Business Law Ethic Case Analysis

Business Law Ethic Case Analysis

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21e S T A N D A R D V O L U M E


And The Legal Environment

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21e S T A N D A R D V O L U M E


And The Legal Environment

DAVID P. TWOMEY Professor of Law

Carroll School of Management Boston College

Member of the Massachusetts and Florida Bars

MARIANNE MOODY JENNINGS Professor of Legal and Ethical Studies

W.P. Carey School of Business Arizona State University

Member of the Arizona Bar

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Anderson’s Business Law and The Legal Environment, 21e David P. Twomey, Marianne Moody Jennings

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brief contents

Preface xxix Acknowledgments xxxvi About the Authors xxxix


1 The Nature and Sources of Law 3 2 The Court System and Dispute Resolution 15 3 Business Ethics, Social Forces, and The Law 39 4 The Constitution as the Foundation of the Legal

Environment 66 5 Government Regulation of Competition and

Prices 87 6 Administrative Agencies 104 7 The Legal Environment of International Trade 126 8 Crimes 155 9 Torts 187

10 Intellectual Property Rights and the Internet 211 11 Cyberlaw 242

PART 2 CONTRACTS 265 12 Nature and Classes of Contracts: Contracting on

the Internet 267 13 Formation of Contracts: Offer and Acceptance 284 14 Capacity and Genuine Assent 307 15 Consideration 331 16 Legality and Public Policy 347 17 Writing, Electronic Forms, and Interpretation of

Contracts 367 18 Third Persons and Contracts 392 19 Discharge of Contracts 410 20 Breach of Contract and Remedies 433

PART 3 SALES AND LEASES OF GOODS 455 21 Personal Property and Bailments 457 22 Legal Aspects of Supply Chain Management 479 23 Nature and Form of Sales 503 24 Title and Risk of Loss 531

25 Product Liability: Warranties and Torts 555 26 Obligations and Performance 580 27 Remedies for Breach of Sales Contracts 598

PART 4 NEGOTIABLE INSTRUMENTS 619 28 Kinds of Instruments, Parties, and

Negotiability 621 29 Transfers of Negotiable Instruments and

Warranties of Parties 641 30 Liability of the Parties Under Negotiable

Instruments 665 31 Checks and Funds Transfers 686

PART 5 DEBTOR-CREDITOR RELATIONSHIPS 715 32 Nature of the Debtor-Creditor Relationship 717 33 Consumer Protection 736 34 Secured Transactions in Personal Property 763 35 Bankruptcy 793 36 Insurance 821

PART 6 AGENCY AND EMPLOYMENT 847 37 Agency 849 38 Third Persons in Agency 874 39 Regulation of Employment 896 40 Equal Employment Opportunity Law 934


1 How to Find the Law A–1 2 The Constitution of the United States A–4 3 Uniform Commercial Code A–14





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Preface xxix Acknowledgments xxxvi About the Authors xxxix




A. Nature of Law and Legal Rights 4 1. Legal Rights 4 2. Individual Rights 4 3. The Right of Privacy 4 CASE SUMMARY 5

4. Privacy and Technology 6 ETHICS & THE LAW 6


B. Sources of Law 7 C. Uniform State Laws 9 D. Classifications of Law 9 SPORTS & ENTERTAINMENT LAW 10



A. The Court System 16 1. The Types of Courts 16 CASE SUMMARY 17

2. The Federal Court System 18 3. State Court Systems 21 B. Court Procedure 22 4. Participants in the Court System 22 5. Which Law Applies—Conflicts of Law 23 6. Initial Steps in a Lawsuit 23 7. The Trial 25 ETHICS & THE LAW 27


8. Posttrial Procedures 28

C. Alternative Dispute Resolution 28 9. Arbitration 29 10. Mediation 30 11. MedArb 30 12. Reference To a Third Person 31 13. Association Tribunals 31 14. Summary Jury Trial 31 15. Rent-A-Judge 31 E-COMMERCE & CYBERLAW 32

16. Minitrial 32 17. Judicial Triage 32 18. Contract Provisions 33 19. Disposition of Complaints and

Ombudsmen 33 LAW FLIX 33


A. What is Business Ethics? 40 1. The Law as the Standard for Business Ethics 40 2. The Notion of Universal Standards for Business

Ethics 41 3. The Standard of Situational Business Ethics or Moral


4. The Business Stakeholder Standard of Behavior 42 ETHICS & THE LAW 44

B. Why is Business Ethics Important? 44 5. The Importance of Trust 44 6. Business Ethics and Financial Performance 45 ETHICS & THE LAW 46

7. The Importance of A Good Reputation 46 8. Business Ethics and Business Regulation: Public

Policy, Law, and Ethics 46 ETHICS & THE LAW 48

C. How to Recognize and Resolve Ethical Dilemmas 51

9. Categories of Ethical Behavior 51 ETHICS & THE LAW 52




10. Resolving Ethical Dilemmas 55 ETHICS & THE LAW 57



A. The U.S. Constitution and the Federal System 67 1. What a Constitution is 67 2. The Branches of Government 67 B. The U.S. Constitution and the States 67 3. Delegated and Shared Powers 68 4. Other Powers 68 5. Federal Supremacy 69 CASE SUMMARY 69

C. Interpreting and Amending the Constitution 70 6. Conflicting Theories 70 7. Amending the Constitution 71 8. The Living Constitution 71 D. Federal Powers 72 9. The Power to Regulate Commerce 72 CASE SUMMARY 73, 74

10. The Financial Powers 75 CASE SUMMARY 76

E. Constitutional Limitations on Government 76 11. Due Process 76 12. Equal Protection of the Law 77 E-COMMERCE & CYBERLAW 77

13. Privileges and Immunities 78 14. Protection of the Person 78 15. The Bill of Rights and Businesses as Persons 79 CASE SUMMARY 80




A. Power to Regulate Business 88 1. Regulation, Free Enterprise, and Deregulation 88 2. Regulation of Production, Distribution, and

Financing 88 3. Regulation of Unfair Competition 89 B. Regulation of Markets and Competition 89 4. Regulation of Prices 89 CASE SUMMARY 90, 91

5. Prevention of Monopolies and Combinations 92 ETHICS & THE LAW 93




C. Power to Protect Business 97 6. Remedies for Anticompetitive Behavior 97 LAW FLIX 98


A. Nature of the Administrative Agency 105 1. Purpose of Administrative Agencies 105 2. Uniqueness of Administrative Agencies 105 3. Open Operation of Administrative Agencies 106 B. Legislative Power of the Agency 107 4. Agency’s Regulations as Law 107 5. Agency Adoption of Regulations 108 ETHICS & THE LAW 109



C. Executive Power of the Agency 112 6. Enforcement or Execution of the Law 112 7. Constitutional Limitations on Administrative

Investigation 112 D. Judicial Power of the Agency 114 8. The Agency as a Specialized Court 114 9. Punishment and Enforcement Powers

of Agencies 116 10. Exhaustion of Administrative Remedies 116 11. Appeal from Administrative Action and Finality

of Administrative Determination 116 CASE SUMMARY 118, 119

12. Liability of the Agency 120 LAW FLIX 120


A. General Principles 127 1. The Legal Background 127 2. International Trade Organizations, Conferences,

and Treaties 129 CASE SUMMARY 131

3. Forms of Business Organizations 132 CASE SUMMARY 134

B. Governmental Regulation 134 4. Export Regulations 134 5. Protection of Intellectual Property Rights 136

xiv Contents


6. Antitrust 137 7. Securities and Tax Fraud Regulation in an

International Environment 140 CASE SUMMARY 141, 142

8. Barriers to Trade 142 CASE SUMMARY 143

9. Relief Mechanisms for Economic Injury Caused by Foreign Trade 143


10. Expropriation 146 11. The Foreign Corrupt Practices Act 146 ETHICS & THE LAW 147




A. General Principles 156 1. Nature and Classification of Crimes 156 2. Basis of Criminal Liability 156 CASE SUMMARY 157, 158

3. Responsibility for Criminal Acts 156 THINKING THINGS THROUGH 162

4. Indemnification of Crime Victims 162 B. White-Collar Crimes 163 5. Conspiracies 163 6. Crimes Related to Production, Competition,

and Marketing 164 7. Money Laundering 164 8. Racketeering 165 9. Bribery 166 10. Commercial Bribery 166 11. Extortion and Blackmail 166 12. Corrupt Influence 166 ETHICS & THE LAW 167

13. Counterfeiting 167 14. Forgery 168 15. Perjury 168 16. False Claims and Pretenses 168 17. Bad Checks 169 18. Credit Card Crimes 169 19. Embezzlement 170 20. Obstruction of Justice: Sarbanes-Oxley 170 21. Corporate Fraud: Sarbanes-Oxley 171 SPORTS & ENTERTAINMENT LAW 171

22. The Common Law Crimes 172 C. Criminal Law and the Computer 173

23. What is a Computer Crime? 173 24. The Computer as Victim 173 25. Unauthorized Use of Computers 174 26. Computer Raiding 174 27. Diverted Delivery by Computer 174 E-COMMERCE & CYBERLAW 175

28. Economic Espionage by Computer 175 29. Electronic Fund Transfer Crimes 175 ETHICS & THE LAW 176

30. Circumventing Copyright Protection Devices Via Computer 176

31. Spamming 177 D. Criminal Procedure Rights for Businesses 177 32. Fourth Amendment Rights for Businesses 177 CASE SUMMARY 178

33. Fifth Amendment Self-Incrimination Rights for Businesses 179


34. Due Process Rights for Businesses 180 CASE SUMMARY 180



A. General Principles 188 1. What is a Tort? 188 2. Tort and Crime Distinguished 188 3. Types of Torts 189 B. Intentional Torts 189 4. Assault 189 5. Battery 190 CASE SUMMARY 190

6. False Imprisonment 190 CASE SUMMARY 191

7. Intentional Infliction of Emotional Distress 192 8. Invasion of Privacy 192 CASE SUMMARY 193

9. Defamation 193 CASE SUMMARY 194, 195

10. Product Disparagement 196 11. Wrongful Interference with Contracts 196 12. Trespass 196 C. Negligence 197 13. Elements of Negligence 197 CASE SUMMARY 199

14. Defenses to Negligence 200 CASE SUMMARY 200


Contents xv

D. Strict Liability 203 THINKING THINGS THROUGH 203

15. What is Strict Liability? 204 16. Imposing Strict Liability 204 LAW FLIX 205


A. Trademarks and Service Marks 212 1. Introduction 212 2. International Registration 213 3. Registrable Marks 213 CASE SUMMARY 214

4. Remedies for Improper Use of Marks 215 CASE SUMMARY 215

5. Abandonment of Exclusive Right to Mark 216 6. Trade Dress Protection 216 7. Limited Lanham Act Protection of Product

Design 217 8. Prevention of Dilution of Famous Marks 218 9. Internet Domain Names and Trademark

Rights 218 E-COMMERCE & CYBERLAW 219

B. Copyrights 220 10. Duration of Copyright 221 11. Copyright Notice 221 12. What is Copyrightable? 221 13. Copyright Ownership and the Internet 222 14. Rights of Copyright Holders 222 15. Limitation on Exclusive Character

of Copyright 223 CASE SUMMARY 223

16. Secondary Liability for Infringement 224 ETHICS & THE LAW 224

17. Digital Millennium Copyright Act 225 C. Patents 225 18. Types, Duration, and Notice 225 19. Patentability 226 CASE SUMMARY 227

20. Patentable Business Methods 227 CASE SUMMARY 228

21. Infringement 229 CASE SUMMARY 229

D. Secret Business Information 230 22. Trade Secrets 230 23. Loss of Protection 231 24. Defensive Measures 231 25. Criminal Sanctions 231

E. Protection of Computer Software and Mask Works 232 26. Copyright Protection of Computer Programs 232 27. Patent Protection of Programs 233 28. Trade Secrets 233 29. Restrictive Licensing 233 30. Semiconductor Chip Protection 233 LAW FLIX 235


A. Introduction to Cyberlaw 243 1. What is Cyberlaw? 243 2. What are the Issues in Cyberlaw? 243 B. Tort Issues in Cyberspace 244 3. Employer/Employee Privacy Issues in Cyberlaw 244 CASE SUMMARY 247

4. Web User Information and Privacy 247 E-COMMERCE & CYBERLAW 248


5. Appropriation in Cyberspace 250 6. Defamation in Cyberspace 250 ETHICS & THE LAW 251

C. Contract Issues in Cyberspace 252 7. Formation of Contracts in Cyberspace 252 8. Misrepresentation and Fraud in Cyberspace 252 D. Intellectual Property Issues in Cyberspace 253 E. Criminal Law Issues in Cyberspace 254 9. Nature and Types of Cyberspace Crimes 254 10. Criminal Procedure and Rights in Cyberspace 255 THINKING THINGS THROUGH 256


F. Constitutional Restraints and Protections in Cyberspace 257

11. First Amendment Rights in Cyberspace 257 12. Commerce Clause Issues in Cyberspace 258 13. Due Process Issues in Cyberspace 258 G. Securities Law Issues in Cyberspace 258 LAW FLIX 259




A. Nature of Contracts 268 1. Definition of a Contract 268

xvi Contents

2. Elements of a Contract 268 3. Subject Matter of Contracts 268 4. Parties to a Contract 268 5. How a Contract Arises 269 6. Intent to Make a Binding Agreement 269 7. Freedom of Contract 270 B. Classes of Contracts 270 8. Formal and Informal Contracts 270 9. Express and Implied Contracts 270 10. Valid and Voidable Contracts and Void

Agreements 271 11. Executed and Executory Contracts 272 12. Bilateral and Unilateral Contracts 272 CASE SUMMARY 273

13. Quasi Contracts 273 CASE SUMMARY 275, 276


C. Contracting on the Internet 278 LAW FLIX 279


A. Requirements of an Offer 285 1. Contractual Intention 285 2. Definiteness 286 CASE SUMMARY 286, 287



3. Communication of Offer to Offeree 291 B. Termination of Offer 291 4. Revocation of Offer by Offeror 292 5. Counteroffer by Offeree 293 6. Rejection of Offer by Offeree 293 7. Lapse of Time 293 8. Death or Disability of Either Party 294 9. Subsequent Illegality 294 C. Acceptance of Offer 294 10. What Constitutes an Acceptance? 294 11. Privilege of Offeree 294 12. Effect of Acceptance 295 13. Nature of Acceptance 295 14. Who May Accept? 295 CASE SUMMARY 296

15. Manner and Time of Acceptance 296 E-COMMERCE & CYBERLAW 297

16. Communication of Acceptance 298 CASE SUMMARY 298, 299

17. Auction Sales 300 LAW FLIX 301


A. Contractual Capacity 308 1. Contractual Capacity Defined 308 CASE SUMMARY 308

2. Minors 309 CASE SUMMARY 311

3. Mentally Incompetent Persons 312 CASE SUMMARY 313

4. Intoxicated Persons 313 ETHICS & THE LAW 314

B. Mistake 314 5. Unilateral Mistake 314 CASE SUMMARY 315

6. Mutual Mistake 315 7. Mistake in the Transcription or Printing of the

Contract: Reformation 316 C. Deception 317 8. Intentional Misrepresentation 317 9. Fraud 317 CASE SUMMARY 318

10. Negligent Misrepresentation 320 11. Nondisclosure 320 CASE SUMMARY 320

D. Pressure 322 12. Undue Influence 322 CASE SUMMARY 322

13. Duress 323 LAW FLIX 324


A. General Principles 332 1. Consideration Defined and Explained 332 2. Gifts 332 CASE SUMMARY 333

3. Adequacy of Consideration 333 CASE SUMMARY 333, 334

4. Forbearance as Consideration 334 5. Illusory Promises 335 B. Special Situations 336 6. Preexisting Legal Obligation 336 CASE SUMMARY 337

7. Past Consideration 338 8. Moral Obligation 339

Contents xvii


C. Exceptions to the Laws of Consideration 340 9. Exceptions to Consideration 340 CASE SUMMARY 341



A. General Principles 348 1. Effect of Illegality 348 CASE SUMMARY 348

2. Exceptions to Effect of Illegality 349 3. Partial Illegality 349 4. Crimes and Civil Wrongs 349 5. Good Faith and Fairness 350 6. Unconscionable Clauses 350 CASE SUMMARY 352

B. Agreements Affecting Public Welfare 352 7. Agreements Contrary to Public Policy 353 CASE SUMMARY 353

8. Gambling, Wagers, and Lotteries 353 C. Regulation of Business 354 9. Effect of Violation 354 10. Statutory Regulation of Contracts 354 11. Licensed Callings or Dealings 354 CASE SUMMARY 355

12. Contracts in Restraint of Trade 355 13. Agreements Not to Compete 355 THINKING THINGS THROUGH 357


14. Usurious Agreements 358 THINKING THINGS THROUGH 359




A. Statute of Frauds 368 1. Validity of Oral Contracts 368 2. Contracts that Must be Evidenced by a Writing 369 CASE SUMMARY 372

3. Note or Memorandum 374 E-COMMERCE & CYBERLAW 375

4. Effect of Noncompliance 377 CASE SUMMARY 377

B. Parol Evidence Rule 378 5. Exclusion of Parol Evidence 378


6. When the Parol Evidence Rule Does Not Apply 379 CASE SUMMARY 380

C. Rules of Construction and Interpretation 381 7. Intention of the Parties 381 CASE SUMMARY 382

8. Whole Contract 382 9. Contradictory and Ambiguous Terms 382 CASE SUMMARY 383

10. Implied Terms 384 11. Conduct and Custom 385 12. Avoidance of Hardship 385 CASE SUMMARY 386



A. Third-Party Beneficiary Contracts 393 1. Definition 393 CASE SUMMARY 394

2. Modification or Termination of Intended Third-Party Beneficiary Contract 394

3. Limitations on Intended Third-Party Beneficiary 395

4. Incidental Beneficiaries 395 CASE SUMMARY 396

B. Assignments 396 5. Definitions 396 6. Form of Assignment 397 7. Notice of Assignment 397 CASE SUMMARY 398

8. Assignment of Right to Money 399 9. Nonassignable Rights 399 10. Rights of Assignee 401 11. Continuing Liability of Assignor 401 12. Liability of Assignee 402 CASE SUMMARY 402

