previous section, this involves the prevention or reduction of waste before it is created. Companies that are highlighting pollution prevention often use “green marketing” plans by developing environmentally friendly packaging, better pollution
controls, and ecologically safer products.
The second level in environmental sustainability is product stewardship, which extends the focus from
production creation to the entire product life cycle. At this level, firms often implement design for environment
(DFE) policies that consider future consequences of the firm’s products. Consequently, firms are taking measures
to find more efficient ways of recovering, reusing, or recycling their products.
The third level is new environmental technologies. Because some companies that have already progressed in
pollution prevention and product stewardship are limited by available technologies, new technologies are sometimes needed to meet their environmental goals.
The fourth level of environmental sustainability is sustainability vision, in which organizations develop a guide
for their firms’ future methods of environmental responsibility. This vision provides a framework for pollution
control, product stewardship, and environmental technology.
By focusing on these four levels of environmental sustainability, there is a greater likelihood that firms using
this management approach will promote the goals of environmentalists, which hopefully will result in a greener
and safer planet. Additionally, these organizations will potentially be at less risk of litigation for unsafe practices
and will, therefore, maintain a more positive image with the general public.
Source: P. Kotler and G. Armstrong, Principles of Marketing (12th ed.). (Upper Saddle River, NJ: Prentice Hall, 2008), 582–85.
THE TRANSNATIONAL NATURE OF POLLUTION
International cooperation on environmental matters is essential because environmental problems do not respect national borders. There are three primary
means by which environmental problems originating in one area of the globe affect other areas: (1) movement of air in prevailing wind patterns, (2) movement
of water through ocean currents, and (3) active and passive migration of numerous species of plants and animals.
Scientists have discovered that air tends to circulate within one of three regional
areas, or belts, that circle the globe north and south of the equator. For example,
between the latitudes 30°N and 60°N of the equator, the prevailing air currents are
the westerly winds. Thus, the air between these latitudes circulates in a westerly
direction all around the globe, remaining primarily within those latitudes.
The United States and China both have much of their land masses within
these two latitudes. As a result, pollutants emitted into the air in the United States
may be carried by these westerly winds to China, just as pollutants emitted into
the air anywhere between 30°N and 60°N of the equator anywhere in the world
may ultimately end up in the air above the United States. Consequently, the
United States could have extremely strict air pollution laws, yet still have polluted
air as a result of other countries’ emissions. Likewise, our failure to enact adequate air pollution control laws can adversely affect air quality in other countries.
Canada, for instance, attributes some of its pollution problems to the United
States’ failure to enact stricter control on sulfur dioxide emissions.
A similar situation exists with respect to the flow of water, except that the
regions are not as clearly defined. All ocean currents ultimately connect with one
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another, so a pollutant discharged into any body of water that flows into an
ocean may end up having a negative impact on water quality hundreds of miles
away from the country in which it was dumped.
The migration of birds and animals also spreads pollutants. Many animals,
such as geese, whales, salmon, seals, and whooping cranes, travel across national borders seasonally. If an animal ingests a hazardous chemical in one country, travels to another country, and is eaten by an animal in that country, that
pollutant has now been inserted into the food web in the second country.
THE GLOBAL COMMONS
Another closely related reason for international cooperation on environmental
matters is that many of the planet’s resources, such as the oceans, are within no
country’s borders and are, therefore, available for everyone’s use. Because of this
availability, these resources are often called the global commons. Because everyone has access to them, they are susceptible to exploitation and overuse. Cooperation to protect these global resources is the only way to preserve them.
PRIMARY RESPONSES OF THE UNITED STATES
The United States has played a role in establishing global environmental policies
in four primary ways: (1) research, (2) conferences, (3) treaties, and (4) economic
aid. Unfortunately, to date, these responses have not been extremely successful,
nor has there been a major commitment of U.S. resources to the resolution of
transnational environmental problems.
Research. Research, the results of which are shared with other nations, is the
typical U.S. response to international environmental issues. For example, in response to international concerns about changes in environmental conditions, the
U.S. government sponsors research in universities and in federal laboratories by
various governmental agencies. Some critics argue that we need to commit more
money to research. Others claim that we use research as an excuse for inaction.
Many environmentalists view a “commitment to research” as a stalling technique
to prevent the imposition of needed controls.
Conferences. Conferences to discuss specific transnational environmental problems are often held; many are arranged through the United Nations. The first such
conference was the United Nations Conference on the Human Environment, held
in Stockholm in 1972. Similarly, in 1992, delegates from more than 120 nations
met in Rio de Janeiro for the United Nations Conference on Environment and
Development, commonly referred to as the Rio Earth Summit. Marking the
10-year anniversary of the Rio Earth Summit, more than 100 heads of state from
around the world gathered for the Johannesburg Earth Summit during the summer of 2002 to discuss global climate change and sustainable development. These
conferences serve primarily to promote an understanding of the global implications of environmental problems. Often these conferences lead to the negotiation
of treaties designed to help resolve environmental problems.
Treaties. Treaties are written agreements between two or more nations that
specify how particular issues are to be resolved. The process of accepting a
treaty varies from country to country. In the United States, a treaty must be negotiated and signed by a representative of the executive branch, generally the
president. Then it must be approved by two-thirds of the U.S. Senate. Implementation of a treaty generally requires the passage of federal legislation that
translates the objectives of the treaty into laws.
The United States has entered into numerous bilateral (signed by only two
nations) and multilateral (signed by more than two nations) treaties, sometimes
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called conventions, in the area of environmental protection. One of the more
successful multilateral treaties the United States has signed is the Montreal Protocol. Originally signed by 24 nations and the European Community on
September 16, 1987, the Montreal Protocol on Substances That Deplete the
Ozone Layer ultimately led to an elimination of the production of ozonedepleting chlorofluorocarbons (CFCs) by January 1, 1996. A series of summits
concerning the problem of ozone depletion has taken place since that initial
meeting, and nations continue to amend the treaty to restrict production of more
ozone-destroying compounds as our understanding of these chemicals grows.
One of the problems with treaties, however, is that they are unenforceable
when the signatories decide not to obey them any longer. Many include clauses
that allow a nation to withdraw from a contract or to cease abiding by particular terms after giving notice of its intent to the other parties to the treaty.
More recently, other methods have been used to foster international environmental action. Trade agreements have started to incorporate provisions regarding
environmental protection. The North American Free Trade Agreement (NAFTA), for
example, included a side agreement on the environment. Although it has been called
the most environmentally sensitive trade agreement ever, there is concern that this
agreement may ultimately result in a lessening of environmental protection.
Aid. A final way in which the United States affects environmental policy worldwide is by the judicious use of foreign aid, either financing pollution control projects or giving economic aid for a particular project only when certain
environmentally sound conditions have been met. Some aid is also given in the
form of technical assistance and training. For example, the U.S. Soil Conservation Service (SCS) provides technical assistance in soil and water conservation to
many Latin American and African countries. The SCS also teaches conservation
techniques to students from these countries.
SUMMARY
There are many ways a nation can protect its environment. Some of these methods include tort law, subsidies, discharge permits, emission charges, and direct
regulation. Beginning in 1970, with the passage of the NEPA, our nation began a
course of environmental protection based primarily on specific direct regulations.
The FWPCA established a discharge permit system designed to make the
waterways fishable and swimmable. The SDWA sets standards to make our
drinking water safe. The Clean Air Act, as amended several times, establishes the
NAAQS, standards designed to ensure that conventional air pollutants do not
pose a risk to human health or the environment. This act also establishes standards for toxic air pollutants.
Hazardous wastes and toxic substances are primarily regulated by four
pieces of legislation. The RCRA sets standards for waste disposal sites and
establishes the manifest system for the tracking of hazardous wastes from creation to disposal. CERCLA, as amended by SARA, provided funding and a mechanism for cleaning up hazardous waste sites. The TSCA provided a mechanism
for testing new chemicals to ensure that they do not pose unreasonable risks
before being used in commerce. Finally, FIFRA established a procedure for the
regulation of pesticides through a registration system.
The newest trend in the environmental area is toward pollution prevention.
This trend is encouraged by the Pollution Prevention Control Act of 1990.
Solving environmental problems requires cooperation among all nations.
Four ways in which the United States works to solve these problems on a global
scale are through shared research, conferences, treaties, and aid.
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REVIEW QUESTIONS
23-1 Explain the common-law methods of resolving pollution problems and evaluate their
effectiveness.
23-2 Explain the circumstances under which an
environmental impact statement must be filed,
and describe the statement’s required content.
23-3 Explain how emission charges and discharge
permits could be used to help control pollution.
23-4 Present the arguments of those who would
abolish the use of the EIS. How would you
evaluate those criticisms?
23-5 Describe the structure of the amended FWPCA,
and explain how each element of the act is designed to further the goals of the FWPCA.
23-6 Compare the structure of the FWPCA with
that of the Clean Air Act.
REVIEW PROBLEMS
23-7 The defendant operated a mining company.
Because he used improper drainage techniques,
drainage of pollutants from his mining operation contaminated the private water supplies of the plaintiff
property owners located downstream from him. What
legal theories would the plaintiffs use to sue the defendant? Would the plaintiffs be likely to win their lawsuit? Why or why not?
23-8 The lead industry challenged the EPA’s establishment of a primary air quality standard for lead that
incorporated an “adequate margin of safety.” In setting
the standard, the EPA had not considered the feasibility or the cost of meeting the standards. Must the EPA
take such factors into consideration in setting primary
air quality standards?
23-9 Ohio’s SIP was submitted to the EPA. Approval
of a portion of the plan was denied because it was not
adequate to ensure the attainment and maintenance of
the primary standard for photochemical oxidants in
the Cincinnati area. The EPA supplemented the Ohio
plan with a provision requiring a vehicle inspection
and registration procedure for the Cincinnati area.
Cincinnati set up the requisite inspection facilities but
refused to withhold registration from those vehicles
failing the inspection. The EPA sought an injunction
ordering Ohio to implement “as written” the inspection and registration procedure described in the plan.
Was the injunction granted?
23-10 The Idaho EPA, in developing its SIP, determined that the maximum sulfur dioxide emissions that
could be captured from zinc smelters with the currently available technology was 72 percent. The state
consequently adopted that standard for zinc smelters
under the SIP. The federal EPA refused to accept that
part of the SIP and promulgated an 82 percent standard. Did the federal EPA have authority to make such
a change in the SIP?
23-11 Kantrell Corporation uses about 50 gallons a
day of a highly corrosive acid as a cleaning agent in its
production process. It collects the used acid and funnels it through a pipe out into a pond located entirely
on company property; the pond was dug to serve as a
place in which to dispose of the acid and other wastes
that could not be incinerated or recycled. Is Kantrell
violating any federal environmental regulations?
23-12 The defendant operated a plant that had
refined coal tar for 55 years. It had disposed of its
wastes on the site. After the plant closed, the land was
purchased by a municipal housing authority. The
wastes buried on the site leaked into the groundwater,
contaminating the drinking water of nearby cities. The
state and the municipalities spent considerable sums
of money cleaning up the site. The U.S. government
joined the suit, seeking to hold the defendant liable
under CERCLA. Was the defendant responsible even
though it no longer owned the dump site?
CASE PROBLEMS
23-13 Carlos Rodriguez-Perez, Carmen Ortiz-Lopez,
Carlos M. Belgodere-Pamies, and Janet Roe owned and
operated a gas station. Operated as a retail service station from the mid-1930s until August 1998 when it
was closed, the station sold gasoline, diesel fuel,
automobile parts, and motor oil. There was significant
disposal of hazardous substances on the premises
during the station’s operation under Rodriguez’s
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management. Motor oil drained from automobiles was
allowed to flow into the Pinones River, a body of
water located behind the station. Similarly, large quantities of used oil filters were found buried in the northern part of the station. Gasoline and diesel used to
flush dirt and grease from vehicles were rinsed onto
the ground and into the river using a pressure hose.
As a result, the premises became contaminated with
a number of hazardous substances, including lead,
chromium, benzene, ethylbenzene, toluene, and
xylene. Esso Standard Oil Company, the owner of the
gas station after Rodriguez-Perez and the others, had
to pay to have the station cleaned up.
Esso brought suit under CERCLA against
Rodriguez-Perez and the other owners. Esso primarily
sought relief contribution under CERCLA § 113(f) for
the response costs that Esso incurred in remedying
environmental contamination at the gasoline station.
The magistrate judge dismissed the CERCLA claim. Did
the magistrate judge err in judgment? Esso Standard
Oil Co. v. Rodriguez-Perez, 455 F.3d 1 (1st Cir. 2006).
23-14 West Coast Home Builders, Inc., is a developer
and builder of homes. West Coast owns a parcel of
property near or adjacent to the Contra Costa Sanitary
Landfill near Antioch, California (the CCSL Landfill).
The CCSL Landfill was used as a disposal area for hazardous materials during the 1960s and 1970s, and for
the disposal of municipal waste, including hazardous
materials, until approximately 1992. West Coast
alleges that the CCSL Landfill is the source of groundwater contamination on and under West Coast’s property. West Coast sought recovery of response costs
and contribution under CERCLA, declaratory relief
under federal law, and monetary and injunctive relief
under state tort law. In addition, West Coast sought
relief through claims of negligence. Was either the
CERCLA or the nuisance claim effective? Why? West
Coast Home Builders, Inc. v. Aventis Cropscience
USA, Inc., 2006 U.S. Dist. LEXIS 48023 (2006).
23-15 B&B was an agricultural chemical company
operating on a piece of property in California. As their
business expanded, they expanded their operations to
adjacent property from two railroad companies. In
their business operations, B&B used a number of hazardous chemicals, including a pesticide they purchased from Shell Oil Company. B&B spilled many of
these hazardous chemical, including the pesticide, on
the ground, contaminating it. Eventually, the EPA discovered the contamination, and, using the Superfund,
cleaned up the contamination at a cost of $8 million.
The EPA sued Shell, as an arranger of the disposal and
the railroad companies as owners of part of the contaminated site to recover the cost. The District Court
found the Railroad Companies and Shell liable for the
cost of the clean up. On appeal, how do you think the
Supreme Court resolved the issue of Shell’s liability?
Why? Burlington Northern and Santa Fe Railway v.
U.S., 129 S.Ct. 1870 (Sup. Ct., 2009).
23-16 Duke Energy Corporation runs 30 coal-fired
electric generating units at eight plants in North and
South Carolina. The units were placed in service
between 1940 and 1975, and each includes a boiler
containing thousands of steel tubes arranged in
sets. Between 1988 and 2000, Duke replaced or
redesigned 29 tube assemblies in order to extend the
life of the units and allow them to run longer each
day. The United States sued, claiming, among other
things, that Duke violated the Prevention of Significant Deterioration (PSD) provisions by doing this
work without permits. Environmental Defense, North
Carolina Sierra Club, and North Carolina Public Interest Research Group Citizen Lobby/Education Fund
intervened as plaintiffs and filed a complaint charging
similar violations.
Duke moved for summary judgment, one of its
positions being that none of the projects was a “major
modification” requiring a PSD permit because none
increased hourly rates of emissions. The district court
agreed with Duke’s reading of the 1980 PSD regulations. The Court of Appeals for the Fourth Circuit
affirmed. How did the Supreme Court rule on appeal?
Environmental Defense v. Duke Energy Corp., 127
S. Ct. 1423 (2007).
23-17 The state of California has expended millions
of dollars to study, plan for, monitor, and respond to
impacts already caused, and likely to occur, as a result
of global warming. Influenced by their findings, the
state of California decided to sue General Motors and
other auto makers. California asserts two causes of
action: (1) public nuisance under federal common law;
and, alternatively, (2) public nuisance under California
law. California wanted to hold each defendant jointly
and severally liable for creating, contributing to, and
maintaining a public nuisance. The defendants argued
that California is improperly attempting to create a
new global warming tort that has no legitimate origins
in federal or state law. Does California state a valid
nuisance claim? If you were an attorney for California,
what would you argue to make your point? California v.
General Motors Corp., et al., 2007 U.S. Dist. LEXIS
68547 (2007).
23-18 An agricultural chemical distributor, B&B,
began operations on a piece of land owned by the
company in Arvin, California, and later expanded
operations onto an adjacent parcel of land owned by
two railroads. Among the hazardous chemicals B&B
used in its operations and spilled on the ground was
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a pesticide that B&B purchased from Shell Oil. The
spilled chemicals ultimately contaminated the land.
After an examination of the site, the EPA ordered a
cleanup and spent $8 million. It then sued Shell and
the railroads to recover the costs. The district court
and court of appeals found the defendant railroads
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and Shell Oil Company liable for the costs as potentially responsible parties. The railroads and Shell appealed to the Supreme Court. How do you think the
high court ultimately ruled? Burlington Northern &
Santa Fe Railway v. United States, 129 S. Ct. 1870
(2009).
As the issue of global climate change comes to the
fore in international discussions, and as countries
attempt to find solutions for climate change, attention
frequently turns to the Kyoto Protocols. By June of
2007, 172 countries had signed and ratified the Kyoto
Protocols. Notably absent from the list of countries ratifying the Protocols are the United States and Australia,
both of which have explicitly stated that they will not
ratify the Protocols. Although some environmentalists
argue that the United States should ratify, the United
States is correct to refuse to ratify the Protocols.
The Kyoto Protocols, although well intentioned, are
doomed to fail. An analysis of them indicates that they
are simply ineffective. Although countries that ratify the
Kyoto Protocols agree to reduce their greenhouse gas
emissions to pre-1990 levels, only 35 countries have
agreed to cap their greenhouse gas emissions. Agreeing
to a cap is not part of the treaty. Also, the Protocols
exempt developing nations, and instead require developed nations to limit their greenhouse gas emissions. By
not requiring developing countries to limit their emissions, those who created the treaty have permitted
these countries to continue to pollute at high volumes,
thus offsetting any of the efforts taken by developed
countries.
What further makes the Kyoto Protocols ineffective is that not only are developing countries excluded
but China is counted as a developing country. By not
having to reduce its emissions, China will continue to
pollute in large quantities, preventing any hope of
curbing global emissions. In addition, it is unfair that
China and other developing countries can pollute at
will, thus avoiding engaging in costly emissionreduction strategies. The ability to avoid paying to
reduce emissions gives China an unfair advantage on
the global market, as it can produce and sell products
cheaper than developed countries that need to pay for
emissions-reducing technology.
There is another irony in the Kyoto Protocols that
China helps to exemplify. If developed nations lower
their demand for fossil fuels in an attempt to reduce
greenhouse gas emissions, this reduction will lower
the price of fossil fuels. As fossil fuels become
cheaper, developing countries, especially China, will
increase their use of cheap fossil fuels, which will produce even more greenhouse gases. Exempting China
means the Protocols cannot work.
Finally, to ratify the Kyoto Protocols would be
equivalent to the United States’ harming its own interests. Were the United States to attempt to comply
with the Protocols, it would cost the U.S. economy
$400 billion, as well as close to 5 million jobs, according to President Bush. Instead of ratifying an ineffective treaty that will harm the United States’ interests,
the United States should continue with its current efforts to limit greenhouse gas emissions. The United
States has signed treaties with other countries regarding strategies to reduce greenhouse gas emissions, as
well as engaged in domestic efforts to limit emissions.
The United States’ current efforts are more than
enough to try to address the problem of global climate
change, thus making ratifying the Kyoto Protocols
wholly unnecessary.
1. What are the issue and conclusion in this essay?
2. Does the argument contain significant ambiguity
in the reasoning?
Clue: What word or phrases could have multiple
meanings?
3. Ask and answer the critical thinking question
that you believe reveals the main problem with the
author’s reasoning in this essay. Explain why
the question you asked is particularly harmful to
the author’s argument.
4. Write an essay from the viewpoint of someone
who holds a different opinion from that of the
essay author.
Clue: What other ethical norms could influence
an opinion about this issue?
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Environmental protection is often a slow and arduous
process because many enforcement efforts end up in
the court system. Using Internet sites such as
LexisNexis or http://topics.law.cornell.edu/wex/
environmental_law, find a recent court case involving a Superfund cleanup site.
What was disputed in the case? What reasons
and/or laws were cited in the court’s decision? How
does the information in this chapter better assist you
in understanding the court’s decision? Who was found
responsible for the cleanup of the site, if cleanup was
done? Finally, do you agree with the ethical norms that
underlie the court’s decision? Why or why not?
ON THE INTERNET
www.epa.gov The EPA home page is a source of valuable information about the main agency responsible for
protecting the environment.
www.unep.org This is the home page of the United Nations Environmental Programme.
sedac.ciesin.columbia.edu/entri/index.jsp This site provides environmental treaties and resource indicators.
www.epa.gov/superfund Information about the EPA’s Superfund program can be found at this site.
www.nrdc.org The National Resource Defense Council works to prevent negative externalities that harm the
environment.
www.eere.energy.gov The U.S. Department of Energy provides information regarding renewable energy
sources, and how this type of energy can help combat pollution and global climate change.
unfccc.int/kyoto_protocol/items/2830.php This site provides information regarding the Kyoto Protocols,
to which the United States is not a signatory.
FOR FUTURE READING
Frederickson, Robert. “A Green Bird in the Hand: An
Example of Environmental Regulations Operating to
Stifle Environmentally Conscious Industry.” Boston
College Environmental Affairs Law Review
34 (2007): 303.
Gaines, Sanford E. “Sustainable Development and
National Security.” William and Mary Environmental
Law and Policy Review 30 (2006): 321.
Grossman, Elizabeth. High Tech Trash: Digital
Devices, Hidden Toxics, and Human Health.
Washington, DC: Island Press, 2006.
Inman, Kelly. “Recent Development: The Symbolic
Copenhagen Accord Falls Short of Goals.” University
of Baltimore Journal of Environmental Law
17 (2010): 219.
Malloy Thomas F. “The Social Construction of Regulation: Lessons from the War Against Command and
Control.” Buffalo Law Review 58 (2010): 267.
Jennie Shufelt. “New York’s Co 2 Cap-And-Trade
Program: Regulating Climate Change Without
Climate Change Legislation.” Albany Law Review
73 (2010): 1583.
Thompson, Aselda. “Comment: Exposing a Gap in
CERCLA Case Law: Is There a Right to Recover Costs
Following Compliance with an Administrative Order
after Atlantic and Aviall?” Houston Law Review
46 (2010): 1679.
24
Rules Governing the Issuance
and Trading of Securities
䊏 INTRODUCTION TO THE REGULATION OF SECURITIES
䊏 DODD-FRANK WALL STREET REFORM AND CONSUMER
PROTECTION ACT OF 2010
䊏 THE SARBANES-OXLEY ACT OF 2002
䊏 THE SECURITIES ACT OF 1933
䊏 THE SECURITIES EXCHANGE ACT OF 1934
䊏 STATE SECURITIES LAWS
䊏 E-COMMERCE, ONLINE SECURITIES DISCLOSURE,
AND FRAUD REGULATION
䊏 GLOBAL DIMENSIONS OF RULES GOVERNING
THE ISSUANCE AND TRADING OF SECURITIES
n Chapter 18, we said that the corporation was the dominant form of business
organization in the United States—and also the most regulated. Two of the
most strongly regulated aspects of corporate business are the issuance and
trading of securities. Corporate securities—stocks and bonds—are, of course,
used to raise capital for the corporation. They are also used by individuals and
institutional investors to accumulate wealth. In the case of individuals, this
wealth is often passed on to heirs, who use it to accumulate more wealth. Thus,
securities provide a means for one generation in a family to “do better” than the
preceding generation. Securities also provide a means for financing pension
funds and insurance plans through institutional investment.
Securities holders are powerful determinants of trends in business: If an
individual company, industry, or segment of the economy is not growing and
paying a good rate of return, investors will switch their funds to another company, industry, or segment in expectation of better returns. Securities holders (or
their proxies) elect the board of directors of a corporation, who, in turn, select
the officers who manage the daily operations of a corporation. Finally, securities
holders’ ability to bring lawsuits helps keep officers and directors honest in their
use of investors’ funds.
Both because of their importance to the operation of our free enterprise
society and because of the ease with which they can be manipulated, securities
have been regulated by governments for nearly a century. This chapter chiefly
examines the role of the federal government in regulating securities. We introduce the subject with a brief history of securities regulation that contains a
summary of the most important federal legislation. We then turn to the creation,
I
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Because securities can be easily manipulated by issuers, federal and state governments have strongly regulated the
issuance and trading of securities. Studying the following case example and answering some critical thinking questions
about it will help you better appreciate the need for regulation of securities.
Jessica received a phone call from a man claiming to represent Buy-It-Here, a corporation that was relocating to
Jessica’s town. The man stated that the corporation was planning to issue new securities, and he was extending this
offer to residents in Jessica’s town. He claimed that Buy-It-Here would easily double its profits within six months. The
man said that if Jessica would send $3,000, he would buy stock in Buy-It-Here for Jessica. Jessica sent the money; two
weeks later, she discovered that Buy-It-Here was in the process of filing for bankruptcy.
1.
This case is an example of the need for government regulation. We want the government to protect citizens from
cases such as Jessica’s buying stock in a bankrupt company. If we want governmental protection from potentially
shady businesses, what ethical norm are we emphasizing?
Clue: Put yourself in Jessica’s place. Why would you want governmental protection? Now match your answer
to an ethical norm listed in Chapter 1. Think about which ethical norm businesses would emphasize.
2.
Jessica wants to sue Buy-It-Here for misrepresentation. Before she brings her case, what additional information
do you think Jessica should discover?
Clue: What additional information do you want to know about the case? Even without having extensive knowledge about securities, you can identify areas in which you might need more information about Jessica’s case. For
example, pay close attention to the role of the telephone caller.
3.
Jessica did some research about securities cases in her state. She discovered a case in which a woman named
Andrea Stevenson had purchased $100,000 worth of stock from a stockbroker. The company went bankrupt three
months later. The stockbroker had known that the company was suffering financial problems, but had said nothing to Andrea. The jury in this case found in favor of Andrea. Jessica wants to use Andrea’s case as an analogy in
her lawsuit. Do you think that Andrea’s case is an appropriate analogy?
Clue: What are the similarities between the cases? How are the cases different? Are these differences so
significant that they overwhelm the similarities?
function, and structure of the Securities and Exchange Commission (SEC). In a
survey of major and representative securities legislation, we examine the provisions of the Dodd-Frank Act of 2010 and the Sarbanes-Oxley Act of 2002. Both
the Securities Act of 1933, which governs the issuance of securities and outlines
the registration requirements for both securities and transactions (and the allowable exemptions from those requirements), and the Securities Exchange Act
of 1934, which governs trading in securities, are discussed. We next examine the
state securities laws and online securities disclosure and fraud regulations. We
end with a discussion of the global dimensions of the 1933 and 1934 securities
acts and the Foreign Corrupt Practices Act. Finally, we briefly examine the Convention on Combating Bribery of Foreign Officials in International Business
Transactions.
Introduction to the Regulation of Securities
Securities have no value in and of themselves. They are not like most goods
produced or consumed (e.g., television sets or toys), which are easily regulated
in terms of their hazards or merchantability. Because they are paper, they can be
produced in unlimited numbers and can easily be manipulated by their issuers.
The first attempt to regulate securities in the United States was made by the
state of Kansas in 1912. When other states followed the Kansas legislature’s
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Rules Governing the Issuance and Trading of Securities
example, corporations played off one state against another by limiting their
securities sales to states that had less stringent regulations. Despite the
corporations’ ability to thwart state efforts at regulation rather easily, there was
strong resistance to the idea of federal regulation in Congress. It was not until
after the collapse of the stock market in 1929 and the free fall of stock prices
on the New York Stock Exchange (NYSE)—when the Dow Jones Industrial
Average registered an 89 percent decline between 1929 and 1933—that
Congress finally acted.
SUMMARY OF FEDERAL SECURITIES LEGISLATION
The following legislation, enacted by Congress since 1933, provides the framework for the federal regulation of securities. It is also important to note that this
legislation is the basis (enabling act) for rulemaking by the SEC. Congressional
legislation is emphasized here, but it is important to remember that SEC rulemaking may be equally significant in the long term. (You will remember that we
discussed rulemaking for federal agencies in Chapter 19.)
• The Securities Act of 1933 (also known as the Securities Act or the 1933 Act)
regulates the initial offering of securities by public corporations by prohibiting an offer or sale of securities not registered with the Securities and Exchange Commission. The 1933 Act sets forth certain exemptions from the
registration process, as well as penalties for violations of the act. This act is
examined in detail in this chapter. Both the 1933 and 1934 Acts have been
amended by Congress and the SEC rulemaking process, much of which is
summarized in the following pages.
• The Securities Exchange Act of 1934 (also known as the Exchange Act) regulates the trading in securities once they are issued. It requires brokers and
dealers who trade in securities to register with the Securities and Exchange
Commission, the regulatory body created to enforce both the 1933 and 1934
Acts. The Exchange Act is also examined in detail in this chapter.
• The Public Utility Holding Company Act of 1935 requires public utility and
holding companies to register with the SEC and to disclose their financial organization, structure, and operating process.
• The Trust Indenture Act of 1939 regulates the public issuance of bonds and
other debt securities in excess of $5 million. This act imposes standards for
trustees to follow to ensure that bondholders are protected.
• The Investment Company Act (ICA) of 1940, as amended in 1970 and 1975,
gives the SEC authority to regulate the structure and operation of public investment companies that invest in and trade in securities. A company is an
investment company under this act if it invests or trades in securities and if
more than 40 percent of its assets are “investment securities” (which are all
corporate securities and securities invested in subsidiaries). Accompanying
legislation, entitled the Investment Advisers Act of 1940, authorizes the SEC
to regulate persons and firms that give investment advice to clients. This act
requires the registration of all such individuals or firms and contains antifraud provisions that seek to protect broker-dealers’ clients.
• The Securities Investor Protection Act (SIPA) of 1970 established the nonprofit Securities Investor Protection Corporation (SIPC) and gave it authority
to supervise the liquidation of brokerage firms that are in financial trouble,
as well as to protect investors from losses up to $500,000 due to the financial failure of a brokerage firm. The SIPC does not have the monitoring and
“bailout” functions that the Federal Deposit Insurance Corporation (FDIC)
has in banking; it only supervises the liquidation of an already financially
troubled brokerage firm through an appointed trustee.
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• Chapter 11 of the Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 gives the SEC the authority to render advice when certain debtor
corporations have filed for reorganization.
• The Foreign Corrupt Practices Act (FCPA) of 1977, as amended in 1988, prohibits the direct or indirect giving of “anything of value” to a foreign official
for the purpose of influencing that official’s actions. The FCPA sets out an intent or “knowing” standard of liability for corporate management. It requires
all companies (whether doing business abroad or not) to set up a system of
internal controls to provide reasonable assurance that the company’s records
“accurately and fairly reflect” its transactions. The FCPA is discussed in detail
in the last section of this chapter.
• The International Securities Enforcement Cooperation Act (ISECA) of 1990
clarifies the SEC’s authority to provide securities regulators of other governments with documents and information and exempts from Freedom of Information Act disclosure requirements all documents given to the SEC by foreign
regulators. The ISECA also authorizes the SEC to impose administrative sanctions on securities buyers and dealers who have engaged in illegal activities
in foreign countries. Finally, it authorizes the SEC to investigate violations of
the securities law set out in the act that occur in foreign countries. The ISECA
is also discussed in the last section of this chapter.
• The Market Reform Act of 1990 authorizes the SEC to regulate trading practices during periods of extreme volatility. For example, the SEC can take such
emergency action as suspending trading when computer program–driven
trading forces the Dow Jones Industrial Average to rise or fall sharply within
a short time period.
• The Securities Enforcement Remedies and Penny Stock Reform Act of 1990
(the 1990 Remedies Act) gives the SEC powerful new means for policing the
securities industry: cease-and-desist powers and the power to impose substantial monetary penalties (up to $650,000) in administrative proceedings.
The 1990 Remedies Act also gives the SEC and the federal courts the following powers over anyone who violates federal securities law:
1. The imposition of monetary penalties by a federal court for a violation
of the securities law on petition by the SEC.
2. The power of the federal courts to bar anyone who has violated the
fraud provisions of the federal securities laws from ever serving as an
officer or director of a publicly held firm.
3. The power of the SEC to issue permanent cease-and-desist orders against
“any person who is violating, has violated, or is about to violate” any
provision of a federal securities law.
This act arms the SEC with some of the most sweeping enforcement powers
ever given to a single administrative agency other than criminal enforcement
agencies such as the Justice Department.
• The Private Securities Litigation Reform Act of 1995 (Reform Act) provides a
safe harbor from liability for companies that make statements to the public
and investors about risk factors that may occur in the future.
• The Securities Litigation Uniform Standards Act of 1998 sets national standards for securities class action lawsuits involving nationally traded securities. This act amends the 1933 and 1934 Acts and prohibits any private class
action suits in state or federal court alleging (1) any untrue statement or
omission in connection with the purchase or sale of a covered security; or
(2) that the defendant used any manipulation or deceptive device in connection with the transaction.
• The Sarbanes-Oxley Act of 2002 amends the 1933 and 1934 Acts. SarbanesOxley includes provisions dealing with corporate governance, financial
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regulation, criminal penalties, and corporate responsibility; all of which are discussed in detail in this chapter. The Credit Rating Agency Reform Act of 2006
creates a new regulatory system by which the SEC identifies and oversees five
nationally recognized agencies that issue credit ratings.
• The Dodd-Frank Act of 2010, a wide-ranging reform of regulatory actions
which seeks to prevent the reoccurrence of a major financial catastrophe
such as the one that occurred in 2008.
For your convenience, some of the federal securities legislation is summarized
in Table 24-1.
THE SECURITIES AND EXCHANGE COMMISSION
Creation and Function. The Securities and Exchange Commission (SEC)
was created under the Securities Exchange Act of 1934 for the purpose of ensuring
that investors receive “full and fair” disclosure of all material facts with regard to
any public offering of securities. The SEC is not charged with evaluating the worth
633
Securities and Exchange
Commission (SEC) The
federal administrative agency
charged with overall
responsibility for the regulation
of securities, including
ensuring that investors receive
“full and fair” disclosure of all
material facts with regard to
any public offering of
securities. It has wide
enforcement powers to protect
investors against price
manipulation, insider trading,
and other dishonest dealings.
TABLE 24-1 SUMMARY OF THE MAJOR FEDERAL SECURITIES LEGISLATION
Federal Securities Legislation
Purpose
Securities Act of 1933
Securities Exchange Act of 1934
Public Utility Holding Company Act of
1935
Trust Indenture Act of 1939
Investment Company Act of 1940
Securities Investor Protection Act
of 1970
Foreign Corrupt Practices Act of 1977,
as amended 1988
International Securities Enforcement
Corporation Act of 1990
Market Reform Act of 1990
Securities Enforcement Remedies and
Penny Reform Act of 1990
Securities Enforcement Remedies and
Penny Reform Act of 1991
Private Securities Litigation Reform
Act of 1995
Securities Litigation Uniform Standards
Act of 1998
Regulates generally the issuance of securities.
SEC regulates trading in securities.
SEC regulates public utility and holding companies through registration
and disclosure processes.
SEC regulates the public issuance of bonds and other debt securities.
SEC regulates the structure and operation of public investment companies.
Securities Investor Protection Corporation supervises the liquidation of financially
troubled brokerage firms.
Prohibits the payment of anything of value to influence foreign officials’ actions.
Sarbanes-Oxley Act of 2002
Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005
Credit Rating Agency Reform Act
of 2006
Dodd-Frank Act of 2010
SEC has authority to provide securities regulators of other governments with
information on alleged violators of securities law in the United States and abroad.
SEC regulates trading practices during periods of extreme volatility.
Requires more stringent regulation of broker-dealers who recommend penny-stock
transactions to customers.
SEC regulates securities industry through cease-and-desist powers and threat of
substantial monetary penalties.
SEC provides a safe harbor from liability for companies that make statements to the
public or investors about risk factors that may occur in the future.
Sets national standards for securities class action lawsuits involving nationally traded
securities. Amends the 1933 and 1934 Acts and prohibits any private class action
suit in state or federal court alleging (1) any untrue statement or omission in
connection with the purchase or sale of a covered security or (2) that the defendant
used manipulation or a deceptive device in connection with the transaction.
Amends the 1933 and 1934 Acts and other federal statutes. Includes provisions
dealing with corporate governance, financial regulation, criminal penalties, and
corporate responsibility.
SEC has authority to advise debtor corporations that have filed for reorganization.
Creates a registration process through the SEC for rating agencies wishing to become
nationally recognized at a time certain. Congress sought to meet the need to increase
the number of agencies from the five established by Section 15E of the 1934 Act.
Seeks to amend several statutes and the regulatory process involving the SEC and
other federal agencies of the federal government. Statute was passed following a
major economic downturn (recession) in 2008.
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of a public offering of securities by a corporation (for example, determining
whether the offering is speculative or not); it is concerned only with whether
potential investors are provided with adequate information to make investment decisions. To this end, the commission was given the power to set up and enforce
proper registration regulations for securities, as well as to prevent fraud in the registration and trading of securities.
Structure. Exhibit 24-1 lays out the structure of the SEC. It has five commissioners (inclusive of the chairman), who are appointed by the president with the
advice and consent of the Senate; each serves for a period of five years, and no
more than three commissioners can be of the same political party. The SEC,
based in Washington, D.C., has nine regional offices across the United States.
There are five divisions: Corporation Finance, Market Regulation, Enforcement,
Corporate Regulation, and Investment Management. (Note in Exhibit 24-1 that
five major offices—Consumer Affairs, Public Affairs, etc.—also serve the
commission, along with an executive director.)
Division of Corporation Finance. The Division of Corporation Finance is responsible for establishing and overseeing adherence to standards of financial reporting and disclosure for all companies that fall under SEC jurisdiction, as well
as for setting and administering the disclosure requirements prescribed by the
1933 and the 1934 Securities Acts, the Public Utility Holding Company Act, and
the Investment Company Act. This division reviews all registration statements,
prospectuses, and quarterly and annual reports of corporations, as well as their
proxy statements. Its importance in offering informal advisory opinions to issuers
(corporations about to make a public offering of stock) cannot be overemphasized. Accountants, lawyers, financial officers, and underwriters all rely heavily
on advice from this division.
Division of Market Regulation. This is the SEC division that regulates the national security exchanges (such as the NYSE), as well as broker-dealers registered under the Investment Advisers Act of 1940. Through ongoing surveillance
of both the exchanges and broker-dealers, the Division of Market Regulation
seeks to discourage manipulation or fraud in the issuance, sale, or purchase of
securities. It can recommend to the full commission the suspension of an exchange for up to one year, as well as the suspension or permanent prohibition
of a broker or dealer because of certain types of conduct. In addition, the division provides valuable informal advice to investors, issuers, and others on securities statutes that come within the SEC’s jurisdiction.
Division of Enforcement. The Division of Enforcement is responsible for the
review and supervision of all enforcement activities recommended by the SEC’s
other divisions and regional offices. It also supervises investigations and the initiation of injunctive actions.
Division of Corporation Regulation. The Division of Corporation Regulation
administers the Public Utility Holding Company Act of 1935 and advises federal
bankruptcy courts in proceedings brought under Chapter 11 of the Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005.
Division of Investment Management. This is the SEC division that administers the ICA of 1940 and the Investment Advisers Act of 1940. All investigations
arising under these acts dealing with issuers and dealers are carried out by this
Division of Investment Management.
Commissioner
Commissioner
Chairman
Commissioner
Commissioner
Executive
Director
Division of
Market
Regulation
Administrative
Law Judges
EDGAR
Inspector
General
Office of
Economic
Analysis
Chief
Accountant
Consumer Affairs
and Information
Services
Division of
Investment
Management
General
Counsel
11 Regional Offices
EXHIBIT 24-1
THE SECURITIES AND EXCHANGE COMMISSION
Division of
Corporation
Finance
Information
Systems
Management
Public Affairs
Division of
Enforcement
Division of
Corporation
Regulation
International
Affairs
Administrative
Services
Personnel
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St. Patrick’s Day Bailout of an Investment Banking Firm
(Bear Stearns, Inc.) by the U.S. Taxpayers
Bear Stearns, Inc. (Bear), an 85-year-old investment banking firm, was headed for insolvency on the weekend of March 15 and 16, 2008, and planned for a bankruptcy filing to take place on Monday, March 17 (St. Patrick’s Day). Fear of a collapse of the
financial system led federal regulators—inclusive of (1) the independent Federal
Reserve Board (Federal Reserve), (2) the Secretary of the Treasury and his many offices
within the Treasury Department, (3) the Office of the Comptroller, (4) the SEC, and
(5) independent advisors from the private sector (e.g., Black Rock, Inc.)—to urge Bear’s
board of directors to sell the firm to J. P. Morgan Chase and Company (J. P. Morgan), at
a price of $2 a share, or $236 million, in a stock-swap transaction for 39.9 percent of
Bear. (On the previous Friday, March 14, the stock value closed on the New York Stock
Exchange at $30 a share, that is, at a market value of $3.54 billion.) Additionally, the
Federal Reserve agreed to fund up to $30 billion of Bear’s nonliquid assets. Regardless
of whether the transaction went through, J. P. Morgan would have the opportunity to
purchase the headquarters of Bear.
This transaction took place in the midst of a nationwide credit crunch caused in
part by cash outflows from subprime and prime mortgage holders, as well as margin calls on derivative contracts held by Bear and other investment banking firms.
The market value of Bear’s stock dropped to $11 per share in the days following the
announcement on March 17.
Response to this “bailout”or “savior”of the economy (U.S. or world) was diverse,
depending on the responder:
• Investors (individual and some institutional). Investors saw this transaction
as a “steal” by J. P. Morgan, and many believed that the market itself would have
solved the problem. Many threatened litigation to stop the bailout. They
pointed out that, unlike other bailouts (e.g., Chrysler), the taxpayers were not
assured any return on their investment. Further, there was no transparency as
to the terms of the secured interest (collateral) for the $30 billion the Federal
Reserve was offering to guarantee Bear’s nonliquid assets.
• Employees of Bear. Approximately 14,000 employees saw their jobs disappear,
along with their life savings. Many had 401K funds as well as private pension
funds invested in Bear stock, which was now worth little. After years of loyalty,
they believed that the board and senior management of Bear had “sold them
out” from a moral perspective.
• Government officials. The chairman of the Federal Reserve and the chairman of
the SEC testified before committees of Congress that they had varying degrees of
advance notice (48–72 hours) of the seriousness of Bear Stearns’ problems. Their
response (as set out earlier) was thus dictated by this short period. The failure to
find a buyer for Bear Stearns could have led to a run on investment as well as commercial banks worldwide. The chairman of the Federal Reserve emphasized that
this was not a “bailout” but rather an action required to save the banking system,
which the Federal Reserve is directed to do by its enabling legislation.
• Political actors. This transaction took place in the midst of a national primary
campaign by the Democratic Party, which had two candidates (Hillary Clinton
and Barack Obama), and a noncontested campaign by the Republican Party
(John McCain). Both parties showed their concern in the House and Senate.
Electronic Media, the Age of the Internet,
and SEC Internal Functions
Through internal rulings, the SEC has recognized that the use of “electronic media . . .
enhances the efficiency of the securities market by allowing for the rapid dissemination of information to investors and financial markets in a more cost-efficient,
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637
1.
What values were in conflict for the parties to this transaction?
Clue: The parties included, among others, the Federal Reserve, the U.S. Secretary of the Treasury and the Treasury
Department, the SEC, and the president of the United States, as well as employees of Bear Stearns. Chapter 1
discusses the values involved in the answer to this question.
2.
Should federal and state “bailouts” of private-sector firms like Bear Stearns take place as a matter of general
principle? If so, why? If not, why not?
Clue: What values are in conflict for federal and state governments? What about taxpayers—or are they
represented? Politicians? Lobbyists?
widespread and equitable manner than traditional paper methods.” The SEC has provided interpretive guidance for the use of electronic media for the delivery of information required by the federal securities law. The SEC has defined electronic media
to include audiotapes, videotapes, CD-ROM, e-mail, bulletin boards, Internet Web
sites, and computer networks.
The SEC has established the EDGAR (electronic data gathering, analysis, and retrieval) computer system, which performs automated collection, validation, indexing, acceptance, and dissemination of reports required to be filed with the SEC. The
SEC requires all domestic companies to make their filings on EDGAR, except those
exempted for hardship. EDGAR filings are posted at the SEC Web site 24 hours after
the date of filing.
Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010
In July 2010, Congress passed a bill that wrought a massive overhaul of federal
government financial regulations, and seemed to affect every sector of the
economy. This piece of legislation became known as the Dodd-Frank bill
(statute)1 so named after its major sponsors: Senator Dodd (D-Conn.), who was
chairman of the Senate Banking Committee, and Congressman Frank (D-Mass.),
who was chairman of the House Financial Affairs Committee. This bill passed
Congress in the midst of a recession and after a collapse of the financial markets in 2008. It sought to respond to the major causes of the financial crises.
Actions taken by Congress, outlined in the following subsection, sought to prevent problems similar to those faced by the nation in the period between 2008
and 2010.
OVERSIGHT OF FINANCIAL PROBLEMS
BY REGULATORY AGENCIES
• A new Financial Stability Oversight Council (Council) was established by the
Dodd-Frank Act. The Council is made up of heads of major regulatory agencies (e.g. Treasury, SEC, FDIC, the Federal Reserve, etc.). The Council will
identify banks or nonbanks that pose a threat to the financial system. The
Fed, with the approval of the Council, will have the power to break up large
firms. It could also require such firms to increase their reserves against future
losses.
1
Pub. L. No. 111–203 (2010).
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• The Fed was to be subject to oversight by the Government Accountability
Office for a short period during 2008, particularly as to its loans via the discount window.
• Hedge funds larger than $100 million must register with the SEC and provide
some information as to trades and their individual portfolios.
• The Office of Thrift Supervision will be absorbed into the Office of the
Comptroller of the Currency.
RISK TAKING BY LARGE BANKS AND NONBANKS
Bank holding companies (e.g., Citigroup and Bear Stearns) participated in speculative trades involving mortgage-backed securities and other financial instruments (e.g., derivatives). When these speculative bets went under, the institutions
involved could not sell the assets involved, which thus became known as “toxic”
assets. The federal government had to spend billions in taxpayer money to bail
out these companies. They are presently repaying these loans (at least in part),
plus interest and/or preferred shares, to the federal government.
The Dodd-Frank legislation was also intended to prevent FDIC-insured institutions from making speculative trades and to require these entities to sell their
interests in hedge funds and private equity funds; only 3 percent of their capital
could remain invested in such funds. Investment banks also had to set aside reserves to cover losses. Originators of mortgage securities must hold 5 percent of
the credit risk, thus retaining an interest in the performance of the securities. For
reasons other than speculation, banks will be allowed to trade in a “proprietary”
manner. Banks can also continue to buy or sell from their own accounts to hedge
against other investments.
EXECUTIVE COMPENSATION
Compensation to executives of the largest financial firms were based upon quarterly
earnings. Earnings increased as these firms sold mortgage-backed securities and
derivatives—until the housing “bubble burst.” When subprime mortgages began to
fail, the federal government had to bail out the large financial institutions that had
speculated heavily in these instruments and derivatives based on them. Anger over
the enormous compensation paid to executives of these institutions became a major
public issue, as taxpayers saw their “bailout” tax dollars apparently being used to
reward executives for serious mismanagement and poor performance.
The Dodd-Frank Act did some things to deal with executive compensation:
• Shareholders were allowed a nonbinding vote on executive compensation,
as directed by the SEC
• Only independent directors of a company could sit on compensation committees of the board
• Companies would be required to take back compensation if it was based on
accounting statements that were later found to be inaccurate
TOO BIG TO FAIL
Nonbank financial companies, such as insurance giant AIG, could not be legally
shut down during the 2008 crisis. The government bailed them out, believing
that their bankruptcy would bring about the collapse of the financial system both
in the United States and markets worldwide.
The new statute gave the FDIC authority to shut down banks and nonbank financial firms. Taxpayers initially would foot the bill for liquidation, but the money
was eventually to be returned to the federal coffers from shareholders and
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unsecured creditors. Further, the statute ordered an increase in the reserve ratio
of the FDIC, but specified that small depository institutions (those with less than
$10 billion in consolidated assets) were exempt from making such increases.
A fund of $11 billion was initially established within the Troubled Asset Relief
Program (TARP) to cover the costs of shutting down companies. In theory, the
government could then shut down huge companies without the taxpayers having
to bail them out.
CREDIT RATING AGENCIES
Credit rating agencies (such as Moodys and Standard and Poors) evaluated and
rated billions in mortgage securities; both the private sector and governments at
all levels relied on these ratings. These agencies were paid by the same companies that were issuing and trading in mortgage securities and other forms of debt
(and thus had a vital interest in positive ratings). When the housing market
crashed, many of the rating agencies sought to downgrade the ratings that they
had given mortgage securities and other assets.
• Despite what appeared to be a conflict of interest, Congress could not agree
on a format to replace the ratings agencies. The Dodd-Frank legislation was
intended to make it easier to sue credit rating agencies. Additionally, this
statute eliminated any federal requirement that banks and other investors
rely on ratings set out by these agencies.
• The legislation orders the SEC to study ways to eliminate ratings shopping
by issuers
• It allows the SEC to deregister ratings agencies that have a bad record of violating financial regulations
• All ratings agencies now have to disclose how they arrive at ratings; and how
they comply with conflict-of-interest regulations
DERIVATIVES
Derivatives are synthetic securities that are dependent upon the movement of underlying variables (e.g., interest rates, commodity prices, security indexes). They
are largely used as hedges against risk; many times they are a form of insurance.
Many times derivatives are negotiated privately between companies. For example,
company X agrees to make a number of payments to company Y, which, in turn,
will pay up if a bond issuer Z defaults. When the terms of derivatives are privately
negotiated, they are more difficult for regulators to track and assess for risk. They
represent a market of approximately $600 trillion. Derivatives played a huge role
in the fall of AIG and the large government bailout that ensued.
The Dodd-Frank statute will standardize derivatives traded on exchanges to increase transparency. Further, derivatives must now be routed through a clearinghouse to ensure that companies using them post collateral (margins). Banks will
have to spin off their riskier derivatives and trade them through a subsidiary. Those
derivatives will include any that deal in energy, mortgages, credit-default swaps,
commodities, and agriculture. Banks can continue to trade derivatives in-house
based on interest rates and foreign exchanges, and for purposes of hedging risk. The
Commodity Futures Trading Commission (CFTC) and the SEC are to be the chief regulators of the derivatives market, by both drafting and interpreting the regulations.
CONSUMER PROTECTION
When Dodd-Frank was written, no regulatory authority had the sole responsibility for protecting consumers from predatory lenders. None of the regulatory
agencies considered consumer protection their number-one priority. Mortgage
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brokers steered huge numbers of home buyers into subprime mortgages, often
without much attention to the buyers’ ability to pay based on their income. When
the credit markets froze up, and the 2008 recession came on, these consumers
were the first to suffer.
The Dodd-Frank Act developed a new independent regulatory agency,
called The Consumer Financial Protection Bureau (Bureau), which was located
within the Federal Reserve Board. The head of the Bureau is appointed by the
president for a five-year term. The Bureau is guaranteed a percentage of the annual Fed’s operating expenses. Initially, the formula agreed upon will bring in
$500 million annually, although the Bureau may request another $200 million
yearly. Staff for this independent agency will be drawn from several federal agencies, including the Federal Reserve, Federal Trade Commission, Federal Deposit
Insurance Corporation, Department of Housing and Urban Development, and
National Credit Union. The purpose of the Bureau is to police the financial markets on behalf of savers and borrowers. The Bureau is charged with regulating
such firms as:
• Banks that issue consumer loans, checking accounts, and/or credit cards
• Mortgage lenders, services, brokers, appraisers, and settlement firms
• Credit counseling firms
• Debt collectors and consumer reporting agencies
• Private-sector student loan companies
EXEMPTIONS
Under Dodd-Frank, Congress has exempted auto dealers from the new agency’s
jurisdiction, even though they originate nearly 80 percent of all auto loans. Also,
99 percent of the nation’s 7,939 banks (as of this writing) and thrifts (those with
less than $10 billion in assets) will not fall under the Bureau’s rules. These banks
will instead be examined by traditional regulators, although the Bureau’s rules
will be enforced by such examiners. These exemptions at the federal level are a
result of strong lobbying at the national and local levels.
The Dodd-Frank statute exempts payday lenders and check-cashing
firms, as well as auto dealers, leaving these entities to local and state regulation. It also failed to deal with Fannie Mae and Freddie Mac, the mortgage
bodies that were responsible for approximately 90 percent of the subprime
mortgages that gave rise to the need for this statute. The Dodd-Frank Act also
provided for limited regulation of asset management and mutual fund
companies.
REGULATION BY REGULATORS
As with all statutes passed by Congress, the regulating agencies charged with carrying out the Dodd-Frank law are important to its actual enforcement. (See the
discussion of rulemaking in Chapter 19 of this text.) With this particular statute,
it is estimated that some 15 separate agencies will be involved in rulemaking and
enforcement. Some of these agencies include the Federal Reserve Board,
the SEC, the Treasury Department, the new Financial Stability Oversight Council, the FDIC, the Commodities Future Trading Commission, the FTC, the OCC,
and the Office of Financial Research.
Following the completion of administrative agency rulemaking, there will ordinarily be appeals by those affected. The federal courts of appeals normally
hears these cases (see Chapter 19 on judicial review of rulemaking).
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641
The Sarbanes-Oxley Act of 2002
Following financial and accounting scandals involving Martha Stewart Living,
Inc., Tyco International, Inc., Enron Corporation, and others, Congress passed a
bipartisan measure in 2002 sponsored by Senator Paul Sarbanes (D-Md.) and
Representative Michael Oxley (R-Ohio) and signed into law by President Bush.2
The act requires a new approach to corporate governance. Chief executive officers (CEOs) and chief financial officers (CFOs) must now certify that statements
and reports are accurate, under pain of imprisonment if intent to mislead can be
shown (Exhibit 24-2). The Public Company Accounting Oversight Board
(PCAOB) was established to regulate accounting firms.3 The SEC was given new,
expansive powers regarding private civil actions, as well as administrative actions. Some of the provisions of Sarbanes-Oxley are outlined in the following
subsections. The SEC, using its rulemaking power, is responsible for implementing these provisions.
CORPORATE ACCOUNTABILITY
Sarbanes-Oxley requires CEOs and CFOs to certify financial reports. Officers
must forfeit profits and bonuses if earnings are restated by a company due to securities fraud. Companies are required to immediately disclose material changes
in their financial condition.
NEW ACCOUNTING REGULATIONS
A five-member board with legislative and disciplinary power was established: the
Public Company Accounting Oversight Board. A majority of the board is independent from publicly held accounting companies. The board is funded by publicly held companies overseen by the SEC.
The act prohibits auditors (accounting firms) from offering nine specific
types of consulting services to their corporate clients.
[Name of principal executive officer or principal financial officer], states and attests that:
• to the best of my knowledge, based upon a review of the covered reports of [company
name], and, except as corrected or supplemented in a subsequent covered report;
• no covered report contained an untrue statement of a material fact as of the end of
the period covered by such report (or, in the case of a report on Form 8-K or definitive
proxy materials, as of the date on which it was filed); and
• no covered report omitted to state a material fact necessary to make the statements
in the covered report, in light of the circumstances under which they were made, not
misleading as of the end of the period covered by such report (or, in the case of a
report on Form 8-K or definitive proxy materials, as of the date on which it was filed).
2
H.R. 3762. The act became effective on August 29, 2002; Pub. L. No. 107–204 (codified as
Exchange Act § 4), 15 U.S.C. § 78(d)–3. See Greg Ip, “Maybe U.S. Markets Are Still Supreme:
Study Finds No Proof that Sarbanes-Oxley Tarnishes the Allure,” Wall Street Journal, C-1
(Apr. 27, 2007).
3
In Free Enterprise Fund v. Public Company Accounting Oversight Board, 129 S. Ct. 2378 (2009),
the board’s membership rules were found to be constitutionally wanting in that members could
be removed only for good cause. The Supreme Court said that this arrangement violated the separation of powers doctrine and the need of the president to manage the executive branch. The
Court ruled 5–4 that the SEC will be able to remove members of the PCAOB at will. However, the
Court unanimously held that the Sarbanes-Oxley Act remained fully operational as law.
EXHIBIT 24-2
STATEMENT UNDER OATH
OF PRINCIPAL EXECUTIVE
OFFICER AND PRINCIPAL
FINANCIAL OFFICER
REGARDING FACTS AND
CIRCUMSTANCES
RELATING TO EXCHANGE
ACT FILINGS
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CRIMINAL PENALTIES
• The maximum penalty for securities fraud was raised to 25 years.
• A new crime was created under this act for destruction, alteration, or fabrication of records; the maximum penalty permitted under the act is 20 years
imprisonment.
• Penalties are increased for CEOs or CFOs who knowingly certify a report that
does not meet the requirements of this act; they are now subject to $1 million
in fines and up to 5 years in prison. If officers “willfully” certify a noncomplying report, the penalty may be up to $5 million in fines or 20 years in prison
or both.
• Under this act, penalties for mail and wire fraud are raised to 20 years, and
for defrauding pension funds, up to 10 years.
Other Sarbanes-Oxley Provisions include:
• Lengthening of the statute of limitations for securities fraud to five years or
two years from discovery.
• Protection for whistleblowers who report wrongdoing to employers or participate in a government investigation involving a potential securities violation.
• Preventing officials who are facing court judgments based on fraud charges
from using bankruptcy laws to escape liability.
• Prohibiting certain loans to directors and officers, if the loans come from
public and private companies that are filing initial public offerings (IPOs).
Arranging, receiving, or maintaining personal loans, except consumer or
housing loans, is forbidden under this act.
The Securities Act of 1933
In the depths of the Great Depression, Congress enacted this first piece of federal legislation regulating securities. Its major purpose, as we have said, was to
ensure full disclosure on new issues of securities.
DEFINITION OF A SECURITY
security A stock, bond, or any
other instrument of interest
that represents an investment
in a common enterprise with
reasonable expectations of
profits that are derived solely
from the efforts of those other
than the investor.
When most people use the word securities, they mean stocks or bonds that are
held personally or as part of a group in a pension fund or a mutual fund.
Congress, the SEC, and the courts, however, have gone far beyond this simple
meaning in defining securities. Section 2(1) of the 1933 Act defines the term
security as:
any note, stock, treasury stock, bond, debenture, evidence of indebtedness,
certificate of interest or participation in any profit sharing agreement, collateral
trust certificate, reorganization certificate or subscription, transferable share,
investment contract, voting trust certificate, certificate of deposit for a security,
fractional undivided interest in oil, gas or other mineral rights, or, in general,
any interest or instrument commonly known as a security.
The words “or, in general, any interest or instrument commonly known as a
security” have led to various interpretations by the SEC and the courts of what
constitutes a security. In the landmark case of SEC v. Howey,4 the Supreme Court
sought to discover the economic realities behind the façade or form of a transaction and set out specific criteria for the courts to use in defining a security. In
Howey, the Court held that the sale to the public of rows of orange trees, with a
4
328 U.S. 293 (1946).
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643
service contract under which the Howey Company cultivated, harvested, and
marketed the oranges, constituted a security within the meaning of Section 2(1)
of the 1933 Act. Its decision was based on three elements or characteristics:
(1) There existed a contract or scheme whereby an individual invested money
in a common enterprise; (2) the investors had reasonable expectations of profits; and (3) the profits were derived solely from the efforts of persons other than
the investors. These criteria are examined in detail here because they have been
the basis of considerable litigation.
Common Enterprise. The first element of the Howey test has been interpreted
by most courts as requiring investors to share in a single pool of assets so that
the fortunes of a single investor are dependent on those of the other investors.
For example, commodities accounts involving commodities brokers’ discretion
have been held to be “securities” on the ground that “the fortunes of all investors
are inextricably tied” to the success of the trading enterprise.
Reasonable Expectations of Profit. The second element of the Howey test requires that the investor enter the transaction with a clear expectation of making a
profit on the money invested. The U.S. Supreme Court has held that neither an interest in a noncontributory, compulsory pension plan nor stock purchases by residents in a low-rent cooperative constitute securities within the definition of Howey.
In the case involving the pension plan,5 the Court stated that the employee expected
funds for his pension to come primarily from contributions made by the employer
rather than from returns on the assets of the pension plan fund. Similarly, in the lowrent housing case,6 the Court decided that shares purchased solely to acquire a lowcost place to live were not bought with a reasonable expectation of profit.
Profits Derived Solely from the Efforts of Others. The third element of the
Howey test requires that profits come “solely” from the efforts of people other
than the investors. The word solely was interpreted to mean that the investors
can exert “some efforts” in bringing other investors into a pyramid sales scheme,
but that the “undeniably significant ones” must be the efforts of management,
not of the investors.
The following case sets out a summary of a U.S. Supreme Court decision on
what constitutes a security.
CASE
24-1
Securities and Exchange Commission v. Edwards
540 U.S. 389 (2004)
C
harles Edwards, the CEO and sole shareholder of ETS
Payphones, Inc., offered the public investment opportunities in payphones. The arrangement involved an
investor paying $7,000 to own a payphone. Each investor
was offered $82 per month under a leaseback and management arrangement with ETS. The investors also were
to recoup their $7,000 investment at the end of five years.
ETS did not generate enough revenue to pay its investors,
so it filed for bankruptcy. The SEC sued ETS for civil
damages arising from alleged violations of federal securities laws. The SEC won at the trial level. The district
judge ruled that payphone leaseback and management
agreements were investment contracts covered by federal securities laws. The Eleventh Circuit Court of Appeals reversed this judgment and ruled in favor of ETS.
The SEC was granted certiorari to have the Supreme
Court review the definition and application of the term
security.
5
International Brotherhood of Teamsters, Chauffeurs, Warehousers, & Helpers of America v.
Daniel, 439 U.S. 551 (1979).
6
United Housing Foundation, Inc. v. SEC, 423 U.S. 884 (1975).
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Justice O’Connor
Congress’s purpose in enacting the securities laws was to
regulate investments, in whatever form they are made and
by whatever name they are called. To that end, it enacted
a broad definition of security, sufficient to encompass virtually any instrument that might be sold as an investment,
investment contract is not itself defined.
The test for whether a particular scheme is an investment contract was established in our decision in SEC v.
W. J. Howey Co., 66 S. Ct. 1100 (1946). We look to whether
the scheme involves an investment of money in a common
enterprise with profits to come solely from the efforts of
others. This definition embodies a flexible rather than a
static principle, one that is capable of adaptation to meet
the countless and variable schemes devised by those who
seek the use of the money of others on the promise of
profits. . . .
There is no reason to distinguish between promises of
fixed returns and promises of variable returns for purposes
of the test. . . . In both cases, the investing public is attracted
by representations of investment income, as purchasers
were in this case by ETS’s invitation to watch the profits add
up. Moreover, investments pitched as low-risk (such as
those offering a “guaranteed” fixed return) are particularly
attractive to individuals more vulnerable to investment
fraud, including older and less sophisticated investors.
Under the reading respondent advances, unscrupulous marketers of investments could evade the securities laws by
picking a rate of return to promise. We will not read into the
securities laws a limitation not compelled by the language
that would so undermine the laws’ purposes.
Respondent protests that including investment schemes
promising a fixed return among investment contracts conflicts with our precedent. We disagree.
Given that respondent’s position is supported neither
by the purposes of the securities laws nor by our precedents, it is no surprise that the SEC has consistently taken
the opposite position, and maintained that a promise of a
fixed return does not preclude a scheme from being an investment contract. It has done so in formal adjudications
and in enforcement actions.
The Eleventh Circuit’s perfunctory alternative holding,
that respondent’s scheme falls outside the definition because purchasers had a contractual entitlement to a return,
is incorrect and inconsistent with our precedent. We are
considering investment contracts. The fact that investors
have bargained for a return on their investment does not
mean that the return is not also expected to come solely
from the efforts of others. Any other conclusion would
conflict with our holding that an investment contract was
offered in Howey itself.
We hold that an investment scheme promising a fixed
rate of return can be an investment contract and thus a
security subject to the federal securities laws.
Reversed and remanded. For the SEC.
REGISTRATION OF SECURITIES UNDER THE 1933 ACT
Purpose and Goals. The 1933 Act requires the registration of nonexempt
securities, as defined by Section 2(1), for the purpose of full disclosure so that
potential investors can make informed decisions on whether to buy a proposed
public offering of stock. As we noted earlier in this chapter, the 1933 Act does
not authorize the SEC or any other agency to decide whether or not the offering
is meritorious and should be sold to the public.
prospectus The first part of
the registration statement the
SEC requires from issuers of
new securities. It contains
material information about the
business and its management,
the offering itself, the use to be
made of the funds obtained,
and certain financial
statements.
Registration Statement and Process. Section 5 of the 1933 Act requires that,
to serve the goals of disclosure, a registration statement consist of two parts—
the prospectus and a “Part II” information statement—to be filed with the SEC
before any security can be sold to the public. The registration statement provides
(1) material information about the business and property of the issuer; (2) description of the significant provisions of the offering; (3) the use to be made of
the funds garnered by the offering and the risks involved for investors; (4) the
managerial experience, history, and remuneration of the principals, including
pensions or stock options; (5) financial statements certified by public accountants attesting to the firm’s financial health; and (6) pending lawsuits. The
prospectus must be given to every prospective buyer of the securities. Part II is
a longer, more detailed statement than the prospectus. It is not given to prospective buyers, but is open for public inspection at the SEC.
Disclosure. Issuers may use the detailed form (Form S-1). Effective December 4,
2005, the SEC amended the disclosure requirement noted here to recognize four
categories of issuers:
1. A nonreporting issuer which is not required to file reports under the 1934
Act. It must use Form S-1, which previously it did not have to do.
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645
2. An unseasoned issuer is an issuer that has reported continuously under the
1934 Act for at least three years. Such an issuer must use Form S-1, but is
permitted to disclose less-detailed information and to incorporate some information by reference to reports filed under the 1934 Act.
3. A seasoned issuer is an issuer that has filed continuously under the 1934 Act
for at least one year and has a minimum market value of publicly held voting and nonvoting stock of $75 million. Such an issuer is permitted to use
Form S-03, thus disclosing even less detail in the 1933 Act registration and
incorporating even more information by reference to 1934 Act reports.
4. A well-known seasoned issuer is an issuer that has filed continuously for at
least one year under the 1934 Act.
During the registration process, the SEC generally bans public statements by
some issuers, other than those contained in the registration statement, until the
effective date of registration. There are three important stages in this process: prefiling, waiting, and posteffective periods. They are summarized in Table 24-2.
Prefiling Period. Section 5(c) of the 1933 Act prohibits any offer to sell or buy
securities before a registration statement is filed. The key question here is what
constitutes an “offer.” Section 2(3) of the act exempts from the definition any preliminary agreements or negotiations between the issuer and the underwriters or
among the underwriters themselves. Underwriters are investment banking
firms that purchase a securities issue from the issuing corporation with a view to
eventually selling the securities to brokerage houses, which, in turn, sell them to
the public. These underwriters—such as Goldman Sachs, Kidder Peabody, or
First Boston—may arrange for distribution of the public offering of securities, but
they cannot make offerings or sales to dealers or the public at this time. During
the prefiling period, the SEC regulations also forbid sales efforts in the form of
speeches or advertising by the issuer that seeks to “hype” the offering or the issuer’s business. However, a press release setting forth the details of the proposed
offering and the issuer’s name, without mentioning the underwriters, is generally permitted.
Waiting Period. In the interim between the filing and the time when registration becomes effective, SEC rules allow oral offers but not sales. The SEC examines the prospectus for completeness during this period. SEC rules permit the
publication of a written preliminary, or red herring, prospectus that summarizes the registration but disavows in red print (hence, its name) any attempt to
offer or sell securities. Notices of underwriters containing certain information
about the proposed issue are also allowed to appear in newspapers during this
period, but such notices must be bordered in black and specify that they are not
offers to sell or solicitations to buy securities.
Stage
Prohibitions
1. Prefiling period
No offer to sell or buy securities may be made before a
registration statement is filed.
2. Waiting period
SEC rules allow oral offers during this period but no sales. A “red
herring” prospectus that disavows any attempt either to offer or
sell securities may be published.
3. Posteffective period
Registration generally becomes effective 20 days after the
registration statement is filed, though effective registration may
be accelerated or postponed by the SEC. Offer and sale of
securities are permitted thereafter.
underwriter Investment
banking firm that agrees to
purchase a securities issue
from the issuer, usually on a
fixed date at a fixed price, with
a view to eventually selling the
securities to brokers, who, in
turn, sell them to the public.
red herring A preliminary
prospectus that contains most
of the information that will
appear in the final prospectus,
except for the price of the
securities. The “red herring”
prospectus may be distributed
to potential buyers during the
waiting period, but no sales
may be finalized during this
period.
TABLE 24-2
STAGES IN THE SECURITIES
REGISTRATION PROCESS
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letter of comment or
deficiency Informal letter
issued by the SEC indicating
what corrections must be
made in a registration
statement for it to become
effective.
Posteffective Period. The third stage in the process is called the posteffective
period because the registration statement usually becomes effective 20 days after it is filed, although sometimes the SEC accelerates or postpones registration
for some reason. Underwriters and lenders can begin to offer and sell securities
after the 20 days or upon commission approval, whichever comes first.
Under Section 8 of the 1933 Act, the SEC may issue a “refusal order” or “stop
order,” which prevents a registration statement from becoming effective or suspends its effectiveness, if the staff discovers a misstatement or omission of a material fact in the statement. Stop orders are reserved for the most serious cases.
In general, the issuers are forewarned by the SEC in informal letters of
comment or deficiency before a stop order is put out, so they have the opportunity to make the necessary revisions. The commission may shorten the
usual 20-day period between registration and effectiveness if the issuer is willing to make the modifications requested by the SEC staff. This procedure, in fact,
is the present trend.
The 1933 Act requires that a prospectus be issued upon every sale of a security in interstate commerce except sales by anyone not an “issuer, underwriter
or dealer.” If a prospectus is delivered more than 9 months after the effective
date of registration, it must be updated so that the information is not more than
16 months old. The burden is on the dealer to update all material information
about the issuer that is not in the prospectus. Dealers who fail to do so risk civil
liability under Sections 12(1) and 12(2) of the 1933 Act.
Communications. The December 2005 revisions brought flexibility to rules regarding written communication by issuers before and during registration of securities. This flexibility depended on certain characteristics of the issuer, including
(1) the type of issuer, (2) the issuer’s history of reporting, and (3) the issuer’s market capitalization. These new rules created a type of written communication called
a “free-writing prospectus,” which is any written offer, including electronic communication (as defined previously) other than a prospectus required by statute. The
new rules provide that:
• Well-known seasoned issuers may engage at any time in oral and written
communications, including a free-writing prospectus, subject to certain
conditions
• All reporting issuers (unseasoned issuers, seasoned issuers, and wellknown seasoned issuers) may at any time continue to publish regularly
released factual business information and forward-looking information
(predictions)
• Nonreporting issuers may at any time continue to publish factual business
information that is regularly released and intended for use by persons other
than in their capacity as investors or potential investors
• Communications by issuers more than 30 days before filing a registration
statement are permitted so long as they do not refer to a securities offering
that is the subject of a registration statement
All issuers may use a free-writing prospectus after the filing of the registration
statement, subject to certain conditions.
shelf registration Procedure
whereby a large corporation
can file a registration
statement for securities it
wishes to sell over a period of
time rather than immediately.