13. Warranties of Assignor 403 14. Delegation of Duties 403 CASE SUMMARY 404



A. Conditions Relating to Performance 411 1. Classifications of Conditions 411 CASE SUMMARY 411


xviii Contents

B. Discharge by Performance 413 2. Normal Discharge of Contracts 413 3. Nature of Performance 413 CASE SUMMARY 414

4. Time of Performance 414 5. Adequacy of Performance 415 CASE SUMMARY 417

C. Discharge by Action of Parties 418 6. Discharge by Unilateral Action 418 7. Discharge by Agreement 419 CASE SUMMARY 420

D. Discharge by External Causes 420 8. Discharge by Impossibility 420 9. Developing Doctrines 422 CASE SUMMARY 422, 423, 424

10. Temporary Impossibility 425 11. Discharge by Operation of Law 426 LAW FLIX 427


A. What Constitutes a Breach of Contract? 434 1. Definition of Breach 434 2. Anticipatory Breach 434 CASE SUMMARY 434


B. Waiver of Breach 436 3. Cure of Breach by Waiver 436 4. Existence and Scope of Waiver 436 CASE SUMMARY 436

5. Reservation of Rights 438 C. Remedies for Breach of Contract 438 6. Remedies Upon Anticipatory Repudiation 438 7. Remedies in General and the Measure of

Damages 438 8. Monetary Damages 440 CASE SUMMARY 440

9. Rescission 442 10. Action for Specific Performance 442 11. Action for an Injunction 443 12. Reformation of Contract by a Court 443 CASE SUMMARY 444

D. Contract Provisions Affecting Remedies and Damages 444

13. Limitation of Remedies 444 14. Liquidated Damages 444 CASE SUMMARY 445, 446

15. Attorneys’ Fees 446 16. Limitation of Liability Clauses 447 LAW FLIX 448




A. Personal Property 458 1. Personal Property in Context 458 2. Title to Personal Property 458 3. Gifts 458 CASE SUMMARY 460, 461, 462

4. Finding of Lost Property 463 5. Occupation of Personal Property 464 CASE SUMMARY 464, 465

6. Escheat 466 CASE SUMMARY 466

7. Multiple Ownership of Personal Property 466 CASE SUMMARY 467

8. Community Property 468 B. Bailments 469 9. Definition 469 10. Elements of Bailment 469 11. Nature of the Parties’ Interests 470 12. Classification of Ordinary Bailments 470 13. Renting of Space Distinguished 471 14. Duties and Rights of the Bailee 471 15. Breach of Duty of Care: Burden of Proof 472 CASE SUMMARY 472

16. Liability for Defects in Bailed Property 473 17. Contract Modification of Liability 473 LAW FLIX 474


A. Warehouses 480 1. Definitions 480 2. Rights and Duties of Warehouses 480 3. Warehouse Receipts 481 4. Rights of Holders of Warehouse Receipts 481 5. Field Warehousing 483

Contents xix

6. Limitation of Liability of Warehouses 485 B. Common Carriers 485 7. Definitions 485 CASE SUMMARY 486

8. Bills of Lading 487 CASE SUMMARY 488

9. Rights of Common Carrier 488 10. Duties of Common Carrier 488 11. Liabilities of Common Carrier 489 CASE SUMMARY 489, 490, 491

C. Factors and Consignments 493 12. Definitions 493 13. Effect of Factor Transaction 493 D. Hotelkeepers 494 14. Definitions 494 15. Duration of Guest Relationship 494 16. Hotelkeeper’s Liability for Guest’s Property 495 CASE SUMMARY 495

17. Hotelkeeper’s Lien 496 18. Boarders or Lodgers 496 LAW FLIX 496


A. Nature of Sales 504 1. Subject Matter of Sales 504 2. Sale Distinguished from Other

Transactions 505 CASE SUMMARY 506

3. Formation of Sales Contracts 507 ETHICS & THE LAW 508

4. Terms in the Formed Contract 512 5. Bulk Transfers 515 B. Form of Sales Contract 515 6. Amount 515 7. Nature of the Writing Required 515 CASE SUMMARY 516, 517

8. Effect of Noncompliance 518 9. Exceptions to Requirement of a Writing 518 10. Noncode Requirements 519 THINKING THINGS THROUGH 520

11. Bill of Sale 520 C. Uniform Law for International Sales 520 12. Scope of the CISG 521 D. Leases of Goods 521 13. Types of Leases 521 14. Form of Lease Contract 522 15. Warranties 522

16. Default 522 E-COMMERCE & CYBERLAW 523



A. Identifying Types of Potential Problems and Transactions 532

1. Damage to Goods 532 2. Creditors’ Claims 532 3. Insurance 533 B. Determining Rights: Identification of Goods 533 4. Existing Goods 533 5. Future Goods 533 6. Fungible Goods 534 7. Effect of Identification 534 C. Determining Rights: Passage of Title 534 8. Passage of Title Using Documents of Title 535 9. Passage of Title in Nonshipment Contracts 535 10. Passage of Title in Warehouse Arrangements 535 11. Passage of Title in Bailments and Other Forms of

Possession 536 CASE SUMMARY 537



12. Delivery and Shipment Terms 539 13. Passage of Title in Shipment Contracts 540 D. Determining Rights: Risk of Loss 541 CASE SUMMARY 542


14. Risk of Loss in Nonshipment Contracts 542 15. Risk of Loss in Shipment Contracts 542 16. Damage to or Destruction of Goods 543 17. Effect of Seller’s Breach in Risk of Loss 544 CASE SUMMARY 545

E. Determining Rights: Special Situations 545 18. Returnable Goods Transactions 545 19. Consignments and Factors 547 20. Self-Service Stores 547 21. Auction Sales 548 LAW FLIX 548


A. General Principles 556 1. Theories of Liability 556

xx Contents

2. Nature of Harm 556 3. Who is Liable in Product Liability 557 B. Express Warranties 558 4. Definition of Express Warranty 558 5. Form of Express Warranty 558 6. Seller’s Opinion or Statement of Value 559 7. Warranty of Conformity to Description, Sample,

or Model 559 8. Federal Regulation of Express Warranties 559 9. Effect of Breach of Express Warranty 560 CASE SUMMARY 561

C. Implied Warranties 561 10. Definition of Implied Warranty 562 11. Implied Warranties of Sellers 562 CASE SUMMARY 563

12. Additional Implied Warranties of Merchant Sellers 563


13. Implied Warranties in Particular Sales 564 CASE SUMMARY 565

14. Necessity of Defect 566 THINKING THINGS THROUGH 566

15. Warranties in the International Sale of Goods 566 D. Disclaimer of Warranties 567 16. Validity of Disclaimer 567 17. Particular Language for Disclaimers 567 18. Exclusion of Warranties by Examination

of Goods 568 19. Postsale Disclaimer 568 E. Other Theories of Product Liability 568 20. Negligence 568 21. Fraud 568 22. Strict Tort Liability 568 23. Cumulative Theories of Liability 570 CASE SUMMARY 570




A. General Principles 581 1. Obligation of Good Faith 581 2. Time Requirements of Obligations 581 3. Repudiation of the Contract 582 4. Adequate Assurance of Performance 582 B. Duties of the Parties 583 5. Seller’s Duty to Deliver 583 CASE SUMMARY 583

6. Buyer’s Duty Upon Receipt of Goods 584 7. Buyer’s Duty to Accept Goods 585 CASE SUMMARY 586



8. Buyer’s Duty to Pay 588 THINKING THINGS THROUGH 589


9. When Duties are Excused 590 CASE SUMMARY 590


A. Statute of Limitations 599 1. Time Limits for Suits Under the UCC 599 2. Time Limits for Other Suits 599 B. Remedies of the Seller 599 3. Seller’s Lien 600 4. Seller’s Remedy of Stopping Shipment 600 5. Resale by Seller 600 6. Cancellation by Seller 600 7. Seller’s Action for Damages Under the Market

Price Formula 601 8. Seller’s Action for Lost Profits 601 9. Other Types of Damages 602 10. Seller’s Action for the Purchase Price 602 11. Seller’s Nonsale Remedies 602 THINKING THINGS THROUGH 602

C. Remedies of the Buyer 603 12. Rejection of Improper Tender 603 13. Revocation of Acceptance 603 14. Buyer’s Action for Damages for Nondelivery—

Market Price Recovery 604 15. Buyer’s Action for Damages for Nondelivery—

Cover Price Recovery 604 16. Other Types of Damages 604 17. Action for Breach of Warranty 604 CASE SUMMARY 605

18. Cancellation by Buyer 605 CASE SUMMARY 606

19. Buyer’s Resale of Goods 606 20. Action for Specific Performance 607 21. Nonsale Remedies of the Buyer 608 D. Contract Provisions on Remedies 608 22. Limitation of Damages 608 CASE SUMMARY 608

23. Down Payments and Deposits 609

Contents xxi

24. Limitation of Remedies 609 25. Waiver of Defenses 610 THINKING THINGS THROUGH 610


26. Preservation of Defenses 611 E. Remedies in the International Sale of Goods 611 27. Remedies of the Seller 611 E-COMMERCE & CYBERLAW 611

28. Remedies of the Buyer 612




A. Types of Negotiable Instruments and Parties 622

1. Definition 622 2. Kinds of Instruments 623 3. Parties To Instruments 624 B. Negotiability 625 4. Definition of Negotiability 625 E-COMMERCE & CYBERLAW 626

5. Requirements of Negotiability 626 CASE SUMMARY 628





6. Factors Not Affecting Negotiability 633 CASE SUMMARY 633

7. Ambiguous Language 634 8. Statute of Limitations 634


A. Transfer of Negotiable Instruments 642 1. Effect of Transfer 642 2. Definition of Negotiation 642 3. How Negotiation Occurs: The Order or Bearer

Character of an Instrument 642 B. How Negotiation Occurs: Bearer Instruments 643


C. How Negotiation Occurs: Order Instruments 644 CASE SUMMARY 644

4. Blank Indorsement 645 E-COMMERCE & CYBERLAW 645

5. Special Indorsement 646 6. Qualified Indorsement 646 7. Restrictive Indorsement 647 CASE SUMMARY 648

8. Correction of Name by Indorsement 648 9. Bank Indorsement 649 10. Multiple Payees and Indorsements 649 11. Agent or Officer Indorsement 650 CASE SUMMARY 650



12. Missing Indorsement 652 D. Problems in Negotiation of Instruments 652 13. Forged and Unauthorized Indorsements 652 14. Quasi Forgeries: The Impostor Rule 652 15. Effect of Incapacity or Misconduct

on Negotiation 654 16. Lost Instruments 654 CASE SUMMARY 654

E. Warranties in Negotiation 655 17. Warranties of Unqualified Indorser 655 18. Warranties of Other Parties 656


A. Parties to Negotiable Instruments: Rights and Liabilities 666

1. Types of Parties 666 2. Ordinary Holders and Assignees 666 3. The Holder-in-Due-Course Protections 667 CASE SUMMARY 669, 670


B. Defenses to Payment of a Negotiable Instrument 672 4. Classification of Defenses 672 5. Defenses Against Assignee or Ordinary Holder 672 6. Limited Defenses not Available Against a Holder

in Due Course 672 7. Universal Defenses Available Against All

Holders 673 8. Denial of Holder-in-Due-Course Protection 675 THINKING THINGS THROUGH 677

xxii Contents

C. Liability Issues: How Payment Rights Arise and Defenses are Used 677

9. The Roles of Parties and Liability 677 10. Attaching Liability of the Primary Parties:

Presentment 678 11. Dishonor and Notice of Dishonor 678 E-COMMERCE & CYBERLAW 679


A. Checks 687 1. Nature of a Check 687 E-COMMERCE & CYBERLAW 689

2. Certified Checks 690 3. Presentment for Obtaining Payment on a Check 690 THINKING THINGS THROUGH 691

4. Dishonor of a Check 692 5. The Customer-Bank Relationship 693 6. Stopping Payment of a Check 694 CASE SUMMARY 694

7. Wrongful Dishonor of a Check 695 8. Agency Status of Collecting Bank 695 9. Bank’s Duty of Care 696 B. Liability of a Bank 696 10. Premature Payment of a Postdated Check 696 11. Payment Over a Stop Payment Order 697 12. Payment on a Forged Signature of Drawer 697 CASE SUMMARY 697

13. Payment on a Forged or Missing Indorsement 698

14. Alteration of a Check 698 15. Unauthorized Collection of a Check 699 CASE SUMMARY 699


16. Time Limitations 700 CASE SUMMARY 702

C. Consumer Funds Transfers 702 17. Electronic Funds Transfer Act 703 18. Types of Electronic Funds Transfer Systems 703 19. Consumer Liability 704 D. Funds Transfers 704 20. What Law Governs? 704 21. Characteristics of Funds Transfers 704 22. Pattern of Funds Transfers 704 23. Scope of UCC Article 4A 705 24. Definitions 705 25. Manner of Transmitting Payment Order 706

26. Regulation by Agreement and Funds Transfer System Rules 706

27. Reimbursement of the Bank 706 28. Error in Funds Transfer 706 29. Liability for Loss 707 LAW FLIX 707




A. Creation of the Credit Relationship 718 B. Suretyship and Guaranty 718 1. Definitions 718 2. Indemnity Contract Distinguished 719 3. Creation of the Relationship 719 4. Rights of Sureties 719 CASE SUMMARY 720

5. Defenses of Sureties 721 THINKING THINGS THROUGH 721


C. Letters of Credit 724 6. Definition 724 ETHICS & THE LAW 726

7. Parties 727 CASE SUMMARY 727

8. Duration 728 9. Form 728 10. Duty of Issuer 728 11. Reimbursement of Issuer 728


A. General Principles 737 1. Expansion of Consumer Protection 737 2. Who is a Consumer? 738 3. Who is Liable Under Consumer Protection

Statutes? 738 4. When is There Liability Under Consumer Protection

Statutes? 738 CASE SUMMARY 739

5. What Remedies do Consumers Have? 740 6. What are the Civil and Criminal Penalties Under

Consumer Protection Statutes? 741

Contents xxiii

B. Areas of Consumer Protection 742 7. Advertising 742 CASE SUMMARY 743




9. Selling Methods 745 10. The Consumer Contract 746 11. Credit Disclosures 748 E-COMMERCE & CYBERLAW 749

12. Credit Cards 749 13. Gift Cards 751 14. Payments 751 15. Preservation of Consumer Defenses 751 16. Product Safety 752 17. Credit, Collection, and Billing Methods 752 CASE SUMMARY 753


18. Protection of Credit Standing and Reputation 755 CASE SUMMARY 756

19. Other Consumer Protections 757


A. Creation of Secured Transactions 764 1. Definitions 764 2. Creation of a Security Interest 765 3. Purchase Money Security Interest 766 4. The Nature and Classification of Collateral 766 CASE SUMMARY 768

B. Perfection of Secured Transactions 769 5. Perfection by Creditor’s Possession 769 6. Perfection for Consumer Goods 769 7. Perfection for Health Care Insurance Receivables 769 8. Automatic Perfection 770 9. Temporary Perfection 770 10. Perfection by Control 770 11. Perfection for Motor Vehicles 770 12. Perfection by Filing a Financing Statement 771 CASE SUMMARY 773


13. Loss of Perfection 775 C. Rights of Parties Before Default 775 14. Statement of Account 775 15. Termination Statements 776

16. Correction Statements 776 D. Priorities 776 17. Unsecured Party Versus Unsecured Party 776 18. Secured Party Versus Unsecured Party 776 19. Secured Party Versus Secured Party 777 20. Perfected Secured Party Versus Secured Party 777 CASE SUMMARY 777

21. Perfected Secured Party Versus Perfected Secured Party 778

22. Secured Party Versus Buyer of Collateral from Debtor 779


E. Rights of Parties After Default 781 23. Creditor’s Possession and Disposition of

Collateral 782 CASE SUMMARY 782

24. Creditor’s Retention of Collateral 782 THINKING THINGS THROUGH 783


25. Debtor’s Right of Redemption 784 26. Disposition of Collateral 784 27. Postdisposition Accounting 784 LAW FLIX 785


A. Bankruptcy Law 794 1. The Federal Law 794 2. Types of Bankruptcy Proceedings 794 ETHICS & THE LAW 795

B. How Bankruptcy is Declared 796 3. Declaration of Voluntary Bankruptcy 796 ETHICS & THE LAW 797

4. Declaration of Involuntary Bankruptcy 798 CASE SUMMARY 798



5. Automatic Stay 801 6. If the Creditors are Wrong: Rights of Debtor

in an Involuntary Bankruptcy 802 C. Administration of the Bankruptcy Estate 802 7. The Order of Relief 802 8. List of Creditors 802 9. Trustee in Bankruptcy 802 10. The Bankrupt’s Estate 803 11. Voidable Preferences 804 12. Proof of Claim 805

xxiv Contents

13. Priority of Claims 805 D. Debtor’s Duties and Exemptions 807 14. Debtor’s Duties 807 15. Debtor’s Exemptions 807 16. Debtor’s Protection Against