Shelf Registration. Traditionally, the marketing of securities has taken place
through underwriters who buy or offer to buy securities and then employ dealers across the United States to sell them to the general public. With Rule 415,
the SEC has established a procedure, called shelf registration, that allows a
large corporation to file a registration statement for securities that it may wish
to sell over a period of time rather than immediately. Once the securities are
registered, the corporation can place them on the “shelf” for future sale and
need not register them again. It can then sell these securities when it needs
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capital and when the marketplace indicators are favorable. A company that files
a shelf-registration statement must file periodic amendments with the SEC if any
fundamental changes occur in its activities that would be material to the average prudent investor’s decision to invest in its stock.
“Fictional Filings” with the SEC
Like an extraordinary whimsical tale, Universal Express (not American Express), a
small company of alleged postal stores, was able to lose money faster than it issued
news releases. The SEC filed suit for fraud against Universal (Company) in 2007, because the company continued to issue billions of unregistered shares following the
issuance of news releases. The unregistered shares were used to finance the company and its officers. In 2004, a federal district court in New York ruled that the
company and its officers had violated the securities laws and ordered them to pay
$21.9 million. The CEO, Richard Altomare, was barred from being an officer or
director of any public company.
Despite the court’s order, Universal continued to issue news releases forecasting
$9 million in annual revenues from 9,000 private postal stores. Judge Lynch of the
federal district court ruled that there was no evidence the company had any such
network of stores. As of the first quarterly report in 2007, Universal said that the
9,000 stores were “members” of its network regardless of the findings of the federal
judge. The SEC in its suit alleged that the company had issued 500 million unregistered shares over 33 months in violation of the 1933 Securities Act and other federal
statutes (the basis for the original SEC suit). The company claimed that its old stock
issues (before 2004) were allowed by a bankruptcy court ruling. Judge Lynch found
such claims to be baseless and dismissed Universal’s justification.
As of 2007, Universal Express continued to trade billions of shares weekly in an
over-the-counter penny-stock bulletin board in California. Shares have never sold
at more than $0.40 a share. In 2006, Universal lost $18.9 million on revenue of
$1.1 million. Altomare acted as the sole member of Universal’s board of directors
and received a salary in 2006 of $650,000 (paid for with the sale of unregistered
stock). As of 2007, news releases continue to be issued, claiming a “network of
postal stores” in the United States producing annual revenues of $9 million.a
a
SEC v. Universal Express, Inc. (SDNY), reported at No. 2267, § 94165 (2007).
SECURITIES AND TRANSACTIONS EXEMPT
FROM REGISTRATION UNDER THE 1933 ACT
Section 5 of the 1933 Act requires registrations of any sale by any person of any
security unless specifically exempted by the 1933 Act. The cost of the registration process, in terms of hiring lawyers, accountants, underwriters, and other financial experts, makes it appealing for a firm to put a transaction together in
such a way as not to fall within the definition of a security. If that is impossible,
firms often attempt to meet the requirements of one of the following four classes
of exemptions to the registration process (summarized in Table 24-3).
Private Placement Exemptions. Section 4(2) of the 1933 Act exempts from
registration transactions by an issuer that do not involve any public offering. Behind this exemption is the theory that institutional investors have the sophisticated knowledge necessary to evaluate the information contained in a private
placement and, thus, unlike the average investor, do not need to be protected
by the registration process set out in the 1933 Act. The private placement exemption is often used in stock option plans, in which a corporation issues securities to its own employees for the purpose of increasing productivity or
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TABLE 24-3
EXEMPTIONS FROM THE
REGISTRATION PROCESS
UNDER THE 1933
SECURITIES ACT
Exemptions
Definition
Private placement
Transactions by an issuing company not involving any public offering.
Usually, the transaction involves sophisticated investors with enough
knowledge to evaluate information given them (e.g., stock option plans for
top-level management).
Any security or part of an offering offered or sold to persons resident
within a single state or territory.
Section 3(b) of the 1933 Act allows the SEC to exempt offerings not
exceeding $5 million. Regulations A and D promulgated by the SEC define
the type of investors and the amount of securities that are exempt within a
certain time period.
By virtue of the 1933 Act, exemptions are allowed for transactions by any
person other than an issuer, underwriter, or dealer. Also, government
securities (federal, state, or municipal bonds) are exempt. Also exempt are
securities issued by banks, charitable organizations, and savings and loans
institutions.
Intrastate offering
Small business
Other offering
exemptions
retaining top-level managers. Because various courts had different views on
what factual situations qualified for the private placement exemption, the SEC
published Rule 146, which seeks to clarify the criteria used by the commission
in allowing this exemption:
1. The number of purchasers of the company’s (issuer’s) securities should not
exceed 35. If a single purchaser buys more than $150,000, that purchaser will
not be counted among the 35.
2. Each purchaser must have access to the same kind of information that would
be available if the issuer had registered the securities.
3. The issuer can sell only to purchasers who it has reason to believe are capable of evaluating the risks and benefits of investment and are able to bear
those risks or to purchasers who have the services of a representative with
the knowledge and experience to evaluate the risks for them.
4. The issuer may not advertise the securities or solicit public customers.
5. The issuer must take precautions to prevent the resale of securities issued
under a private placement exemption.
Intrastate Offering Exemption. Section 3 of the 1933 Act provides an exemption for any “security which is part of an issue offered or sold to persons resident
within a single state or territory, where the issuer of such security is a resident
and doing business within, or, if a corporation, incorporated by, or doing business within such a state.” To qualify for this exemption, an issuer must meet the
strictly interpreted doing-business-within-a-state requirement: The issuer must be
a resident of the state and “do business” solely with (i.e., offer securities to) people who live within the state.
Courts have interpreted Section 3 very strictly. One federal court ruled that
a company incorporated in the state of California and making an offering of common stock solely to residents of California did not qualify for the intrastate exemption because it advertised in the Los Angeles Times, a newspaper sold by mail
to residents of other states. Another factor in the court’s decision in this case was
that 20 percent of the proceeds from the securities sale were to be used to refurbish a hotel in Las Vegas, Nevada.7
After that decision, the SEC issued Rule 147, which sets standards for the intrastate exemption by defining important terms in Section 3 of the 1933 Act. For
7
SEC v. Trustee Showboat, 157 F. Supp. 824 (S.D. Cal. 1957).
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example, an issuer is “doing business within” a state if (1) it receives at least
80 percent of its gross revenue from within the state; (2) at least 80 percent of
its assets are within the state; (3) it intends to use 80 percent of the net proceeds
of the offering within the state; and (4) its principal office is located in the state.
Rule 147 is also concerned with whether the offering has “come to rest” within
a state or whether it is the beginning of an interstate distribution. An offering is
considered intrastate only if no resales are made to nonresidents of the state for
at least nine months after the initial distribution of securities is completed.
Small Business Exemptions. Section 3(b) of the 1933 Act authorizes the SEC,
by use of its rulemaking power, to exempt offerings not exceeding $5 million
when it finds registration unnecessary. Under this authority, the commission has
promulgated Regulations A and D.
Regulation A exempts small public offerings made by an issuer, defined as offerings not exceeding $5 million over a 12-month period. The issuer must file an
“offerings” and a “notification circular” with an SEC regional office 10 days before
each proposed offering. The circular contains information similar to that required
for a 1933 Act registration prospectus, but in less detail, and the accompanying financial statements may be unaudited. It should be noted that for these small business offerings, the SEC staff follows the same “letter of comment” procedure
associated with registration statements; thus, a Regulation A filing may be delayed.
Regulation A circulars do not give rise to civil liability under Section 11 of the 1933
Act (discussed later in this chapter), but they do make an issuer liable under Section 12(2) for misstatements or omissions (also discussed later in this chapter). The
advantages of this regulation for small businesses are that the preparation of forms
is simpler and less costly, and the SEC staff can usually act more quickly.
Regulation D, which includes Rules 501–506, attempts to implement Section 3
of the 1933 Act. Rule 501 defines an accredited investor as a bank; an insurance
or investment company; an employee benefit plan; a business development
company; a charitable or educational institution (with assets of $5 million or
more); any director, officer, or general partner of an issuer; any person with a
net worth of $1 million or more; or any person with an annual income of more
than $200,000. This definition is important because an accredited investor, as defined by Rule 501, is not likely to need the protection of the 1933 Act’s registration process.
Rule 504 allows any noninvestment company (one whose primary business is not investing or trading in securities) to sell up to $1 million worth of securities in a 12-month period to any number of purchasers, accredited or
nonaccredited, without furnishing any information to the purchaser. This $1 million
maximum, however, is reduced by the amount of securities sold under any other
exemption.
Rule 505 allows any private noninvestment company to sell up to $5 million
of securities in a 12-month period to any number of accredited investors (as previously defined) and to up to 35 nonaccredited purchasers. Sales to nonaccredited
purchasers are subject to certain restrictions concerning the manner of offering—
for example, no public advertising is allowed—and resale of the securities.
Rule 506 allows an issuer to sell an unlimited number of securities to any
number of accredited investors and to up to 35 nonaccredited purchasers. The
issuer, however, must have reason to believe that each nonaccredited purchaser
or representative has enough knowledge or experience in business to be able to
evaluate the merits and risks of the prospective investment. Again, certain resale
restrictions are attached to offerings made under this rule, as well as a prohibition against advertising. Rule 506 seeks to clarify Section 4(2) of the 1933 Act,
dealing with private placement exemptions, as already discussed.
Other Offering Exemptions. Section 4(2) of the 1933 Act allows exemptions
for “transactions by any person other than an issuer, underwriter or dealer.”
noninvestment company
A company whose primary
business is not in investing
or trading in securities.
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Because Sections 4(3) and 4(4) allow qualified exemptions for dealers and brokers, the issuer and the underwriters become the only ones not exempted. SEC
Rules 144 and 144a define the conditions under which a person is not an underwriter and is not involved in selling securities.
Exempt Securities. Government securities issued or regulated by agencies
other than the SEC are exempt from the 1933 Act. For example, debt issued by
or guaranteed by federal, state, or local governments, as well as securities issued
by banks, religious and charitable organizations, savings and loan associations,
and common carriers under the Interstate Commerce Commission, are exempt.
These securities usually fall under the jurisdiction of other federal agencies, such
as the Federal Reserve System or the Federal Home Loan Board, or of state or
local agencies.
The collapse of the Penn Central Railroad in 1970 and the default of the cities
of Cleveland and New York on municipal bonds led Congress and the SEC to reexamine certain exemptions with a view to eliminating them. In fact, the Railroad Revitalization Act of 1976 eliminated the 1933 Act exemption for securities
issued by railroads (other than trust certificates for certain equipment), and 1975
amendments to the securities acts now require firms that deal solely in state and
local government securities to register with the commission and to adhere to
rules laid down by the Municipal Securities Rulemaking Board.
Other exempt securities are those issued in a corporate reorganization or
bankruptcy, and securities issued in stock dividends or stock splits.
RESALE RESTRICTIONS
Restrictions are placed on the resale of securities issued for investment purposes
pursuant to intrastate, private placement, or small business exemptions.
• Rule 147 states that securities sold pursuant to an intrastate offering exemption (mentioned previously) cannot be sold to nonresidents for nine months.
• Rule 144 states that securities sold pursuant to the private placement or
small business exemptions must be held one year from the date the securities are sold.
• Rule 144(a) permits “qualified institutional investors” (institutions that own
and invest $100 million in securities, such as banks, insurance companies, or
investment companies) to buy unregistered securities without being subject
to the holding period of Rule 144. This rule seeks to permit foreign issuers
to raise capital in this country from sophisticated investors without registration process disclosures. This also seeks to create a domestic market for unregistered securities.
• Regulation S and Rule 144(a) have attempted to expand the private placement market. See the section in this chapter on the “Global Dimensions of
Rules Governing the Issuance and Trading of Securities.”
LIABILITY, REMEDIES, AND DEFENSES
UNDER THE 1933 SECURITIES ACT
Private Remedies. The 1933 Act provides remedies for individuals who have
been victims of (1) misrepresentations in a registration statement, (2) an issuer’s
failure to file a registration statement with the SEC, or (3) misrepresentation or
fraud in the sale of securities. Each is examined here, along with some affirmative defenses.
Misrepresentations in a Registration Statement. Section 11 of the 1933 Act
imposes liability for certain untruths or omissions in a registration statement.
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Section 11 allows a right of action to “any person acquiring such a security” who
can show (1) a material misstatement or omission in a registration statement and
(2) monetary damages. The term material is defined by SEC Rule 405 as pertaining to matters “of which an average prudent investor ought reasonably to be
informed before purchasing the security registered.” In addition, the issuer’s
omission of such facts as might cause investors to change their minds about investing in a particular security are considered material omissions for the purposes of Section 11. These facts include an impending bankruptcy, new
government regulations that may be costly to the company, and the impending
conviction and sentencing of the company’s top executives for numerous violations of the FCPA of 1977 (discussed later in this chapter).
Three affirmative defenses are available to defendants:
1. The purchaser (plaintiff) knew of the omission or untruth.
2. The decline in value of the security resulted from causes other than the misstatement or omission in the registration statement.
3. The statement was prepared with the due diligence expected of each
defendant.
Whereas others associated with the company can raise the due diligence
defense, the issuing company itself cannot. Section 11(a) is very specific about
what other individuals may be held jointly or severally liable in addition to the
issuing company:
1. Every person who signed the registration statement (Section 16 of the 1933
Act requires signing by the issuer, the issuing company’s CEO, the company’s financial and accounting officers, and a majority of the company’s
board of directors)
2. All directors
3. Accountants, appraisers, engineers, and other experts who consented to being named as having prepared all or part of the registration statement
4. Every underwriter of the securities
It should be noted that there are two exceptions to Section 11 liability:
1. An expert is liable only for the misstatements or omissions in the portion of
the registration statement that the expert prepared or certified.
2. An underwriter is liable only for the aggregate public offering portion of the
securities it underwrote.
Section 11 liability has made such a strong impact that today virtually all professionals and experts involved in the preparation of a registration statement
make precise agreements concerning the assignment of responsibility for that
statement. Failure to grasp the import of Section 11 and related sections of the
1933 and 1934 Acts can lead to loss of reputation and employment by businesspersons and professionals. The first case brought under Section 118 sent
tremors through Wall Street, the accounting profession, and outside directors. In
that case, the court evaluated each defendant’s plea of due diligence on the basis of each individual’s relationship to the corporation and expected knowledge
of registration requirements.
Failure to File a Registration Statement. Failure to file a registration statement with the SEC when selling a nonexempt security is the second basis for a
private action by the purchaser for rescission (cancellation of the sale). Section
12(1) of the 1933 Act provides that any person who sells a security in violation
8
Escott v. Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968).
due diligence defense An
affirmative defense raised in
lawsuits charging
misrepresentation in a
registration statement. It is
based on the defendant’s claim
to have had reasonable
grounds to believe that all
statements in the registration
statement were true and no
omission of material fact had
been made. This defense is not
available to the issuer of the
security.
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of Section 5 (which you recall from our discussion of the registration statement)
is liable to the purchaser to refund the full purchase price. A purchaser whose
investment has decreased in value may recover the full purchase price without
showing a misstatement or fraud if the seller is unable to meet the conditions of
one of the exemptions discussed earlier. In short, a business that fails to file a
registration statement because of a mistaken assumption that it has qualified for
one of the exemptions could be making a very expensive mistake.
Misrepresentation or Fraud in the Sale of a Security. A third basis for a private action is misrepresentation in the sale of a security, as defined by Section
12(2) of the 1933 Act, which holds liable any person who offers or sells securities by means of any written or oral statement that misstates a material fact or
omits a material fact that is necessary to make the statement truthful. Unlike
Section 11, Section 12(2) is applicable whether or not the security is subject to
the registration provisions of the 1933 Act, provided there is use of the mails or
other facilities in interstate commerce. The persons liable are only those from
whom the purchaser bought the security. For example, under Section 12(2), a
purchaser who bought the security from an underwriter, a dealer, or a broker
cannot sue the issuer unless able to show that the issuer was “a substantial factor in causing the transaction to take place.” A further requirement is that the
purchaser must prove that the sale was made “by means of” the misleading communications. The defense usually raised by sellers in such suits is that they did
not know, and using reasonable care could not have known, of the untruth or
omission at the time the statement was made.
Fraud in the sale of a security is covered by Section 17(a) of the 1933 Act,
which imposes criminal, and possibly civil, liability on anyone who aids and
abets any fraud in connection with the offer or sale of a security. Violators may
be penalized by fines of up to $10,000, imprisonment up to 5 years, or both.
Section 12(a)(2) and Section 17(a) of the 1933 Act set out antifraud enforcement
mechanisms. Rule 10(b)(5) applies to the issuance or sales of securities under
the 1934 Act and other securities acts, even those exempted by the 1933 Act.
Governmental Remedies. When a staff investigation uncovers evidence of a
violation of the securities laws, the SEC can (1) take administrative action,
(2) take injunctive action, or (3) recommend a criminal prosecution to the Justice Department.
Administrative Action. Upon receiving information of a possible violation of
the 1933 Act, the SEC staff undertakes an informal inquiry. This involves interviewing witnesses but generally does not involve issuing subpoenas. If the staff
uncovers evidence of a possible violation of a securities act, it asks the full commission for a formal order of investigation. A formal investigation is usually conducted in private under SEC rules. A witness compelled to testify or to produce
evidence may be represented by counsel, but no other witness or counsel may
be present during the testimony. A witness may be denied a copy of the transcript of his or her own testimony for good cause, although the witness is allowed to inspect the transcript.
Witnesses at a private SEC investigation do not enjoy the ordinary exercise
of Fourth, Fifth, and Sixth Amendment rights. For example, Fourth Amendment
rights are limited because the securities industry is subject to pervasive government regulation, and those going into it know this in advance. Fifth Amendment
rights are limited because the production of records related to a business may
be compelled despite a claim of self-incrimination. (See the sections on the
Fourth and Fifth Amendments in Chapter 5.) As for the Sixth Amendment, in a
private investigation, the SEC is not required to notify the targets of the investigation, nor do such targets have a right to appear before the staff or the full commission to defend themselves against charges. The wide scope of SEC powers in
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these nonpublic investigations was reinforced when the U.S. Supreme Court upheld a lower court’s decision to deny injunctive relief with regard to subpoenas
directed at plaintiffs in an SEC private investigation.9
An administrative proceeding may be ordered by the full commission if the
SEC staff uncovers evidence of a violation of the securities laws. This proceeding before an administrative law judge (ALJ) can be brought only against a person or firm that is registered with the commission (an investment company, a
dealer, or a broker). The ALJ has the power to impose sanctions, including censure, revocation of registration, and limitations on the person’s or the firm’s
activities or practice.
In addition, after a hearing, the full commission may issue a stop order to
suspend a registration statement found to contain a material misstatement or
omission. If the statement is later amended, the stop order will be lifted. As mentioned earlier in the chapter, stop orders are usually reserved for the most serious cases. The SEC more frequently uses letters of deficiency to obtain
corrections to registration statements. The remedies available under the 1991
Remedies Act, discussed earlier in this chapter under “Summary of Federal
Securities Legislation,” apply here as well.
Injunctive Action. The SEC may commence an injunctive action when there
is a “reasonable likelihood of further violation in the future” or when a defendant is considered a “continuing menace” to the public. For example, under the
1933 Act, the SEC may go to court to seek an injunction to prevent a party from
using the interstate mails to sell a nonexempt security. Violation of an injunctive order may give rise to a contempt citation. Also, parties under such an order
are disqualified from receiving an exemption under Regulation A (the small
business exemption). Again, the remedies available under the 1991 Remedies Act
apply here.
Criminal Penalties. Willful violations of the securities acts and the rules and regulations promulgated pursuant to those acts are subject to criminal penalties. Anyone convicted of willfully omitting a material fact or making an untrue statement
in connection with the offering or sale of a security can be fined up to $1 million
for each offense or imprisoned for up to 5 years or both. The SEC does not prosecute criminal cases itself, but instead refers them to the Justice Department.
The Securities Exchange Act of 1934
One year after passing the Securities Act of 1933, Congress crafted this second
extremely important piece of securities legislation to come out of the Great Depression. More comprehensive than the 1933 Act, it had two major purposes: to
regulate trading in securities and to establish the SEC to oversee all securities regulations and bar the kind of large market manipulations that had characterized
the 1920s and previous boom periods.
REGISTRATION OF SECURITIES ISSUERS,
BROKERS, AND DEALERS
Registration of Securities Issuers. Section 12 of the 1934 Securities Exchange
Act requires every issuer of debt and equity securities to register with both the
SEC and the national exchange on which its securities are to be traded. Congress
extended this requirement to all corporations that (1) have assets of more than
9
SEC v. Jerry T. O’Brien, Inc., et al., 467 U.S. 735 (1984).
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$10 million, (2) have a class of equity securities with more than 500 shareholders, and (3) are involved in interstate commerce. Registration becomes effective
within 60 days after filing, unless the SEC accelerates the process. Such companies are referred to as “Section 12” companies.
The commission has devised forms to ensure that potential investors will
have updated information on all registrants whose securities are being traded on
the national exchanges. Thus, registrants are required to file annual reports
(Form 10-K) and quarterly reports (Form 10-Q), as well as SEC-requested current reports (Form 8-K). This last form must be filed within 15 days of the
request, which is usually made in response to a perceived material change in the
corporation’s position (e.g., a potential merger or bankruptcy) that the commission’s staff believes a prudent investor should know about. It should be noted
that the Sarbanes-Oxley Act, discussed earlier in this chapter, should be reviewed
for all requirements regarding CEOs and CFOs of issuing companies. Further, the
accounting requirements of the FCPA of 1977 set out at the end of this chapter
should be reviewed as to company officers’ duties.
In a proposed Codification of the Federal Securities Law (CFSL), the American Law Institute has sought to streamline the registration process under the 1933
and 1934 Acts by requiring single-issuance registration under the 1933 Act and
an annual company “offering statement” for securities traded on a national exchange under the 1934 Act. At present, Section 22 of the Exchange Act makes a
registering company liable for civil damages to securities purchasers who can
show that they relied on a misleading statement contained in any of the SECrequired reports.
dealer A person engaged in
the business of buying and
selling securities for his or her
own account.
broker A person engaged in
the business of buying and
selling securities for others’
accounts.
Registration of Brokers and Dealers. Brokers and dealers are required to register with the SEC under the Exchange Act unless exempted. A dealer, as defined by the 1934 Act, is a “person engaged in the business of buying and selling
securities for his own account,” whereas a broker is a person engaged in the
business of “effectuating transactions in securities for the account of others.” We
use the convenient term broker-dealer throughout to refer to all those who trade
in securities and the specific term broker or dealer when only one type of trader
is meant.
Broker-dealers must meet a financial responsibility standard that is based on
a net capital formula; a minimum capital of $25,000 is required in most cases.
Brokers are obliged to segregate customer funds and securities.
Analysts or “Cheerleaders?” Conflicts of Interest
In July 2001, Merrill Lynch barred its stock analysts from investing in stock that they
researched, in order to prevent a potential conflict of interest. This was a reaction
to several events:
• Individuals and members of Congress had lost confidence in analysts, particularly in an economy and market that had been in a turndown for 18 months.
Never before had so many individual investors actually invested in stocks and
bonds and seen their paper wealth grow and then fall. The “party” appeared to
be over for a time.
• Federal investigators were alleging the manipulation of Internet stock IPOs and
the taking of kickbacks by investment bankers in July 2001.
• The same trading companies that had investment banking divisions floating new
issuances of securities hired securities analysts to rank the securities of companies for which they were raising. The individual investor had begun to realize
that there existed no “Chinese wall” between stock analysts and investment
bankers in the same brokerage firm. In fact, some companies gave stock analysts
bonuses when they helped encourage investment banking business by giving
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stocks high ratings. For example, one study showed that bullish ratings were so
meaningless that “sell” ratings were less than 2 percent of all ratings shown. In
many cases, stocks fell as much as 90 percent from their high before analysts removed their “buy” ratings.a This could be called “cheerleading.”
• Money managers who ran large mutual funds with money from IRAs, Keoghs,
401Ks, and 403(b)s became skeptical of analysts as investors lost confidence in
the mutual funds and their managers. These investors, who tended to be passive in nature and dependent on the fund managers and the analysts, saw their
retirement funds dwindling rapidly (and in some instances disappearing almost
entirely).
While this assessment appeared gloomy, many investors argued that analysts
should be encouraged to own stocks in the companies on which they do research,
believing that they should “put their money where their mouth is.”Some argued that
the very purpose of the securities laws is full disclosure and that all analysts should
be forced to disclose what holdings they have and to advise investors when they
have a potential conflict of interest.
a
“Stock Analysts Get Overall Rap for Deceiving Investors,” USA Today, July 5, 2001, 10A.
The Securities Investment Protection Act (SIPA) provides a basis for indemnifying the customers of a brokerage firm that becomes insolvent: All registered
brokers must contribute to a SIPA fund managed by the SIPC, a nonprofit corporation whose functions are to liquidate an insolvent brokerage firm and to protect customer investments up to a maximum of $500,000. Upon application to
the SEC, SIPC can borrow up to $1 billion from the U.S. Treasury to supplement
the fund when necessary.
Under Section 15(b) of the Exchange Act, which contains the antifraud provisions, the SEC may revoke or suspend a broker-dealer’s registration or may
censure a broker-dealer. (Municipal securities dealers and investment advisers
are subject to similar penalties.) In general, the commission takes such actions
against broker-dealers either for putting enhancement of their personal worth
ahead of their professional obligation to their customers—conflict of interest—
or for trading in or recommending certain securities without having reliable information about the company. Broker-dealers are liable to both government and
private action for failing to disclose conflicts of interest. When even the potential for such a conflict exists, a broker must supply a customer with written confirmation of each transaction, including full disclosure of whom the broker is
representing in the transaction.
Monday, October 23, 2000, was an important day for securities analysts: that
was when Regulation Fair Disclosure (FD) became effective. This new rule required companies to publicize all potentially market-moving data at the time the
data become available. No longer could such data be made available only to certain analysts in a securities firm before being given to the public at large. Analysts
traditionally followed one industry and were in frequent contact by phone or
e-mail with its CFOs, investor relations officials, and often CEOs. By gaining bits
of information from several companies in an industry, they were able to provide
earning forecasts and then determine buy, sell, and hold ratings for the trading
company they were employed by.
For example, Hallie Frobose, an analyst for 17 years for Brennan and
Kubasek Company, may have concentrated on companies that were involved in
lumber and forest products. By making telephone calls in the pre-Regulation
FD days, she could obtain financial factors off the record for hundreds of variables that might affect earnings expectations for a major company (e.g., Lumber
Pacific). By constructing a model with all the important variables, and checking
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them with officers of the lumber company, recommendations could be made to
Brennan and Kubasek’s large investors; this was no longer the case for Hallie or
her company following October 2000.
Those opposed to Regulation FD argue that it has a “chilling effect” on analysts and contacts they once had with corporate managers, and has led to a decrease in the predictability of earnings reports like Hallie’s. Market inefficiency
is a result in the eyes of many.
Those favoring Regulation FD argue that the major purpose of our securities
laws is full disclosure and that both large and small investors should have access
to the same data, resulting in a “level playing field.”
DISCLOSURE: COMPENSATION
In discussing registration of securities and securities issuers, it is important to
note that in 2006, pursuant to its mandate under the Exchange Act of 1934, the
SEC set out rules requiring clearer and more complete disclosure of compensation paid to directors, the principal executives, and the three most highly paid
executive officers. The issuer (usually a company) must disclose executives’
compensation over the last three years, including salary, bonuses, a dollar value
of stock and option awards, amount of compensation over nonequity plans, annual changes in present value of accumulated pension benefits, and all other
compensation including perquisites. This type of disclosure is a start toward
meeting some of the political arguments made by unions, and other groups, that
compensation has not been fully disclosed to shareholders.
SECURITIES MARKETS
exchange market A securities
market that provides a physical
facility for the buying and
selling of stocks and
prescribes the number and
qualifications of its brokermembers. These brokers buy
and sell stocks through the
exchange’s registered
specialists, who are dealers on
the floor of the exchange.
over-the-counter (OTC)
market A securities market
that has no physical facility
and no membership
qualifications and whose
broker-dealers are market
makers who buy and sell
stocks directly from the public.
Earlier in this chapter, we defined a security as a stock or bond or any other instrument or interest that represents an investment in a common enterprise with
reasonable expectations of profits derived solely from the efforts of people other
than the investors. A security can also be considered as a form of currency that,
once issued, can be traded for other securities on what is called a securities market. We are concerned here with the markets for stocks and how they are regulated under the Exchange Act.
There are generally two types of markets in stocks: exchange markets and
over-the-counter (OTC) markets. The exchange market provides for the buying and selling of securities within a physical facility such as the NYSE or regional exchanges such as the Boston, Detroit, Midwest (Chicago), Pacific Coast
(Los Angeles and San Francisco), and Philadelphia exchanges. (This, however,
is changing as computer and Internet systems are increasingly the medium
through which stock sales or trades are made.) These exchanges traditionally
prescribed not only the number and the qualifications of their broker-members
but also the commissions they could charge. In 1975, commissions were deregulated by the SEC; since then, brokers have been free to set the commissions
they charge their customers. Brokers do not trade directly on an exchange market, but rather transmit a customer’s order to a registered specialist in a stock,
who buys and sells that security for his or her own account on the floor of the
exchange. The NYSE has now become a publicly traded company. In 2007, the
SEC approved rule changes by the NYSE relating to the combination of Euronext
and NYSE Group. Euronext owns five European exchanges. The combined company now competes with other national and international exchanges for securities business. The SEC will continue to regulate the NYSE Group in the same
manner as noted here.
The over-the-counter (OTC) market has no physical facility—computers
and telephones link OTC members—and no qualifications for membership. Its
commissions have always been determined by the law of supply and demand.
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OTC firms serve as dealers or market makers in stocks and deal directly with
the public.
Today the National Association of Securities Dealers (NASD) and the exchanges
help the SEC to regulate the securities market. In enacting the Securities Exchange
Act in 1934, Congress recognized that the stock exchanges had been regulating their
members for 140 years, and did not seek to dismantle their self-regulatory mechanisms. Rather, it superimposed the SEC on already existing self-regulatory bodies
by requiring every “national securities exchange” to register with the SEC. Under
Section 6(b) of the Exchange Act, an exchange cannot be registered unless the SEC
determines that its rules are designed “to prevent fraudulent and manipulative acts
and practices” and to discipline its members for any violations of its rules or the securities laws. Both the NYSE and the NASD have promulgated rules relating to stock
transactions and qualifications for those participating in such transactions. In general, these rules are enforced by the self-regulating bodies.
To clarify the SEC’s role, Congress amended the Exchange Act in 1975 to give
the SEC explicit authority over all self-regulating organizations (SROs). Any exchange or OTC rule change now requires advance approval from the SEC. The
commission also has reviewing power over all disciplinary actions taken by
the SROs. Moreover, as mentioned earlier, the 1975 amendments eliminated the
power of exchanges to fix minimum commission rates.
The movement by exchanges to “go public” (sell shares and, thus, ownership
rights in the exchanges) has changed their nonregulatory aspects as traded companies. The regulatory function continues through SEC oversight. The Financial
Industry Regulatory Authority (FINRA) was created as an SRO in 2007 when the
NASD merged with the New York Stock Exchange’s regulatory arm. FINRA may
soon be overseeing both brokers and financial advisors.
PROXY SOLICITATIONS
Procedural and Substantive Rules. Section 14 of the Exchange Act and the
accompanying SEC regulations set forth the ground rules governing proxy solicitations by inside management, dissident shareholders, and potential acquirers of a company. You will remember from our discussion in Chapter 18 that
proxies are documents by which the shareholders of a publicly registered company designate another individual or institution to vote their shares at a shareholders’ meeting. They are often used by inside management to defeat proposals
by dissident shareholders or to prevent a takeover by a “hostile” company. The
real significance of the proxy solicitation process, however, is that it may result
in materially changing the direction of the corporation without its owners’
(the shareholders’) awareness. Because very few individual shareholders (under
1 percent) attend annual shareholders’ meetings, proxy voting is management’s
major instrument for electing the directors and setting the policy it wants.
Against this background, Congress enacted Section 14 of the Exchange Act—
the section known as the Williams Act—making it unlawful for a company to solicit proxies in “contravention of such rules and regulations as the Commission
[SEC] may prescribe as necessary or appropriate in the public interest or for the
protection of investors.” With this broad statutory authority, the SEC has promulgated rules and regulations that require all companies registered under the
securities acts to file proxy statements with the commission 10 days before mailing them to shareholders. During this 10-day period, the SEC staff comments on
the statements and sometimes asks for changes, usually because it believes that
not all material information has been included. Under its Rule 22, the commission requires proxy statements to carry several items of information, ranging
from a notice on the revocability of proxies to a notification of the interest that
the soliciting individuals or institutions have in the subject matter to be voted on.
The purpose of this procedure is to make sure that shareholders have full disclosure on a matter before they agree to any grant of their proxy. The SEC also
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requires companies to send shareholders a form on which they can mark their
approval or disapproval of the subject matter to be voted on. If a proxy is solicited for electing new directors, the shareholders must receive an annual report
of the corporation as well.
Shareholder Proposals. If a shareholder of a registered issuing company wishes
to place an item on the agenda, Rule 14(a)(8) requires that management be notified in a timely way before a regular shareholder meeting or a special meeting.
Once notified, management must include the proposal (200 words or fewer) in the
proxy statement it sends to all the shareholders. Management may also include its
own view on the proposal. Shareholder proposals in recent years have included
prohibitions against discrimination, pollution, dumping of wastes, “golden parachutes,” “poison pills,” and “greenmail” (the last three topics are discussed later in
this section under the heading “Remedies and Defensive Strategies”). In a sense,
proxy solicitation became a form of shareholder democracy—one that corporate
management felt was getting out of hand. After vigorous debate by all interested
groups, the SEC amended Rule 14(a) in 1983 to allow management to exclude a
shareholder proposal if:
1. under the particular state law governing the corporation, the proposal would
be unlawful if agreed to by the directors;
2. it involves a personal grievance;
3. it is related to ordinary operational business functions;
4. it is a matter not significantly related to the company’s business (the commission has defined this criterion as matters accounting for less than 5 percent of
the assets, earnings, and sales of a company);
5. the stockholder making the proposal has not owned more than $1,000 worth of
stock or 1 percent of the shares outstanding for a period of 1 year or more
(although several shareholders may accumulate shares to meet this criterion); and
6. the shareholder proposal received less than 5 percent of the votes when submitted in a previous year.
Furthermore, shareholders are limited to one proposal per annual company
meeting.
If management excludes a proposal, it must explain why, and the shareholder may then appeal to the SEC. The SEC staff decides whether the proposal
should be placed on the agenda for the next annual meeting. The Dodd-Frank
Act (examined earlier in this chapter) gives shareholders a nonbinding vote on
executive compensation as directed by the SEC (see Chapter 19).
Proxy Contests. Proxy contests normally come about when an insurgent group
of shareholders seeks to elect its own slate of candidates to the board of directors to replace management’s slate. Both insurgent shareholders and management may seek shareholder proxies in this contest.
The SEC has set out specific rules governing disclosure by insurgents and
management and the rights of each. An information statement must be filed by
the insurgents, disclosing all participants in their group and the background of
each, including past employment and any criminal history. In 2010 the SEC set
out the “proxy access” role which requires companies to include the names of all
board nominees (even those not backed by the company), directly on the standard ballots distributed before shareholder annual meetings. To win the right to
nominate, the investor or group of investors must own at least 3% of the company’s stock and have held shares for a minimum of three years. If dissident
shareholders wish to oust board members, current shareholders must foot the bill
for preparation and mailing of the official proxy for themselves and the dissidents.
Both criminal and civil liability attach to a company that sends a misleading proxy statement to its shareholders. The civil liability is based on a
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659
negligence standard (preponderance of the evidence). The SEC may, through
injunctive relief, prevent the solicitation of proxies or may declare an election
of directors, based on misleading proxies, to be invalid. Under the Insider
Trader Sanctions Act of 1984 (discussed later in this chapter), the commission
may also institute criminal and administrative proceedings against a company.
Furthermore, persons who rely on a misleading proxy statement to buy or sell
securities have the right to institute a private action, as do insurgent shareholders in a proxy fight.
TENDER OFFERS AND TAKEOVER BIDS
A series of hostile takeovers in the 1990s, and creative defensive strategies used
by management of some targeted companies, renewed concerned parties’ interest in the regulation of tender offers and takeover bids.
In a takeover bid, the acquiring company or individual, using a public
tender offer, seeks to purchase a controlling interest (51 percent) in another
company—the target company—which would lead to a takeover of that company’s board of directors and management. The acquiring company makes this
public offer in such national newspapers as the Wall Street Journal or the New
York Times to company shareholders, requesting that they tender their shares for
cash or for the acquiring company’s securities, or for both, usually at a price exceeding that quoted for the shares on a national exchange. Because of abuses in
the 1960s, when shareholders frequently were given only a short time to make
up their minds and, thus, could not properly evaluate tender offers, Congress enacted legislation to give shareholders more information and a longer period to
make a decision. This legislation became Sections 13 and 14 of the Securities
Exchange Act.
Rules Governing Tender Offers. Sections 13 and 14 together constitute the
regulatory framework for tender offers. Section 13 requires any person (or
group) that acquires more than 5 percent of any class of registered securities to
file within 10 days a statement with both the issuer (the target company) and the
SEC. This statement must set forth (1) the background of the acquiring person
or group, (2) the source of the funds used to acquire the 5 percent, (3) the purpose(s) of the acquisition of the stock, (4) the number of shares presently
owned, (5) any relevant contracts with the target company, and (6) plans of the
person or group for the targeted company.
Section 14 provides that no one may make a tender offer that results in ownership of more than 5 percent of a class of registered securities unless that person or group files with the SEC, and also with each offeree, a statement
containing information similar to that required by Section 13. It also restricts the
terms of the offer, particularly the right of withdrawal by the offerer and extensions or changes in the offer. The “best price” rule applies during tender offers
but only to consideration paid for past or future services.
The SEC has issued detailed rules concerning Section 14. For example,
even if the offer is a hostile bid—meaning that the management of the target
company opposes it—the target company must either mail the tender offer to
all shareholders or promptly forward a list of the shareholders to the tender offerer. Management must also, within 10 days of receiving a tender offer, state
whether it opposes or favors it or lacks enough information to make a judgment. SEC rules also compel management to file a form called Schedule 14-9.
Schedule 14-9 requires top managers to: (1) disclose whether they intend to
hold their shares in the company or tender them to the offerer; (2) describe
any agreements they may have made with the tender offerer; and (3) disclose,
if the tender offer is hostile, whether they have engaged in any negotiations
with a friendly or “white knight” company.
tender offer A public offer by
an individual or corporation
made directly to the
shareholders of another
corporation in an effort to
acquire the targeted
corporation at a specific price.
hostile bid A tender offer that
is opposed by the management
of the target company.
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Section 14 of the 1934 Act and SEC rules require that a tender offer be open
for at least 20 days so that shareholders will have a reasonable amount of time
to consider it. The SEC has also set out certain withdrawal rights for shareholders who have tendered their shares.
REMEDIES AND DEFENSIVE STRATEGIES
Remedies. Section 14(e) (known as the Williams Act) makes it a criminal offense to make an untrue or misleading statement or to engage in fraudulent
acts or deceptive practices in connection with a tender offer. The emphasis
here is on intent to deceive. Shareholders of a targeted company can bring civil
actions under Section 14(e) for violations of Sections 13(d) and 14(b) if they
can show that they have been injured because they relied on fraudulent statements in the tender offer. In addition, under the Insider Trader Sanctions Act
(discussed later in this section under “Securities Fraud”), the SEC may start administrative proceedings against violators, which is a much quicker remedy
than going to court.
In the landmark case that follows, in which the U.S. Supreme Court interpreted the meaning of Section 14(e) of the Securities Act, note the Court’s concern over the correct interpretation of the word manipulative, which is the basis
for causes of actions brought under this section.
CASE
24-2
Barbara Schreiber v. Burlington Northern, Inc.
472 U.S. 1 (1985)
P
etitioner Schreiber, on behalf of herself and other
shareholders of El Paso Gas Company, sued Respondent Burlington Northern, claiming that the company
had violated Section 14(e) of the Securities Exchange Act
of 1934. In December 1982, Burlington issued a hostile
tender offer for El Paso Gas Company. Burlington did not
accept the shares tendered by a majority of shareholders
of El Paso but instead rescinded the December offer and
substituted another offer for El Paso in January. The
rescission of the first tender offer resulted in a smaller
payment per share to El Paso shareholders who retendered after the January offer. The petitioners claimed
that Burlington’s withdrawal of the December tender offer and the substitution of the January offer were a “manipulative” distortion of the market for El Paso stock and
a violation of Section 14(e). The respondent argued that
“manipulative” acts under 14(e) require misrepresentation or nondisclosure and that no such acts had taken
place in this case. Therefore, the respondent moved for
dismissal of the case based on failure to state a cause of
action. The federal district court granted the motion for
dismissal. The court of appeals affirmed. Schreiber appealed to the U.S. Supreme Court.
Chief Justice Burger
We are asked in this case to interpret Section 14(e) of the
Securities Exchange Act. The starting point is the language
of the statute. Section 14(e) provides:
It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any
material fact necessary in order to make the statements made, in the light of the circumstances under
which they are made, not misleading, or to engage in
any fraudulent, deceptive or manipulative acts or
practices, in connection with any tender offer or request or invitation for tenders, or any solicitation of
security holders in opposition to or in favor of any
such offer, request, or invitation. The Commission
shall, for the purposes of this subsection, by rules and
regulations define, and prescribe means reasonably
designed to prevent, such acts and practices as are
fraudulent, deceptive, or manipulative.
Our conclusion that “manipulative” acts under Section
14(e) require misrepresentation or nondisclosure is
buttressed by the purpose and legislative history of the
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provision. Section 14(e) was originally added to the
Securities Exchange Act as part of the Williams Act.
It is clear that Congress relied primarily on disclosure to
implement the purpose of the Williams Act. Senator
Williams, the bill’s Senate sponsor, stated in the debate:
Today, the public shareholder in deciding whether to accept or reject a tender offer possesses limited information. No matter what he does, he acts without adequate
knowledge to enable him to decide rationally what is
the best course of action. This is precisely the dilemma
which our securities laws are designed to prevent.
The expressed legislative intent was to preserve a
neutral setting in which the contenders could fully present their arguments. To implement this objective, the
Williams Act added Sections 13(d), 13(e), 14(e), and 14(f)
to the Securities Exchange Act. Some relate to disclosure;
Sections 13(d), 14(d), and 14(f) all add specific registration and disclosure provisions. Others—Sections 13(e)
and 14(d)—require or prohibit certain acts so that investors will possess additional time within which to
take advantage of the disclosed information.
To adopt the reading of the term “manipulative” urged
by petitioner would not only be unwarranted in light of the
legislative purpose but would be at odds with it. Inviting
judges to read the term “manipulative” with their own
sense of what constitutes “unfair” or “artificial” conduct
would inject uncertainty into the tender offer process. An
661
essential piece of information—whether the court would
deem the fully disclosed actions of one side or the other to
be “manipulative”—would not be available until after the
tender offer had closed.
This uncertainty would directly contradict the expressed
Congressional desire to give investors full information.
Congress’s consistent emphasis on disclosure persuades
us that it intended takeover contests to be addressed to shareholders. In pursuit of this goal, Congress, consistent with the
core mechanism of the Securities Exchange Act, created
sweeping disclosure requirements and narrow substantive
safeguards. The same Congress that placed such emphasis on
shareholder choice would not at the same time have required
judges to oversee tender offers for substantive fairness.
We hold that the term “manipulative”as used in Section
14(e) requires misrepresentation or nondisclosure. It connotes “conduct designed to deceive or defraud investors
by controlling or artificially affecting the price of securities.”Ernst & Ernst v. Hochfelder, 425 U.S., at 199. Without
misrepresentation or nondisclosure, Section 14(e) has not
been violated.
Applying that definition to this case, we hold that the
actions of respondents were not manipulative. The
amended complaint fails to allege that the cancellation of
the first tender offer was accompanied by any misrepresentation, nondisclosure, or deception.
Affirmed in favor of Defendant, Burlington Northern.
Sometimes ambiguity is present in the court’s own reasoning; for example, a judge might argue that a “reasonable”
person would not be offended by sexual advances made by a fellow employee. At other times, the court must interpret
ambiguity in congressional legislation to make a legal judgment.
Case 24-2 deals with the second of those judicial confrontations with ambiguity. It is important to be aware not
only of the Court’s interpretation of an ambiguity, but also of the evidence it selects to support that interpretation. The
very fact that an important term is ambiguous means that there might be other legitimate interpretations; thus, in judging whether you agree with the particular interpretation at hand, you must evaluate the evidence presented for it. It
is also important to recognize the primary ethical norm that informed the Court’s interpretation. The following
questions address those considerations.
1.
What legislative ambiguity was the Court dealing with in Case 24-2?
Clue: The meaning of this term is the central issue of the case.
2.
Specifically, to what evidence did the Court refer to support its own interpretation of the ambiguity?
Clue: Reread the paragraph immediately following the quotation from Section 14(e).
3.
In supporting its strict interpretation of legislative ambiguity, the Court stated that Congress intended to leave
issues of fairness up to shareholders and not judges, making full disclosure the most important consideration. In
this prioritization of the liberty (of shareholders) over potentially more just outcomes (allowing judges to decide
fairness), one might argue that the primary ethical norm of liberty drove the Court’s reasoning. What other primary ethical norm is implicit in this prioritization?
Clue: Consider the primary ethical norm that would be damaged if judges decided fairness (especially with the
inevitable increase in court cases).
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Defensive Strategies. The business judgment rule, which we discussed in
Chapter 18, is based primarily on the 50 states’ case law and the Revised Model
Business Corporations Act. It has traditionally allowed wide latitude to the managers of targeted companies, as long as they act in good faith in the best interests
of shareholders, do not waste the corporate assets, and do not enter into conflictof-interest situations.
Here is a list of defensive strategies that managements of targeted companies have used to repel hostile takeovers in recent years.
• Awarding large compensation packages (golden parachutes) to target-company
management when a takeover is rumored.
• Issuing new classes of securities before or during a takeover battle that require a tender offerer to pay much more than the market price for the stock
(poison pill).
• Buying out a “hostile” shareholder at a price far above the current market
price of the target company’s stock in exchange for the hostile shareholder’s
agreement not to buy more shares for a period of time (greenmail). Congress
has now eliminated this defense by legislation.
• Writing supermajority requirements for merger approval into the bylaws and
articles of incorporation (porcupine provisions).
• Issuing treasury shares (stock that was repurchased by the issuing corporation) to friendly parties.
• Moving to states with strong antitakeover (shark repellent) laws.
• Bankrupting the company (scorched-earth policy).
• Prevailing upon another company or individual (a white knight) to buy out
the hostile bidder to prevent the undesirable takeover.
Competition between State Legislatures
Antitakeover Regulations
With more than 40 states having statutes that seek to regulate takeovers, it is wise to
note that target companies often have sought protection from takeovers by lobbying with state legislatures for detailed regulatory or antitakeover statutes. There are
several types of state statutes:
• Statutes similar to the Williams Act (see Section 14 of the 1934 Act).
• Statutes that allow the state legislature to review the merits of a tender offer
and/or the adequacy of disclosure. Many of these exempt tender offers that are
supported by the target company’s management. Strong lobbying is often involved here.
• Statutes that require “fair prices” Acquirers must pay all shareholders the highest price paid to any shareholders.
• Statutes that prohibit transactions with an acquirer for a specified period of time
after a change in control, unless disinterested shareholders approve.
This has led to some debate as to whether such statutes are in the best interest
of shareholders (e.g., pension funds, insurance companies, and large institutional
shareholders) or voters. Such statutes may be in the short-term interest of a company located in state X, but may be contrary to the best interests of the population
of the state when Company Y is looking for a place to locate. There are arguments
from both sides as to whether such regulatory statutes are helpful when states are
competing to obtain corporate opportunities and the jobs that go with them.
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663
SECURITIES FRAUD
The courts have had a difficult time defining securities fraud. An appellate court
once stated:
Fraud is infinite, and were a Court of Equity once to lay down rules, how far they
would go, and no further, in extending their relief against it, or to define strictly
the species or evidence of it, the jurisdiction would be cramped, and perpetually
eluded by new schemes which the fertility of man’s invention would contrive.
This is the philosophical position that has been adopted by the SEC: There cannot be a law against every type of fraud imaginable. Instead, the SEC staff has
sought to use Section 10(b) of the Securities Act broadly, going beyond its exact
language to develop a “fraud-on-the-market” theory that does not require the
investor-plaintiff ever to have relied on false documents or specific acts, but only
on the integrity of the market and a fair stock price.
Section 10(b) of the Securities Exchange Act. One of the purposes of the
Securities Exchange Act of 1934 was to ensure the full disclosure of all material
information to potential investors. Full disclosure enables the market mechanism
to operate efficiently and ensures that consumers are provided with a fair price
for securities. Section 10(b) prohibits the use of the mails or other facilities
(e.g., truck or car and satellite or data transmission) in interstate commerce
in connection with the purchase or sale of any security, any manipulative or
deceptive device or contrivance in contravention of such rules and regulations
as the Commission may prescribe as necessary or appropriate in the public
interest or for the protection of investors.
This broad statutory language signals a congressional intent to cover all possible forms of fraud. To that end,
it shall be unlawful for any person, directly or indirectly, by the use of any
means or instrumentality of interstate commerce, or of the mails, or of any
facility of any national securities exchange, (1) to employ any device, scheme,
or artifice to defraud, (2) to make any untrue statement of a material fact
necessary in order to make the statements made, in the light of circumstances
under which they were made, not misleading or (3) to engage in any act,
practice, or course of business which operates or would operate as a fraud or
deceit upon any person, in connection with the purchase or sale of any security.
A private party’s standing to sue under Section 10(b) and associated SEC Rule
10(b)-5 has been upheld in cases in which manipulative or deceptive acts were
committed in connection with the purchase or sale of securities. The question of
standing that the Supreme Court answers again in the following case is whether
civil liability under Rule 10(b)-5 extends also to those who aid and abet violators. Additionally, the Court denies the use of a “fraud-on-the-market theory” set
forth by the plaintiff to prove an essential element of fraud.
CASE
24-3
Stoneridge Investment Partners, LLC, et al. v. Scientific-Atlanta Inc., et al.
552 U.S. 148 (2008)
S
toneridge et al. (plaintiff-petitioners) were investors
in this class action suit filed against ScientificAtlanta, Charter Communications, and others (defendantrespondents) in the U.S. district court based upon
alleged violation of Section 10(b) of the Securities
Exchange Act of 1934 and Rule 10(b)-5. Acting as Charter customers and suppliers, respondents had agreed to
arrangements that allowed Charter to mislead its auditor
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and issue a misleading financial statement affecting its
stock price, but they had no role in preparing or disseminating the financial statement. Affirming the district
court’s dismissal of the respondents, the Eighth Circuit
ruled that the allegations did not show that the respondents had made misstatements relied upon by the public
or violated a duty to disclose. The circuit court observed
that, at most, the respondents had aided and abetted
Charter’s misstatement, and noted that the private cause
of action the Supreme Court had found implied in Section 10(b) and Rule 10(b)-5, in Superintendent of Insurance of New York v. Bankers Life & Casualty Co., 404
U.S. 6, 13 n.9, did not extend to aiding and abetting a Section 10(b) violation. See Central Bank of Denver, N. A. v.
First Interstate Bank of Denver, N. A., 511 U.S. 164, 191
(1994).
Justice Kennedy
In a typical §10(b) private action a plaintiff must prove
(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a
security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.
In Central Bank, the Court determined that §10(b) liability did not extend to aiders and abettors. The Court
found the scope of §10b to be delimited by the text, which
makes no mention of aiding and abetting liability. The
court doubted the implied §10(b) action should extend to
aiders and abettors when none of the express causes of action in the securities Acts included that liability.
The decision in Central Bank led to calls for Congress
to create an express cause of action for aiding and abetting
within the Securities Exchange Act. Then-SEC Chairman
Arthur Levitt, testifying before the Senate Securities Subcommittee, cited Central Bank and recommended that
aiding and abetting liability in private claims be established. Congress did not follow this course. Instead, in
§104 of the Private Securities Litigation Reform Act of
1995 (PSLRA), it directed prosecution of aiders and abettors by the SEC. 15 U.S.C. §78t(e).
The §10(b) implied private right of action does not extend to aiders and abettors. The conduct of a secondary actor must satisfy each of the elements or preconditions for
liability; and we consider whether the allegations here are
sufficient to do so.
Reliance by the plaintiff upon the defendant’s deceptive acts is an essential element of the §10(b) private
cause of action. It ensures that, for liability to arise, the
“requisite causal connection between a defendant’s
misrepresentation and a plaintiff’s injury” exists as a
predicate for liability. We have found a rebuttable presumption of reliance in two different circumstances.
First, if there is an omission of a material fact by one with
a duty to disclose, the investor to whom the duty was
owed need not provide specific proof of reliance.
Second, under the fraud-on-the-market doctrine, reliance
is presumed when the statements at issue become public. The public information is reflected in the market
price of the security. Then it can be assumed that an investor who buys or sells stock at the market price relies
upon the statement.
Neither presumption applies here. Respondents had no
duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of
respondents’ deceptive acts during the relevant times. Petitioner, as a result, cannot show reliance upon any of respondents’ actions except in an indirect chain that we find
too remote for liability.
Invoking what some courts call “scheme liability,” see,
e.g., In re Enron Corp. Securities, Derivative, & “ERISA”
Litigation, 439 F. Supp. 2d 692, 723 (S.D. Tex. 2006),
petitioner nonetheless seeks to impose liability on respondents even absent a public statement. In our view
this approach does not answer the objection that petitioner did not in fact rely upon respondents’ own deceptive conduct.
Liability is appropriate, petitioner contends, because respondents engaged in conduct with the purpose and effect
of creating a false appearance of material fact to further a
scheme to misrepresent Charter’s revenue. The argument
is that the financial statement Charter released to the public was a natural and expected consequence of respondents’ deceptive acts; had respondents not assisted
Charter, Charter’s auditor would not have been fooled, and
the financial statement would have been a more accurate
reflection of Charter’s financial condition. That causal link
is sufficient, petitioner argues, to apply a presumption of
reliance to respondents’ acts.
In effect petitioner contends that in an efficient market
investors rely not only upon the public statements relating
to a security but also upon the transactions those statements reflect. Were this concept of reliance to be adopted,
the implied cause of action would reach the whole marketplace in which the issuing company does business; and
there is no authority for this rule.
Petitioner’s theory would put an unsupportable interpretation on Congress’ specific response to Central Bank
in §104 of the PSLRA. Congress amended the securities
laws to provide for limited coverage of aiders and abettors.
Aiding and abetting liability is authorized in actions
brought by the SEC but not by private parties. See 15
U.S.C. §78t(e). Petitioner’s view of primary liability makes
any aider and abettor liable under §10(b) if he or she committed a deceptive act in the process of providing assistance. Were we to adopt this construction of §10(b), it
would revive in substance the implied cause of action
against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud;
and we would undermine Congress’ determination that
this class of defendants should be pursued by the SEC and
not by private litigants.
Affirmed in Favor of Defendants, Scientific-Atlanta,
Charter Communications (et al.).
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665
COMMENT: One week after this case, the U.S. Supreme Court denied a petition for review in the In re Enron Corporation, Securities, Derivative, & ERISA
Litigation case cited in the excerpt. This denial of further review signaled the
end of the Enron bankruptcy case, which led to the criminal sentencing of
several top executives of the company. It should be noted that in both this
case and in Enron there was a conflict between federal circuit courts of appeals, which led to the U.S. Supreme Court decision excerpted here. Following the precedent of Denver Central Bank, it appears that with this case a
majority of the court (5–3 decision) seeks to limit private rights of action in
securities class action cases to the four preconditions of liability outlined here
by the Court.
The plaintiffs in this case (Stoneridge et al.) sought to portray the defendants (Scientific-Atlanta, Charter Communications, et al.) as primary violators under the theory that they participated in a “scheme” to defraud.
1.
The Supreme Court rejected this theory for several reasons outlined in this case. What are those reasons? Explain.
2.
Are these defrauders (defendants) to be allowed to get away with this? If not, how are they to be brought to
justice?
In Skilling v. United States (130 S. Ct. 2836 [2010]), the U.S. Supreme Court,
in a criminal case, held a law unconstitutional that makes it a crime to deprive
the public or shareholders of the “intangible right to honest services.” The court
stated that such a law applies only to bribery and kickbacks. This decision invalidated part of the conviction of former Enron executive Jeffrey Skilling.
The use of Section 10(b) and Rule 10(b)-5 has been controversial in three major areas of securities fraud: insider trading, misstatements by corporate management, and mismanagement of a corporation (Table 24-4). After exploring each of
these areas in turn, we will say something about a new concept that shareholder
suits based on fraud have been invoking: fraud-on-the-market theory.
Insider Trading and Section 10(b) of the Securities Act. Insider trading is
the use of material, nonpublic information received from a corporate source by
an individual who has a fiduciary obligation to shareholders and potential investors and who benefits from trading on such information. Insiders have been
found by the courts to be (1) officers and directors of a corporation, (2) partners
in investment banking and brokerage firms, (3) attorneys in a retained law firm,
Activity
Definition
Insider trading
The use of nonpublic information received from a corporate source by an
individual(s) who has a fiduciary obligation to shareholders and potential
investors and who benefits from trading on such information.
Any report, release, financial statement, or any other statement that is
released by an officer, director, or employee of a corporation in connection
with the purchase or sale of a security that shows an intent to mislead
shareholders or potential investors.
Any transaction involving the purchase or sale of a security in which there is
fraud based on an action of management. The plaintiff must be either a
purchaser or a seller of securities in such a transaction.
Misstatement of
corporation
Corporate
mismanagement
insider trading The use of
material, nonpublic information
received from a corporate
source by someone who has a
fiduciary obligation to
shareholders and potential
investors and who benefits
from trading on such
information.
TABLE 24-4
SECURITIES FRAUD UNDER
SECTION 10(B) OF THE
SECURITIES EXCHANGE
ACT OF 1934
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Insiders: Who Are They?
The Key Inside Players
These are the ones directly responsible for setting up the mergers and acquisitions that will have a significant effect on
stock.
The CEO
Vice Chairman
Board of Directors
General Counsel
A Host of Other Related Insiders
A host of people outside the firm have information about key transactions long before the public knows.
Research Analysts from
Investment Banks
Merger and Acquisition
Teams
Law Firms
Public Relations
Proxy Solicitors
Secretaries
Friends and Relatives of Key Players who get information from the players.
EXHIBIT 24-3
INSIDER TRADERS
(4) underwriters and broker-dealers, (5) financial reporters, and (6) in a unique
case, an employee of a financial printing firm that printed documents for a tender
offer. (See Exhibit 24-3 for a look at Wall Street’s army of insiders, from the general to the grunts.)
“Holy Toledo”: Securities Fraud May Be Easy
On April 29, 1999, Martin Frankel, a high-school graduate and a native of Toledo, Ohio,
absconded with a reputed $335 million. A string of eight insurance companies in several southern states had provided Mr. Frankel with large sums of money to invest, in
his capacity as founder of “Thunor Trust.” The con was uncovered when the Franklin
American Corporation, owner of these insurance companies, introduced Frankel as a
prominent bond trader on April 28, 1999. After failing to attend a meeting with regulators, Frankel wired $334.6 million of Franklin American’s money to a foreign bank
account. Additionally, he burned all the documents at his Greenwich, Connecticut,
mansion, creating a suspicious fire that led to a police search. He then fled to Europe,
ending up in jail in Germany. After a period of six months, he was extradited to the
United States and was convicted of fraud charges after pleading guilty. Five states
sought roughly $215 million, which Frankel was charged with stealing. Approximately $9 million was received at an auction of 822 diamonds seized from Frankel. On
December 10, 2004, he was sentenced to a federal prison for 16 years, 6 months.
Unlike convicted felons Ivan Boesky and Michael Milken, Frankel was not a highprofile individual. The use of aliases and the pretension of being a multimillionaire
were all that was required. The fact that he used state-regulated insurance
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667
companies in this case may have helped the scheme. The SEC and the Justice
Department did not become involved until he fled the country.
Sources: L. Mergener, “Frankel Gets 16 Years for Fraud,” The Blade, December 11, 2004, 1;
A. Cowan, “Onetime Fugitive Gets 17 Years for Looting Insurers,”New York Times, December 11,
2004, PB–3; L. Vellequette, “Frankel to Be Subject of CNBC Show,” The Blade, March 18,
2008, 27.
The expansion of targets in insider-trading cases, from management and corporate directors to a Wall Street Journal reporter and a printer employee, has resulted from the SEC enforcement staff’s determination that in order to provide full
disclosure in the marketplace for potential investors, it had to extend its jurisdiction over tippers (insiders) and tippees (those who receive tips from insiders).
Misstatements of Corporations and Section 10(b). The second area of controversy regarding Section 10(b) application involves statements by corporate executives. Any report, release, or financial statement or any other statement that
sets forth material information (information that would affect the judgment of the
average prudent investor) falls within Section 10(b).
Whereas Sections 13 and 14 of the Exchange Act (discussed earlier) apply
only to reports, proxy statements, and other documents filed by a company registered with the SEC and a national exchange, Rule 10(b)-5 applies to any statement made by any issuer, registered or not. To be considered a securities fraud,
corporate misstatements must meet two requirements: (1) they must be issued
“in connection with the purchase or sale of any security,” and (2) there must be
a showing of scienter (intent). As you read the following case, try to determine
how closely the defendants met those requirements.
scienter Knowledge that a
representation is false.
Economics: Efficient Markets
In microeconomics, you learned that the law of supply and demand brings about equilibrium price levels, assuming a free flow of information and mobility of resources. These factors will create efficient markets.
Microeconomics presents an important link to securities law. When plaintiffs argue a fraud-on-the-market theory, they are arguing that there is a distortion or omission of information and, thus, the purchase or sale of the
security is subject to fraud and a violation of securities law.
CASE
24-4
Securities and Exchange Commission v. Texas Gulf Sulphur Co.
United States Court of Appeals
401 F.2d 833 (2d Cir. 1968)
T
he SEC (plaintiff) brought an action against the Texas
Gulf Sulphur Company (TGS) and 13 of its directors, officers, and employees (defendants) for violation of Section
10(b) of the Exchange Act and SEC Rule 10(b)-5, seeking an
injunction against further misleading press releases and requesting rescission of the defendants’ purchases and stock
options. On June 6, 1963, TGS had acquired an option to
buy 160 acres of land in Timmons, Ontario. On November 11,
1963, preliminary drilling indicated that there would be
major copper and zinc finds. TGS acquired the land and resumed drilling on March 31, 1964, and by April 8, it was evident that there were substantial copper and zinc deposits.
On April 9, Toronto and New York newspapers reported
that TGS had discovered “one of the largest copper deposits
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in America.” On April 12, TGS’s management said that the
rumors of a major find were without factual basis. At 10:00 AM
on April 14, the board of directors authorized the issuance
of a statement confirming the copper and zinc finds and announcing the discovery of silver deposits as well. On April
20, the NYSE announced that it “was barring stop orders
[orders to brokers to buy a stock if its price rises to a certain
level to lock in profits in case of a sharp rally in that stock]
in Texas Gulf Sulphur” because of the extreme volatility in
the trading of the stock.
Approximately one month later, rumors circulated
about insider trading. It was later found that when drilling
began on November 12, 1963, TGS’s directors, officers,
and employees owned only 1,135 shares of stock in the
company and had no calls (options to purchase shares at a
fixed price). By March 31, 1964, when drilling resumed, insiders (tippers) and their tippees had acquired an additional 7,100 shares and 12,300 calls. On February 20, 1964,
TGS had issued stock options to three officers and two
other employees as part of a compensation package.
From April 9, 1964, to April 14, 1964, when the confirmatory press release was issued, 10 insiders and their
tippees made estimated profits of $273,892 on the purchase of their shares or calls of TGS stock. The federal district court dismissed charges against all but two
defendants. Those defendants, Clayton and Crawford, appealed, and the SEC appealed from the part of the district
court decision that had dismissed the complaint against
TGS and the nine other individual defendants.
Judge Waterman
Rule 10(b)-5 was promulgated pursuant to the grant of authority given the SEC by Congress in Section 10(b) of the
Securities Exchange Act of 1934. By that Act Congress proposed to prevent inequitable and unfair practices and to
ensure fairness in securities transactions generally,
whether conducted face-to-face, over the counter, or on
exchanges. The Act and the Rule apply to the transactions
here, all of which were consummated on exchanges.
The essence of the Rule is that anyone who, trading for
his own account in the securities of a corporation, has “access, directly or indirectly, to information intended to be
available only for a corporate purpose and not for the personal benefit of anyone” may not take “advantage of such
information knowing it is unavailable to those with whom
he is dealing,” i.e., the investing public. Insiders, as directors or management officers, are, of course, by this Rule,
precluded from so unfairly dealing, but the Rule is also applicable to one possessing the information who may not be
strictly termed an “insider” within the means of Sec. 10(b)
of the Act. Thus, anyone in possession of material inside
information must either disclose it to the investing public,
or, if he is disabled from disclosing it in order to protect
a corporate confidence, or he chooses not to do so, must
abstain from trading in or recommending the securities
concerned while such insider information remains undisclosed. So, it is here no justification for insider activity
that disclosure was forbidden by the legitimate corporate
objective of acquiring options to purchase the land surrounding the exploration site; if the information was, as
the SEC contends, material, its possessors should have
kept out of the market until disclosure was accomplished.
As we stated in List v. Fashion Park, Inc., “The basic test
of materiality is whether a reasonable man would attach
importance in determining his choice of action in the
transaction in question.” This, of course, encompasses any
fact “which in reasonable and objective contemplation
might affect the value of the corporation’s stock or securities.” Such a fact is a material fact and must be effectively
disclosed to the investing public prior to the commencement of insider trading in the corporation’s securities. The
speculators and chartists of Wall and Bay Streets are also
“reasonable”investors entitled to the same legal protection
afforded conservative traders. Thus, material facts include
not only information disclosing the earnings and distributions of a company but also those facts which affect the
probable future of the company and those which may
affect the desire of investors to buy, sell, or hold the company’s securities.
The core of Rule 10(b)-5 is the implementation of the
Congressional purpose that all investors should have equal
access to the rewards of participation in securities transactions. It was the intent of Congress that all members of the
investing public should be subject to identical market
risks—which market risks include, of course, the risk that
one’s evaluative capacity or one’s capital available to put at
risk may exceed another’s capacity or capital. The insiders
here were not trading on an equal footing with the outside
investors. They alone were in a position to evaluate the
probability and magnitude of what seemed from the outset
to be a major ore strike; they alone could invest safely, secure in the expectation that the price of TGS stock would
rise substantially in the event such a major strike should materialize, but would decline little, if at all, in the event of failure, for the public, ignorant at the outset of the favorable
probabilities, would likewise be unaware of the unproductive exploration, and the additional exploration costs would
not significantly affect TGS market prices. Such inequities
based upon unequal access to knowledge should not be
shrugged off as inevitable in our way of life, or, in view of
the congressional concern in the area, remain uncorrected.
We hold, therefore, that all transactions in TGS stock or
calls by individuals apprised of the drilling results of K-55-1
were made in violation of Rule 10(b)-5.
Reversed and remanded in favor of Plaintiff, SEC.
Corporate Mismanagement and Section 10(b). The third controversial area
of securities fraud under Section 10(b) is corporate mismanagement. Suits alleging corporate mismanagement and fraud brought by minority shareholders in
class action or derivative suits must prove three elements: (1) that the transaction being attacked (e.g., the sale of a controlling stock interest in a corporation
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at a premium) involves the purchase or sale of securities, (2) that the alleged
fraud is in connection with a purchase or sale, and (3) that the plaintiff is either
a purchaser or a seller of securities in the transaction involved. The Hochfelder
case, referred to in the Schreiber case excerpted earlier in this chapter, is an example of fraud perpetrated on shareholders by management. Other cases alleging fraud dealing with reorganizations and mergers have been brought, but since
the mid-1970s, the Supreme Court has been reluctant to allow cases brought under Section 10(b) to preempt state laws and, thus, has made plaintiffs meet all
three elements in an exacting manner.
Fraud-on-the-Market Theory and Section 10(b). The Supreme Court has attached stringent criteria to all private-party actions brought under Section 10(b)-5
and SEC Rule 10(b)-5. Defrauded investors generally need to show that their
losses resulted from specific conduct of the company or its employees or agents
and that they relied on specific misstatements, omissions, or fraudulent actions in
making investment decisions. More recently, shareholders have used an efficientmarket concept as the basis for suits claiming fraud. That is, they have alleged
that they relied on the integrity of an efficient market to assimilate all information about a company and to reflect this information in a fair price for securities.
The plaintiff in such a suit argues that when a company makes fraudulent
disclosures or omissions, it distorts the information flow to the market and thus
fixes the price of the company’s securities too high, in violation of Section 10(b)
and Rule 10(b)-5. This fraud-on-the-market theory assumes that the market
price reflects all known material information. In a landmark decision (United
States v. James O’Hagan 117 S.Ct. 2199 (1997)) the U.S. Supreme Court upheld
this theory.
LIABILITY AND REMEDIES UNDER THE 1934 EXCHANGE ACT
Criminal Penalties. Violations of Section 10(b) and Rule 10(b) may lead individuals to be fined up to $5 million or imprisoned up to 20 years or both under
the Sarbanes-Oxley Act discussed earlier in this chapter. A partnership or corporation may be fined $25 million for a proven willful violation. The violator may
be imprisoned for 25 years, plus a fine. The SEC must refer all criminal action to
the Justice Department.
SEC Action. Under the Insider Trading Sanctions Act of 198410 and the Insider
Trading and Securities Enforcement Act of 1988, the SEC may bring a civil suit
against anyone violating or aiding or abetting a violation of the 1934 Act or an
SEC rule by purchasing or selling a security while in possession of material, nonpublic information. Violations must occur on or through a national securities exchange or from or through a broker or dealer. If the defendant is found liable,
the court may impose a fine in an amount triple (treble) the profits that were
gained illegally.