Discrimination 808 E. Discharge in Bankruptcy 808 17. Denial of Discharge 808 ETHICS & THE LAW 809

F. Reorganization Plans Under Chapter 810 18. Contents of the Plan 811 CASE SUMMARY 811

19. Confirmation of the Plan 812 G. Payment Plans Under Chapter 13 812 20. Contents of the Plan 812 21. Confirmation of the Plan 812 22. Discharge of the Debtor 812


A. The Insurance Contract 822 1. The Parties 822 2. Insurable Interest 822 CASE SUMMARY 823, 824

3. The Contract 824 4. Antilapse and Cancellation Statutes and

Provisions 825 E-COMMERCE & CYBERLAW 826

5. Modification of Contract 826 6. Interpretation of Contract 826 7. Burden of Proof 827 8. Insurer Bad Faith 827 9. Time Limitations on Insured 828 10. Subrogation of Insurer 829 ETHICS & THE LAW 830

B. Kinds of Insurance 830 11. Business Liability Insurance 831 CASE SUMMARY 831

12. Marine Insurance 832 CASE SUMMARY 832

13. Fire and Homeowners Insurance 833 CASE SUMMARY 834

14. Automobile Insurance 835 CASE SUMMARY 836

15. Life Insurance 836 CASE SUMMARY 838





A. Nature of the Agency Relationship 850 1. Definitions and Distinctions 850 CASE SUMMARY 852

2. Classification of Agents 852 3. Agency Coupled with an Interest 853 B. Creating the Agency 853 4. Authorization by Appointment 853 5. Authorization by Conduct 853 CASE SUMMARY 854

6. Agency by Ratification 854 7. Proving the Agency Relationship 856 C. Agent’s Authority 856 8. Scope of Agent’s Authority 856 CASE SUMMARY 857

9. Effect of Proper Exercise of Authority 857 10. Duty to Ascertain Extent of Agent’s Authority 857 11. Limitations on Agent’s Authority 858 CASE SUMMARY 859

D. Duties and Liabilities of Principal and Agent 859 12. Duties and Liabilities of Agent during Agency 859 CASE SUMMARY 860

13. Duties and Liabilities of Agent after Termination of Agency 862

14. Duties and Liabilities of Principal to Agent 862 E. Termination of Agency 863 15. Termination by Act of Parties 863 16. Termination by Operation of Law 863 CASE SUMMARY 863

17. Disability of the Principal Under the UDPAA 864 CASE SUMMARY 864

18. Termination of Agency Coupled with an Interest 865 19. Protection of Agent from Termination

of Authority 865 20. Effect of Termination of Authority 865


A. Liability of Agent to Third Person 875 1. Action of Authorized Agent of Disclosed

Principal 875 2. Unauthorized Action 875

Contents xxv


3. Disclosure of Principal 876 CASE SUMMARY 877

4. Assumption of Liability 877 5. Execution of Contract 878 CASE SUMMARY 878

6. Torts and Crimes 879 CASE SUMMARY 879

B. Liability of Principal to Third Person 879 ETHICS & THE LAW 880

7. Agent’s Contracts 880 8. Payment to Agent 881 CASE SUMMARY 881

9. Agent’s Statements 882 10. Agent’s Knowledge 882 C. Liability of Principal for Torts and Crimes of Agent 882 11. Vicarious Liability for Torts and Crimes 882 CASE SUMMARY 884

12. Negligent Hiring and Retention of Employees 885 CASE SUMMARY 886

13. Negligent Supervision and Training 886 14. Agent’s Crimes 887 15. Owner’s Liability for Acts of an Independent

Contractor 887 CASE SUMMARY 888

16. Enforcement of Claim by Third Person 889 D. Transactions with Sales Personnel 889 17. Soliciting and Contracting Agents 889


A. The Employment Relationship 897 1. Characteristics of Relationship 897 2. Creation of Employment Relationship 897 3. Duration and Termination of Employment

Contract 898 CASE SUMMARY 898, 900

4. WhistleBlower Protection Under the Sarbanes-Oxley Act 901

5. Duties of the Employee 902 6. Rights of the Employee 903 CASE SUMMARY 903

B. Labor Relations Laws 905 7. The National Labor Relations Act 905 8. National Labor Relations Board 907 9. Election Conduct 907 10. Union Activity on Private Property 907


11. Firing Employees for Union Activity 908 CASE SUMMARY 909

12. Duty of Employer to Bargain Collectively 910 CASE SUMMARY 910

13. Right to Work 910 14. Strike and Picketing Activity 911 CASE SUMMARY 911

15. Regulation of Internal Union Affairs 912 C. Pension Plans and Federal Regulation 912 16. Erisa 912 CASE SUMMARY 913

D. Unemployment Benefits, Family Leaves, and Social Security 915

17. Unemployment Compensation 915 CASE SUMMARY 915

18. Family and Medical Leaves of Absence 916 19. Leaves for Military Service Under Userra 917 20. Social Security 918 E. Employees’ Health and Safety 918 21. Standards 919 22. Employer Duties 919 23. Enforcement 919 THINKING THINGS THROUGH 920

24. State “Right-To-Know” Legislation 921 F. Compensation for Employees’ Injuries 921 25. Common Law Status of Employer 921 26. Statutory Changes 921 CASE SUMMARY 922

G. Employee Privacy 923 27. Source of Privacy Rights 923 28. Monitoring Employee Telephone

Conversations 923 29. E-Mail Monitoring 924 30. Property Searches 924 31. Drug and Alcohol Testing 925 H. Employer-Related Immigration Laws 926 32. Employer Liability 926 33. Employer Verification and Special Hiring

Programs 926


A. Title VII of the Civil Rights Act of 1964, as Amended 935

1. Theories of Discrimination 935

xxvi Contents


2. The Equal Employment Opportunity Commission 937

B. Protected Classes and Exceptions 938 3. Race and Color 938 4. Religion 938 5. Sex 940 6. Sexual Harassment 941 7. Protection Against Retaliation 944 CASE SUMMARY 944

8. National Origin 945 CASE SUMMARY 945

9. Title VII Exceptions 945 CASE SUMMARY 946

10. Affirmative Action and Reverse Discrimination 947

C. Other Equal Employment Opportunity (EEO) Laws 948

11. Equal Pay 948 12. Age Discrimination 949 CASE SUMMARY 949

13. Discrimination against Persons with Disabilities 950

D. Extraterritorial Employment 953 LAW FLIX 954

APPENDICES 1. How to Find the Law A–1 2. The Constitution of the United States A–4 3. Uniform Commercial Code A–14




Contents xxvii

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Regardless of the day of the week, newspapers and magazines constantly carry stories about law and business together. Galleon Hedge Fund has been accused of being at the center of an insider trading ring that had netted 14 arrests by late 2009. BP, the international energy company, paid a $50 million fine to the EPA for a burst pipeline and the damage to Alaska, an accident that followed years of warning about corrosion in BP pipes near Prudhoe Bay, Alaska. Fannie Mae, the federal mortgage company, was forced in 2005 to remove its CEO and make an $11 billion restatement on its financials after auditors uncovered earnings manipulation. By 2008, Fannie Mae, reeling from heavy losses in the mortgage-backed debt instrument market, had to be taken over by the federal government in an effort to avoid financial market collapses. And all of these events are years after we saw the financial collapses of Enron, WorldCom, HealthSouth, and the passage of extensive legal and governance reforms.

Why, we even lost Martha Stewart to a five-month prison sentence for her lies to prosecutors about how she managed to sell her shares of ImClone stock just before the company announced some problems with its new key drug. Martha Stewart has done much for our homes and cooking, but her case can teach us much about obstruction of justice, regulatory consent decrees, jury voir dire and selection, appellate courts, and reversible error. Martha Stewart’s legal difficulties presented a richness of legal issues each step of the way. What happened when she sold those shares? Did she indeed violate the law? Was it insider trading? What are the shareholders’ rights? What about the creditors?

And there are so many other companies, here in the United States and around the world. Did Lehman Brothers, Bear Stearns, and Merrill Lynch company officers intentionally misrepresent the risk on mortgage-based obligations? If so, are they criminally liable? And who is responsible for crimes committed by companies? As major corporations have continued to experience major criminal, legal, and ethical difficulties since 2007, we can see how important it is for business managers to understand the law and the foundations of ethics. When a manager has a void in knowledge on law and ethics, running a company can be tricky business. Microsoft

Corporation learned the intricacies of federal antitrust laws while its charges of monopolization were tried in federal court. Wall Street bond analysts learned that internal e-mails are discoverable and admissible as evidence. And when those e-mails to co-workers and friends are inconsistent with public statements those analysts made about companies and the value of their stocks, there is more than embarrassment. The analysts’ companies learned through nearly one billion dollars in fines that lesson about e-mails and the law.

When an entrepreneur is struggling with the decision of whether to incorporate or create an LLC, or the shareholders of Disney are grappling with issues about their rights when their CEO makes a bad decision, the law is there. No business or manager can hope to succeed without an understanding of the laws and legal environment of business. Students in business must be prepared with both knowledge of the law and the skill of applying it in the business setting. We learn


principles and application through interaction with examples and by working our way through dilemmas, issues, and problems. This 21st edition of Anderson’s Business Law and the Legal Environment enhances the learning process while still providing a detailed and rigorous case approach.

FEATURES OF THE TEXT The features of this text make the business and law connection easily understood and offer students clarity for grasping the often challenging complexities of law. The features are summarized in the following sections, which offer an overview of this edition.

Learning Outcomes Your students will better see and understand the relationship between legal concepts and their application in real-life situations by using the new chapter Learning Outcomes. These are featured at the end of each chapter – along with the Summary and new Key Terms list – in an all-encompassing “Make the Connection” section. The Learning Outcomes also encourage students to utilize the existing text pedagogy by serving as a direct reference point for selected “For Example” call-outs, case summaries and feature boxes.

Sports and Entertainment Law Using pop culture, this feature teaches students about law and ethics in a way that is sure to engage them. Michael Phelps lost endorsement contracts after a YouTube posting surfaced in which he was shown to be using a bong. Can contracts be terminated because of public behavior? Who won’t learn what obstruction of justice is if they learn it through Martha Stewart’s conduct? Was Heath Ledger’s will, one that was drawn up and executed before he had a child, still valid? Does his child inherit from his estate or does the will control? And what about baseball fans who lease space on rooftops to watch baseball games in stadiums across the way? And all without paying? What are their rights? What are the rights of the teams and stadium owners? Students have the chance to explore the law through these examples of sports figures’ and entertainers’ brushes with the law.

LawFlix At the end of most chapters you can find a reference to a Hollywood film, one that could be used to study and understand the concepts presented in the chapter. For example, what better film for understanding insurance law than Billy Wilder’s Double Indemnity? And you can find a clip on insurable interest in the Digital Video Library ( Or you can assign the students the enviable task of watching the movie and determining the insurance law issues. Or, for contract formation you can watch another clip from Midnight Run and witness the great Robert DeNiro playing a bounty hunter who is trying to negotiate a binding contract with a bailbondsman. There is offer, counteroffer, statute of frauds, and good fun all in a short clip to get the students involved and thinking.

xxx Preface

Clarity The writing style has been evolving and, once again, we have changed those passages that fell victim to the passive voice. The writing is clear and lively. The examples are student-friendly, and the discussions of law are grounded in the book’s strong connection to business. The principles of law are taught in the language and examples of business. Students can relate to the examples, which provide memorable illustrations of complex but critical legal concepts.

CPA Helps As always, the text provides coverage for all the legal topics covered on the CPA exam. Several topics have been eliminated from the content for the CPA exam as of October 2009. However, the exam lags behind the content change, so the eliminated topics may continue to appear on the exam for six to 18 months. Below is the new business law/regulatory content for the CPA exam. The topics of property, bailments, insurance, and estates will be eliminated going forward with more emphasis on federal regulation, including in the areas of antitrust and employment law.

Business Law (17% – 21%)

A. Agency

1. Formation and termination

2. Authority of agents and principals

3. Duties and liabilities of agents and principals

B. Contracts

1. Formation

2. Performance

3. Third party assignments

4. Discharge, breach, and remedies

C. Uniform Commercial Code

1. Sales contracts

2. Negotiable instruments

3. Secured transactions

4. Documents of title and title transfer

D. Debtor-Creditor Relationships

1. Rights, duties, and liabilities of debtors, creditors, and guarantors

2. Bankruptcy and insolvency

E. Government Regulation of Business

1. Federal securities regulation

2. Other federal laws and regulations (antitrust, copyright, patents, moneylaundering, labor, employment, and ERISA)

Preface xxxi

F. Business Structure (Selection of a Business Entity) 1. Advantages, disadvantages, implications, and constraints

2. Formation, operation, and termination

3. Financial structure, capitalization, profit and loss allocation, and distributions

4. Rights, duties, legal obligations, and authority of owners and management

Business organizations, now a substantial portion of the exam, remain a focus of eight chapters with up-to-date coverage of Sarbanes-Oxley and its impact on business forms and disclosures. This edition continues to feature sample CPA exam questions at the end of those chapters that include legal areas covered on the exam. This edition still contains the questions for the topics that will be eliminated because of the transition period between content adoption and exam adaptation. Answers for the odd-numbered CPA exam questions in each of the appropriate chapters are given in the Instructor’s Manual along with explanations for the answers. This edition of the book also continues to use a CPA highlight icon to alert students to those areas that are particularly critical in preparing for the law portion of the CPA exam.

Innovative Chapters Updated for this edition, the Cyberlaw chapter (chapter 11) provides students with a look at how the Internet and new technology have resulted in new interpretations of existing laws as well as new laws that govern the unique commerce issues involving these tools. Bloggers and spammers beware, for the law has caught up with you. The chapter has been shortened because so much of the cyberlaw material is now mainstream in other topic areas. But, the chapter provides a nice introductory tool for instructors who want to show how much the law affects this new generation of Internet-savvy students.

Case Summaries Specially selected case summaries appear in abundance and are still at the core of this text. Most chapters include three to five case summaries, many of them with 2009 decision dates. Landmark decisions also appear. To highlight the charm and induce the student’s recall of the principles of the cases, a one-line title appears above each case. These can be a humorous introduction, a play on words, or a simple memorable description of the parties or facts of the case. The one-line introduction is intriguing for students and makes the strong cases even more memorable.

e-Commerce and Cyberlaw This feature covers e-mail privacy, Internet taxes, identity theft, contract formation on the Internet, e-commerce employment rules, electronic signatures, and more. Chapter 11 on Cyberlaw explains how e-commerce affects contracts, sales, copyrights, privacy, and even torts. Chapter 8, the criminal law chapter, includes great detail on the new and evolving computer crimes. Chapter 10, the intellectual

xxxii Preface

property chapter, features a section on Protection of Computer Software and Mask Works, covering copyright and patent protection of computer programs, restrictive licensing, semiconductor chip protection, and more.

Thinking Things Through This feature is designed to help students apply the law they have learned from the chapter and cases to a hypothetical or another case that varies slightly from the examples in the reading. With these problems built into the reading, students have the chance to really think through what they have just read and studied with regard to the law presented in that chapter. This feature can be used to promote classroom discussion or as an assignment for analysis. For example, in Chapter 8, students can walk through an example that finds an employee simply following orders of an employer when that employee has concerns about the conduct. When does criminal liability apply to employees? Employers? To companies? This example walks the students through criminal culpability of business.

Major Regulatory Reforms: USA Patriot Act, Sarbanes-Oxley, and the ADA Amendments Act Businesses continue to be dramatically affected not only by laws at the federal level, but also by complex and intricate new federal regulatory schemes. Sarbanes-Oxley affects everything from corporate governance to the Federal Sentencing Guidelines to accountants’ liability. The USA Patriot Act has an impact on searches, funds transfers, and issues of citizenship for employers. These dramatic pieces of legislation enjoy coverage throughout this edition. The ADA Amendments Act of 2008 effectively overturned two U.S. Supreme Court decisions, restoring the original congressional intent of providing broad protection for individuals who face discrimination on the basis of disability.

Ethical Focus In addition to Chapter 3, which is devoted exclusively to the current issues in business ethics, each chapter continues to provide students with an ethical dilemma related to that particular area of law. The Ethics & the Law feature presents problems in each area of law. Students will be able to analyze ethical issues and problems that are very real and very challenging for anyone in business—for example, the issues involved in Lil Wayne using one of the Rolling Stones’ songs to make a rap song, AIG executives and their bonuses following the company’s government bail-out, and Wi-Fi piggybacking.

Weekly Updates Users of this text have the opportunity to catch up on new cases, business events, and changing laws and regulations with the weekly updates prepared by co-author Marianne Jennings. These updates carry information on law and business practice, which is often just days old and allows students to stay up-to-date. Instructors can

Preface xxxiii

use the cases, examples, and questions from the weekly updates for quizzes, class discussion, or exam questions. The weekly updates provide a never-ending resource for new and enhancing materials for lectures, discussions, assignments, and group work. Available to instructors and students, the weekly updates on the law are at

Critical Thinking The American Assembly of Collegiate Schools of Business (AACSB) mandate on critical thinking is addressed by this text. The Thinking Things Through feature asks students to analyze a problem that requires application of the law and examination of slight changes in factual patterns from examples in the text and the cases. For example, in the negotiable instruments chapters, students can look at a sample instrument in one problem and apply the requirements for negotiability to determine whether the instrument is indeed negotiable. In the Ethics & the Law feature, students must connect ethical thought with law and public policy and walk through the logic of application and results. End-of-chapter problems are, for the most part, real cases that summarize fact patterns and ask the students to find the applicable laws in the chapter and determine applicability and results. The fact patterns in the chapter problems are detailed and realistic and offer students the chance to test their mastery of the chapter concepts.