The Insider Trading and Securities Fraud Enforcement Act of 1988 enlarged
the class of people who may be subject to civil liability for insider trading. Also,
bonus payments can be given to anyone providing information leading to the
prosecution of insider-trading violations.11
Private Actions. Private parties may sue violators under Rule 10-5 and Section
10(b). Potential violators include accountants, attorneys, and others who aid and
abet violations of Section 10(b). As noted later in this chapter, a corporation can
bring an action to recover short-swing profits under Section 16(b). Under Section
10(b), a private plaintiff may seek rescission of a securities contract or recover
10
11
15 U.S.C. § 78u(d)(2)(A).
15 U.S.C. § 78u-1.
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damages for breach by disgorgement of illegal profits gained. In the following
case, the U.S. Supreme Court emphasizes the role of a private plaintiff in actions
for securities fraud violations.
CASE
24-5
The Wharf (Holdings) Limited v. United International Holdings, Inc.
121 S. Ct. 1776 (2001)
U
nited International Holding, Inc., sued the Wharf
(Holdings) Limited in federal district court for securities fraud for violating Section 10(b) and Rule 10(6)-5 of
the 1934 Exchange Act.
The Wharf (Holdings) Limited is a Hong Kong firm that
was interested in obtaining a license to operate a cable television system in Hong Kong. In 1991, the Hong Kong government announced that it would accept bids for the
award of an exclusive license to operate a cable television
system in Hong Kong. Wharf decided to find a business
partner with cable system experience. Wharf located
United International Holdings, Inc., a Colorado-based company with substantial experience in operating cable television systems. Wharf orally agreed to grant United an
option to buy 10 percent of the stock of the new Hong
Kong cable system if Wharf was awarded the license.
In May 1993, Hong Kong awarded the cable franchise
to Wharf. When United raised $66 million and tried to exercise its option to invest 10 percent in the new cable
company, Wharf refused to permit United to buy any of
the new company’s stock. Documents and other evidence
showed that at the time Wharf orally granted United the
10 percent stock option, it had not intended ever to sell
United any stock in the new venture. The jury held for
United and awarded it $67 million in compensatory damages and $58.5 million in punitive damages against Wharf.
The court of appeals affirmed. The U.S. Supreme Court
granted review.
Justice Breyer
Wharf points out that its agreement to grant United an option to purchase shares in the cable system was an oral
agreement. And it says that Section 10(b) does not cover
oral contracts of sale. There is no convincing reason to interpret the Act to exclude oral contracts as a class. The Act
itself says that it applies to “any contract” for the purchase
or sale of a security. Oral contracts for the sale of securities
are sufficiently common that the Uniform Commercial
Code and statutes of frauds in every State now consider
them enforceable. To sell an option while secretly intending not to permit the option’s exercise is misleading, because a buyer normally presumes good faith. Since Wharf
did not intend to honor the option, the option was, unbeknownst to United, valueless.
Affirmed for Plaintiff, United.
SHORT-SWING PROFITS
short-swing profits Profits
made by directors, officers, or
owners of 10 percent or more
of the securities of a
corporation as a result of
buying and selling the
securities within a 6-month
period.
Purpose and Coverage. Section 16(b) of the Exchange Act seeks to further the
goal of complete disclosure of insider trading by requiring directors, officers, and
owners of more than 10 percent of a class of stock of a registered company to
file regular reports with the SEC and the exchanges on which the stock trades.
Directors and officers must file an initial statement of their holdings in the company when they take office, and the others must file when they come to own
more than 10 percent. A follow-up statement is due monthly if they change their
holdings in any manner. Any profits made by a director or officer or a 10 percent beneficial owner as a result of buying and selling the securities within a
6-month period—known as short-swing profits—are presumed to be based on
insider information. A plaintiff does not have to show that these insiders had access to, relied on, or took advantage of any insider information. In 1991, the SEC
adopted new rules relating to Section 16 that (1) created a new form (Form 5)
that must be filed by all insiders within 45 days of the end of the issuer’s calendar year; (2) waive liability for insiders for transactions that occur within
6 months of becoming an insider; (3) make the acquisition of a derivative
security (e.g., warrant) fall under Section 16; and (4) define an officer under
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Section 16 as a person who has a policy function (e.g., CEO, president, and vice
president). Now those company officers who handle day-to-day operations do
not fall under Section 16.
Insider Trading Worldwide
Over the past 20 years, insider trading has been vigorously prosecuted. From 1995 to 2005, the stock markets of
Britain, Germany, France, Italy, and Switzerland had only 19 criminal convictions. In the United States, the total
for Manhattan alone during the same time period was 46 convictions. Britain had only three in this time frame.
France had none. From a comparative viewpoint, why the differences in convictions, and what are the implications for people doing business in the United States as opposed to other nations?
The United States has uniform requirements for disclosure for primary offerings and proxy voting. Practices
outside the United States are not uniform.a Further, the regulatory framework set out by the United States is in
sharp contrast to the European and Japanese frameworks. Enforcement is weak with regard to insider trading in
many countries. The following chart compares just the size of regulatory staffs of securities agencies in various
countries.
Country
Staff
Listed Companies
Austria
Belgium
Denmark
Europe
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Sweden
Switzerland
United Kingdom
United States
30
80
20
1,616
27
219
130
65
10
403
5
43
112
92
50
30
200
2,807
96
156
242
6,483
129
784
741
246
78
239
53
214
135
481
258
232
2,399
6,850
Some Comparative Results
From a comparative viewpoint, it is very difficult for U.S. companies and U.S. citizens to believe that laws dealing with insider trading are not the same in civil law, socialist, or emerging nations’ legal systems. Often, they
know only vaguely about their own laws dealing with insider trading (unless advised by specialized counsel),
much less about those of other nations. They are shocked when they are cited for violations of many securities
laws outlined in this chapter (e.g., the FCPA of 1977 as amended) or of laws of other nations.
Even more striking is the globalization of insider trading when it is alleged to have taken place in another country that has a weak insider-trading regulatory structure (e.g., Pakistan). When a foreign citizen takes part in insider
trading on a U.S. exchange following a tip by another foreign citizen, both are stunned when the U.S. Justice
Department charges them with insider trading for which criminal penalties are possible.b The SEC and Justice Department have entered into separate agreements with several nations for assistance in enforcing U.S. securities laws.
a
L. Thomas M. deMercedi, “Insider Trading Can Now Touch Many Corners of the World,” New York Times, August 4,
2007, C-1.
b
H. Immons and K. Bennhold, “Call for Foreigners to Have a Say on U.S. Market Rules,” New York Times, August 29,
2007, C-1.
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Liability. Suits based on short-swing profits seek to force the insiders to return
the profits to the corporation. Only the issuers—meaning the directors and officers of the corporation—and the shareholders have standing to sue. Officers and
directors generally do not sue other officers and directors, so virtually all suits
are brought by other shareholders. The expense of such litigation, however,
makes use of this enforcement action infrequent.
State Securities Laws
State securities laws, often referred to as “blue sky” laws, regulate securities
purchased and sold in intrastate commerce. Securities are regulated (concurrently) by both state and federal laws. State laws require that securities be registered (or qualified) with both federal and state authorities. There is usually
a state official or office so designated. State disclosure requirements and
antifraud provisions are similar both to each other and to their federal counterparts, such as the Securities Exchange Act of 1934, SEC Rule 10(b), and
Section 10(b).
The Uniform Securities Act has been adopted in part by some states in order to bring uniformity to state security laws. The 1995 National Securities
Markets Improvement Act limited regulation of investment companies to the SEC
and did away with some state authority in this area.
E-Commerce, Online Securities Disclosure,
and Fraud Regulation
MARKETPLACE OF SECURITIES
The Internet is now used daily to register securities. Online IPOs are a frequent
occurrence that has brought efficiency (in economic terms) to the marketplace
of securities. Small companies in particular use the Internet to avoid paying commissions to brokers or underwriters. Regulation A, discussed in this chapter, allows a simple method of registration.
In addition to using the Internet to provide information (e.g., 10-K) to the
SEC as required by the 1933 and 1934 Acts, as well as others, potential investors
receive information more rapidly and are willing to take advantage of this to purchase or sell securities. Online filing of many documents with the SEC is now
routine for most large corporations, which benefit by the additional time given
to them that did not exist when they had to use “snail mail.”
Furthermore, investors and companies can take advantage of the EDGAR
database, which includes proxy statements, annual corporate reports, and a multitude of other documents that are filed with the commission. All of this allows
the SEC to accomplish its goal of full disclosure.
E-COMMERCE AND FRAUD IN THE MARKETPLACE
The SEC continues to deal with fraud in the marketplace via the Internet. Chat
rooms in particular have become cyberworld locations for violations of the 1933
and 1934 Securities Acts. Often, a stock price is “pumped up” as a result of information obtained in chat rooms. After it is “pumped,” it is quickly “dumped.”
The SEC has been tracing such actions that seek to manipulate stock prices in
violation of the 1934 Exchange Act. As noted in our discussion of the SarbanesOxley Act, penalties can be costly, not only in dollar terms but also in possible
prison time.
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Global Dimensions of Rules Governing
the Issuance and Trading of Securities
The growing internationalization of money and securities markets has made it
important to understand the transnational reach of U.S. securities regulations.
Both the 1933 Act and the Exchange Act speak of the use of “facilities or instrumentation in interstate commerce.” Interstate commerce is defined in the
1933 Act to include “commerce between any foreign country and the United
States.”
This section discusses (1) legislation prohibiting certain forms of bribery
and money laundering overseas by U.S.-based corporations, and (2) legislation
governing foreign securities sold in the United States. You will notice throughout our discussion that provisions of the 1933 Act and the 1934 Exchange Act
overlap.
LEGISLATION PROHIBITING BRIBERY
AND MONEY LAUNDERING OVERSEAS
The Foreign Corrupt Practices Act of 1977, as Amended in 1988. In the
course of investigating illegal corporate payments made to President Nixon’s
1972 reelection campaign, the SEC staff came across information showing that
hundreds of corporations had also made questionable payments to foreign political parties, heads of state, and individuals to obtain business that they would
not otherwise have gained. The companies argued that these payments were not
illegal under U.S. law, and also that they were necessary to compete with foreign state-owned and state-operated enterprises and with state-subsidized multinationals. The SEC, however, considered this information material under both
the 1933 and 1934 securities acts because it affected the integrity of management
and the records of the corporations involved. In 1974 and 1975, the SEC allowed
approximately 435 companies to enter into consent orders whereby the companies did not admit to making illegal payments but agreed to report such payments in the future to the SEC. The SEC also urged Congress to enact legislation
prohibiting bribery overseas by U.S. corporations.
The FCPA of 1977, as amended in 1988, does just that. It applies both to companies registered under the Securities Acts of 1933 and 1934 and to all other domestic concerns, whether they do business abroad or not. Its antibribery provisions
prohibit all domestic firms from offering or authorizing a “corrupt” payment to a
foreign official, a foreign political party, or a foreign political candidate to induce
the recipient to act, or to refrain from acting, so that a U.S. corporation can obtain
business it would not ordinarily get without the payment. The standard of criminal conduct to which corporate officials and employees are held is “knowing.” If
such a payment is known to violate the FCPA, the corporation can be fined up to
$2 million, and its officers, directors, stockholders, employees, and U.S. agents can
be fined up to $100,000 and imprisoned for up to 5 years. In addition to prohibiting the payment of bribes, the FCPA also bans the “offer” or “promise” of “anything of value,” even if the offer or promise is never consummated. “Facilitating or
expediting payments” to ensure routine governmental action is not prohibited.
However, under the 1988 amendments, liability can be avoided if the defendant
proves that the payments were legal in the foreign country where they were made.
The FCPA’s accounting provisions, enacted as amendments to Section 13(b)
of the Exchange Act, apply only to registered nonexempt companies. They require that companies make and keep records and accounts in “reasonable detail” that “accurately and fairly” reflect transactions. Also, companies are required
to maintain systems that provide “reasonable assurance” that transactions have
been recorded in accordance with generally accepted accounting principles.
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The FCPA is jointly enforced by the Justice Department and the SEC. The SEC
can investigate and bring civil charges under the act’s bribery provisions, but it
refers criminal cases to the Justice Department for prosecution. The Justice Department can bring both civil and criminal charges against alleged violators of
the FCPA. The SEC is charged with enforcement of the accounting provisions and
can bring both civil actions and administrative proceedings.
Convention on Combating Bribery of Foreign Officials in International
Business Transactions. The Convention on Combating Bribery of Foreign Officials in International Business Transactions (CCBFOIBT) was signed in December
1997 by 34 countries after debate by the Organization for Economic Cooperation
and Development (OECD). Signatories are required to criminalize bribery of foreign officials, eliminate the tax deductibility of bribes, and subject companies to
wider disclosure. Russia (an observer) and China are not signatories; the 34 signatories include the United States, Canada, Japan, and Germany. The treaty creates one loophole: “grease payments.” It is acknowledged that these facilitating
payments are the cost of doing business and can be paid to low-level officials.
The major change for the United States was the need to amend the FCPA to
cover foreign subsidiaries of U.S. companies whose activities have a nexus with
interstate or foreign commerce. Under current U.S. law, such subsidiaries are not
subject to the FCPA.
The International Securities Enforcement Cooperation Act of 1990. After
it was found that many insider traders in the United States were holding secret
accounts in Switzerland, the SEC in June 1982 entered into a memorandum of
understanding with the Swiss government that established a procedure for processing SEC requests for information about Swiss bank clients suspected of insider trading. As reports of overseas “money laundering” of profits made from
insider trading in the United States mounted throughout the late 1980s, the SEC
encouraged Congress to clarify the commission’s authority to act, not only against
those who were sheltering their profits from illegal insider trading in foreign
countries, but also against others who were violating U.S. securities laws abroad.
In 1990, Congress passed the International Securities Enforcement Cooperation Act (ISECA). The most important provisions of this act are as follows:
1. It provides for giving foreign regulators U.S. government documents and information needed to trace laundered money and those suspected of doing
the laundering.
2. It exempts from the Freedom of Information Act (FOIA) disclosure requirements documents given to the SEC by foreign regulators. Without this exemption, foreign regulators would be reluctant to provide U.S. regulators
with information, and alleged violators could obtain information too easily.
3. It gives the SEC authority to impose administrative sanctions on buyers and
dealers who engage in activities that are illegal under U.S. law while they are
in foreign countries.
4. It authorizes the SEC to investigate violations of all U.S. securities laws that
occur in foreign countries.
LEGISLATION GOVERNING FOREIGN SECURITIES
SOLD IN THE UNITED STATES
Schedule B of the Securities Act of 1933 sets forth disclosure requirements for
initial offerings by foreign issuers of stock on U.S. exchanges. Foreign issuers
are entitled to some of the same exemptions in this area as domestic issuers, except that exemptions under Regulation A are granted only to U.S. and Canadian
issuers. Also, the SEC has special registration forms for initial foreign offerings.
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In Section 12(g)(3) of the Exchange Act, Congress gave the SEC power to exempt foreign issuers whose securities are traded on U.S. exchanges or the OTC
markets from certain registration requirements if the commission believes that
such action would be in the public interest. Under SEC Rule 12(g)(3)-2, the securities of a foreign issuer are exempt from annual and current reports if the issuer or its government furnishes the SEC with annual information material to
investors, which is made public in the issuer’s own country. In 1983, the commission published a list of exemptions for foreign-issued securities and adopted
regulations that generally require foreign securities registered under the Exchange Act to be quoted also on the National Association of Securities Dealers
Authorized Quotations (NASDAQ).
REGULATIONS AND OFFSHORE TRANSACTIONS
Regulation S governs offers and sales of any securities made in offshore transactions. Such transactions are defined as those in which no offer is made to a
person in the United States and (1) the buyer is outside the United States at the
time the buy order is originated; or (2) the transaction is executed in, on, or
through the facilities of a designated offshore securities market. No directed selling efforts may be made in the United States.
Regulation S allows U.S. companies to offer securities abroad with some certainty that such securities will be exempt from federal securities registration. The
combination of Rule 144A and Regulation S has expanded the private placement
market by increasing the liquidity of private placement securities.
SUMMARY
The SEC is the federal agency responsible for overseeing the securities markets
and enforcing federal securities legislation.
Several pieces of legislation provide the framework for the federal regulation of securities issuance and trading, but the most important are the Securities
Act of 1933 and the Securities Exchange Act of 1934. The most recent additions
are the Dodd-Frank Act; the Sarbanes-Oxley Act, which amends both the 1933
and 1934 acts.
The Securities Act of 1933 seeks to ensure that investors receive full and fair
disclosure of all material information about a new stock issue. It prescribes a
three-stage registration process for new securities: prefiling, filing, and postfiling. Several types of securities are exempt from registration, principally private
placements, intrastate offerings, and small business offerings.
The Securities Exchange Act of 1934 governs six areas of securities trading:
the registration of securities issuers and broker-dealers, securities markets,
proxy solicitations, tender offers and takeover bids, securities fraud, and shortswing profits. Provisions of the act dealing with securities fraud address insider
trading, misstatements by corporate management, and mismanagement of a
corporation.
The e-commerce world has made online investing via the Internet a common occurrence. The SEC, with the help of EDGAR, has sought to modernize
the securities regulatory system and assist both investors and issuing companies.
The increasing internationalization of securities markets has led Congress
and the SEC to extend the reach of U.S. securities regulations through specific
agreements with foreign governments and through provisions of the FCPA and
the ISECA.
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REVIEW QUESTIONS
24-1 Describe the differences between insider trading and short-swing trading. Explain.
24-2 Explain what is meant by shelf registration of
securities.
24-3 Under the proxy rules, when may the management of a registered issuing company exclude
a shareholder proposal from the agenda of an
annual meeting?
24-4 What criteria do the courts use to determine
whether an instrument or transaction will be
called a security?
24-5 Which securities must be registered under the
1933 Act? Explain.
24-6 Which securities are exempt from registration
under the 1933 Act? Explain.
REVIEW PROBLEMS
24-7 Livingston had worked for Merrill Lynch for
20 years as a securities sales representative (account
executive). In January 1972, he and 47 other account
executives were given the honorary title of “vice
president” because of their outstanding sales records.
None of their duties changed, however, and they
never attended a meeting of the board of directors. In
November and December 1972, Livingston sold and
repurchased the same number of shares of Merrill
Lynch, making a profit of $14,836.37. Merrill Lynch
sued Livingston for recovery of the profits, claiming
that he had violated Section 16(b) of the Securities and
Exchange Act of 1934. Livingston denied such
charges. Who won this case, and why?
24-8 Daniel had been a member of the Teamsters
Union and an employee of the same trucking firm for
23 years. The company had signed a collective bargaining agreement with the union, and that agreement
contained a pension plan. Under the plan, an employee had to work for 20 continuous years for the
company. Daniel had not worked for 20 continuous
years because he had had a single short break in his
employment. He claimed that the pension plan constituted a “security” under the 1933 and 1934 Securities
Acts, and he sued the union for fraud under Section
10(b) of the 1934 Act and SEC Rule 10(b)-5. The
union denied that the pension plan qualified as a security. Who won this case, and why?
24-9 Panzirer read an article in the Wall Street Journal stating that buying stock in a specific company
would be a wise investment. She purchased stock in
that company. The company later went bankrupt and
Panzirer lost her investment. She sued the company’s
officers, directors, and independent accountants under SEC Rule 10(b)-5, claiming that, although she had
never read the company’s annual report, she had satisfied the reliance requirement for fraud because she
had relied on the “integrity of the marketplace,” and a
“fraud on the market” had been committed by the
company. Who won this case, and why?
24-10 Schlitz Brewing Company failed to disclose on
its registration statement, as well as in its periodic reports to the SEC, certain kickback payments that it
was making to retailers to encourage them to sell
Schlitz products, as well as the fact that the company
had been convicted of violating a Spanish tax law. The
SEC claimed that the failure to include such information was a violation of the antifraud provisions of the
1933 and 1934 Acts because it was material. Schlitz
claimed that the information was not material because
the kickbacks represented only $3 million, a tiny sum
compared with the company’s $1 billion in revenues.
Was the information material, and was its omission
thus a violation of Section 10(b) of the 1934 Act and
SEC Rule 10(b)-5? Explain.
24-11 International Mining Exchange and a person
named Parker sold a “Gold Tax Shelter Investment Program.” Anyone who wished to invest had to write a
check payable to an individual designated by International Mining and sign certain papers. Investors acquired a leasehold interest in a gold mine with proven
reserves, and they agreed to allow International Mining to arrange for sale options to purchase the gold
that would be mined. In effect, investors received the
right to profits from the gold mined, plus a tax deduction based on the cost of developing the mine. The
SEC claimed that this transaction involved “securities”
and thus was not exempt from registration under the
1933 Act. International Mining claimed that this transaction did not fall within the definition of a security.
What was the result? Explain.
24-12 Continental, a manufacturer of cigarettes, sold
to a group of 38 investors bonds with warrants
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attached to purchase common stock. The sales took
place in a high-pressure atmosphere in a room with
phones ringing and new orders apparently coming in.
Each investor signed an agreement that she or he had
received written information about the corporation,
and each testified to having access to additional
677
information if requested. The SEC brought an action
claiming that Continental was in violation of the registration provisions of the 1933 Act for selling unregistered nonexempt securities. Continental argued that it
qualified for a private placement exemption. What
was the result? Explain.
CASE PROBLEMS
24-13 In 1998, after working at two banks for about
10 years, Bryan J. Mitchell helped found MCG Capital
Corporation, a venture capital firm that invested in the
media, communications, and technology sectors. MCG
went public in 2001, and Mitchell served as its CEO
and chair of the board. Various documents filed with
the SEC stated that Mitchell had “earned a B.A. in economics from Syracuse University.” In fact, he attended
Syracuse for only three years and did not graduate. After being pressured by a journalist, Mitchell disclosed
the misrepresentation to the MCG board. The same
day, the company issued a press release correcting the
statement. The board subsequently stripped Mitchell
of his title as chair of the board and made him repay
certain bonuses and loans.
The press responded negatively to “another CEO
that lied about his resume” and speculated about
“what else might not be right.” On the day the press
release was issued, MCG’s stock price dropped from
$11.85 per share to $8.40, although it fully recovered
within a month.
Shareholders sued, alleging that the misrepresentation violated Section 11 of the 1933 Act, Section 10(b)
of the 1934 Act, and Rule 10(b)-5. Was Mitchell’s lie
about having a college degree material? If you had
been a member of the MCG board, would you have
been comfortable keeping Mitchell as CEO?
Greenhouse v. MCG Capital Corp., 392 F.3d 650
(4th Cir. 2004).
24-14 The Todman & Co. accounting firm audited
the financial statements of Direct Brokerage, Inc.
(DBI), from 1999 through 2002. Each year Todman issued an unqualified opinion that DBI’s financial statements accurately portrayed DBI’s finances. In fact, DBI
failed to pay its payroll taxes for 1999 or 2000, a fact
that came to light in 2003. After DBI collapsed in
2004, investors sued Todman, alleging that Todman
was aware of DBI’s undisclosed liability and its need
for an infusion of capital but failed to correct or withdraw its 2002 certified opinion or to advise DBI to
withdraw its financial statements. The plaintiffs identified five red flags:
• In 1998, a Todman auditor noted a “large payroll
tax payable at the end of the year” necessitating
further analysis, but no analysis was ever done.
• Todman did not investigate DBI’s failure to pay any
payroll tax after June 1998.
• Todman knew that DBI’s payroll taxes dropped
from $248,899 to zero between 1998 and 1999,
but never investigated.
• Todman knew that DBI’s employee compensation
rose significantly in 1999 while its payroll taxes
plunged, but did not investigate.
• That trend continued in 2000, and Todman knew
it but did not investigate.
Did Todman violate Section 10(b) or Rule 10b-5?
Overton v. Todman & Co., 478 F.3d 479 (2d Cir. 2007)
24-15 Ronald Bleakney, an officer at Natural
Microsystems Corp. (NMC), a Section 12 corporation,
directed NMC sales in North America, South America,
and Europe. In November 1998, Bleakney sold more
than 7,500 shares of NMC stock. The following March,
Bleakney resigned from the firm, and the next month,
he bought more than 20,000 shares of its stock. NMC
provided some guidance to employees concerning the
rules of insider trading, and the corporation said nothing about potential liability with regard to Bleakney’s
transactions. Richard Morales, an NMC shareholder,
filed a suit against NMC and Bleakney to compel recovery, under Section 16(b) of the Securities Exchange
Act of 1934, of Bleakney’s profits from the purchase
and sale of his shares. (When Morales died, his executor Deborah Donoghue became the plaintiff.)
Bleakney argued that he should not be liable because
he relied on NMC’s advice. Should the court order
Bleakney to disgorge his profits? Explain. Donoghue v.
Natural Microsystems Corp., 198 F. Supp. 2d 487
(S.D.N.Y. 2002).
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Our laws are far too easy on those who commit securities fraud. Ten thousand dollars and five years in
prison are not penalties stiff enough for those who violate the public’s trust in the stock market and thereby
undermine our economy.
Because our economy is based on capitalism, our
businesses are dependent upon outside sources of
funding. If a company wishes to expand or purchase
another company, it needs access to outside funds. Additionally, people need to make money, and their
prospects in today’s job market are uncertain. Thus,
people need to supplement their income. For this reason, they are willing to “loan” businesses money to expand by purchasing securities.
When people commit securities fraud, they cause
two undesirable outcomes. First of all, they cause investors to lose their money. Many of these investors are
counting on their investments to enable them to survive after retirement. By committing fraud, white-collar
criminals wipe out the investors’ savings and force
them to work extra years. In this sense, these corporate con artists are not just taking money away from
the investors; they’re taking away years of their lives.
Second, when members of the public hear about
acts of securities fraud, they become afraid to invest.
When people fail to invest, businesses are unable to
raise the capital they need. This lack of capital may
cause them to lay off workers, close down divisions,
or possibly, close altogether. At any rate, lack of capital
makes our economy run less efficiently, and when that
happens, we all suffer.
Clearly, securities fraud isn’t a small crime committed against a business. Instead, its effects are felt by
companies, investors, and even workers all across the
country. Because acts of securities fraud have such farreaching effects, those who commit them must be subject to stiffer punishment.
1. What reasons does the author give for harshly
punishing those who use securities to defraud
people?
2. What evidence does the author provide to support
these reasons?
3. What information would be helpful for you to
have in evaluating the worth of the author’s
claims? (Refer to your answer to question 2.)
4. Which words or phrases in this essay are especially ambiguous?
5. Set out some arguments for the hypothesis: “Our
laws are far too hard on those who commit securities fraud.”
The SEC brings civil lawsuits against individuals who
are accused of violating one or more securities laws,
regulations, or rules. Using the Internet, visit the Securities and Exchange Commission’s litigation Web site
(www.sec.gov/litigation.shtml) and read a brief or
press release of a recent case. What rule or regulation
was violated? What did the individual do that violated
the rule or regulation? Finally, how does examining the
reasoning in a court’s decision about securities law help
you to better understand the chapter you just read?
ON THE INTERNET
securities.stanford.edu
The Securities Action Clearinghouse provides a wealth of information about federal securities litigation, including
cases, statutes, reports, and settlements.
www.sec.gov/index.htm
This is the home page of the Securities and Exchange Commission.
www.nasaa.org
From this page, find out about the North American Securities Administration Association, an organization devoted to investor protection.
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679
www.seclaw.com/secrules.htm
This site provides securities statutes, rules, and regulations at both state and federal levels.
www.law.cornell.edu/topics/securities.html
This site contains a basic overview of securities law as well as recent judicial decisions about securities law.
www.findlaw.com/01topics/34securities/publications.html
This site contains numerous links to securities laws and securities fraud information.
FOR FUTURE READING
Miller, Sandra K., Penelope Sue Greenberg, and Ralph H.
Greenberg. “An Empirical Glimpse into Limited Liability Companies: Assessing the Need to Protect Minority Investors.” American Business Law Journal 43
(2006): 609.
Soderquist, Larry D., and Theresa A. Gabaldon.
Securities Law (Concepts and Insights). Mineola, NY:
Foundation Press (2006).
25
Antitrust Laws
䊏 INTRODUCTION TO ANTITRUST LAW
䊏 ENFORCEMENT OF AND EXEMPTIONS FROM THE
ANTITRUST LAWS
䊏 THE SHERMAN ACT OF 1890
䊏 THE CLAYTON ACT OF 1914
䊏 OTHER ANTITRUST STATUTES
䊏 GLOBAL DIMENSIONS OF ANTITRUST STATUTES
here is disagreement in many areas of public law between those who believe that business conduct should be disciplined through government regulation and those who favor the marketplace and economic-efficiency
criteria as the sole instruments of business discipline. Nowhere is this struggle
sharper than in the area of antitrust law.
American attitudes toward government restraints in the area of contracts
originated in the English common law, which traditionally upheld the freedom
of the individual to contract. U.S. courts generally refused to interfere with commercial agreements: Price-fixing and horizontal and vertical territorial divisions
of markets were considered part of the business environment and, hence, legal.
This laissez-faire approach was accepted up to the second half of the nineteenth
century, when the economic might of huge monopolies stirred Congress to enact the Interstate Commerce Act of 1887 and the Sherman Act of 1890. Despite
the advance of technology and 117 years of knowledge and court decisions, the
goals of antitrust laws continue to be debated.
This chapter begins with an introduction to the meaning of antitrust and a
summary of the federal antitrust statutes. It then discusses enforcement of the antitrust laws and exemptions made to those laws. Next it examines the types of
business conduct that are forbidden by the Sherman Act, as well as the Clayton
Act, the Federal Trade Commission Act, and the Bank Merger Act of 1966. Because these acts have affected, directly and indirectly, almost every business and
political institution in American society, and carry criminal and/or civil penalties,
much of the chapter focuses on dissecting them. Finally, it examines the global
dimensions of antitrust policy.
T
Antitrust law is full of controversial cases. Should the government restrict businesses? To what extent? Should we prevent businesses from creating monopolies? These questions are addressed in a variety of laws regarding antitrust policy. A fairly recent antitrust action by the government involved Microsoft, which was charged with unfair monopolistic
practices. The government claimed that Microsoft unfairly restricted its competitors by forcing computer manufacturers
680
CHAPTER 25
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Antitrust Laws
681
to ship the Microsoft Internet Explorer browser along with Windows 95. Answering the following questions about
Microsoft can help you think critically about antitrust law.
1.
Before you can critically evaluate claims, you need to identify the reasons and conclusion. To get in the habit of
paying attention to reasons, try to generate reasons for and against governmental intervention in Microsoft’s
practices.
Clue: Reread the introduction. Why would Microsoft want to be free of governmental intervention? Why would
the government want to regulate Microsoft?
2.
Your roommate makes the following statement: “Businesses have to comply with far too many regulations. They
should just be free to make their own rules. Businesses that aren’t fair to the public will not be successful. The
government shouldn’t regulate Microsoft.” How would you respond to your roommate?
Clue: Even though you have not yet read this chapter, you can evaluate your roommate’s statement. Do you
see any problems with this statement?
3.
Microsoft argues that the Internet Explorer browser is simply part of its Windows operating system. Furthermore,
Microsoft claims that it is serving its customers by including the Internet Explorer. Customers don’t have to worry
about finding or installing an additional Web browser. Thus, the government is essentially hurting the public by
regulating Microsoft. Are you persuaded by Microsoft’s argument?
Clue: What information might be missing from Microsoft’s argument? What more would you like to know about
the Web browser industry?
Introduction to Antitrust Law
A DEFINITION OF ANTITRUST
Trusts were originally business arrangements in which owners of stocks in several companies placed their securities in the hands of trustees, who controlled
and managed the companies. The securities owners, in return, received certificates that gave each a specified share of the earnings of the jointly managed
companies. The trust device itself was not—and is not today—illegal. In the late
1880s and 1890s, however, trusts were used by a few companies to buy up or
drive out of business many small companies in a single industry. Standard Oil
Company, for example, used this process to monopolize the oil industry. Large
trusts used unscrupulous methods of competition—such as bribery, setting up
bogus companies, and harassing small companies with lawsuits—to gain
monopolistic profits. Magazine and newspaper exposures of scandalous transactions involving trusts shook the public’s confidence in unregulated markets.
Against this background, the Sherman Act was enacted in 1890. Because it was
aimed at monopolies that called themselves trusts, it was called an antitrust
statute.
LAW AND ECONOMICS: SETTING AND ENFORCING
ANTITRUST POLICY
The formulation and enforcement of antitrust policy have been substantially
affected by the disciplines of law and economics. Moreover, there is a strong
difference of opinion about antitrust law between lawyers and economists
who favor some government regulation of business and those who want to
see deregulation or, more radically, no regulation at all. These two approaches
to antitrust policy are known, respectively, as the Harvard School and the
Chicago School, after the universities where many of their proponents have
taught and written.
trust A business arrangement
in which owners of stocks in
several companies place their
securities with trustees, who
jointly manage the companies
and pay out a specific share of
their earnings to the securities
holders.
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Chicago School An approach
to antitrust policy that is based
solely on the goal of economic
efficiency or the maximization
of consumer welfare.
Harvard School An approach
to antitrust policy that is based
on the desirability of
preserving competition to
prevent the accumulation of
economic and political power,
the dislocation of labor, and
market inefficiency.
TABLE 25-1
CHICAGO AND HARVARD
SCHOOLS’ APPROACHES
TO ANTITRUST POLICY
The Chicago School (a market or efficiency approach to antitrust policy) argues that antitrust decisions should be based solely on the criterion of
economic efficiency—that is, the maximization of consumer welfare, which
may be defined as improving the allocation of scarce resources without in
some way decreasing productive efficiencies. In our discussion of antitrust
goals, you will find that one of these goals is the “promotion of the maximization of consumer welfare using market principles and efficiency criteria”; however, the Chicago School argues that unless efficiency is the sole
criterion for antitrust policy making, consumers will not be able to obtain
goods at the lowest price possible, and U.S.-based multinationals will not be
able to compete with foreign multinationals. Adherents of the Chicago School
would like to see antitrust statutes enforced less strictly, especially in the areas of vertical price and territorial restraints, and would decriminalize many
antitrust offenses. Finally, proponents of this approach believe that large size
in U.S. business is far from bad, considering that competitive foreign firms
are big and are sometimes aided by their governments as well. You will see
the Chicago approach at work when you come to read the GTE Sylvania case
later in this chapter.
The Harvard School (a structural approach to antitrust policy) favors the
preservation of an economy characterized by many buyers and sellers, with little domination by anyone. Adherents of this approach condemn the accumulation of economic power because they believe that it leads to substantial political
power at the federal, state, and local levels as politicians are “bought” by the
holders of economic power. The resulting concentration of economic and political power allows a small elite to dominate society and to dictate the closing of
plants, downsizing, and the loss of jobs from a community. The Harvard School’s
position on the creation and enforcement of antitrust policy is embodied in all
four of the antitrust goals we next discuss.
Try not to take sides on this issue until you have read and critically analyzed
this chapter. Whatever you decide, it is important that you understand from the
outset of your study of antitrust policy that the political, economic, and judicial
systems of this country are profoundly affected by these two opposing schools
of thought (Table 25-1). Also, it might be interesting to see how the courts have
adopted some criteria belonging to both schools.
Chicago
Harvard School
1. Sole criterion for formulating
antitrust policy is efficiency: the
maximization of consumer
welfare.
1. Several criteria, including (a) preservation of many
buyers and sellers in the economy, (b) prevention
of concentration of political and economic power,
(c) preservation of local control of business and
prevention of dislocation of labor markets, and
(d) efficiency of markets.
2. Decriminalize many offenses, including vertical
restraints of trade and monopolies.
2. Enforce the antitrust statutes
rigorously and increase the
criminal penalties in most areas
of antitrust.
3. Encourage joint ventures between
the United States and foreign
multinationals without requiring
government approval.
3. Allow joint ventures but retain strict oversight by
the Justice Department and Federal Trade
Commission to prevent worldwide concentration
and division of global markets by multinationals.
CHAPTER 25
GOALS OF THE ANTITRUST STATUTES
A century of debate by lawyers, economists, and others has not produced a
real consensus on the goals of the antitrust statutes. Nonetheless, these four
goals can be derived from the study of antitrust legislation and case law:
1. The preservation of small businesses and an economy characterized by many
sellers competing with one another. Proponents of this goal would break up
large corporations such as General Motors (GM), International Business
Machines (IBM), and Microsoft.
2. The prevention of concentration of political and economic power in the hands
of a few sellers in each industry. Proponents of this goal argue that there is a direct correlation between large corporations, economic power, and control of the
political process. They point to 1980, 1984, and 2000 postpresidential election
analyses indicating that well-financed political action committees (PACs) controlled by big businesses had a tremendous effect on the elections’ outcomes.
3. The preservation of local control of business and protection against the effects
of labor dislocation. The advocates of this antitrust goal argue that when large
companies are allowed to merge, fix prices, and participate in joint ventures,
jobs are lost and plants are shut down in some areas. The consequences are
a dislocation of labor and a decline in local and state economies as their tax
bases shrink because people are moving elsewhere in pursuit of jobs.
4. The promotion of the maximization of consumer welfare using market principles and efficiency criteria. Advocates of this goal define consumer welfare
as an improvement in the allocation of resources without an impairment to
productive efficiency. In effect, the proponents of this goal argue that, by encouraging the allocation of resources in an efficient manner, antitrust enforcement can make sure that consumers will be provided goods at the
lowest possible prices.
Some of these goals conflict.1 For example, the Harvard School proponents
of goal 1 (preserving small businesses) are criticized by adherents of the Chicago
School, who favor only goal 4 (consumer welfare maximization), because they
believe that large firms are needed to manufacture goods at the lowest cost per
unit. They point out that until Henry Ford introduced the assembly-line production of automobiles, few people could afford cars. Many small businesses are
economically inefficient, they say, and attempts to preserve them through antitrust policy will be underwritten by consumers in the form of higher prices. The
Chicago School also insists that if U.S. manufacturers are not allowed to merge
and participate in joint ventures, they will be unable to compete with large foreign multinationals and foreign companies owned or subsidized by their governments. One of the reasons the Justice Department moved to dismiss an
antitrust suit against the International Business Machines Corporation in 1982
was that the computer market had become international in character since the
original government complaint against IBM in 1972. If IBM had been broken up,
it would not have been able to compete with large foreign multinationals either
in the United States or in other countries.
A summary of the major federal antitrust statutes is provided in Table 25-2.
1
T o examine four conflicting opinions on the goals of antitrust, see T. Calvani, “Consumer
Welfare Is Prime Objective of Antitrust,” Legal Times 4 (Dec. 24–31, 1984); B. Brennan, “A LegalEconomic Dichotomy: Contribution to Failure in Regulatory Policy,” American Business Law
Journal 4: 52 (1976); W. Cann Jr., “The New Merger Guidelines: Is the Justice Department
Enforcing the Law?” American Business Law Journal 21: 12–13 (1983); R. Bork, The Antitrust
Paradox 90–91, 104, 108 (1978).
䉬
Antitrust Laws
683
684
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TABLE 25-2
Act
SUMMARY OF MAJOR
FEDERAL ANTITRUST LAWS
Sherman Act of 1890
Section 1
Provisions
Section 2
Clayton Act of 1914
Section 2
Section 3
Section 7
Federal Trade
Commission Act
of 1914
Makes illegal every contract, combination, or conspiracy in restraint
of trade; felony offense punishable by fine up to $100 million per
corporation and up to $1 million per individual; a person may be
imprisoned up to 10 years, fined, or both.
Forbids monopolizing, attempts to monopolize, or conspiracies to
monopolize; penalties are the same as for Section 1.
Forbids discrimination in price between different purchasers of
goods of like grade and quality where the effect may be to lessen
competition or to tend to create a monopoly in any line of
commerce, or to injure, destroy, or prevent competition with the
seller, the buyer, or either’s customers.
Forbids selling or leasing goods on the condition that the buyer or
lessee shall not use or deal in goods sold or leased by the seller’s or
lessor’s competitor, where the effect of such an agreement may be to
substantially lessen competition or to tend to create a monopoly. In
effect, this section outlaws exclusive dealing and tying arrangements.
Forbids unlawful selling of corporate assets or stock mergers when
the effect may be to substantially lessen competition or to tend to
create a monopoly.
Forbids unfair methods of competition in commerce and unfair or
deceptive acts in commerce.
Enforcement of and Exemptions
from the Antitrust Laws
ENFORCEMENT
Enforcement of the antitrust laws is carried out in both the public and the private sectors. The Department of Justice and the Federal Trade Commission (FTC)
(see Table 25-3) are primarily responsible for enforcement in the public sector,
whereas any individual or business entity in the private sector that establishes
that it has been directly injured by illegal business conduct may bring an action
under the federal statutes outlined here (as well as under state antitrust statutes).
Table 25-3 shows which parties have enforcement powers for the three major
federal antitrust statutes.
Public Enforcement. The Antitrust Division of the Justice Department exclusively enforces the Sherman Act and has concurrent jurisdiction with the FTC to
enforce the Clayton Act. The FTC has exclusive jurisdiction to enforce the
Federal Trade Commission Act (FTCA).
TABLE 25-3
PARTIES THAT ENFORCE
THE FEDERAL ANTITRUST
LAW
Justice
Department
Federal Trade
Commission
Private parties
Sherman Act
Clayton Act
Civil and criminal
enforcement powers
No power to enforce
Civil enforcement
power
Civil enforcement
power
Power to enforce
civil litigation
Power to enforce civil
litigation
Federal Trade
Commission Act
No power to enforce
Civil enforcement
power
No power to enforce
CHAPTER 25
Usually, the Justice Department files civil suits in a federal district court. The
remedy requested is ordinarily an injunction to prevent a particular action from
occurring, along with a specific order requiring the business to change its conduct or operation. Most of the time, the defending parties, because of the cost
of litigation and the attendant bad publicity, choose not to fight the case and instead enter into a consent decree (consent order) with the Justice Department,
which binds them to stop the activity complained of (e.g., attempting to manipulate a market). As you know from our discussion of administrative agencies in
Chapter 19, entering into a consent order does not involve admitting to any guilt
or liability. The federal district court must approve the consent order.
For serious violations of the Sherman Act (e.g., price-fixing among competitors), the Justice Department may bring a criminal action. A corporation convicted of criminal conduct under the act faces a fine of up to $100 million for
each offense; individual officers and employees who are convicted face a maximum $1 million fine for each offense or up to 10 years in jail or both. Nolo contendere pleas are often negotiated between the Justice Department and
corporate or individual criminal defendants. This plea of no contest subjects the
defendant to a lesser punishment than would result from conviction at a trial.
Though technically not an admission of guilt, a nolo contendere plea is treated
as such by a judge. Like a consent decree, it must be approved by the court.
Both consent decrees in a civil action and nolo contendere pleas in a criminal action are often entered into by defendants to avoid the cost of litigation
and publicity. Another advantage of these decrees and pleas for defendants is
that they cannot be used as a basis for shareholder derivative or indemnity
suits. For the Justice Department, such decrees and pleas save time and taxpayers’ money.
In December 1997, at the urging of the Justice Department, a federal judge
issued a temporary restraining order to prevent Microsoft from allegedly violating a 1995 court order by forcing computer makers to install its Internet
browser software along with its Windows 95 operating system. Several days
later, the federal court issued a contempt order advising that the company was
making a mockery of the court’s order. Microsoft appealed in January 1998.
Violation of antitrust laws was at issue. On another front, 18 states have brought
a separate antitrust action (later joined with the federal government), which has
wider implications than the mere tying of a browser system to Windows 95. In
this case, the 18 state attorneys general sought to show an effort by Microsoft
to eliminate competition under Clayton Act Section 7, and to fix prices under
Section 1 of the Sherman Act, as well as several other anticompetitive practices
to be studied in this chapter. This action by the states was a continuation of
their joint efforts to pursue cases against the tobacco companies, telemarketing advertisers, and environmental violators, all in the name of consumer protection. For elected attorneys general, these are popular cases to be litigated.2
In 2004, all the states except Massachusetts settled with Microsoft (some contested it). Also, in 2004, the D.C. Circuit Court of Appeals ruled against Massachusetts, and affirmed the settlement.
The settlement allowed Microsoft to remain one company under certain
conditions:
• Microsoft may not retaliate against a computer maker in any way, including
raising prices or withholding support for dealing with Microsoft’s competitors.
• Microsoft must establish a schedule of fixed prices.
2
See J. Marttott, “13 States Planning Broader Suits against Microsoft,” New York Times (Apr. 30,
1988).
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• Other computer makers (IBM, Gateway, and Dell) were allowed to install
non-Microsoft products and desktop shortcuts of any size or shape on the
computers.
• Microsoft had to reveal previously confidential programming interfaces that
its products rely on to link to Windows code.
Furthermore, Microsoft was not to retaliate against other companies because
their products compete with other Microsoft applications.
The FTC can bring only civil actions, which are usually argued before an administrative law judge (ALJ). The ALJ makes findings of fact and recommends action to the full five-member commission, which may issue a cease-and
desist-order. The defendant has the option of appealing such an order to a U.S.
Court of Appeals and further to the Supreme Court, but usually such cease-anddesist orders are negotiated by the parties before a hearing by the ALJ and are
approved by the commission. Failure to abide by a cease-and-desist order carries a penalty of $10,000 a day for each day the defendant is not in compliance.
Private Enforcement. Section 4 of the Clayton Act says that
any person who shall be injured in his person or in his business or property by
reason of anything forbidden in the antitrust laws may sue [and] . . . shall
recover threefold the damages by him sustained and the cost of suit including a
reasonable attorney’s fee.
class action suit A lawsuit
brought by a member of a
group of persons on behalf of
all members of the group.
parens patriae suit A lawsuit
brought by a state attorney
general on behalf of the
citizenry of that state.
This section provides the incentive for private enforcement of our antitrust laws,
because it requires the court to triple the amount of damages awarded to a plaintiff by a jury or by a judge. It also awards reasonable attorney’s fees to the plaintiff’s attorney.
Private actions can be brought by individuals or businesses against perceived violators of the antitrust laws. In recent years, approximately 90 percent
of all antitrust claims were brought by private-party plaintiffs. Moreover, when
a small company, such as Microwave Communication, Inc. (MCI), sues a large
company, such as American Telephone and Telegraph (AT&T), for antitrust violations, victory has the double advantage of enhancing its cash flow and showing bond-rating agencies and investors that it is a viable entity able to take on
a big company.
Individuals in a class action suit and state attorneys general in parens patriae
actions on behalf of their citizenry can also bring suits. In a class action suit,
one member of a group of plaintiffs injured by an antitrust violation (e.g., pricefixing, which results in higher prices for direct purchasers) institutes an action
on behalf of the entire group. This kind of suit is particularly useful when the
amount of each individual claim is small. Similar to class actions are parens
patriae suits, which are usually brought by a state attorney general on behalf
of purchasers and taxpayers in a state (previously discussed in relation to the action against Microsoft and actions against tobacco companies by attorneys general of several states).
EXEMPTIONS
Several activities and industries are fully or partially exempt from the antitrust
statutes (Table 25-4). These exemptions are based on federally enacted statutes
or case law of the courts. When exemptions are granted by statute, they are
largely the result of successful lobbying of Congress by an industry. Soft-drink
franchisers, for example, lobbied successfully in 1980 to obtain a limited exemption from the antitrust statutes, and shipping lines received a similar exemption in 1984.
CHAPTER 25
Activity
Basis for Exemption and Examples
Regulated industries
Labor union activities
Intrastate activities
Transportation, electric, gas, telephone, and securities.
Collective bargaining.
Intrastate telephone calls are regulated by state public utility
commissions.
Farmers may belong to cooperatives that legally set prices.
The U.S. Supreme Court declared baseball a sport, not a trade. No
other professional sport has been exempted by the Congress or
courts.
In Parker v. Brown, 317 U.S. 341 (1943), the U.S. Supreme Court
held a state marketing program that was clearly anticompetitive to be
exempt from the federal antitrust statutes, because it obtained its
authority from a “clearly articulated legislative command of the state.”
The Court looks at the degree of involvement before exempting any
activity under this doctrine.
The Local Government Antitrust Act of 1984 prohibits monetary
recovery under the federal antitrust laws from any of these local
subdivisions or from local officials, agents, or employees.
The Webb-Pomerene Trade Act of 1918 and the Export Trading
Company Act of 1982 made the formation of selling cooperatives of
U.S. exporters exempt. Also, the Joint Venture Trading Act of 1983
exempted certain joint ventures of competing companies when
seeking to compete with foreign companies that are private and/or
state controlled. Approval of the Justice Department is required.
The Shipping Act of 1984 allows shipping lines to enter into joint
ventures and to participate in international shipping conferences
that set worldwide rates and divide routes and shipments.
The Interstate Oil Compact of 1935 allows states to set quotas on
oil to the market in interstate commerce.
Such actions are exempt unless it is an attempt to make
anticompetitive use of governmental processes. See Eastern Railroad
v. Noer Main Freight, 365 U.S. 127 (1961).
Agricultural activities
Baseball
Activities falling
within the “state
action” doctrine
Cities’, towns’, and
villages’ activities
Export activities
Oil marketing
Joint efforts by
businesses to seek
government action
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TABLE 25-4
SELECT ACTIVITIES EXEMPT
UNDER U.S. ANTITRUST
LAW
The Sherman Act of 1890
The Sherman Act of 1890 is intended to prevent control of markets by any one powerful entity. In other words, it is designed to thwart anticompetitive behavior. Sections 1 and 2 of the act, covered in this section, profoundly affect decisions and
behaviors of business managers. As we shall see, the Sherman Act is also an important tool to protect consumers from a number of activities discussed in this chapter.
SECTION 1: COMBINATIONS AND RESTRAINTS OF TRADE
Section 1 of the Sherman Act reads:
Every contract, combination in the form of trust or otherwise, or conspiracy, in
restraint of trade or commerce among the several States, or with foreign nations, is
declared to be illegal. Every person who shall make any contract or engage in any
combination or conspiracy hereby declared to be illegal shall be deemed guilty of
a felony, and, on conviction thereof shall be punished by fine not exceeding ten
million dollars if a corporation, or, if any other person, three hundred fifty
thousand dollars or by imprisonment not exceeding three years, or by both.
The Sherman Act requires three elements for a violation: (1) a combination, contract, or conspiracy; (2) a restraint of trade that is unreasonable; and
(3) a restraint that is involved in interstate, as opposed to intrastate, commerce.
Sherman Act Federal statutes
that makes illegal every
combination, contract, or
conspiracy that is an
unreasonable restraint of trade
when this concerted action
involves interstate commerce.
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We examined the third element in Chapter 5, when we discussed the effects of
the Commerce Clause on business. Here we analyze the first two elements.
collusion Concerted action by
two or more individuals or
business entities in violation of
the Sherman Act.
conscious parallelism
Identical actions (usually price
increases) that are taken
independently but nearly
simultaneously by two or more
leading companies in an
industry.
restraint of trade Action that
interferes with the economic
law of supply and demand.
rule-of-reason standard A
legal standard holding that
only unreasonable restraints of
trade violate Section 1 of the
Sherman Act. If the court
determines that an action’s
anticompetitive effects
outweigh its procompetitive
effects, the restraint is
unreasonable.
per se standard A legal
standard applicable to
restraints of trade that are
inherently anticompetitive.
Because such restraints are
automatically in violation of
Section 1 of the Sherman
Act, courts do not balance
procompetitive and
anticompetitive effects in
such cases.
Combination, Contract, or Conspiracy. The Sherman Act requires a contract,
combination, or conspiracy, so more than one person must be involved (one
cannot make a contract or conspire or combine with oneself). Just as an offeror
and an offeree are necessary parties to a contract, there must be coconspirators
in a conspiracy. In other words, there must be concerted action (action taken together) by two or more individuals or business entities. In antitrust language,
there must be an “agreement” or collusion. Such an agreement can be expressed in writing or orally, or it can be implied, as established by circumstantial evidence such as trends toward uniformity in pricing in an industry and
opportunities to conspire.
It is in cases of implied agreements established by circumstantial evidence
that the courts deal with two major problems: (1) whether there can be an intraenterprise conspiracy that violates the Sherman Act and (2) what actions constitute conscious parallelism as opposed to price-fixing. Conscious parallelism
exists when identical actions (usually price increases) are taken independently
and nearly simultaneously by two or more leading companies in an industry and
thus have the apparent effect of having arisen from a conspiracy.
The courts’ solution to the first problem has generally been that there can be
no conspiracy between two divisions, departments, or subsidiaries of the same
corporation. In answer to the second problem, the courts have generally held that
if there is supportable evidence of conscious parallelism, as opposed to an expressed or implied agreement among competitors, no antitrust violation exists.
Restraints of Trade. The second element required to prove a violation of
Section 1 of the Sherman Act is that there be a restraint of trade and that this
restraint be “unreasonable” as defined by the courts. In enacting the Sherman
Act, Congress gave no indication of whether it meant all restraints or just some.
Rule-of-Reason Standard. Taking its direction from the English courts, the
U.S. Supreme Court adopted a rule-of-reason standard. Over time, the Court
has followed certain indices, laid out by Justice Louis D. Brandeis in 1918, to determine whether a specific business activity is an unreasonable restraint of trade:
1. The nature and purpose of the restraint
2. The scope of the restraint
3. Its effect on the business and on competitors
4. Its intent
When using a rule-of-reason standard, the U.S. Supreme Court terms a restraint reasonable, and therefore legal, if it has a procompetitive purpose and its
effect does not go beyond that purpose. A restraint is unreasonable and unlawful if it allows the parties to substitute themselves and their judgment for the laws
of supply and demand. Restraints that are judged by a rule-of-reason standard to
determine if they are in violation of Section 1 of the Sherman Act (as seen in the
Microsoft litigation discussed in this chapter) include some tying arrangements,
activities of trade and athletic associations, some exclusive-dealing arrangements, nonprice vertical restraints, and some franchising arrangements. Most of
these are discussed later in this chapter.
Per Se Standard. Over time, the courts have judged certain business activities
and arrangements facially so anticompetitive in nature that they have seen no need
to listen to any procompetitive economic justifications. This per se standard favors the plaintiff because all that has to be proved is that the restraint (e.g., pricefixing) took place; the only defense possible is that the activity did not occur.
Because the present Supreme Court, however, began looking at the economic impact of previous per se rulings, the number of restraints of trade in this category has
CHAPTER 25
Antitrust Laws
689
TABLE 25-5
Per Se Standard
Rule-of-Reason Standard
Price-fixing—horizontal
agreements
Group boycotts
Restrictive covenant in a sale or employment, vertical price
and nonprice restraints
Location and resale restraints by manufacturer on some tying
arrangements
Exchange of information
Joint research and development ventures; some horizontal
price tampering based on unique nature of industry
Some tying arrangements
Some divisions of markets
䉬
SHERMAN ACT SECTION 1
ACTIVITIES JUDGED BY THE
PER SE STANDARD AND
THE RULE-OF-REASON
STANDARD
fallen. Restraints that are judged by the per se standard, and are therefore
automatically in violation of Section 1 of the Sherman Act, include horizontal pricefixing, some tying arrangements, some divisions of markets, and group boycotts.
Table 25-5 compares the types of activities that come under each of these standards.
We will now discuss the various activities that are considered restraints of
trade under two headings: horizontal restraints and vertical restraints.
Horizontal Restraints. Horizontal restraints of trade are those that take
place between competitors at the same level of the marketing structure. Three
types of activities are considered horizontal restraints: horizontal price-fixing,
horizontal divisions of markets, and horizontal boycotts.
Horizontal Price-Fixing. Suppose that competitors X, Y, and Z are the only
manufacturers of a certain heat tape used in the construction of office buildings.
They agree to take turns bidding on certain jobs, thus eliminating competition
and keeping prices at a certain level. From the viewpoint of these companies,
this is a way to make high profits, stay in business, and keep their employees
working. The Supreme Court, however, views such horizontal price-fixing as
a per se illegal restraint because it interferes with the price mechanism—that is,
the law of supply and demand—which requires that competing sellers make decisions about prices on their own without agreement or collusion, either expressed or implied. In addition to direct price-fixing agreements, the Court has
struck down such indirect price-fixing arrangements as minimum fee schedules
for lawyers and engineers, exchanges of price information among groups of
competitors, and agreements between competitors about terms of credit when
these become part of the overall price structure in an industry.
The case that follows illustrates a possible agreement among competitors that
may affect prices. Note carefully that this conduct (conscious parallelism) is carefully
examined by the court to make sure it does not in fact constitute illegal price-fixing.
CASE
horizontal restraint of trade
Restraint of trade that occurs
between competitors at the
same level of the marketing
structure.
horizontal price-fixing
Collusion between two or more
competitors to set prices for a
product or service, directly or
indirectly.
25-1
Williamson Oil Co. v. Philip Morris, USA
United States Court of Appeals for the Eleventh Circuit
346 F.3d 1287 (2003)
B
etween 1993 and 2000, Philip Morris (PM),
R.J. Reynolds (RJR), Brown & Williamson (B&W), and
Lorillard (the manufacturers) produced more than 97 percent of the cigarettes sold in the United States. During the
early 1990s, as a price gap widened between premium
brands, such as Marlboro and Camel, and discount brands,
such as Basic and Doral, some “premium smokers”began to
shift to nonpremium brands. By 1993, nonpremium brands
had captured more than 40 percent of the U.S. market.
Although this trend benefited RJR and B&W, it was undesirable for premium-intensive manufacturers, such as PM
and Lorillard. PM then began to look for ways to reverse
the trend toward discount cigarettes. In 1993, PM announced that it was cutting the retail price of Marlboro cigarettes, the single best-selling brand in America, by 40 cents
per pack and forgoing price increases on other premium
brands “for the foreseeable future.” This price cut was followed by price cuts on PM’s other premium brands. PM’s
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price cuts set off a price war, as RJR, B&W, and Lorillard
matched PM’s retail price reductions, which cut into the
market share held by the discount brands.
Subsequently, however, RJR announced that it would
no longer sacrifice profitability for market share and increased the price of its premium and discount brands. The
other manufacturers matched the increases within a couple of weeks. Eleven more parallel increases occurred between May 1995 and January 2000.
A class of several hundred cigarette wholesalers (plaintiffs) sued the manufacturers, alleging that they had conspired between 1993 and 2000 to fix cigarette prices at
unnaturally high levels, which resulted in wholesale listprice overcharges of nearly $12 billion. The district court
entered summary judgment in favor of the manufacturers
after concluding that the wholesalers had failed to demonstrate the existence of a “plus factor.” The court went on to
state that even if the class had shown that a plus factor was
present, the manufacturers had rebutted the inference of
collusion because the economic realities of the 1990s cigarette market made the class’s conspiracy theory untenable. The district court characterized the manufacturers’
pricing behavior as nothing more than “conscious parallelism,” a perfectly legal phenomenon often associated
with oligopolistic industries. The wholesalers appealed.
Justice Marcus
[T]he distinctive characteristic of oligopoly is recognized
interdependence among the leading firms: the profitmaximizing choice of price and output for one depends on
the choices made by others.
When they are the product of a rational, independent
calculus by each member of the oligopoly, as opposed to
collusion, these types of synchronous actions have become known as “conscious parallelism.” The Court has defined this phenomenon as the process, not in itself
unlawful, by which firms in a concentrated market might
in effect share monopoly power, setting their prices at a
profit-maximizing, supra-competitive level by recognizing
their share of economic interests and their interdependence with respect to price and output decisions.
As numerous courts have recognized, it often is difficult
to determine which of these situations—illegal price fixing
or conscious parallelism—is present in a given case.
[P]rice fixing plaintiffs are relegated to relying on indirect means of proof. The problem with this reliance on circumstantial evidence, however, is that such evidence is by
its nature ambiguous, and necessarily requires the drawing
of one or more inferences in order to substantiate claims of
illegal conspiracy.
“[T]o survive a motion for summary judgment . . . a
plaintiff seeking damages for [collusive price-fixing] . . .
must present evidence that tends to exclude the possibility that the alleged conspirators acted independently.” Evidence that does not support the existence of a price fixing
conspiracy any more strongly than it supports conscious
parallelism is insufficient to survive a defendant’s summary
judgment motion.
In applying these principles, we have fashioned a test
under which price fixing plaintiffs must demonstrate the
existence of “plus factors”that remove their evidence from
the realm of equipoise and render that evidence more probative of conspiracy than of conscious parallelism.
[T]he district court delineated distinct factors that appellants had denominated “plus factors.” These are:
“(1) signaling of intentions; (2) permanent allocations programs; (3) monitoring of sales; (4) actions taken contrary
to economic self-interest.”
[W]e are satisfied that none of the actions on which appellants’ arguments are based rise to the level of plus factors. . . . Indeed, when all of appellees’ actions are
considered together, the class has established nothing
more than that the tobacco industry is a classic oligopoly,
replete with consciously parallel pricing behavior, and that
its members act as such.
Affirmed the district court’s grant of summary judgment
for the defendants. The suit was dismissed.
1.
What reasons would the plaintiff have had to advance to avoid summary judgment against it?
Clue: How can a plaintiff show that more than conscious parallelism is the explanation for the imitative pricing behavior?
2.
What is the difference between “signaling of intentions” and being the first oligopolist to increase prices?
Clue: In that the first may be illegal and the second is not, the difference may be one of degree.
How “per se” is the per se rule in the area of price-fixing? For example, it is
clear that certain forms of price-fixing are per se legal by statute. Before deregulation of long-distance telephone service in the early 1980s, prices for this service were set by the Federal Communications Commission and, therefore, were
exempt from the Sherman Act. Similarly, before deregulation of the trucking industry, trucking rates were set by the Interstate Commerce Commission and,
CHAPTER 25
therefore, were exempt. In contrast, organizations of engineers, lawyers, and
doctors have been found guilty of per se illegal price-fixing when they set minimum or maximum schedules of rates or recommend certain minimum prices.
There is no bright line in this area of antitrust law showing which pricing activities will be judged per se illegal in the future.
Horizontal Division of Markets. Territorial division, customer allocation, and
product-line division of markets between competitors have traditionally been
deemed illegal per se. The horizontal division of markets is considered particularly dangerous to a free-market economy because it eliminates all forms of
competition, in contrast to price-fixing, which eliminates only price competition.
“Naked” horizontal agreements to divide markets, customers, or product lines
have had no redeeming value in the eyes of the courts.
More recently, however, it has been argued that price-fixing and division-ofmarket agreements that are part of cooperative productive activity (as opposed
to “naked” restraints) are economically efficient and therefore desirable. Thus,
the advocates of these “more-than-naked horizontal agreements” contend that a
rule-of-reason standard should guide the courts.
An example of price-fixing and division of markets that has been long accepted is a law partnership. Lawyers who would ordinarily compete with each
other eliminate competition by signing a partnership agreement that restricts work
output to their specialization (market division) and that sets the fees to be charged
by partners and their associates (price-fixing). In effect, an integrated economic
unit fixes prices and divides markets (output) internally so that the partnership
may operate more efficiently in competing externally with other law firms.
Horizontal Boycotts. Trade associations frequently promulgate rules among
their memberships that amount to concerted refusals to deal with members who
do not follow the association’s regulations. This activity constitutes a horizontal
boycott and is per se illegal because it takes away the freedom of other members to interact with the boycotted members and, in many instances, lessens the
ability of a boycotted member to compete.
Many professional associations have rules that contain sanctions for violations, ranging from reprimands to suspension or expulsion from the association.
In this era of deregulation and the resulting indirect encouragement of industry
self-regulation, certain antitrust cases have become extremely important. If an industry’s own rules are arbitrary and capricious or lacking in due process, the courts
will generally not uphold them under the rule of reason. For example, when the
New York Stock Exchange, without a hearing, ordered all exchange members to
withdraw wire connection with a nonmember broker, the Supreme Court held that
concerted termination of trade relations, which would ordinarily constitute an
illegal boycott, might be exempt from the antitrust law as a result of the duty of
self-regulation imposed on the Exchange [by Congress and the Securities and
Exchange Commission], but only if fair procedures were followed, including
notice and hearing.3
In another case,4 however, the Court found no unreasonable restraint of trade arising out of the program established by the National Sanitation Foundation (NSF)
for testing products and issuing a seal of approval for products that complied with
the NSF’s promulgated standards, which were strictly enforced among manufacturers. The Court has indicated that when an alleged boycott of an unapproved
manufacturer takes place, the plaintiff must show either that it was discriminated
against vis-à-vis its competitors or that it was subjected to anticompetitive conduct.
Clearly, the courts will continue to watch self-regulatory associations carefully
for due process and reasonable conduct. In July 1985, the Supreme Court ruled
3
4
See Silver v. New York Stock Exchange, 373 U.S. 341 (1965).
E liason Corp. v. National Sanitation Foundation, 614 F.2d 126 (6th Cir. 1980).
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horizontal division of
markets Collusion between
two or more competitors to
divide markets, customers,
or product lines among
themselves.
horizontal boycott A
concerted refusal by a trade
association to deal with
members that do not follow
the association’s regulations.
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that a wholesale purchasing cooperative’s expulsion of a member without
notice, a hearing, or an opportunity to challenge the decision could not be
conclusively presumed to be a per se violation of Section 1 of the Sherman Act.5
The Court remanded the case to the federal district court, directing that a ruleof-reason approach be used to determine whether the cooperative had the market
power to exclude competitors and whether the expulsion of a member was
likely to have an anticompetitive effect.
In the case of noncommercial refusals to deal, it is clear that the courts will not
apply the per se rule. For example, when the National Organization of Women
(NOW) organized a boycott of convention facilities in all states that had refused to
endorse the proposed Equal Rights Amendment to the U.S. Constitution, Missouri
sued NOW, claiming that the organization was in violation of Section 1 of the
Sherman Act. The circuit court of appeals stated that the Sherman Act was not
applicable in this case because the boycott had a noncommercial goal, namely, to
influence legislation in the political arena.6 The court used the rule-of-reason standard to determine whether the group’s purpose was truly noncommercial in nature.
A conflict between constitutional principles—such as the right to free speech
and to petition one’s government under the First Amendment of the Constitution—and enforcement of the Sherman Act against boycotts or refusals to deal
must often be resolved by the courts. Usually, as in the NOW case, constitutional
principles have prevailed when noncommercial groups have been involved.
vertical restraint of trade
Restraint that occurs between
individuals or corporations at
different levels of the
marketing structure.
Vertical Restraints Those restraints agreed to between individuals or corporations at different levels of the manufacturing and distribution process are called
vertical restraints of trade. For example, manufacturers and retailers, as well
as franchisors and franchisees, are often involved in the following types of vertical restraints: resale-price maintenance (price-fixing), territorial and customer
restrictions, tying agreements, and exclusive-dealing contracts. Although the latter two restraints involve violations of Section 3 of the Clayton Act, the courts
have also condemned such actions under Section 1 of the Sherman Act.
As we examine these vertical restraints, we would like you to focus on two
policy implications for business managers:
1. What effect do court decisions have on intrabrand competition (retailers
competing with one another in selling the same manufacturer’s brand) and
interbrand competition (competition between different manufacturers of a
similar product when sold at the retail level)?
2. Are the courts moving in the direction of judging such restraints by a per se
or a rule-of-reason standard?
vertical price-fixing
Stipulation by a manufacturer
to a retailer to which it sells
products as to what price the
retailer must charge for those
products.
Vertical Price-Fixing (Resale Price-Maintenance). When a manufacturer
sells to a retailer, the manufacturer may attempt to specify what price it expects
the retailer to charge for the product or, at least, a minimum price. Vertical
price-fixing agreements of this type have traditionally been judged per se illegal by the courts if a “contract, combination, or conspiracy” exists under Section 1
of the Sherman Act. This has been true regardless of whether the manufacturer
coerced the retailer into entering the agreement (by refusing to supply the product) or the retailer entered the agreement voluntarily.
The courts’ major concern in this area has been whether the retailer made
the pricing decision independently or by agreement with the manufacturer. For
example, many manufacturers offer suggested prices to their retailers in the form
of price lists. The question often before the court is what type of surveillance the
manufacturer uses to coerce an initial agreement or to gain compliance. If the
prices are truly just suggestions, how many times has the retailer deviated from
5
6
Northwest Wholesale Stationers, Inc. v. Pacific Stationery & Printing Co., 472 U.S. 284 (1985).
Missouri v. NOW, Inc., 620 F.2d 1301 (8th Cir. 1980), cert. denied, 449 U.S. 8412 (1981).
CHAPTER 25
䉬
Antitrust Laws
693
Economics
You will learn in this chapter that Section 2 of the Sherman Act of 1890 attempted to deal with monopolies (cartels) or attempts to monopolize and conspiracies to monopolize by using criminal and civil sanctions. Additionally, with regard to enforcement of Section 1 of the act, emphasis has been placed on agreements to fix prices
(a legal issue) rather than the effect of the seller’s conduct on price and output (an economic issue). Smoothly
functioning cartels have historically failed to produce witnesses to written or oral agreements.
Some characteristics that indicate a tendency toward price-fixing are shown by use of economic analysis. You
may remember some of these from your economics courses:
1. When there is one seller. For example, there are fewer costs of coordinating activities.
2. The homogeneity of a product. The monopoly or cartel cannot easily change the quality of the product because it will be obvious.
3. The elasticity of demand with respect to price. Other matters being equal, the less elastic demand is, the
larger will be the profits that a monopoly price will generate, and the greater the incentive to monopolize.
4. The conditions of entry for other entrants is important. If entry can take place rapidly and there will not
be higher longer-run costs, the profit of cartelization will be small.
Think about these tendencies toward price-fixing and monopolization when reading the cases in this chapter.
Source: George J. Stigler, “The Economic Effects of Antitrust Laws,” Organization of Industry, 259 (1968). ©1968 The University of Chicago Press, reprinted by permission.
such prices, and what has been the manufacturer’s response? The courts have
scrutinized manufacturers’ responses carefully, particularly when there is evidence of a manufacturer’s refusal to deal. The courts have generally agreed that
a manufacturer, on its own initiative, can announce in advance an intention not
to deal with an individual retailer who does not sell the manufacturer’s product
at a specific price. No agreement is involved in these unilateral cases. The court,
however, will infer an agreement, and thus per se illegal price-fixing, if the manufacturer refuses to deal with a retailer who fails to adhere to a resale price and
then reinstates the retailer when it agrees to conform. In the following case excerpt, the issue is whether the setting of a minimum resale price was a per se violation of the Sherman Act or a resale activity to be judged by a rule of reason.
CASE
25-2
Leegin Creative Leather Products, Inc. v. PSKS, Inc.,
dba Kay’s Kloset, Kay’s Shoes
United State Supreme Court
127 S. Ct. 2705 (2007)
G
iven its policy of refusing to sell to retailers that discount
its goods below suggested prices, the petitioner (Leegin)
stopped selling to the respondent’s (PSKS) store. PSKS filed
suit, alleging, among other things, that Leegin violated the
antitrust laws by entering into vertical agreements with its
retailers to set minimum resale prices. The district court
7
220 U.S. 373, 31 S. Ct. 376 (1911).
excluded expert testimony about the procompetitive
effects of Leegin’s pricing policy on the ground that Dr. Miles
7
Medical Co. v. John D. Park & Sons Co. makes it per se illegal under Section 1 of the Sherman Act for a manufacturer
and its distributor to agree on the minimum price the distributor can charge for the manufacturer’s goods. At trial,
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PSKS alleged that Leegin and its retailers had agreed to fix
prices, but Leegin argued that its pricing policy was lawful
under Section 1 of the Sherman Act. The jury found for
PSKS. On appeal, the Fifth Circuit declined to apply the rule
of reason to Leegin’s vertical price-fixing agreements and affirmed, finding that the Dr. Miles per se rule rendered irrelevant any procompetitive justifications for Leegin’s policy.
Justice Kennedy
In Dr. Miles Medical Co. v. John Park & Sons Co., the Court
reestablished the rule that it is per se illegal, under §1 of the
Sherman Act, for a manufacturer to agree with its distributor to set the minimum price the distributor can charge for
the manufacturer’s good.
Section 1 of the Sherman Act prohibits “[e]very contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several
States.” The Court has never “taken a literal approach to
[its] language.” Rather, the Court has repeated time and
again that §1 “outlaw[s] only unreasonable restraints.”
The rule of reason is the accepted standard for testing
whether a practice restrains trade in violation of §1. Under this rule, the factfinder weighs all of the circumstances of a case in deciding whether a restrictive
practice should be prohibited as imposing an unreasonable restraint on competition. Appropriate factors to take
into account include “specific information about the
relevant business” and “the restraint’s history, nature, and
effect.” Whether the businesses involved have market
power is a further, significant consideration. In its design
and function the rule distinguishes between restraints
with anticompetitive effect that are harmful to the consumer and restraints stimulating competition that are in
the consumer’s best interest.
Resort to per se rules is confined to restraints “that
would always or almost always tend to restrict competition
and decrease output.” To justify a per se prohibition, a restraint must have “manifestly anticompetitive” effects, and
lack any redeeming virtue.
As a consequence, the per se rule is appropriate only
after courts have had considerable experience with the
type of restraint at issue and only if courts can predict
with confidence that it would be invalidated in all or almost all instances under the rule of reason. It should
come as no surprise, then, that we have expressed reluctance to adopt per se rules with regard to restraints
imposed in the context of business relationships where
the economic impact of certain practices is not immediately obvious.
The Court has interpreted Dr. Miles Medical Co. v. John D.
Park & Sons Co. as establishing a per se rule against a vertical
agreement between a manufacturer and its distributor to set
minimum resale prices. In Dr. Miles the plaintiff, a manufacturer of medicines, sold its products only to distributors who
agreed to resell them at set prices. The Court found the manufacturer’s control of resale prices to be unlawful. It relied on
the common-law rule that “a general restraint upon alienation
is ordinarily invalid.” The Court then explained that the
agreements would advantage the distributors, not the manufacturer, and were analogous to a combination among competing distributors, which the law treated as void.
The reasoning of the Court’s more recent jurisprudence
has rejected the rationales on which Dr. Miles was based. By
relying on the common-law rule against restraints on alienation, the Court justified its decision based on “formalistic”
legal doctrine rather than “demonstrable economic effect.”
The Court in Dr. Miles relied on a treatise published in 1628
but failed to discuss in detail the business reasons that would
motivate a manufacturer situated in 1911 to make use of vertical price restraints. Yet the Sherman Act’s use of “restraint
of trade” invokes the common law itself . . . not merely the
static content that the common law had assigned to the term
in 1890. The general restraint on alienation, especially in the
age when then Justice Hughes used the term, tended to
evoke policy concerns extraneous to the question that controls here. Usually associated with land, not chattels, the rule
arose from restrictions removing real property from the
stream of commerce for generations. The Court should be
cautious about putting dispositive weight on doctrines from
antiquity but of slight relevance. We reaffirm that “the state
of the common law 400 or even 100 years ago is irrelevant to
the issue before us: the effect of the antitrust laws upon vertical distributional restraints in the American economy today.”
Dr. Miles, furthermore, treated vertical agreements a manufacturer makes with its distributors as analogous to a horizontal combination among competing distributors. In later
cases, however, the Court rejected the approach of reliance
on rules governing horizontal restraints when defining rules
applicable to vertical ones. Our recent cases formulate antitrust principles in accordance with the appreciated differences in economic effect between vertical and horizontal
agreements, differences the Dr. Miles Court failed to consider.
The judgment of the Court of Appeals is reversed in favor
of Leegins (appellant, plaintiff).
Is Price Fixing Legal?
Consequences of a Landmark Decision
In June of 2007, the U.S. Supreme Court overruled with Leegin a near-century-old
decision (Dr. Miles) that had made price-fixing (minimum resale maintenance) per
se illegal. Henceforth, such activity will be judged by a rule of reason. See Table 25-5
for a brief outline of some activities that are judged by either standard.
The impact of this decision raises some questions. (Remember that you have just
read only an excerpt of the case).
• Is vertical price-fixing legal, or can such activity be judged illegal by a court of
law based upon this decision?
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• Why did the U.S. Supreme Court change its mind in this case? Do you need more
information to answer this question? Does the concept of stare decisis no longer
have any meaning for the U.S. Supreme Court?
• Why did the four dissenting judges reach a different decision? What ethical standards are involved here?
What is the global impact of this decision? Assume that high courts in other commonlaw and some civil-law countries follow U.S. Supreme Court decisions; assume that the
United States and foreign multinationals doing business in the United States and in other
nations follow U.S. Supreme Court rulings. What approach should they take to this decision to bring company policy into accord with the Leegin case—or should they?
Vertical Territorial and Customer Restraints. The restraints used by a manufacturer to limit the territory in which a retailer may sell the company’s product and to restrict the number of retailer-owned stores, as well as the customers
a retailer can serve in a location, are classified as nonprice vertical restraints.
Lawyers, economists, and scholars in many disciplines have studied nonprice
vertical restraints in great depth.
Those urging that a rule-of-reason standard be applied to such territorial restraints argue that they encourage economic efficiencies and, thus, provide for
spirited interbrand competition. Vertical restraints allow a manufacturer to concentrate its advertising and distributional programs on one or two retailers in a
location, making it better able to compete at the retail level with different brand
manufacturers of the same product. Customer restrictions are also beneficial, in
this view, because they enable a manufacturer to give better service and to cut
out the costs of distributors’ and retailers’ services. For example, a manufacturer
may reserve certain large commercial customers for itself, selling directly to them
in large quantities and disallowing retailer involvement with them.
Those arguing that a per se standard should be applied to vertical territorial
restraints suggest not only that intrabrand competition is enhanced by this approach, but also that customers are better able to compare the prices charged by
different retailers selling the same brand. They argue that the elimination of intrabrand competition reduces the number of sellers of a leading brand in a market and increases overall market concentration in the product.
In the following landmark opinion, the U.S. Supreme Court changed the
standard for judging vertical territorial and customer restrictions from the per se
to the rule-of-reason standard. This was just 10 years after it had gone in the opposite direction in another case.8
CASE
nonprice vertical restraint
Restraint used by a
manufacturer to limit the
territory in which a retailer
may sell the manufacturer’s
products and the number of
stores the retailer can operate,
as well as the customers the
retailer can serve, in a
location.
25-3
Continental TV, Inc. v. GTE Sylvania
433 U.S. 36 (1977)
B
efore 1962, GTE Sylvania (the plaintiff-respondent)
found that it was losing market share to other television manufacturers, so it adopted a plan that placed
both territorial and customer restrictions on its retailers
and phased out its wholesale distributors. Sylvania
limited the number of retailers selling its product in
8
United States v. Schwinn & Co., 388 U.S. 365 (1967).
each area and designated the location within each area
where the stores could be located. When Sylvania
became unhappy with its sales in San Francisco, it
established another retailer besides Continental (the
defendant-appellant) to carry its product. Continental
protested, canceled a large order of Sylvania televisions,
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and ordered a competitor’s product. Continental then
requested permission to open another store in Sacramento. Sylvania opposed such an opening, claiming that
it would be in violation of Continental’s franchise agreement. When Continental advised Sylvania that it was
nevertheless going to open in the new location, Sylvania
cut Continental’s credit line, and Continental, in turn,
withheld all payments on inventory owed to the manufacturer’s credit company. Sylvania terminated the franchise and sued for the money owed and the Sylvania
merchandise in the hands of the defendant. Continental
filed a cross-claim, alleging that Sylvania had violated
Section 1 of the Sherman Act with its restriction on the
locations of the retailers that could sell its product. The
district court found in favor of Continental on the crossclaim. The U.S. Court of Appeals reversed for Sylvania.
Continental appealed to the U.S. Supreme Court.
Justice Powell
The Court [in Schwinn (1967)] proceeded to articulate
the following “bright line” per se rule of illegality for
vertical restrictions. “Under the Sherman Act, it is unreasonable for a manufacturer to seek to restrict and confine
areas or persons with whom an article may be treated after the manufacturer has parted with dominion over it.”
But the Court expressly stated that the rule of reason
governs when “the manufacturer retains title, dominion,
and risk with respect to the product and the position and
function of the dealer in question are, in fact, indistinguishable from those of an agent or salesman of the
manufacturer.”
In the present case, it is undisputed that title to
the televisions passed from Sylvania to Continental.
Thus, the Schwinn per se rule applies unless Sylvania’s
restriction on locations falls outside Schwinn’s prohibition against a manufacturer attempting to restrict a
“retailer’s freedom as to where and to whom it will
resell the products.”
Sylvania argues that if Schwinn cannot be distinguished, it should be reconsidered. Although Schwinn
is supported by the principle of stare decisis, we are
convinced that the need for clarification in this area
justified reconsideration. Since its announcement,
Schwinn has been the subject of continuing controversy and confusion, both in the scholarly journals and
in the federal courts. The great weight of scholarly opinion has been critical of the decision, and a number
of the federal courts confronted with analogous vertical
restrictions have sought to limit its reach. In our view,
the experience of the past 10 years should be brought
to bear on this subject of considerable commercial
importance.
In essence, the issue before us is whether Schwinn’s
per se rule can be justified under the demanding standards
of Northern Pac. R. Co. (1958). The Court’s refusal to
endorse a per se standard in White Motor Co. (1963) was
based on its uncertainty as to whether vertical restrictions
satisfied those standards. Addressing this question for the
first time, the Court stated:
We need to know more than we do about the actual
impact of these arrangements on competition to decide whether they have such a “pernicious effect on
competition and lack . . . any redeeming virtue” and
therefore should be classified as per se violations of
the Sherman Act.
Only four years later, the Court in Schwinn announced its
sweeping per se rule without even a reference to Northern
Pac. R. Co. and with no explanation of its sudden change
in position.
The question remains whether the per se rule stated in
Schwinn should be expanded to include nonsale transactions or abandoned in favor of a return to the rule of reason. We have found no persuasive support for expanding
the rule. As noted above, the Schwinn Court recognized
the undesirability of “prohibit[ing] all vertical restrictions
of territory and all franchising.” And even Continental
does not urge us to hold that all such restrictions are per
se illegal.
We revert to the standard articulated in Northern
Pac. R. Co., and reiterated in White Motor, for determining whether vertical restriction must be “conclusively
presumed to be unreasonable and therefore illegal without elaborate inquiry as to the precise harm they have
caused or the business excuse for their use.” Such restrictions, in varying forms, are widely used in our free
market economy. As indicated above, there is substantial scholarly and judicial authority supporting their economic utility. There is relatively little authority to the
contrary. Certainly, there has been no showing in this
case, either generally or with respect to Sylvania’s agreements, that vertical restrictions have or are likely to have
a “pernicious effect on competition” or that they “lack
. . . any redeeming virtue.” Accordingly, we conclude
that the per se rule stated in Schwinn must be overruled. In so holding, we do not foreclose the possibility
that particular applications of vertical restrictions might
justify per se prohibition under Northern Pac. R. Co. But
we do make clear that departure from the rule-of-reason
standard must be based upon demonstrable economic
effect rather than—as in Schwinn—upon formalistic line
drawing.
In sum, we conclude that the appropriate decision is to
return to the rule of reason that governed vertical restrictions prior to Schwinn.
Affirmed in favor of Plaintiff, Sylvania.
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697
The Supreme Court’s decision in Case 25-3 had a significant impact on the standard by which vertical territorial and
consumer restraints are judged. The Supreme Court overturned the per se standard set out in the Schwinn case. The
Court’s decision, however, is not arbitrary. The Justices attempted to provide sound reasoning for their decision to move
away from the precedent established in the Schwinn case—but before we can evaluate the soundness of the Supreme
Court’s argument, we must first find the argument. The following questions highlight the crucial steps prior to evaluation of an argument: finding the issue, conclusion, and reasons.
1.
State the issue in Case 25-3 in question form. What is the Court’s conclusion?
Clue: Remember that the issue is the primary question that a court is addressing. The conclusion is the court’s
response to the issue.
2.
What reasons does the Court provide for its conclusion?
Clue: In Case 25-3, the reasons answer the question, “Why did the Court overturn the Schwinn per se
standard?”
Tying Arrangements. As discussed previously in the enforcement section of
this chapter (and the Microsoft case), a tying arrangement is one in which a single party agrees to sell a product or service (tying product, e.g., Windows 95) on
condition that the other party agrees to buy a second (tied) product service (e.g.,
Internet browser). For example, if a company owns a patent on a tabulating machine (tying product), it will attempt to get its customers to buy only tabulating
cards produced by it (tied product); or if a franchisor owns a trademark symbol
such as golden arches (tied product), it will seek to get its franchisees to use only
products with the designated trademark symbol on them or products approved
or manufactured by the franchisor (tying products). As noted in Table 25-2, tying
arrangements are violations of Section 3 of the Clayton Act; however, that section
of the act applies only to tying arrangements involving tangible commodities.
Therefore, actions are frequently brought under Section 1 of the Sherman Act
when either the tying or tied products involve services or real property.
Tying arrangements have generally been adjudged per se illegal if the manufacturer of the tying product has a monopoly on the tying product either by
virtue of a patent or as a result of a natural monopoly situation. If the tying
arrangement does not exist in a monopoly situation, it may still be an illegal vertical restraint of trade if the following three conditions are present:
1. The manufacturer or seller of the tying product has sufficient economic
power to lessen competition in the market of the tied product. For example, if
the owner A of a patent on salt-dispensing machines (tying product) leases
the machines only to companies or individuals B who agree to buy salt (tied
product) from A, such an agreement may be considered per se illegal because it limits the sellers of the tied product (salt) from competing vigorously
in the salt market. If, however, there are similar salt-dispensing-machine
manufacturers and lessors that the lessees B can buy from, it is clear that A
will not be able to lessen competition in the salt market.
2. A substantial amount of interstate commerce is affected. If the tying agreement between the manufacturer and the lessor of the salt machines has little
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impact on the market of the tied product (salt), the courts will not consider
this agreement to be per se illegal and, using a rule-of-reason approach, will
dismiss the case.
3. Two separate products or services are involved. Some franchisors have argued
successfully that their trademark (e.g., the golden arches) and their products
and services (building, equipment, and service contract) are one and the same
package rather than separate products, and thus no tying arrangement exists.
exclusive-dealing contract
Agreement in which one party
requires another party to sell
and promote only the brand of
goods supplied by the first
party.
Exclusive-Dealing Contracts. Agreements between manufacturers and retailers (dealers), or between franchisors and franchisees, which require the second
party to sell and promote only the brand of goods supplied by the first party, are
known as exclusive-dealing contracts. For example, the Standard Oil Company
of California had exclusive-dealing contracts with independent stations in seven
western states that required the stations to buy all their oil and other petroleum
products from Standard Oil. Sales under that exclusive-dealing contract involved
approximately 7 percent of all sales of such products in the seven states. Using a
comparative substantiability test (one comparing the effect of such agreements on
competing sellers of petroleum products in the geographic area), the U.S.
Supreme Court found a violation of Section 3 of the Clayton Act.9
Since that case, the Court has generally followed a rule-of-reason approach
in cases involving exclusive-dealing agreements. Such agreements are found to
be illegal when they foreclose a substantial portion of a relevant market. The
Court has found that legitimate business reasons for exclusive-dealing contracts
exist in certain industries. For example, it ruled that an exclusive-dealing contract between an electrical utility and a coal supplier extending 20 years was lawful because it had procompetitive effects.10 The contract assured the utility and
its customers a regular supply of coal at a reasonable fixed rate and allowed the
coal company to better plan its production and employment needs over a long
period; in turn, it was able to offer the utility a lower price.
SECTION 2: MONOPOLIES
Section 2 of the Sherman Act reads:
Every person who shall monopolize, or attempt to monopolize, or combine or
conspire with any other person or persons to monopolize any part of trade or
commerce among the several states, or with foreign nations, shall be deemed guilty
of a felony, and on conviction thereof shall be punished by a fine not exceeding
one million dollars if a corporation or, if any other person, one hundred thousand
dollars, or by imprisonment not exceeding three years, or by both.
Section 2, therefore, prohibits monopolization, attempts to monopolize, and conspiracies to monopolize. Each of these prohibitions is examined in this section.
In reading this material, keep the following four factors in mind:
1. One of the purposes of antitrust law, as stated earlier in this chapter, is to
promote a competitive model. Such a model traditionally assumes the existence of many buyers and sellers who have equal access to information
about the marketplace and labor that is mobile.
2. In framing Section 2 of the Sherman Act, Congress was vague about what it
meant by a monopoly. Therefore, it has been up to the courts to define the
concept case by case, sometimes with the aid of economic analysis.
3. Some claim that U.S. corporations need to be large in order to compete with
state-owned and state-supported foreign multinationals.
monopoly An economic
market situation in which a
single business has the power
to fix the price of goods or
services.
9
Standard Oil Co. of California v. United States, 337 U.S. 293 (1949).
Tampa Electric Co. v. Nashville Coal Co., 365 U.S. 320 (1961).
10
CHAPTER 25
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699
4. Large companies that have attained their monopolistic positions through
innovation and research, leading to patents, may be forced in some cases to
share the results of their efforts with competitors to avoid bringing down on
themselves a Section 2 enforcement and possible penalties (fines, imprisonment, or both).
Monopolization. The U.S. Supreme Court has developed three criteria, or
steps, to determine whether a firm has attained a monopolistic position and is
misusing its power in violation of Section 2 of the Sherman Act:
1. It determines the relevant product and geographic markets within which the
alleged monopolist operates.
2. It determines whether the defendant has overwhelming power in the relevant markets.
3. It examines whether there is an intent on the part of the alleged monopolist
to monopolize.
Relevant Product and Geographic Markets. Markets are divided into product
and geographic markets. How the courts determine the boundaries of those markets helps decide what market share a company has and, thus, its market power.
The courts have generally defined the relevant product market as that in
which the company alleged to be a monopolist can raise or lower prices with relative independence of the forces of supply and demand. In a monopoly situation, the courts look to the concept of cross-elasticity of demand or
substitutability.
Cross-elasticity of demand measures the impact that upward and downward
changes in price have on the demand for the product. If cross-elasticity of demand is positive, an increase in price of the alleged monopolistic product will
result in consumers’ switching to a substitute product. For example, in a landmark case,11 the government charged the DuPont Company with monopolizing
the cellophane industry because it produced 75 percent of all the cellophane
sold in the United States. DuPont argued that cellophane was not the correct
product market because there were many substitutes for cellophane; rather, flexible packaging materials was the correct product market to consider in this case.
If the court agreed, DuPont would not be a monopolist because cellophane constituted only 25 percent of the flexible packaging materials market. The U.S.
Supreme Court did rule in favor of DuPont, on the basis of the availability of
substitutes and the high elasticity of demand for cellophane. The Court noted
that a slight increase in the price of cellophane caused many customers to switch
to other flexible wrapping materials, which showed that there was a positive
cross-elasticity of demand and that DuPont lacked monopoly status.
The courts generally have defined the geographic market as the area where the
defendant’s firm competes head-on with others in the previously determined relevant product market. Usually, geographic markets are stipulated (agreed to) by the
plaintiff and the defendant as regional, national, or international. An exception, however, occurred in a leading monopoly case decided by the Supreme Court.12 In this
case, the parties argued over whether the products that were sold were at a regional
market level (Grinnell) or at a national level (United States). The products in which
Grinnell had ownership interests included tires, sprinklers, plumbing supplies, and
burglar-alarm systems, together called accredited central station protection services.
The case that follows illustrates a question often faced by business leaders
and lawyers. What is the “relevant market”?
11
12
United States v. DuPont Co., 351 U.S. 3717 (1956).
United States v. Grinnell Co., 384 U.S. 563 (1966).
cross-elasticity of demand
or substitutability If an
increase in the price of one
product leads consumers to
purchase another product, the
two products are substitutable
and there is said to be crosselasticity of demand.
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CASE
䉬
25-4
Newcal Industries, Inc. v. Ikon Office Solutions
United States Court of Appeals, Ninth Circuit
513 F.3d 1038. (2008)
N
ewcal Industries (Plaintiff-Appellant) and Ikon Office
Solutions (IKON) Defendant-Respondent) compete in
the brand-name copier equipment-leasing market for commercial customers and in the provision of service.
When a lease approaches its term, these companies compete for the lease of upgraded copier equipment. When a
service contract approaches its term, these companies also
compete to buy out the service contract in order to provide
another one. Newcal alleged that IKON “tricked” its customers by amending its lease agreements and service contracts without disclosing that such amendments would
lengthen the terms of the original agreements. The purpose
of these contract extensions was to shield IKON customers
from competition in the aftermarkets for upgraded copier
equipment and service agreements. When IKON succeeded
in extending the terms of the original contract, it was able
to raise that contract’s value. Consequently, Newcal and
other competitors had to pay higher prices to buy out such
contracts in the aftermarkets for upgraded equipment and
services. Newcal brought claims under the Sherman Act, alleging antitrust violations. The district court held that
Newcal had failed to allege a legally recognizable “relevant
market” under the Sherman Act. Newcal appealed.
Justice Thomas
First and foremost, the relevant market must be a product
market. The consumers do not define the boundaries of
the market; the products or producers do. Second, the
market must encompass the product at issue as well as all
economic substitutes for the product. As the Supreme
Court has instructed, “The outer boundaries of a product
market are determined by the reasonable interchangeability of use between the product itself and substitutes for it.”
As such, the relevant market must include all economic
substitutes; it is legally permissible to premise antitrust allegations on a submarket. That is, an antitrust claim may,
under certain circumstances, allege restraints of trade
within or monopolization of a small part of the general
market of substitutable products. In order to establish the
existence of a legally cognizable submarket, the plaintiff
must be able to show (but need not necessarily establish
in the complaint) that the alleged submarket is economically distinct from the general product market. In [another
case], the Supreme Court listed several “practical indicia”
of an economically distinct submarket: “industry or
public recognition of the submarket as a separate economic entity the product’s peculiar characteristics and
uses, unique production facilities, distinct customers, distinct prices, sensitivity to price changes and specialized
vendors.”
First, the law permits an antitrust claimant to restrict the
relevant market to a single brand of the product at issue. Second, the law prohibits an antitrust claimant from resting on
market power that arises solely from contractual rights that
consumers knowingly and voluntarily gave to the defendant. Third, in determining whether the defendant’s market
power falls in the category of contractually-created market
power or in the category of economic market power, the
law permits an inquiry into whether a consumer’s selection
of a particular brand in the competitive market is the functional equivalent of a contractual commitment, giving that
brand an agreed-upon right to monopolize its consumers in
an aftermarket. The law permits an inquiry into whether
consumers entered into such “contracts”knowing that they
were agreeing to such a commitment.
The relevance of this point to the legal viability of
Newcal’s market definition may not be intuitively obvious,
but it is nevertheless significant. IKON has a contractuallycreated monopoly over services provided under original
IKON contracts. That contractually-created monopoly
then gives IKON a unique relationship with those consumers, and the contractual relationship gives IKON a
unique position in the wholly derivative aftermarket for replacement equipment and lease-end services. The allegation here is that IKON is exploiting its unique position—its
unique contractual relationship—to gain monopoly power
in a derivative aftermarket in which its power is not contractually mandated.
This case is not a case in which the alleged market power
flows from contractual exclusivity. IKON is not simply enforcing a contractual provision that gives it the exclusive
right to provide replacement equipment and lease-end services. Rather, it is leveraging a special relationship with its
contracting partners to restrain trade in a wholly derivative
aftermarket. We therefore reverse the district court’s holding that Newcal’s complaint is legally invalid.
That holding, however, does not quite end the matter.
In considering the legal validity of Newcal’s alleged market, we must also determine whether IKON customers
constitute a cognizable subset of the aftermarket, such that
they qualify as a submarket. That is, we have thus far
concluded only that there is no per se rule against recognizing contractually-created submarkets and that such
submarkets are potentially viable when the market at issue
is a wholly derivative aftermarket. A submarket must bear
the “practical indicia” [indicators] of an independent economic entity in order to qualify as a cognizable submarket.
In this case, Newcal’s complaint sufficiently alleges that
IKON customers constitute a submarket according to all of
those practical indicia.
Reversed and remanded.
CHAPTER 25
Overwhelming Power in the Market. Once the relevant markets have been
determined, the alleged monopolist’s market power to control prices and to exclude fringe competition is significant. The courts are interested in whether the
defendant has overwhelming market power, not absolute power, because there
are usually small competitors that produce poor substitutes. The courts ask: Do
the pricing and output of the alleged monopolist control the conduct of the few
competitors in the industry?
To answer that question, the courts have traditionally looked at five factors: market share, the size of other firms in the industry or market, the pricing structure of the market, entry barriers, and the unique nature of the
industry. In the case of Aspen Skiing Company v. Aspen Highlands Skiing
Corp.,13 the U.S. Supreme Court stated that in viewing market power, it would
look not only at the market share that the alleged monopolist held, but also at
whether the power was acquired and maintained through predatory conduct
that would be illegal or as a result of a superior product, business acumen, or
historical accident. This approach is fair, because a corporation attaining monopoly power through innovation and research could easily be punished instead of rewarded if market share were the sole measure of overwhelming
market power. A company would then have little incentive to compete to gain
a market share in excess of 50 percent, because if it did gain that much (or perhaps even less), it would risk being charged as a monopolist under Section 2
of the Sherman Act.
Intent to Monopolize. After defining the relevant product and geographic
markets and determining whether the company has overwhelming market
power, the courts must decide if the company has a general intent to monopolize the market. This step is significant because having overwhelming
power by virtue of being “big” in the market is not enough to make a firm liable for a Section 2 violation. The courts will look at specific conduct that
tends to show intent, such as attempts to exclude competitors or to raise barriers to entry. In particular, they look at the foreseeable consequences of an
alleged monopolist’s actions: Would these actions naturally lead to a monopoly position? For example, the Aluminum Company of America (ALCOA) anticipated every demand increase and expanded its output in the aluminum
industry. It was thus able to exclude competitors from the aluminum ingot
market by lowering prices. These generally would be good business practices
if ALCOA had not been judged to have overwhelming market power in the
relevant product market. The courts draw a fine line between a monopoly
gained by innovation, patents, and business acumen and one attained by conduct whose foreseeable consequence is the reinforcement of a monopoly position. The first position is gained in a passive manner, the second in an active
manner that shows intent to monopolize. Note carefully the court’s analysis
outlined in the case that follows.
The following case includes an allegation of a violation of Section 2 of the
Sherman Act involving monopolization.
13
388 U.S. 365 (1967).
䉬
Antitrust Laws
701
702
PART THREE
CASE
䉬
25-5
United States v. Microsoft Corporation
United States Court of Appeals for the District of Columbia Circuit
253 F.3d 34 (2001)
T
he authors recommend a close reading of the facts of
United States v. Microsoft set out earlier in this text.
Section 2 of the Sherman Act makes it unlawful for a
firm to “monopolize.” The offense of monopolization has
two elements: (1) the possession of monopoly power in
the relevant market and (2) the willful acquisition or maintenance of that power as distinguished from growth or development as a consequence of a superior product,
business acumen, or historic accident.
The district court found that Microsoft possessed monopoly power in the market for Intel-compatible PC operating systems. Focusing primarily on Microsoft’s efforts to
suppress Netscape Navigator’s threat to its operating systems monopoly, the court also found that Microsoft maintained its power not through competition on the merits
but through unlawful means. Microsoft challenged both
conclusions on appeal.
Per Curiam (by the whole
Court of Appeals)
We begin by considering whether Microsoft possesses monopoly power and finding that it does, we turn to the question [of] whether it maintained this power through
anticompetitive means. Agreeing with the District Court
that the company behaved anticompetitively and that
these actions contributed to the maintenance of its monopoly power, we affirm the court’s finding of liability for
monopolization.
Monopoly Power
While merely possessing monopoly power is not itself
an antitrust violation, it is a necessary element of a monopolization charge. The Supreme Court has defined
monopoly power as the power to control prices or exclude competition. More precisely, a firm is a monopolist if it can profitably raise prices substantially above the
competitive level[;] where [there is] evidence that a
firm has in fact probably done so, the existence of monopoly power is clear. Because such direct proof is only
rarely available, courts more typically examine market
structure in search of circumstantial evidence of monopoly power. Under this structural approach monopoly power may be inferred from a firm’s possession of a
dominant share of a relevant market that is protected by
entry barriers.
“Entry barriers” are factors (such as certain regulatory
requirements) that prevent new rivals from timely responding to an increase in price above the competitive
level.
The District Court considered these structural factors
and concluded that Microsoft possesses monopoly power in
a relevant market. Defining the market as Intel-compatible
PC operating systems, the District Court found that Microsoft has a greater than 95% share. It also found the company’s market position protected by a substantial entry
barrier.
Microsoft argues that the District Court incorrectly
defined the relevant market. It also claims that there is no
barrier to entry in that market. Alternatively, Microsoft
argues that because the software industry is uniquely dynamic, direct proof, rather than circumstantial evidence,
more appropriately indicates whether it possesses
monopoly power. Rejecting each argument, we uphold
the District Court’s finding of monopoly power in its
entirety.
Microsoft’s pattern of exclusionary conduct could only
be rational if the firm knew that it possessed monopoly
power. It is to that conduct that we now turn.
Provisions in Microsoft’s agreements licensing Windows
to [computer makers] reduce usage share of Netscape’s
browser and, hence, protect Microsoft’s operating system
monopoly.
Therefore, Microsoft’s efforts to gain market share in
one market (browsers) served to meet the threat to
Microsoft’s monopoly in another market (operating
systems) by keeping rival browsers from gaining the
critical mass of users necessary to attract developer
attention away from Windows as the platform for software development.
We conclude that Microsoft’s commingling of browser
and nonbrowser code has an anticompetitive effect; the
commingling deters computer makers from pre-installing
rival browsers, thereby reducing the rivals’ usage share
and, hence, developers’ interest in rivals.
By ensuring that the majority of all [ISP] subscribers
are offered [Internet Explorer] either as the default
browser or as the only browser, Microsoft’s deals with the
[ISP] clearly have a significant effect in preserving its
monopoly.
Microsoft’s exclusive deals with the [Internet software
vendors] had a substantial effect in further foreclosing rival
browsers from the market.
Judgment in favor of the United States (plaintiff)
affirming the U.S. District Court decision that Microsoft
did possess and maintain monopoly power in the
market for Intel-compatible operating systems.
An appellate court reversed other holdings
of the district court and remanded these matters for
further proceedings.
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COMMENT: The European Court of First Instance upheld a $600 million fine
against Microsoft in September of 2007. The fine had been levied by the
European Commission (see Chapter 9 for the European Union court structure). A spokesman for the U.S. Justice Department expressed regret at the
European court’s opinion and indicated such a decision might limit innovation on the part of multinational companies such as Microsoft.
Attempt to Monopolize. Section 2 of the Sherman Act forbids not only monopolization but also attempts to monopolize, because the drafters of the section were
concerned about the damage that efforts to attain a monopoly could inflict on an industry even if such efforts failed. So great was their concern, in fact, that the penalties are the same for both monopolization and attempts to monopolize. Case law
indicates that after determining the relevant geographic and product markets, the
courts look for one or some combination of three factors when a firm is charged
with an attempt to monopolize: specific intent, predatory conduct, and a dangerous
probability of success. We will discuss the first two; the third is self-explanatory.
Specific intent is shown by bringing forth evidence that a firm has engaged in
predatory or anticompetitive conduct aimed at a stated or potential competitor.
Predatory conduct includes (1) stealing trade secrets, (2) interfering unlawfully in requirement contracts that third parties have with other competitors, and
(3) attempting to destroy the reputation of a competitor through defamatory actions. Recently, the courts have added predatory pricing—pricing below average variable cost (or, in some cases, below average total cost)—to this list, on the
ground that when a company is pricing below average variable cost, it is not seeking to maximize profits but is intending to drive a competitor out of business.
See Matsushita Electric Industrial Co. v. Zenith Radio Corp.,14 in which the
U.S. Supreme Court accepted the argument that predatory pricing (predation) at
some point is an irrational strategy. Debate exists as whether predatory pricing
may exist at below average variable cost, below average total cost, above average total cost, or a quantitative rule that forbids increasing output by a monopolist when a new entrant comes into the market.
predatory pricing Pricing
below the average variable
cost in order to drive out
competition.
The Clayton Act of 1914
The Clayton Act was enacted in 1914 after a major debate in the presidential campaign of 1912. The Supreme Court had ruled in 1911 that only restraints that were
unreasonable by their nature or in their effect could be declared unlawful under
the Sherman Act. This ruling left much room for interpretation by federal judges as
well as by Justice Department prosecutors. Democratic candidate Woodrow Wilson
argued during the presidential campaign that the Supreme Court was hostile to the
antitrust laws and that businesspeople needed guidance as to what specific practices were illegal. He urged the creation of an agency to investigate trade practices
and to advise businesspeople about which actions were lawful and which were not.
Upon election, Wilson proposed a bill that, after strenuous debate and a good deal
of compromise in Congress, was enacted into law as the Clayton Act of 1914. It
declared the following acts to be illegal under certain circumstances:
1. Price discrimination (Section 2)
2. Tying arrangements and exclusive-dealing contracts (Section 3)
3. Corporate mergers and acquisitions that tend to lessen competition or to
create a monopoly (Section 7)
4. Interlocking directorates (Section 8)
At the same time, Congress passed the FTCA of 1914, setting up the FTC and
giving it authority to police these and other “unfair or deceptive acts or practices
affecting interstate commerce.”
14
475 U.S. 574 (1986).
Clayton Act Prohibits
price discrimination, tying,
exclusive-dealing
arrangements, and corporate
mergers that substantially
lessen competition or tend to
create a monopoly in interstate
commerce.
704
PART THREE
䉬
TABLE 25-6
SUMMARY OF PROVISIONS
OF THE CLAYTON ACT AS
AMENDED BY THE
ROBINSON–PATMAN ACT
Section
Action(s) Prohibited
Defense
2(a)
Discrimination in price by seller between two
purchasers of a commodity of like grade and quality
where effect may be to substantially lessen
competition or tend to create a monopoly.
Cost justification or a
good-faith attempt to meet
equally low prices of
competitors.
2(c)
Fictitious brokerage payments (or discounts where
services not rendered).
Payments for promotions or allowances for
promotional services by seller unless made available
to all buyers on proportionately equal terms.
Promotional services by seller unless provided to all
buyers on proportionately equal terms.
Inducing to discriminate in price or knowingly
receiving the benefits of such discrimination.
None.
2(d)
2(e)
2(f)
Meeting competition.
Meeting competition for
seller.
Cost justification.
SECTION 2: PRICE DISCRIMINATION
Section 2 of the Clayton Act (as amended in 1936 by the Robinson-Patman Act)
prohibits each of the business activities set out in Table 25-6. As you read the
following paragraphs, pay attention to all the italicized words, because they have
been the source of litigation and acceptable defenses to the charges raised in that
litigation.
Section 2(a) of the Clayton Act prohibits discrimination in price by seller between two purchasers of a commodity of like grade and quality, in interstate
commerce, and resulting in injury to competition. Each of these elements must
be proved by a plaintiff in any action brought under Section 2(a). Let us dissect
these elements one by one.
price discrimination A price
differential that is below the
average variable cost for the
seller; considered predatory,
and therefore illegal, under the
Clayton Act.
• Price. Section 2(a) forbids direct or indirect discrimination in price. Price
discrimination is deemed by most courts and scholars to be a price differential that is below the average variable cost for the seller and, thus, is
“predatory” and illegal. An example of indirect price discrimination would
be a seller’s giving a preferred buyer a 60-day option to purchase a product
at the present price, while giving another purchaser only a 30-day option.
The courts have ruled that this situation constitutes price discrimination under Section 2(a).
• Sales. There must be two actual sales (not leases or consignments) by a
single seller that are close in time. Say that seller A offers to sell to B a widget
for $1.00 and then sells the widget to C for $0.95. If B charges price discrimination, that claim will not be upheld because there was no sale between
A and B, but merely an offer to sell. A sale exists only when there is an
enforceable contract.
• Commodities. Commodities are movable or tangible properties (e.g., milk or
bicycle tires). Services and other intangibles are not covered by Section 2(a).
• Like Grade and Quality. The commodities must be of similar grade and quality; they need not be exactly the same. For example, price differences in milk
cartons that are slightly different in size do fall under Section 2(a) jurisdiction. However, differences in price between car tires and bicycle tires are differences in prices of commodities of different grade and quality, so they do
not fall under Section 2(a) jurisdiction.
• Interstate Commerce. The sales must occur in interstate commerce. If the two
sales by a single seller to two purchasers take place in intrastate commerce,
the Clayton Act, being a federal statute, does not apply.
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• Competitive Injury. Finally, the plaintiff must show that the price discrimination caused competitive injury, which under the Clayton Act is price discrimination that either substantially lessens competition, tends to create a
monopoly, or injures, destroys, or prevents competition with the person or
firm that knowingly receives the benefits of discrimination.
Injury to competition includes the following:
1. Primary-line injury (at the seller level), which occurs when a seller cuts
prices in one geographic area in order to drive out a local competitor.
2. Secondary-line injury (at the buyer level), which occurs when competitors
of one of the buyers are injured because the seller sold to that one buyer at
a lower price than it sold to the others. The buyer that received the lower
wholesale price can then undersell the other buyers, which may substantially
lessen competition.
3. Tertiary-line injury (at the retailer level), which occurs when a discriminatory price is passed along from a secondary-line buyer to a retailer. Retailers that get the benefit of a seller’s lower price to a buyer will be able to
undersell their competitors.
primary-line injury A form of
price discrimination in which a
seller attempts to put a local
competitive firm out of
business by lowering its prices
only in the region where the
local firm sells its products.
The Meeting-the-Competition Defense. Section 2(b) of the Clayton Act allows
a seller to discriminate in price if that seller is able to show that the lower price
“was made in good faith to meet an equally low price of a competitor.” The seller
can discriminate to meet the competition but not to “bury” or “beat” the competition. The breadth of the meeting-the-competition defense has long been debated.
tertiary-line injury A form of
price discrimination in which a
discriminatory price is passed
along from a secondary-line
party to a favored party at the
next level of distribution.
SECTION 3: TYING ARRANGEMENTS
AND EXCLUSIVE-DEALING CONTRACTS
Section 3 of the Clayton Act reads:
. . . I[i]t shall be unlawful for any person engaged in commerce, in the course of
such commerce, to lease or make a sale or contract for sale of goods, wares,
merchandise, machinery, supplies, or other commodities, whether patented or
unpatented for use, consumption or resale within the United States or any
territory thereof or the District of Columbia or any insular possession or other
place under the jurisdiction of the United States, or fix a price charged therefore,
or discount from or rebate upon, such price, on the condition, agreement or
understanding that the lessee or purchaser thereof shall not use or deal in the
goods, wares, merchandise, machinery, supplies, or other commodities of a
competitor or competitors of the lessor or seller, where the effect of such lease,
sale, or contact for sale or such condition, agreement or understanding may be
to substantially lessen competition or tend to create a monopoly in any line of
commerce.
This is the section of the act on which courts have generally relied in cases
concerning tying arrangements and exclusive-dealing contracts. Tying arrangements and exclusive-dealing contracts may not be per se illegal in a particular
instance, despite past treatment of them as per se illegal in other instances by
the courts.
SECTION 7: MERGERS AND ACQUISITIONS
Section 7 of the Clayton Act reads:
[N]o corporation engaged in commerce shall acquire, directly or indirectly, the
whole or any part of the stock or other share capital and no corporation subject
to the jurisdiction of the Federal Trade Commission shall acquire the whole or
secondary-line injury A form
of price discrimination in
which a seller offers a
discriminatory price to one
buyer but not to another buyer.
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䉬
any part of the assets of another corporation engaged also in commerce, where
in any line of commerce in any section of the country, the effect of such
acquisition may be substantially to lessen competition, or to tend to create a
monopoly.
merger One company’s
acquisition of another
company’s assets or stock in
such a way that the second
company is absorbed by the
first.
The purpose of Section 7 of the Clayton Act, as amended in 1950, is to prohibit anticompetitive mergers and acquisitions that tend to lessen competition at
their incipiency—that is, in the words of Justice Brennan, “to arrest apprehended
consequences of intercorporate relationships before those relationships [can]
work their evil, which may be at or any time after the acquisition.”15
The language of the statute has led to controversy and considerable litigation, especially because the business world went on a merger binge in the early
1980s. There were more than 2,000 mergers each year from 1983 through 1986,
and some of this country’s largest corporations were involved in the deal-making.
For example, in 1984, Chevron purchased Gulf Oil for $13.2 billion, and Texaco
bought Getty for $10.1 billion. The emphasis in 1983 and 1984 was on large oil
company acquisitions, but 1985 and 1986 saw acquisitions by companies in the
manufacturing, technology, and service areas of the economy as well. Although the
1980s is the decade associated with big deal-making, the merger frenzy continued
into the 1990s and finally decreased in 2001 (see Exhibit 25-1).
Reasons for the Increase in Mergers. Mergers are a method of external
growth as opposed to internal corporate expansion. They may take place for one
or any combination of the following reasons:
1. Undervalued assets. It is cheaper for a company such as GM to buy Electronic Data Systems (EDS) and Hughes Aircraft in order to obtain computer
capabilities, a computer transmission network, and telecommunications capabilities than to borrow money and expand internally in those areas. In
the opinion of GM and its investment banking advisers, both EDS and
Hughes Aircraft were undervalued stocks in the marketplace and, therefore,
a “good buy.”
2. Diversification. During a recession (e.g., 1981–1983; 2008–2010), when
stocks are generally underpriced, companies may seek to diversify—that
is, to reduce their risks in one industry’s business cycle by investing in another industry. U.S. Steel’s acquisition of Marathon Oil Company was an
attempt at diversification by a steel company hit hard by recession and foreign imports.
3. Tax credits for research and development. Between the middle of 1981 and
the end of 1985, the Internal Revenue Code allowed a 25 percent tax credit
for increases in research capabilities acquired through mergers.
EXHIBIT 25-1
GLOBAL M&A DOLLAR
VOLUME, ADJUSTED FOR
INFLATION (DOLLARS IN
TRILLIONS)
2007–through September 1,
2007.
5
4
3
2
1
0
15
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
United States v. E.I. du Pont de Nemours & Co., 353 U.S. 586 (1957).
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4. Economies of scale. A merger often brings about greater efficiency and lower
unit costs, particularly in research and development and in manufacturing.
5. The philosophy that “bigness” is not “bad.” This flexible approach to mergers
was embodied in the Justice Department’s Merger Guidelines in the period
2001–2008.
Criteria for Determining the Legality of Mergers under Section 7. The U.S.
Supreme Court, the lower federal courts, the Justice Department, and the FTC
use the following criteria, or steps, to decide on the legality of a merger:
1. Relevant product and geographic markets
2. Probable impact of the merger on competition in the relevant product and
geographic markets
Relevant Product and Geographic Markets. We said in our discussion of monopolies that how courts determine the boundaries of the product and geographic markets helps them decide what market share a company has and,
hence, its market power. The same holds true when the courts are ruling on
mergers: The market share of the new, combined company will have a strong
bearing on the court’s decision as to the legality of the merger.
The primary criterion the courts use in determining the relevant product
market is, again, substitutability or cross-elasticity of demand for a product.
Other factors used are (1) public recognition of the product market, (2) distinct
customer prices, (3) the product’s sensitivity to price changes, (4) whether
unique facilities are necessary for production, and (5) peculiar product
characteristics.
When identifying the geographic market, what the courts are interested in is
where the merging companies compete. The courts may decide that this geographic market includes all cities with a population of more than 10,000, or they
may judge this market to be regional, national, or international.
Probable Impact on Competition. The courts have traditionally gauged a
merger’s impact on competition by examining factors such as:
1. Market foreclosure, resulting from the merger of a customer and its supplier,
so that competing customers may be foreclosed from the market if the supplier’s goods are in demand and that demand exceeds supply.
2. Potential elimination of competition from a market if two competing firms
merge.
3. Entrenchment of a smaller firm in a market if a large firm with “deep pockets” acquires it and supplies the capital the small firm needs to eliminate
competitors.
4. Trends in the market revealing a high rate of concentration, as measured by
percentage of the market that the leading four to six competitors in an industry have.
5. Postmerger evidence revealing anticompetitive effects on a market.
Types of Mergers. The courts have distinguished among horizontal, vertical,
and conglomerate mergers because each type has a potentially different impact
on competition. Horizontal mergers involve the acquisition of one firm by another that is at the same competitive level in the distribution system. This type
of merger usually leads to the elimination of a competitor. For example, in 1984,
Chevron’s purchase of the Gulf Oil Corporation eliminated one oil company at
Chevron’s level in the industry.
Vertical mergers involve the acquisition of one firm by another that is at
a different level in the distribution system. For example, if a shoe manufacturer acquires a company that has many retail shoe outlets, the merger is
horizontal merger A merger
between two or more
companies producing the
same or a similar product and
competing for sales in the
same geographic market.
vertical merger A merger that
integrates two firms that have
a supplier–customer
relationship.
708
PART THREE
conglomerate merger A
merger in which the
businesses of the acquiring
and the acquired firm are
totally unrelated.
䉬
termed vertical because one company is at the manufacturing level and the
other is at the retailing level of the distribution system.
Conglomerate mergers involve the acquisition by one firm of another that
produces products or services that are not directly related to those of the acquiring firm. For example, the acquisition by GM (an automobile company) of
EDS (a technology company) merged two companies that did not produce directly related products and services.
Horizontal Mergers. In the 1960s and early 1970s, whenever a merger would
result in what was labeled undue concentration in a particular market, there was
a presumption of illegality. In a landmark case,16 the Supreme Court termed a
postacquisition market share of 30 percent or more prima facie illegal. In another
equally important case involving the merger of two retail grocery store chains,17
the Court, perceiving a trend toward fewer competitors in the retail-store market, held a postacquisition share of 8.9 percent presumptively illegal. In both
cases, the Court’s initial determination of the relevant product and geographic
markets and the percentage of market shares the merged company would have
became determinative of the result.
Vertical Mergers. Vertical mergers are termed backward when a retailer attempts to acquire a supplier and forward when a supplier attempts to acquire a
retailer. In vertical merger cases, unlike in horizontal merger cases, the courts
have tended not to put great emphasis on market share percentage. Instead, they
have generally examined the potential for foreclosing competition in the relevant market. For example, if a retailer acquires a supplier of widgets, will other
widget suppliers be foreclosed from selling to the retailer? What impact will that
foreclosure have on the widget market? The courts also look at the trend in the
supplier’s market toward concentration, barriers to entry, and the financial health
of the acquired firm.
Conglomerate Mergers. As with horizontal and vertical mergers, the courts,
using a case-by-case approach, have developed criteria that they use in conglomerate merger situations to determine whether Section 7 of the Clayton Act
has been violated. Because conglomerate mergers result in the combining of firms
in different fields that are not competing with each other, the courts have found
for the plaintiffs when it can be shown that the acquiring firm was already planning to move into the field and did not move into it only because it had “acquired”
its way in; in effect, the conglomerate merger had prevented a company that was
a potential entrant from entering and increasing the number of competitors.
Defenses to Section 7 Complaints. In cases brought under Section 7 of the
Clayton Act, defendants have met complaints by private plaintiffs, as well as those
filed by the Justice Department or the FTC, by asserting the following defenses:
1. The merger does not have a substantial effect on interstate commerce. For the
Clayton Act to be applicable, the merger must be shown to have a substantial effect on interstate commerce, for the federal government may act—and
a federal statute may be applied—only if interstate activity, as opposed to intrastate activity, is involved. As we noted in Chapter 5, however, activities involving interstate commerce have been broadly interpreted under the
Commerce Clause of the Constitution by the federal courts.
2. The merger does not have the probability of substantially lessening competition or tending to create a monopoly. Since the 1980s, firms have argued that
mergers are procompetitive and beneficial to the economy and the nation
because they improve economic efficiency and enable U.S.-based companies
to compete with state-subsidized and state-owned foreign multinationals.
16
17
United States v. Philadelphia National Bank, 374 U.S. 321 (1963).
United States v. Vons Grocery, 384 U.S. 270 (1966).
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3. One of the companies to the merger is failing. This defense must meet three
criteria: (a) The failing company had little hope of survival without the
merger; (b) the acquiring company is the only one interested in purchasing
the failing company or, if there are several interested purchasers, it is the least
threat to competition in the relevant market; and (c) all possible methods of
saving the failing company have been tried and have been unsuccessful.
4. The merger is solely for investment purposes. Section 7 does not apply to a
corporation’s purchase of stock in another company “solely for investment
purposes,” so long as the acquiring corporation does not use its stock purchase for “voting or otherwise to bring about, or attempting to bring about,
the substantial lessening of competition.” The courts look on this defense
skeptically, especially when purchases of a company’s stock by another
company exceed 5 percent of the shares outstanding.
Enforcement. The Justice Department, the FTC, and private individuals and
corporations can all enforce Section 7. The Justice Department divides authority
with the FTC on the basis of areas of historical interest as well as according to
the expertise of the staff of each agency.
When the Clayton Act was enacted, it provided no criminal punishment for
violators, but merely allowed the Justice Department to obtain injunctions to prevent further violations. Recall that Sections 1 and 2 of the Sherman Act do establish criminal sanctions and that Section 4 of the Clayton Act (see section titled
“Private Enforcement”) allows individuals to sue on their own behalf and to obtain triple damages, court costs, and attorney’s fees if they can show injury based
on violations of either the Sherman Act or the Clayton Act. The Clayton Act also
allows individuals to obtain injunctions. Furthermore, if a business is found guilty
of violating the Sherman Act in a suit brought by the Justice Department, this finding is prima facie evidence of a violation when a private party sues for treble damages under the Clayton Act. That is, the private party need not prove a violation
of the antitrust statutes over again, but merely introduces into evidence a copy
of the court order that found the defendant guilty of a Sherman Act violation.
Merger Guidelines. The Justice Department has sought to put the business
community on notice about what it views as violations of Section 7, and
when it is most likely to bring an enforcement action, by issuing Merger
Guidelines. These guidelines do not constitute law; they serve only an advisory function. They can be changed by each new administration to fit preordained political goals. The FTC generally follows the Justice Department’s
Merger Guidelines.
The first guidelines, issued in 1968, were based essentially on market share
analysis. In 1982, the guidelines were substantially revised to reflect the courts’
growing emphasis on economic analysis that goes beyond the traditional
postacquisition market share criterion. The Hertindahl–Hirschman Index
(HHI) is now used to determine whether the Justice Department will challenge
a horizontal merger. This index is calculated by adding the squares of the market shares of a firm in the relevant product and geographic markets. For example, if two firms each control 50 percent of the relevant market, the HHI is equal
to 502 ⫹ 502, or 5,000. The smaller the HHI, the less concentrated the market,
and the less likely the Justice Department is to challenge the merger. A postmerger HHI below 1,000 is unlikely to be challenged, and a postmerger HHI
between 1,000 and 1,800 will probably be challenged only if the merger produces an increase in the HHI of more than 100 points. Whether a postmerger
HHI of more than 1,800 will be challenged depends on whether a leading firm
is involved, the ease of entry into the relevant market, the nature of the product, market performance, and certain other factors the department regards as
relevant in a particular case.
Hertindahl–Hirschman Index
(HHI) An index calculated by
adding the squares of the
shares of the relevant market
held by each firm in a
horizontal merger to determine
the competitive effects of the
merger. In using the HHI to
decide whether to challenge
a merger, the Justice
Department considers both the
level of the postmerger HHI
and the increase in the HHI
caused by the merger.
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In general, the Justice Department did not challenge vertical mergers in 1982
to 1992 unless they facilitated collusion or raised barriers to entry. Usually, the
HHI has to exceed 1,800 to gain the department’s attention. The 1982 Merger
Guidelines made no mention of conglomerate mergers.
In 1984, the Merger Guidelines were revised again to set out changes and
clarifications. One important difference was that the guidelines allowed the Justice Department to take into consideration foreign competition in determining
whether to bring an enforcement action. This revision was prompted by the
Commerce Department, which was concerned about the ability of large U.S.based corporations to compete with foreign multinationals. When a foreign firm
imports into a relevant U.S. product and geographic market in a particular
merger case, its impact on that market will be considered by the FTC and the
Justice Department when deciding whether to challenge the merger.
A new political administration in Washington in 1993 produced new guidelines with a five-step approach to challenge horizontal mergers:
Step 1: Before challenging a merger, the Antitrust Division of the Justice Department will determine whether the merger significantly increases market concentration. The definition of market participation was broadened to include all
current producers and potential entrants. The 1982 HHI remains the measuring
stick.
Step 2: Next, the division will determine the potential adverse competitive effect of a merger. The focus here was changed from the potential for postmerger collusion to the potential for “coordinated interaction among
participants.”
Step 3: The division will then look at whether entry into the market is so easy
that prices will not profitably increase after the proposed merger.
Step 4: The 1993 Merger Guidelines omit the previous guidelines’ requirement
that the merging companies present clear and convincing evidence of these efficiencies of scale.
Step 5: Finally, the division will determine whether one of the merging companies is a “failing” firm or company division that would leave the market unless allowed to merge with the stronger company. Under the 1993 Merger Guidelines,
the failing-company defense will be limited to firms in liquidation; Chapter 11 reorganization under the bankruptcy laws will not be enough to meet the guidelines.
Since 2001, the Justice Department and the FTC, under the Bush administration, have sought to negotiate with parties seeking to merge or to enter into
acquisitions. A market-oriented policy based on efficiency standards has become
significant in determining whether a proposed merger will tend to create a monopoly under Section 7. Often, parties may have to agree to divest themselves
of companies they own in order to obtain approval of a proposed merger. As
discussed in the accompanying feature outlining two possible mergers in the
gaming industry, it is expected that some properties owned by the acquiring parties will be subject to divestment in order to gain government agencies’ approval.
In October 2004, the Justice Department set forth some “guiding principles”
emphasizing structural remedies involving divestiture of assets, rather than remedies that control conduct, in all antitrust enforcement merger and acquisition activities. There are continual updates to these important “guiding principles.”
The Merger Guidelines as of this writing will most likely be modified by the
Obama administration to provide stricter enforcement of the antitrust laws as affecting mergers.
CHAPTER 25
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The Love of Gambling
Two companies, Harrah’s and MGM, sought the acquisition of properties belonging
to Caesars Entertainment, Inc., and Mandalay, respectively, in Las Vegas in June and
July 2004. These two major companies would then dominate what is known as the
Las Vegas Strip (see Table 25-7).
As the popularity of gambling increased in the 1990s and early 2000s, Las Vegas
became a tourist and convention center. Although growth was slowing in 11 states
that allowed gambling in traditional casino forms by the year 2000, there were alternative gambling locations in such places as Indian reservations; slot machines at
racetracks, online gambling on the Internet worldwide, and new places such as
Macao where Las Vegas casino owners began operating in 2004. These alternatives,
and the search by state governments for additional revenues, led to Harrah’s and
MGM’s attempts to acquire properties.
For Harrah’s, the largest of all casinos owners, there was a need to funnel its customers from its riverboat and other properties throughout the United States to the
“gambling mecca”of Las Vegas and its acquired properties of Caesars Entertainment.
Loyalty from its customers in the “heartland”and Atlantic City and its huge customer
database would assist it in this effort.a
MGM was seeking to become the sole “high roller”on the Las Vegas Strip with its
possible acquisition of Mandalay properties. Harrah’s, fearing this possibility, realized it needed to acquire properties before it was not a contender on the Strip,
where it held one large property (Harrah’s) and the Rio casino just off the Strip.
A favorable tax environment and few government restrictions in Nevada made capital
investment in gambling easier.
When the Justice Department and the FTC examined these proposed mergers,
the important issue was to determine the relevant geographic market. What would
be the effect of these acquisitions on the gaming market? Was there a tendency toward monopoly and a lessening of competition in the gaming industry? Were there
political implications of these acquisitions? What cultural and moral implications
were involved? What information is needed for the readers of this text to make these
decisions? (See Chapter 1 of this text, particularly the steps outlined for critical
thinking.)
a
Properties to Be Combined by
the Harrah’s-Ceasar’s Merger
Properties to Be Combined by
the Mirage-Mandalay Bay Merger
Bally’s
Bellagio
Caesars Palace
Circus Circus
Flamingo
Colorado Belle
Grand Casinos
Excalibur
Harrah’s
Luxor
Harveys brands
Mandalay Bay
Hilton
MGM Grand
Horseshoe
New York-New York
Paris
The Mirage
Showboat
Treasure Island
See C. Woodward and M. Krantz, “Latest Vegas Marriage,” USA Today, July 16, 2004, B-1, 2.
TABLE 25-7
CASINO GIANTS
Source: Adapted from the
Wall Street Journal, July 15,
2004, 2.
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premerger notification
requirement The legislatively
mandated requirement that
certain types of firms notify the
FTC and the Justice
Department 30 days before
finalizing a merger so that
these agencies can investigate
and challenge any mergers
they find anticompetitive.
Premerger Notification. The Hart–Scott Robinson Act of 1976, which
amended Section 7 of the Clayton Act, introduced a premerger notification
requirement into the area of mergers. If the acquiring company has sales of
$100 million or more, if the acquired firm has sales of $10 million or more, and
if either affects interstate commerce, both firms must file notice of the pending
merger with the Justice Department and the FTC 30 days before the merger is finalized. This notice enables the department and the FTC to assess the probable
competitive impact of the merger before it takes place.
Remedies. When parties decide to go ahead with a merger despite being advised that an enforcement action will be brought, the Justice Department and the
FTC have three basic civil remedies available: civil injunctions, cease-and-desist
orders, and divestiture. The Antitrust Division of the Justice Department, however, tries to avoid using these remedies. Instead, it seeks compromise. Thus, at
times it has succeeded in getting the acquiring firm to agree to a divestiture of
some subsidiaries of the postmerger firm. At other times it has prevailed on the
acquiring firm to agree that the postmerger firm will refrain from some form of
business conduct—for example, that it will not compete in certain geographic areas for a period of years.
Individuals and corporations may also bring private civil actions for triple
damages against a firm that violates Section 7 of the Clayton Act. These private
actions, which far outnumber government antitrust cases, are important for preserving a competitive business environment.
SECTION 8: INTERLOCKING DIRECTORATES
Section 8 prohibits an individual from becoming a director in two or more
corporations if any of them has capital, surplus, and individual profits aggregating more than $21,327,000 or competitive sales of $2,132,000 (in 2005; the
amount is to be adjusted each year by the FTC) when engaged in interstate
commerce, if any of them were or are competitors, or where agreements to
eliminate competition between such corporations would be a violation of the
antitrust law.
With the growing number of conglomerates and the rise of the “professional”
director who sits on many companies’ boards for a fee, this long-dormant section of the Clayton Act has been the basis of some private civil litigation in recent years. The trend toward diversification by many large firms has resulted in
overlapping areas of competition in many corporations, so there are potential violations of Section 8 for outside directors of these firms.
It should be noted that Section 8 excludes from its coverage banks, banking
associations, and trust companies. Directors of corporations in these industries,
therefore, do not have to be concerned about a potential Section 8 violation.
Other Antitrust Statutes
FEDERAL TRADE COMMISSION ACT OF 1914
The outburst of reform that produced the Clayton Act also produced the FTCA,
which prohibits “unfair methods of competition.” This broad, sweeping language,
and the courts’ interpretation of it, allow the FTC to bring antitrust enforcement actions against business conduct prohibited by the Sherman and Clayton Acts. When
prosecution may be difficult because of the level of proof required under those acts,
the FTC may bring a civil action under the FTCA. Also, business conduct that may
not quite reach the level of prohibition under either the Sherman or the Clayton Act
may be actionable under the “unfair” competition language of the FTCA.
The following case illustrates the reach of this statute.
CHAPTER 25
CASE
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25-6
California Dental Association v. Federal Trade Commission
526 U.S. 756 (1999)
T
he California Dental Association (CDA) (defendant) is a
nonprofit association of local dentists’ organizations to
which about 75 percent of California’s dentists belong.
The CDA provides insurance arrangements and other benefits for its members and engages in lobbying, litigation,
marketing, and public relations on its members’ behalf.
The CDA’s members agree to abide by the association’s
Code of Ethics, which, among other things, prohibits false
or misleading advertising. The CDA has issued interpretive
advisory opinions and guidelines relating to advertising.
These guidelines included restrictions on two types of
truthful, nondeceptive advertising: price advertising, particularly discounted fees, and advertising relating to the
quality of dental services.
The FTC filed a complaint with an ALJ, alleging that the
CDA violated Section 5 of the FTCA in applying its guidelines
to restrict price and quality advertising. The ALJ found that
the CDA violated Section 5. On appeal, the FTC upheld this
finding, as did the U.S. Court of Appeals for the Ninth Circuit.
Justice Souter
Even on the view that bars [prohibitions] on truthful and
verifiable price and quality advertising are prima facie anticompetitive and place the burden of procompetitive justification on those who agree to adopt them, the very issue at
the threshold of this case is whether professional price and
quality advertising is sufficiently verifiable in theory and in
fact to fall within such a general rule. . . . [I]t seems to us that
the CDA’s advertising restrictions might plausibly be
thought to have a net procompetitive effect, or possibly no
effect at all on competition. The restrictions on . . . advertising are, at least on their face, designed to avoid false or deceptive advertising in a market characterized by striking
disparities between the information available to the professional and the patient. In a market for professional services,
in which advertising is relatively rare and the comparability
of service packages not easily established, the difficulty for
customers or potential competitors to get and verify information about the price and availability of services magnifies
the dangers to competition associated with misleading advertising. What is more, the quality of professional services
tends to resist either calibration or monitoring by individual
patients or clients, partly because of the specialized knowledge required to evaluate the services, and partly because of
the difficulty in determining whether, and the degree to
which, an outcome is attributable to the quality of services
(like a poor job of tooth-filling) or to something else (like a
very tough walnut). Patients’ attachments to particular professionals, the rationality of which is difficult to assess, complicate the picture even further. The existence of such
significant challenges to informed decision making by the
customer for professional services immediately suggests
that advertising restrictions arguably protecting patients
from misleading or irrelevant advertising call for more than
cursory treatment as obviously comparable to classic horizontal agreements to limit output or price competition.
Judgment for the Defendants.
Vacated and remanded to Court of Appeals.
One of the central ideas of critical thinking is that the quality of anyone’s conclusion, including that of Justice Souter, is
closely related to the quality of the evidence used to support that particular conclusion. Although Justice Souter is not
making the final decision in Case 25-5, what he did certainly supports the CDA’s efforts to continue its current restrictions on its members. Evaluating evidence is often made easier by asking, what kinds of evidence would have been ideal.
1.
To form his argument, Justice Souter makes a number of assertions. Name two claims he made in Case 25-5 for
which additional evidence would enhance our confidence in their accuracy.
Clue: Find places where Justice Souter makes factual claims but offers no evidence beyond his statement to
support their validity.
2.
To demonstrate to yourself that evidence is necessary for us to believe someone, locate two assertions made by
Justice Souter in Case 25-5 that have no supporting evidence. Write two statements that say the opposite of what
Justice Souter said. Do your statements assist the plaintiff in this case?
Clue: If your statements were true, would the CDA’s restrictions on advertising be more likely to harm consumers than if Justice Souter’s statements were true?
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BANK MERGER ACT OF 1966
The Bank Merger Act of 1966 requires that all bank mergers be approved in advance by the banking agency having jurisdiction—that is, the Federal Reserve
Board, the Federal Deposit Insurance Corporation (FDIC), or the Comptroller of
the Currency. The agency with jurisdiction must obtain a report “on the competitive factors involved” from the U.S. attorney general, and from the other two
agencies as well, before making a decision.
Even if the agency approves the merger, the Justice Department may bring a
suit within 30 days. This action automatically stays the merger, and a federal district court must then review all issues concerning the merger de novo (newly or
from the beginning). If not challenged by the U.S. attorney general within 30 days,
a bank merger is still subject to liability under Section 2 of the Sherman Act if it is
shown to have resulted in a monopoly. Acquisitions by bank holding companies
are subject to the same antitrust standards that are applied to other industries.
The Bank Merger Act has become more significant in light of a 1985 decision of the U.S. Supreme Court approving regional banking and acquisitions by
banks across state lines, when state legislatures have given prior approval. Furthermore, major bank, insurance, and brokerage companies (e.g., Travelers and
Citicorp) have merged, and large banks have merged with each other (e.g., Bank
One and National Bank of Chicago).
Global Dimensions of Antitrust Statutes
TRANSNATIONAL REACH OF U.S. ANTITRUST LEGISLATION
Sections 1 and 2 of the Sherman Act explicitly apply to “trade or commerce . . .
with foreign nations,” so they obviously have transnational reach. In contrast,
Sections 2 and 3 of the Clayton Act, because they apply to price discrimination,
tying arrangements, and exclusive-dealing contracts for commodities sold for
“use, consumption, or resale within the United States,” have no transnational
reach. Section 5 of the FTCA, however, is given express transnational reach by
Section 4 of the Export Trading Company Act (Webb–Pomerene Export Act),
which extends the meaning of “unfair methods of competition” to practices in
export trade against other competitors engaged in such trade even though acts
constituting unfair methods of competition “are done without the territorial jurisdiction of the United States.” The courts, using a case-by-case approach, have
interpreted the language of these statutes so as to establish principles of law that
guide companies and their management in determining whether certain activities are illegal because of their transnational impact.
In 1994, Congress passed the Antitrust Enforcement Assistance Act of 1994,
which gave the Department of Justice authority to negotiate “mutual assistance”
agreements with foreign antitrust enforcers. Also in 1994, the Justice Department
and the FTC issued guidelines, based on current statutory and case law, that tell
foreign and U.S. companies when either of the agencies is likely to act against
alleged anticompetitive action in international trade. The following kinds of behavior may be investigated under the guidelines:
1. A merger of foreign companies that have significant sales in the United States
2. Conduct by foreign companies that has a direct, substantial, and reasonably
foreseeable effect on commerce within the United States or on U.S. companies’ export business
3. Anticompetitive schemes by importers that have a significant impact on the
United States
4. Anticompetitive actions by foreign firms selling to the U.S. government
CHAPTER 25
GLOBAL DIMENSIONS OF U.S. ANTITRUST LAWS
The general principle guiding the courts in application of the Sherman Act (and
other U.S. antitrust laws) has been that if United States or foreign private companies enter into an agreement forbidden by Section 1, and that agreement affects the foreign commerce of the United States, then the U.S. courts have
jurisdiction. The question then becomes: How much commerce must be affected
before U.S. courts will assume jurisdiction? The Department of Justice’s guidelines on its foreign antitrust enforcement policy announced a jurisdictional standard that requires business practices to have a “substantial and foreseeable effect
on the foreign commerce of the United States.” An example would be an agreement by U.S. corporations selling roller bearings to divide up markets in Latin
America. The department has stated that this country’s antitrust laws will not be
applied to certain business practices if they have no “direct or intended effect,”
and most commentators agree that trivial restraints affecting the foreign commerce of the United States are not likely to be prosecuted. (The Assignment on
the Internet at the end of this chapter encourages readers to deal with some of
the issues raised here.)
U.S. appellate courts have held that U.S. courts do have jurisdiction over business conduct by a foreign corporation that is based on a decision by the corporation’s government to replace a competitive economic model with a state-regulated
model. State-regulated models encourage price-fixing and collaboration among
competitors, especially when a government actually prohibits competition between firms. The courts of the United States do not evaluate the lawfulness of acts
of foreign sovereigns performed within their own territories, even if the foreign
commerce of the United States is affected by those acts, because the act-of-state
doctrine forbids them to do so. Under this doctrine (discussed in Chapter 3), when
the illegal conduct is that of a foreign government (as opposed to that of foreign
individuals), the courts are not permitted to examine and decide the merits of any
claim alleged. This approach applies to any case in which a statute, a decree, an
order, or a resolution of a foreign government or governments is alleged to be
unlawful under U.S. law. For instance, when the International Association of
Machinists brought a suit claiming that an agreement by member states of the
Organization of Petroleum Exporting Countries (OPEC) to increase the price of
crude oil through taxes and price-setting was in violation of Sections 1 and 2 of
the Sherman Act, the federal district court dismissed the case for lack of jurisdiction based on the act-of-state doctrine.
ENFORCEMENT
A court decision condemning certain business practices prohibited by U.S. antitrust laws—such as price-fixing, allocation of markets, or boycotts—may give a
plaintiff satisfaction but no equitable relief. For example, if a U.S. corporation enters into a price-fixing agreement with a foreign corporation to determine the
price of uranium worldwide, the foreign corporation may be made a defendant
in a U.S. court and the plaintiff may win the case. Can the foreign defendant, however, be forced to pay triple damages? Usually not, unless it has assets in the
United States that can be seized, or there is a treaty of friendship and commerce
between the United States and the foreign corporation’s home country providing
for the implementation of judicial decrees of U.S. courts in that country’s courts.
The second possibility is limited by the fact that very few treaties contain such
terms. The first possibility is more promising because many foreign corporations
have assets, such as bank accounts, in the United States. The plaintiff can get a
decree freezing those assets until the corporation pays the court-ordered damages, because Section 6 of the Sherman Act provides for forfeiture of property to
enforce an antitrust decree.
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Antitrust Laws
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In the OPEC case referred to earlier, a group of foreign governments colluded to fix prices, but the crude oil was extracted, transported, and sold by U.S.
oil corporations. Would it have been appropriate for the plaintiffs in that case to
obtain a court decree ordering the seizure of the assets of the oil companies on
the ground that they were coconspirators in the price-fixings? Would OPEC have
cared about U.S. oil companies’ assets? If it did care, would it have ceased selling oil to the United States? The answer to that question would probably depend
on the supply and demand of oil on the world market.
Antitrust Laws in the United States and the European Union
In this chapter, we have reviewed the major antitrust laws in the United States (Table 25-2). The European Union
is governed by Articles 8 and 82 of the Treaty of Amsterdam and the Merger Control Regulation.