For Additional Help in Teaching and Learning For more detailed information about any of the following ancillaries, contact your local South-Western sales representative or visit the Anderson’s Business Law and the Legal Environment Web site at

STUDENT STUDY GUIDE (ISBN: 0324829787). Students may purchase a study guide that includes chapter outlines, general rules, study hints, and review and application exercises. Solutions to all study guide case problems are also included.

INSTRUCTOR’S RESOURCE CD (IRCD) (ISBN: 0324834306). The IRCD contains the Instructor’s Manual in Microsoft Word files as well as the ExamView testing software files, Microsoft Word test bank files, and PowerPoint lecture slides.

INSTRUCTOR’S MANUAL. The Instructor’s Manual is prepared by Marianne Jennings, one of the textbook authors. It provides instructor insights, chapter outlines, and teaching strategies for each chapter. Discussion points are provided for Thinking Things Through, Ethics & the Law vignettes and for each case referenced in the new Learning Outcomes. Also included are answers to CPA questions. Download the Instructor Manual at or access it from the IRCD.

EXAMVIEW TESTING SOFTWARE—COMPUTERIZED TESTING SOFTWARE. This testing software contains all of the questions in the printed test bank. This program is an easy-to-use test creation software compatible with Microsoft Windows. Instructors can add or edit questions, instructions, and answers; and they can select questions by previewing them on the screen, selecting them randomly, or selecting them by number. Instructors can also create and administer quizzes online, whether over the

xxxiv Preface

Internet, a local area network (LAN), or a wide area network (WAN). The ExamView testing software is only available on the IRCD.

TEST BANK. The Test Bank includes thousands of true/false, multiple-choice, and case questions. The test bank is only available on the IRCD or textbook companion Web site (

MICROSOFT POWERPOINT LECTURE REVIEW SLIDES. PowerPoint slides are available for use by instructors for enhancing their lectures. Download these slides at or access them on the IRCD.

BUSINESS LAW DIGITAL VIDEO LIBRARY. This dynamic online video library features more than 60 video clips that spark class discussion and clarify core legal principles. The library, recently updated with new videos, is organized into five series including classic business and modern business and e-commerce scenarios, straightforward lecture-style explanations of concepts for student review, and clips from many popular films. Access for students is free when bundled with a new textbook or can be purchased for an additional charge. For more information about the Digital Video Library, visit:

CENGAGE LEARNING CUSTOM SOLUTIONS. Whether you need print, digital, or hybrid course materials, Cengage Learning Custom Solutions can help you create your perfect learning solution. Draw from Cengage Learning’s extensive library of texts and collections, add or create your own original work, and create customized media and technology to match your learning and course objectives. Our editorial team will work with you through each step, allowing you to concentrate on the most important thing—your students. Learn more about all our services at

CENGAGE LEARNING’S GLOBAL ECONOMIC WATCH. Make the current global economic downturn a teachable moment with Cengage Learning’s Global Economic Watch— a powerful online portal that brings these pivotal current events into the classroom. The Watch includes:

● A content-rich blog of breaking news, expert analysis and commentary—updated multiple times daily—plus links to many other blogs

● A powerful real-time database of hundreds of relevant and vetted journal, newspaper, and periodical articles, videos, and podcasts—updated four times every day

● A thorough overview and timeline of events leading up to the global economic crisis

● Discussion and testing content, PowerPoint slides on key topics, sample syllabi, and other teaching resources

● Social Networking tools: Instructor and student forums encourage students

For more information on how you can access this resource, please visit

Preface xxxv


The development and revision of a textbook represents teamwork in its highest form. We thank the innumerable instructors, students, attorneys, and managers who have added to the quality of this textbook through its many editions. In particular, we thank the following reviewers who provided their honest and valuable commentary to this text:

Robert A. Arnold Thomas More College

Weldon M. Blake, JD Bethune-Cookman University

Bob Blinderman WTAMU and Amarillo College

Norman Bradshaw Alvin Community College

Thomas L. Brooks, Jr. Purdue University

Myra Bruegger Southeastern Community College

Barry Bunn Valencia Community College

Jarrod Y. Burch, JD Saint Leo University and American Intercontinental University

Deborah Carter Coahoma Community College

Shoshana Dennis San Diego City College

Andrea Foster John Tyler Community College

Leslie L. Francis CUNY-York College

Kimberly Goudy Central Ohio Technical College

Patrick J. Griffin, CPA, LL.M, JD Lewis University

Francis A. Hatstat, MBA, JD Bellevue College

David Lewis Jordan Emmanuel College

Virginia Edgerton Law, JD Saint Leo University

Paolo Longo, Jr. Valencia Community College

Linda McCarley Bevill State Community College

Derek Mosley Meridian Community College

Michael Murphy Langston University – Tulsa

Jeffrey D. Penley, JD Catawba Valley Community College

Simone I. Rosenberg Valencia Community College – East Campus

Joseph A. Spadaro Naugatuck Valley Community College

Darrell H. Thompson Mountain View College

Cathy Trecek Iowa Western Community College

Thomas K. Ware Johnson State College

Lisa Wilhite Bevill State Community College


We also thank the instructors who have reviewed previous editions of this text:

Dean Alexander Miami-Dade Community College

Robert A. Arnold Thomas More College

John T. Ballantine University of Colorado

Todd Barnet Pace University

Marie F. Benjamin Valencia Community College

Kenneth V. Bevan Valencia Community College

Robert Boeke Delta College

Greg Cermigiano Widener University

David A. Clough Naugatuck Valley Community College

Anne Cohen University of Massachusetts

Thomas S. Collins Loras College

Lawrence J. Danks Camden County College

Darrell Dies Illinois State University

De Vee E. Dykstra University of South Dakota

Adam Epstein University of Tennessee

Phillip Evans Kutztown University of Pennsylvania

Deborah Lynn Bundy Ferry Marquette University

Darrel Ford University of Central Oklahoma

Edward J. Gac University of Colorado

Teresa R. Gillespie Northwest University

David Grigg Pfeiffer University

Ronald Groeber Ball State University

Heidi Helgren Delta College

Florence Elliot Howard Stephen F. Austin University

Richard Hurley Francis Marion University

Lawrence A. Joel Bergen Community College

Michael A. Katz Delaware State University

Thomas E. Knothe Viterbo University

Ruth Kraft Audrey Cohen College

Claire La Roche Longwood College

Susan D. Looney Mohave Community College

Roy J. Millender, Jr. Westmont College

Steven Murray Community College of Rhode Island

Ann Olazábal University of Miami

Neal Orkin Drexel University

Ronald Picker St. Mary’s of the Woods College

Francis Polk Ocean County College

Robert Prentice University of Texas at Austin

Linda Reppert Marymount University

Richard J. Riley Samford University

Acknowledgments xxxvii

Gary Sambol Rutgers University School of Business

Samuel L. Schrager University of Connecticut

Lester Smith Eastern New Mexico University

Michael Sugameli Oakland University

Cathy L. Taylor Park University and Webster University

Mike Teel Samford University

Bob Vicars Bluefield State University

James Welch Kentucky Wesleyan College

We extend our thanks to our families for their support and patience as we work our long hours to ensure that each edition is better than the last.

xxxviii Acknowledgments

about the authors

Professor David Twomey has been a member of the Business Law Department in the Carroll School of Management at Boston College since 1968. As department chair for over a decade, and four term chairman of the school’s Education Policy Committee, he served as a spokesperson for a strong legal and ethical component in both the undergraduate and graduate curriculum. The author of some thirty two editions of textbooks on labor, employment and business law topics, the 14th edition of his Labor & Employment Law book was published in 2009. His articles have appeared in journals such as Best’s Review, The American Business Law Journal, The Massachusetts Law Quarterly, The Florida Bar Journal and The Business Law Review. His most recent work entitled “The Employee Free Choice Act: Congress, Where Do We Go From Here?” was published as the lead article in the Labor Law Journal (2009).

He has served as arbitrator in over two thousand labor-management disputes throughout the country. His service includes appointments by Presidents Ronald Reagan, George H. W. Bush, William J. Clinton, and George W. Bush to eight Presidential Emergency Boards, whose recommendations served as a basis for the resolution of major disputes in the rail and airline industries.

After service in the U.S. Marine Corps, he graduated from Boston College, earned his M.B.A. at the University of Massachusetts, Amherst and a J.D. degree at Boston College Law School. He is a member of the Massachusetts and Florida Bars; and a member of the National Academy of Arbitrators.

Professor Marianne M. Jennings has been a member of the Department of Manage- ment in the W.P. Carey School of Business at Arizona State University and a professor of legal and ethical studies in business there since 1977. She served as director of the Joan and David Lincoln Center for Applied Ethics from 1995-1999. She has done consulting work for law firms, businesses and professional groups including AES, AICPA, Anderson Windows, Boeing, Dial Corporation, Edward Jones, Mattel, Motorola, CFA Institute, Southern California Edison, the Institute of Internal Auditors, AIMR, DuPont, Blue Cross Blue Shield, Motorola, Hy-Vee Foods, IBM, Bell Helicopter, Amgen, Raytheon, and VIAD. The sixth edition of her textbook, Case Studies in Business Ethics, and the eighth edition of her textbook, Business: lts Legal, Ethical and Global Environment, were released in January 2008. The ninth edition of her book, Real Estate Law, will be published in 2010. Her book, A Business Tale: A Story of Ethics, Choices, Success, and a Very Large Rabbit, a fable about business ethics, was chosen by Library Journal in 2004 as its business book of the year. Her book on long-term success, Building a Business Through Good Times and Bad: Lessons from Fifteen Companies, Each With a Century of Dividends, was published in October 2002 and has been used by Booz Allen Hamilton for its work on business longevity. Her most recent book, The Seven Signs of Ethical Collapse, was published by St. Martin’s Press in July 2006.

Her work has appeared in the Wall Street Journal, the Chicago Tribune, the New York Times, Washington Post, and the Reader’s Digest. She has been a commentator on business issues on All Things Considered for National Public Radio.


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1 The Nature and Sources of Law

2 The Court System and Dispute Resolution

3 Business Ethics, Social Forces, and the Law

4 The Constitution as the Foundation of the Legal Environment

5 Government Regulation of Competition and Prices

6 Administrative Agencies

7 The Legal Environment of International Trade

8 Crimes

9 Torts

10 Intellectual Property Rights and the Internet

11 Cyberlaw

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Chapter 1


A. Nature of Law and Legal Rights





B. Sources of Law

C. Uniform State Laws

D. Classifications of Law

W hy have law? If you have ever been stuck in a traffic jam or jostledin a crowd leaving a stadium, you have observed the need for orderto keep those involved moving in an efficient and safe manner. The interruptions and damages from Internet viruses demonstrate the need for rules

and order in this era of new technology. When our interactions are not orderly,

whether at our concerts or through our e-mail, all of us and our rights are affected. The

order or pattern of rules that society uses to govern the conduct of individuals and

their relationships is called law. Law keeps society running smoothly and efficiently.

A. NATURE OF LAW AND LEGAL RIGHTS Law consists of the body of principles that govern conduct and that can be enforced in courts or by administrative agencies. The law could also be described as a collection or bundle of rights.

1. Legal Rights A right is a legal capacity to require another person to perform or refrain from performing an act. Our rights flow from the U.S. Constitution, state constitutions, federal and state statutes, and ordinances at the local levels, including cities, counties, and boroughs. Within these sources of rights are also duties. A duty is an obligation of law imposed on a person to perform or refrain from performing a certain act.

Duties and rights coexist. No right exists in one person without a corresponding duty resting on some other person or persons. For example, if the terms of a lease provide that the premises will remain in a condition of good repair so that the tenant can live there comfortably, the landlord has a corresponding duty to provide a dwelling that has hot and cold running water.

2. Individual Rights The U.S. Constitution gives individuals certain rights. Those rights include the right to freedom of speech, the right to due process or the right to have a hearing before any freedom is taken away, and the right to vote. There are also duties that accompany individual rights, such as the duty to speak in a way that does not cause harm to others. For example, individuals are free to express their opinions about the government or its officials, but they would not be permitted to yell “Fire!” in a crowded theater and cause unnecessary harm to others. The rights given in the U.S. Constitution are rights that cannot be taken away or violated by any statutes, ordinances, or court decisions. These rights provide a framework for the structure of government and other laws.

3. The Right of Privacy One very important individual legal right is the right of privacy, which has two components. The first is the right to be secure against unreasonable searches and seizures by the government. The Fourth Amendment of the U.S. Constitution

law– the order or pattern of rules that society establishes to govern the conduct of individuals and the relationships among them.

right– legal capacity to require another person to perform or refrain from an action.

duty–an obligation of law imposed on a person to perform or refrain from performing a certain act.

4 Part 1 The Legal and Social Environment of Business

guarantees this portion of the right of privacy. A police officer, for example, may not search your home unless the officer has a reasonable suspicion (which is generally established through a warrant) that your home contains evidence of a crime, such as illegal drugs. If your home or business is searched unlawfully, any items obtained during that unlawful search could be excluded as evidence in a criminal trial because of the Fourth Amendment’s exclusionary rule. For Example, in the murder trial of O.J. Simpson, Judge Lance Ito excluded some of the evidence the police had obtained from inside Mr. Simpson’s Ford Bronco, which was parked on the street outside his home. Judge Ito ruled that the officers should have first obtained a warrant for the locked vehicle, which was not going to be taken anywhere because Mr. Simpson was out of town at that time.

When Warrants Are Involved, No Brief Photographs

FACTS: In the early morning hours of April 16, 1992, a special team of Deputy U.S. Marshals and police officers executed warrants that had been issued against Dominic Wilson, who was wanted for robbery, theft, and assault and who had a “use caution” warning posted on law enforcement files and records. The team was accompanied by a reporter and a photographer from the Washington Post, who had been invited by the marshals to accompany them as

part of a Marshals Service ride-along policy. The officers, with media representatives in tow, entered the dwelling noted in the warrant at

6:45 A.M. The home they entered and that was on the arrest warrant actually belonged to Dominic’s parents, Charles and Geraldine Wilson. Charles and Geraldine were still in bed. When they heard the officers enter the home, Charles Wilson, dressed only in a pair of briefs, ran into the living room to investigate. He angrily cursed the officers. Geraldine Wilson then entered the living room to investigate, wearing only a nightgown. She observed her husband being restrained by the armed officers. Dominic Wilson was not in the house, and the officers left. However, the Washington Post photographer had already taken numerous pictures of the confrontation between the police and Charles Wilson. The Washington Post never published its photographs of the incident.

The Wilsons filed suit against the officers for invasion of their privacy and violation of their Fourth Amendment rights. The district court found that the officers could be held liable. The Court of Appeals reversed and found that the officers had immunity. The U.S. Supreme Court granted certiorari because of several conflicting circuit decisions on the issue of cameras and reporters being present during arrests and warrant executions.

DECISION: The Court held that although there were reasons for having the reporters and cameras present, such as public relations, safety for officers, and assistance, those reasons were not sufficient enough to disregard the Fourth Amendment rights of the homeowners. Citing “a man’s home is his castle,” the Court noted the longstanding history of protecting individuals in their homes. The Court held that having reporters and photographers along in the execution of a warrant is a violation of the Fourth Amendment rights of the parties being searched. Officers can be subject to some liability for their failure to honor privacy protections. [Wilson v Layne, 526 US 603 (1999)]1

1 Police officers who record the arrest of a DUI suspect have not violated the suspect’s privacy, State v Morris, 214 P 3d 883 (UT App 2009).

right of privacy– the right to be free from unreasonable intrusion by others.

Chapter 1 The Nature and Sources of Law 5

A second aspect of the right of privacy protects individuals against intrusions by others. Your private life is not subject to public scrutiny when you are a private citizen. This right is provided in many state constitutions and exists through interpretation at the federal level in the landmark case of Roe v Wade,2 in which the U.S. Supreme Court established a right of privacy that gives women the right to choose whether to have an abortion.

These two components of the right to privacy have many interpretations. These interpretations are often found in statutes that afford privacy rights with respect to certain types of conduct. For Example, a federal statute provides a right of privacy to bank customers that prevents their banks from giving out information about their accounts except to law enforcement agencies conducting investigations. Some laws protect the rights of students. For Example, the Family Educational Rights and Privacy Act of 1974 (FERPA, also known as the Buckley Amendment) prevents colleges and universities from disclosing students’ grades to third parties without the students’ permission. From your credit information to your Social Security number, you have great privacy protections.

4. Privacy and Technology Technology creates new situations that may require the application of new rules of law. Technology has changed the way we interact with each other, and new rules of law have developed to protect our rights. Today, business is conducted by computers, wire transfers of funds, e-mail, electronic data interchange (EDI) order

Googling Job Applicants

A recent survey shows a new component in the background searches performed by potential employers of job applicants:

● 61 percent of professional service firms, including accounting, consulting, engineering, and law firms, do Google searches on their job candidates.

● Fifty percent of professional services hired by employers to do background checks use Google.

One employer commented that a Google search is so simple that it would be irresponsible not to conduct

such a search. Experts tell college students to remember that what may seem to be something noncontroversial in your youth can later come back to haunt you when you begin your professional career. Their advice is to watch what you put in MySpace, Facebook, and all other Internet sites. Dis-

cuss privacy rights and whether there is any legal issue when information is posted voluntarily on the Internet. Is there an ethical issue with these types of searches?

Source: Sandhya Bathija , “Have a Profile on MySpace? Better Keep It Clean,” National Law Journal, June 4, 2007, 10.

2 410 US 113 (1973).