If you are an employee or an officer of a U.S. company doing business in any of the 26 EU countries, it may be
well to look at the comparative difference of antitrust laws. For example, we know that Section 1 of the Sherman
Act prohibits “concerted” or conspiratorial practices (two or more) such as price-fixing, output restrictions, tying arrangements, and the like, as outlined in this chapter. In contrast, the EU through its Competition Directorate
has issued a number of “blocks” or group exceptions that exempt whole categories of agreements. Even if there
is not a block exemption, individual exemptions can be granted for specific agreements. Exemptions are binding
on all national authorities and the courts of member nations. Case law and legislation have created exemptions
to U.S. antitrust laws (Table 25-4), but they are more difficult to obtain.
Although civil penalties in the form of fines are permitted under EU regulations, both criminal and civil actions may be brought in the United States; no private enforcement of EU laws is possible. Thus, while doing business in the EU, it behooves the businessperson to know a great deal about EU law, most particularly block and
individual exemptions of certain practices (e.g., price-fixing) that may be punishable in the United States both
civilly and criminally, but not in the EU.
Also, the standards by which a practice may be judged differ considerably. For example, judging of monopoly
positions under Article 8-2 of the EU treaty may be stricter, because “the abuse” of the company’s dominant position is broader than the concept of “monopolization” and “attempted monopolization” under Section 2 of the
Sherman Act. It would be well to seek the advice of counsel if you were a Microsoft company officer, for example, or an employee selling Microsoft products in EU countries. (In September of 2007, the European Court of
First Instance upheld a $600 million fine against Microsoft, levied initially by the European Commission, because
of “abuse” of the company’s “dominant position” in Intel-compatible PC operating systems markets.)
SUMMARY
This chapter included a history and summary of sections of the Sherman Act,
Clayton Act, Federal Trade Commission Act, and Bank Merger Act. We have
sought to examine the policy implications of these acts for business managers
and consumers. We also examined the international dimensions of U.S. antitrust
statutes in light of multinationals doing business in the United States, as well as
the impact of the U.S. antitrust statutes on those doing business in other countries. With this transnational reach of antitrust legislation, enforcement by the
U.S. federal courts in both types of circumstances has become more frequent.
CHAPTER 25
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Antitrust Laws
717
REVIEW QUESTIONS
25-1 Who is responsible for enforcement of the antitrust statutes?
25-2 What industries and activities are exempt from
U.S. antitrust law?
25-3 Explain the difference between horizontal and
vertical restraints under Section 1 of the Sherman Act.
25-4 List and define three types of mergers.
25-5 Describe the approach the Justice Department
takes to horizontal mergers under its current
Merger Guidelines.
REVIEW PROBLEMS
25-6 Ronwin was an unsuccessful candidate for admission to the Arizona State Bar. Under Arizona
Supreme Court rules, a Committee on Examinations
and Admissions appointed by the court was authorized to examine the applicants on specified subjects,
to grade the examinations according to a formula submitted to the court before the examination, and then
to submit its recommendations to the court. A rejected applicant could seek review of the state
supreme court’s decision. After he was rejected by
both the committee and the state supreme court,
Ronwin appealed to the U.S. Supreme Court, claiming
that the committee had violated Section 1 of the
Sherman Act by artificially reducing the number of
attorneys in the state. He argued that the committee
had set the grading scale with reference to the number
of new attorneys it thought was desirable in Arizona,
as opposed to a “suitable” level of competence. The
defendants argued that they were immune from antitrust liability under the act-of-state doctrine. Who
won this case and why?
25-7 Topco is a cooperative association of 25 smalland medium-sized regional supermarket chains that operate in 33 states. To compete with large supermarket
chains, Topco buys and distributes for its members
quality merchandise under private labels. Each member
of the cooperative has to sign an agreement promising
to sell Topco-brand products only in a certain designated territory. The government sued Topco, claiming
it was horizontally dividing markets in violation of
Section 1 of the Sherman Act. The defendant argued
that this territorial restriction was necessary to compete with large chains. Who won this case and why?
25-8 Falstaff Brewing Company was the fourthlargest brewer in the United States, with 5.9 percent
of the national market. Falstaff acquired a local New
England brewery, Narragansett, in order to penetrate
the New England market. Narragansett had 20 percent
of that market. The Justice Department filed suit
against Falstaff under Section 7 of the Clayton Act.
What was the result? Explain.
25-9 Alcoa was the leading producer of aluminum
conductors in the United States, with 27.8 percent of
the market. Alcoa acquired Rome Electric, which had
1.3 percent of the market. Rome ranked ninth among
all companies in the aluminum conductor market. The
Justice Department sued, claiming a violation of
Section 7 of the Clayton Act and asking for a divestiture by Alcoa. What was the result? Explain.
25-10 Ford Motor acquired Autolite, an independent manufacturer of spark plugs that accounted for
15 percent of national sales of spark plugs. GM,
through its AC brand, accounted for another
30 percent of national sales. After Ford’s acquisition
of Autolite, Champion was the only independent
manufacturer of spark plugs remaining in the market.
Its market share declined from 50 percent to
33 percent after the acquisition. The Justice Department sued Ford for violation of Section 7, and the
federal district court ruled in favor of the United
States. The court ordered Ford to do the following:
(1) divest itself of Autolite; (2) stop manufacturing
spark plugs for 10 years; and (3) purchase 50 percent
of its requirements from Autolite for 5 years. Ford
appealed. Who won and why?
718
PART THREE
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CASE PROBLEMS
25-11 Dentsply International, Inc., is one of a dozen
manufacturers of artificial teeth for dentures and other
restorative devices. Dentsply sells its teeth to 23 dealers of dental products. The dealers supply the teeth to
dental laboratories, which fabricate dentures for sale
to dentists. There are hundreds of other dealers who
compete with one another on the basis of price and
service. Some manufacturers sell directly to the laboratories. There are also thousands of laboratories that
compete with one another on the basis of price and
service. Because of advances in dental medicine, however, artificial tooth manufacturing is marked by low
growth potential, and Dentsply dominates the industry. Dentsply’s market share is greater than 75 percent
and is about 15 times larger than that of its next-closest
competitor. Dentsply prohibits its dealers from
marketing competitors’ teeth unless they were selling
those teeth before 1993. The federal government filed
suit in a federal district court against Dentsply, alleging in part a violation of Section 2 of the Sherman
Act. How should the court rule? Explain. United
States v. Dentsply International., Inc., 399 F.3d 181
(3d Cir. 2005).
25-12 High fructose corn syrup (HFCS) is a sweetener made from corn and used in food products.
There are two grades, HFCS 42 and HFCS 55. The five
principal HFCS makers, including Archer Daniels
Midland Co. (ADM), account for 90 percent of the
sales. In 1988, ADM announced that it was raising its
price for HFCS 42 to 90 percent of the price of HFCS
55. It cost only 65 percent as much to manufacture
HFCS 42, but the other makers followed suit. Over the
next seven years, the makers sometimes bought HFCS
from each other even when they could have produced
the amount at a lower cost, and many sales to other
customers were made at prices below the list prices.
After Wilson, head of ADM’s corn-processing division,
was imprisoned for antitrust violations with regard to
other ADM products, HFCS buyers filed a suit in a federal district court against the makers, alleging a per se
violation of the Sherman Act and seeking billions of
dollars in damages. How should the court rule? Discuss. In re High Fructose Corn Syrup Antitrust Litigation, 295 F.3d 651 (7th Cir. 2002).
25-13 Wisconsin passed a law, titled the Unfair
Sales Act, that required retail gasoline to be marked
up at least 9.18 percent over wholesale price. In 2008,
when gas went over $4.00 a gallon, the law required
the retail price to be increased by an additional
38 cents. Flying J, a corporation that operates travel
plazas, did not want to comply with the law, so it
filed suit, challenging the statute as being an unlawful
restraint on trade. The state contended that it was
immune from antitrust actions. Do you think the
court found the law to be valid? Flying J v. Van
Hollen, 597 F. Supp. 2d 848; 2009 WL 33034
(E.D. Wis. 2009).
25-14 Visa U.S.A., Inc., MasterCard International,
Inc., American Express (Amex), and Discover are the
four major credit- and charge-card networks in the
United States. Visa and MasterCard are joint ventures,
owned by the thousands of banks that are their members. The banks issue the cards, clear transactions, and
collect fees from the merchants that accept the cards.
By contrast, Amex and Discover themselves issue cards
to customers, process transactions, and collect fees.
Since 1995, Amex has asked banks to issue its cards.
No bank has been willing to do so, however, because it
would have to stop issuing Visa and MasterCard cards
under those networks’ rules barring member banks
from issuing cards on rival networks. The U.S. Department of Justice filed a suit in a federal district court
against Visa and MasterCard, alleging in part that the
rules were illegal restraints of trade under the Sherman
Act. Do the rules harm competition? If so, how? United
States v. Visa U.S.A., Inc., 344 F.3d 229 (2d Cir. 2003).
25-15 Oracle Corporation initiated a tender offer for
the shares of PeopleSoft, Inc., on June 6, 2003. The
U.S. government, acting through the Antitrust Division
of the Department of Justice, and the states of
Connecticut, Hawaii, Maryland, Massachusetts,
Michigan, Minnesota, New York, North Dakota, Ohio,
and Texas (collectively, the plaintiffs) brought suit on
February 26, 2004, seeking to enjoin Oracle from
acquiring, directly or indirectly, all or any part of the
stock of PeopleSoft.
Both Oracle and PeopleSoft license software applications that automate the overall data-processing functions of businesses and similar entities. These
applications are called enterprise application software
(EAS). Oracle and PeopleSoft both develop, produce,
market, and service enterprise resource planning (ERP)
system software, which integrates most of an entity’s
data across all or most of the entity’s activities. ERP
software includes programs for human relations management (HRM), financial management systems (FMS),
customer relations management (CRM), supply chain
management (SCM), product life cycle management,
and business intelligence (BI), among many others.
These are called the pillars.
Although ERP encompasses many pillars, the
plaintiffs asserted claims with respect to only two pillars: HRM and FMS. They defined the relevant product
market as those HRM and FMS products able to meet
CHAPTER 25
the needs of large and complex enterprises with “high
functional needs” and asserted that the only players in
this market were Oracle, PeopleSoft, and SAP America.
The plaintiffs also alleged that the relevant geographic
market was confined to the United States. As a result,
they argued that the proposed merger would constrict
this highly concentrated oligopoly to a duopoly of SAP
and a merged Oracle/PeopleSoft.
Oracle contended that this market definition was
legally and practicably too narrow for a number of
䉬
Antitrust Laws
719
reasons, including (1) “high function” HRM and FMS
software does not exist and is only a label created by
the plaintiffs; (2) there is just one market for all HRM
and FMS/ERP products; (3) many firms besides the
three compete in the larger HRM/FMS market; and
(4) the geographic area of competition is worldwide
or, at the very least, the United States and Europe.
Is Oracle in violation of Section 7 of the Clayton Act?
Explain. United States v. Oracle Corp., 331 F. Supp.
2d 1098 (N.D. Cal. 2004).
Our antitrust laws are far too weak. If you just take a
look at the business world today, it is blatantly obvious
that companies are gaining too much power.
Take, for example, Microsoft. This company is so
big that its president, Bill Gates, has more power than
the president of the United States. Microsoft controls
over 90 percent of the market for computer operating
system software, and it is showing no signs of losing
any of its market share. Other companies are powerful, too. Consider Nike, a company that can pay its
workers only pennies per hour and then charge consumers hundreds of dollars for its products. Another
example is General Electric. Not only is General Electric powerful in the electronics industry, it has also
branched out into other industries as well. It owns
NBC, a network that many Americans depend on for
news. In the past, Americans could count on the news
to give them an objective report of what’s going on in
our nation. Now, they hear only the stories that the
corporate bigwigs want them to hear.
These corporations are so powerful and so impersonal that they’ll just get up and leave if they think
they can get more money elsewhere. New York City
lost over a million jobs in the manufacturing industry
between 1970 and 1984 because companies would
rather put their factories in Third World nations than
pay Americans a decent wage.
If our society is to return to its status as the greatest in the world, Congress and the courts need to
broaden the scope of antitrust laws. We need to make
sure that any corporation powerful enough to control
public opinion or to ignore its obligations to society is
broken up.
1. What ethical values seem to support this author’s
conclusion? Explain.
2. What words or phrases are ambiguous in this essay? Explain.
3. Construct an essay giving an opinion opposite to
that of the author of this essay.
This chapter introduces you to antitrust law in the
United States and the global dimensions of these laws.
A Supreme Court decision, Hoffman-LaRoche Ltd. v.
Empagran S.A., clarified the reach of the Foreign
Trade Antitrust Improvement Act. Use the Internet to
read a brief summary of the case at the following site:
www.oyez.org/oyez/resource/case/1746. What
specific issue did the Court address? Do you agree
with the Court’s reasoning? Why? (See the section in
this chapter on “Global Dimensions of Antitrust
Statutes.”)
Finally, use the Internet to search for commentary
on the case. What do other legal scholars have to say
about the Court’s decision?
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ON THE INTERNET
www.findlaw.com/01topics/01antitrust/mail_usenet.html
This is a site where you can begin your search for legal resources related to antitrust law and policy.
www.stolaf.edu/people/becker/antitrust
The Antitrust Case Browser located at this address provides a collection of U.S. Supreme Court case summaries
dealing with violations of antitrust statutes.
www.law.cornell.edu/topics/antitrust.html
The Legal Information Institute provides an overview to antitrust law as well as links to recent antitrust court
decisions.
www.usdoj.gov/atr
This is the Web address of the Department of Justice Antitrust Division.
www.antitrustinstitute.org/index.cfm
The American Antitrust Institute home page contains news and information about antitrust enforcement.
www.ftc.gov/ftc/antitrust.htm
This is the Federal Trade Commission’s antitrust Web site, which contains numerous links to current antitrust
issues.
FOR FUTURE READING
Gellhorn, Ernest, William E. Kovacic, and Stephen
Calkins. Antitrust Law and Economics in a Nutshell.
St. Paul, MN: West, 2004.
Miller, Sandra K., Penelope Sue Greenberg, and Ralph H.
Greenberg. “An Empirical Glimpse into Limited
Liability Companies: Assessing the Need to Protect Minority Investors.” American Business Law Journal 43
(2006): 609.
26
Laws of Debtor–Creditor
Relations and Consumer
Protection
䊏 DEBTOR–CREDITOR RELATIONS
䊏 THE FEDERAL BANKRUPTCY CODE AND THE
INCORPORATION OF THE BANKRUPTCY ABUSE
PREVENTION AND CONSUMER PROTECTION ACT OF 2005
䊏 THE EVOLUTION OF CONSUMER LAW
䊏 FEDERAL REGULATION OF BUSINESS TRADE PRACTICES
AND CONSUMER–BUSINESS RELATIONSHIPS
䊏 FEDERAL LAWS REGULATING CONSUMER CREDIT
AND BUSINESS DEBT-COLLECTION PRACTICES
䊏 DODD-FRANK ACT AND CONSUMER PROTECTION
䊏 STATE CONSUMER LEGISLATION
䊏 GLOBAL DIMENSIONS OF CONSUMER PROTECTION LAWS
n Chapters 10 and 11 covering contract law, we offered a view of private law
and how it governs the relationship between two individuals or corporations
that buy and sell items. When you went to the bookstore (or on the Internet)
to buy this textbook, you entered into a legally binding contract. The bookstore
made an offer, and you, as buyer, accepted that offer. Your acceptance was
signified by your picking out the book and paying for it at the cash register.
Assuming that there was consideration, mutual assent, competent parties, and a
legal object (and we are convinced that this text is a legal object), you entered
into an enforceable contract. Before taking this course, you probably never
thought of the act of buying a textbook as a legally binding transaction. Most
consumers do not. They generally see it as an exchange of money for something
that they want or are required to buy.
Because consumers do not think of buying a product as a formal legal transaction, they are usually unaware of the legal implications of an exchange of
money for a product or service until they have problems. The posttransaction
business–consumer relationship then becomes the basis for angry exchanges,
hurt feelings, and sometimes litigation. If both business managers and consumers
had some knowledge of the requirements of contract law, as well as federal,
state, and local statutes governing consumer transactions, there would be less
friction between these two important parties in our economy (and fewer disputes
over the types of product and service liabilities we discuss in Chapter 13).
I
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In this chapter, we describe debtor–creditor relationships; the Bankruptcy Act
of 2005,1 which amends the federal Bankruptcy Code; and the evolution of
consumer law through legislation and case law. We then examine major federal
legislation governing such trade practices as advertising, labeling, and the
issuance of warranties on products. Federal laws pertaining to the credit arrangements entered into by consumers and the debt-collection practices of businesses
are discussed, as are state laws governing consumer transactions. The chapter
ends with an examination of the global dimensions of consumer protection laws.
Debtor–Creditor Relations
creditor The lender in a
transaction.
debtor The borrower in a
transaction.
In this section we briefly describe the rights of and remedies for creditors and
debtors. Both the case law of federal and state courts and federal and state statutory law play a significant role. The U.S. economy has more and more become a
credit-based economy. One can use a Visa or MasterCard to purchase everything
from a home and automobile to clothes and a computer. When these transactions
take place, a creditor and a debtor are created. We will define the creditor as the
lender in the transaction (e.g., the bank that issues the credit card) and the debtor
as the borrower (e.g., the business or individual that uses the credit card).
When a legal entity is unable to pay its debts, bankruptcy law provides various options for the entity or individual to
resolve those debts. Bankruptcy remedies are available to individuals, partnerships, and corporations. In 2009, more
than 1.5 million bankruptcies were filed; more than 30,000 business firms filed for bankruptcy. The legal actions that
result involve basic ethical norms, particularly those of fairness and compassion. Debtors, whether they are large firms
or your neighbors, are in trouble. Should we help them?
Before we can answer that question, we should consider several issues. What are the costs of that help? Should
people or firms be able to consume resources without paying for them? What kinds of incentive effects do we create
if we allow debtors to escape their obligations?
Consider the following case example and, specifically, the effect of ethical norms in shaping your reaction to the
situation.
Woodcock graduated from law school and finished his MBA in 1983. His student loans came due nine months later.
Because he was a part-time student until 1990, he requested that payment be deferred. Because he was not in a degree
program, payment should not have been deferred under the terms of the loan, but the lender incorrectly approved the
deferral. Woodcock filed for bankruptcy in 1992, more than seven years after the loans first became due. Hence, that
debt was discharged unless there was an “applicable suspension of the repayment period.” The Dodd-Frank financial
overhaul statute of 2010 created the Consumer Financial Protection Bureau which may regulate lenders that provide
private student loans.a
1.
What are the relevant ethical norms that affect your reaction to this case?
Clue: Go back to the first place in the text where the concept of ethical norms first appears (Chapter 1). Which
of the norms discussed there apply to the proper legal reaction to Woodcock’s debt?
2.
Our legal system is in many regards governed by principles of personal responsibility. When a person signs a
contract or accepts credit, we ordinarily expect that person to fulfill the terms of what we see as that person’s
choice. Which ethical norms attach most closely to this theme of personal responsibility?
Clue: For each ethical norm, ask yourself: Does this norm strengthen or weaken personal responsibility?
a
Woodcock v. Chemical Bank, 144 F.3d 1340 (10th Cir. 1998).
1
11 U.S.C. § 101 (Pub. L. No. 109-8).
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Laws of Debtor–Creditor Relations and Consumer Protection
723
RIGHTS OF AND REMEDIES FOR CREDITORS
The following rights and remedies are most commonly used by creditors to enforce
their rights. They include liens, garnishments, creditor’s composition agreements,
mortgage foreclosures, and debtor’s assignment of assets for the credits.
Liens. A lien is a claim on the debtor’s property that must be satisfied before
any creditor can make a claim. We have both statutory liens (mechanic’s liens)
and common-law liens (artisan’s and innkeeper’s liens).
A mechanic’s lien is placed on the real property of a debtor when the latter does not pay for the work done by the creditor. In effect, a debtor–creditor
relationship is created, in which the real property becomes the security interest
for the debt owed. For example, when a contractor adds a room onto the house
of the debtor, and payment is not made, the contractor becomes a lienholder on
the property after a period of time (usually 60–120 days), and foreclosure may
take place. Notice of foreclosure must be given to the debtor in advance.
An artisan’s lien is created by common law that enables a creditor to recover
payment from a debtor for labor and services provided on the latter’s personal
property. For example, Andrew leaves a lawn mower at Jake’s repair shop. Jake
repairs the lawn mower, but Andrew never picks up his personal property. After
a period of time, Jake can attach the lawn mower.
Once a debt is due and the creditor brings legal action, the debtor’s property
may be seized by virtue of a judicial lien. Types of judicial liens include attachment, writ of execution, and garnishment.
Attachment involves a court-ordered judgment allowing a local officer of
the court (e.g., sheriff) to seize property of a debtor. On the motion of the creditor, this order of seizure may take place after all procedures have been followed
according to state law. This is usually a prejudgment remedy, but not always. If
at trial the creditor prevails, the court will order the seized property to be sold
to satisfy the judgment rendered.
If the debtor refuses to pay the creditor or cannot pay, usually a clerk of the
court will direct the sheriff, in a writ of execution, to seize any of the debtor’s
(nonexempt) real or personal property within the court’s jurisdiction. Any excess
after the sale will be returned to the debtor.
A creditor may ask for a garnishment order of the court, usually directed at
wages owed by an employer or a bank where the debtor has an account. This can
be either a postjudgment or a prejudgment remedy, although the latter requires a
hearing. Both federal and state laws limit the amount of money that a debtor’s takehome pay may be garnished for.2
lien A claim on a debtor’s
property that must be satisfied
before any creditor can make
a claim.
mechanic’s lien A lien placed
on the real property of a debtor
when the latter does not pay
for the work done by the
creditor.
artisan’s lien A lien that
enables a creditor to recover
payment from a debtor for
labor and services provided on
the debtor’s personal property
(for example, fixing a lawn
mower).
attachment A court-ordered
judgment allowing a local
officer of the court to seize
property of a debtor.
writ of execution An order
by a clerk of the court directing
the sheriff to seize any of the
nonexempt real or personal
property of a debtor who
refuses to or cannot pay
a creditor.
garnishment An order of the
Mortgage Foreclosure. Creditors called mortgage holders (mortgagees) have a
right to foreclose on real property when a debtor (mortgagor) defaults. There
are statutes in each of the 50 states calling for the process of foreclosure. In general, a court-ordered sale of the property takes place when the debtor receives
notice and cannot pay. After the costs of foreclosure and the mortgage debt have
been satisfied, the mortgagor (debtor) may receive the surplus. It should be
noted that mortgage foreclosures are an important source of income for those
advising debtors, including lawyers and finance firms that advise debtors.
court granted to a creditor to
seize wages or bank accounts
of a debtor.
Suretyship and Guaranty Contracts. A contract of suretyship allows a third
person to pay the debt of another (debtor) which is owed to a creditor, in the
event the debtor does not pay. The suretyship creates an express contract with
the creditor, under which the surety is primarily liable. In Chapter 10, we discussed this matter with regard to third-party beneficiary contracts.
suretyship A contract between
2
Consumer Credit Protection Act of 1968, 15 U.S.C. § 60 et seq., allows a debtor to retain 75 percent of the debtor’s disposable weekly income per week, or the sum equivalent to 30 hours paid
at federal minimum wage, whichever is greater.
a third party and a creditor that
allows the third party to pay the
debt of the debtor; the surety is
primarily liable.
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guaranty Similar to a
suretyship except that the third
person is secondarily liable
(i.e., required to pay only after
the debtor has defaulted).
A guaranty contract is similar to a suretyship arrangement except that the
third person is secondarily liable to the creditor. The guarantor is required to pay the
debtor’s obligation only after the debtor has defaulted and usually only after
the creditor has made an attempt to collect. In Chapter 10, we discussed primary
and secondary liability under the statute of frauds, which requires that a guaranty contract be in writing. The case of primary liability is the main exception to
that requirement.
RIGHTS AND REMEDIES FOR DEBTORS
Debtors as well as creditors are protected by the law. For example, property is
exempt from creditors’ actions. Federal and state consumer protection statutes
are discussed at length in this chapter. We also discuss bankruptcy laws as they
apply to debtors and creditors.
Exemptions to Attachments. We have indicated that creditors can attach, or
levy on, real and personal property. To protect debtors, however, certain
exemptions are made. The best-known exemption for debtors is the homestead
exemption. Historically, people have been allowed to retain a home up to a specified dollar amount or in the entirety. The purpose is to prevent a person from
losing his or her home if forced into bankruptcy or faced with a claim from an
unsecured creditor. Texas and California offer by far the most generous homestead exemption in bankruptcy proceedings. Many people move to one of these
states when faced with bankruptcy.
Some personal properties are exempt, depending on state statutory law.
Some examples include household furniture, a vehicle to get to work with,
equipment used in a trade, and animals used on a farm.
Digging a Deeper Hole for Debtors
Between 2008 and 2010, in the midst of a deep recession, television advertisements
were run (sometimes with the White House pictured in the background!), claiming
that they would solve debtors’ credit card and other financial problems—although
there were fine-print disclaimers below the ad. The debt settlement industry is made
up of companies that charge fees ranging from 15 to 20 percent of an individual’s
credit card balances. Such fees are usually collected up front. Worried about credit
scores and possible bankruptcy, many of those seeing these ads are willing to pay
whatever is necessary. Using the debt settlement industry figures, only approximately
one-third of applicants either completed a debt settlement program or were still
involved with a company to save money in order to pay off their debts.
The Dodd-Frank Financial Regulatory Reform Act of 2010 (Dodd-Frank), previously discussed in Chapter 24, constrains the debt settlement industry and offers
some exemptions, as follows:
• It directs the Federal Reserve Board (the Fed) to cap debit card fees at a level
that is “reasonable and proportional to the cost of processing transactions.” Fee
caps apply only to debit cards issued by banks with more than $10 billion in
assets. This covers about 12 of the largest U.S. banks, which controlled about
two-thirds of debit transactions.
• It directs the Fed to consider the cost of fraud involving debit cards.
• It excludes debit cards issued by banks on behalf of state and federal agencies
to recipients of beneficiaries of programs such as unemployment insurance and
child support.
• It exempts prepaid debit cards generally used by people who do not have bank
accounts.
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Even after the passage of Dodd-Frank, some questions remain: (1) What does
“reasonable and proportional” to the cost of processing a transaction mean? Who
will determine this? Explain. (2) What are the arguments in favor of debt settlement
companies? Explain. (3) What are the arguments of those that would regulate debt
settlement companies? Explain. (4) What sources would you consult to answer
these questions? Explain.
The Federal Bankruptcy Code
and the Incorporation of the Bankruptcy
Abuse Prevention and Consumer
Protection Act of 2005
HISTORY AND BACKGROUND
The Constitution of the United States provides another debtor right: namely, the
right to petition for bankruptcy. Congress has authority to establish “uniform
laws” on the subject of bankruptcy throughout the United States (Article 1,
Section 8). The U.S. Bankruptcy Code (Code) has several major goals: (1) to
bring about the equitable distribution of the debtor’s property among the
debtor’s creditors; (2) to discharge the debtor from its debts, enabling the debtor
to rehabilitate itself and start fresh; (3) to preserve ongoing business relations;
and (4) to stabilize commercial usage.
The Code was based in large part on a series of amendments, such as the
Bankruptcy Reform Act of 1978. In 2005, the most significant changes ever to be
made to the Code took place with enactment of the Bankruptcy Abuse Prevention
and Consumer Protection Act of 2005 (the 2005 Act). This act was intended to overhaul, in large part, certain provisions of the Bankruptcy Code. The 2005 Act was
an attempt to meet the complaints of the business community with regard to the
increase in the number of filings for personal bankruptcy. From 1980 to 2000, these
filings increased markedly (by 300,000 to 1.5 million per year), allegedly for
the purpose of evading the payment of debts by debtors.
Provisions. The U.S. Bankruptcy Code (Code) is composed of nine chapters.
Chapters 1, 3, and 5 apply to the management and administration of the Code,
particularly the substantive law set out in Chapters 7, 9, 11, 12, and 13 that will
be examined here. Straight bankruptcy (Chapter 7) provides for the liquidation
of the debtor’s property. Other proceedings generally apply to the
reorganization and adjustment of the debtor’s debts (Chapters 11, 12, 13). The
2005 Act added Chapter 15 to the Code for cross-border solvency cases. It incorporates the Model Law on Cross-Border Insolvency promulgated by the UN Commission on International Trade Law. Chapter 1 and some sections of Chapters 2
and 5 apply to the definition of terms and administration of the new Chapter 15,
which seeks to make cross-border filings easier to accomplish. It also encourages
cooperation between the United States and foreign countries with regard to
transnational insolvency cases.
BANKRUPTCY MANAGEMENT AND PROCEEDINGS
Courts. The Bankruptcy Code, inclusive of all amendments, including those of
the 2005 Act, grants to the U.S. district courts original and exclusive jurisdiction
over all bankruptcy cases. Bankruptcy courts are attached to each of the 96 federal district courts across the nation, to prevent the district courts from being
overwhelmed by bankruptcy cases that are both numerous and complex.
Bankruptcy judges are specialists who hear only bankruptcy proceedings. They
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are appointed by the U.S. court of appeals for the circuit in which the bankruptcy court is located for a period of 14 years. Among other things, the 2005
Act increased the number of bankruptcy judges to handle the burgeoning workload. The federal district courts may hear appeals from the bankruptcy courts.
A Bankruptcy Appellate Panel service is available if all parties consent to such
a hearing.
Federal law provides for a federal government official called a United States
Trustee, who supervises and handles many of the administrative details associated with these complex cases. For example, the Trustee may appoint an interim
trustee to take control of a debtor’s estate before the appointment of a permanent
trustee who is elected by the creditors as set forth in cases under Chapters 7, 11,
12, or 13.
Bankruptcy Petition. The filing of a bankruptcy petition initiates a case. Petitions
usually are set forth in one of two forms:
• Voluntary Petition. Usually filed by a debtor under the following chapters:
Chapter 7 (liquidation), Chapter 11 (reorganization), Chapter 12 (family farmer
or fisherman), and Chapter 13 (adjustment-of-debts cases). The petition must
clearly state the debts of the debtor.
• Involuntary Petition. A creditor(s) places the debtor in bankruptcy. An involuntary petition must set forth a statement that the debtor is not paying its debts
as they become due. If the debtor has 12 or more creditors, the petition must
be signed by a minimum of 3. If there are fewer than 12 creditors, any number can sign the petition. Those who sign the involuntary petition must have
unsecured claims of at least $12,300 in the aggregate (this number will increase
over time).
Bankruptcy Schedules. An individual debtor must submit the schedules (lists
and statements) noted here after it files a voluntary petition:
• A list of creditors with addresses
• A list of all property the debtor owns
• A statement of the debtor’s financial affairs
• A statement of the debtor’s monthly income
• A current income and expense statement
• A copy of the debtor’s federal income tax returns for the most recent years
before the filing of the petition
Usually, attorneys who specialize in bankruptcy law assist in preparing these
schedules. The 2005 Act requires the attorneys involved to certify the information contained in the petition and the schedules under penalty of perjury. It is
now necessary for attorneys to make a thorough investigation of the financial
position of any debtor the attorney represents. This adds to the cost of filing for
bankruptcy.
The bankruptcy court will file an order for relief unless the debtor challenges
an involuntary petition. In that instance, a trial will be held to determine whether
the order for relief should be granted.
Creditors’ Meeting. Within a reasonable time after an order of relief is granted
(10–30 days), the court will call a meeting of the creditors (first meeting of creditors). Without a judge present, the debtor must appear for questioning by the
creditors. The debtor may be accompanied by his or her attorney. A proof of
claim must be filed by each of the creditors in a timely manner.
Bankruptcy Trustee. Trustees are appointed in Chapters 7, 12, and 13 cases. In
a Chapter 13 proceeding, if there is a showing of fraud, dishonesty, or incompetence, a trustee is appointed. He or she becomes a legal representative of the
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debtor’s estate. Trustees generally are lawyers, accountants, or business professionals. They have wide powers that include but are not limited to the following:
• Taking immediate possession of the debtor’s property
• Under the 2005 Act, protecting domestic support creditors (e.g., children of
the debtor)
• Separating secured and unsecured debts
• Under the 2005 Act, filing a statement as to whether the case is presumed to
be an abuse under the means test (Chapter 7 proceedings only)
• Setting aside exempt property
• Investigating the debtor’s financial affairs
• Employing a professional to assist in administration of the case
• Distributing the proceeds of the estate
Automatic Stay. When a debtor petitions for bankruptcy, certain activities of the
creditors are immediately suspended (stayed). A stay applies to collection activities
of both secured and unsecured creditors. Many debtors file for bankruptcy before
foreclosure to prevent the loss of crucial assets or to stave off litigation from
creditors. Some creditors’ actions are automatically stayed:
• Legal action to collect debts before petitioning for bankruptcy
• Enforcing judgments obtained against a debtor
• Enforcing liens against property of the debtor
• Nonjudicial collection efforts by a creditor (e.g., repossession of an automobile)
There are exceptions to stays:
• Creditors can recover prior domestic support (e.g., alimony and child support).
• Criminal actions against debtors are not stayed.
• Certain securities and financial transactions are not stayed.
• Action taken pursuant to certain government or police regulatory/powers
are not stayed.
Relief from a stay may be granted by a court on petition by a secured creditor
when certain assets are depreciating and are not protected during the bankruptcy
procedure.
Discharge. In Chapters 7, 11, 12, and 13 bankruptcies, if all the requirements
are met, the court relieves the debtor of responsibility to pay its debts, and it
grants the debtor a discharge of all or some of its debts.
Certain debts, however, are nondischargeable:
• Certain taxes and customs duties and debt incurred to pay such taxes or
custom duties
• Legal liabilities resulting from obtaining money, property, or services by false
pretenses, false representations, or actual fraud
• Legal liability for willful and malicious injuries to the person or property of
another
• Domestic support obligations and property settlements arising from divorce
or separation proceedings
• Student loans unless excepting the debt would impose undue hardship
• Debts that were or could have been listed in a previous bankruptcy in which
the debtor waived or was denied a discharge
• Consumer debts for luxury goods or services in excess of $500 per creditor,
if incurred by an individual debtor on or within 90 days before the order for
relief (these are presumed to be nondischargeable)
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• Cash advances aggregating more than $750 obtained by an individual debtor
under an open-ended credit plan within 70 days before the order for relief
(these are presumed to be nondischargeable)
• Fines, penalties, or forfeitures owed to a governmental entity
Bankruptcy Estate. When a bankruptcy case is commenced, a separate legal
entity is created, which is often referred to in the proceedings as an estate. This
estate consists of all legal and equitable interests of the debtor in nonexempt
property. The estate includes property of the debtor that the debtor acquires, within
180 days after the filing of the petition, by inheritance, by a property settlement, by
divorce decree, or as a beneficiary of a life insurance policy. Additionally, the estate
includes proceeds, rents, and profits from the property. The 2005 Act excluded
from the bankruptcy estate savings for postsecondary education through education
individual retirement accounts (education IRAs) and 529 plans.
Estate Exemptions. The federal Bankruptcy Code establishes a list of estate
property and assets that the debtor can claim as exempt property. Such exemptions are adjusted every three years to reflect the consumer price index. The
following exemptions and dollar limits were set by the 2005 Act:
• Interest up to $18,450 in equity in property used as a residence and burial
plots (called the homestead exemption)
• Interest up to $2,950 in value in one motor vehicle. New York State has increased the value up to $4,000 or $10,000 for a disabled debtor in December
of 2010.
• Interest up to $475 per item in household goods and furnishings, wearing
apparel, appliances, books, animals, crops, or musical instruments, up to an
aggregate value of $9,850 for all items
• Interest in jewelry up to $1,225
• Interest in any property the debtor chooses (including cash) up to $975, plus
up to $9,250 of any unused portion of the homestead exemption. New York
State has increased the value of property that people can retain when they
declare bankruptcy or when creditors win judgments against them. The
homestead exemption has been increased from $50,000 to either $75,000,
$125,000 or $250,000 depending on your county of residence.
• Interest up to $1,850 in value in implements, tools, or professional books
used in the debtor’s trade
• Professionally prescribed health aids
• Many government benefits regardless of value, including Social Security
benefits, welfare benefits, unemployment compensation, veteran’s benefits,
disability benefits, and public assistance benefits
• Certain rights to receive income, including domestic support payments (e.g.,
alimony, child support), certain pension benefits, profit-sharing payments,
and annuity payments
• Interests in wrongful death benefits and life insurance proceeds to the extent
necessary to support the debtor or his or her dependents
• Personal injury awards up to $18,450
Retirement funds that are in a fund or an account that is exempt from taxation under the Internal Revenue Code shall not exceed $1 million for an individual unless the interests of justice require this amount to be increased. There
is an exemption for IRAs.
State Exemption. The Code also provides for certain exemptions by states; that
is, the states are permitted to enact their own legislation allowing exemptions. If
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they do so, they may (1) give debtors the option of choosing between federal
and state exemptions or (2) require debtors to follow state law.
Fraudulent Transfers. The 2005 Act gave the bankruptcy courts the power to
void certain fraudulent transfers of the debtor’s property and obligations incurred
by the debtor within two years of the filing of the petition for bankruptcy:
• Debtor’s transfer of property for less than a reasonable equivalent consideration when he or she is insolvent.
• Debtor’s transfer of property with the intent to delay or defraud the creditor.
• Debtor’s transfer of assets to a living will; these can be voided if (1) the transfer was made within 10 years before the date of the filing of the petition for
bankruptcy, (2) the transfer was made to a self-settled trust, and (3) the
debtor is the beneficiary of the trust.
CHAPTER 7
Under Chapter 7 (straight bankruptcy), a debtor turns all assets over to a trustee.
The trustee sells the nonexempt assets and distributes the proceeds to creditors.
The remaining debts are discharged. The nonexempt estate assets for a debtor
were discussed previously. Before the 2005 Act, Chapter 7 bankruptcy proceedings became part of many individuals’ financial planning, as debts were easily
discharged and the debtor was freed to start over. The 2005 Act restricts debtors’
ability to obtain a Chapter 7 bankruptcy. Now, a dollar-based means test, as well
as a medium income test based on the debtor’s state of residence, must be met
before a debtor may discharge its debts. If these tests are not met, the 2005 Act
provides that the debtor’s Chapter 7 proceeding may, with the debtor’s consent, be
dismissed or converted to a Chapter 13 or Chapter 11 bankruptcy. The 2005 Act in
effect pushed many debtors out of Chapter 7 and into Chapter 13 debt-adjustment
bankruptcy. Debtors were forced to pay some of their future income over a period
of five years to pay off debts owed before petitioning for bankruptcy.
The goals of the 2005 Act are to (1) deny Chapter 7 discharge to debtors who
have the means to pay some of their unsecured debts from earnings following
the filing of a petition for bankruptcy, and (2) to steer most Chapter 7 bankruptcies to Chapter 13 instead.
Under Section 707(b) of the 2005 Act, the bankruptcy court may dismiss a
Chapter 7 liquidation filing by an individual debtor whose debts are primarily consumer in nature if the court finds that granting relief to the debtor would be an abuse
of Chapter 7 (the means and median income tests will be determinative). Consumer
debts are defined as debts incurred for personal, family, or household use. Within
10 days after the first meeting of creditors, as previously discussed, the trustee must
file a statement with the court as to whether the debtor filing is abusive.
Discharge of Debts. Discharge enables the debtor to say that it is no longer
legally responsible for paying certain claims by creditors on unsecured debts. In
a Chapter 7 proceeding, such a discharge of debts is important because it is
granted soon after the petition is filed. Under the 2005 Act, the debtor can be
granted Chapter 7 relief only after eight years, following Chapter 7 or Chapter 11
bankruptcy, and only after six years following Chapter 12 or 13 relief.
Discharge is not available to partnerships, limited liability companies, and
corporations under the federal Bankruptcy Code. All of these must liquidate
under state law before or upon completion of a Chapter 7 proceeding.
Acts Barring Discharge. A debtor will be denied discharge of his or her
debts based on certain acts:
• False representation of his or her financial position when credit is extended
• Falsifying, destroying, or concealing financial records
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• Failing to account for assets
• Failing to submit to questioning of creditors
• Failing to complete an instructional course on financial management as
required by the 2005 Act when filing under Chapter 7
Student loans cannot be discharged under Chapter 7. Student loans are
defined by the Code as those made, or guaranteed, by governmental units. The
2005 Act added student loans made by nongovernmental commercial institutions
such as banks, as well as funds for scholarships, benefits, or stipends granted by
educational institutions. The Code states that student loans can be discharged in
bankruptcy only if a denial of discharge would cause “undue hardship” (defined
as “severe mental or physical disability of debtor or inability to pay for necessities of him, her, or dependent”). In the following case excerpt, the court seeks
to define undue hardship.
CASE
26-1
In re Savage v. United State Bankruptcy
Appellate Panel (First Circuit)
311 Bankr. 835 (2004)
B
renda Savage attended college in the mid-1980s—
taking out five student loans—but she did not graduate.
In 2003, at the age of 41, single, and in good health, she
lived with her 15-year-old son in an apartment in Boston,
Massachusetts. Her son attended Boston Trinity Academy,
a private school. Savage worked 37.5 hours per week for
Blue Cross/Blue Shield of Massachusetts. Her monthly gross
wages were $3,079.79. Her employment provided health
insurance, dental insurance, life insurance, a retirement
savings plan, and paid vacations and personal days. She also
received monthly child-support income of $180.60. After
deductions, her total net monthly income was $2,030.72.
Her monthly expenses included, among other things,
$607 for rent, $221 for utilities, $76 for phone, $23.99 for
an Internet connection, $430 for food, $75 for clothing,
$12.50 for laundry and dry cleaning, $23 for medical
expenses, $95.50 for transportation, $193.50 for charitable
contributions, $43 for entertainment, $277.50 for her son’s
tuition, and $50 for his books. In February, Savage filed a
petition for bankruptcy, seeking to discharge her student
loan obligations to Educational Credit Management Corporation (ECMC). At the time, she owed $32,248.45. The
court ordered a discharge of all but $3,120. ECMC appealed
to the U.S. Bankruptcy Appellate Panel for the First Circuit.
Judge Haines
Under 11 U.S.C. Section 523(a)(8), debtors are not permitted to discharge educational loans unless excepting the
loans from discharge will impose an undue hardship on the
debtor and the debtor’s dependents.
Under “totality of the circumstances” analysis, a debtor
seeking discharge of student loans must prove by a preponderance of [the] evidence that (1) her past, present, and rea-
sonably reliable future financial resources; (2) her and
her dependents’ reasonably necessary living expenses;
and (3) other relevant facts or circumstances unique to the
case prevent her from paying the student loans in question
while still maintaining a minimal standard of living, even
when aided by a discharge of other pre-petition debts.
The debtor must show not only that her current income
is insufficient to pay her student loans, but also that her
prospects for increasing her income in the future are too
limited to afford her sufficient resources to repay the student loans and provide herself and her dependents with a
minimal (but fair) standard of living.
Ms. Savage has not demonstrated that her current level of
income and future prospects warrant discharge of her loans.
Her present income may be insufficient to pay her student
loans and still maintain precisely the standard of living she
now has. But it would enable her to repay the loans without
undue hardship. Moreover, the record plainly establishes
that her prospects for a steady increase in income over time
are promising. She has been steadily employed at the same
job and regularly receives annual raises. Nothing indicates
change is in the wind. Moreover, Ms. Savage currently works
3712⁄ hours a week, leaving time for some part-time work (or
longer hours at her present job).
To prove undue hardship for purposes of Section
523(a)(8), a debtor must show that her necessary and
reasonable expenses leave her with too little to afford
repayment.
Private school tuition is not generally considered a reasonably necessary expense in bankruptcy cases. Although
compelling circumstances may distinguish a given case,
the [courts] uniformly hold that a debtor’s mere preference for private schooling is insufficient to qualify the
attendant expense as necessary and reasonable.
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Ms. Savage did not demonstrate a satisfactory reason
why her son needs to attend private school at a monthly
cost of $277.50 (plus $50 for books). When asked to
explain why she did so, she testified:
There were a lot of fights, a lot of swearing, a lot of
other things going on. I mean he would wake up every
morning crying because he didn’t want to go to
school. So I had to find a school to put him in—where
he was going to—I mean, he didn’t do well that whole
year. I had to keep going down to the school several
times. He was just a mess the whole school year. So I
had to find another school.
Although we understand why Ms. Savage prefers that
her son attend private school, she has not demonstrated
731
that the public school system cannot adequately meet her
son’s educational needs. Her preference appears sincere,
but that alone is not sufficient to sustain the bankruptcy
court’s implicit conclusion that forgoing this expense
would constitute undue hardship.
Given the fact that at least $322.50 (private school
tuition and books) in expense can be eliminated from
Ms. Savage’s budget without creating undue hardship, her
student loans cannot be discharged under Section
523(a)(8). It is worth noting, as well, that Ms. Savage’s son
will reach majority in just a few years, a consequence that
will reduce her required expenses considerably.
Reversed the order of the bankruptcy court and
remanded the case for judgment in ECMC’s favor.
The legal rule in a case is expressed in words, but in this case, as in any legal reasoning, words are slippery characters.
They need a lot of attention if we are to avoid being misled by them. It would have been quite possible, for instance,
for Savage to have known the rule of law in this situation and to have honestly believed that she deserved to have the
debt discharged.
1.
What is the legal rule in this case?
Clue: When it was time for the court to make its decision, what standard did it use to reach its conclusion?
2.
What is the key ambiguous phrase in this decision? What alternative meanings does that phrase have?
Clue: Can you imagine any reasonable person believing that private school in Savage’s situation is a necessary
expenditure for her family?
A bankruptcy court may revoke a discharge within one year after it is granted
if it was obtained through fraud of the debtor, concealment or destruction of property; or through a proceeding in which the debtor may be guilty of a felony.
Statutory Distribution of Property. If a debtor qualifies for Chapter 7 bankruptcy, the nonexempt property of the bankruptcy estate (previously examined)
must be distributed to secured and unsecured creditors. Under the Code, priorities are established. The trustee in bankruptcy collects and distributes property
in most voluntary bankruptcies.
CHAPTER 13
Under Chapter 13 of the Code (the wage earner’s plan), a portion of the
consumer-debtor’s earnings is paid into the court for distribution to creditors
over three years or, with court approval, over five years. Both wage earners and
individuals engaged in business whose unsecured debts are not in excess of
$307,675 and who have secured debts not in excess of $922,975 may qualify
under Chapter 13. Only voluntary petitions for bankruptcy may be filed under
this chapter. Creditors cannot force petitioners into Chapter 13 bankruptcy.
Often, creditors agree to a composition plan, whereby each creditor receives a percentage of what the debtor owes in exchange for releasing the debtor from the debt.
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The plan of payment set out under the 2005 Act may be up to three years or
five years based on the following:
• If the debtor’s or debtor’s and spouse’s monthly income multiplied by 12 is
less than the state’s median income for the year for the same size family up
to four members plus $525 per month for each member in excess of four
members, the plan period may not exceed three years, unless the court
approves a period up to five years for cause.
• If the debtor’s or debtor’s and spouse’s monthly income multiplied by 12 is
equal to or more than the state’s median income for the year for the same
size family up to four members plus $525 per month for each member in
excess of four members, the plan period may not be longer than five years.
The bankruptcy court can confirm a Chapter 13 plan if it (1) was proposed
in good faith, (2) passes a feasibility test, and (3) is in the best interest of the
creditors.
Some Advantages and Disadvantages of Bankruptcy
Debtors
Advantages
Disadvantages
Automatic Stay
Administrative Costs
• Instantly suspends most litigation and collection
activities against the debtor, its property, or the
bankruptcy estate.
• Legal and accounting expenses.
Control
• Official creditors’ committee fees.
Reduction in Autonomy
• Creditor oversight.
• Debtor retains possession of the bankruptcy estate
(unless a trustee is appointed).
• Chapter 11 permits the debtor to operate in the
ordinary course of business.
• Management’s ability to make and implement
decisions rapidly and autonomously is curtailed.
Stigma of Bankruptcy
• Morale or confidence problems among staff, vendors,
or customers.
• Customer anxiety regarding future warranty claims
or product support.
Creditors
Enhanced Value and Participation
Suspension of Individual Remedies
• Preserves going-concern value of an insolvent business.
• Automatic stay stalls foreclosure.
• Debtor-in-possession is more accountable due to
bankruptcy reporting and notice requirements.
• Nondebtor parties to executor contracts
and unexpired leases are left in limbo.
Equitable Distribution
Reduced Distribution
• When inequitable conduct by any creditor (typically
an insider) has prejudiced others, bankruptcy court has
authority to subordinate all or part of the transgressor’s
claim to payment of other creditors.
• Only a small fraction of Chapter 11 cases filed result
in a successful reorganization. Continued operation
results in less funds to distribute at liquidation.
Involuntary Petitions
• Creditors may file an involuntary petition for relief
under Chapter 7 or (more rarely) Chapter 11 and force
the debtor into bankruptcy.
CHAPTER 11
Chapter 11 of the Bankruptcy Code is generally aimed at financially troubled
businesses, but individuals (with the exception of stockbrokers) are also eligible. Its purpose is to allow a business to reorganize and continue to function
while it is arranging for the discharge of its debts. Note the contrast to Chapter 7,
which discharges debts by selling off all assets; you can see why Chapter 11 is
more advantageous for individuals who qualify. Reorganization under Chapter 11
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may be voluntary or involuntary. The court, after receiving the debtor’s petition
and ordering relief, appoints committees representing stockholders in the business as well as creditors. If these groups can agree to a fair and reasonable plan
that satisfies their constituencies, the court will order its implementation. If some
creditors or stockholders disagree on the plan, the court will still order it implemented if the judge finds it fair and reasonable under the circumstances.
In most cases, the debtor continues to operate the business during the reorganization process (as a debtor-in-possession or DIP). He or she can enter into
contracts, purchase supplies, incur debts, and carry on other activities of the
business. The bankruptcy court may appoint a trustee at any time if there is a
showing of fraud, dishonesty, or gross mismanagement by the debtor.
The debtor has the exclusive right to file a plan of reorganization with the
bankruptcy court within 120 days after the order for relief; under the 2005 Act,
this period is extended to 18 months from the date of the order of relief. The
debtor has the right to obtain creditors’ approval of a plan within 180 days from
the date of the order of relief. If the debtor fails to file a plan, any interested
party (e.g., trustee, creditor, or equity holder) may do so within 20 months of the
order. A plan of reorganization may be confirmed by the bankruptcy court. The
conditions for confirmation usually include: (1) that the plan is in the best interest of the creditors, that is, they will receive at least what they would receive
under a Chapter 7 liquidation proceeding; (2) the plan is feasible; and (3) each
class of creditors accepts the plan. If a class of creditors does not accept the plan,
a bankruptcy court, under the Code, may confirm the plan under a cram-down
provision. At least one class of creditors must have voted to accept the plan if
the court is to use this provision, and no creditors may be discriminated against.
Individuals Filing under Chapter 11 Reorganization. Under the 2005 Act,
special rules are established when individuals, as opposed to firms, apply for
reorganization. The 2005 Act states that the plan for payment to creditors must
provide for the payment of a portion of the debtor’s earnings from personal services that are earned after commencement of the case. These payments must be
made by the debtor under the plan and be completed before the court will grant
a discharge of any unpaid debts to the debtor.
Small Business Bankruptcy. A “test track” Chapter 11 exists for small businesses, if their liabilities do not exceed $2 million and they do not own or manage real property. This allows a bankruptcy proceeding without the appointment
of a creditors’ committee, saving time and costs. A small business debtor has
180 days from the order of relief to file a reorganization plan. If such a debtor fails
to do so, creditor(s) or other interested parties may do so within 300 days after the
order of relief. The bankruptcy court must confirm the small business debtor’s plan
within 45 days after the plan is filed if it meets the requirements of Chapter 11.
CHAPTER 12
Under Chapter 12, family farmers and fishermen have a right to file for bankruptcy reorganization under the Code, as amended by the 2005 Act (adjustment
of debts of a family farmer or fisherman with regular income). In the 2005 Act,
“family farmers” and “fisherman” are defined as follows:
• Family farmers are individuals or spouses with a debt of less than $3,273,000
and at least 50 percent related to farming, and whose gross income for the
preceding petitioned year or second and third year was at least 50 percent
earned from farming operations. Corporations or partnerships owned by a
family or relatives with more than 80 percent of its assets related to farming
operation and a total business debt not exceeding $3,273,000 (2005 figures
that are adjusted yearly) are defined as family partners.
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TABLE 26-1 TYPES OF BANKRUPTCY PROCEEDINGS
Chapter 7
Chapter 11
Chapter 12
Chapter 13
Purpose
Liquidation
Reorganization
Adjustment
Adjustment
Eligible
Debtors
Most debtors
Most debtors,
including railroads
Family farmer who meets
certain debt limitations
Individual with regular income
who meets certain debt limitations
Type of
Petition
Voluntary or
involuntary
Voluntary or
involuntary
Voluntary
Voluntary
• Family fisherman has about the same definition of family and spouse as for
farmers. The total debt must not exceed $1,500,000, and 80 percent of it
must be related to commercial fishing operation. The same percentages are
used for a corporation or partnership as for farmers. The total debt must not
exceed $1,500,000.
A debtor can convert a Chapter 12 reorganization to a Chapter 7 at any time.
A family farmer or fisherman debtor, as defined here, must file a plan of reorganization. Usually, the plan should provide for payments to creditors over no
longer than a three-year period. The plan must be confirmed by the bankruptcy
court after a hearing at which creditors can appear and object to the plan. Priority
is given to unsecured and secured creditors under Chapter 12 for distribution.
As stated previously in this chapter, Section 5 of the Bankruptcy Code defines
certain unsecured claims as priority claims (Table 26-1).
Chapter 12 Discharge. After all payments are made by a farmer or fisherman
debtor (usually over a period of three years), the court will grant the debtor(s)
discharge of all debts covered by the plan. For example, if the plan calls for
35 percent of the outstanding unsecured debt to be repaid to unsecured creditors, and if it is in fact paid, the court will grant discharge of the unpaid 65 percent
barring statutory or creditor’s objections.
Who Won with the Enactment of the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005?
The Bankruptcy Reform Act of 1978 was the last major piece of legislation Congress
enacted that amended the Federal Bankruptcy Code. Many claimed that it made
bankruptcy too easy. To support such claims, they pointed to the increase in bankruptcy filings between 1978 and 2003, which peaked at 1,619,097. Business groups,
credit card companies, and firms providing automobile loans claimed that the bankruptcy process was being abused (note the title of the 2005 Act).
In contrast, consumer groups opposed the proposed reforms. They claimed that
“special interests” wrote the legislation as it moved through congressional committees, most particularly in the House–Senate Conference Committee. They also argued
that it was the loose credit card policy of banks and credit card companies that drove
people into bankruptcy. They further argued that medical costs were a large reason
for bankruptcy filings. One study found that 46.4 percent of those filing for personal
bankruptcy did so for medical reasons.
Under the 2005 Act, whenever a debtor has an annual income in excess of the
mean income of his or her state of residence, the debtor may be forced into a
Chapter 13 reorganization plan and thus make periodic payments over a period of
five years. Previously, under Chapter 7, most debtors had few durable assets; thus,
few Chapter 13 proceedings (20 percent or less) were filed as personal bankruptcies.
Most creditors saw debtors walk away from their debts.
CHAPTER 26
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735
Critics of the 2005 Act complain that it is too costly to declare personal bankruptcy under a Chapter 13 repayment plan, which mandates that they pay a portion
of their debts over a five-year period. Also, the paperwork increases the costs to all
people who work on bankruptcies. For example (as noted previously), attorneys
have to certify the accuracy of petitions and schedules or be subject to sanctions by
the court. Private investigators may have to be employed. These costs are passed on
to the debtor. Finally, there is a serious problem as to whether Chapter 13 reorganization plans actually are completed, or whether debtors default on those plans.
Those who favored the 2005 Act argued that debtors will now no longer look at
bankruptcy as a planning tool. Critics argued that the act would prevent debtors from
obtaining a financial “fresh start,” which is a basic purpose of the bankruptcy laws.
Who wins? It might depend on whether you are a debtor or a creditor.
The Evolution of Consumer Law
As Adam Smith’s laissez-faire philosophy, with its revolt against government
intervention in the economy, gained popularity in the eighteenth and nineteenth
centuries, the freedom-to-contract doctrine evolved through case law out of
our state court systems. The courts said that, assuming parties were legally competent, they should be allowed to enter into whatever contracts they wished.
Neither the courts nor any other public authority should intervene except in
cases of fraud, undue influence, duress, or some other illegality. Governed by
this doctrine, the U.S. courts throughout the nineteenth century generally refused
to interfere in contractual relations merely because one party was more economically powerful or better able to drive a hard bargain. In effect, they upheld
the principle of caveat emptor (let the buyer beware).
Since the 1930s, state courts (and some federal courts) have curtailed the
traditional freedom to contract by establishing rules of public policy and doctrines
of unconscionability and fundamental breach that allow the courts to interfere in
contractual relationships, especially when the seller is in the stronger economic
position and a consumer has no other source to buy from. The doctrine of freedom to contract has also been limited by the implied warranty doctrine, as well
as by the courts’ relaxation of strict privity relationships between manufacturers
and consumers. (These aspects of contract and product and service liability law
were discussed in Chapters 10, 11, and 13.)
ECONOMICS
In previous chapters, we studied the role of business organizations (Chapters 17
and 18); here we study the interaction between consumers and government
(federal, state, and local). The role of government in this area has been that of
an actor and a referee between consumers and the business community.
As an actor, the government at all levels consumes about 20 percent of the
nation’s total output and employs 21 million individuals. State and local governments employ more than 18 million people and spend $1 trillion a year.3
In its role as referee, we have seen that rules (laws) have been set out over
a period of time that may interfere in classical economic theory (marketplace
economics). The laws of supply and demand may not function when competition is affected by consumer legislation such as the Fair Credit Reporting Act
(FCRA), the Fair Credit Billing Act (FCBA), and the Equal Credit Opportunity Act
(ECOA). These rules or laws may be based on political rather than economic
foundations and decisions. Before these forms of legislation in the 1960s and
1970s, consumers were told that caveat emptor (consumer beware) was the
3
D. Colander, Microeconomics (5th ed.). (New York: McGraw-Hill, 2003), 66, 67.
freedom-to-contract
doctrine Parties who are
legally competent are allowed
to enter into whatever
contracts they wish.
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golden rule. Today, though, government’s role as referee has become prominent.
Nevertheless, debate continues among economists, political scientists, and legal
scholars as to what role, if any, the government should play in the relationship
between consumers and business organizations.4
Federal Regulation of Business Trade Practices
and Consumer–Business Relationships
THE FEDERAL TRADE COMMISSION:
FUNCTIONS, STRUCTURE, AND ENFORCEMENT POWERS
Functions. The Federal Trade Commission (FTC) has been discussed throughout this book. It was created by the Federal Trade Commission Act (FTCA)
expressly to enforce Section 5 of that act, which forbids “unfair methods of competition.” Section 5 was originally intended to be used to regulate anticompetitive business practices not reached by the Sherman Act. In 1938, it was amended
by the Wheeler–Lea Act to prohibit “unfair or deceptive acts or practices.” From
then on, even if a business practice did not violate the Sherman or Clayton
antitrust statutes, the FTC could use the broad “unfair or deceptive” language of
Section 5 to protect consumers against misleading advertising and labeling of
goods, as well as against other anticompetitive conduct by business. Thus, the
FTC became the leading federal consumer protection agency.
Since 1938, Congress has passed several statutes delegating further administrative and enforcement authority to the FTC. Among them are the Fair Packaging and
Labeling Act, the Lanham Act, the Magnuson-Moss Warranty–Federal Trade
Improvement Act, the Telemarketing and Consumer Fraud and Abuse Prevention
Act, important sections of the Consumer Credit Protection Act, the Bankruptcy
Reform Act, the Hobby Protection Act, the Wool Products Labeling Act, the Hart-ScottRodino Antitrust Improvement Act, and the Food, Drug, and Cosmetics Act.
Structure and Enforcement Powers. In Chapter 19, we used the FTC in our
example of the adjudicative process for federal administrative agencies, and we
presented a diagram of the agency’s structure in Exhibit 19-2. Before you read
any further here, you may want to turn back to that exhibit to get a quick picture
of how the agency is organized.
Selected Consumer Protection Laws
Agency, Department,
or Commission
Regulation of Consumer
Credit Assets
Regulation
of Fraud Issues
Federal Trade Commission
Established: 1914
Credit advertising; Fair
Credit Reporting Act;
Fair Debt Collection Practices
Act; Credit Card Accountability,
Responsibility and Disclosure
Act of 2009 (effective February
2010); Dodd-Frank Wall Street
Reform and Consumer
Protection Act of 2010
Advertising; sales
practices
Food and Drug Administration
(U.S. Department of Health
and Human Services)
Established: 1930
Regulation of Consumer Health
and Safety Issues
Labeling of food (except meat, poultry,
and eggs), drugs, and cosmetics;
adulterated food and cosmetics;
approval of drugs and medical devices
4
R. Posner, Economic Analysis of Law (6th ed.). (New York: Aspen/LittleBrown, 2003), ch. 2.
CHAPTER 26
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737
U.S. Department
of Agriculture
Established: 1862
Labeling of meat, poultry, and eggs;
inspection of meat-, poultry-,
and egg-processing facilities
Consumer Product Safety
Commission
Established: 1972
Consumer Product Safety Act (CPSA)
Federal Communications
Commission
Established: 1934
Telemarketing
U.S. Postal Service
Established: 1775
Sales practices
Securities and Exchange
Commission
Established: 1934
Securities fraud
Federal Reserve Board
Established: 1913
Broadcast standards
Truth in Lending Act
(Regulation Z); Consumer
Leasing Act (Regulation M):
ECOA (Regulation B); Electronic
Fund Transfer Act (Regulation E)
U.S. Department of Labor
Established: 1913
Bankruptcy courts
Chapter 13 consumer
bankruptcy
The commission is composed of a chairperson and four commissioners, who
are nominated by the president and confirmed by the Senate. No more than
three commissioners may come from the same political party.
The FTC’s Bureau of Competition is responsible for the investigation of
complaints of “unfair or deceptive practices” under Section 5 of the FTCA. If the
bureau finds merit in the complaint and cannot get the offending party either to
voluntarily stop the deceptive or unfair practice or to enter into a consent order,
it issues a formal complaint, which leads to a hearing before an administrative
law judge.
The FTC also has other enforcement weapons at its disposal. It may assess
fines, obtain injunctive orders, order corrective advertising, order rescissions of
contracts and refunds to consumers, and obtain court orders forcing sellers to
pay damages to consumers.
DECEPTIVE AND UNFAIR ADVERTISING
Deceptive Advertising. In passing the 1938 Wheeler–Lea Act amending
Section 5 of the FTCA, Congress made it clear that it wished to give the FTC the
power “to cover every form of advertising deception over which it would be
humanly practicable to exercise government control.” Through their interpretation of the “unfair or deceptive” language of Section 5 over the years, the commission and the courts have evolved a three-part standard whereby the FTC staff
must show that:
1. there is a misrepresentation or omission in the advertising likely to mislead
consumers;
2. consumers are acting reasonably under the circumstances; and
3. the misrepresentation or omission is material. Neither intent to deceive nor
reliance on the advertising need be shown.
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CASE
䉬
26-2
Federal Trade Commission v. Verity International, Ltd.
United States Court of Appeals, Second Circuit
443 F.3d 48 (2006)
T
he incessant demand for pornography, some have said, is
an engine of technological development. The telephonic system at dispute in this appeal is an example of that
phenomenon—it was designed and implemented to ensure
that consumers paid charges for accessing pornography and
other adult entertainment. The system identified the user of
an online adult-entertainment service by the telephone line
used to access that service and then billed the telephoneline subscriber for the cost of that service as if it were a
charge for an international phone call to Madagascar. This
system had the advantage that the user’s credit card never
had to be processed, but it had a problem as well: It was
possible for someone to access an adult-entertainment
service over a telephone line without authorization from the
telephone-line subscriber who understands herself to be
contractually bound to pay all telephone charges, including
those that disguised fees for the adult entertainment.
The Federal Trade Commission brought suit to shut
down such a telephone business as a deceptive and unfair
trade practice within the meaning of Section 5(a)(1) of the
Federal Trade Commission Act. The FTC sued Verity International, Ltd. (Verity) and Automatic Communications, Ltd.
(ACL), corporations that operated this billing system, as
well as Robert Green and Marilyn Shein, who controlled
these corporations.
The court entered an order against the defendantsappellants for a total of $17.9 million. The defendantsappellants appealed to the U.S. Court of Appeals.
Justice Walker
[To prove a deceptive act or practice under Section 5(a)(1)
of the FTC Act, the FTC must show that an act or practice
was false or misleading, that consumers acted reasonably
under the circumstances, and that the practice or representation complained of was material.]
The FTC contends that the first element is satisfied by
proof that the defendants-appellants caused telephone-line
subscribers to receive explicit and implicit representations
that they could not successfully avoid paying charges for
adult entertainment that had been accessed over their phone
lines—what we call a “representation of incontestability.
The defendants-appellants caused charges for adult entertainment to appear on phone bills as telephone calls, thereby
capitalizing on the common and well-founded perception
held by consumers that they must pay their telephone bills,
irrespective of whether they made or authorized the calls.
[This] conveyed a representation of incontestability.
[As for the second element, the] FTC contends that
the representation of incontestability was false and therefore likely to mislead consumers who did not use or
authorize others to use the adult entertainment in question;
the defendants-appellants contend that the representation
was rendered true by agency principles.
Under common law agency principles, a person is liable
to pay for services that she does not herself contract for if
another person has authority to consent on her behalf to
pay for the services.
[But a] computer is not primarily understood as a
payment mechanism, and in the ordinary habits of human
behavior, one does not reasonably infer that because a person is authorized to use a computer, the subscriber to the
telephone line connected to that computer has authorized
the computer user to purchase online content.
The FTC proved the second element of its claim.
Finally [with respect to the third element,] telephoneline subscribers found the representation material to their
decision whether to pay the billed charges because of the
worry of telephone-line disconnection, the perception of
the futility of challenging the charges, the desire to avoid
credit-score injury, or some combination of these factors.
The district court measured the appropriate amount of
[the judgment] as “the full amount lost by consumers.” This
was error. The appropriate measure is the benefit unjustly
received by the defendants.
[Phone service providers] received some fraction of the
money before any payments were made to the defendantsappellants.
[Also,] some fraction of consumers actually used or
authorized others to use the services at issue.
We affirm all components of the district court’s
order of relief except for the monetary judgment.
The case is remanded to the district court consistent
with this opinion.
We look at three types of deceptive advertising in this section: (1) that involving
prices, (2) that involving product quality and quantity, and (3) testimonials by wellknown sports, entertainment, and business figures. False price comparisons are one
form of deceptive price advertising. Another is offers of a “free” item to a customer
who buys one at a “regular” price, when, in fact, the “regular” price covers the cost
of the “free” good. The classic deceptive price advertising is the “bait and switch”
tactic, which consists of advertising one product at a low price to entice customers
into the store and then switching their attention to a higher-priced product.
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Secondly, advertising about product quality and quantity is often found to be
deceptive under Section 5 of the FTCA. For example, when a car sales representative tells a customer, “This car is the best-running car that has ever been sold,”
is this mere puffery, or is it deception? This kind of hype is usually considered an
acceptable form of puffery. However, had the sales representative said, “This car
will run at least 50,000 miles without a change of oil,” the claim would cross the
line into the territory of deception.
The FTC staff does not have to show that a claim is expressly deceptive; it is
sufficient to show that deception is implicit. Also, the FTC must present evidence
that there is no basis for the claim made by the advertiser. When an advertiser
claims a certain quality in a product on the basis of what “studies show,” it must
possess reasonable substantiation of its claim. The commission will consider the
cost of substantiation, the consequences of a false claim, the nature of the
product, and what experts believe constitutes reasonable substantiation before
deciding whether the advertising was deceptive.
Years ago, American Home Products, manufacturers of Anacin, advertised
that its drug had a unique painkilling formula that was superior to the formulas
of all other drugs containing analgesics. The FTC staff charged that this claim was
deceptive because there was insufficient substantiation to show that Anacin was
either unique or superior to other nonprescription drugs containing the same
ingredients (aspirin and caffeine).5 The full commission and the court of appeals
agreed after examining the evidence presented by American Home Products. In
a similar case in 1984, the FTC filed a complaint against General Nutrition (GN),
charging it with deceptive advertising for claiming, purportedly on the basis of
a National Academy of Science report, that consumption of its dietary supplement Healthy Greens was related to reduced rates of cancer in humans. GN
entered into a consent order in which it agreed to cease such advertising.6
CASE
739
puffery An exaggerated
recommendation made in
a sales talk to promote
the product.
26-3
Federal Trade Commission v. QT, Inc.
United States Court of Appeals, Seventh Circuit
512 F.3d 858 (2008)
Q
T, Inc., and assorted related companies, heavily promoted
the Q-Ray Ionized Bracelet on television infomercials as
well as on its Web site. In its promotions, the company made
many claims about the pain-relief powers of these bracelets,
including that the bracelet offered immediate, significant, or
complete pain relief and could cure chronic pain. At trial in
the U.S. District Court for the Northern District of Illinois, the
presiding judge labeled all such claims as fraudulent; forbade
further promotional claims; and ordered the company to pay
$16 million, plus interest, into a fund to be distributed to all
customers. QT, Inc., appealed.
Justice Easterbrook
According to the district court’s findings, almost everything that defendants have said about the bracelet is false.
Here are some highlights:
5
6
• Defendants promoted the bracelet as a miraculous
cure for chronic pain, but it has no therapeutic effect.
• Defendants told consumers that claims of “immediate,
significant or complete pain relief” had been “test
proven,” they hadn’t.
• Defendants represented that the therapeutic effect
wears off in a year or two, despite knowing that the
bracelet’s properties do not change. This assertion is
designed to lead customers to buy new bracelets.
Likewise the false statement that the bracelet has a
“memory cycle specific to each individual wearer” so
that only the bracelet’s original wearer can experience
pain relief is designed to increase sales by eliminating
the second hand market and “explaining” the otherwise embarrassing fact that the buyer’s friends and
neighbors can’t perceive any effect.
American Home Products v. FTC, 695 F.2d 681 (3d Cir. 1982).
“General Nutrition Inc. Prohibited Trade Practices,” 54 Federal Register 9198 (Mar. 6, 1989).
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The magistrate judge did not commit a clear error, or
abuse his discretion, in concluding that the defendants set
out to bilk unsophisticated persons who found themselves
in pain from arthritis and other chronic conditions.
Defendants maintain that the magistrate judge subjected
their statements to an excessively rigorous standard of proof.
The Federal Trade Commission Act forbids false and
misleading statements, and a statement that is plausible but
has not been tested in the most reliable way cannot be
condemned out of hand.
For the Q-Ray Ionized Bracelet, all statements about
how the product works—Q-Ray, ionization, enhancing the
flow of bio energy, and the like—are blather. Defendants
might as well have said: “Beneficent creatures from the
17th Dimension use this bracelet as a beacon to locate
people who need pain relief, and whisk them off to their
homeworld every night to provide help in ways unknown
to our science.”
Proof is what separates an effect new to science from
a swindle. Defendants themselves told customers that
the bracelet’s efficacy had been “test-proven,” but defendants have no proof of the Q-Ray Ionized Bracelet’s efficacy. The “tests” on which they relied were bunk. What
remain are testimonials, which are not a form of proof.
That’s why the “testimonial” of someone who keeps elephants off the streets of a large city by snapping his fingers is the basis of a joke rather than proof of cause and
effect.
Physicians know how to treat pain. Why pay $200 for a
Q-Ray Ionized Bracelet when you can get relief from an
aspirin tablet that costs 1¢?
Affirmed, in favor of plaintiff.
The U.S. Court of Appeals for the Seventh Circuit affirmed the district court’s decision. QT, Inc., was required to stop its deceptive advertising and to pay the $16 million, plus interest, so that its customers could be reimbursed.
Is there any reasonable basis on which a firm could sell this Ionized Bracelet and believe that it was not engaged in
deceptive advertising, using the facts in this case? Reasons are tools, and in most situations one can provide a reason
for what seems like even the most bizarre behavior. This case provides you an opportunity to think about the need to
be very careful to examine the quality of reasons. The existence of a reason is only the first step in propounding an
argument on which we should rely.
1.
What logic might QT use to justify its claim that the district court used an overly rigorous standard of proof in
finding against QT?
Clue: Does deception require more than the possibility of potential deception before it rises to the level of
illegal advertising? Might the claims QT was making be so outrageous that no reasonable consumer would have
believed them?
2.
What is the relevance of Judge Easterbrook’s elephants-in-the-streets analogy to an assessment of QT’s reasoning?
Clue: Why do we even require claims to have reliable proof?
testimonial A statement by
a public figure professing the
merits of some product
or service.
The third form of deceptive advertising discussed here is testimonials by
public figures (e.g., athletes and entertainers) endorsing a product. The FTC guidelines require that such figures actually use the product they are touting and prefer
it to competitive products. The FTC’s Bureau of Consumer Protection also monitors claims by public figures that they have superior knowledge of a product. For
example, singer Pat Boone represented Acne Stain as a cure for acne when there
was no scientific basis for the claim; he also failed to disclose a financial interest
he had in Acne Stain. After the FTC filed a complaint against him, Boone agreed
to enter into a consent order.7
Unfair Advertising. Section 5 of the FTCA also forbids “unfair” advertising. The
FTC guidelines consider advertising to be unfair if consumers cannot reasonably
avoid injury, the injury is harmful in its net effect, or it causes substantiated harm
to a consumer. In 1975, the commission promulgated a rule for public comment
7
In re Cooga Mooga, Inc., & Charles E. Boorea, 92 FTC 310 (1978).
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that forbade all television advertising related to children. This action came about
after complaints that advertising by cereal and toy companies on Saturday morning television programs was addressed to a select age group that could not weigh
the advertising rationally; thus, the advertising was “unfair.” In 1980, Congress
terminated the FTC rulemaking proceedings dealing with children’s advertising
for political reasons and, for good measure, forbade the FTC to initiate rulemaking proceedings of any type based on the concept of “unfairness.” The commission may still challenge individual acts or practices as unfair under Section 5
of the FTCA in an adjudicatory context. In 2000, the FTC issued new guidelines
to help online businesses comply with existing laws.8
Private-Party Suits and Deceptive Advertising. A company may sue a competitor under the Lanham Act of 1947 (see the discussion in Chapter 15 about
trademarks), which forbids “false description or representation.” Parties bringing
actions based on violations of this act may request an injunction or corrective
advertising. For example, McDonald’s and Wendy’s, in separate cases, accused
Burger King of falsely portraying its hamburgers as superior to rivals’ burgers on
the basis of an alleged taste test. In their suits, McDonald’s and Wendy’s questioned the scientific basis of Burger King’s survey and its analysis of the results.
Both cases were settled out of court.9
The FTC and Deceptive Labeling and Packaging. Under the Fair Packaging
and Labeling Act (FPLA), the Department of Health and Human Services (DHHS)
promulgates rules governing the labeling and packaging of products. The DHHS
has issued rules governing the packaging of foods, drugs, and cosmetics—all of
which the FTC has enforcement jurisdiction over. The FPLA and the enacted rules
require that such product packaging contain the name and address of the manufacturer or distributor; the net quantity, which must be placed in a conspicuous
location on the package front; and an accurate description of all contents. The
purpose of the FPLA is to allow consumers to compare prices on the basis of some
uniform measure of content. The Nutrition Labeling and Education Act of 1990
requires standard nutrition facts on all labels and regulates the use of such terms.
The FTC enforces terms with Food and Drug Administration (FDA) approval.
CONSUMER LEGISLATION
Franchising Relationships. Misrepresentation by franchisors of the potential
profits to be made by franchisees is a violation of Section 5 of the FTCA, which
prohibits “unfair” methods of competition as well as “unfair and deceptive trade
practices.” To combat blatant fraud involved in franchising (discussed in Chapter 17),
the FTC in 1979 promulgated rules governing franchise systems.
In its 1979 Franchising Rule, the commission defines a franchise as a commercial operation in which the franchisee pays a minimum fee of $500 to use
the trademark of, or to sell goods and services supplied by, a franchisor that
exercises significant control over, or promises significant aid to, the franchisee’s
business operation. The fee must be paid within six months after the business is
begun. For example, McDonald’s franchisees receive the trademark (the “golden
arches”) in return for an initial fee and a percentage of revenues that go to the
McDonald’s Corporation (the franchisor). McDonald’s, in its franchising agreement, specifies the products that must be bought from McDonald’s, the quality
of food to be served, the store hours, cleanliness standards, and grounds for
termination of the franchising agreement.
8
Advertising and Marketing on the Internet: Rules of the Road (Sept. 2000).
McDonald’s v. Burger King, 82/2005 (S.D. Fla. 19982); Wendy’s International Inc. v. Burger
King, C-2-82-1179 (S.D. Ohio 19982).
9
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The FTC rule governing franchising requires each franchisor to provide a disclosure document to prospective franchisees that sets out such pertinent information as the names and addresses of the officers of the franchisor, any felony
convictions of those officers, their involvement in any bankruptcy proceedings,
all restrictions on a franchisee’s territories or the customers it may sell to, and any
training or financing the franchisor makes available to franchisees. If a franchisor
suggests a potential level of sales, income, or profits, all materials that form the
basis of those predictions must be made available to prospective franchisees and
the FTC.
Violations of the FTC Franchising Rule may lead to a fine of up to $10,000.
The FTC can bring a civil action for damages on behalf of franchisees in federal
district court as well as administrative enforcement actions before an administrative law judge.
Consumer Warranties. The FTC is also in charge of enforcing the MagnusonMoss Warranty Act—Federal Trade Improvement Act of 1975, which applies to manufacturers and sellers of consumer products that make an express written warranty.
You will recall from our discussion of product and service liability law in Chapter 13
that an express warranty is a guarantee or promise by the seller or manufacturer
that goods (products) meet certain standards of performance. Note that the act does
not cover oral warranties, whether express or implied. Consumer products, as
defined by the act, are goods that are normally purchased for personal, family, or
household use. The courts have interpreted this definition liberally.
The purpose of the Magnuson-Moss Warranty Act is to prevent sellers and
manufacturers from passing on confusing and misleading information to consumers. To that end, the act requires that all conditions of a warranty be clearly
and conspicuously disclosed for any product sold in interstate commerce that
costs more than $10. Furthermore, consumers must be told what to do if a product
is defective.
Before this act was passed, a consumer purchasing a video recorder, for
instance, could not be sure whether the “limited warranty” covered all labor and
parts or only some labor and parts. Thus, after sending the video recorder back
to the manufacturer or authorized dealer for repairs, the consumer might discover that the warranty covered a $50 part but not $150 in labor costs—a rather
nasty surprise.
full warranty Under the
Magnuson-Moss Warranty
Act, a written protection for
buyers that guarantees free
repair of a defective product. If
the product cannot be fixed,
the consumer must be given a
choice of a refund or a
replacement free of charge.
limited warranty Under the
Magnuson-Moss Warranty
Act, any written warranty that
does not meet the conditions
of a full warranty.
Full or Limited Warranties. All written warranties of consumer products that
cost more than $10 must be designated as “full” or “limited.” A full warranty
means that the manufacturer or dealer must fix a defective product; if it does not,
the warranty is breached and the consumer has grounds for a breach-of-warranty
suit. If efforts to fix the product fail, the consumer must be given a choice of
refund or replacement free of charge. A manufacturer or supplier that gives only
a limited warranty on its product can restrict the duration of implied warranties
if the limit is designated conspicuously on the product. In effect, a limited
warranty is any warranty that does not meet the conditions of a full warranty.
Second buyers and bailees, as well as bystanders, are covered by the
Magnuson-Moss act and pertinent FTC regulations. Also, manufacturers or sellers
cannot limit the time period within which implied warranties of the product are
effective. Finally, damages to the consumer cannot be limited unless the limits
are expressly stated on the face of the product.
Remedies. The Magnuson-Moss Warranty Act gives an individual consumer, or
a class of consumers, the right to bring a private action for a breach of a written
(though not an oral) warranty. Consumers who bring such actions can recover
the costs of the suit, including attorney’s fees, if they win. Before they file suit,
however, they must give the manufacturer or seller a reasonable opportunity to
“cure” the breach of warranty by replacing or fixing the product.
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Telemarketing Legislation. The Telephone Consumer Protection Act of 1991
restricts the activities of telemarketers and bans certain interstate telephone sales
practices altogether. Some of the prohibited practices include:
• Calling a person’s residence at any time other than between 8:00 AM and
8:00 PM
• Claiming an affiliation with a governmental agency at any level when such
an affiliation does not exist
• Claiming an ability to improve a consumer’s credit records or to obtain loans
for a person regardless of that person’s credit history
• Not telling the receiver of the call that it is a sales call
• Claiming an ability to recover goods or money lost by a consumer
Each violation of these regulations is punishable by a fine of up to $10,000; exempted are insurers, franchisers, online services, stocks and bonds salespeople
regulated by the SEC, and not-for-profit organizations.
The FTC’s regulations are an outgrowth of a federal statute, the Telemarketing
and Consumer Fraud and Abuse Prevention Act of 1994, and the Telemarketing
Sales Rule of 1995. Consumers can recover actual monetary loss, or $500 for each
violation of the act. Treble damages are allowed. Congress passed this statute after
holding hearings which revealed that some telemarketing firms (“budget shops”)
used imaginary sweepstakes and other schemes to bilk $40 billion a year from
consumers (particularly the elderly) and small businesses. The Telemarketing Sales
Rule fleshed out details of the 1994 legislation.
The statute and the FTC regulations were made enforceable in the federal
courts by the 50 state attorneys general as well as by the FTC. This broad scope
was intended to put an end to the situation in which telemarketers who engaged
in fraud moved quickly from one state to another without being caught because
state attorneys general did not have the authority to pursue them under federal
law. Moreover, state law often did not provide for suitable punishment when
such telemarketers were caught.
The “Do Not Call” Registry, which allows consumers to sign up with the FTC
in order to eliminate some calls coming from “pitch men” or telemarketers, has had
some 50 million registrants since it became effective in October of 2003. Most states
now have “baby” Do Not Call laws, which cover intrastate telemarketing calls.
Many exceptions are allowed under the Telephone Consumer Protection Act;
for example, calls from people conducting surveys or raising funds for charities
or politicians. Calls are allowed from people with whom consumers have “established relationships”; for example, firms to which consumers pay bills or obtain
a delivery service. It is possible that some businesses will attempt to exploit this
exemption by using questionnaires, raffle entries, or coupons in order to establish a “relationship.”
Just as consumer dislike of junk telephone calls eventually led to congressional
action, the advent of spam or junk e-mail has elicited frustration and disgusted
reactions from consumers who use the Internet. Yahoo! and other Internet service
providers are also opposed to the overwhelming amount of spam they are forced
by the nature of their business to carry, albeit inadvertently.
The FTC has brought a small number of enforcement actions under the Controlling the Assault of Non-Solicited Pornography and Marketing Act (CAN-SPAM
Act) of 2003, which was intended to reduce the quantity of unsolicited e-mails.
The law bars senders of commercial e-mail from using fictitious identities and
requires them to provide ways for recipients to remove themselves from mailing
lists. The difficulty in these cases is largely based on gaining jurisdiction over
elusive defendants.
According to some industry estimates, spam now accounts for 85 percent of
all e-mail traffic. The cost to U.S. business may be as high as $2,000 per employee
743
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TECHNOLOGY AND THE LEGAL ENVIRONMENT
E-Commerce: Junk Telephone Calls,
Junk Faxes, “Do Not Call,”
and Antispam Legislation
The Telephone Consumer Protection Act of 1991
restricts automated devices that make thousands of
calls an hour to play recorded advertising messages
without prior written consent of the called parties.
The act exempts emergency calls, calls made to businesses, and calls made to or by nonprofit organizations. Personal calls are not covered by the act. The
Federal Communications Commission enforces the
act. In a court of appeals decision, the law was upheld
as a valid restriction on commercial speech.a
Another provision of the 1991 act bans unsolicited
faxes that contain advertisements. Junk faxes were
a
outlawed to prevent owners of fax machines from having to pay for paper as a receiver. Private and political
faxes are exempt. The act has a damage maximum of
$500 in damages for each violation. A class action suit
against Hooters of America in a federal district court in
Georgia, in which a local businessman, Sam Nicholson
(and 1,320 other people), sued, resulted in a jury
verdict of $12 million. In the Hooters case, 42 reams of
paper with Hooters’ advertisements in the form of
coupons were introduced into evidence.
Public response to unwanted (unsolicited) advertising has led to legislation and an increasing number
of cases. Some have argued that we need to learn to
push the “delete” button instead of requesting more
legislation. Advertisers blame the trial lawyers and fax
or telephone marketers.
Moser v. Federal Communications Commission, 46 F.3d 970 (9th Cir. 1995).
in wasted productivity, according to one analysis by Nucleus Research, a technology research firm. Compliance with the CAN-SPAM Act has dwindled to 1 percent
based on a study of a quarter million e-mail messages by MX Logic, Inc., a software company that produces spam-blocking programs.10
At the state level, several states have enacted antispam statutes. See, for
example, State v. Heckel,11 in which the State of Washington’s Supreme Court
upheld an antispam statute that prohibits false and misleading e-mail messages.
As of October 2004, the FTC had joined with 19 agencies from 15 countries to
combat unsolicited e-mail or spam in an Action Plan for Enforcement.
Federal Laws Regulating Consumer Credit
and Business Debt-Collection Practices
Consumer credit means buyer power, which translates into demand for products,
which, in turn, increases the supply of products produced by manufacturers. In
short, this nation’s economy runs on credit. With Americans owing more than
$1.5 trillion and businesses and banks mailing out thousands of credit card
applications almost daily, it is imperative that both business managers and
consumers understand the rules governing credit arrangements.
Until 1969, when Congress passed the Consumer Credit Protection Act, most
consumer protection was left to the states. There were many abuses in the
issuance and reporting of credit terms. Often, consumer-debtors were ignorant of
the annual percentage rates they were being charged, which made it impossible
for them to shop around and compare rates. The Consumer Credit Protection Act
(CCPA) of 1969 was designed to give consumers a fair shake in all areas of credit.
We examine here several important sections of this comprehensive act under their
popular titles: the Truth-in-Lending Act; the Electronic Fund Transfer Act (EFTA);
10
H. Witt, “The Spam King,” Toledo Blade (Knight-Ryder), D-1 (Aug. 7, 2004); Nasaw, “Federal
Law Fails to Lessen Flow of Junk E-Mail,” Wall Street Journal, D-2 (Aug. 10, 2004).
11
24 P.3d 4004 (Wash. 2001).
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745
EXHIBIT 26-1
Consumer Credit Protection Act (CCPA)
SIGNIFICANT SECTIONS
OF THE CONSUMER CREDIT
PROTECTION ACT
Fair Debt
Collection
Practices Act
Truth-inLending Act
Consumer
Leasing Act
Fair Credit
Reporting Act
Equal Credit
Opportunity
Act
Electronic
Funds
Transfer Act
Fair Credit
Billing Act
the FCRA; the ECOA; the Fair Credit Billing Act; the Fair Debt Collection Practices
Act (FDCPA); and the Consumer Leasing Act (CLA) (see Exhibit 26-1).
TRUTH-IN-LENDING ACT
Goals. The Truth-in-Lending Act of 1969 (TILA), as amended in 1982, seeks to
make creditors disclose all terms of a credit arrangement before they enter into an
agreement with a consumer-debtor. By mandating uniform terms and standards, it
also seeks to give consumers a basis for comparative shopping: consumers’ ability
to shop around for the lowest interest rates or finance charges promotes competition in the consumer credit market.
Scope. The TILA applies to creditors that regularly extend credit for less than
$25,000 to natural persons for personal and family purposes. Corporations and
persons applying for more than $25,000 in credit (except for buying a home) are
not covered by the act. To be covered by the TILA, creditors must regularly
extend credit (e.g., banks, finance companies, retail stores, credit card issuers, or
savings and loans institutions), demand payment in more than four installments,
or assess a finance charge.
Provisions. The TILA is a complex, detailed, and costly act for both management (creditors) and consumers (debtors). Six important provisions of the TILA
deal with general disclosure, finance charges, the annual percentage rate, the
right to cancel a contract, open- and closed-end credit transactions, and credit
advertising.
General Disclosure. The general disclosure provisions of the TILA require all
qualified creditors to disclose all terms clearly and conspicuously in meaningful
sequence and to furnish the consumer with a copy of the disclosure requirements.
Additional information may be incorporated into the disclosure statement, so long
as it is not confusing.
Finance Charges. The finance charge provisions of the TILA—as well as the
Federal Reserve Board’s Regulation Z, which implements some provisions of
the act—require a system of charge disclosure so that consumers can compare
credit costs using uniform standards. A finance charge includes any dollar
charges that make up the cost of credit to the consumer. These may be interest
rates; service, carrying, or transaction charges; charges for mandatory credit life
insurance on an installment loan in the event of the death of the debtor; loan
fees; “points” when buying a home; and appraisal fees.
Annual Percentage Rate. The annual percentage rate (APR)—the effective
annual rate of interest being charged by the creditor—must be disclosed in a
meaningful and sequential way to all consumers of credit. Annual percentage
rates differ according to the compounding period being used by the creditor,
Regulation Z A group of rules,
set forth by the Federal
Reserve Board, to implement
some provisions of the Truthin-Lending Act, requiring
lenders to disclose certain
information to borrowers.
annual percentage rate
(APR) The effective annual
rate of interest being charged
a consumer by a creditor,
which depends on the
compounding period the
creditor is using.
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so this disclosure requirement makes it easy for consumers to see exactly what
interest rate they are paying and to do some comparison shopping. The Federal Reserve Board publishes Regulation Z annual percentage tables. If creditors use these tables and follow their instructions, there is a legal presumption
of correctness.
Right to Cancel. The right to cancel a contract applies only to home loans. A
consumer has a right to cancel such a loan three days after entering the contract.
The three-day period begins after the proper truth-in-lending disclosures have
been made, usually at the closing by a bank employee. Because so many documents are being signed at this time, the disclosure statement is sometimes overlooked by both the bank employee and the borrower. The TILA was amended
in 1995 to prevent borrowers from rescinding loans for minor clerical errors in
closing documents.
open-end credit Credit
extended on an account for an
indefinite time period so that
the debtor can keep charging
on the account, up to a certain
amount, while paying the
outstanding balance either in
full or in installment payments.
closed-end credit A credit
arrangement in which credit is
extended for a specific period
of time, and the exact number
of payments and the total
amount due have been agreed
upon between the borrower
and the creditor.
Open- and Closed-End Credit Transactions. Regulation Z distinguishes
between open-end credit and closed-end credit; each has separate disclosure
requirements. An open-end credit transaction (e.g., MasterCard or a revolving
charge account in a retail store such as Sears) extends credit for an indefinite
time period and gives the debtor the option to pay in full or in installments.
The initial statement to the debtor with such an account must include such
items as the elements of any finance charge and the conditions under which it
will be imposed, the APR as estimated at the time of credit extension, if and
when overcharges will be imposed, and the minimum payment for each periodic
statement.
A closed-end credit transaction (e.g., a personal consumer loan, a student
loan, or a car loan) is extended by the creditor for a limited time period. All conditions of the loan, including the total amount financed, the number of payments,
and the due dates, have to be agreed on before the loan is extended. For this type
of credit transaction, Regulation Z requires creditors to disclose the total finance
charges, the APR, the total number of payments due, any security interest, and
any prepayment penalties or rebates to the consumer if payment is made ahead
of time.
Credit Advertising. The TILA governs all advertising or “commercial messages” to the public that “aid, promote, or assist” in the extension of consumer
credit. Thus, many television and radio commercials, newspaper ads, direct mail,
store postings, and all announcements of a “blue ribbon” extension of credit to
customers in a store must meet certain disclosure requirements. These include
the amount of the down payment, the conditions of repayment, and the finance
charges expressed in annual percentage terms.
Remedies. The FTC and seven other federal agencies are responsible for
enforcement of the TILA. All these agencies have at their disposal uniform
corrective actions that can be brought on behalf of a consumer-debtor.
First, a consumer can be reimbursed for a creditor’s overcharging and for
billing errors with regard to finance charges. Second, if the creditor has exhibited a pattern of negligence, misleading statements, or an intentional failure to
disclose, the case may be referred to the Justice Department for criminal action.
Conviction in such cases can bring a fine of up to $5,000, imprisonment up to
1 year, or both.
Private parties are the major enforcers of the TILA. A private party who brings
suit must first show that the transaction affected interstate commerce; it must then
show that the creditor failed to comply with the TILA or Regulation Z. Private
parties (usually consumer-debtors) do not have to show that they were injured
by the failure to disclose. Moreover, the creditor’s noncompliance need only be
slight. Damages recovered are usually actual damages plus a penalty of twice the
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747
finance charges imposed in connection with the transaction. “Reasonable attorney fees,” as determined by the court, can also be collected.
Class actions brought on behalf of consumer-debtors are also permissible
under the TILA. Usually, these are brought by legal aid societies or other
nonprofit groups against creditors with a history of blatantly unscrupulous
dealings with consumers. See Case 26-4 for the U.S. Supreme Court’s view of
TILA material.
CASE
26-4
Household Credit Services, Inc. v. Pfenning
541 U.S. 232 (2004)
S
haron Pfenning holds a credit card initially issued by
Household Credit services, Inc., but in which MBNA
American Bank, N.A., now holds an interest through the
acquisition of Household’s credit card operation. Although
the terms of Pfenning’s credit card agreement set her
credit limit at $2,000, Pfenning was able to make charges
exceeding that limit, subject to a $29 “over-limit fee” for
each month in which her balance exceeded $2,000.
On August 24, 1999, Pfenning filed a complaint in the U.S.
District Court for the Southern District of Ohio on behalf of
a purported nationwide class of all consumers who were
charged over-limit fees by Household or MBNA (the defendants). Pfenning alleged that the defendants allowed her and
the other members of the class to exceed their credit limits, thereby subjecting them to over-limit fees. Pfenning
claims that the defendants violated the TILA by failing to
classify the over-limit fees as “finance charges” and thereby
“misrepresented the true cost of credit.” The defendants
moved to dismiss the complaint on the ground that Regulation Z specifically excludes over-limit fees from the definition
of “finance charge.” The district court granted the petitioners’ motion to dismiss. On appeal, Pfenning argued, and the
court of appeals agreed, that Regulation Z’s explicit exclusion of over-limit fees from the definition of “finance charge”
conflicts with the TILA. Household Credit appealed.
Justice Thomas
TILA itself does not explicitly address whether over-limit
fees are included within the definition of “finance charge.”
Congress defined “finance charge” as “all charges, payable
directly or indirectly by the person to whom the credit is extended, and imposed directly or indirectly by the creditor as
an incident to the extension of credit.” § 1605(a). Because
petitioners would not have imposed the over-limit fee had
they not “granted [respondent’s] request for additional
credit, which resulted in her exceeding her credit limit,”the
Court of Appeals held that the over-limit fee in this case fell
squarely within § 1605(a)’s definition of “finance charge.”
The Court of Appeals’ characterization of the transaction in this case, however, is not supported even by the
facts as set forth in respondent’s complaint. Respondent
alleged in her complaint that the over-limit fee is imposed
for each month in which her balance exceeds the original
credit limit. If this were true, however, the over-limit fee
would be imposed not as a direct result of an extension of
credit for a purchase that caused respondent to exceed her
$2,000 limit, but rather as a result of the fact that her
charges exceeded her $2,000 limit at the time respondent’s
monthly charges were officially calculated. Because overlimit fees, regardless of a creditor’s particular billing practices, are imposed only when a consumer exceeds his
credit limit, it is perfectly reasonable to characterize an
over-limit fee not as a charge imposed for obtaining an
extension of credit over a consumer’s credit limit, but
rather as a penalty for violating the credit agreement.
Moreover, an examination of TILA’s related provisions,
as well as the full text of § 1605 itself, casts doubt on the
Court of Appeals’ interpretation of the statute. A consumer holding an open-end credit plan may incur two
types of charges—finance charges and “other charges
which may be imposed as part of the plan.” . . . TILA does
not make clear which charges fall into each category. But
TILA’s recognition of at least two categories of charges
does make clear that Congress did not contemplate that
all charges made in connection with an open-end credit
plan would be considered “finance charges.” And where
TILA does explicitly address over-limit fees, it defines
them as fees imposed “in connection with an extension
of credit,” rather than “incident to the extension of
credit,” §1605(a).
Regulation Z’s exclusion of over-limit fees from the
term “finance charge” is in no way manifestly contrary to
§ 1605. Regulation Z defines the term “finance charge” as
“the cost of consumer credit.” . . .
Because over-limit fees, which are imposed only when
a consumer breaches the terms of his credit agreement,
can reasonably be characterized as a penalty for defaulting on the credit agreement, the Board’s decision to
exclude them from the term “finance charge” is surely
reasonable.
The Supreme Court reversed the court of appeals and
ruled in favor of the Defendant, Household.
748
PART THREE
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CREDIT CARD ACCOUNTABILITY, RESPONSIBILITY
AND DISCLOSURE ACT OF 2009
The Credit Card Accountability, Responsibility and Disclosure Act of 2009, which
became effective in February of 2010, instituted some new provisions regarding
rates, fees, disclosures and notices, and billing practices. It also left untouched
more than a few issuer practices about which consumers had complained.
Rates. The 2009 Act did not limit the rates an issuer can charge new customers, nor did it limit how much issuers can raise rates on future purchases.
However, credit card issuers (banks and others) can no longer raise interest
rates on existing balances. Issuers also cannot raise rates on new accounts for
12 months.
Fees. Credit card issuers are no longer allowed to charge a fee when the debtor
exceeds the credit limit unless the debtor agrees to this arrangement and signs
up for this service. In essence, issuers cannot charge extra because of the way
you pay your bills. However, credit card companies can still charge annual fees,
inactivity fees, and other fees.
Disclosure and Notice. Credit card issuers must give 45 days’ notice before
raising interest rates, before charging certain fees such as annual fees or cash
advance fees, and before making other significant account changes. Card issuers
can close your account or lower your credit limit for any reason without giving
advance notice, though. In the months before this law became effective, credit
card companies sharply lowered limits for thousands of card holders.
Billing Practices. Many customers (borrowers) have several lines of credit with
different interest rates on the same credit card. For example, you may get one
rate for a cash advance and another for purchases on the same card. Issuers are
now required to apply any amount paid by the customer above the minimum to
the balance with the highest rate. The new law made no change to another common situation, though: When card holders have credit lines with different interest rates, card issuers are still allowed to apply the minimum payment to the
lowest-rate debt.
Credit card companies must now mail or deliver the debtor’s bill at least 21 days
before payment is due, and the due date must be the same every month. Banks can
no longer use a customer’s average daily balance over two months to calculate
interest.
THE ELECTRONIC FUND TRANSFER ACT
Goals. In 1978, Congress amended the TILA and enacted the EFTA to regulate
financial institutions that offer electronic fund transfers involving an account held
by a customer. The Federal Reserve Board was empowered to enforce the provisions of the EFTA and adopted Regulation E to further interpret the act. Types
of consumer electronic funds include automated teller machines (ATMs), pointof-sale terminals (e.g., debit cards), pay-by-phone systems, and direct deposit
and withdrawals.
Provisions. Consumer rights established by the EFTA apply in the following
areas:
1. Unsolicited cards. Banks can send an unsolicited EFTA card to a consumer
only if the card is not valid for use when received.
2. Errors in billing. Customers have 60 days from the receipt of a bank statement to notify the bank of its error. The bank has 10 days to investigate. The
bank can recredit the customer account to gain 45 more days to investigate.
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3. Lost or stolen debit cards. If the bank is notified within 2 days from the time
a card is lost, the customer can be liable for only $50 in unauthorized use.
Liability increases to $300 up to 60 days, and more than $500 after 60 days
when no notice is given.
4. Transactions. A bank has to provide written evidence of a transaction made
through a computer terminal.
5. Statements. Banks must provide a monthly statement to an EFTA customer
at the end of a month in which a transaction is made. If no transactions are
made, a quarterly statement must be provided.
The EFTA covers only transactions involving accounts held by natural persons
for personal, family, or household purposes. Many fund transfers fall outside the
EFTA. An attempt to create a uniform body of law in the 50 states took place in
1989 with the creation of Article 4A of the UCC, but Article 4A and the EFTA are
mutually exclusive. Article 4A does not apply to or regulate any part of an electronic fund transfer that is subject to the EFTA.
Remedies. Under the EFTA, a financial institution is liable to any customer for
all damages caused by its failure to make an electronic transfer in a timely manner and when instructed to do so by the customer. The institution is liable for
damages caused by its failure to credit a deposit of funds and by its failure to
make a preauthorized transfer from a customer account.
If an act of God or other circumstance beyond its control or a technical malfunction takes place, the financial institution is not liable.
A PLASTIC SOCIETY
With credit cards, consumers can spend more money and more quickly than
when using cash. As of 2004, consumer debt is at an estimated $838 billion. Card
issuers obtain anywhere from 1 to 5 percent commission on each transaction.12
The facts that credit cards are omnipresent and susceptible to theft made the
EFTA necessary for consumer protection.
Technological advances may limit the use of cards in the future. With an
increase in online shopping, the credit industry is looking forward to using
advanced identification methods such as silicon wafers embedded in the computer keyboard, which would read a fingerprint and match it online with a bank
copy so that the bank can then authorize (or be alerted to) the sale. Could the
“plastic society” be changing?
THE FAIR CREDIT REPORTING ACT
Goals. The FCRA was enacted by Congress in 1970 as an amendment to the CCPA
to ensure that credit information obtained by credit agencies would remain confidential. Individual privacy is a major concern in an era in which three major credit
bureaus (TRW, TransUnion, and Equifax) hold files on a majority of U.S. citizens.
At the same time, Congress wanted to force the agencies to adopt reasonable procedures to allow lenders, such as banks and finance corporations, to have access
to the information they need to make decisions on whether to lend money.
The FCRA sought especially to correct three common abuses by credit agencies: the failure to set uniform standards for keeping information confidential,
the retention of irrelevant and sometimes inaccurate information in their files,
and the failure to respond to consumer requests for information.
12
See J. Sapsford, “As Cash Wanes, America Becomes a Plastic Nation,” Wall Street Journal, A-1,
A-6 (Jul. 23, 2004).
749
750
PART THREE
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Provisions. The following are the most important provisions of the FCRA:
1. The creditor or lender must give notice to a consumer whenever that consumer
has been unfavorably affected by an adverse credit report from a consumer
reporting agency. A consumer reporting agency is defined as any entity that
“regularly engages in the practice of assembling or evaluating consumer credit
or other information on consumers for the purpose of furnishing consumer
reports to third parties.” If a company infrequently furnishes information to a
third party or collects it for internal use only, it does not fall within the FCRA.
2. The consumer may go to the credit agency that issued the adverse report
and be “informed of the nature and substance” of the information on file. A
written request for information by a consumer must also be honored.
3. Credit reporting agencies are required to keep files up-to-date and delete
inaccuracies. If these inaccuracies have been passed on to lenders, the agencies are also required to notify them of the errors. Agencies cannot retain
stale information and must follow reasonable procedures to update information dealing with bankruptcies, tax liens, criminal records, and bad debts.
If a credit transaction involves $50,000 or more, these agency actions are not
necessary before issuing a credit report.
4. If consumers do not agree with what is in their files, or with what has been
reported by the credit agency to a lender, they can file a written report (of
100 words or less) giving their side of the dispute.
5. A consumer credit agency may issue credit information reports to (a) a court
in response to a court order; (b) the consumer to whom the report relates
(upon written request); (c) a person or entity whom the agency has reason to
believe will use the information in connection with making a credit transaction, obtaining employment, licensing, or obtaining personal or family insurance; and (d) anyone having a legitimate business need for the information in
order to carry on a business transaction with a consumer.
6. In 1997, the act was amended to restrict the use of credit reports by employers. An employer must notify a job applicant or current employee that a report
may be used and must obtain the applicant’s consent before requesting an
individual credit report from a credit bureau. Additionally, before refusing to
hire or terminating or denying a promotion, the employer must provide an
individual with a “pre-adverse action disclosure,” which must contain the
individual’s credit report and a copy of the FTC’s “A Summary of Your Rights
under the Fair Credit Reporting Act.”
The following case sets out the standard for civil liability under the FCRA.
CASE
26-5
Safeco Insurance Co. v. Burr
127 S. Ct. 2201 (2007)
S
afeco Insurance Company and GEICO General Insurance Company issued automobile insurance policies to
three applicants without telling them that the companies
had obtained credit reports on the applicants. One applicant filed a lawsuit against Safeco and two applicants sued
GEICO under the Fair Credit Reporting Act.
Justice Souter
The Fair Credit Reporting Act requires notice to any consumer subjected to “adverse action based in whole or in part
on any information contained in a consumer credit report.”
Anyone who “willfully fails”to provide notice is civilly liable
CHAPTER 26
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to the consumer. The questions in these consolidated cases
are whether willful failure covers a violation committed in
reckless disregard of the notice violation, and, if so, whether
petitioners Safeco and GEICO committed reckless violations. We hold that reckless action is covered, that GEICO
did not violate the statute, and that while Safeco might have,
it did not act recklessly.
Congress enacted the Act in 1970 to ensure fair and
accurate credit reporting, promote efficiency in the banking system, and protect consumer privacy. The Act requires, among other things, that “any person who takes
any adverse action with respect to any consumer that is
based in whole or in part on any information contained in
a consumer report” must notify the affected consumer.
The notice must point out the adverse action, explain how
to reach the agency that reported on the consumer’s
credit, and tell the consumer that he can get a free copy of
the report and dispute its accuracy with the agency. As it
applies to an insurance company, “adverse action”is “a denial or cancellation of, an increase in any charge for, or a
reduction or other adverse or unfavorable change in the
terms of coverage or amount of any insurance, existing or
applied for.”
In GEICO’s case, the initial rate offered to Edo [one of
the applicants] was the one he would have received if his
751
credit score had not been taken into account, and GEICO
owed him no adverse action notice under the Act.
Safeco did not give Burr and Massey (the other applicants)
any notice because it thought the Act did not apply to an initial application, a mistake that left the company in violation
of the statute if Burr and Massey received higher rates “based
in whole or in part”on their credit reports; if they did, Safeco
would be liable to them on a showing of reckless conduct (or
worse). The first issue we can forget, however, for although
the record does not reliably indicate what rights they would
have obtained if their credit reports had not been considered, it is clear enough that if Safeco did violate the statute,
the company was not reckless in falling down in its duty.
There being no indication that Congress had something
different in mind, we have no reason to deviate from the
common law understanding in applying the statute. Thus,
a company subject to the Act does not act in reckless disregard of it unless the action is not only a violation under a
reasonable reading of the statute’s terms, but shows that
the company ran a risk of violating the law substantially
greater than the risk associated with a reading that was
merely careless. Here, there is no need to pinpoint the negligence/recklessness line, for Safeco’s reading of the statute,
albeit erroneous, was not objectively unreasonable.
Reversed, in favor of defendant and remanded.
The Court of Appeals correctly held that reckless disregard of a requirement of the Act would qualify as a willful violation within the
meaning of the Act. But there was no need for that court to remand the cases for factual development. GEICO’s decision to issue no
adverse action notice to Edo was not a violation of the Act, and Safeco’s misreading of the statute was not reckless. The judgments
of the Court of Appeals are therefore reversed in both cases, which are remanded for further proceedings consistent with this opinion.
Very early in our lives, most of us are told that “ignorance of the law is no excuse.” Are Safeco and GEICO being
permitted to violate the law on the ground that they were unaware of the meaning of the law?
1.
Express the legal rule in this case in a manner that addresses the Court’s apparent understanding of reckless
disregard of a statute.
Clue: Does Justice Souter believe that reckless disregard constitutes violation of a statute? When would
disregard become reckless?
2.
What facts would have made this case go in favor of the plaintiffs?
Clue: Construct a set of facts under which each insurance company would have violated the statute.
Remedies. The FTC may bring actions in the federal courts to obtain cease-anddesist orders against credit agencies and users of information, or it may seek to
obtain administrative enforcement orders from an administrative law judge.
Violations of the FCRA are considered “unfair or deceptive practices” under
Section 5 of the FTCA. An agency that fails to comply with FCRA is liable for
actual damages plus additional damages not to exceed $1,000, plus attorney’s
fees. Seven other government entities can also enforce the FCRA: the Federal
Reserve Board, the Comptroller of the Currency, the Federal Home Loan Bank
Board, the National Credit Union, the Interstate Commerce Commission, and the
Secretary of Agriculture.
752
PART THREE
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IDENTITY THEFT AND CREDIT RATINGS
Identity theft may be defined as the use of another’s name to obtain some illegal
gain through financial instruments held or owned by another. Often, this includes
stolen credit cards, Social Security numbers, computer codes, telephone numbers,
and so on.
The Fair and Accurate Credit Transaction Act of 200313 (FACTA) (which
amends the FCRA) seeks to combat identity theft by allowing consumers to place
fraud alerts in their credit files and to block information from being placed in a
file if caused by identity theft or fraud. Additionally, FACTA provides the FTC,
and other federal regulatory agencies, with rulemaking authority to combat identity theft, which the agencies previously lacked. The FTC may receive reports
and studies on identity theft by nongovernmental national credit agencies, and
other private-sector firms, and consumers may receive the same.
FACTA provides that the FTC and other agencies may study the effect of
credit scores, collected by credit agencies, and their effect on the affordability of
financial products such as mortgages and insurance. Consumers may now have
access to their individual credit reports once a year free of charge from one of
the three national nongovernmental credit agencies (Equifax, Experian, and
TransUnion). In applying for mortgages, insurance, loans, and other financial
tools, credit reports will be helpful.
Criminal liability is incurred by a person who “knowingly and willfully obtains
information on a consumer from a consumer reporting agency under false
pretenses.” Anyone convicted of this charge is subject to a fine up to $5,000 and
possible imprisonment for a maximum of one year.
Civil liability is incurred by a credit agency for any user of credit agency
information (e.g., a bank) if a consumer, in a private action, can show that the
agency willfully violated the FCRA through repetitive errors. For such violations,
the court may assess punitive and actual damages, court costs, and attorney’s fees.
A consumer who is able to show negligence on the part of the credit agency or
user will obtain actual damages, court costs, and reasonable attorney’s fees.
EQUAL CREDIT OPPORTUNITY ACT
Goals. When Congress enacted the ECOA in 1974, it was trying to eliminate all
forms of discrimination in granting credit, including those based on race, sex,
color, religion, national origin, marital status, receipt of public assistance—and
exercise of one’s rights under the act. The Federal Reserve Board, which is
charged with implementing ECOA’s regulations, may exempt any “classes of
transactions not primarily for household or family purposes.” Thus, most commercial transactions are exempt from the ECOA.
Provisions. The ECOA and Regulation B, promulgated by the Federal Reserve
Board, provide that:
1. A creditor may not request information from a credit applicant about a
spouse or a former spouse, the applicant’s marital status, any alimony and
child support received, gender, childbearing, race, color, religion, or national origin.
2. A creditor must notify the applicant of what action has been taken on the
application within 30 days of receiving it. The notification must contain (a) a
statement of the action taken and, if the application is denied, either a statement of the reasons for the denial or a disclosure of the applicant’s right to
13
15 U.S.C. § 168; Pub. L. No. 108-159 (2003).
CHAPTER 26
䉬
receive a statement of such reasons; (b) a statement of the basic provisions of
the ECOA; and (c) the name and address of the relevant administrative agency
that deals with compliance by creditors.
A two-year statute of limitations applies to suits brought under the ECOA.
This, however, sometimes does not apply when the act is used as a defense.
For example, there is a conflict among state and federal court decisions in
cases in which the wife is illegally required under ECOA to cosign a loan guarantee for her husband’s business. When the bank later brings suit to collect
on the promissory note that the husband has defaulted on, the wife raises the
defense of a violation of the act even though the two-year statute of limitations has run.
Other ECOA violations, besides requiring a spouse to cosign, include (a) asking for information about an applicant’s spouse or former spouse when not
relevant; (b) taking race, sex, or national origin into account when making a
credit decision; (c) requiring certain types of life insurance before issuing a loan;
(d) basing a credit decision on the area in which the applicant lives; and (e) asking about an applicant’s intent to have children.
Remedies. The FTC and other agencies can bring administrative actions on behalf
of consumers before an administrative law judge, as well as civil injunctive actions
in the federal district courts. In addition, if a creditor violates the ECOA, individuals who feel they have been injured under the act can bring an action in federal
district court for actual and punitive damages. Punitive damages may not exceed
$10,000 for an individual successful plaintiff, but they may go as high as $500,000
for successful class action plaintiffs. Plaintiffs may also ask for injunctive relief to
prohibit future discriminatory actions by the creditor.
THE FAIR CREDIT BILLING ACT
Goals. Congress enacted the FCBA as an amendment to the TILA in 1974 in
order to eliminate inaccurate and unfair billing practices, as well as to limit the
liability of consumer debtors for the unauthorized use of their credit cards.
Provisions. The FCBA provisions cover (1) issuers of credit cards, (2) creditors
who extend credit over more than four monthly installments, and (3) creditors
who assess finance charges. The following provisions of the act establish a procedure for correcting billing errors:
1. All creditors must notify consumer-debtors of their rights and duties when
an account is opened and every six months thereafter. They must notify
debtors on the billing statement where they may inquire (provide contact
information) when they notice a billing error.
2. Consumer-debtors who believe their billing statement contains an error must
notify the creditor in writing within 60 days, identifying themselves, their
account number, the item, and the amount in dispute. Within 30 days, the
creditor must notify the debtor that it has received notice of the alleged billing
error. Within 90 days, or two billing cycles, the creditor must notify the
consumer-debtor of the outcome of its investigation. During this period, the
creditor cannot take any action to collect the debt in dispute. It may continue
to send billing statements listing the disputed item, but these statements must
give notice to the consumer that the item in dispute does not have to be paid.
If after investigation the creditor finds that there was a billing error, it must
correct the error and notify the consumer. If it finds no error, it must notify the
consumer-debtor and substantiate its reason. A bad credit report cannot be filed
until 10 days after the substantiation has been sent out.
753
754
PART THREE
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If a faulty product is purchased on credit, the consumer can withhold payment
until the dispute is settled, provided that he or she notifies the creditor immediately
after finding the fault in the product. The creditor is then obligated to attempt to
negotiate the dispute between the seller of the product and the consumer-debtor.
Remedies. Individual consumer-debtors, as well as government agencies, can
bring actions against creditors who violate the FCBA. The only penalty set forth
in the act is that creditors forfeit their right to collect up to $50 on each item in
dispute on each periodic statement. This amount includes interest and finance
charges on the amount in dispute.
THE FAIR DEBT COLLECTION PRACTICES ACT
Goals. The purpose of the FDCPA is to prevent creditors or debt collectors from
harassing consumer-debtors at their places of work or at home. The act defines
debt collectors as those who are in the business of collecting debts from others.
In 1987, attorneys who regularly perform debt activities were brought under the
provisions of the FDCPA.14
Approximately 5,000 debt-collection agencies seek about $5 billion in debts
from some 8 million consumers annually. Many use sophisticated WATS telephone lines and computers. They are paid 20–50 percent commission on what
they collect, so they often are quite aggressive in their collection methods, as
well as successful—so successful that in the 1980s, the federal government
turned over many outstanding federal loans (including student loans) to these
private collection agencies.
States are exempt from FDCPA enforcement within their boundaries if they
have laws meeting the FDCPA requirements. Actually, state laws are often more
vigorously enforced than the federal law.
Provisions. The FDCPA prohibits the following activities by debt collectors
who are covered by the act:
1. They may not contact a third party (other than the debtor’s family and
lawyer) except to find out where the debtor is. The idea behind this provision is that the debtor’s name (reputation) among friends, acquaintances, or
employers should not be ruined.
2. They may not contact a debtor during “inconvenient” hours. This provision
seeks to prevent creditors from harassing a debtor in the middle of the night.
“Inconvenient hours” are considered to be from 9:00 PM to 8:00 AM for a
debtor whose workday is normally 8:00 AM to 5:00 PM. If the credit collection
agency knows that the debtor is represented by a lawyer, it may not contact
the debtor at all.
3. They cannot contact a debtor in an abusive, deceptive, or unfair way. For
example, posing as a lawyer or police officer is forbidden.
The act requires a debt collector, within five days of the initial communication
with a consumer, to provide the consumer with a written notice that includes (1) the
amount of the debt, (2) the name of the current creditor, and (3) a statement informing the consumer that he or she can request verification of the alleged debt. The
consumer can recover damages from the collection agency for violations of the act.
The following case illustrates the importance of language in statutory interpretation; in this instance, of the FDCPA.
14
See Heinz v. Jenkins, 513 U.S. 1109 (1995).
CHAPTER 26
CASE
䉬
755
26-6
Miller v. McCalla, Raymer Padrick and Clark, LLC
United States Court of Appeals for the Seventh Circuit
214 F.3d 872 (2000)
M
iller (plaintiff) sued McCalla (defendant) for violation
of the FDCPA (Act) for failing to state “the amount of
the debt” in a dunning letter that the defendant sent. The
plaintiff argued that the relevant time for determining
debt is when it first arises, not when collection begins.
The defendants replied that they did state the amount of
the debt.
The lower court granted summary judgment for the
defendants. The plaintiff appealed.
Justice Posner
The defendants [argue] that since the Act under which the
plaintiff is suing governs debt collection, the relevant time
is when the attempt at collection is made. Oddly, there are
no reported appellate decisions on the issue, though it was
assumed that the relevant time is when the loan is made,
not when collection is attempted.
The language of the statute favors this interpretation.
“Debt”is defined as “any obligation or alleged obligation of
a consumer to pay money arising out of a transaction in
which the money, property, insurance, or services which
are the subject of the transaction are primarily for personal, family, or household purposes.”
So the Act is applicable and we move to the question
[of] whether the defendants violated the statutory duty
to state the amount of the loan. The dunning letter said
that the “unpaid principal balance” of the loan was
$178,844.65, but added that “this amount does not include accrued but unpaid interest, unpaid late charges,
escrow advances or other charges for preservation
and protection of the lender’s interest in the property, as
authorized by your loan agreement. The amount to reinstate or pay off your loan changes daily. You may call our
office for complete reinstatement and payoff figures.” An
800 number is given.
The statement does not comply with the Act (again we
can find no case on the question). The unpaid principal
balance is not the debt; it is only a part of the debt; the Act
requires statement of the debt.
We hold that the following statement satisfies the debt
collector’s duty to state the amount of the debt in cases like
this where the amount varies from day to day:
“As of the date of this letter, you owe $_____ [the exact amount due]. Because of interest, late charges,
and other charges that may vary from day to day, the
amount due on the day you pay may be greater.
Hence, if you pay the amount shown above, an adjustment may be necessary after we receive your
check, in which event we will inform you before depositing the check for collection. For further information, write the undersigned or call 1-800-[phone
number].”
A debt collector who uses this form will not violate the
“amount of the debt” provision, provided, of course, that
the information he furnishes is accurate and he does not obscure it by adding confusing other information (or misinformation). Of course we do not hold that a debt collector
must use this form of words to avoid violating the statute;
but if he does, and (to repeat an essential qualification) does
not add other words that confuse the message, he will as a
matter of law have discharged his duty to state clearly the
amount due. No reasonable person could conclude that the
statement that we have drafted does not inform the debtor
of the amount due.
Reversed and remanded to the lower court in favor
of Plaintiff, Miller.
Remedies. A violation of the FDCPA is considered a violation of Section 5 of
the FTCA. The FTC and individual debtors may both bring actions. The FTC may
issue cease-and-desist orders and levy fines after an internal administrative
agency proceeding.
Individual debtors may bring civil actions to recover actual damages, including those for embarrassment and mental distress. An additional $1,000 may be
assessed for each violation for malicious damages. Attorney’s fees are recoverable
by debtors who win their suits and also in the event that the creditor brings an
action against the debtor that is found to be “harassing.”
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E-Commerce and Consumer Protection
The FTC has indicated that more than 160,000 Internet-related fraud complaints were
received in 2003, with estimated losses of nearly $200 million.a About 50 percent of
the complaints involved online auctions. Despite these numbers, very few cases are
actually filed in courts or with administrative agencies because fraud on the Internet
is often practiced by people in foreign countries. Jurisdiction over these cases has
become important. Additionally, the staffs of local, state, and federal governments
combined have too few enforcers. Also, there is a fear of disclosing some suspects
because it may assist other alleged criminals in evading law enforcement authorities.
Government regulators at all levels have sought to keep up with scammers who use
“phishing”techniques. “Phishers”send e-mails to Internet users asking for passwords and
other information, disguising the messages as official communications from companies
such as eBay and many others. In eBay’s case, this method is used to swipe the identities
of users, in particular eBay sellers who have built a reputation for honesty.b This identity
scam allows those seeking to defraud others to obtain thousands of potential targets.
The FTC (and other federal and state agencies) has become a referee for business
and consumer transactions on the Internet. Everything from airline tickets to books
to pianos may be purchased on the Web. As this activity increases, so does the
number of techniques for committing fraud. As discussed in this chapter, deceptive
advertising never ceases; it seems to be an entrenched part of transactions involving
business and consumer. “Junk” faxes, telephone calls, and spam lead to cases of
fraud. The best weapon for consumer protection may be an educated consumer
working with business and government agencies.
At the state level, consumer protection statutes have been amended to cover
Internet transactions. Often, the most effective consumer protection is initiated at
local levels. The Internet complaint process has become an important tool.
a
b
N. Wingfield, “Problem for Cops on eBay Beat,” Wall Street Journal, A-1, A-8 (Aug. 8, 2007).
Id.
Dodd-Frank Act and Consumer Protection
Credit and Debit Cards. The Act includes a provision at reducing “interchange
fees”. These are fees that banks charge retailers when consumers pay with debit
cards. Under the Dodd-Frank Act the Federal Reserve Board (Fed) will determine
what constitutes a “reasonable and proportional” fee for debit card transactions
which usually run about 1% of the transaction, and are passed on to the consumer. If they are lowered prices to consumers may be lowered. Retailers are allowed to require a minimum purchase before they accept a debit or credit card.
Banks have indicated they may have to eliminate debit card reward programs
and increase other fees to make up for lost revenue.
Consumer Loans. The new Consumer Financial Protection Bureau will regulate
mortgage credit cards, some payday lenders and check cashing companies, and
lenders that provide private student loans. Auto dealers’ financing and insurance
arms are exempt from the Bureau’s jurisdiction, after extensive lobbying.
Credit Scores. Consumers who are turned down for a loan are entitled to receive
a copy of the credit score that the lender used to make the decision. Consumers are
entitled to a free score if they were offered a loan at a rate higher than the one provided to borrowers with excellent credit. Consumers can obtain a credit score free
if the score results in an “adverse action” such as loss of a job applied for or a higher
insurance rate, or other matters which depend on such scores.
Residential Mortgages. Lenders are no longer allowed to pay mortgage brokers a commission based on the interest rate for a home loan.
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The Dodd-Frank Act would prevent borrowers from paying a portion of the
closing cost up front, and rolling the rest into the loan in the form of a higher
interest rate:
• Prepayment penalties would be limited or prohibited depending on the type
of loan;
• Lenders would be required to determine if the borrower can afford the
monthly mortgage/payments, combined with insurance and assessments.
State Consumer Legislation
It has often been argued that state, city, county, and private agencies (e.g., the
Better Business Bureau) are closer geographically to the problems that the
average consumer encounters, and thus are more effective at resolving them
than are federal agencies, particularly when relatively small amounts of money
are involved. In this section, we examine some consumer-oriented legislation
originating with the states. Though state law is often overlooked in treatments
of consumer protection law, it is important because it touches the lives of many
Americans daily.
UNIFORM CONSUMER CREDIT CODE
The Uniform Consumer Credit Code (UCCC) was drafted by the National Conference of Commissioners on State Laws in 1968 and revised in 1974 and 1982.
The commissioners’ aim was to replace the patchwork of differing state consumer
laws with a uniform state law in the area of consumer credit.
The UCCC takes a disclosure approach to consumer credit similar to that of
the federal legislation discussed in this chapter. It regulates interest and finance
rates, sets out creditors’ remedies, and prohibits fine-print clauses. (It incorporates
the TILA by reference.) Like the FTC regulations, the UCCC gives the consumer
three days to cancel a sale when it is made as a result of home solicitations. So
far, only 10 states have adopted the UCCC, and each of them has somewhat
altered the original uniform statute.
UNFAIR AND DECEPTIVE PRACTICES STATUTES
All states and the District of Columbia have statutes forbidding deceptive acts and
practices in a way similar to Section 5 of the FTCA. So closely are they modeled
on that act, in fact, that these statutes are often called baby FTC laws.
State attorney general offices typically have consumer fraud divisions that
investigate consumer fraud and false advertising and that seek injunctions, fines,
or restitution in state courts. Often, notice of investigation by a state attorney
general’s office is sufficient to discourage a practice such as false advertising.
Furthermore, private consumer actions, as well as class actions, are permitted
under most state statutes. Usually, consumers may obtain actual and punitive
damages as well as court costs and attorney’s fees.
Attempts to combat consumer fraud at the state level range from mandatory disclosure statutes, requiring merchants to set out all terms and conditions in a financing agreement, to laws requiring “cooling-off” periods that
allow consumers a set number of days to cancel a purchase sold by a doorto-door salesperson. One class of state consumer laws, the “lemon laws,”
gives consumers warranty and refund rights on used cars when a material defect can be shown. Mandatory seat-belt-use laws and license-suspension
statutes are also consumer oriented in that they protect buyers and drivers of
automobiles.
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ARBITRATION OF DISPUTES
State attorneys general have been encouraging private groups, such as the Better
Business Bureau, to play a role in exposing fraudulent sales tactics and in
arbitrating disputes. One excellent example in this area is a formal agreement
between General Motors (GM) and the Better Business Bureau that allows consumers to bring their complaints about car engines to the bureau. GM has agreed
to be bound by the bureau’s decisions, although consumers have the right to go
to court if they disagree with a decision.
Global Dimensions of Consumer
Protection Laws
As companies have become multinational, they have had to look at varying
national consumer protection laws and how they differ. For example, a company
such as Coca-Cola seeks to standardize its advertising for purposes of reducing
costs and improving quality and appeal to internationally mobile consumers. One
of the factors that prevents complete standardization of advertising is legality. Differing national views on consumer protection, protection of competition, and
standards of morality and nationalism may prevent a multinational company from
delivering the same advertising message in each nation where it sells goods.
In the area of consumer protection, countries differ on the amount of deception permitted in advertising. For example, the United Kingdom and the United
States allow competing companies to advertise in a comparative way (for example,
Burger King and McDonald’s). In contrast, the Philippines prohibits this form of
advertising. In the United States, we are concerned with sexism in advertising, as
well as advertising of tobacco. Most countries in Europe, Asia, and Latin America
have few, if any, prohibitions in those areas.
In 1984, the European Union’s Commission adopted what was termed a
“Misleading Advertising Directive.” Similar to Section 5 of the FTCA, the directive called on member states of the European Union to prohibit misleading
advertising by statute and to create means to enforce such laws. Similar to the
U.S. laws, the directive requires that courts and agencies within member states
be given the power to require companies to substantiate claims made in advertisements. Member nations have gradually enacted legislation that fits the cultural
mores to which it is to be applied.
In Mexico, the Federal Consumer Protection Act of 1975 (FCPA) was modeled
in large part after several U.S. statutes. Some provisions dealing with advertising include the “principle of truthfulness” between customers and merchants. Labeling instructions must be clear as to content. There must be warnings on all advertised
products, as well as truthfulness in advertising on radio and television. In addition
to advertising, the FCPA covers areas such as warranties, consumer credit disclosure,
and unconscionable clauses in contracts. Both private parties and the federal attorney general for consumer affairs may bring actions in courts of law. With the advent
of NAFTA, the FCPA has become more important as the United States, Canada, and
Mexico seek to bring some uniformity to their consumer protection laws.
SUMMARY
This chapter examined debtor-creditor relations, particularly as related to the
Bankruptcy Reform Act of 2005. Consumer law originated in the 1930s in case
law and evolved quickly during the consumer rights movement of the 1960s and
1970s. Federal regulation of business and trade practices is highly dependent
on the Federal Trade Commission, which is the watchdog agency charged with
enforcing Section 5 of the FTCA, which forbids unfair or deceptive business
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759
practices and unfair methods of competition. Prohibited trade practices include
deceptive and unfair advertising, misrepresentation by franchisors, deceptive or
confusing warranties, and deceptive telemarketing practices.
Federal laws regulating consumer credit all come under the comprehensive
umbrella of the Consumer Credit Protection Act. Important parts of this umbrella
act are the TILA, which forces creditors to disclose all terms of a credit arrangement to consumer-debtors before they sign the agreement; the FCRA, which
seeks to ensure that credit agencies keep accurate, confidential records; the
ECOA; the Fair Credit Billing Act; the FDCPA; and the Consumer Leasing Act. The
Dodd-Frank Act of 2010 deals with credit and debit cards, consumer loans, and
residential mortgages.
State consumer legislation is important because state and local agencies are
often closer to consumers’ problems than federal agencies and, therefore, are
more effective.
As international business grows, it is important for companies to be aware
of their rights and duties under consumer protection laws around the world.
REVIEW QUESTIONS
26-1 What is meant by the term discharge as used
in the federal Bankruptcy Code?
26-2 How does the Bankruptcy Act of 2005 change
the federal Bankruptcy Code?
26-3 With which general types of deceptive
advertising is the FTC most concerned?
26-4 What must franchisors disclose to prospective
franchisees under the FTC rule governing
franchising?
26-5 What must be disclosed by a consumer credit
reporting agency under the FCRA?
26-6 What enforcement weapon does the FTC
use against parties that violate the ECOA?
Explain.
REVIEW PROBLEMS
26-7 Robert Martin allowed a business associate,
E. L. McBride, to use his American Express Card in a
joint business venture in which they were involved. He
orally authorized McBride to use the card to charge
anything up to $500. Martin received a statement from
American Express 3 months later; the amount due on
his account was $5,300. Martin refused to pay, claiming
that he had not signed the invoices, and therefore was
liable, under the TILA, only up to $50 for “unauthorized
use” of the card. American Express claimed that
McBride was an “authorized” user and sued for the full
balance of the account. Who won this case, and why?
26-8 Joe T. Morris received a bad credit rating from
the Credit Bureau of Cincinnati based on a bankruptcy
filing by his wife that had occurred before their marriage and two unpaid delinquent department-store
accounts that were also his wife’s. (The delinquent
accounts had ended up in his file by accident.) He was
denied credit in several instances. After he reported
the error to the credit bureau, the bureau corrected
his record, but by mistake it opened another account
using the name “Joseph T. Morris” with the same
inaccurate information. Once again, Morris was denied
credit. He sued under the FCRA, requesting compensatory and punitive damages. Who won? Explain.
26-9 When Jerry Markham and Marcia Harris
became engaged, they found a house that they wanted
to buy and jointly applied for a mortgage to Colonial
Mortgage Service Company, an agent of Illinois Federal
Savings and Loan Association. Three days before the
closing date for the purchase of the house, the loan
committee of Illinois Federal rejected the couple’s loan
application, claiming that their separate incomes were
not sufficient to meet the bank’s criteria for “loan and
job tenure.” Markham and Harris sued, claiming a violation of the ECOA, which forbids discrimination based
on marital status when the creditworthiness of individuals is evaluated. Who won this case, and why?
26-10 Campbell Soup ran ads on television showing
solid ingredients at the top of a bowl of soup in a
“mock-up” display. The company placed marbles at the
bottom of the bowl to force the solid ingredients to
the top. The FTC claimed that this was a violation of
Section 5 of the FTCA, in that it was deceptive advertising. Who won? Explain.
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26-11 In a television advertisement, Tropicana Products, Inc., had Bruce Jenner, U.S. Olympic decathlon
champion, squeezing an orange. As the juice went
into a Tropicana carton, he said, “It’s pure, pasteurized
juice as it comes from the orange.” The voice-over then
stated, “It’s the only leading brand not made with concentrate and water.” Coca-Cola, owner of Minute Maid,
sued Tropicana for false advertising under the Lanham
Act. It claimed that the juice was not freshly squeezed
juice but was often heated and frozen before packaging. Who won this case, and why?
26-12 Millstone applied for a new automobile insurance policy after he moved from Washington, D.C., to
St. Louis. He was told that a background investigation
would be conducted in connection with the application. One week later, he was notified that the policy
would not be granted because of a report that the
insurance company had received from Investigative
Reports, a credit bureau. After repeated efforts to
obtain his file, Millstone was informed by Investigative
Reports that his former neighbors in Washington
considered him a “hippie,” a drug user, and a possible
political dissident. Investigative Reports refused to
discuss the matter further. Has Investigative Reports
fulfilled its obligations to Millstone? Explain.
CASE PROBLEMS
26-13 On January 22, 2001, Marlene Moffett bought a
used 1998 Honda Accord from Hendrick Honda in
Woodbridge, Virginia. Moffett agreed to pay $20,024.25,
with interest, in 60 monthly installments, and Hendrick
retained a security interest in the car. (Hendrick thus had
the right to repossess the car in the event of default,
subject to Moffett’s right of redemption.) Hendrick assigned its rights under the sales agreement to Tidewater
Finance Co., which perfected its security interest. The
car was Moffett’s only means of traveling the 40 miles
from her home to her workplace. In March and April
2002, Moffett missed two monthly payments. On
April 25, Tidewater repossessed the car. On the same
day, Moffett filed a Chapter 13 plan in a federal bankruptcy court. Moffett asked that the car be returned to
her, in part under the Bankruptcy Code’s automatic-stay
provision. Tidewater asked the court to terminate the
automatic stay so that it could sell the car. How should
the court rule? Explain. In re Moffett, 356 F.3d 518
(4th Cir. 2004).
26-14 Jon Goulet attended the University of
Wisconsin in Eau Claire and Regis University in
Denver, Colorado, from which he earned a bachelor’s
degree in history in 1972. Over the next 10 years, he
worked as a bartender and restaurant manager. In
1984, he became a life insurance agent and his income
rose from $20,000 to $30,000. In 1989, however, his
agent’s license was revoked for insurance fraud, and
he was arrested for cocaine possession. From 1991 to
1995, Goulet was again at the University of Wisconsin,
working toward, but failing to obtain, a master’s
degree in psychology. To pay for his studies, he took
out student loans totaling $76,000. Goulet then
returned to bartending and restaurant management
and tried real estate sales. His income for the year
2000 was $1,490, and his expenses, excluding a
child-support obligation, were $5,904. When the
student loans came due, Goulet filed a petition for
bankruptcy. On what ground might the loans be
dischargeable? Should the court grant a discharge on
this ground? Goulet v. Education Credit Management
Corp., 284 F.3d 773 (7th Cir. 2002).
26-15 In 1990, Greg Henson sold his 1980 Chevrolet
Camaro Z-28 to his brother, Jeff Henson. To purchase
the car, Jeff secured a loan with Cosco Federal Credit
Union (Cosco). Soon thereafter, the car was stolen and
Jeff stopped making payments on his loan from Cosco.
At the time, Cosco was unsure whether Greg retained
an interest in the car, so Cosco sued both Jeff and
Greg for possession of the car. The trial court rendered a default judgment against Jeff and ruled that
Greg no longer had any interest in the car. The clerk,
however, erroneously noted in the judgment docket
that the money judgment had been rendered against
Greg as well as against Jeff. The official record of judgments and orders, however, correctly reflected that
only Jeff was affected by the money judgment. Two
credit agencies, CSC Credit Services (CSC) and TransUnion Corporation (TransUnion), relied on the state
court judgment docket and indicated in Greg’s credit
report that he owed the money judgment. Greg and
his wife, Mary Henson, allege that they then “contacted Trans [Union] twice, in writing, to correct this
horrible injustice.” When TransUnion did not respond,
the Hensons brought this action alleging violations of
the Federal Credit Reporting Act. The district court,
noting that to state a claim under FCRA a consumer
must allege that a credit reporting agency prepared a
credit report containing inaccurate information,
granted the defendants’ motions to dismiss. Who won
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on appeal? Explain. Henson v. CSC Credit Services,
29 F.3d 280 (7th Cir. 1994), 529 U.S. 765 (2000).
26-16 CrossCheck, Inc., provides check authorization services to retail merchants. When a customer
presents a check, the merchant contacts CrossCheck,
which estimates the probability that the check will
clear the bank. If the check is within an acceptable
statistical range, CrossCheck notifies the merchant. If
the check is dishonored, the merchant sends it to
CrossCheck, which pays it. CrossCheck then attempts
to redeposit the check. If this fails, CrossCheck takes
further steps to collect the amount. William Winterstein took his truck to C&P Auto Service Center, Inc.,
for a tune-up and paid for the service with a check.
C&P contacted CrossCheck and, on its recommendation, accepted the check. When the check was
dishonored, C&P mailed it to CrossCheck, which
reimbursed C&P and sent a letter to Winterstein,
requesting payment. Winterstein filed a suit in a
federal district court against CrossCheck, asserting
that the letter violated the FDCPA. CrossCheck filed a
motion for summary judgment. Who won? Explain.
Winterstein v. CrossCheck, Inc., 149 F. Supp. 2d 466
(N.D. Ill. 2001).
761
26-17 Source One Associates, Inc., is based in
Poughquag, New York. Peter Easton, Source One’s
president, is responsible for its daily operations.
Between 1995 and 1997, Source One received
requests from persons in Massachusetts seeking
financial information about individuals and businesses.
To obtain this information, Easton first obtained the
targeted individuals’ credit reports through Equifax
Consumer Information Services by claiming that the
reports would be used only in connection with credit
transactions involving the consumers. From the reports, Easton identified financial institutions at which
individuals held accounts and then called the institutions to learn the account balances by impersonating
either officers of the institutions or the account holders. The information was then provided to Source
One’s customers for a fee. Easton did not know why
the customers wanted the information. The Commonwealth of Massachusetts filed a suit in a Massachusetts
state court against Source One and Easton, alleging
violations of the FCRA. Did the defendants violate the
FCRA? Explain. Commonwealth v. Source One
Associates, Inc., 436 Mass. 118, 763 N.E.2d 42 (2002).
The FTC needs to set tighter standards with regard to
advertising aimed at children. The FTCA is supposed
to protect consumers from deceptive advertising,
and it is about time the FTC does its job and enforces
the law.
Children are less sophisticated than adults, and
they’re unable to separate reality from fiction. Therefore, they are more susceptible to the cunning ploys of
marketing and advertising wizards. These people
show no shame, endlessly manipulating small children
just to make money.
“How are our children being manipulated?” you
ask. It’s obvious. Every time they turn on the TV,
they’re subjected to a plethora of commercial advertisements. Many of the TV shows that kids watch are
nothing more than half-hour advertisements for a
particular toy. Additionally, the ads themselves mislead
children. In the ads, toy companies show kids looking
as happy and satisfied as possible while they play with
the toys. The children who see these images are
convinced that if they only had the toy, they would be
just as happy. When they actually receive the toy,
however, they find that it’s fun to play with for a few
hours, but not much longer. They never experience
the continuing climax of joy that the advertisers make
them think they will. Such disappointments are likely
to harm the children psychologically, making them
become cynical at a young age.
For these reasons, the FTC must step in to
protect our children from these money-hungry
marketers. To fail to do so is to jeopardize America’s
future: its children.
1. What primary ethical norm is downplayed by
this argument?
2. In this argument, what is the relevant rule of law
to which the author refers?
3. What reasons does the author give for tighter
control of advertising aimed at children?
4. Please state opposing arguments to those set out
by the author in this essay.
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As e-commerce continues to grow in the United States
and abroad, new consumer protection laws are
needed. Now that you know something about current
consumer protection laws in the United States, use the
Internet to research recent developments in consumer
protection for transactions through cyberspace. Make
a list of recommendations for new regulations or rules
that you would like to see enacted. What ethical
norms are implicit in your recommendations?
ON THE INTERNET
www.lectlaw.com//tcos.html Here is a law library site that is a good place from which to begin your research
about consumer protection issues.
www.law.cornell.edu/topics/debtor_creditor.html The Legal Information Institute provides an overview
of debtor–creditor law, as well as links to recent debtor–creditor law decisions.
www.ct.gov/dcp/site/default.asp The Connecticut State Department of Consumer Protection Web site
provides citizens of that state with consumer information. Many states similarly offer some form of consumer
protection information online.
www.ftc.gov/bcp/consumer.shtm The FTC maintains a Web site with consumer information.
www.library.lp.findlaw.com/bankruptcy.html This site contains information about bankruptcy law and links
to related issues.
www.nclc.org This site is the National Consumer Law Center, which provides a wealth of information on the
topic of debtor-creditor relations and consumer protection.
FOR FUTURE READING
Carlson, David Gray. “Cars and Homes in Chapter 13
after the 2005 Amendments to the Bankruptcy Code.”
American Bankruptcy Institute Law Review 14
(2006): 301.
Nickles, Steve H. “Behavioral Effect of New Bankruptcy
Law on Management and Lawyers: Collage of Recent
Statutes and Cases Discouraging Chapter 11 Bankruptcy.” Arkansas Law Review 59 (2006): 329.