6 Part 1 The Legal and Social Environment of Business

placements, and the Internet. We still expect that our communication is private. However, technology also affords others the ability to eavesdrop on conversations and intercept electronic messages. The law has stepped in to reestablish that the right of privacy still exists even in these technologically nonprivate circumstances. Some laws now make it a crime and a breach of privacy to engage in such interceptions of communications.3 (See Chapter 11)

B. SOURCES OF LAW Several layers of law are enacted at different levels of government to provide the framework for business and personal rights and duties. At the base of this framework of laws is constitutional law. Constitutional law is the branch of law that is based on the constitution for a particular level of government. A constitution is a

Employers, E-mail, and Privacy

Scott Kennedy, a computer system admin- istrator for Qualcomm Corporation in San Diego, California, discovered that some- body had obtained unauthorized access (or “hacked into,” in popular parlance) the company’s computer network. Kennedy contacted the Federal Bureau of Investiga- tion (FBI). Working together, Kennedy and the FBI were able to trace the intrusion to a computer on the University of Wisconsin at Madison network. They contacted Jeffrey Savoy, the University of Wisconsin computer network investigator, who found evidence that someone using a computer on the university network was in fact hacking into the Qualcomm system and that the user had gained unauthorized access to the university’s system as well. Savoy traced the source of intrusion to a computer located in university housing, the room of Jerome Heckenkamp, a computer science graduate student at the university. Savoy knew that Heckenkamp had been terminated from his job at the university computer help desk two years earlier for similar unauthorized activity.

While Heckenkamp was online and logged into the university’s system, Savoy, along with detectives, went to Heckenkamp’s room. The door was ajar, and nobody was in the room. Savoy entered the room and disconnected the network cord that attached the computer

to the network. In order to be sure that the computer he had disconnected from the network was the computer that had gained unauthorized access to the university server, Savoy wanted to run some commands on the computer. Detectives located Heckenkamp, explained the situation, and asked for Heckenkamp’s password, which Heckenkamp voluntarily provided. Savoy then ran tests on the computer and copied the hard drive without a warrant. When Heckenkamp was charged with several federal computer crimes, he challenged the university’s access to his account and Savoy’s steps that night, including the copy of the hard drive, as a breach of his privacy. Was Heckenkamp correct? Was his privacy breached?

[U.S. v Heckenkamp, 482 F3d 1132 (CA 9 2007).]

3 State v Christensen, 79 P3d 12 (CA Wash 2003).

constitution–a body of principles that establishes the structure of a government and the relationship of the government to the people who are governed.

Chapter 1 The Nature and Sources of Law 7

body of principles that establishes the structure of a government and the relationship of that government to the people who are governed. A constitution is generally a combination of the written document and the practices and customs that develop with the passage of time and the emergence of new problems. In each state, two constitutions are in force: the state constitution and the federal Constitution.

Statutory law includes legislative acts. Both Congress and the state legislatures enact statutory law. Examples of congressional legislative enactments include the Securities Act of 1933 (Chapter 46), the Sherman Antitrust Act (Chapter 5), the bankruptcy laws (Chapter 35), and consumer credit protection provisions (Chapter 33). At the state level, statutes govern the creation of corporations, probate of wills, and the transfer of title to property. In addition to the state legislatures and the U.S. Congress, all cities, counties, and other governmental subdivisions have some power to adopt ordinances within their sphere of operation. Examples of the types of laws found at this level of government include traffic laws, zoning laws, and pet and bicycle licensing laws.

Administrative regulations are rules promulgated by state and federal admin- istrative agencies, such as the Securities and Exchange Commission and the National Labor Relations Board. These regulations generally have the force of statutes.

Even individuals and businesses create their own laws, or private law. Private law consists of the rules and regulations parties agree to as part of their contractual relationships. For Example, landlords develop rules for tenants on everything from parking to laundry room use. Employers develop rules for employees on everything from proper computer use to posting pictures and information on bulletin boards located within the company walls. Homeowner associations have rules on everything from your landscaping to the color of your house paint.

Law also includes principles that are expressed for the first time in court decisions. This form of law is called case law. When a court decides a new question or problem, its decision becomes a precedent, which stands as the law in future cases that involve that particular problem.

Using precedent and following decisions in similar cases is the doctrine of stare decisis. However, the rule of stare decisis is not cast in stone. Judges have some flexibility. When a court finds an earlier decision to be incorrect, it overrules that decision. For Example, in 1954, the U.S. Supreme Court departed from the general rule of stare decisis in Brown v Board of Education.4 In that case, the Court decided that its 1896 decision Plessy v Ferguson,5 that held separate facilities for blacks were equal to facilities for whites, was incorrect.

Court decisions do not always deal with new problems or make new rules. In many cases, courts apply rules as they have been for many years, even centuries. These time-honored rules of the community are called the common law. Statutes sometimes repeal or redeclare the common law rules. Many statutes depend on the common law for definitions of the terms in the statutes.

Law also includes treaties made by the United States and proclamations and executive orders of the president of the United States or of other public officials.

4 349 US 294 (1954). 5 163 US 537 (1895).

statutory law– legislative acts declaring, commanding, or prohibiting something.

administrative regulations– rules made by state and federal administrative agencies.

private law– the rules and regulations parties agree to as part of their contractual relationships.

case law– law that includes principles that are expressed for the first time in court decisions.

precedent–a decision of a court that stands as the law for a particular problem in the future.

stare decisis–“let the decision stand”; the principle that the decision of a court should serve as a guide or precedent and control the decision of a similar case in the future.

common law– the body of unwritten principles originally based upon the usages and customs of the community that were recognized and enforced by the courts.

8 Part 1 The Legal and Social Environment of Business

C. UNIFORM STATE LAWS To facilitate the national nature of business and transactions, the National Conference of Commissioners on Uniform State Laws (NCCUSL), composed of representatives from every state, has drafted statutes on various subjects for adoption by the states. The best example of such laws is the Uniform Commercial Code (UCC).6

(See Chapters 23–31, Chapter 34.) The UCC regulates the sale and leasing of goods; commercial paper, such as checks; funds transfers; secured transactions in personal property; banking; and letters of credit. Having the same principles of law on contracts for the sale of goods and other commercial transactions in most of the 50 states makes doing business easier and less expensive. Other examples of uniform laws across the states include the Model Business Corporations Act (Chapter 44), the Uniform Partnership Act (Chapter 42), and the Uniform Residential Landlord Tenant Act (Chapter 51). The Uniform Computer Information Transactions Act (UCITA) as well as the Uniform Electronic Transactions Act (UETA) are new technology statutes that have been adopted or are under consideration for passage by the states. These two uniform laws and versions of them take contract law from the traditional paper era to the paperless computer age.

D. CLASSIFICATIONS OF LAW Law is classified in many ways. Substantive law creates, defines, and regulates rights and liabilities. Procedural law specifies the steps that must be followed in enforcing those rights and liabilities. For example, the laws that grant employees protection against discrimination are substantive laws. The regulations of the Equal Employ- ment Opportunity Commission (EEOC) for bringing suits against or investigations of employers for discrimination charges are procedural laws. The laws that prohibit computer theft are substantive laws. The prosecution of someone for computer theft follows procedural law. Law may also be classified in terms of its origin from Roman (or civil) law, from English common law based on customs and usages of the community,7 or from the law merchant. Law may be classified according to subject matter, such as the law of contracts, the law of real estate, or the law of wills.

Law is at times classified in terms of principles of law and principles of equity. The early English courts were very limited as to the kinds of cases they could handle. Persons who could not obtain relief in those courts would petition the king to grant them special relief according to principles of equity and justice. In the course of time, these special cases developed certain rules that are called principles of equity. In general,

6 The UCC has been adopted in every state, except that Louisiana has not adopted Article 2, Sales. Guam, the Virgin Islands, and the District of Columbia have also adopted the UCC. The NCCUSL has adopted amendments to Article 8, Investment Securities (1977 and 1994), and Article 9, Secured Transactions (1999, and as amended 2001). There have been new articles of the UCC: Article 2A, Leases, and Article 4A, Funds Transfers. The United Nations Convention on Contracts for the International Sale of Goods (CISG) has been adopted as the means for achieving uniformity in sale- of-goods contracts on an international level. Provisions of CISG were strongly influenced by Article 2 of the UCC.

7 For example, in Washington State Grange v Washington Republican Party, 552 US 442 (2008), Justice Antonin Scalia wrote, “Washington’s law is like a law that encourages Oscar the Grouch (Sesame Street’s famed bad-taste resident of a garbage can) to state a “preference” for Campbell’s at every point of sale, while barring the soup company from disavowing his endorsement, or indeed using its name at all, in those same crucial locations.” In BMW of North America, Inc. v Gore, 517 US 559 (1996), Justice Scalia, in his dissenting opinion, wrote, “One expects the court to conclude, ‘To thine own self be true.’”

substantive law– the law that defines rights and liabilities.

procedural law– the law that must be followed in enforcing rights and liabilities.

equity– the body of principles that originally developed because of the inadequacy of the rules then applied by the common law courts of England.

Chapter 1 The Nature and Sources of Law 9

the rules of equity apply when the remedies provided at law cannot provide adequate relief in the form of monetary damages. At one time, the United States had separate law courts and equity courts. Except in a few states, these courts have been combined so that one court applies principles of both law and equity. A party may ask for both legal and equitable remedies in a single court.8 For Example, suppose a homeowner contracts to sell his home to a buyer. If the homeowner then refuses to go through with the contract, the buyer has the legal remedy of recovering damages. The rules of equity go further, when appropriate, and could require the owner to actually transfer the ownership of the house to the buyer. Such remedies require a court order for specific conduct, known as specific performance. Equitable remedies may also be available in certain contract breaches (see Chapter 2, 12 and 20).

On March 17, 2005, former and current major league baseball (MLB) players, Commissioner Bud Selig, and the parents of young baseball players who had taken their own lives after taking steroids testified before the U.S. House of Representatives Government Reform Committee. The House held the hearings to determine whether government regulation of baseball is necessary.

Committee Chair Tom Davis made an opening statement with the following excerpts:

Fourteen years ago, anabolic steroids were added to the Controlled Substance Act as a Schedule III drug, making it illegal to possess or sell them without a valid prescription. Today, however, evidence strongly suggests that ster- oid use among teenagers—especially aspiring athletes—is a large and growing problem.

Today we take the committee’s first steps toward understanding how we got here, and how we begin turning those numbers around. Down the road, we need to look at whether and how Congress should exercise its legisla- tive powers to further restrict the use and distribution of these substances.

Our specific purpose today is to consider MLB’s recently negotiated drug policy; how

the testing policy will be implemented; how it will effectively address the use of prohibited drugs by players; and, most importantly, the larger societal and public health ramifications of steroid use.

Mark McGwire, now a retired MLB player and a record holder, stated during the hearings:

Asking me, or any other player, to answer questions about who took steroids in front of television cameras, will not solve this problem. If a player answers ‘no,’ he simply will not be believed. If he answers ‘yes,’ he risks public scorn and endless government investigations. My lawyers have advised me that I cannot answer these questions without jeopardizing my friends, my family, or myself. I intend to follow their advice.*

Give a list of all the laws, rights, and duties you can find in this information.

8 For example, Jennifer Lopez and Marc Anthony filed suit against the manufacturer of a British company that produces baby carriages for using their images on its Web site and in ads without permission; they asked for $5 million in damages as well as an injunction to stop use of their photos and likenesses in the company’s ads. Lopez v Silver Cross, 2009 WL 481386 (CD Cal).

* EventID=1637. Click on Mark McGwire

10 Part 1 The Legal and Social Environment of Business

And Justice for All (1979) (R)

An excellent film that gives an overview of the judicial system in Maryland. Rights, precedent, and the role of lawyers are all topics for satire and analysis in the movie.

Check out LawFlix at to access movie clips that illustrate business law concepts.



Law provides rights and imposes duties. One such right is the right of privacy, which affords protection against unreasonable searches of our property and intrusion into or disclosure of our private affairs.

Law consists of the pattern of rules established by society to govern conduct and relationships. These rules can be expressed as constitutional provisions, statutes, administrative regulations, and case decisions. Law can be classified as substantive or procedural, and it can be described in terms of its historical origins, by the subject to which it relates, or in terms of law or equity.

The sources of law include constitutions, federal and state statutes, administrative regulations, ordinances, and uniform laws generally codified by the states in their statutes. The courts are also a source of law through their adherence to case precedent under the doctrine of stare decisis and through their development of time- honored principles called the common law.

LEARNING OUTCOMES After studying this chapter, you should be able to clearly explain:

A. NATURE OF LAW AND LEGAL RIGHTS LO.1 Discuss the nature of law and legal rights

See Wilson v Layne, p. 5. See E-Commerce and Cyberlaw, p. 7.

B. SOURCES OF LAW LO.2 List the sources of law

See the For Example discussion of landlords developing rules for tenants on everything from parking to laundry room use on p. 8.

Chapter 1 The Nature and Sources of Law 11

See the Sports & Entertainment Law discussion of steroids in baseball on p. 10.

C. UNIFORM STATE LAWS LO.3 Explain uniform state laws

See the list and explanation of uniform laws on p. 9.

D. CLASSIFICATIONS OF LAW LO.4 Describe the classifications of law

See the discussion of law, equity, and substantive law on p. 9. See footnote 8 with the discussion of the Jennifer Lopez/Marc Anthony suit on p. 10.

KEY TERMS administrative

regulations case law common law constitution duty

equity law precedent private law procedural law right of privacy

right stare decisis statutory law substantive law

QUESTIONS AND CASE PROBLEMS 1. Glenda Brunette, a 60-year old widow, operates a pedigreed cat breeding

business on her 11-acre ranch and avocado farm in Ojai, California. You can enter Brunette’s ranch only by passing through a locked gate that has a “No Trespass” sign. Concerned citizens reported to the Humane Society that Brunette was “selling cats that looked sick, with eyes matted shut and covered in flies and feces.” The Humane Society, a quasi-public body in California, can investigate reports of animal cruelty, impound animals, place liens on property, and bring criminal charges against citizens. The Humane Society obtained a warrant to search Brunette’s property and invited Tim Dewar of the Ojai Valley News to come along and photograph the search of the ranch. Dewar came in his own car and arrived after the Humane Society had severed the lock on the gate. When he arrived, Dewar went in and began photographing the search, the animals, and Brunette. Brunette filed suit against Dewar and the Ojai Valley News for invasion of her privacy. Can she recover damages? Be sure to refer to the Wilson v Layne case (on p. 5) as you consider your answer. Brunette v Humane Society of Ventura County, 294 F3d 1205 (CA 9).

2. The Family Educational Rights and Privacy Act (FERPA) protects students’ rights to keep their academic records private. What duties are imposed and upon whom because of this protection of rights? Discuss the relationship between rights and duties.

12 Part 1 The Legal and Social Environment of Business

3. List the sources of law.

4. What is the difference between common law and statutory law?

5. Classify the following laws as substantive or procedural:

a. A law that requires public schools to hold a hearing before a student is expelled

b. A law that establishes a maximum interest rate for credit transactions of 24 percent

c. A law that provides employee leave for the birth or adoption of a child for up to 12 weeks

d. A law that requires the county assessor to send four notices of taxes due and owing before a lien can be filed (attached) to the property

6. What do uniform laws accomplish? Why do states adopt them? Give an example of a uniform law.

7. Cindy Nathan is a student at West University. While she was at her 9:00 A.M. anthropology class, campus security entered her dorm room and searched all areas, including her closet and drawers. When Cindy returned to her room and discovered what had happened, she complained to the dorm’s senior resident. The senior resident said that this was the university’s property and that Cindy had no right of privacy. Do you agree with the senior resident’s statement? Is there a right of privacy in a dorm room?

8. Professor Lucas Phelps sent the following e-mail to Professor Marlin Jones: “I recently read the opinion piece you wrote for the Sacramento Bee on affirmative action. Your opinion is incorrect, your reasoning and analysis are poor, and I am embarrassed that you are a member of the faculty here at Cal State Yolinda.” Professor Jones forwarded the note from Professor Phelps to the provost of the university and asked that Professor Phelps be disciplined for using the university e-mail system for harassment purposes. Professor Phelps objected when the provost contacted him: “He had no right to forward that e-mail to you. That was private correspondence. And you have no right of access to my e-mail. I have privacy rights.” Do you agree with Professor Phelps? Was there a breach of privacy?

9. Under what circumstances would a court disregard precedent?

10. What is the difference between a statute and an administrative regulation?

11. What is the difference between a remedy in equity and other forms of judicial remedies?

12. Give examples of areas covered by federal laws. Give examples of areas covered by city ordinances. What are the limitations on these two sources of laws? What could the laws at these two levels not do?

13. What is the principle of stare decisis?

14. List some purposes of law that you were able to spot in reading this chapter.

Chapter 1 The Nature and Sources of Law 13

15. During the 2001 baseball season, San Francisco Giants player Barry Bonds hit 73 home runs, a new record that broke the one set by Mark McGwire in 2000 (72 home runs). FN Be sure to read the text box on p.9 for more background on McGwire’s hitting prowess. When Mr. Bonds hit his record- breaking home run, the ball went into the so-called cheap seats. Alex Popov was sitting in those seats and had brought along his baseball glove for purposes of catching any hits that might come into the stands. Everyone sitting in the area agreed that Mr. Popov’s glove touched Bonds’s home-run ball. Videotape also shows Mr. Popov’s glove on the ball. However, the ball dropped and, following a melee among the cheap-seat fans, Patrick Hayashi ended up with Bonds’s home-run ball. Mr. Popov filed suit for the ball, claiming it as his property. Such baseballs can be very valuable. The baseball from Mr. McGwire’s record- breaking home run in 2000 sold for $3 million. List those areas of law that will apply as the case is tried and the owner of the baseball is determined.