APPENDIX A
The Constitution of the United States
PREAMBLE
We the People of the United States, in Order to form a more perfect
Union, establish Justice, insure domestic Tranquility, provide for the
common defence, promote the general Welfare, and secure the
Blessings of Liberty to ourselves and our Posterity, do ordain and
establish this Constitution for the United States of America.
ARTICLE I
Section 1. All legislative Powers herein granted shall be vested in a
Congress of the United States, which shall consist of a Senate and a
House of Representatives.
Section 2. [1] The House of Representatives shall be composed of
Members chosen every second Year by the People of the several States,
and the Electors in each State shall have the Qualifications requisite for
Electors of the most numerous Branch of the State Legislature.
[2] No Person shall be a Representative who shall not have attained to the Age of twenty five Years, and been seven Years a Citizen
of the United States, and who shall not, when elected, be an
Inhabitant of that State in which he shall be chosen.
[3] Representatives and direct Taxes shall be apportioned among
the several States which may be included within this Union, according
to their respective Numbers, which shall be determined by adding to the
whole Number of free Persons, including those bound to Service for a
Term of Years, and excluding Indians not taxed, three fifths of all other
Persons. The actual Enumeration shall be made within three Years after
the first Meeting of the Congress of the United States, and within every
subsequent Term of ten Years, in such Manner as they shall by Law
direct. The Number of Representatives shall not exceed one for every
thirty Thousand, but each State shall have at Least one Representative;
and until such enumeration shall be made, the State of New Hampshire
shall be entitled to choose three, Massachoosetts eight, Rhode Island and
Providence Plantations one, Connecticut five, New York six, New
Jersey four, Pennsylvania eight, Delaware one, Maryland six, Virginia
ten, North Carolina five, South Carolina five, and Georgia three.
[4] When vacancies happen in the Representation from any State,
the Executive Authority thereof shall issue Writs of Election to fill
such Vacancies.
[5] The House of Representatives shall choose their Speaker and
other Officers and shall have the sole Power of Impeachment.
Section 3. [1] The Senate of the United States shall be composed
of two Senators from each State, chosen by the Legislature thereof, for
six Years; and each Senator shall have one vote.
[2] Immediately after they shall be assembled in Consequence of
the first Election, they shall be divided as equally as may be into three
Classes. The Seats of the Senators of the first Class shall be vacated at
the Expiration of the Second Year, of the second Class at the
Expiration of the fourth Year, and of the third Class at the Expiration
of the sixth Year, so that one third may be chosen every second Year,
and if Vacancies happen by Resignation, or otherwise, during the
Recess of the Legislature of any State, the Executive thereof may make
temporary Appointments until the next Meeting of the Legislature,
which shall then fill such Vacancies.
[3] No Person shall be a Senator who shall not have attained to the
Age of thirty Years, and been nine Years a Citizen of the United States,
and who shall not, when elected, be an Inhabitant of that State for
which he shall be chosen.
[4] The Vice President of the United States shall be President of
the Senate, but shall have no Vote, unless they be equally divided.
[5] The Senate shall choose their other Officers, and also a
President pro tempore, in the Absence of the Vice President, or when
he shall exercise the Office of President of the United States.
[6] The Senate shall have the sole Power to try all Impeachments.
When sitting for that Purpose, they shall be on Oath or Affirmation.
When the President of the United States is tried, the Chief Justice shall
preside: And no Person shall be convicted without the Concurrence
of two thirds of the Members present.
[7] Judgment in Cases of Impeachment shall not extend further
than to removal from Office, and disqualification to hold and enjoy
any Office of honor, Trust, or Profit under the United States: but the
Party convicted shall nevertheless be liable and subject to Indictment,
Trial, Judgment, and Punishment, according to Law.
Section 4. [1] The Times, Places and Manner of holding Elections
for Senators and Representatives, shall be prescribed in each State by
the Legislature thereof; but the Congress may at any time by Law make
or alter such Regulations, except as to the Places of choosing
Senators.
[2] The Congress shall assemble at least once in every Year, and
such Meeting shall be on the first Monday in December, unless they
shall by Law appoint a different Day.
Section 5. [1] Each House shall be the Judge of the Elections,
Returns, and Qualifications of its own Members, and a Majority of
each shall constitute a Quorum to do Business, but a smaller Number
may adjourn from day to day, and may be authorized to compel the
Attendance of absent Members, in such Manner, and under such
Penalties as each House may provide.
[2] Each House may determine the Rules of its Proceedings, punish its Members for Disorderly Behavior, and, with the Concurrence
of two thirds, expel a Member.
[3] Each House shall keep a Journal of its Proceedings, and from
time to time publish the same, excepting such Parts as may in their
Judgment require Secrecy; and the Yeas and Nays of the Members of
either House on any question shall, at the Desire of one fifth of those
Present, be entered on the Journal.
[4] Neither House, during the Session of Congress, shall, without
the Consent of the other, adjourn for more than three days, nor to any
other Place than that in which the two Houses shall be sitting.
Section 6. [1] The Senators and Representatives shall receive a
Compensation for their Services, to be ascertained by Law, and paid
out of the Treasury of the United States. They shall in all Cases, except
Treason, Felony and Breach of the Peace, be privileged from Arrest
during their Attendance at the Session of their respective Houses, and
in going to and returning from the same; and for any speech or Debate
in either House, they shall not be questioned in any other Place.
[2] No Senator or Representative shall, during the Time for which
he was elected, be appointed to any civil Office under the Authority
of the United States, which shall have been created, or the Emoluments
whereof shall have been increased during such time and no Person
holding any Office under the United States, shall be a Member of either
House during his Continuance in Office.
Section 7. [1] All Bills for raising Revenue shall originate in the
House of Representatives; but the Senate may propose or concur with
Amendments as on other Bills.
[2] Every Bill which shall have passed the House of Representatives
and the Senate, shall, before it become a Law, be presented to the
President of the United States; If he approve he shall sign it, but if not
he shall return it, with his Objections to the House in which it shall
have originated, who shall enter the Objections at large on their
Journal, and proceed to reconsider it. If after such Reconsideration
two thirds of that House shall agree to pass the Bill, it shall be sent
together with the Objections, to the other House, by which it shall
likewise be reconsidered, and if approved by two thirds of that House,
it shall become a Law. But in all such Cases the Votes of both Houses
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shall be determined by Yeas and Nays, and the Names of the Persons
voting for and against the Bill shall be entered on the Journal of each
House respectively. If any Bill shall not be returned by the President
within ten Days (Sundays excepted) after it shall have been presented
to him, the Same shall be a Law, in like Manner as if he had signed it,
unless the Congress by their Adjournment prevent its Return in
which Case it shall not be a Law.
[3] Every Order, Resolution, or Vote, to Which the Concurrence
of the Senate and House of Representatives may be necessary (except
on a question of Adjournment) shall be presented to the President of
the United States; and before the Same shall take Effect, shall be
approved by him, or being disapproved by him, shall be repassed by
two thirds of the Senate and House of Representatives, according to
the Rules and Limitations prescribed in the Case of a Bill.
Section 8. [1] The Congress shall have Power To lay and collect
Taxes, Duties, Imposts and Excises, to pay the Debts and provide for
the common Defence and general Welfare of the United States; but
all Duties, Imposts and Excises shall be uniform throughout the
United States;
[2] To borrow money on the credit of the United States;
[3] To regulate Commerce with foreign Nations, and among the
several States, and with the Indian Tribes;
[4] To establish an uniform Rule of Naturalization, and uniform
Laws on the subject of Bankruptcies throughout the United States;
[5] To coin Money, regulate the Value thereof, and of foreign
Coin, and fix the Standard of Weights and Measures;
[6] To provide for the Punishment of counterfeiting the Securities
and current Coin of the United States;
[7] To Establish Post Offices and Post Roads;
[8] To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to
their respective Writings and Discoveries;
[9] To constitute Tribunals inferior to the Supreme Court;
[10] To define and punish Piracies and Felonies committed on the
high Seas, and Offenses against the Law of Nations;
[11] To declare War, grant Letters of Marque and Reprisal, and
make Rules concerning Captures on Land and Water;
[12] To raise and support Armies, but no Appropriation of Money
to that Use shall be for a longer Term than two Years;
[13] To provide and maintain a Navy;
[14] To make Rules for the Government and Regulation of the
land and naval Forces;
[15] To provide for calling forth the Militia to execute the Laws of
the Union, suppress Insurrections and repel Invasions;
[16] To provide for organizing, arming, and disciplining, the Militia,
and for governing such Part of them as may be employed in the Service
of the United States, reserving to the States respectively, the
Appointment of the Officers, and the Authority of training the Militia
according to the discipline prescribed by Congress;
[17] To exercise exclusive Legislation in all Cases whatsoever,
over such District (not exceeding ten Miles square) as may, by Cession
of particular States, and the Acceptance of Congress, become the Seat
of the Government of the United States, and to exercise like Authority
over all Places purchased by the consent of the Legislature of the State
in which the Same shall be, for the Erection of Forts, Magazines,
Arsenals, dock-Yards, and other needful Buildings;—And
[18] To make all Laws which shall be necessary and proper for
carrying into Execution the foregoing Powers, and all other Powers
vested by this Constitution in the Government of the United States, or
in any department or Officer thereof.
Section 9. [1] The Migration or Importation of Such Persons as any
of the States now existing shall think proper to admit, shall not be prohibited by the Congress prior to the Year one thousand eight hundred
and eight, but a Tax or duty may be imposed on such Importation, not
exceeding ten dollars for each Person.
[2] The privilege of the Writ of Habeas Corpus shall not be suspended, unless when in Cases of Rebellion or Invasion the public
Safety may require it.
[3] No Bill of Attainder or ex post facto law shall be passed.
[4] No Capitation, or other direct, Tax shall be laid, unless in
Proportion to the Census or Enumeration herein before directed to
be taken.
[5] No Tax or Duty shall be laid on articles exported from any State.
[6] No Preference shall be given by any Regulation of Commerce
or Revenue to the Ports of one State over those of another: nor shall
Vessels bound to, or from, one State be obliged to enter, clear, or pay
Duties in another.
[7] No money shall be drawn from the Treasury, but in
Consequence of Appropriations made by Law; and a regular Statement
and Account of the Receipts and Expenditures of all public Money
shall be published from time to time.
[8] No Title of Nobility shall be granted by the United States: And
no Person holding any Office of Profit or Trust under them, shall, without the Consent of the Congress, accept of any present, Emolument,
Office, or Title, of any kind whatever, from any King, Prince, or foreign
State.
Section 10. [1] No State shall enter into any Treaty, Alliance, or
Confederation; grant Letters of Marque and Reprisal; coin Money;
emit Bills of Credit; make any Thing but gold and silver Coin a
Tender in Payment of Debts; pass any Bill of Attainder, ex post facto
Law, or Law impairing the Obligation of Contracts, or grant any
Title of Nobility.
[2] No State shall, without the Consent of the Congress, lay any
Imposts or Duties on Imports or Exports, except what may be absolutely
necesarry for executing its inspection Laws: and the net Produce of all
Duties and Imposts, laid by any States on Imports or Exports, shall be for
the Use of the Treasury of the United States; and all such Laws shall be
subject to the Revision and Control of the Congress.
[3] No State shall, without the Consent of Congress, lay any Duty
of Tonnage, keep Troops, or Ships of War in time of Peace, enter into
any Agreement or Compact with another State, or with a foreign
Power, or engage in War, unless actually invaded, or in such imminent
Danger as will not admit of delay.
ARTICLE II
Section 1. [1] The executive Power shall be vested in a President
of the United States of America. He shall hold his Office during the
Term of four Years, and, together with the Vice President, chosen for
the same Term, be elected, as follows:
[2] Each State shall appoint, in such Manner as the Legislature
thereof may direct, a Number of Electors, equal to the whole Number
of Senators and Representative to which the State may be entitled in the
Congress; but no Senator or Representative, or Person holding an Office
of Trust or Profit under the United States, shall be appointed as Elector.
[3] The Electors shall meet in their respective States, and vote by
Ballot for two Persons, of whom one at least shall not be an Inhabitant
of the same State with themselves. And they shall make a List of all
the Persons voted for, and of the Number of Votes for each; which List
they shall sign and certify, and transmit sealed to the Seat of the
Government of the United States, directed to the President of the
Senate. The President of the Senate shall, in the Presence of the Senate
and House of Representatives, open all the Certificates, and the Votes
shall then be counted. The Person having the greatest Number of
Votes shall be the President, if such Number be a Majority of the whole
Number of Electors appointed; and if there be more than one who
have such Majority, and have an equal Number of Votes, then the
House of Representatives shall immediately choose by Ballot one of
them for President; and if no Person have a Majority, then from the five
highest on the List the said House shall in like Manner choose the
President. But in choosing the President, the Votes shall be taken by
States the Representation from each State having one Vote; A quorum
for this Purpose shall consist of a Member or Members from two thirds
of the States, and a Majority of all the States shall be necessary to a
Choice. In every Case, after the Choice of the President, the Person
having the greater Number of Votes of the Electors shall be the Vice
President. But if there should remain two or more who have equal
Votes, the Senate shall choose from them by Ballot the Vice President.
[4] The Congress may determine the Time of choosing the
Electors, and the Day on which they shall give their Votes; which Day
shall be the same throughout the United States.
[5] No person except a natural born Citizen, or a Citizen of the
United States, at the time of the Adoption of this constitution, shall
be eligible to the Office of President; neither shall any Person be eligible
to that Office who shall not have attained to the Age of thirty five Years,
and been fourteen Years a Resident within the United States.
APPENDIX A
[6] In case of the removal of the President from Office, or of his
Death, Resignation or Inability to discharge the Powers and Duties of
the said Office, the Same shall devolve on the Vice President, and the
Congress may by Law provide for the Case of Removal, Death,
Resignation or Inability, both of the President and Vice President,
declaring what Officer shall then act as President, and such Officer
shall act accordingly, until the disability be removed, or a President
shall be elected.
[7] The President shall, at stated Times, receive for his Services, a
Compensation, which shall neither be increased nor diminished
during the Period for which he shall have been elected, and he shall
not receive within that Period any other Emolument from the United
States, or any of them.
[8] Before he enter on the Execution of his Office, he shall take the
following Oath or Affirmation: “I do solemnly swear (or affirm) that I
will faithfully execute the Office of President of the United States, and
will to the best of my Ability, preserve, protect and defend the
Constitution of the United States.”
Section 2. [1] The President shall be Commander in Chief of the
Army and Navy of the United States, and of the militia of the several
States, when called into the actual Service of the United States; he may
require the Opinion, in writing, of the principal Officer in each of the
Executive Departments, upon any Subject relating to the Duties of
their respective Offices, and he shall have Power to grant Reprieves
and Pardons for Offenses against the United States, except in Cases of
Impeachment.
[2] He shall have Power, by and with the Advice and Consent of
the Senate to make Treaties, provided two thirds of the Senators present concur, and he shall nominate, and by and with the Advice and
Consent of the Senate, shall appoint Ambassadors, other public
Ministers and Consuls, Judges of the supreme Court, and all other
Officers of the United States, whose Appointments are not herein
otherwise provided for, and which shall be established by Law; but
the Congress may by Law vest the Appointment of such inferior
Officers, as they think proper, in the President alone, in the Courts of
Law, or in the Heads of Departments.
[3] The President shall have Power to fill up all Vacancies that may
happen during the Recess of the Senate, by granting Commissions
which shall expire at the End of their next Session.
Section 3. He shall from time to time give to the Congress
Information of the State of the Union, and recommend to their
Consideration such Measures as he shall judge necessary and expedient; he may, on extraordinary Occasions, convene both Houses, or
either of them, and in Case of Disagreement between them, with
Respect to the Time of Adjournment, he may adjourn them to such
Time as he shall think proper; he shall receive Ambassadors and other
public Ministers; he shall take Care that the Laws be faithfully executed, and shall Commission all the Officers of the United States.
Section 4. The President, Vice President and all civil Officers of
the United States shall be removed from Office on Impeachment for,
and Conviction of, Treason, Bribery, or other high Crimes and
Misdemeanors.
ARTICLE III
Section 1. The judicial Power of the United States, shall be vested
in one supreme Court, and in such inferior Courts as the Congress
may from time to time ordain and establish. The Judges, both of the
supreme and inferior Courts, shall hold their Offices during good
Behaviour, and shall, at stated Times, receive for their Services a
Compensation, which shall not be diminished during their
Continuance in Office.
Section 2. [1] The judicial Power shall extend to all Cases, in Law
and Equity, arising under this Constitution, the Laws of the United
States, and Treaties made, or which shall be made, under their
Authority;—to all Cases affecting Ambassadors, other public
Ministers and Consuls;—to all Cases of admiralty and maritime
Jurisdiction;—to Controversies to which the United States shall be a
Party;—to Controversies between two or more States;—between a
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State and Citizens of another State;—between Citizens of different
States;—between Citizens of the same State claiming Lands under the
Grants of different States, and between a State, or the Citizens thereof,
and foreign States, Citizens or Subjects.
[2] In all Cases affecting Ambassadors, other public Ministers and
Consuls, and those in which a State shall be a Party, the supreme Court
shall have original Jurisdiction. In all the other Cases before mentioned, the supreme Court shall have appellate Jurisdiction, both as
to Law and Fact, with such Exceptions, and under such Regulations as
the Congress shall make.
[3] The trial of all Crimes, except in Cases of Impeachment, shall
be by Jury; and such Trial shall be held in the State where the said
Crimes shall have been committed; but when not committed within
any State, the Trial shall be at such Place or Places as the Congress may
by Law have directed.
Section 3. [1] Treason against the United States, shall consist only
in levying War against them, or, in adhering to their Enemies, giving
them Aid and Comfort. No Person shall be convicted of Treason unless on the Testimony of two Witnesses to the same overt Act, or on
Confession in open Court.
[2] The Congress shall have Power to declare the Punishment of
Treason, but no Attainder of Treason shall work Corruption of Blood,
or Forfeiture except during the Life of the Person attainted.
ARTICLE IV
Section 1. Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State. And the
Congress may by general Laws prescribe the Manner in which such
Acts, Records and Proceedings shall be proved, and the Effect thereof.
Section 2. [1] The Citizens of each State shall be entitled to all
Privileges and Immunities of Citizens in the Several States.
[2] A Person charged in any State with Treason, Felony, or other
Crime, who shall flee from Justice, and be found in another State,
shall on demand of the executive Authority of the State from which
he fled, be delivered up, to be removed to the State having
Jurisdiction of the Crime.
[3] No Person held to Service or Labour in one State, under the
Laws thereof, escaping into another, shall, in Consequence of any Law
or Regulation therein, be discharged from such Service or Labour, but
shall be delivered up on Claim of the Party to whom such Service or
Labour may be due.
Section 3. [1] New States may be admitted by the Congress into
this Union; but no new State shall be formed or erected within the
Jurisdiction of any other State; nor any State be formed by the
Junction of two or more States, or Parts of States, without the Consent
of the Legislatures of the States concerned as well as of the Congress.
[2] The Congress shall have Power to dispose of and make all
needful Rules and Regulations respecting the Territory or other
Property belonging to the United States; and nothing in this
Constitution shall be so construed as to Prejudice any Claims of the
United States, or of any particular State.
Section 4. The United States shall guarantee to every State in this
Union a Republican Form of Government, and shall protect each of
them against Invasion; and on Application of the Legislature, or of the
Executive (when the Legislature cannot be convened) against domestic
Violence.
ARTICLE V
The Congress, whenever two thirds of both Houses shall deem it
necessary, shall propose Amendments to this Constitution, or, on the
Application of the Legislatures of two thirds of the several States,
shall call a Convention for proposing Amendments, which, in either
Case, shall be valid to all Intents and Purposes, as part of this
Constitution, when ratified by the Legislatures of three fourths of the
several States, or by Conventions in three fourths thereof, as the one
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or the other Mode of Ratification may be proposed by the Congress;
Provided that no Amendment which may be made prior to the Year
One thousand eight hundred and eight shall in any Manner affect the
first and fourth Clauses in the Ninth Section of the first Article; and
that no State, without its Consent, shall be deprived of its equal
Suffrage in the Senate.
subject for the same offence to be twice put in jeopardy of life or limb;
nor shall be compelled in any criminal case to be a witness against
himself, nor be deprived of life, liberty, or property, without due
process of law; nor shall private property be taken for public use,
without just compensation.
AMENDMENT VI [1791]
ARTICLE VI
[1] All Debts contracted and Engagements entered into, before the
Adoption of this Constitution shall be as valid against the United States
under this Constitution, as under the Confederation.
[2] This Constitution, and the Laws of the United States which shall
be made in Pursuance thereof; and all Treaties made, or which shall be
made, under the Authority of the United States, shall be the supreme
Law of the Land; and the Judges in every State shall be bound thereby,
any Thing in the Constitution or Laws of any State to the Contrary
notwithstanding.
[3] The Senators and Representatives before mentioned, and the
Members of the several State Legislatures, and all executive and
judicial Officers, both of the United States and of the several States,
shall be bound by Oath or Affirmation, to support this Constitution;
but no religious Test shall ever be required as a Qualification to any
Office or public Trust under the United States.
In all criminal prosecutions, the accused shall enjoy the right to a
speedy and public trial, by an impartial jury of the State and district
wherein the crime shall have been committed, which district shall have
been previously ascertained by law, and to be informed of the nature
and cause of the accusation; to be confronted with the witnesses
against him; to have compulsory process for obtaining witnesses in his
favor, and to have the Assistance of Counsel for his defence.
AMENDMENT VII [1791]
In Suits at common law, where the value in controversy shall exceed
twenty dollars, the right of trial by jury shall be preserved, and no fact
tried by jury, shall be otherwise re-examined in any Court of the
United States, than according to the rules of the common law.
AMENDMENT VIII [1791]
ARTICLE VII
The Ratification of the conventions of nine States shall be sufficient
for the Establishment of this Constitution between the States so ratifying the Same.
Articles in addition to, and amendment of, the constitution of
the united states of america, proposed by congress, and ratified by the
legislatures of the several states pursuant to the fifth article of the original constitution.
Excessive bail shall not be required, nor excessive fines imposed, nor
cruel and unusual punishments inflicted.
AMENDMENT IX [1791]
The enumeration in the Constitution, of certain rights, shall not be
construed to deny or disparage others retained by the people.
AMENDMENT I [1791]
AMENDMENT X [1791]
Congress shall make no law respecting an establishment of religion, or
prohibiting the free exercise thereof; or abridging the freedom of
speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.
The powers not delegated to the United States by the Constitution,
nor prohibited by it to the States, are reserved to the States respectively, or to the people.
AMENDMENT XI [1798]
AMENDMENT II [1791]
A well regulated Militia, being necessary to the security of a free State,
the right of the people to keep and bear Arms, shall not be infringed.
The Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against
one of the United States by Citizens of another State, or by Citizens or
Subjects of any Foreign State.
AMENDMENT III [1791]
AMENDMENT XII [1804]
No Soldier shall, in time of peace be quartered in any house, without
the consent of the Owner, nor in time of war, but in a manner to be
prescribed by law.
AMENDMENT IV [1791]
The right of the people to be secure in their persons, houses, papers,
and effects, against unreasonable searches and seizures, shall not be
violated, and no Warrants shall issue, but upon probable cause,
supported by Oath or affirmation, and particularly describing the
place to be searched, and the persons or things to be seized.
AMENDMENT V [1791]
No person shall be held to answer for a capital, or otherwise infamous
crime, unless on a presentment or indictment of a Grand Jury, except
in cases arising in the land or naval forces, or in the Militia, when in
actual service in time of War or public danger, nor shall any person be
The Electors shall meet in their respective states and vote by ballot for
President and Vice-President, one of whom, at least, shall not be an
inhabitant of the same state with themselves; they shall name in their
ballots the person voted for as President, and in distinct ballots the
person voted for as Vice-President, and they shall make distinct lists of
all persons voted for as President, and of all persons voted for as VicePresident, and of the number of votes for each, which lists they shall
sign and certify, and transmit sealed to the seat of the government of the
United States, directed to the President of the Senate;—The President
of the Senate shall, in the presence of the Senate and House of
Representatives, open all the certificates and the votes shall then be
counted;—The person having the greatest number of votes for
President, shall be the President, if such number be a majority of the
whole number of Electors appointed; and if no person have such majority, then from the persons having the highest numbers not exceeding three on the list of those voted for as President, the House of
Representatives shall choose immediately, by ballot, the President. But
in choosing the President, the votes shall be taken by states, the representation from each state having one vote; a quorum for this purpose
APPENDIX A
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767
shall consist of a member or members from two-thirds of the states, and
a majority of all the states shall be necessary to a choice. And if the
House of Representatives shall not choose a President whenever the
right of choice shall devolve upon them before the fourth day of March
next following, then the Vice-President shall act as President, as in the
case of the death or other constitutional disability of the President.—
The person having the greatest number of votes as Vice-President, shall
be the Vice-President, if such number be a majority of the whole number of Electors appointed, and if no person have a majority, then from
the two highest numbers on the list, the Senate shall choose the VicePresident; a quorum for the purpose shall consist of two-thirds of the
whole number of Senators, and a majority of the whole number shall
be necessary to a choice. But no person constitutionally ineligible to the
office of President shall be eligible to that of Vice-President of the
United States.
AMENDMENT XV [1870]
AMENDMENT XIII [1865]
AMENDMENT XVII [1913]
Section 1. Neither slavery nor involuntary servitude, except as a
punishment for crime whereof the party shall have been duly convicted, shall exist within the United States, or any place subject to their
jurisdiction.
[1] The Senate of the United States shall be composed of two
Senators from each State, elected by the people thereof, for six years
and each Senator shall have one vote. The electors in each State shall
have the qualifications requisite for electors of the most numerous
branch of the State legislatures.
[2] When vacancies happen in the representation of any State in
the Senate, the executive authority of such State shall issue writs of
election to fill such vacancies: Provided, That the legislature of any
State may empower the executive thereof to make temporary
appointments until the people fill the vacancies by election as the
legislature may direct.
[3] This amendment shall not be so construed as to affect the
election or term of any Senator chosen before it becomes valid as part
of the Constitution.
Section 2. Congress shall have power to enforce this article by
appropriate legislation.
AMENDMENT XIV [1868]
Section 1. All persons born or naturalized in the United States, and
subject to the jurisdiction thereof, are citizens of the United States and
of the State wherein they reside. No State shall make or enforce any
law which shall abridge the privileges or immunities of citizens of the
United States; nor shall any State deprive any person of life, liberty, or
property, without due process of law; nor deny to any person within
its jurisdiction the equal protection of the laws.
Section 2. Representatives shall be apportioned among the several
States according to their respective numbers, counting the whole
number of persons in each State excluding Indians not taxed. But
when the right to vote at any election for the choice of electors for
President and Vice President of the United States, Representatives in
Congress, the Executive and Judicial officers of a State, or the members of the Legislature thereof, is denied to any of the male inhabitants
of such State, being twenty-one years of age, and citizens of the United
States, or in any way abridged, except for participation in rebellion, or
other crime, the basis of representation therein shall be reduced in the
proportion which the number of such male citizens shall bear to the
whole number of male citizens twenty-one years of age in such State.
Section 3. No person shall be a Senator or Representative in
Congress, or elector of President and Vice President, or hold any
office, civil or military, under the United States, as a member of any
State, who having previously taken an oath, as a member of Congress,
or as an officer of the United States, or as a member of any State legislature, or as an executive or judicial officer of any State, to support
the Constitution of the United States, shall have engaged in insurrection or rebellion against the same, or given aid or comfort to the
enemies thereof. But Congress may by a vote of two-thirds of each
House, remove such disability.
Section 4. The validity of the public debt of the United States,
authorized by law, including debts incurred for payment of pensions
and bounties for services in suppressing insurrection or rebellion,
shall not be questioned. But neither the United States nor any State
shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or
emancipation of any slave; but all such debts, obligations and claims
shall be held illegal and void.
Section 5. The Congress shall have power to enforce, by appropriate legislation, the provisions of this article.
Section 1. The right of citizens of the United States to vote shall not
be denied or abridged by the United States or by any State on account
of race, color, or previous condition of servitude.
Section 2. The Congress shall have power to enforce this article by
AMENDMENT XVI [1913]
The Congress shall have power to lay and collect taxes on incomes,
from whatever source derived, without apportionment among the
several States, and without regard to any census or enumeration.
AMENDMENT XVIII [1919]
Section 1. After one year from the ratification of this article the
manufacture, sale, or transportation of intoxicating liquors within,
the importation thereof into, or the exportation thereof from the
United States and all territory subject to the jurisdiction thereof for
beverage purposes is hereby prohibited.
Section 2. The Congress and the several States shall have concurrent power to enforce this article by appropriate legislation.
Section 3. This article shall be inoperative unless it shall have been
ratified as an amendment to the Constitution by the legislatures of
the several States, as provided in the Constitution, within seven
years from the date of the submission hereof to the States by the
Congress.
AMENDMENT XIX [1920]
[1] The right of citizens of the United States to vote shall not be
denied or abridged by the United States or by any State on account
of sex.
[2] Congress shall have power to enforce this article by appropriate legislation.
AMENDMENT XX [1933]
Section 1. The terms of the President and Vice President shall end
at noon on the 20th day of January, and the terms of Senators and
Representatives at noon on the 3d day of January, of the years in
which such terms would have ended if this article had not been
ratified; and the terms of their successors shall then begin.
Section 2. The Congress shall assemble at least once in every year,
and such meeting shall begin at noon on the 3d day of January, unless
they shall by law appoint a different day.
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Section 3. If, at the time fixed for the beginning of the term of the
President, the President elect shall have died, the Vice President elect
shall become President. If the President shall not have been chosen
before the time fixed for the beginning of his term, or if the President
elect shall have failed to qualify, then the Vice President elect shall act
as President until a President shall have qualified; and the Congress
may by law provide for the case wherein neither a President elect nor
a Vice President elect shall have qualified, declaring who shall then
act as President, or the manner in which one who is to act shall be
selected, and such person shall act accordingly until a President or
Vice President shall have qualified.
Section 4. The Congress may by law provide for the case of the
death of any of the persons from whom the House of Representatives
may choose a President whenever the right choice shall have
devolved upon them, and for the case of the death of any of the persons from whom the Senate may choose a Vice President whenever
the right of choice shall have devolved upon them.
Section 5. Sections 1 and 2 shall take effect on the 15th day of
October following the ratification of this article.
ratified as an amendment to the Constitution by the legislatures of
three-fourths of the several States within seven years from the date
of its submission.
AMENDMENT XXI [1933]
Section 1. The eighteenth article of amendment to the Constitution
of the United States is hereby repealed.
Section 2. The transportation or importation into any State,
Territory, or possession of the United States for delivery or use therein
of intoxicating liquors, in violation of the laws thereof, is hereby
prohibited.
ratified as an amendment to the Constitution by conventions in the
several States, as provided in the Constitution, within seven years
from the date of the submission hereof to the States by the Congress.
AMENDMENT XXII [1951]
Section 1. No person shall be elected to the office of the President
more than twice, and no person who has held the office of President,
or acted as President, for more than two years of a term to which some
other person was elected President shall be elected to the office of
President more than once. But this Article shall not apply to any person
holding the office of President when this Article was proposed by the
Congress, and shall not prevent any person who may be holding the
office of President, or acting as President, during the term within which
this Article becomes operative from holding the office of President or
acting as President during the remainder of such term.
ratified as an amendment to the Constitution by the legislatures
of three-fourths of the several States within seven years from the date
of its submission to the States by the Congress.
AMENDMENT XXIII [1961]
Section 1. The District constituting the seat of Government of the
United States shall appoint in such manner as the Congress may direct:
A number of electors of President and Vice President equal to the
whole number of Senators and Representatives in Congress to which
the District would be entitled if it were a State, but in no event more
than the least populous state; they shall be in addition to those
appointed by the states, but they shall be considered, for the purposes
of the election of President and Vice President, to be electors
appointed by a state; and they shall meet in the District and perform
such duties as provided by the twelfth article of amendment.
AMENDMENT XXIV [1964]
Section 1. The right of citizens of the United States to vote in any
primary or other election for President or Vice President, for electors
for President or Vice President, or for Senator or Representative in
Congress, shall not be denied or abridged by the United States, or any
State by reason of failure to pay any poll tax or other tax.
AMENDMENT XXV [1967]
Section 1. In case of the removal of the President from office or of
his death or resignation, the Vice President shall become President.
Section 2. Whenever there is a vacancy in the office of the Vice
President, the President shall nominate a Vice President who shall take
office upon confirmation by a majority vote of both Houses of Congress.
Section 3. Whenever the President transmits to the President pro
tempore of the Senate and the Speaker of the House of Representatives
his written declaration that he is unable to discharge the powers and
duties of his office, and until he transmits to them a written declaration
to the contrary, such powers and duties shall be discharged by the Vice
President as Acting President.
Section 4. Whenever the Vice President and a majority of either the
principal officers of the executive departments or of such other body
as Congress may by law provide, transmit to the President pro tempore of the Senate and the Speaker of the House of Representatives
their written declaration that the President is unable to discharge the
powers and duties of his office, the Vice President shall immediately
assume the powers and duties of the office as Acting President.
Thereafter, when the President transmits to the President pro tempore of the Senate and the Speaker of the House of Representatives
his written declaration that no inability exists, he shall resume the
powers and duties of his office unless the Vice President and a majority of either the principal officers of the executive department or
of such other body as Congress may by law provide, transmit within
four days to the President pro tempore of the Senate and the Speaker
of the House of Representatives their written declaration and the
President is unable to discharge the powers and duties of his office.
Thereupon Congress shall decide the issue, assembling within fortyeight hours for that purpose if not in session. If the Congress, within
twenty-one days after receipt of the latter written declaration, or, if
Congress is not in session, within twenty-one days after Congress is
required to assemble, determines by two-thirds vote of both Houses
that the President is unable to discharge the power and duties of his
office, the Vice President shall continue to discharge the same as
Acting President; otherwise, the President shall resume the powers
and duties of his office.
AMENDMENT XXVI [1971]
Section 1. The right of citizens of the United States, who are
eighteen years of age or older, to vote shall not be denied or
abridged by the United States or by any State on account of age.
AMENDMENT XXVII [1996]
No law, varying the compensation for the services of the Senators and
Representatives, shall take effect, until an election of Representatives
shall have intervened.
APPENDIX B
Uniform Commercial Code
(2000 Official Text), Article 2
TABLE OF SECTION
ARTICLE 2. SALES
Part 1. Short Title, General Construction
and Subject Matter
Section
2–101. Short Title.
2–102. Scope; Certain Security and Other Transactions Excluded
from This Article.
2–103. Definitions and Index of Definitions.
2–104. Definitions: “Merchant”; “Between Merchants”;
“Financing Agency”.
2–105. Definitions: “Transferability”; “Goods”; “Future” Goods;
“Lot”; “Commercial Unit”.
2–106. Definitions: “Contract”; “Agreement”; “Contract for
Sale”; “Sale”; “Present Sale”; “Conforming” to Contract;
“Termination”; “Cancellation”.
2–107. Goods to Be Severed from Realty: Recording.
Part 2. Form, Formation and Readjustment of Contract
2–201.
2–202.
2–203.
2–204.
2–205.
2–206.
2–207.
2–208.
2–209.
2–210.
Formal Requirements; Statute of Frauds.
Final Written Expression: Parol or Extrinsic Evidence.
Seals Inoperative.
Formation in General.
Firm Offers.
Offer and Acceptance in Formation of Contract.
Additional Terms in Acceptance or Confirmation.
Course of Performance or Practical Construction.
Modification, Rescission and Waiver.
Delegation of Performance; Assignment of Rights.
Part 3. General Obligation and Construction of Contract
2–301.
2–302.
2–303.
2–304.
2–305.
2–306.
2–307.
2–308.
2–309.
2–310.
2–311.
2–312.
2–313.
2–314.
2–315.
2–316.
2–317.
2–318.
2–319.
2–320.
2–321.
2–322.
General Obligations of Parties.
Unconscionable Contract or Clause.
Allocation or Division of Risks.
Price Payable in Money, Goods, Realty, or Otherwise.
Open Price Term.
Output, Requirements and Exclusive Dealings.
Delivery in Single Lot or Several Lots.
Absence of Specified Place for Delivery.
Absence of Specific Time Provisions; Notice
of Termination.
Open Time for Payment or Running of Credit; Authority
to Ship Under Reservation.
Options and Cooperation Respecting Performance.
Warranty of Title and Against Infringement; Buyer’s
Obligation Against Infringement.
Express Warranties by Affirmation, Promise,
Description, Sample.
Implied Warranty: Merchantability; Usage of Trade.
Implied Warranty: Fitness for Particular Purpose.
Exclusion or Modification of Warranties.
Cumulation and Conflict of Warranties Express
or Implied.
Third Party Beneficiaries of Warranties Express
or Implied.
F.O.B. and F.A.S. Terms.
C.I.F. and C. & F. Terms.
C.I.F. or C. & F.: “Net Landed Weights”; “Payment on
Arrival”; Warranty of Condition on Arrival.
Delivery “Ex-Ship”.
2–323. Form of Bill of Lading Required in Overseas Shipment;
“Overseas”.
2–324. “No Arrival, No Sale” Term.
2–325. “Letter of Credit” Term; “Confirmed Credit”.
2–326. Sale on Approval and Sale or Return; Rights of Creditors.
2–327. Special Incidents of Sale on Approval and Sale or Return.
2–328. Sale by Auction.
Part 4. Title, Creditors and Good Faith Purchasers
2–401. Passing of Title; Reservation for Security; Limited
Application of This Section.
2–402. Rights of Seller’s Creditors Against Sold Goods.
2–403. Power to Transfer; Good Faith Purchase of Goods;
“Entrusting”.
Part 5. Performance
2–501. Insurable Interest in Goods; Manner of Identification
of Goods.
2–502. Buyer’s Right to Goods on Seller’s Insolvency.
2–503. Manner of Seller’s Tender of Delivery.
2–504. Shipment by Seller.
2–505. Seller’s Shipment Under Reservation.
2–506. Rights of Financing Agency.
2–507. Effect of Seller’s Tender; Delivery on Condition.
2–508. Cure by Seller of Improper Tender or Delivery;
Replacement.
2–509. Risk of Loss in the Absence of Breach.
2–510. Effect of Breach on Risk of Loss.
2–511. Tender of Payment by Buyer; Payment by Check.
2–512. Payment by Buyer Before Inspection.
2–513. Buyer’s Right to Inspection of Goods.
2–514. When Documents Deliverable on Acceptance;
When on Payment.
2–515. Preserving Evidence of Goods in Dispute.
Part 6. Breach, Repudiation and Excuse
2–601.
2–602.
2–603.
2–604.
2–605.
2–606.
2–607.
2–608.
2–609.
2–610.
2–611.
2–612.
2–613.
2–614.
2–615.
2–616.
Buyer’s Rights on Improper Delivery.
Manner and Effect of Rightful Rejection.
Merchant Buyer’s Duties as to Rightfully Rejected Goods.
Buyer’s Options as to Salvage of Rightfully Rejected Goods.
Waiver of Buyer’s Objections by Failure to Particularize.
What Constitutes Acceptance of Goods.
Effect of Acceptance; Notice of Breach; Burden of
Establishing Breach After Acceptance; Notice of Claim
or Litigation to Person Answerable Over.
Revocation of Acceptance in Whole or in Part.
Right to Adequate Assurance of Performance.
Anticipatory Repudiation.
Retraction of Anticipatory Repudiation.
“Installment Contract”; Breach.
Casualty to Identified Goods.
Substituted Performance.
Excuse by Failure of Presupposed Conditions.
Procedure on Notice Claiming Excuse.
Part 7. Remedies
2–701.
2–702.
2–703.
2–704.
Remedies for Breach of Collateral Contracts Not Impaired.
Seller’s Remedies on Discovery of Buyer’s Insolvency.
Seller’s Remedies in General.
Seller’s Right to Identify Goods to the Contract
Notwithstanding Breach or to Salvage Unfinished Goods.
769
770
2–705.
2–706.
2–707.
2–708.
2–709.
2–710.
2–711.
2–712.
2–713.
2–714.
2–715.
2–716.
2–717.
2–718.
2–719.
2–720.
2–721.
2–722.
2–723.
2–724.
2–725.
APPENDIX B
䉬
Uniform Commercial Code (2000 Official Text), Article 2
Seller’s Stoppage of Delivery in Transit or Otherwise.
Seller’s Resale Including Contract for Resale.
“Person in the Position of a Seller”.
Seller’s Damages for Non-acceptance or Repudiation.
Action for the Price.
Seller’s Incidental Damages.
Buyer’s Remedies in General; Buyer’s Security Interest
in Rejected Goods.
“Cover”; Buyer’s Procurement of Substitute Goods.
Buyer’s Damages for Nondelivery or Repudiation.
Buyer’s Damages for Breach in Regard to Accepted Goods.
Buyer’s Incidental and Consequential Damages.
Buyer’s Right to Specific Performance or Replevin.
Deduction of Damages from the Price.
Liquidation or Limitation of Damages; Deposits.
Contractual Modification or Limitation of Remedy.
Effect of “Cancellation” or “Rescission” on Claims for
Antecedent Breach.
Remedies for Fraud.
Who Can Sue Third Parties for Injury to Goods.
Proof of Market Price: Time and Place.
Admissibility of Market Quotations.
Statute of Limitations in Contracts for Sale.
ARTICLE 2.
SALES
Part 1. Short Title, General Construction
and Subject Matter
§ 2–101.
Short Title.
This Article shall be known and may be cited as Uniform Commercial
Code—Sales.
§ 2–102. Scope; Certain Security and Other Transactions
Excluded From This Article.
Unless the context otherwise requires, this Article applies to transactions in goods; it does not apply to any transaction which although in
the form of an unconditional contract to sell or present sale is intended
to operate only as a security transaction nor does this Article impair or
repeal any statute regulating sales to consumers, farmers or other
specified classes of buyers.
§ 2–103.
Definitions and Index of Definitions.
(1) In this Article unless the context otherwise requires
(a) “Buyer” means a person who buys or contracts to buy
goods.
(b) “Good faith”in the case of a merchant means honesty in fact
and the observance of reasonable commercial standards of
fair dealing in the trade.
(c) “Receipt” of goods means taking physical possession of
them.
(d) “Seller”means a person who sells or contracts to sell goods.
(2) Other definitions applying to this Article or to specified Parts
thereof, and the sections in which they appear are:
“Acceptance”
Section 2–606.
“Banker’s credit”
Section 2–325.
“Between merchants”
Section 2–104.
“Cancellation”
Section 2–106(4).
“Commercial unit”
Section 2–105.
“Confirmed credit”
Section 2–325.
“Conforming to contract”
Section 2–106.
“Contract for sale”
Section 2–106.
“Cover”
Section 2–712.
“Entrusting”
Section 2–403.
“Financing agency”
Section 2–104.
“Future goods”
Section 2–105.
“Goods”
Section 2–105.
“Identification”
Section 2–501.
“Installment contract”
Section 2–612.
“Letter of Credit”
Section 2–325.
“Lot”
Section 2–105.
“Merchant”
Section 2–104.
“Overseas”
Section 2–323.
“Person in position of seller” Section 2–707.
“Present sale”
“Sale”
“Sale on approval”
“Sale or return”
“Termination”
Section 2–106.
Section 2–106.
Section 2–326.
Section 2–326.
Section 2–106.
(3) The following definitions in other Articles apply to this Article:
“Check”
Section 3–104.
“Consignee”
Section 7–102.
“Consignor”
Section 7–102.
“Consumer goods”
Section 9–102.
“Dishonor”
Section 3–502.
“Draft”
Section 3–104.
(4) In addition Article 1 contains general definitions and principles
of construction and interpretation applicable throughout this Article.
§ 2–104. Definitions: “Merchant”; “Between Merchants”;
“Financing Agency”.
(1) “Merchant” means a person who deals in goods of the kind or
otherwise by his occupation holds himself out as having knowledge
or skill peculiar to the practices or goods involved in the transaction
or to whom such knowledge or skill may be attributed by his
employment of an agent or broker or other intermediary who by his
occupation holds himself out as having such knowledge or skill.
(2) “Financing agency” means a bank, finance company or other
person who in the ordinary course of business makes advances
against goods or documents of title or who by arrangement with
either the seller or the buyer intervenes in ordinary course to
make or collect payment due or claimed under the contract for sale,
as by purchasing or paying the seller’s draft or making advances
against it or by merely taking it for collection whether or not the
documents of title accompany the draft. “Financing agency” includes
also a bank or other person who similarly intervenes between
persons who are in the position of seller and buyer in respect to the
goods (Section 2–707).
(3) “Between merchants” means in any transaction with respect
to which both parties are chargeable with the knowledge or skill
of merchants.
§ 2–105. Definitions: Transferability; “Goods”; “Future”
Goods; “Lot”; “Commercial Unit”.
(1) “Goods” means all things (including specially manufactured
goods) which are movable at the time of identification to the contract
for sale other than the money in which the price is to be paid, investment securities (Article 8) and things in action. “Goods” also includes
the unborn young of animals and growing crops and other identified
things attached to realty as described in the section on goods to be
severed from realty (Section 2–107).
(2) Goods must be both existing and identified before any interest
in them can pass. Goods which are not both existing and identified
are “future”goods. A purported present sale of future goods or of any
interest therein operates as a contract to sell.
(3) There may be a sale of a part interest in existing identified goods.
(4) An undivided share in an identified bulk of fungible goods is
sufficiently identified to be sold although the quantity of the bulk is
not determined. Any agreed proportion of such a bulk or any quantity
thereof agreed upon by number, weight or other measure may to the
extent of the seller’s interest in the bulk be sold to the buyer who then
becomes an owner in common.
(5) “Lot” means a parcel or a single article which is the subject
matter of a separate sale or delivery, whether or not it is sufficient to
perform the contract.
(6) “Commercial unit” means such a unit of goods as by commercial usage is a single whole for purposes of sale and division of which
materially impairs its character or value on the market or in use.
A commercial unit may be a single article (as a machine) or a set of
articles (as a suite of furniture or an assortment of sizes) or a quantity
(as a bale, gross, or carload) or any other unit treated in use or in the
relevant market as a single whole.
§ 2–106. Definitions: “Contract”; “Agreement”; “Contract
for Sale”; “Sale”; “Present Sale”; “Conforming” to Contract;
“Termination”; “Cancellation”.
(1) In this Article unless the context otherwise requires “contract”
and “agreement” are limited to those relating to the present or future
sale of goods. “Contract for sale” includes both a present sale of goods
APPENDIX B
䉬
and a contract to sell goods at a future time. A “sale” consists in the
passing of title from the seller to the buyer for a price (Section 2–401).
A “present sale” means a sale which is accomplished by the making of
the contract.
(2) Goods or conduct including any part of a performance are
“conforming”or conform to the contract when they are in accordance
with the obligations under the contract.
(3) “Termination” occurs when either party pursuant to a power
created by agreement or law puts an end to the contract otherwise
than for its breach. On “termination” all obligations which are still
executory on both sides are discharged but any right based on prior
breach or performance survives.
(4) “Cancellation” occurs when either party puts an end to the
contract for breach by the other and its effect is the same as that of
“termination”except that the cancelling party also retains any remedy
for breach of the whole contract or any unperformed balance.
§ 2–107.
Goods to Be Severed From Realty: Recording.
(1) A contract for the sale of minerals or the like (including oil and
gas) or a structure or its materials to be removed from realty is a contract for the sale of goods within this Article if they are to be severed
by the seller but until severance a purported present sale thereof
which is not effective as a transfer of an interest in land is effective
only as a contract to sell.
(2) A contract for the sale apart from the land of growing crops or
other things attached to realty and capable of severance without
material harm thereto but not described in subsection (1) or of timber
to be cut is a contract for the sale of goods within this Article whether
the subject matter is to be severed by the buyer or by the seller even
though it forms part of the realty at the time of contracting, and the
parties can by identification effect a present sale before severance.
(3) The provisions of this section are subject to any third party
rights provided by the law relating to realty records, and the contract
for sale may be executed and recorded as a document transferring an
interest in land and shall then constitute notice to third parties of the
buyer’s right under the contract for sale.
Part 2. Form, Formation and Readjustment of Contra
§ 2–201.
Formal Requirements; Statute of Frauds.
(1) Except as otherwise provided in this section a contract for the
sale of goods for the price of $500 or more is not enforceable by way of
action or defense unless there is some writing sufficient to indicate that
a contract for sale has been made between the parties and signed by the
party against whom enforcement is sought or by his authorized agent
or broker. A writing is not insufficient because it omits or incorrectly
states a term agreed upon but the contract is not enforceable under this
paragraph beyond the quantity of goods shown in such writing.
(2) Between merchants if within a reasonable time a writing in confirmation of the contract and sufficient against the sender is received
and the party receiving it has reason to know its contents, it satisfies the
requirements of subsection (1) against such party unless written notice
of objection to its contents is given within 10 days after it is received.
(3) A contract which does not satisfy the requirements of subsection (1) but which is valid in other respects is enforceable
(a) if the goods are to be specially manufactured for the buyer
and are not suitable for sale to others in the ordinary
course of the seller’s business and the seller, before notice
of repudiation is received and under circumstances which
reasonably indicate that the goods are for the buyer, has
made either a substantial beginning of their manufacture
or commitments for their procurement; or
(b) if the party against whom enforcement is sought admits in
his pleading, testimony or otherwise in court that a contract
for sale was made, but the contract is not enforceable under
this provision beyond the quantity of goods admitted; or
(c) with respect to goods for which payment has been made
and accepted or which have been received and accepted
(Section 2–606).
§ 2–202. Final Written Expression: Parol
or Extrinsic Evidence.
Terms with respect to which the confirmatory memoranda of the
parties agree or which are otherwise set forth in a writing intended
by the parties as a final expression of their agreement with respect to
771
such terms as are included therein may not be contradicted by
evidence of any prior agreement or of a contemporaneous oral agreement but may be explained or supplemented
(a) by course and dealing or usage of trade (Section 1–205) or
by course of performance (Section 2–208); and
(b) by evidence of consistent additional terms unless the
court finds the writing to have been intended also as a
complete and exclusive statement of the terms of the
agreement.
§ 2–203.
Seals Inoperative.
The affixing of a seal to a writing evidencing a contract for sale or an
offer to buy or sell goods does not constitute the writing a sealed
instrument and the law with respect to sealed instruments does not
apply to such a contract or offer.
§ 2–204.
Formation in General.
(1) A contract for sale of goods may be made in any manner sufficient to show agreement, including conduct by both parties which
recognizes the existence of such a contract.
(2) An agreement sufficient to constitute a contract for sale may
be found even though the moment of its making is undetermined.
(3) Even though one or more terms are left open a contract for
sale does not fail for indefiniteness if the parties have intended to
make a contract and there is a reasonably certain basis for giving an
appropriate remedy.
§ 2–205.
Firm Offers.
An offer by a merchant to buy or sell goods in a signed writing which
by its terms gives assurance that it will be held open is not revocable,
for lack of consideration, during the time stated or if no time is stated
for a reasonable time, but in no event may such period of irrevocability exceed three months; but any such term of assurance on a form
supplied by the offeree must be separately signed by the offeror.
§ 2–206.
Offer and Acceptance in Formation of Contract.
(1) Unless otherwise unambiguously indicated by the language or
circumstances
(a) an offer to make a contract shall be construed as inviting
acceptance in any manner and by any medium reasonable
in the circumstances;
(b) an order or other offer to buy goods for prompt or current
shipment shall be construed as inviting acceptance either
by a prompt promise to ship or by the prompt or current
shipment of conforming or non-conforming goods, but
such a shipment of non-conforming goods does not constitute an acceptance if the seller seasonably notifies the
buyer that the shipment is offered only as an accommodation to the buyer.
(2) Where the beginning of a requested performance is a reasonable mode of acceptance an offeror who is not notified of acceptance
within a reasonable time may treat the offer as having lapsed before
acceptance.
§ 2–207.
Additional Terms in Acceptance or Confirmation.
(1) A definite and seasonable expression of acceptance or a
written confirmation which is sent within a reasonable time
operates as an acceptance even though it states terms additional to
or different from those offered or agreed upon, unless acceptance
is expressly made conditional on assent to the additional or different terms.
(2) The additional terms are to be construed as proposals for addition to the contract. Between merchants such terms become part of
the contract unless:
(a) the offer expressly limits acceptance to the terms of the
offer;
(b) they materially alter it; or
(c) notification of objection to them has already been given
or is given within a reasonable time after notice of them
is received.
(3) Conduct by both parties which recognizes the existence of
a contract is sufficient to establish a contract for sale although the
writings of the parties do not otherwise establish a contract. In
such case the terms of the particular contract consist of those
terms on which the writings of the parties agree, together with any
supplementary terms incorporated under any other provisions of
this Act.
772
§ 2–208.
APPENDIX B
䉬
Course of Performance or Practical Construction.
(1) Where the contract for sale involves repeated occasions for
performance by either party with knowledge of the nature of the performance and opportunity for objection to it by the other, any course
of performance accepted or acquiesced in without objection shall be
relevant to determine the meaning of the agreement.
(2) The express terms of the agreement and any such course of
performance, as well as any course of dealing and usage of trade, shall
be construed whenever reasonable as consistent with each other; but
when such construction is unreasonable, express terms shall control
course of performance and course of performance shall control both
course of dealing and usage of trade (Section 1–205).
(3) Subject to the provisions of the next section on modification
and waiver, such course of performance shall be relevant to show a
waiver or modification of any term inconsistent with such course of
performance.
§ 2–209.
Modification, Rescission and Waiver.
(1) An agreement modifying a contract within this Article needs
no consideration to be binding.
(2) A signed agreement which excludes modification or rescission
except by a signed writing cannot be otherwise modified or rescinded,
but except as between merchants such a requirement on a form supplied by the merchant must be separately signed by the other party.
(3) The requirements of the statute of frauds section of this
Article (Section 2–201) must be satisfied if the contract as modified is
within its provisions.
(4) Although an attempt at modification or rescission does not satisfy the requirements of subsection (2) or (3) it can operate as a waiver.
(5) A party who has made a waiver affecting an executory portion
of the contract may retract the waiver by reasonable notification
received by the other party that strict performance will be required of
any term waived, unless the retraction would be unjust in view of a
material change of position in reliance on the waiver.
§ 2–210. Delegation of Performance;
Assignment of Rights.
(1) A party may perform his duty through a delegate unless
otherwise agreed or unless the other party has a substantial interest
in having his original promisor perform or control the acts required
by the contract. No delegation of performance relieves the party
delegating of any duty to perform or any liability for breach.
(2) Except as otherwise provided in Section 9–406, unless otherwise agreed all rights of either seller or buyer can be assigned except
where the assignment would materially change the duty of the other
party, or increase materially the burden or risk imposed on him by his
contract, or impair materially his chance of obtaining return performance. A right to damages for breach of the whole contract or a right
arising out of the assignor’s due performance of his entire obligation
can be assigned despite agreement otherwise.
(3) The creation, attachment, perfection, or enforcement of a
security interest in the seller’s interest under a contract is not a transfer that materially changes the duty of or increases materially the burden or risk imposed on the buyer or impairs materially the buyer’s
chance of obtaining return performance within the purview of
subsection (2) unless, and then only to the extent that, enforcement
actually results in a delegation of material performance of the seller.
Even in that event, the creation, attachment, perfection, and enforcement of the security interest remain effective, but (i) the seller is liable
to the buyer for damages caused by the delegation to the extent that
the damages could not reasonably be prevented by the buyer, and
(ii) a court having jurisdiction may grant other appropriate relief, including cancellation of the contract for sale or an injunction against
enforcement of the security interest or consummation of the
enforcement.
(4) Unless the circumstances indicate the contrary a prohibition
of assignment of “the contract” is to be construed as barring only the
delegation to the assignee of the assignor’s performance.
(5) An assignment of “the contract” or of “all my rights under the
contract” or an assignment in similar general terms is an assignment of
rights and unless the language or the circumstances (as in an assignment
for security) indicate the contrary, it is a delegation of performance of
the duties of the assignor and its acceptance by the assignee constitutes
a promise by him to perform those duties. This promise is enforceable
by either the assignor or the other party to the original contract.
(6) The other party may treat any assignment which delegates performance as creating reasonable grounds for insecurity and may without prejudice to his rights against the assignor demand assurances
from the assignee (Section 2–609).
Part 3. General Obligation and Construction of Contract
§ 2–301.
General Obligations of Parties.
The obligation of the seller is to transfer and deliver and that of the
buyer is to accept and pay in accordance with the contract.
§ 2–302.
Unconscionable Contract or Clause.
(1) If the court as a matter of law finds the contract or any clause
of the contract to have been unconscionable at the time it was made
the court may refuse to enforce the contract, or it may enforce the
remainder of the contract without the unconscionable clause, or it
may so limit the application of any unconscionable clause as to avoid
any unconscionable result.
(2) When it is claimed or appears to the court that the contract or
any clause thereof may be unconscionable the parties shall be afforded
a reasonable opportunity to present evidence as to its commercial setting, purpose and effect to aid the court in making the determination.
§ 2–303.
Allocation or Division of Risks.
Where this Article allocates a risk or a burden as between the parties
“unless otherwise agreed,” the agreement may not only shift the
allocation but may also divide the risk or burden.
§ 2–304. Price Payable in Money, Goods, Realty,
or Otherwise.
(1) The price can be made payable in money or otherwise. If it is
payable in whole or in part in goods each party is a seller of the goods
which he is to transfer.
(2) Even though all or part of the price is payable in an interest in
realty the transfer of the goods and the seller’s obligations with reference to them are subject to this Article, but not the transfer of the interest in realty or the transferor’s obligations in connection therewith.
§ 2–305.
Open Price Term.
(1) The parties if they so intend can conclude a contract for sale
even though the price is not settled. In such a case the price is a reasonable price at the time for delivery if
(a) nothing is said as to price; or
(b) the price is left to be agreed by the parties and they fail to
agree; or
(c) the price is to be fixed in terms of some agreed market or
other standard as set or recorded by a third person or
agency and it is not so set or recorded.
(2) A price to be fixed by the seller or by the buyer means a price
for him to fix in good faith.
(3) When a price left to be fixed otherwise than by agreement of
the parties fails to be fixed through fault of one party the other may
at his option treat the contract as cancelled or himself fix a reasonable price.
(4) Where, however, the parties intend not to be bound unless the
price be fixed or agreed and it is not fixed or agreed there is no contract. In such a case the buyer must return any goods already received
or if unable so to do must pay their reasonable value at the time of
delivery and the seller must return any portion of the price paid on
account.
§ 2–306.
Output, Requirements and Exclusive Dealings.
(1) A term which measures the quantity by the output of the seller
or the requirements of the buyer means such actual output or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate or in the absence
of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded.
(2) A lawful agreement by either the seller or the buyer for exclusive dealing in the kind of goods concerned imposes unless otherwise
agreed an obligation by the seller to use best efforts to supply the
goods and by the buyer to use best efforts to promote their sale.
§ 2–307.
Delivery in Single Lot or Several Lots.
Unless otherwise agreed all goods called for by a contract for sale
must be tendered in a single delivery and payment is due only on such
tender but where the circumstances give either party the right to
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make or demand delivery in lots the price if it can be apportioned may
be demanded for each lot.
§ 2–308.
Absence of Specified Place for Delivery.
Unless otherwise agreed
(a) the place for delivery of goods is the seller’s place of business or if he has none his residence; but
(b) in a contract for sale of identified goods which to the knowledge of the parties at the time of contracting are in some
other place, that place is the place for their delivery; and
(c) documents of title may be delivered through customary
banking channels.
§ 2–309. Absence of Specific Time Provisions;
Notice of Termination.
(1) The time for shipment or delivery or any other action under a
contract if not provided in this Article or agreed upon shall be a reasonable time.
(2) Where the contract provides for successive performance but
is indefinite in duration it is valid for a reasonable time but unless otherwise agreed may be terminated at any time by either party.
(3) Termination of a contract by one party except on the
happening of an agreed event requires that reasonable notification be
received by the other party and an agreement dispensing with notification is invalid if its operation would be unconscionable.
§ 2–310. Open Time for Payment or Running of Credit;
Authority to Ship Under Reservation.
Unless otherwise agreed
(a) payment is due at the time and place at which the buyer is to
receive the goods even though the place of shipment is the
place of delivery; and
(b) if the seller is authorized to send the goods he may ship them
under reservation, and may tender the documents of title, but
the buyer may inspect the goods after their arrival before
payment is due unless such inspection is inconsistent with the
terms of the contract (Section 2–513); and
(c) if delivery is authorized and made by way of documents of title
otherwise than by subsection (b) then payment is due at the time
and place at which the buyer is to receive the documents
regardless of where the goods are to be received; and
(d) where the seller is required or authorized to ship the goods on
credit the credit period runs from the time of shipment but
post-dating the invoice or delaying its dispatch will correspondingly delay the starting of the credit period.
§ 2–311. Options and Cooperation Respecting
Performance.
(1) An agreement for sale which is otherwise sufficiently definite
(subsection (3) of Section 2–204) to be a contract is not made invalid
by the fact that it leaves particulars of performance to be specified by
one of the parties. Any such specification must be made in good faith
and within limits set by commercial reasonableness.
(2) Unless otherwise agreed specifications relating to assortment
of the goods are at the buyer’s option and except as otherwise
provided in subsections (1) (c) and (3) of Section 2–319 specifications
or arrangements relating to shipment are at the seller’s option.
(3) Where such specification would materially affect the other
party’s performance but is not seasonably made or where one party’s cooperation is necessary to the agreed performance of the other but is not
seasonably forthcoming, the other party in addition to all other remedies
(a) is excused for any resulting delay in his own performance;
and
(b) may also either proceed to perform in any reasonable manner or after the time for a material part of his own performance treat the failure to specify or to cooperate as a
breach by failure to deliver or accept the goods.
§ 2–312. Warranty of Title and Against Infringement;
Buyer’s Obligation Against Infringement.
(1) Subject to subsection (2) there is in a contract for sale a warranty by the seller that
(a) the title conveyed shall be good, and its transfer rightful; and
(b) the goods shall be delivered free from any security interest
or other lien or encumbrance of which the buyer at the
time of contracting has no knowledge.
773
(2) A warranty under subsection (1) will be excluded or modified
only by specific language or by circumstances which give the buyer
reason to know that the person selling does not claim title in himself
or that he is purporting to sell only such right or title as he or a third
person may have.
(3) Unless otherwise agreed a seller who is a merchant regularly
dealing in goods of the kind warrants that the goods shall be delivered
free of the rightful claim of any third person by way of infringement
or the like but a buyer who furnishes specifications to the seller must
hold the seller harmless against any such claim which arises out of
compliance with the specifications.
§ 2–313. Express Warranties by Affirmation, Promise,
Description, Sample.
(1) Express warranties by the seller are created as follows:
(a) Any affirmation of fact or promise made by the seller to the
buyer which relates to the goods and becomes part of
the basis of the bargain creates an express warranty that the
goods shall conform to the affirmation or promise.
(b) Any description of the goods which is made part of the
basis of the bargain creates an express warranty that the
goods shall conform to the description.
(c) Any sample or model which is made part of the basis of the
bargain creates an express warranty that the whole of the
goods shall conform to the sample or model.
(2) It is not necessary to the creation of an express warranty that
the seller use formal words such as “warrant”or “guarantee”or that he
have a specific intention to make a warranty, but an affirmation
merely of the value of the goods or a statement purporting to be
merely the seller’s opinion or commendation of the goods does not
create a warranty.
§ 2–314. Implied Warranty: Merchantability;
Usage of Trade.
(1) Unless excluded or modified (Section 2–316), a warranty that
the goods shall be merchantable is implied in a contract for their sale
if the seller is a merchant with respect to goods of that kind. Under
this section the serving for value of food or drink to be consumed
either on the premises or elsewhere is a sale.
(2) Goods to be merchantable must be at least such as
(a) pass without objection in the trade under the contract
description; and
(b) in the case of fungible goods, are of fair average quality
within the description; and
(c) are fit for the ordinary purposes for which such goods are
used; and
(d) run, within the variations permitted by the agreement, of
even kind, quality and quantity within each unit and
among all units involved; and
(e) are adequately contained, packaged, and labeled as the
agreement may require; and
(f) conform to the promises or affirmations of fact made on
the container or label if any.
(3) Unless excluded or modified (Section 2–316) other implied
warranties may arise from course of dealing or usage of trade.
§ 2–315.
Implied Warranty: Fitness for Particular Purpose.
Where the seller at the time of contracting has reason to know any
particular purpose for which the goods are required and that the buyer
is relying on the seller’s skill or judgment to select or furnish suitable
goods, there is unless excluded or modified under the next section an
implied warranty that the goods shall be fit for such purpose.
§ 2–316.
Exclusion or Modification of Warranties.
(1) Words or conduct relevant to the creation of an express
warranty and words or conduct tending to negate or limit warranty
shall be construed wherever reasonable as consistent with each other,
but subject to the provisions of this Article on parol or extrinsic
evidence (Section 2–202) negation or limitation is inoperative to the
extent that such construction is unreasonable.
(2) Subject to subsection (3), to exclude or modify the implied
warranty of merchantability or any part of it the language must
mention merchantability and in case of a writing must be conspicuous, and to exclude or modify any implied warranty of fitness the exclusion must be by a writing and conspicuous. Language to exclude
all implied warranties of fitness is sufficient if it states, for example,
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that “There are no warranties which extend beyond the description
on the face hereof.”
(3) Notwithstanding subsection (2)
(a) unless the circumstances indicate otherwise, all implied
warranties are excluded by expression like “as is,” “with all
faults”or other language which in common understanding
calls the buyer’s attention to the exclusion of warranties
and makes plain that there is no implied warranty; and
(b) when the buyer before entering into the contract has examined the goods or the sample or model as fully as he desired
or has refused to examine the goods there is no implied
warranty with regard to defects which an examination ought
in the circumstances to have revealed to him; and
(c) an implied warranty can also be excluded or modified by
course of dealing or course of performance or usage of trade.
(4) Remedies for breach of warranty can be limited in accordance
with the provisions of this Article on liquidation or limitation of
damages and on contractual modification of remedy (Sections 2–718
and 2–719).
§ 2–317. Cumulation and Conflict of Warranties
Express or Implied.
Warranties whether express or implied shall be construed as consistent with each other and as cumulative, but if such construction is
unreasonable the intention of the parties shall determine which
warranty is dominant. In ascertaining that intention the following
rules apply:
(a) Exact or technical specifications displace an inconsistent
sample or model or general language of description.
(b) A sample from an existing bulk displaces inconsistent general
language of description.
(c) Express warranties displace inconsistent implied warranties
other than an implied warranty of fitness for a particular
purpose.
§ 2–318. Third Party Beneficiaries of Warranties
Express or Implied.
Note: If this Act is introduced in the Congress of the United
States this section should be omitted. (States to select one
alternative.)
Alternative A. A seller’s warranty whether express or implied
extends to any natural person who is in the family or household of his
buyer or who is a guest in his home if it is reasonable to expect that
such person may use, consume or be affected by the goods and who
is injured in person by breach of the warranty. A seller may not
exclude or limit the operation of this section.
Alternative B. A seller’s warranty whether express or implied
extends to any natural person who may reasonably be expected to
use, consume or be affected by the goods and who is injured in
person by breach of the warranty. A seller may not exclude or limit
the operation of this section.
Alternative C. A seller’s warranty whether express or implied
extends to any person who may reasonably be expected to use,
consume or be affected by the goods and who is injured by breach of
the warranty. A seller may not exclude or limit the operation of this
section with respect to injury to the person of an individual to whom
the warranty extends.
§ 2–319.
F.O.B. and F.A.S. Terms.
(1) Unless otherwise agreed the term F.O.B. (which means “free
on board”) at a named place, even though used only in connection
with the stated price, is a delivery term under which
(a) when the term is F.O.B. the place of shipment, the seller
must at that place ship the goods in the manner provided
in this Article (Section 2–504) and bear the expense and
risk of putting them into the possession of the carrier; or
(b) when the term is F.O.B. the place of destination, the seller
must at his own expense and risk transport the goods to
that place and there tender delivery of them in the manner
provided in this Article (Section 2–503);
(c) when under either (a) or (b) the term is also F.O.B. vessel, car or other vehicle, the seller must in addition at his
own expense and risk load the goods on board. If the
term is F.O.B. vessel the buyer must name the vessel and
in an appropriate case the seller must comply with the
provisions of this Article on the form of bill of lading
(Section 2–323).
(2) Unless otherwise agreed the term F.A.S. vessel (which means
“free alongside”) at a named port, even though used only in connection
with the stated price, is a delivery term under which the seller must
(a) at his own expense and risk deliver the goods alongside
the vessel in the manner usual in that port or on a dock
designated and provided by the buyer; and
(b) obtain and tender a receipt for the goods in exchange for
which the carrier is under a duty to issue a bill of lading.
(3) Unless otherwise agreed in any case falling within subsection
(1)(a) or (c) or subsection (2) the buyer must seasonably give any
needed instructions for making delivery, including when the term is
F.A.S. or F.O.B. the loading berth of the vessel and in an appropriate
case its name and sailing date. The seller may treat the failure of
needed instructions as a failure of cooperation under this Article
(Section 2–311). He may also at his option move the goods in any
reasonable manner preparatory to delivery or shipment.
(4) Under the term F.O.B. vessel or F.A.S. unless otherwise agreed
the buyer must make payment against tender of the required documents and the seller may not tender nor the buyer demand delivery
of the goods in substitution for the documents.
§ 2–320.
C.I.F. and C. & F. Terms.
(1) The term C.I.F. means that the price includes in a lump sum
the cost of the goods and the insurance and freight to the named
destination. The term C. & F. or C. F. means that the price so includes
cost and freight to the named destination.
(2) Unless otherwise agreed and even though used only in connection with the stated price and destination, the term C.I.F. destination or
its equivalent requires the seller at his own expense and risk to
(a) put the goods into the possession of a carrier at the port
for shipment and obtain a negotiable bill or bills of lading
covering the entire transportation to the named destination; and
(b) load the goods and obtain a receipt from the carrier
(which may be contained in the bill of lading) showing
that the freight has been paid or provided for; and
(c) obtain a policy or certificate of insurance, including any
war risk insurance, of a kind and on terms then current at
the port of shipment in the usual amount, in the currency
of the contract, shown to cover the same goods covered
by the bill of lading and providing for payment of loss to
the order of the buyer or for the account of whom it may
concern; but the seller may add to the price the amount of
the premium for any such war risk insurance; and
(d) prepare an invoice of the goods and procure any other
documents required to effect shipment or to comply with
the contract; and
(e) forward and tender with commercial promptness all the
documents in due form and with any indorsement necessary to perfect the buyer’s rights.
(3) Unless otherwise agreed the term C. & F. or its equivalent has
the same effect and imposes upon the seller the same obligations and
risks as a C.I.F. term except the obligation as to insurance.