14 Part 1 The Legal and Social Environment of Business

Chapter 2


A. The Court System




B. Court Procedure






C. Alternative Dispute Resolution (ADR)












Despite carefully negotiated and well-written contracts and high safetystandards in the workplace or in product design and production,businesses can still encounter disputes that may result in a lawsuit. For Example, you could hire the brightest and most expensive lawyer in

town to prepare a contract with another party and believe the final agreement is

“bulletproof.” However, even a bulletproof contract does not guarantee performance

by the other party, and a lawsuit for damages may be necessary.

Business disputes can be resolved in court or through alternative means. This

chapter covers the structure of the court system and the litigation process as well as

alternative means used outside the court system to resolve disputes.

A. THE COURT SYSTEM A court is a tribunal established by government to hear and decide matters brought before it, provide remedies when a wrong has been committed, and prevent possible wrongs from happening. A court could award money damages to a business party for a breach of contract, but it could also issue an injunction to halt patent infringement. For Example, in 2006, a court’s threat to issue an injunction to shut down operation of the BlackBerry wireless e-mail device system resulted in a settlement of the patent infringement case between Research in Motion, Ltd. (RIM), the BlackBerry service provider, and NTP, Inc., the company that had won its patent infringement case against RIM for the technology used in the BlackBerry device.1

1. The Types of Courts Every type of court is given the authority to decide certain types or classes of cases. The power to hear cases is called jurisdiction. One form of jurisdiction, subject matter jurisdiction, covers the type of proceedings that the court holds. A court with original jurisdiction is the trial court or the court with the authority to conduct the first proceedings in the case. For Example, a court of original jurisdiction would be one where the witnesses actually testify, the documents are admitted into evidence, and the jury, in the case of a jury trial, is present to hear all the evidence and to make a decision.

Other types of subject matter jurisdiction are applicable to courts. A court with general jurisdiction has broad authority over different types of cases. The authority of a court with general jurisdiction can extend to both general civil and criminal cases. When a general jurisdiction trial court hears criminal cases, it conducts the trials of those charged with crimes. When a general trial court exercises its civil jurisdiction, it uses its authority to hear civil disputes, such as breach of contract cases and disputes about leases between landlords and tenants.

1 RIM eventually settled the suit with NTP by agreeing to pay $612.5 million.

court–a tribunal established by government to hear and decide matters properly brought to it.

jurisdiction– the power of a court to hear and determine a given class of cases; the power to act over a particular defendant.

subject matter jurisdiction– judicial authority to hear a particular type of case.

original jurisdiction– the authority to hear a controversy when it is first brought to court.

general jurisdiction– the power to hear and decide most controversies involving legal rights and duties.

16 Part 1 The Legal and Social Environment of Business

A court with limited or special jurisdiction has the authority to hear only particular kinds of cases. For Example, many states have courts that can hear only disputes in which the damages are $10,000 or less. Many types of courts have special jurisdiction, including juvenile courts, probate courts, and domestic relations courts. States vary in the names they give these courts, but all are courts of special or limited jurisdiction because they have very narrow authority for their subject matter jurisdiction. In the federal system, courts with limited or special jurisdiction include bankruptcy courts and the U.S. Tax Court.

A court with appellate jurisdiction reviews the work of a lower court. For Example, a trial court may issue a judgment that a defendant in a breach of contract suit should pay $500,000 in damages. That defendant could appeal the decision to an appellate court and seek review of the decision itself or even the amount of the damages.2 An appeal is a review of the trial and decision of the lower court. An appellate court does not hear witnesses or take testimony. An appellate court, usually a panel of three judges, simply reviews the transcript and evidence from the lower court and determines whether there has been reversible error. A reversible error is a mistake in applying the law or a mistake in admitting evidence that affected the outcome of the case. An appellate court can affirm or reverse a lower court decision or remand that decision for another trial or additional hearings.

Law and Order on TV and in the Court

FACTS: Andrea Yates was charged with capital murder in the drowning deaths of her five young children. Mrs. Yates had been in and out of treatment facilities, had been taking antidepressants, and was under the care of several experts for her depression. She was also experiencing postpartum depression when she drowned each of her five children in the bathtub at their family home. She then called her husband to ask him to come home and also called 9-1-1.

She entered a “not guilty by reason of insanity” plea, and 10 psychiatrists and two psychologists testified at the trial about Mrs. Yates’s mental condition before, during, and after the deaths of the children.

Dr. Parke Dietz, the psychiatrist for the prosecution, testified that he believed Mrs. Yates knew right from wrong and that she was not insane at the time of the drownings. Dr. Dietz had also served as a consultant for the television series Law and Order and testified as follows about one of the shows in the series:

As a matter of fact, there was a show of a woman with postpartum depression who drowned her children in the bathtub and was found insane and it was aired shortly before the crime occurred.

The prosecution used this information about the television show to cross-examine witnesses for Mrs. Yates and also raised its airing in its closing argument to the jury.

2 A case that is sent back for a redetermination of damages is remanded for what is known as remittur.

limited (special) jurisdiction– the authority to hear only particular kinds of cases.

appellate jurisdiction– the power of a court to hear and decide a given class of cases on appeal from another court or administrative agency.

appeal– taking a case to a reviewing court to determine whether the judgment of the lower court or administrative agency was correct. (Parties– appellant, appellee)

reversible error–an error or defect in court proceedings of so serious a nature that on appeal the appellate court will set aside the proceedings of the lower court.

affirm–action taken by an appellate court that approves the decision of the court below.

reverse– the term used when the appellate court sets aside the verdict or judgment of a lower court.

remand– term used when an appellate court sends a case back to trial court for additional hearings or a new trial.

Chapter 2 The Court System and Dispute Resolution 17

2. The Federal Court System The federal court system consists of three levels of courts. Figure 2.1 illustrates federal court structure.

(A) FEDERAL DISTRICT COURTS. The federal district courts are the general trial courts of the federal system. They are courts of original jurisdiction that hear both civil and criminal matters. Criminal cases in federal district courts are those in which the defendant is charged with a violation of federal law (the U.S. Code). In addition to the criminal cases, the types of civil cases that can be brought in federal district courts include (1) civil suits in which the United States is a party, (2) cases between citizens of different states that involve damages of $75,000 or more, and (3) cases that arise under the U.S. Constitution or federal laws and treaties.

Federal district courts are organized within each of the states. There are 94 federal districts (each state has at least one federal district and there are 89 federal districts in the United States with the remaining courts found in Puerto Rico, Guam, etc.). Judges and courtrooms are assigned according to the caseload in that geographic area of the state.4 Some states, such as New York and California, have several federal districts because of the population base and the resulting caseload. Figure 2.2 shows the geographic structure of the federal court system, including the appellate circuits.

The federal system has additional trial courts with limited jurisdiction, differing from the general jurisdiction of the federal district courts. These courts include, for example, the federal bankruptcy courts, Indian tribal courts, Tax Court, Court of Federal Claims, Court of Veterans Appeals, and the Court of International Trade.

(B) U.S. COURTS OF APPEALS. The final decision in a federal district court can be appealed to a court with appellate jurisdiction. In the federal court system, the federal districts are grouped together geographically into 12 judicial circuits, including one for the District of Columbia. Additionally, a thirteenth federal circuit, called the Federal Circuit, hears certain types of appeals from all of the circuits,


The jury found Mrs. Yates guilty. The defense lawyers later discovered that Dr. Dietz was mistaken and that there had been no such Law and Order show on postpartum depression. They appealed on the grounds that the evidence was material, prejudiced the jury, and required a new trial.

DECISION: The court held that because Dr. Dietz had testified about the show, that his testimony and the subject matter of the show were a part of the prosecution’s examination of defense witnesses, that the prosecution raised the airing of the show in closing arguments, and that the defense had to respond by talking about it meant that the testimony was material. Inasmuch as it was false, there was a reversible error and a retrial was required without the untrue and highly prejudicial evidence. [Yates v State, 171 SW 3d 215 (Tex App 2005)]3

3 Mrs. Yates was found to be criminally insane in her 2006 retrial and is now institutionalized. 4 For complete information about the courts and the number of judgeships, go to 28 USC §§ 81-144 and 28 USC §133.

federal district court–a general trial court of the federal system.

18 Part 1 The Legal and Social Environment of Business

including specialty cases such as patent appeals. Each circuit has an appellate court called the U.S. Court of Appeals, and the judges for these courts review the decisions of the federal district courts. Generally, a panel of three judges reviews the cases. However, some decisions, called en banc decisions, are made by the circuit’s full panel of judges. For Example, in 2003, the Ninth Circuit heard an appeal on a father’s right to challenge the requirement that his daughter recite the Pledge of Allegiance in the public school she attended. The contentious case had so many issues that the Ninth Circuit issued three opinions and the third opinion was issued after the case was heard en banc. 5

(C) U.S. SUPREME COURT. The final court in the federal system is the U.S. Supreme Court. The U.S. Supreme Court has appellate jurisdiction over cases that are appealed from the federal courts of appeals as well as from state supreme courts

FIGURE 2-1 The Federal Court System












*Appeals often go directly to U.S. Courts of Appeals.

5 Newdow v U.S. Congress, 292 F3d 597, 602 (CA 9 2002) (Newdow I); Newdow v U.S. Congress, 313 F3d 500, 502 (CA 9 2002) (Newdow II); and Newdow v U.S. Congress, 328 F3d 466, 468 (CA 9 2003) (Newdow III). The U.S. Supreme Court eventually heard the case. Elkgrove Unified School District v Newdow, 542 US 1 (2004). Another en banc hearing occurred at the Ninth Circuit over the issues in the California gubernatorial recall election. The three- judge panel held that the voting methods in California violated the rights of voters and therefore placed a stay on the election. However, the Ninth Circuit then heard the case en banc and reversed the decision of the original three-judge panel. The recall election then proceeded.

en banc– the term used when the full panel of judges on the appellate court hears a case.

Chapter 2 The Court System and Dispute Resolution 19

when a constitutional issue is involved in the case or a state court has reversed a federal court ruling. The U.S. Supreme Court does not hear all cases from the federal courts of appeals but has a process called granting a writ of certiorari, which is a preliminary review of those cases appealed to decide whether a case will be heard or allowed to stand as ruled on by the lower courts.6

The U.S. Supreme Court is the only court expressly created in the U.S. Constitution. All other courts in the federal system were created by Congress pursuant to its Constitutional power. The Constitution also makes the U.S. Supreme Court a court of original jurisdiction. The U.S. Supreme Court serves as the trial court for cases involving ambassadors, public ministers, or consuls and for cases in which two states are involved in a lawsuit. For Example, the U.S. Supreme

FIGURE 2-2 The Thirteen Federal Judicial Circuits




Nevada Utah

Arizona New Mexico

Colorado 10




Montana North Dakota

South Dakota







Missouri ST. LOUIS








Mississippi Alabama



South Carolina

North Carolina

Virginia Pennsylvania


Rhode Island


Connecticut NEW YORK

Maryland Delaware


New Hampshire

New York Idaho Massachusetts


















Virgin Islands

Puerto Rico

D.C. Circuit Washington, D.C.*

Federal Circuit Washington, D.C.**






Westest Virginiairginia

West Virginia

*A sizable portion of the caseload of the D.C. Circuit comes from the federal administrative agencies and offices located in Washington, D.C., such as the Securities and Exchange Commission, the National Labor Relations Board, the Federal Trade Commission, the Secretary of the Treasury, and the Labor Department, as well as appeals from the U.S. District Court of the District of Columbia. **Rather than being defined by geography like the regional courts of appeals, the Federal Circuit is defined by subject matter, having jurisdiction over such matters as patent infringement cases, appeals from the Court of Federal Claims and the Court of International Trade, and appeals from administrative rulings regarding subject matter such as unfair import practices and tariff schedule disputes.

6 For example, the Supreme Court refused to grant certiorari in a Fifth Circuit case on law school admissions at the University of Texas. However, it granted certiorari in a later case involving law school admissions at the University of Michigan. Gratz v Bollinger, 539 US 244 (2003).

writ of certiorari–order by the U.S. Supreme Court granting a right of review by the court of a lower court decision.

20 Part 1 The Legal and Social Environment of Business

Court has served for a number of years as the trial court for a Colorado River water rights case in which California, Nevada, and Arizona are parties.

3. State Court Systems (A) GENERAL TRIAL COURTS. Most states have trial courts of general jurisdiction that may be called superior courts, circuit courts, or county courts. These courts of general and original jurisdiction usually hear both criminal and civil cases. Cases that do not meet the jurisdictional requirements for the federal district courts would be tried in these courts. Figure 2.3 illustrates a sample state court system.

(B) SPECIALTY COURTS. Most states also have courts with limited jurisdiction, sometimes referred to as specialty courts. For Example, most states have juvenile courts, or courts with limited jurisdiction over criminal matters that involve defendants who are under the age of 18. Other specialty courts or lesser courts in state systems are probate and family law courts.

FIGURE 2-3 Sample State Court System













Chapter 2 The Court System and Dispute Resolution 21

(C) CITY, MUNICIPAL, AND JUSTICE COURTS. Cities and counties may also have lesser courts with limited jurisdiction, which may be referred to as municipal courts or justice courts. These courts generally handle civil matters in which the claim made in the suit is an amount below a certain level, such as $5,000 or $10,000. These courts may also handle misdemeanor types of offenses, such as traffic violations or violations of noise ordinances, and the trials for them.

(D) SMALL CLAIMS COURTS. Most states also have small claims courts at the county or city level. These are courts of limited jurisdiction where parties with small amounts in dispute may come to have a third party, such as a justice of the peace or city judge, review their disputes and determine how they should be resolved. A true small claims court is one in which the parties are not permitted to be represented by counsel. Rather, the parties present their cases to the judge in an informal manner without the strict procedural rules that apply in courts of general jurisdiction. Small claims courts provide a faster and inexpensive means for resolving a dispute that does not involve a large amount of claimed damages.

(E) STATE APPELLATE COURTS. Most states also have intermediate-level courts similar to the federal courts of appeals. They are courts with appellate jurisdiction that review the decisions of lower courts in that state. Decisions of the general trial courts in a state would be appealed to these courts.

(F) STATE SUPREME COURTS. The highest court in most states is generally known as the state supreme court, but a few states, such as New York, may call their highest court the court of appeals; Maine and Massachusetts, for example, call their highest court the supreme judicial court. State supreme courts primarily have appellate jurisdiction, but some states’ courts do have original jurisdiction, such as in Arizona, where counties in litigation have their trial at the supreme court level. Most state supreme courts also have a screening process for cases. They are required to hear some cases, such as criminal cases in which the defendant has received the death penalty. A decision of a state supreme court is final except in those circumstances in which a federal law or treaty or the U.S. Constitution is involved. Cases with these federal subject matter issues can then be appealed to the U.S. Supreme Court.

B. COURT PROCEDURE Once a party decides to use the court system for resolution of a dispute, that party enters a world with specific rules, procedures, and terms that must be used to have a case proceed.

4. Participants in the Court System The plaintiff is the party that initiates the proceedings in a court of original jurisdiction. In a criminal case in which charges are brought, the party initiating the proceedings would be called the prosecutor. The party against whom the civil or criminal proceedings are brought is the defendant. A judge is the primary officer of the court and is either an elected or an appointed official who presides over the

small claims courts–courts that resolve disputes between parties when those disputes do not exceed a minimal level; no lawyers are permitted; the parties represent themselves.

plaintiff–party who initiates a lawsuit.

prosecutor–party who originates a criminal proceeding.

defendant–party charged with a violation of civil or criminal law in a proceeding.

judge–primary officer of the court.

22 Part 1 The Legal and Social Environment of Business

matters brought before the court. Attorneys or lawyers are representatives for the plaintiff and the defendant for purposes of presenting their cases. Lawyers and clients have a privilege of confidentiality know as the attorney-client privilege. Lawyers cannot disclose what their clients tell them unless the client is committing, or plans to commit, a crime.

A jury is a body of citizens sworn by a court to reach a verdict on the basis of the case presented to them. Jurors are chosen for service based on lists compiled from voter registration and driver’s license records.

5. Which Law Applies—Conflicts of Law When a lawsuit is brought, there is not just the question of where a case will be tried but also of what law will be applied in determining the rights of the parties. The principle that determines when a court applies the law of its own state—the law of the forum—or some foreign law is called conflict of laws. Because there are 50 state court systems and a federal court system, as well as a high degree of interstate activity, conflicts of law questions arise frequently.

Some general rules apply. For example, the law of the state in which the court is located governs the case on procedural issues and rules of evidence. In contract litigation, the court applies the law of the state in which the contract was made for determining issues of formation. Performance disputes and damages for non- performance are generally governed by the law of the state where the contract is to be performed. International contracts follow similar rules. For Example, a California court will apply Swiss law to a contract made in Switzerland that is to be performed in that country.

However, it is becoming more common for the parties to specify their choice of law in their contract. In the absence of a law-selecting provision in the contract, there is a growing acceptance of the rule that a contract should be governed by the law of the state that has the most significant contacts with the transaction.

For Example, assume the buyer’s place of business and the seller’s plant are located in Nebraska, and the buyer is purchasing goods from the seller to resell to Nebraska customers. Many courts will hold that this is a contract governed by the law of Nebraska. In determining which state has the most significant contacts, the court considers the place of contracting, negotiating, and performing; the location of the subject matter of the contract; and the domicile (residence), states of incorporation, and principal place of business of the parties.

6. Initial Steps in a Lawsuit The following steps in a lawsuit generally apply in cases brought in courts of original jurisdiction. Not every step applies in every case, but understanding litigation steps and terms is important for businesspeople.