(4) Under the term C.I.F. or C. & F. unless otherwise agreed the
buyer must make payment against tender of the required documents
and the seller may not tender nor the buyer demand delivery of the
goods in substitution for the documents.
§ 2–321. C.I.F. or C. & F.: “Net Landed Weights”; “Payment
on Arrival”; Warranty of Condition on Arrival.
Under a contract containing a term C.I.F. or C. & F.
(1) Where the price is based on or is to be adjusted according to
“net landed weights,” “delivered weights,” “out turn”quantity or quality or the like, unless otherwise agreed the seller must reasonably estimate the price. The payment due on tender of the documents called
for by the contract is the amount so estimated, but after final adjustment of the price a settlement must be made with commercial
promptness.
(2) An agreement described in subsection (1) or any warranty of
quality or condition of the goods on arrival places upon the seller the
risk of ordinary deterioration, shrinkage and the like in transportation
but has no effect on the place or time of identification to the contract
for sale or delivery or on the passing of the risk of loss.
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(3) Unless otherwise agreed where the contract provides for payment on or after arrival of the goods the seller must before payment
allow such preliminary inspection as is feasible; but if the goods are
lost delivery of the documents and payment are due when the goods
should have arrived.
§ 2–322.
Delivery “Ex-Ship”.
(1) Unless otherwise agreed a term for delivery of goods “ex-ship”
(which means from the carrying vessel) or in equivalent language is
not restricted to a particular ship and requires delivery from a ship
which has reached a place at the named port of destination where
goods of the kind are usually discharged.
(2) Under such a term unless otherwise agreed
(a) the seller must discharge all liens arising out of the carriage
and furnish the buyer with a direction which puts the
carrier under a duty to deliver the goods; and
(b) the risk of loss does not pass to the buyer until the goods
leave the ship’s tackle or are otherwise properly unloaded.
§ 2–323. Form of Bill of Lading Required in Overseas
Shipment; “Overseas”.
(1) Where the contract contemplates overseas shipment and
contains a term C.I.F. or C. & F. or F.O.B. vessel, the seller unless
otherwise agreed must obtain a negotiable bill of lading stating that
the goods have been loaded on board or, in the case of a term C.I.F. or
C. & F., received for shipment.
(2) Where in a case within subsection (1) a bill of lading has been
issued in a set of parts, unless otherwise agreed if the documents are
not to be sent from abroad the buyer may demand tender of the full
set; otherwise only one part of the bill of lading need be tendered.
Even if the agreement expressly requires a full set
(a) due tender of a single part is acceptable within the provisions of this Article on cure of improper delivery (subsection (1) of Section 2–508); and
(b) even though the full set is demanded, if the documents are
sent from abroad the person tendering an incomplete set
may nevertheless require payment upon furnishing an
indemnity which the buyer in good faith deems adequate.
(3) A shipment by water or by air or a contract contemplating
such shipment is “overseas” insofar as by usage of trade or agreement
it is subject to the commercial, financing or shipping practices
characteristic of international deep water commerce.
§ 2–324.
“No Arrival, No Sale” Term.
Under a term “no arrival, no sale” or terms of like meaning, unless
otherwise agreed.
(a) the seller must properly ship conforming goods and if they
arrive by any means he must tender them on arrival but he
assumes no obligation that the goods will arrive unless he
has caused the non-arrival; and
(b) where without fault of the seller the goods are in part lost
or have so deteriorated as no longer to conform to the
contract or arrive after the contract time, the buyer may
proceed as if there had been casualty to identified goods
(Section 2–613).
§ 2–325.
“Letter of Credit” Term; “Confirmed Credit”.
(1) Failure of the buyer seasonably to furnish an agreed letter of
credit is a breach of the contract for sale.
(2) The delivery to seller of a proper letter of credit suspends the
buyer’s obligation to pay. If the letter of credit is dishonored, the seller
may on seasonable notification to the buyer require payment directly
from him.
(3) Unless otherwise agreed the term “letter of credit”or “banker’s
credit” in a contract for sale means an irrevocable credit issued by a
financing agency of good repute and, where the shipment is overseas,
of good international repute. The term “confirmed credit” means that
the credit must also carry the direct obligation of such an agency
which does business in the seller’s financial market.
§ 2–326. Sale on Approval and Sale or Return;
Rights of Creditors.
(1) Unless otherwise agreed, if delivered goods may be returned by
the buyer even though they conform to the contract, the transaction is
(a) a “sale on approval”if the goods are delivered primarily for
use, and
(b) a “sale or return”if the goods are delivered primarily for resale.
775
(2) Goods held on approval are not subject to the claims of the
buyer’s creditors until acceptance; goods held on sale or return are
subject to such claims while in the buyer’s possession.
(3) Any “or return” term of a contract for sale is to be treated as a
separate contract for sale within the statute of frauds section of this
Article (Section 2–201) and as contradicting the sale aspect of the
contract within the provisions of this Article on parol or extrinsic
evidence (Section 2–202).
§ 2–327. Special Incidents of Sale on Approval
and Sale or Return.
(1) Under a sale on approval unless otherwise agreed
(a) although the goods are identified to the contract the risk
of loss and the title do not pass to the buyer until acceptance; and
(b) use of the goods consistent with the purpose of trial is not
acceptance but failure seasonably to notify the seller of
election to return the goods is acceptance, and if the
goods conform to the contract acceptance of any part is
acceptance of the whole; and
(c) after due notification of election to return, the return is at
the seller’s risk and expense but a merchant buyer must
follow any reasonable instructions.
(2) Under a sale or return unless otherwise agreed
(a) the option to return extends to the whole or any commercial unit of the goods while in substantially their original
condition, but must be exercised seasonably; and
(b) the return is at the buyer’s risk and expense.
§ 2–328.
Sale by Auction.
(1) In a sale by auction if goods are put up in lots each lot is the
subject of a separate sale.
(2) A sale by auction is complete when the auctioneer so announces by the fall of the hammer or in other customary manner.
Where a bid is made while the hammer is falling in acceptance of a prior
bid the auctioneer may in his discretion reopen the bidding or declare
the goods sold under the bid on which the hammer was falling.
(3) Such a sale is with reserve unless the goods are in explicit terms
put up without reserve. In an auction with reserve the auctioneer
may withdraw the goods at any time until he announces completion
of the sale. In an auction without reserve, after the auctioneer calls
for bids on an article or lot, that article or lot cannot be withdrawn
unless no bid is made within a reasonable time. In either case a
bidder may retract his bid until the auctioneer’s announcement of
completion of the sale, but a bidder’s retraction does not revive any
previous bid.
(4) If the auctioneer knowingly receives a bid on the seller’s
behalf or the seller makes or procures such a bid, and notice has not
been given that liberty for such bidding is reserved, the buyer may at
his option avoid the sale or take the goods at the price of the last good
faith bid prior to the completion of the sale. This subsection shall not
apply to any bid at a forced sale.
Part 4. Title, Creditors and Good Faith Purchasers
§ 2–401. Passing of Title; Reservation for Security;
Limited Application of This Section.
Each provision of this Article with regard to the rights, obligations
and remedies of the seller, the buyer, purchasers or other third parties
applies irrespective of title to the goods except where the provision
refers to such title. Insofar as situations are not covered by the other
provisions of this Article and matters concerning title become material the following rules apply:
(1) Title to goods cannot pass under a contract for sale prior to
their identification to the contract (Section 2–501), and unless otherwise explicitly agreed the buyer acquires by their identification a
special property as limited by this Act. Any retention or reservation
by the seller of the title (property) in goods shipped or delivered to
the buyer is limited in effect to a reservation of a security interest.
Subject to these provisions and to the provisions of the Article on
Secured Transactions (Article 9), title to goods passes from the seller
to the buyer in any manner and on any conditions explicitly agreed on
by the parties.
(2) Unless otherwise explicitly agreed title passes to the buyer at
the time and place at which the seller completes his performance
with reference to the physical delivery of the goods, despite any
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reservation of a security interest and even though a document of title
is to be delivered at a different time or place; and in particular and
despite any reservation of a security interest by the bill of lading
(a) if the contract requires or authorizes the seller to send the
goods to the buyer but does not require him to deliver
them at destination, title passes to the buyer at the time
and place of shipment; but
(b) if the contract requires delivery at destination, title passes
on tender there.
(3) Unless otherwise explicitly agreed where delivery is to be
made without moving the goods.
(a) if the seller is to deliver a document of title, title passes
at the time when and the place where he delivers such
documents; or
(b) if the goods are at the time of contracting already identified and no documents are to be delivered, title passes at
the time and place of contracting.
(4) A rejection or other refusal by the buyer to receive or retain
the goods, whether or not justified, or a justified revocation of acceptance revests title to the goods in the seller. Such revesting occurs
by operation of law and is not a “sale”.
§ 2–402.
Rights of Seller’s Creditors Against Sold Goods.
(1) Except as provided in subsections (2) and (3), rights of unsecured creditors of the seller with respect to goods which have been
identified to a contract for sale are subject to the buyer’s rights to
recover the goods under this Article (Sections 2–502 and 2–716).
(2) A creditor of the seller may treat a sale or an identification of
goods to a contract for sale as void if as against him a retention of
possession by the seller is fraudulent under any rule of law of the
state where the goods are situated, except that retention of possession in good faith and current course of trade by a merchant-seller for
a commercially reasonable time after a sale or identification is not
fraudulent.
(3) Nothing in this Article shall be deemed to impair the rights of
creditors of the seller
(a) under the provisions of the Article on Secured Transactions
(Article 9); or
(b) where identification to the contract or delivery is made
not in current course of trade but in satisfaction of or as
security for a pre-existing claim for money, security or the
like and is made under circumstances which under any
rule of law of the state where the goods are situated would
apart from this Article constitute the transaction a fraudulent transfer or voidable preference.
§ 2–403. Power to Transfer; Good Faith Purchase
of Goods; “Entrusting”.
(1) A purchaser of goods acquires all title which his transferor
had or had power to transfer except that a purchaser of a limited
interest acquires rights only to the extent of the interest purchased.
A person with voidable title has power to transfer a good title to a
good faith purchaser for value. When goods have been delivered
under a transaction of purchase the purchaser has such power
even though
(a) the transferor was deceived as to the identity of the
purchaser, or
(b) the delivery was in exchange for a check which is later
dishonored, or
(c) it was agreed that the transaction was to be a “cash
sale,” or
(d) the delivery was procured through fraud punishable as
larcenous under the criminal law.
(2) Any entrusting of possession of goods to a merchant who
deals in goods of that kind gives him power to transfer all rights of the
entruster to a buyer in ordinary course of business.
(3) “Entrusting” includes any delivery and any acquiescence in
retention of possession regardless of any condition expressed
between the parties to the delivery or acquiescence and regardless
of whether the procurement of the entrusting or the possessor’s
disposition of the goods have been such as to be larcenous under the
criminal law.
(4) The rights of other purchasers of goods and of lien creditors
are governed by the Articles on Secured Transactions (Article 9).
[Bulk Transfers/Sales (Article 6)* and Documents of Title (Article 7)].
Part 5. Performance
§ 2–501. Insurable Interest in Goods; Manner
of Identification of Goods.
(1) The buyer obtains a special property and an insurable interest
in goods by identification of existing goods as goods to which the contract refers even though the goods so identified are non-conforming
and he has an option to return or reject them. Such identification can
be made at any time and in any manner explicitly agreed to by the
parties. In the absence of explicit agreement identification occurs.
(a) when the contract is made if it is for the sale of goods
already existing and identified;
(b) if the contract is for the sale of future goods other than
those described in paragraph (c), when goods are shipped,
marked or otherwise designated by the seller as goods to
which the contract refers;
(c) when the crops are planted or otherwise become growing
crops or the young are conceived if the contract is for the
sale of unborn young to be born within twelve months
after contracting or for the sale of crops to be harvested
within twelve months or the next normal harvest season
after contracting, whichever is longer.
(2) The seller retains an insurable interest in goods so long as title
to or any security interest in the goods remains in him and where the
identification is by the seller alone he may until default or insolvency
or notification to the buyer that the identification is final substitute
other goods for those identified.
(3) Nothing in this section impairs any insurable interest recognized under any other statute or rule of law.
§ 2–502.
Buyer’s Right to Goods on Seller’s Insolvency.
(1) Subject to subsections (2) and (3) and even though the goods
have not been shipped a buyer who has paid a part or all of the price
of goods in which he has a special property under the provisions of
the immediately preceding section may on making and keeping good
a tender of any unpaid portion of their price recover them from the
seller if:
(a) in the case of goods bought for personal, family, or household purposes, the seller repudiates or fails to deliver as
required by the contract; or
(b) in all cases, the seller becomes insolvent within ten days
after receipt of the first installment on their price.
(2) The buyer’s right to recover the goods under subsection (1)(a)
vests upon acquisition of a special property, even if the seller had not
then repudiated or failed to deliver.
(3) If the identification creating his special property has been
made by the buyer he acquires the right to recover the goods only if
they conform to the contract for sale.
§ 2–503.
Manner of Seller’s Tender of Delivery.
(1) Tender of delivery requires that the seller put and hold
conforming goods at the buyer’s disposition and give the buyer any
notification reasonably necessary to enable him to take delivery. The
manner, time and place for tender are determined by the agreement
and this Article, and in particular
(a) tender must be at a reasonable hour, and if it is of goods
they must be kept available for the period reasonably
necessary to enable the buyer to take possession; but
(b) unless otherwise agreed the buyer must furnish facilities
reasonably suited to the receipt of the goods.
(2) Where the case is within the next section respecting shipment
tender requires that the seller comply with its provisions.
(3) Where the seller is required to deliver at a particular destination tender requires that he comply with subsection (1) and also in
any appropriate case tender documents as described in subsections
(4) and (5) of this section.
(4) Where goods are in the possession of a bailee and are to be
delivered without being moved
(a) tender requires that the seller either tender a negotiable
document of title covering such goods or procure acknowledgment by the bailee of the buyer’s right to possession of
the goods; but
(b) tender to the buyer of a non-negotiable document of title
or of a written direction to the bailee to deliver is sufficient
tender unless the buyer seasonably objects, and receipt by
APPENDIX B
䉬
the bailee of notification of the buyer’s rights fixes those
rights as against the bailee and all third persons; but risk of
loss of the goods and of any failure by the bailee to honor
the non-negotiable document of title or to obey the direction remains on the seller until the buyer has had a reasonable time to present the document or direction, and a
refusal by the bailee to honor the document or to obey the
direction defeats the tender.
(5) Where the contract requires the seller to deliver documents
(a) he must tender all such documents in correct form, except
as provided in this Article with respect to bills of lading in
a set (subsection (2) of Section 2–323); and
(b) tender through customary banking channels is sufficient
and dishonor of a draft accompanying the documents constitutes non-acceptance or rejection.
§ 2–504.
Shipment by Seller.
Where the seller is required or authorized to send the goods to the
buyer and the contract does not require him to deliver them at a
particular destination, then unless otherwise agreed he must
(a) put the goods in the possession of such a carrier and make
such a contract for their transportation as may be reasonable
having regard to the nature of the goods and other circumstances of the case; and
(b) obtain and promptly deliver or tender in due form any document necessary to enable the buyer to obtain possession of the
goods or otherwise required by the agreement or by usage of
trade; and
(c) promptly notify the buyer of the shipment.
Failure to notify the buyer under paragraph (c) or to make a proper
contract under paragraph (a) is a ground for rejection only if material
delay or loss ensues.
§ 2–505.
Seller’s Shipment Under Reservation.
(1) Where the seller has identified goods to the contract by or
before shipment:
(a) his procurement of a negotiable bill of lading to his own
order or otherwise reserves in him a security interest in
the goods. His procurement of the bill to the order of a
financing agency or of the buyer indicates in addition only
the seller’s expectation of transferring that interest to the
person named.
(b) a non-negotiable bill of lading to himself or his nominee
reserves possession of the goods as security but except in
a case of conditional delivery (subsection (2) of Section
2–507) a non-negotiable bill of lading naming the buyer as
consignee reserves no security interest even though the
seller retains possession of the bill of lading.
(2) When shipment by the seller with reservation of a security
interest is in violation of the contract for sale it constitutes an improper
contract for transportation within the preceding section but impairs
neither the rights given to the buyer by shipment and identification of
the goods to the contract nor the seller’s powers as a holder of a negotiable document.
§ 2–506.
Rights of Financing Agency.
(1) A financing agency by paying or purchasing for value a draft
which relates to a shipment of goods acquires to the extent of the
payment or purchase and in addition to its own rights under the draft
and any document of title securing it any rights of the shipper in the
goods including the right to stop delivery and the shipper’s right to
have the draft honored by the buyer.
(2) The right to reimbursement of a financing agency which has
in good faith honored or purchased the draft under commitment to or
authority from the buyer is not impaired by subsequent discovery of
defects with reference to any relevant document which was apparently regular on its face.
§ 2–507.
Effect of Seller’s Tender; Delivery on Condition.
(1) Tender of delivery is a condition to the buyer’s duty to accept
the goods and, unless otherwise agreed, to his duty to pay for them.
Tender entitles the seller to acceptance of the goods and to payment
according to the contract.
(2) Where payment is due and demanded on the delivery to the
buyer of goods or documents of title, his right as against the seller to retain or dispose of them is conditional upon his making the payment due.
777
§ 2–508. Cure by Seller of Improper Tender
or Delivery; Replacement.
(1) Where any tender or delivery by the seller is rejected because
non-conforming and the time for performance has not yet expired,
the seller may seasonably notify the buyer of his intention to cure and
may then within the contract time make a conforming delivery.
(2) Where the buyer rejects a non-conforming tender which the
seller had reasonable grounds to believe would be acceptable with
or without money allowance the seller may if he seasonably notifies
the buyer have a further reasonable time to substitute a conforming
tender.
§ 2–509.
Risk of Loss in the Absence of Breach.
(1) Where the contract requires or authorizes the seller to ship
the goods by carrier
(a) if it does not require him to deliver them at a particular
destination, the risk of loss passes to the buyer when the
goods are duly delivered to the carrier even though the
shipment is under reservation (Section 2–505); but
(b) if it does require him to deliver them at a particular destination and the goods are there duly tendered while in the
possession of the carrier, the risk of loss passes to the buyer
when the goods are there duly so tendered as to enable the
buyer to take delivery.
(2) Where the goods are held by a bailee to be delivered without
being moved, the risk of loss passes to the buyer
(a) on his receipt of a negotiable document of title covering
the goods; or
(b) on acknowledgment by the bailee of the buyer’s right to
possession of the goods; or
(c) after his receipt of a non-negotiable document of title or
other written direction to deliver, as provided in subsection (4)(b) of Section 2–503.
(3) In any case not within subsection (1) or (2), the risk of loss
passes to the buyer on his receipt of the goods if the seller is a merchant; otherwise the risk passes to the buyer on tender of delivery.
(4) The provisions of this section are subject to contrary agreement
of the parties and to the provisions of this Article on sale on approval
(Section 2–327) and on effect of breach on risk of loss (Section 2–510).
§ 2–510.
Effect of Breach on Risk of Loss.
(1) Where a tender or delivery of goods so fails to conform to the
contract as to give a right of rejection the risk of their loss remains on
the seller until cure or acceptance.
(2) Where the buyer rightfully revokes acceptance he may to the
extent of any deficiency in his effective insurance coverage treat the
risk of loss as having rested on the seller from the beginning.
(3) Where the buyer as to conforming goods already identified to
the contract for sale repudiates or is otherwise in breach before risk
of their loss has passed to him, the seller may to the extent of any
deficiency in his effective insurance coverage treat the risk of loss as
resting on the buyer for a commercially reasonable time.
§ 2–511.
Tender of Payment by Buyer; Payment by Check.
(1) Unless otherwise agreed tender of payment is a condition to
the seller’s duty to tender and complete any delivery.
(2) Tender of payment is sufficient when made by any means or
in any manner current in the ordinary course of business unless the
seller demands payment in legal tender and gives any extension of
time reasonably necessary to procure it.
(3) Subject to the provisions of this Act on the effect of an
instrument on an obligation (Section 3–310), payment by check is
conditional and is defeated as between the parties by dishonor of the
check on due presentment.
§ 2–512.
Payment by Buyer Before Inspection.
(1) Where the contract requires payment before inspection nonconformity of the goods does not excuse the buyer from so making
payment unless
(a) the non-conformity appears without inspection; or
(b) despite tender of the required documents the circumstances would justify injunction against honor under this
Act (Section 5–109(b)).
(2) Payment pursuant to subsection (1) does not constitute an
acceptance of goods or impair the buyer’s right to inspect or any of
his remedies.
778
§ 2–513.
APPENDIX B
䉬
Buyer’s Right to Inspection of Goods.
(1) Unless otherwise agreed and subject to subsection (3), where
goods are tendered or delivered or identified to the contract for sale,
the buyer has a right before payment or acceptance to inspect them
at any reasonable place and time and in any reasonable manner. When
the seller is required or authorized to send the goods to the buyer, the
inspection may be after their arrival.
(2) Expenses of inspection must be borne by the buyer but may be
recovered from the seller if the goods do not conform and are rejected.
(3) Unless otherwise agreed and subject to the provisions of this
Article on C.I.F. contracts (subsection (3) of Section 2–321), the buyer
is not entitled to inspect the goods before payment of the price when
the contract provides
(a) for delivery “C.O.D.” or on other like terms; or
(b) for payment against documents of title, except where such
payment is due only after the goods are to become available for inspection.
(4) A place or method of inspection fixed by the parties is presumed to be exclusive but unless otherwise expressly agreed it does
not postpone identification or shift the place for delivery or for passing the risk of loss. If compliance becomes impossible, inspection
shall be as provided in this section unless the place or method fixed
was clearly intended as an indispensable condition failure of which
avoids the contract.
§ 2–514. When Documents Deliverable on Acceptance;
When on Payment.
Unless otherwise agreed documents against which a draft is drawn
are to be delivered to the drawee on acceptance of the draft if it is
payable more than three days after presentment; otherwise, only on
payment.
§ 2–515.
Preserving Evidence of Goods in Dispute.
In furtherance of the adjustment of any claim or dispute
(a) either party on reasonable notification to the other and for the
purpose of ascertaining the facts and preserving evidence has
the right to inspect, test and sample the goods including
such of them as may be in the possession or control of the
other; and
(b) the parties may agree to a third party inspection or survey to
determine the conformity or condition of the goods and may
agree that the findings shall be binding upon them in any subsequent litigation or adjustment.
Part 6. Breach, Repudiation and Excuse
§ 2–601.
Buyer’s Rights on Improper Delivery.
Subject to the provisions of this Article on breach in installment contracts (Section 2–612) and unless otherwise agreed under the sections
on contractual limitations of remedy (Sections 2–718 and 2–719), if
the goods or the tender of delivery fail in any respect to conform to
the contract, the buyer may
(a) reject the whole; or
(b) accept the whole; or
(c) accept any commercial unit or units and reject the rest.
§ 2–602.
Manner and Effect of Rightful Rejection.
(1) Rejection of goods must be within a reasonable time after their
delivery or tender. It is ineffective unless the buyer seasonably notifies
the seller.
(2) Subject to the provisions of the two following sections on
rejected goods (Sections 2–603 and 2–604),
(a) after rejection any exercise of ownership by the buyer
with respect to any commercial unit is wrongful as against
the seller; and
(b) if the buyer has before rejection taken physical possession
of goods in which he does not have a security interest
under the provisions of this Article (subsection (3) of
Section 2–711), he is under a duty after rejection to hold
them with reasonable care at the seller’s disposition for a
time sufficient to permit the seller to remove them; but
(c) the buyer has no further obligations with regard to goods
rightfully rejected.
(3) The seller’s rights with respect to goods wrongfully rejected
are governed by the provisions of this Article on Seller’s remedies in
general (Section 2–703).
§ 2–603. Merchant Buyer’s Duties as to Rightfully
Rejected Goods.
(1) Subject to any security interest in the buyer (subsection (3) of
Section 2–711), when the seller has no agent or place of business at
the market of rejection a merchant buyer is under a duty after rejection of goods in his possession or control to follow any reasonable
instructions received from the seller with respect to the goods and in
the absence of such instructions to make reasonable efforts to sell
them for the seller’s account if they are perishable or threaten to
decline in value speedily. Instructions are not reasonable if on demand
indemnity for expenses is not forthcoming.
(2) When the buyer sells goods under subsection (1), he is
entitled to reimbursement from the seller or out of the proceeds for
reasonable expenses of caring for and selling them, and if the
expenses include no selling commission then to such commission as
is usual in the trade or if there is none to a reasonable sum not
exceeding ten percent on the gross proceeds.
(3) In complying with this section the buyer is held only to good
faith and good faith conduct hereunder is neither acceptance nor conversion nor the basis of an action for damages.
§ 2–604. Buyer’s Options as to Salvage of Rightfully
Rejected Goods.
Subject to the provisions of the immediately preceding section on
perishables if the seller gives no instructions within a reasonable time
after notification of rejection the buyer may store the rejected goods
for the seller’s account or reship them to him or resell them for the
seller’s account with reimbursement as provided in the preceding
section. Such action is not acceptance or conversion.
§ 2–605. Waiver of Buyer’s Objections by Failure
to Particularize.
(1) The buyer’s failure to state in connection with rejection a
particular defect which is ascertainable by reasonable inspection
precludes him from relying on the unstated defect to justify rejection
or to establish breach
(a) where the seller could have cured it if stated seasonably; or
(b) between merchants when the seller has after rejection
made a request in writing for a full and final written statement of all defects on which the buyer proposes to rely.
(2) Payment against documents made without reservation of
rights precludes recovery of the payment for defects apparent on the
face of the documents.
§ 2–606.
What Constitutes Acceptance of Goods.
(1) Acceptance of goods occurs when the buyer
(a) after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming or that he
will take or retain them in spite of their non-conformity; or
(b) fails to make an effective rejection (subsection (1) of
Section 2–602), but such acceptance does not occur until
the buyer has had a reasonable opportunity to inspect
them; or
(c) does any act inconsistent with the seller’s ownership; but
if such act is wrongful as against the seller it is an acceptance only if ratified by him.
(2) Acceptance of a part of any commercial unit is acceptance of
that entire unit.
§ 2–607. Effect of Acceptance; Notice of Breach; Burden
of Establishing Breach After Acceptance; Notice of Claim
or Litigation to Person Answerable Over.
(1) The buyer must pay at the contract rate for any goods accepted.
(2) Acceptance of goods by the buyer precludes rejection of the
goods accepted and if made with knowledge of a non-conformity
cannot be revoked because of it unless the acceptance was on the
reasonable assumption that the non-conformity would be seasonably
cured but acceptance does not of itself impair any other remedy
provided by this Article for non-conformity.
(3) Where a tender has been accepted
(a) the buyer must within a reasonable time after he discovers
or should have discovered any breach notify the seller of
breach or be barred from any remedy; and
(b) if the claim is one for infringement or the like (subsection (3)
of Section 2–312) and the buyer is sued as a result of such a
breach he must so notify the seller within a reasonable time
APPENDIX B
䉬
after he receives notice of the litigation or be barred from
any remedy over for liability established by the litigation.
(4) The burden is on the buyer to establish any breach with
respect to the goods accepted.
(5) Where the buyer is sued for breach of a warranty or other
obligation for which his seller is answerable over
(a) he may give his seller written notice of the litigation. If the
notice states that the seller may come in and defend and
that if the seller does not do so he will be bound in any
action against him by his buyer by any determination of
fact common to the two litigations, then unless the seller
after seasonable receipt of the notice does come in and
defend he is so bound.
(b) if the claim is one for infringement or the like (subsection
(3) of Section 2–312) the original seller may demand in
writing that his buyer turn over to him control of the
litigation including settlement or else be barred from any
remedy over and if he also agrees to bear all expense and
to satisfy any adverse judgment, then unless the buyer
after seasonable receipt of the demand does turn over
control the buyer is so barred.
(6) The provisions of subsection (3), (4) and (5) apply to any
obligation of a buyer to hold the seller harmless against infringement
or the like (subsection (3) of Section 2–312).
§ 2–608.
Revocation of Acceptance in Whole or in Part.
(1) The buyer may revoke his acceptance of a lot or commercial
unit whose non-conformity substantially impairs its value to him if he
has accepted it
(a) on the reasonable assumption that its non-conformity
would be cured and it has not been seasonably cured; or
(b) without discovery of such non-conformity if his acceptance was reasonably induced either by the difficulty of discovery before acceptance or by the seller’s assurances.
(2) Revocation of acceptance must occur within a reasonable
time after the buyer discovers or should have discovered the ground
for it and before any substantial change in condition of the goods
which is not caused by their own defects. It is not effective until the
buyer notifies the seller of it.
(3) A buyer who so revokes has the same rights and duties with
regard to the goods involved as if he had rejected them.
§ 2–609.
Right to Adequate Assurance of Performance.
(1) A contract for sale imposes an obligation on each party that
the other’s expectation of receiving due performance will not be
impaired. When reasonable grounds for insecurity arise with respect
to the performance of either party the other may in writing demand
adequate assurance of due performance and until he receives such
assurance may if commercially reasonable suspend any performance
for which he has not already received the agreed return.
(2) Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined
according to commercial standards.
(3) Acceptance of any improper delivery or payment does not
prejudice the aggrieved party’s right to demand adequate assurance
of future performance.
(4) After receipt of a justified demand failure to provide within a
reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular
case is a repudiation of the contract.
§ 2–610.
Anticipatory Repudiation.
When either party repudiates the contract with respect to a performance not yet due the loss of which will substantially impair the value
of the contract to the other, the aggrieved party may
(a) for a commercially reasonable time await performance by the
repudiating party; or
(b) resort to any remedy for breach (Section 2–703 or Section
2–711), even though he has notified the repudiating party that
he would await the latter’s performance and has urged retraction; and
(c) in either case suspend his own performance or proceed in
accordance with the provisions of this Article on the seller’s
right to identify goods to the contract notwithstanding breach
or to salvage unfinished goods (Section 2–704).
§ 2–611.
779
Retraction of Anticipatory Repudiation.
(1) Until the repudiating party’s next performance is due he can
retract his repudiation unless the aggrieved party has since the repudiation cancelled or materially changed his position or otherwise
indicated that he considers the repudiation final.
(2) Retraction may be by any method which clearly indicates to
the aggrieved party that the repudiating party intends to perform, but
must include any assurance justifiably demanded under the provisions
of this Article (Section 2–609).
(3) Retraction reinstates the repudiating party’s rights under the
contract with due excuse and allowance to the aggrieved party for any
delay occasioned by the repudiation.
§ 2–612.
“Installment Contract”; Breach.
(1) An “installment contract” is one which requires or authorizes
the delivery of goods in separate lots to be separately accepted, even
though the contract contains a clause “each delivery is a separate contract” or its equivalent.
(2) The buyer may reject any installment which is non-conforming
if the non-conformity substantially impairs the value of that installment
and cannot be cured or if the non-conformity is a defect in the required
documents; but if the non-conformity does not fall within subsection
(3) and the seller gives adequate assurance of its cure the buyer must
accept that installment.
(3) Whenever non-conformity or default with respect to one or
more installments substantially impairs the value of the whole contract
there is a breach of the whole. But the aggrieved party reinstates the
contract if he accepts a non-conforming installment without seasonably
notifying of cancellation or if he brings an action with respect only to
past installments or demands performance as to future installments.
§ 2–613.
Casualty to Identified Goods.
Where the contract requires for its performance goods identified
when the contract is made, and the goods suffer casualty without fault
of either party before the risk of loss passes to the buyer, or in a proper
case under a “no arrival, no sale” term (Section 2–324) then
(a) if the loss is total the contract is avoided; and
(b) if the loss is partial or the goods have so deteriorated as no
longer to conform to the contract the buyer may nevertheless demand inspection and at his option either treat
the contract as avoided or accept the goods with due
allowance from the contract price for the deterioration or
the deficiency in quantity but without further right against
the seller.
§ 2–614.
Substituted Performance.
(1) Where without fault of either party the agreed berthing, loading,
or unloading facilities fail or an agreed type of carrier becomes unavailable or the agreed manner of delivery otherwise becomes commercially
impracticable but a commercially reasonable substitute is available, such
substitute performance must be tendered and accepted.
(2) If the agreed means or manner of payment fails because of
domestic or foreign governmental regulation, the seller may withhold
or stop delivery unless the buyer provides a means or manner of
payment which is commercially a substantial equivalent. If delivery
has already been taken, payment by the means or in the manner
provided by the regulation discharges the buyers obligation unless the
regulation is discriminatory, oppressive or predatory.
§ 2–615.
Excuse by Failure of Presupposed Conditions.
Except so far as a seller may have assumed a greater obligation and
subject to the preceding section on substituted performance:
(a) Delay in delivery or non-delivery in whole or in part by a seller
who complies with paragraphs (b) and (c) is not a breach of
his duty under a contract for sale if performance as agreed has
been made impracticable by the occurrence of a contingency
the non-occurrence of which was a basic assumption on
which the contract was made or by compliance in good faith
with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid.
(b) Where the causes mentioned in paragraph (a) affect only a
part of the seller’s capacity to perform, he must allocate
production and deliveries among his customers but may at his
option include regular customers not then under contract as
well as his own requirements for further manufacture. He may
so allocate in any manner which is fair and reasonable.
780
APPENDIX B
䉬
(c) The seller must notify the buyer seasonably that there will be
delay or non-delivery and, when allocation is required under
paragraph (b), of the estimated quota thus made available for
the buyer.
§ 2–616.
Procedure on Notice Claiming Excuse.
(1) Where the buyer receives notification of a material or indefinite delay or an allocation justified under the preceding section he
may by written notification to the seller as to any delivery concerned,
and where the prospective deficiency substantially impairs the value
of the whole contract under the provisions of this Article relating to
breach of installment contracts (Section 2–612), then also as to the
whole,
(a) terminate and thereby discharge any unexecuted portion
of the contract; or
(b) modify the contract by agreeing to take his available quota
in substitution.
(2) If after receipt of such notification from the seller the buyer
fails so to modify the contract within a reasonable time not
exceeding thirty days the contract lapses with respect to any deliveries affected.
(3) The provisions of this section may not be negated by agreement except in so far as the seller has assumed a greater obligation
under the preceding section.
Part 7. Remedies
§ 2–701. Remedies for Breach of Collateral
Contracts Not Impaired.
Remedies for breach of any obligation or promise collateral or
ancillary to a contract for sale or not impaired by the provisions of
this Article.
§ 2–702. Seller’s Remedies on Discovery
of Buyer’s Insolvency.
(1) Where the seller discovers the buyer to be insolvent he may
refuse delivery except for cash including payment for all goods therefore delivered under the contract, and stop delivery under this Article
(Section 2–705).
(2) Where the seller discovers that the buyer has received goods
on credit while insolvent he may reclaim the goods upon demand
made within ten days after the receipt, but if misrepresentation of
solvency has been made to the particular seller in writing within three
months before delivery the ten day limitation does not apply. Except
as provided in this subsection the seller may not base a right to
reclaim goods on the buyer’s fraudulent or innocent misrepresentation of solvency or of intent to pay.
(3) The seller’s right to reclaim under subsection (2) is subject to
the rights of a buyer in ordinary course or other good faith purchaser
under this Article (Section 2–403). Successful reclamation of goods
excludes all other remedies with respect to them.
§ 2–703.
Seller’s Remedies in General.
Where the buyer wrongfully rejects or revokes acceptance of goods
or fails to make a payment due on or before delivery or repudiates
with respect to a part or the whole, then with respect to any goods
directly affected and, if the breach is of the whole contract (Section
2–612), then also with respect to the whole undelivered balance, the
aggrieved seller may
(a) withhold delivery of such goods;
(b) stop delivery by any bailee as hereafter provided (Section
2–705);
(c) proceed under the next section respecting goods still unidentified to the contract;
(d) resell and recover damages as hereafter provided (Section
2–706);
(e) recover damages for non-acceptance (Section 2–708) or in a
proper case the price (Section 2–709);
(f) cancel.
§ 2–704. Seller’s Right to Identify Goods to the Contract
Notwithstanding Breach or to Salvage Unfinished Goods.
(1) An aggrieved seller under the preceding section may
(a) identify to the contract conforming goods not already
identified if at the time he learned of the breach they are
in his possession or control;
(b) treat as the subject of resale goods which have demonstrably been intended for the particular contract even
though those goods are unfinished.
(2) Where the goods are unfinished an aggrieved seller may in the
exercise of reasonable commercial judgment for the purposes of
avoiding loss and of effective realization either complete the manufacture and wholly identify the goods to the contract or cease manufacture and resell for scrap or salvage value or proceed in any other
reasonable manner.
§ 2–705. Seller’s Stoppage of Delivery in Transit
or Otherwise.
(1) The seller may stop delivery of goods in the possession of a
carrier or other bailee when he discovers the buyer to be insolvent
(Section 2–702) and may stop delivery of carload, truckload, planeload or larger shipments of express or freight when the buyer repudiates or fails to make a payment due before delivery or if for any other
reason the seller has a right to withhold or reclaim the goods.
(2) As against such buyer the seller may stop delivery until
(a) receipt of the goods by the buyer; or
(b) acknowledgment to the buyer by any bailee of the goods
except a carrier that the bailee holds the goods for the
buyer; or
(c) such acknowledgment to the buyer by a carrier by reshipment or as warehouseman; or
(d) negotiation to the buyer of any negotiable document of
title covering the goods.
(3) (a) To stop delivery the seller must so notify as to enable the
bailee by reasonable diligence to prevent delivery of the goods.
(b) After such notification the bailee must hold and deliver
the goods according to the directions of the seller but the
seller is liable to the bailee for any ensuing charges or
damages.
(c) If a negotiable document of title has been issued for goods
the bailee is not obliged to obey a notification to stop until
surrender of the document.
(d) A carrier who has issued a non-negotiable bill of lading is
not obliged to obey a notification to stop received from a
person other than the consignor.
§ 2–706.
Seller’s Resale Including Contract for Resale.
(1) Under the conditions stated in Section 2–703 on seller’s remedies, the seller may resell the goods concerned or the undelivered
balance thereof. Where the resale is made in good faith and in a
commercially reasonable manner the seller may recover the difference
between the resale price and the contract price together with any
incidental damages allowed under the provisions of this Article
(Section 2–710), but less expenses saved in consequence of the
buyer’s breach.
(2) Except as otherwise provided in subsection (3) or unless
otherwise agreed resale may be at public or private sale including sale
by way of one or more contracts to sell or of identification to an
existing contract of the seller. Sale may be as a unit or in parcels and
at any time and place and on any terms but every aspect of the sale
including the method, manner, time, place and terms must be commercially reasonable. The resale must be reasonably identified as
referring to the broken contract, but it is not necessary that the goods
be in existence or that any or all of them have been identified to the
contract before the breach.
(3) Where the resale is at private sale the seller must give the
buyer reasonable notification of his intention to resell.
(4) Where the resale is at public sale
(a) only identified goods can be sold except where there is a
recognized market for a public sale of futures in goods of
the kind; and
(b) it must be made at a usual place or market for public sale
if one is reasonably available and except in the case of
goods which are perishable or threaten to decline in value
speedily the seller must give the buyer reasonable notice
of the time and place of the resale; and
(c) if the goods are not to be within the view of those attending the sale the notification of sale must state the place
where the goods are located and provide for their reasonable inspection by prospective bidders; and
(d) the seller may buy.
APPENDIX B
䉬
(5) A purchaser who buys in good faith at a resale takes the goods
free of any rights of the original buyer even though the seller fails to
comply with one or more of the requirements of this section.
(6) The seller is not accountable to the buyer for any profit made
on any resale. A person in the position of a seller (Section 2–707) or
a buyer who has rightfully rejected or justifiably revoked acceptance
must account for any excess over the amount of his security interest,
as hereinafter defined (subsection (3) of Section 2–711).
§ 2–707.
“Person in the Position of a Seller”.
(1) A “person in the position of a seller”includes as against a principal an agent who has paid or become responsible for the price of
goods on behalf of his principal or anyone who otherwise holds a
security interest or other right in goods similar to that of a seller.
(2) A person in the position of a seller may as provided in this
Article withhold or stop delivery (Section 2–705) and resell (Section
2–706) and recover incidental damages (Section 2–710).
§ 2–708. Seller’s Damages for Non-Acceptance
or Repudiation.
(1) Subject to subsection (2) and to the provisions of this Article
with respect to proof of market price (Section 2–723), the measure of
damages for non-acceptance or repudiation by the buyer is the difference between the market price at the time and place for tender and
the unpaid contract price together with any incidental damages
provided in this Article (Section 2–710), but less expenses saved in
consequence of the buyer’s breach.
(2) If the measure of damages provided in subsection (1) is inadequate to put the seller in as good a position as performance would
have done then the measure of damages is the profit (including
reasonable overhead) which the seller would have made from full
performance by the buyer, together with any incidental damages
provided in this Article (Section 2–710), due allowance for costs reasonably incurred and due credit for payments or proceeds of resale.
§ 2–709.
Action for the Price.
(1) When the buyer fails to pay the price as it becomes due the
seller may recover, together with any incidental damages under the
next section, the price
(a) of goods accepted or of conforming goods lost or damaged
within a commercially reasonable time after risk of their
loss has passed to the buyer; and
(b) of goods identified to the contract if the seller is unable
after reasonable effort to resell them at a reasonable price
or the circumstances reasonably indicate that such effort
will be unavailing.
(2) Where the seller sues for the price he must hold for the buyer
any goods which have been identified to the contract and are still in
his control except that if resale becomes possible he may resell them
at any time prior to the collection of the judgment. The net proceeds
of any such resale must be credited to the buyer and payment of the
judgment entitles him to any goods not resold.
(3) After the buyer has wrongfully rejected or revoked acceptance
of the goods or has failed to make a payment due or has repudiated
(Section 2–610), a seller who is held not entitled to the price under this
section shall nevertheless be awarded damages for non-acceptance
under the preceding section.
§ 2–710.
Seller’s Incidental Damages.
Incidental damages to an aggrieved seller include any commercially
reasonable charges, expenses or commissions incurred in stopping
delivery, in the transportation, care and custody of goods after the
buyer’s breach, in connection with return or resale of the goods or
otherwise resulting from the breach.
§ 2–711. Buyer’s Remedies in General; Buyer’s Security
Interest in Rejected Goods.
(1) Where the seller fails to make delivery or repudiates or the
buyer rightfully rejects or justifiably revokes acceptance then with respect to any goods involved, and with respect to the whole if the
breach goes to the whole contract (Section 2–612), the buyer may
cancel and whether or not he has done so may in addition to recovering so much of the price as has been paid
(a) “cover” and have damages under the next section as to all
the goods affected whether or not they have been identified to the contract; or
781
(b) recover damages for non-delivery as provided in this
Article (Section 2–713).
(2) Where the seller fails to deliver or repudiates the buyer may also
(a) if the goods have been identified recover them as provided
in this Article (Section 2–502); or
(b) in a proper case obtain specific performance or replevy
the goods as provided in this Article (Section 2–716).
(3) On rightful rejection of justifiable revocation of acceptance a
buyer has a security interest in goods in his possession or control for
any payments made on their price and any expenses reasonably
incurred in their inspection, receipt, transportation, care and custody
and may hold such goods and resell them in like manner as an
aggrieved seller (Section 2–706).
§ 2–712. “Cover”; Buyer’s Procurement
of Substitute Goods.
(1) After a breach within the preceding section the buyer may
“cover” by making in good faith and without unreasonable delay any
reasonable purchase of or contract to purchase goods in substitution
for those due from the seller.
(2) The buyer may recover from the seller as damages the difference between the cost of cover and the contract price together with
any incidental or consequential damages as hereinafter defined
(Section 2–715), but less expenses saved in consequence of the
seller’s breach.
(3) Failure of the buyer to effect cover within this section does not
bar him from any other remedy.
§ 2–713. Buyer’s Damages for Non-Delivery
or Repudiation.
(1) Subject to the provisions of this Article with respect to proof
of market price (Section 2–723), the measure of damages for nondelivery or repudiation by the seller is the difference between the
market price at the time when the buyer learned of the breach and
the contract price together with any incidental and consequential
damages provided in this Article (Section 2–715), but less expenses
saved in consequence of the seller’s breach.
(2) Market price is to be determined as of the place for tender or,
in cases of rejection after arrival or revocation of acceptance, as of the
place of arrival.
§ 2–714. Buyer’s Damages for Breach in Regard
to Accepted Goods.
(1) Where the buyer has accepted goods and given notification
(subsection (3) of Section 2–607) he may recover as damages for any
non-conformity of tender the loss resulting in the ordinary course of
events from the seller’s breach as determined in any manner which is
reasonable.
(2) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the
goods accepted and the value they would have had if they had been
as warranted, unless special circumstances show proximate damages
of a different amount.
(3) In a proper case any incidental and consequential damages
under the next section may also be recovered.
§ 2–715.
Buyer’s Incidental and Consequential Damages.
(1) Incidental damages resulting from the seller’s breach include
expenses reasonably incurred in inspection, receipt, transportation
and care and custody of goods rightfully rejected, any commercially
reasonable charges, expenses or commissions in connection with
effecting cover and any other reasonable expense incident to the
delay or other breach.
(2) Consequential damages resulting from the seller’s breach
include
(a) any loss resulting from general or particular requirements
and needs of which the seller at the time of contracting
had reason to know and which could not reasonably be
prevented by cover or otherwise; and
(b) injury to person or property proximately resulting from
any breach of warranty.
§ 2–716. Buyer’s Right to Specific Performance
or Replevin.
(1) Specific performance may be decreed where the goods are
unique or in other proper circumstances.
782
APPENDIX B
䉬
(2) The decree for specific performance may include such terms
and conditions as to payment of the price, damages, or other relief as
the court may deem just.
(3) The buyer has a right of replevin for goods identified to the
contract if after reasonable effort he is unable to effect cover for such
goods or the circumstances reasonably indicate that such effort will be
unavailing or if the goods have been shipped under reservation and satisfaction of the security interest in them has been made or tendered. In
the case of goods bought for personal, family, or household purposes,
the buyer’s right of replevin vests upon acquisition of a special property, even if the seller had not then repudiated or failed to deliver.
§ 2–717.
Deduction of Damages From the Price.
The buyer on notifying the seller of his intention to do so may deduct
all or any part of the damages resulting from any breach of the
contract from any part of the price still due under the same contract.
§ 2–718.
Liquidation or Limitation of Damages; Deposits.
(1) Damages for breach by either party may be liquidated in the
agreement but only at an amount which is reasonable in the light of
the anticipated or actual harm caused by the breach, the difficulties
of proof of loss, and the inconvenience of nonfeasibility of otherwise
obtaining an adequate remedy. A team fixing unreasonably large
liquidated damages is void as a penalty.
(2) Where the seller justifiably withholds delivery of goods because
of the buyer’s breach, the buyer is entitled to restitution of any amount
by which the sum of his payments exceeds
(a) the amount to which the seller is entitled by virtue of
terms liquidating the seller’s damages in accordance with
subsection (1), or
(b) in the absence of such terms, twenty percent of the value
of the total performance for which the buyer is obligated
under the contract or $500, whichever is smaller.
(3) The buyer’s right to restitution under subsection (2) is subject
to offset to the extent that the seller establishes
(a) a right to recover damages under the provisions of this
Article other than subsection (1), and
(b) the amount or value of any benefits received by the buyer
directly or indirectly by reason of the contract.
(4) Where a seller has received payment in goods their reasonable
value or the proceeds of their resale shall be treated as payments for
the purposes of subsection (2); but if the seller has notice of the
buyer’s breach before reselling goods received in part performance,
his resale is subject to the conditions laid down in this Article on
resale by an aggrieved seller (Section 2–706).
§ 2–719.
Contractual Modification or Limitation of Remedy.
(1) Subject to the provisions of subsections (2) and (3) of this
section and of the preceding section on liquidation and limitation of
damages,
(a) the agreement may provide for remedies in addition to or
in substitution for those provided in this Article and may
limit or alter the measure of damages recoverable under
this Article, as by limiting the buyer’s remedies to return
of the goods and repayment of the price or to repair and
replacement of non-conforming goods or parts; and
(b) resort to a remedy as provided is optional unless the remedy is expressly agreed to be exclusive, in which case it is
the sole remedy.
(2) Where circumstances cause an exclusive or limited remedy to
fail of its essential purpose, remedy may be had as provided in this Act.
(3) Consequential damages may be limited or excluded unless the
limitation or exclusion is unconscionable. Limitation of consequential
damages for injury to the person in the case of consumer goods is
prima facie unconscionable but limitation of damages where the loss
is commercial is not.
§ 2–720. Effect of “Cancellation” or “Rescission”
on Claims for Antecedent Breach.
Unless the contrary intention clearly appears, expressions of “cancellation”or “rescission”of the contract or the like shall not be construed as
a renunciation or discharge of any claim in damages for an antecedent
breach.
§ 2–721.
Remedies for Fraud.
Remedies for material misrepresentation or fraud include all remedies
available under this Article for non-fraudulent breach. Neither rescission or a claim for rescission of the contract for sale nor rejection or
return of the goods shall bar or be deemed inconsistent with a claim
for damages or other remedy.
§ 2–722.
Who Can Sue Third Parties for Injury to Goods.
Where a third party so deals with goods which have been identified
to a contract for sale as to cause actionable injury to a party to that
contract
(a) a right of action against the third party is in either party to the
contract for sale who has title to or a security interest or a
special property or an insurable interest in the goods; and if
the goods have been destroyed or converted a right of action
is also in the party who either bore the risk of loss under the
contract for sale or has since the injury assumed that risk as
against the other,
(b) if at the time of the injury the party plaintiff did not bear the
risk of loss as against the other party to the contract for sale
and there is no arrangement between them for disposition of
the recovery, his suit or settlement is, subject to his own
interest, as a fiduciary for the other party to the contract;
(c) either party may with the consent of the other sue for the benefit of whom it may concern.
§ 2–723.
Proof of Market Price: Time and Place.
(1) If an action based on anticipatory repudiation comes to trial before the time for performance with respect to some or all of the goods,
any damages based on market price (Section 2–708 or Section 2–713)
shall be determined according to the price of such goods prevailing at
the time when the aggrieved party learned of the repudiation.
(2) If evidence of a price prevailing at the times or places described in this Article is not readily available the price prevailing
within any reasonable time before or after the time described or at any
other place which in commercial judgment or under usage of trade
would serve as a reasonable substitute for the one described may be
used, making any proper allowance for the cost of transporting the
goods to or from such other place.
(3) Evidence of a relevant price prevailing at a time or place other
than the one described in this Article offered by one party is not
admissible unless and until he has given the other party such notice
as the court finds sufficient to prevent unfair surprise.
§ 2–724.
Admissibility of Market Quotations.
Whenever the prevailing price or value of any goods regularly bought
and sold in any established commodity market is in issue, reports in
official publications or trade journals or in newspapers or periodicals
of general circulation published as the reports of such market shall be
admissible in evidence. The circumstances of the preparation of such
a report may be shown to affect its weight but not its admissibility.
§ 2–725.
Statute of Limitations in Contracts for Sale.
(1) An action for breach of any contract for sale must be commenced within four years after the cause of action has accrued. By the
original agreement the parties may reduce the period of limitation to
not less than one year but may not extend it.
(2) A cause of action accrues when the breach occurs, regardless of
the aggrieved party’s lack of knowledge of the breach. A breach of
warranty occurs when tender of delivery is made, except that where a
warranty explicitly extends to future performance of the goods and discovery of the breach must await the time of such performance the cause
of action accrues when the breach is or should have been discovered.
(3) Where an action commenced within the time limited by
subsection (1) is so terminated as to leave available a remedy by another
action for the same breach such other action may be commenced after
the expiration of the time limited and within six months after the termination of the first action unless the termination resulted from voluntary discontinuance or from dismissal for failure or neglect to prosecute.
(4) This section does not alter the law on tolling of the statute of
limitations nor does it apply to causes of action which have accrued
before this Act becomes effective.
Glossary
24-hour rule Prohibits both union representatives and
agency by estoppel (apparent authority) An agency
employers from making speeches to “captive audiences”
of employees within 24 hours of a representative
election.
absolute privilege The right to make any statement,
true or false, about someone and not be held liable for
defamation.
acid rain Precipitation with a high acidic content (pH
level of less than 5) caused by atmospheric pollutants.
act-of-state doctrine A state that each nation is bound
to respect the independence of another and the courts
of one nation will not sit in judgment on the acts of the
courts of another nation.
actual authority Includes expressed authority as well
as implied authority, or that authority customarily
given to an agent in an industry, trade, or profession.
administrative agency Any body that is created by the
legislative branch to carry out specific duties.
administrative law Any rule (statute or regulation) that
directly or indirectly affects an administrative agency.
administrative law judge (ALJ) A judge, selected on the
basis of a merit exam, who is assigned to a specific
administrative agency.
Administrative Procedure Act (APA) Law that establishes the standards and procedures federal administrative agencies must follow in their rulemaking and
adjudicative functions.
adversarial system System of litigation in which the
judge hears evidence and arguments presented by both
sides in a case and then makes an objective decision
based on the facts and the law as presented by each side.
adverse possession Acquiring ownership of realty by
openly treating it as one’s own, with neither protest nor
permission from the real owner, for a statutorily
established period of time.
affirm Term for an appellate court’s decision to
uphold the decision of a lower court in a case that has
been appealed.
affirmative action plans Programs adopted by
employers to increase the representation of women
and minorities in their workforces.
relationship in which the principal is estopped from
denying that someone is the principal’s agent after leading a third party to believe that the person is an agent.
Age Discrimination in Employment Act of 1967
(ADEA) Statute that prohibits employers from refus-
ing to hire, discharging, or discriminating against people in terms or conditions of employment on the basis
of age.
agency A fiduciary relationship between two persons
in which one (the agent) acts on behalf of, and is
subject to the control of, the other (the principal).
agency by implied authority Agency relationship in
which customs and circumstances, rather than a detailed
formal agreement, determine the agent’s authority.
agency by ratification Agency relationship in which an
unauthorized agent commits the principal to an agreement and the principal later accepts the unauthorized
agreement, thus ratifying the agency relationship.
alternative dispute resolution (ADR) Resolving legal
disputes through methods other than litigation, such as
negotiation and settlement, arbitration, mediation,
private trials, minitrials, summary jury trials, and early
neutral case evaluation.
ambiguous Susceptible to two or more possible
interpretations.
Americans with Disabilities Act of 1991 (ADA) Statute
requiring that employers make reasonable accommodations to the known disabilities of an otherwise
qualified job applicant or employee with a disability,
unless the necessary accommodation would impose an
undue burden on the employer’s business.
amicus curiae Someone, not a party to the case, who
is permitted by the court to offer information or advice
to assist the court in deciding a matter before it.
analogy A comparison based on the assumption that if
two things are alike in some respect, they must be alike
in other respects.
annual percentage rate (APR) The effective annual rate
of interest being charged a consumer by a creditor,
which depends on the compounding period the
creditor is using.
appellate jurisdiction The power to review a decision
previously made by a trial court.
appropriate bargaining unit May be an entire plant, a
single department, or all employees of a single employer, as long as there is a mutuality of interest among
the proposed members of the unit.
appropriation A privacy tort that consists of using a
person’s name or likeness for commercial gain without
the person’s permission.
arbitration A dispute resolution method whereby two
parties submit their disagreement to a neutral decision
maker and agree to abide by the decision.
arraignment Formal appearance of the defendant in
court to answer the indictment by entering a plea of
guilty or not guilty.
783
784
GLOSSARY
arrest To seize and hold under the authority of the law.
capital structure The percentage of each type of
artisan’s lien A lien that enables a creditor to recover
capital—debt, preferred stock, and common equity—
used by the corporation.
case law Law resulting from judicial interpretations of
constitutions and statutes.
Chicago School An approach to antitrust policy that is
based solely on the goal of economic efficiency or the
maximization of consumer welfare.
civil law Law governing litigation between two private
parties.
Civil Rights Act of 1866 Statute guaranteeing that all
persons in the United States have the same right to
make and enforce contracts and have the full and equal
benefit of the law.
Civil Rights Act of 1871 Statute that prohibits discrimination by state and local governments.
class action suit A lawsuit brought by a member of a
group of persons on behalf of all members of the
group.
Clayton Act Prohibits price discrimination, tying,
exclusive-dealing arrangements, and corporate mergers that substantially lessen competition or tend to create a monopoly in interstate commerce.
closed-end credit A credit arrangement in which credit is
extended for a specific period of time, and the exact number of payments and the total amount due have been
agreed upon between the borrower and the creditor.
closely held corporation A corporation whose stock is
not traded on the national securities exchanges but is
privately held by a small group of people.
payment from a debtor for labor and services provided
on the debtor’s personal property (for example, fixing
a lawn mower).
assault Intentional placing of a person in fear or
apprehension of an immediate, offensive bodily contact.
assignment The present transfer of an existing right.
assumption of the risk A defense to negligence based
on showing that the plaintiff voluntarily and unreasonably encountered a known risk and that the harm the
plaintiff suffered was the harm that was risked.
attachment A court-ordered judgment allowing a local
officer of the court to seize property of a debtor.
attorney–client privilege Provides that information
furnished by a client to an attorney in confidence, in
conjunction with a legal matter, may not be revealed
by the attorney without the client’s permission.
award The arbitrator’s decision.
bail An amount of money the defendant pays to the
court upon release from custody as security that he or
she will return for trial.
bailment A relationship in which one person (the
bailor) transfers possession of personal property to
another (the bailee) to be used in an agreed-on manner for an agreed-on period of time.
battery Intentional, unwanted, and offensive bodily
contact.
bilateral contract The exchange of one promise for
another promise.
bilateral investment treaties (BITs) Treaty between
two parties to outline conditions for investment in either country.
binding arbitration clause A provision in a contract
mandating that all disputes arising under the contract
be settled by arbitration.
bonds Long-term loans secured by a lien or mortgage
on corporate assets.
boycott A refusal to deal with, purchase goods from,
or work for a business.
bribery The offering, giving, soliciting, or receiving of
money or any object of value for the purpose of influencing the judgment or conduct of a person in a position of trust, especially a government official.
broker A person engaged in the business of buying
and selling securities for others’ accounts.
business ethics The study of what makes up good and
bad conduct as related to business activities and values.
business judgment rule A rule that says corporate
officers and directors are not liable for honest mistakes
of business judgment.
co-ownership Ownership of land by multiple persons
or business organizations; all tenants have an equal
right to occupy all of the property.
collective bargaining Negotiations between an em-
ployer and a union over, primarily, wages, hours, and
terms and conditions of employment.
collusion Concerted action by two or more individuals
or business entities in violation of the Sherman Act.
Commerce Clause Empowers Congress to regulate
commerce with foreign nations, with Indian tribes, and
among the states; found in Article I.
commercial impracticability Situation that makes performance of a contract unreasonably expensive, injurious, or costly to a party.
common stock A class of stock that entitles its owner
to vote for the corporation’s board of directors, receive
dividends, and participate in the net assets upon liquidation of the corporation.
comparative negligence A defense that allocates
recovery based on percentage of fault allocated to
plaintiff and defendant; available in either pure or
modified form.
GLOSSARY
compensatory damages Monetary damages awarded
for a breach of contract that results in higher costs or
lost profits for the injured party.
competency A person’s ability to understand the nature
of the transaction and the consequences of entering
into it at the time the contract was entered into.
complaint The initial pleading in a case that states the
names of the parties to the action, the basis for the
court’s subject matter jurisdiction, the facts on which
the party’s claim is based, and the relief that the party
is seeking.
complete performance Completion of all the terms of
the contract.
conclusion A position or stance on an issue; the goal
toward which reasoning pushes us.
concurrent jurisdiction Applies to cases that may be
heard in either the federal or the state court system.
condemnation The process whereby the government
acquires the ownership of private property for a public
use over the protest of the owner.
condition precedent A particular event that must take
place to give rise to a duty of performance of a
contract.
condition subsequent A particular event that, when it
follows the execution of a contract, terminates the
contract.
conditional estate The right to own and possess the
land, subject to a condition whose happening (or
nonhappening) will terminate the estate.
conditional privilege The right to make a false statement
about someone and not be held liable for defamation
provided the statement was made without malice.
conflict of interest A conflict that occurs when a
corporate officer or director enters into a transaction
with the corporation in which he or she has a personal
interest.
conglomerate merger A merger in which the businesses of the acquiring and the acquired firm are totally
unrelated.
conscious parallelism Identical actions (usually price
increases) that are taken independently but nearly
simultaneously by two or more leading companies in
an industry.
consent order An agreement by a business to stop an
activity an administrative agency alleges to be unlawful and to accept the remedy the agency imposes; no
admission of guilt is necessary.
consideration A bargained-for exchange of promises
in which a legal detriment is suffered by the promisee.
contingency fee Agent’s compensation that consists of
a percentage of the amount the agent secured for the
principal in a business transaction.
785
contract A legally enforceable exchange of promises
or an exchange of a promise for an act.
contributory copyright infringement The act of presenting material on a Web site that encourages site
users to violate copyright laws.
contributory negligence A defense to negligence that
consists of proving that the plaintiff did not exercise
the ordinary degree of care to protect against an
unreasonable risk of harm and that this failure
contributed to causing the plaintiff’s harm.
conversion Intentional permanent removal of property from the rightful owner’s possession and control.
copyright The exclusive legal right to reproduce,
publish, and sell the fixed form of an expression of an
original creative idea.
corporate opportunity doctrine A doctrine, established by case law, that says corporate officers, directors, and agents cannot take personal advantage of an
opportunity that in all fairness should have belonged
to the corporation.
corporation An entity formed and authorized by state
law to act as a single legal person and to raise capital
by issuing stock to investors who are the owners of the
corporation.
counterclaim Defendant’s statement of facts showing
cause for action against the plaintiff and a request for
appropriate relief.
creditor–beneficiary contract A contract in which the
promisee obtains a promise from the promisor to fulfill
a legal obligation of the promisee to a third party.
creditor The lender in a transaction.
criminal fraud Intentional use of some sort of misrepresentation to gain an advantage over another party.
criminal law Composed of federal and state statutes prohibiting wrongful conduct ranging from murder to fraud.
critical thinking skills The ability to understand the
structure of an argument and apply a set of evaluative
criteria to assess its merits.
cross-elasticity of demand or substitutability If an increase in the price of one product leads consumers to
purchase another product, the two products are substitutable and there is said to be cross-elasticity of demand.
cross-licensing An illegal practice in which two patent
holders license each other to use their patented objects
only on condition that neither will license anyone else to
use those patented objects without the other’s consent.
culture Learned norms of society based on values and
beliefs.
cybersquatters (cyberpirates) Individuals or businesses
that intentionally obtain a domain name registration for
a company’s trademark so that it can sell the domain
name back to the trademark owner.
786
GLOSSARY
dealer A person engaged in the business of buying
duress defense An affirmative defense claiming that
and selling securities for his or her own account.
the defendant was forced to commit the wrongful act
by threat of immediate bodily harm or loss of life.
debentures Unsecured long-term corporate loans.
debtor The borrower in a transaction.
deed Instrument of conveyance of property.
defamation Intentional publication (communication to
a third party) of a false statement that is harmful to the
plaintiff’s reputation.
defendant Party against whom an action is being
brought.
denial-of-service attack A crime that occurs when
hackers clog a Web site’s equipment by sending it too
many requests for information.
deposition Pretrial testimony by witnesses who are
examined under oath.
disclaimer Disavowal of liability for breach of warranty
by the manufacturer or seller of a good in advance of
the sale of the good.
disclosed principal One whose identity is known by
the third party when the latter enters into an agreement
negotiated by the agent.
discovery The pretrial gathering of information from
each other by the parties.
disparagement Intentionally defaming a business prod-
uct or service.
disparate impact Occurs when the employer’s facially
neutral policy or practice has a discriminatory effect on
employees who belong to a protected class.
early neutral case evaluation When parties explain
their respective positions to a neutral third party who
then evaluates the strengths and weaknesses of the
cases. This evaluation then guides the parties in reaching a settlement.
easement An irrevocable right to use some portion of
another’s land for a specific purpose.
economic strike A nonviolent work stoppage for the
purpose of obtaining better terms and conditions of
employment under a collective bargaining agreement.
effluent limitations Maximum allowable amounts of
pollutants that can be discharged from a point source
within a given time period.
embezzlement The wrongful conversion of the prop-
erty of another by one who is lawfully in possession of
that property.
eminent domain The constitutional right of the government to take privately owned real property for a
public purpose in exchange for just compensation to
the owner.
employer–employee relationship One in which an
agent (employee) who works for pay and is subject to
the control of the principal (employer) may enter into
contractual relationships on the latter’s behalf.
employer–independent contractor relationship One
one employee less favorably than another because of that
employee’s color, race, religion, sex, or national origin.
in which the agent (independent contractor) is hired by
the principal (employer) to do a specific job but is not
controlled with respect to physical conduct or details
of work performance.
domain names Text names matched to particular
employment-at-will doctrine A contract of employment
Internet protocols or addresses.
for an indeterminate term is terminable at will by either
the employer or the employee; the traditional American
rule governing employer–employee relations.
disparate treatment Occurs when the employer treats
donative intent Intent to transfer ownership to another
at the time the donor makes actual or constructive
delivery of the gift to the donee.
donee–beneficiary contract A contract in which the
promisee obtains a promise from the promisor to make
a gift to a third party.
due diligence defense An affirmative defense raised in
lawsuits charging misrepresentation in a registration
statement. It is based on the defendant’s claim to have
had reasonable grounds to believe that all statements
in the registration statement were true and no omission
of material fact had been made. This defense is not
available to the issuer of the security.
Due Process Clause Provides that no one can be de-
prived of life, liberty, or property without “due process
of law”; found in the Fifth Amendment.
duress Any wrongful act or threat that prevents a party
from exercising free will when executing a contract.
enabling legislation Legislation that grants lawful
power to an administrative agency to issue rules,
investigate potential violations of rules or statutes, and
adjudicate disputes.
entrapment An affirmative defense claiming that the
idea for the crime did not originate with the defendant
but was put into the defendant’s mind by a police
officer or other government official.
Environmental Impact Statement (EIS) A statement
that must be prepared for every major federal activity
that would significantly affect the quality of the human
environment.
Environmental Protection Agency (EPA) The federal
agency charged with the responsibility for conducting
an integrated, coordinated attack on all forms of pollution of the environment.
GLOSSARY
787
Equal Pay Act of 1963 Statute that prohibits wage
discrimination based on sex.
(including multiple copies for classroom use), scholarship, and research.”
equitable remedies Nonmonetary damages awarded
false light A privacy tort that consists of intentionally
taking actions that would lead observers to make false
assumptions about the person.
for breach of contract when monetary damages would
be inadequate or impracticable.
estoppel A legal bar to either alleging or denying a fact
because of one’s own previous words or actions to the
contrary.
Family and Medical Leave Act (FMLA) A law designed
good or virtuous.
to guarantee that workers facing a medical catastrophe
or certain specified family responsibilities will be able
to take needed time off from work without pay but
without losing medical benefits or their jobs.
ethics The study of what makes up good and bad con-
federal preemption Constitutional doctrine stating that
duct, inclusive of related actions and values.
in an area in which federal regulation is pervasive, state
legislation cannot stand.
ethical norms Standards of conduct that we consider
exchange market A securities market that provides a
physical facility for the buying and selling of stocks and
prescribes the number and qualifications of its brokermembers. These brokers buy and sell stocks through
the exchange’s registered specialists, who are dealers
on the floor of the exchange.
federal supremacy Principle declaring that any state or
local law that directly conflicts with the federal Constitution, laws, or treaties is void.
exclusive federal jurisdiction Applies to cases that may
federalism A system of government in which power is
divided between a central authority and constituent
political units.
be heard only in the federal court system.
fee simple absolute The right to own and possess the
exclusive-dealing contract Agreement in which one
land against all others, without conditions.
party requires another party to sell and promote only
the brand of goods supplied by the first party.
felony A serious crime that is punishable by death or
executed contract A contract of which all the terms
Fifth Amendment Protects individuals against self-
have been performed.
executive administrative agency An agency located
within a department of the executive branch of government; heads and appointed members serve at the
pleasure of the president.
executive exemption Exemption to the ADEA that al-
lows mandatory retirement of executives at age 65.
imprisonment in a penitentiary.
incrimination and double jeopardy and guarantees
them the right to trial by jury; protects both individuals
and businesses through the Due Process Clause and
the Takings Clause.
First Amendment Guarantees freedom of speech, press,
and religion and the right to peacefully assemble and to
petition the government for redress of grievances.
executive power The power delegated by Congress to
an administrative agency to investigate whether the
rules enacted by the agency have been properly followed by businesses and individuals.
first appearance Appearance of the defendant before
express contract An exchange of oral or written prom-
property but is later attached permanently to the realty
and is treated as part of the realty.
ises between parties, which are enforceable in a court
of law.
express warranty A warranty that is clearly stated by
the seller or manufacturer.
expressed agency (agency by agreement) Agency
relationship formed through oral or written agreement.
expressed authority Authority that arises from specific
statements made by the principal (employer) to the
agent (employee).
expropriation The taking of private property by a
host country government for political or economic
reasons.
fair use doctrine A legal doctrine providing that a
copyrighted work may be reproduced for purposes
of “criticism, comment, news reporting, teaching
a magistrate, who determines whether there was probable cause for the arrest.
fixture An item that is initially a piece of personal
foreign subsidiary A company that is wholly or
partially owned and controlled in a company based in
another country.
Fourteenth Amendment Applies the entire Bill of Rights,
excepting parts of the Fifth Amendment, to the states.
Fourth Amendment Protects the right of individuals to
be secure in their persons, homes, and personal property by prohibiting the government from conducting
unreasonable searches of individuals and seizing their
property.
franchising A commercial agreement between a party
that owns a trade name or trademark (the franchisor)
and a party that sells or distributes goods or services
using that trade name or trademark (the franchisee).
788
GLOSSARY
fraud Misrepresentation of a material fact made with
intent to deceive the other party to a contract, who
reasonably relied on the misrepresentation and was
injured as a result. See also criminal fraud.
freedom-to-contract doctrine Parties who are legally
competent are allowed to enter into whatever contracts
they wish.
full warranty Under the Magnuson-Moss Warranty Act,
a written protection for buyers that guarantees free
repair of a defective product. If the product cannot be
fixed, the consumer must be given a choice of a refund
or a replacement free of charge.
future interest The present right to possess and own
the land in the future.
horizontal division of markets Collusion between two
or more competitors to divide markets, customers, or
product lines among themselves.
horizontal merger A merger between two or more
companies producing the same or a similar product
and competing for sales in the same geographic
market.
horizontal price-fixing Collusion between two or
more competitors to set prices for a product or service,
directly or indirectly.
horizontal restraint of trade Restraint of trade that
occurs between competitors at the same level of the
marketing structure.
hostile bid A tender offer that is opposed by the
garnishment An order of the court granted to a credi-
management of the target company.

The Legal Environment of Business: A Critical Thinking Approach

Transcription

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