(A) COMMENCEMENT OF A LAWSUIT. A lawsuit begins with the filing of a complaint. The complaint generally contains a description of the wrongful conduct and a request for damages, such as a monetary amount. For Example, a plaintiff in a contract suit would describe the contract, when it was entered into, and when the

attorney-client privilege– right of individual to have discussions with his/her attorney kept private and confidential

jury–a body of citizens sworn by a court to determine by verdict the issues of fact submitted to them.

complaint– the initial pleading filed by the plaintiff in many actions, which in many states may be served as original process to acquire jurisdiction over the defendant.

Chapter 2 The Court System and Dispute Resolution 23

defendant stopped performance on the contract. A copy of the contract would be attached to the complaint.

(B) SERVICE OF PROCESS. Once the plaintiff has filed the complaint with the proper court, the plaintiff has the responsibility of notifying the defendant that the lawsuit has been filed. The defendant must be served with process. Process, often called a writ, notice, or summons, is delivered to the defendant and includes a copy of the complaint and notification that the defendant must appear and respond to the allegations in the complaint.

(C) THE DEFENDANT’S RESPONSE AND THE PLEADINGS. After the defendant is served with process in the case, the defendant is required to respond to or answer the complaint within the time provided under the court’s rules. In answering the plaintiff’s complaint, the defendant has several options. For example, the defendant could make a motion to dismiss, which is a request to the court to dismiss the lawsuit on the grounds that, even if everything the plaintiff said in the complaint were true, there is still no right of recovery. A motion to dismiss is also called a demurrer.

A defendant could also respond and deny the allegations. For Example, in a contract lawsuit, the defendant-seller could say he did not breach the contract but stopped shipment of the goods because the plaintiff-buyer did not pay for the goods in advance as the contract required. A defendant could also counterclaim in the answer, which is asking the court for damages as a result of the underlying dispute. For Example, the defendant-seller in the contract lawsuit might ask for damages for the plaintiff-buyer’s failure to pay as the contract required.

All documents filed in this initial phase of the case are referred to as the pleadings. The pleadings are a statement of the case and the basis for recovery if all the facts alleged can be proved.

(D) DISCOVERY. The Federal Rules of Civil Procedure and similar rules in all states permit one party to obtain from the adverse party information about all witnesses, documents, and any other items relevant to the case. Discovery requires each side to name its potential witnesses and to provide each side the chance to question those witnesses in advance of the trial. Each party also has the opportunity to examine, inspect, and photograph books, records, buildings, and machines. Even examining the physical or mental condition of a party is part of discovery when it has relevance in the case. The scope of discovery is extremely broad because the rules permit any questions that are likely to lead to admissible evidence.

Deposition. A deposition is the testimony of a witness taken under oath outside the courtroom; it is transcribed by a court reporter. Each party is permitted to question the witness. If a party or a witness gives testimony at the trial that is inconsistent with her deposition testimony, the prior inconsistent testimony can be used to impeach the witness’s credibility at trial

Depositions can be taken either for discovery purposes or to preserve the testimony of a witness who will not be available during the trial. Some states now permit depositions to be videotaped. A videotape is a more effective way of

process–paperwork served personally on a defendant in a civil case.

answer–what a defendant must file to admit or deny facts asserted by the plaintiff.

motion to dismiss–a pleading that may be filed to attack the adverse party’s pleading as not stating a cause of action or a defense.

demurrer–a pleading to dismiss the adverse party’s pleading for not stating a cause of action or a defense.

counterclaim–a claim that the defendant in an action may make against the plaintiff.

pleadings– the papers filed by the parties in an action in order to set forth the facts and frame the issues to be tried, although, under some systems, the pleadings merely give notice or a general indication of the nature of the issues.

discovery–procedures for ascertaining facts prior to the time of trial in order to eliminate the element of surprise in litigation.

deposition– the testimony of a witness taken out of court before a person authorized to administer oaths.

impeach–using prior inconsistent evidence to challenge the credibility of a witness.

24 Part 1 The Legal and Social Environment of Business

presenting deposition testimony than reading that testimony at trial from a reporter’s transcript because jurors can see the witness and the witness’s demeanor and hear the words as they were spoken, complete with inflection.7

Other Forms of Discovery. Other forms of discovery include written interrogatories (questions) and written requests for production of documents. These discovery requests can be very time consuming to the answering party and often lead to pretrial legal disputes between the parties and their attorneys as a result of the legal expenses involved.

(E) MOTION FOR SUMMARY JUDGMENT. If a case has no material facts in dispute, either party can file a motion for summary judgment. Using affidavits or deposition testimony obtained in discovery, the court can find that there are no factual issues and decide the case as a matter of law. For Example, suppose that the parties can agree that they entered into a life insurance contract but dispute whether the policy applies when there is a suicide. The facts are not in dispute; the law on payment of insurance proceeds in the event of a suicide is the issue. Such a case is one that is appropriate for summary judgment.

(F) DESIGNATION OF EXPERT WITNESSES. In some cases, such as those involving product safety, the parties may want to designate an expert witness. An expert witness is a witness who has some special expertise, such as an economist who gives expert opinion on the value of future lost income or a scientist who testifies about the safety of a prescription drug. There are rules for naming expert witnesses as well as for admitting into evidence any studies or documents of the expert.8 The purpose of these rules is to avoid the problem of what has been called junk science, or the admission of experts’ testimony and research that has not been properly conducted or reviewed by peers.

7. The Trial (A) SELECTING A JURY. Jurors drawn for service are questioned by the judge and lawyers to determine whether they are biased or have any preformed judgments about the parties in the case. Jury selection is called voir dire examination. For Example, in the trial of Martha Stewart, the multimedia home and garden diva, it took a great deal of time for the lawyers to question the potential jurors about their prior knowledge concerning the case, which had received nationwide attention and much media coverage. Lawyers have the opportunity to remove jurors who know parties in the case or who indicate they have already formed opinions about guilt or innocence. The attorneys question the potential jurors to determine if a juror should be challenged for cause (e.g., when the prospective juror states he is employed by the plaintiff’s company). Challenges for cause are unlimited, but each side can also

7 At the civil trial of O.J. Simpson for the wrongful death of Nicole Brown Simpson and Ronald Goldman, Daniel Petrocelli used a videotape of Mr. Simpson’s deposition very effectively in impeaching Mr. Simpson’s testimony at trial. Daniel Petrocelli, Triumph of Justice: The Final Judgment on the Simpson Saga (New York: Crown, 1998).

8 Daubert v Merrell Dow Pharmaceuticals, Inc., 509 US 579 (1993).

interrogatories–written questions used as a discovery tool that must be answered under oath.

request for production of documents–discovery tool for uncovering paper evidence in a case.

motion for summary judgment– request that the court decide a case on basis of law only because there are no material issues disputed by the parties.

expert witness–one who has acquired special knowledge in a particular field as through practical experience or study, or both, whose opinion is admissible as an aid to the trier of fact.

voir dire examination– the preliminary examination of a juror or a witness to ascertain fitness to act as such.

Chapter 2 The Court System and Dispute Resolution 25

exercise six to eight peremptory challenges.9 A peremptory challenge is an arbitrary challenge that may be used to strike (remove) a juror except for racial reasons.

(B) OPENING STATEMENTS. After the jury is called, the opposing attorneys make their opening statements to the jury. An opening statement, as one lawyer has explained, makes a puzzle frame for the case so jurors can follow the witnesses and place the pieces of the case—the various forms of evidence—within the frame.

(C) THE PRESENTATION OF EVIDENCE. Following the opening statements, the plaintiff then begins to present his case with witnesses and other evidence. A judge rules on the admissibility of evidence. Evidence can consist of documents, testimony, and even physical evidence.

In the case of testimony, the attorney for the plaintiff conducts direct examination of his witnesses during his case, and the defense attorney conducts cross-examination of the plaintiff’s witnesses. The plaintiff ’s attorney can then ask questions again of his witnesses in what is called redirect examination. Finally, the defense attorney may question the plaintiff’s witnesses again in recross-examination. This procedure is followed with all of the plaintiff’s witnesses, and then the defendant presents her case after the plaintiff’s case concludes. During the defendant’s case, the lawyer for the defendant conducts direct examination of the defendant’s witnesses, and the plaintiff’s lawyer can then cross-examine the defendant’s witnesses.

(D) MOTION FOR A DIRECTED VERDICT. A motion for a directed verdict asks the court to grant a verdict because even if all the evidence that has been presented by each side were true, there is either no basis for recovery or no defense to recovery. For example, in some states, the defendant can make a motion for a directed verdict after the plaintiff’s case is concluded. The defendant’s motion argues that even if the plaintiff’s case were 100 percent true, there is no basis in law for recovery. It is also possible for either side to move for a directed verdict after both sides have presented their cases. The defendant is arguing the same position as stated earlier, that there is no basis for recovery even assuming all facts to be true. The plaintiff is arguing that even if everything the defendant presented were 100 percent true, there was nothing in the defense case that challenged the plaintiff’s right to recovery.

(E) SUMMATION. After the witnesses for both parties have been examined and all the evidence has been presented, each attorney makes another address to the jury. These statements are called summations or closing arguments; they summarize the case and suggest that a particular verdict be returned by the jury.

(F) MOTION FOR MISTRIAL. During the course of a trial, when necessary to avoid great injustice, the trial court may declare that there has been a mistrial. The declaration of a mistrial terminates the trial and requires that it start over with a new jury. A mistrial can be declared for jury or attorney misconduct. For Example, if a juror were caught fraternizing with one of the lawyers in the case, objectivity would be compromised and the court would most likely declare a mistrial.

9 The number of peremptory challenges varies from state to state and may also vary within a particular state depending on the type of case. For example, in Arizona, peremptory challenges are unlimited in capital cases.

opening statements– statements by opposing attorneys that tell the jury what their cases will prove.

admissibility– the quality of the evidence in a case that allows it to be presented to the jury.

direct examination– examination of a witness by his or her attorney.

cross-examination– the examination made of a witness by the attorney for the adverse party.

redirect examination– questioning after cross- examination, in which the attorney for the witness testifying may ask the same witness other questions to overcome effects of the cross-examination.

recross-examination–an examination by the other side’s attorney that follows the redirect examination.

directed verdict–a direction by the trial judge to the jury to return a verdict in favor of a specified party to the action.

summation– the attorney address that follows all the evidence presented in court and sums up a case and recommends a particular verdict be returned by the jury.

mistrial–a court’s declaration that terminates a trial and postpones it to a later date; commonly entered when evidence has been of a highly prejudicial character or when a juror has been guilty of misconduct.

26 Part 1 The Legal and Social Environment of Business

Qualcomm filed suit against Broadcom for alleged patent infringement. Broadcom made a discovery request from Qualcomm for copies of e-mail and other correspon- dence among and between Qualcomm employees and others in their industry. Qualcomm lawyers turned over a handful of e-mails but did not turn over 200,000 pages of e-mails, memoranda, and other company documents,

all of which had important information that undercut Qualcomm’s patent infrin- gement claim. In fact, Qualcomm’s legal counsel, while preparing a key Qual- comm witness for her testimony, stripped over 50 pages of e-mails from her email archives. Evaluate the ethics of Qual-

comm’s lawyer [Qualcomm, Inc. v Broadcom, Inc., 539 F Supp 2d 1214 SD Cal 2007]

Why Do We Require Sworn Testimony?

There is a difference between what people say in conversation (and even what com- pany executives say in speeches and reports) and what they are willing to say under oath. Speaking under oath often means that different information and re- collections emerge. The oath is symbolic and carries the penalty of criminal prosecution for perjury if the testimony given is false.

The Wall Street Journal has reported that the testimony of executives in the Microsoft antitrust trial and their statements regarding their business relation- ships outside the courtroom are quite different. For example, the following quotations indicate some dis- crepancies. Eric Benhamou, the chief executive officer (CEO) of Palm, Inc., said:

We believe that the handheld opportunity remains wide open…. Unlike the PC industry, there is no monopoly of silicon, there is no monopoly of software.

However, at the Microsoft trial, another officer of Palm, Michael Mace, offered the following testimony:

We believe that there is a very substantial risk that Microsoft could manipulate its products and its standards in order to exclude Palm from the market- place in the future.

Likewise, Microsoft has taken different positions inside and outside the courtroom. For example, an attorney for Microsoft stated that Microsoft had “zero deployments of its interactive TV middleware products connected to cable systems in the United States.” How- ever, Microsoft’s marketing materials provide as follows:

Microsoft’s multiple deployments around the world now including Charter-show Microsoft TV is ready to deploy now and set the standard for what TV can be.*

Explain why the executives had differing statements. For more information on the Microsoft antitrust cases, go to or

* Rebecca Buckman and Nicholas Kulish, “Microsoft Trial Prompts an Outbreak of Doublespeak,” Wall Street Journal, April 15, 2002, B1, B3.

Chapter 2 The Court System and Dispute Resolution 27

(G) JURY INSTRUCTIONS AND VERDICT. After the summation by the attorneys, the court gives the jurors instructions on the appropriate law to apply to the facts presented. The jury then deliberates and renders its verdict. After the jury verdict, the court enters a judgment. If the jury is deadlocked and unable to reach a verdict, the case is reset for a new trial at some future date.

(H) MOTION FOR NEW TRIAL; MOTION FOR JUDGMENT N.O.V. A court may grant a judgment non obstante veredicto or a judgment n.o.v. (notwithstanding the verdict) if the verdict is clearly wrong as a matter of law. The court can set aside the verdict and enter a judgment in favor of the other party. Perhaps one of the most famous judgments n.o.v. occurred in Boston in 1997 when a judge reversed the murder conviction of nanny Louise Woodward, who was charged with the murder of one of her young charges.

8. Posttrial Procedures (A) RECOVERY OF COSTS/ATTORNEY FEES. Generally, the prevailing party is awarded costs. Costs include filing fees, service-of-process fees, witness fees, deposition transcript costs, and jury fees. Costs do not include compensation spent by a party for preparing the case or being present at trial, including the time lost from work because of the case and the fee paid to the attorney, although lost wages from an injury are generally part of damages.

Attorney fees may be recovered by a party who prevails if a statute permits the recovery of attorney fees or if the complaint involves a claim for breach of contract and the contract contains a clause providing for recovery of attorney fees.

(B) EXECUTION OF JUDGMENT. After a judgment has been entered or all appeals or appeal rights have ended, the losing party must pay that judgment. The winning party can also take steps to execute, or carry out, the judgment. The execution is accomplished by the seizure and sale of the losing party’s assets by the sheriff according to a writ of execution or a writ of possession.

Garnishment is a common method of satisfying a judgment. When the judgment debtor is an employee, the appropriate judicial authority in the state garnishes (by written notice to the employer) a portion of the employee’s wages on a regular basis until the judgment is paid.


Parties can use means other than litigation to resolve disagreements or disputes. Litigation takes significant time and money, so many businesses use alternative methods for resolving disputes. Those methods, which include arbitration, mediation, and several other formats, are enjoying increasing popularity. Figure 2.4 provides an overall view of dispute resolution procedures.

instruction– summary of the law given to jurors by the judge before deliberation begins.

judgment n.o.v.–or non obstante veredicto (notwithstanding the verdict), a judgment entered after verdict upon the motion of the losing party on the ground that the verdict is so wrong that a judgment should be entered the opposite of the verdict.

execution– the carrying out of a judgment of a court, generally directing that property owned by the defendant be sold and the proceeds first be used to pay the execution or judgment creditor.

garnishment– the name given in some states to attachment proceedings.

28 Part 1 The Legal and Social Environment of Business

9. Arbitration In arbitration, arbitrators (disinterested persons selected by the parties to the dispute) hear evidence and determine a resolution. Arbitration enables the parties to present the facts before trained experts familiar with the industry practices that may affect the nature and outcome of the dispute. Arbitration first reached extensive use in the field of commercial contracts and is encouraged as a means of avoiding expensive litigation and easing the workload of courts.10

A number of states have adopted the Uniform Arbitration Act.11 Under this act and similar statutes, the parties to a contract may agree in advance that all disputes arising under it will be submitted to arbitration. In some instances, the contract will name the arbitrators for the duration of the contract. The uniform act requires a written agreement to arbitrate.12

FIGURE 2-4 Dispute Resolution Procedures













10 Warfield v Beth Israel Deaconess Medical Center, Inc., 910 NE2d 317, 454 Mass 390 (2009). Arbitration has existed in the United States since 1920 when New York passed an arbitration statute. For a look at the history of arbitration, see Charles L. Knapp, “Taking Contracts Private: The Quiet Revolution in Contract Law,” 71 Fordham L. Rev. 761 (2002).

11 On August 3, 2000, the National Conference of Commissioners on Uniform State Laws unanimously passed major revisions to the Uniform Arbitration Act (UAA). These revisions were the first major changes in 45 years to the UAA, which is the basis of arbitration law in 49 states, although not all states have adopted it in its entirety. Thirty-five states and the District of Columbia have adopted the 1955 version. Only 13 states have adopted the UAA 2000 revisions. Donald L. Carpo & John B. LaRocco, “A Comparison of Litigation, Arbitration, and Mediation,” 63 Dispute Resolution J. 48 (2008).

12 Fawzy v Fawzy, 973 A2d 347 (NJ 2009).

arbitration– the settlement of disputed questions, whether of law or fact, by one or more arbitrators by whose decision the parties agree to be bound.

Chapter 2 The Court System and Dispute Resolution 29

The Federal Arbitration Act13 provides that an arbitration clause in a contract relating to an interstate transaction is valid, irrevocable, and enforceable. When a contract subject to the Federal Arbitration Act provides for the arbitration of disputes, the parties are bound to arbitrate in accordance with the federal statute even if the agreement to arbitrate would not be binding under state law.

(A) MANDATORY ARBITRATION. In contrast with statutes that merely regulate arbitration when it is selected voluntarily by the parties, some statutes require that certain kinds of disputes be submitted to arbitration. In some states, by rule or statute, the arbitration of small claims is required.

(B) SCOPE OF ARBITRATION. When arbitration is required by statute, the terms of the statute will define the scope of the arbitration. When the parties have voluntarily agreed to arbitrate, their agreement will control the scope of the dispute. Because arbitration is now favored, any doubt as to its scope will be decided in favor of arbitration by the arbitrator.14

(C) FINALITY OF ARBITRATION. Most parties provide, within their arbitration agree- ments, that the decision of the arbitrator will be final. Such a clause is binding on the parties, even when the decision seems to be wrong, and can be set aside only if there is clear proof of fraud, arbitrary conduct, or a significant procedural error.15

If the arbitration is mandatory under statute or rule, the losing party generally may appeal such arbitration to a court.16 The appeal proceeds just as though there had never been any prior arbitration. This new court proceeding is called a trial de novo and is necessary to preserve the constitutional right to a jury trial. As a practical matter, however, relatively few appeals are taken from arbitration decisions.

10. Mediation In mediation, a neutral person acts as a messenger between opposing sides of a dispute, carrying to each side the latest settlement offer made by the other. The mediator has no authority to make a decision, although in some cases the mediator may make suggestions that might ultimately be accepted by the disputing parties.

The use of mediation has the advantage of keeping discussions going when the disputing parties have developed such fixed attitudes or personal animosity that direct discussion between them has become impossible.

11. MedArb In this new form of alternative dispute resolution (ADR), the arbitrator is also empowered to act as a mediator. Beyond just hearing a case, the arbitrator acts as a messenger for the parties on unresolved issues.

13 9 USC § 114 et. seq. 14 First Options v Kaplan, 514 US 938 (1995). See also Hialeah Automotive, LLC v Basulto— So2d —, 2009 WL 187584

(Fla App). 15 Apache Bohai Corp. LDC v Texaco China BV, 480 F.3d 397 (CA 5 2007). 16 U.S. v Park Place Associates, 563 F3d 907 (CA 9 2009).

trial de novo–a trial required to preserve the constitutional right to a jury trial by allowing an appeal to proceed as though there never had been any prior hearing or decision.

mediation– the settlement of a dispute through the use of a messenger who carries to each side of the dispute the issues and offers in the case.

30 Part 1 The Legal and Social Environment of Business

12. Reference To a Third Person Many types of transactions provide for reference to a third person, in which a third person or a committee makes an out-of-court determination of the rights of persons. For Example, employees and an employer may have agreed as a term of the employment contract that claims of employees under retirement plans will be decided by a designated board or committee. In a sales contract, the seller and buyer can select a third person to determine the price to be paid for goods. Construction contracts often include a provision for disputes to be referred to the architect in charge of the construction with the architect’s decision being final.

These referrals often eliminate the disputes or pursuit of remedies. For Example, fire insurance policies commonly provide that if the parties cannot agree on the amount of the loss, each will appoint an appraiser, the two appraisers will appoint a third appraiser, and the three will determine the amount of the loss the insurer is required to pay.

13. Association Tribunals Many disputes never reach the courts because both parties to a dispute belong to a group or an association, and the association tribunal created by the group or association disposes of the matter. Trade associations commonly require their members to employ out-of-court methods of dispute settlement. For Example, the National Association of Home Builders requires its member builders to employ arbitration. The National Automobile Dealers Association provides for panels to determine warranty claims of customers. The decision of such panels is final as to the builder or dealer, but the consumer can still bring a regular lawsuit after losing before the panel. Members of an association must use the association tribunal, which means they cannot bypass the association tribunal and go directly to a law court.17

14. Summary Jury Trial A summary jury trial is a dry-run or mock trial in which the lawyers present their claims before a jury of six persons. The object is to get the reaction of a sample jury. No evidence is presented before this jury, and it bases its opinion solely on what the lawyers state. The determination of the jury has no binding effect, but it has value in that it gives the lawyers some idea of what a jury might think if there were an actual trial. This type of ADR has special value when the heart of a case is whether something is reasonable under all circumstances. When the lawyers and their clients see how the sample jury reacts, they may moderate their positions and reach a settlement.

15. Rent-A-Judge Under the rent-a-judge plan, the parties hire a judge to hear the case. In many states, the parties voluntarily choose the judge as a “referee,” and the judge acts under a statute authorizing the appointment of referees. Under such a statute, the referee hears all evidence just as though there were a regular trial, and the rented judge’s determination is binding on the parties unless reversed on appeal if such an appeal

17 The securities industry follows this process as well.

reference to a third person– settlement that allows a nonparty to resolve the dispute.

association tribunal–a court created by a trade association or group for the resolution of disputes among its members.

summary jury trial–a mock or dry-run trial for parties to get a feel for how their cases will play to a jury.

rent-a-judge plan–dispute resolution through private courts with judges paid to be referees for the cases.

Chapter 2 The Court System and Dispute Resolution 31

(like a court trial) is permitted under the parties’ agreement. In some jurisdictions, the parties can agree that the decision of the judge selected as referee will be final.

16. Minitrial When only part of a case is disputed, the parties may stay within the framework of a lawsuit but agree that only the disputed issues will be taken to trial and submitted to a jury. When there is no real dispute over the liability of the defendant but the parties disagree as to the damages, the issue of damages alone may be submitted to the jury. This shortened trial is often called a minitrial. A minitrial may use a retired judge to listen to the evidence on just the disputed issues and decide the case. The agreement of the parties for the minitrial may specify whether this decision will be binding on the parties. As a practical matter, the evaluation of a case by a neutral person often brings the opposing parties together to reach a settlement.

17. Judicial Triage The court systems, experiencing heavy caseloads, now practice judicial triage. Judges examine cases from a timeliness perspective. For example, in asbestos cases, judges are now evaluating plaintiffs on the basis of “how sick they are” and expediting trials for those plaintiffs who are the most ill from the alleged effects of asbestos that are the subject of their suits. The trials of those who do not have medical documentation of current illness are postponed and placed on the inactive docket until the court can get to them or until the plaintiffs become sick. Using triage, one judge has been able to bring to trial 40 percent of all asbestos cases brought since 1992.18

Referred to as the “Google Mistrial,” a federal judge in Florida declared a mistrial after a juror told that judge that he had been doing research on the Internet on the drug trial in which he was serving When the judge declared the mistrial, eight other jurors confessed that they had been doing the same thing.

Judges have long warned jurors about using outside sources, including the Internet, but BlackBerries and iPhones have proven to be mighty tempting for jurors. Some jurors are using Facebook to announce when verdicts are coming. One juror even looked up evi- dence that had been excluded by the judge in the case. When asked why he violated the judge’s order, the juror said simply, “Well, I was curious.”

A judge in Arkansas is reviewing a request for a reversal of a $12.6 million jury verdict against a company

from one of the company’s lawyers based on the court’s discovery that one of the jurors was using Twitter to send out post- ings about how the trial was proceeding. An excerpt from the posting follows:

“Oh, and nobody buy Stoam. It’s bad mojo and they’ll probably

cease to Exist now that their wallet is $12m lighter … So, Jonathan, what did you do today? Oh nothing really, I just gave away TWELVE MILLION DOLLARS of somebody else’s money.”*

What is the problem with jurors using these electronic tools during their cases?

18 Susan Warren, “Swamped Courts Practice Plaintiff Triage,” Wall Street Journal, January 27, 2003, B1, B3.

* John Schwartz, “As Jurors Turn to Google and Twitter, Mistrials Are Popping Up,” New York Times, March 18, 2009, A1.

minitrial–a trial held on portions of the case or certain issues in the case.

judicial triage–court management tool used by judges to expedite certain cases in which time is of the essence, such as asbestos cases in which the plaintiffs are gravely ill.

32 Part 1 The Legal and Social Environment of Business

18. Contract Provisions The parties’ contract may pave the way for the settlement of future disputes by containing clauses requiring the parties to use one of the procedures already described. In addition, contracts may provide that no action may be taken until after the expiration of a specified cooling-off period. Contracts may also specify that the parties should continue in the performance of their contract even though a dispute between them still exists.

19. Disposition of Complaints and Ombudsmen In contrast with the traditional and alternative procedures for resolving disputes are the procedures aimed at removing the grounds for a complaint before it develops into a dispute that requires resolution. For Example, the complaint department in a department store is often be able to iron out a difficulty before the customer and the store are locked in an adversarial position that could end in a lawsuit. Some states have a public official, called an ombudsman, who receive complaints and then make recommendations for improvements.

Class Action (1991) (R)

Here is a good movie to illustrate discovery and the ethics of withholding paperwork.

Twelve Angry Men (1957) G

A movie that shows the jury process, rights of parties in court, jury instructions, and group think, all wrapped up in terrific dialogue.

Check out LawFlix at to access movie clips that illustrate business law concepts.



Courts have been created to hear and resolve legal disputes. A court’s specific power is defined by its jurisdiction. Courts of original jurisdiction are trial courts, and courts that review the decisions of trial courts are appellate courts. Trial courts may have general jurisdiction to hear a wide range of civil and criminal matters, or they may be courts of limited jurisdiction—such as a probate court or the Tax Court— with the subject matter of their cases restricted to certain areas.

ombudsman–a government official designated by a statute to examine citizen complaints.

Chapter 2 The Court System and Dispute Resolution 33

The courts in the United States are organized into two different systems: the state and federal court systems. There are three levels of courts, for the most part, in each system, with trial courts, appellate courts, and a supreme court in each. The federal courts are federal district courts, federal courts of appeals, and the U.S. Supreme Court. In the states, there may be specialized courts, such as municipal, justice, and small claims courts, for trial courts. Within the courts of original jurisdiction, there are rules for procedures in all matters brought before them. A civil case begins with the filing of a complaint by a plaintiff, which is then answered by a defendant. The parties may be represented by their attorneys. Discovery is the pretrial process used by the parties to find out the evidence in the case. The parties can use depositions, interrogatories, and document requests to uncover relevant information.

The case is managed by a judge and may be tried to a jury selected through the process of voir dire, with the parties permitted to challenge jurors on the basis of cause or through the use of their peremptory challenges. The trial begins following discovery and involves opening statements and the presentation of evidence, including the direct examination and cross-examination of witnesses. Once a judgment is entered, the party who has won can collect the judgment through garnishment and a writ of execution.

Alternatives to litigation for dispute resolution are available, including arbitration, mediation, MedArb, reference to a third party, association tribunals, summary jury trials, rent-a-judge plans, minitrials, judicial triage, and the use of ombudsmen. Court dockets are relieved and cases consolidated using judicial triage, a process in which courts hear the cases involving the most serious medical issues and health conditions first. Triage is a blending of the judicial and alternative dispute resolution mechanisms.

LEARNING OUTCOMES After studying this chapter, you should be able to clearly explain:

A. THE COURT SYSTEM LO.1 Explain the federal and state court systems

See Figure 2-1 on p. 19 and accompanying text. See Figure 2-3 on p. 21 and accompanying text.

B. COURT PROCEDURE LO.2 Describe court procedures

See the discussion of steps in litigation that begins on p. 23. See the For Example discussion of the Martha Stewart voir dire example on p. 25.

C. ALTERNATIVE DISPUTE RESOLUTION (ADR) LO.3 List the forms of alternative dispute resolution and distinguish among them

See the discussion of arbitration that begins on p. 29. See the discussion of other forms of ADR, mediation, minitrials, rent-a- judge, MedArb, judicial triage, and referral to a third party that begins on p. 28. See the discussion of employee and employer referrals of disputes to a designated board or committee on p. 31.

34 Part 1 The Legal and Social Environment of Business


admissibility affirm answer appeal appellate jurisdiction arbitration association tribunal attorney-client privilege complaint counterclaim court cross-examination defendant demurrer deposition direct examination directed verdict discovery en banc execution expert witness

federal district courts garnishment general jurisdiction impeach instructions interrogatories judge judgment n.o.v. judicial triage jurisdiction jury limited jurisdiction mediation minitrial mistrial motion for summary

judgment motion to dismiss ombudsman opening statements original jurisdiction

plaintiff pleadings process prosecutor recross-examination redirect examination reference to a third person remand rent-a-judge plan requests for production of

documents reverse reversible error small claims courts special jurisdiction subject matter jurisdiction summary jury trial summations trial de novo voir dire examination writ of certiorari

QUESTIONS AND CASE PROBLEMS 1. List the steps in a lawsuit. Begin with the filing of the complaint, and explain

the points at which there can be a final determination of the parties’ rights in the case.

2. Distinguish between mandatory and voluntary arbitration. What is the difference between mediation and arbitration?

3. Ralph Dewey has been charged with a violation of the Electronic Espionage Act, a federal statute that prohibits the transfer, by computer or disk or other electronic means, of a company’s proprietary data and information. Ralph is curious. What type of court has jurisdiction? Can you determine which court?

4. Jerry Lewinsky was called for jury duty. When voir dire began, Jerry realized that the case involved his supervisor at work. Can Jerry remain as a juror on the case? Why or why not?

5. Carolyn, Elwood, and Isabella are involved in a real estate development. The development is a failure, and Carolyn, Elwood, and Isabella want to have their rights determined. They could bring a lawsuit, but they are afraid the case is so complicated that a judge and jury not familiar with the problems of real estate development would not reach a proper result. What can they do?

Chapter 2 The Court System and Dispute Resolution 35

6. Larketta Randolph purchased a mobile home from Better Cents Home Builders, Inc., and financed her purchase through Green Tree Financial Corporation. Ms. Randolph signed a standard form contract that required her to buy Vendor’s Single Interest insurance, which protects the seller against the costs of repossession in the event of default. The agreement also provided that all disputes arising from the contract would be resolved by binding arbitration. Larketta found that there was an additional $15 in finance charges that were not disclosed in the contract. She and other Green Tree customers filed a class- action suit to recover the fees. Green Tree moved to dismiss the suit because Larketta had not submitted the issue to arbitration. Larketta protests, “But I want the right to go to court!” Does she have that right? What are the rights of parties under a contract with an arbitration clause? [Green Tree Financial Corp. v Randolph, 531 US 79]

7. John Watson invested $5,000,000 in SmartRead, Inc., a company that was developing an electronic reading device. Within a few months, the $5,000,000 was spent but SmartRead never developed the reading device. John filed suit against directors of SmartRead for their failure to supervise SmartRead’s CEO in his operation of the company. The directors used an expert on corporate governance to testify that the directors had done all that they could to oversee the company. The expert did not disclose that he had served as a director of a company and had been found to be negligent in his role there and had been required to pay $370,000 to shareholders. The directors won the case. Is there anything Watson can do?

8. Indicate whether the following courts are courts of original, general, limited, or appellate jurisdiction:

a. Small claims court

b. Federal bankruptcy court

c. Federal district court

d. U.S. Supreme Court

e. Municipal court

f. Probate court

g. Federal court of appeals

9. The Nursing Home Pension Fund filed suit against Oracle Corporation alleging that Larry Ellison, the company’s CEO, misled investors in 2001 about the true financial condition of the company. During the time of the alleged misrepresentation, Mr. Ellison was working with a biographer on his life story and there are videotapes of Mr. Ellison’s interviews with his biographer as well as e-mails between the two that discuss Oracle. Could the Nursing Home Pension Fund have access to the tapes and e-mails? Explain how. [Nursing Home Pension Fund, Local 144 v Oracle Corp., 380 F3d 1226 (CA 9)]

10. Mostek Corp., a Texas corporation, made a contract to sell computer-related products to North American Foreign Trading Corp., a New York corporation.

36 Part 1 The Legal and Social Environment of Business

North American used its own purchase order form, on which appeared the statement that any dispute arising out of an order would be submitted to arbitration, as provided in the terms set forth on the back of the order. Acting on the purchase order, Mostek delivered almost all of the goods but failed to deliver the final installment. North American then demanded that the matter be arbitrated. Mostek refused to do so. Was arbitration required? [Application of Mostek Corp., 120 App Div 2d 383, 502 NYS2d 181]

11. Ceasar Wright was a longshoreman in Charleston, South Carolina, and a member of the International Longshoremen’s Association (AFL-CIO). Wright used the union hiring hall. The collective bargaining agreement (CBA) of Wright’s union provides for arbitration of all grievances. Another clause of the CBA states: “It is the intention and purpose of all parties hereto that no provision or part of this Agreement shall be violative of any Federal or State Law.”

On February 18, 1992, while Wright was working for Stevens Shipping and Terminal Company (Stevens), he injured his right heel and back. He sought permanent compensation from Stevens and settled his claims for $250,000 and another $10,000 in attorney fees. Wright was also awarded Social Security disability benefits.

In January 1995, Wright, whose doctor had approved his return to work, returned to the hiring hall and asked to be referred for work. Wright did work between January 2 and January 11, 1995, but when the companies realized Wright had been certified as permanently disabled, they deemed him not qualified for longshoreman work under the CBA and refused to allow him to work for them.

Wright did not file a grievance under the union agreement but instead hired a lawyer and proceeded with a claim under the Americans with Disabilities Act. The district court dismissed the case because Wright had failed to pursue the grievance procedure provided by the CBA. Must Wright pursue the dispute procedure first, or can he go right to court on the basis of his federal rights under the Americans with Disabilities Act? [Wright v Universal Maritime Service Corp., 525 US 70]

12. Winona Ryder was arrested for shoplifting from Saks Fifth Avenue in California. One of the members of the jury panel for her trial was Peter Guber, a Hollywood executive in charge of the production of three films in which Ms. Ryder starred, including Bram Stoker’s Dracula, The Age of Innocence, and Little Women. If you were the prosecuting attorney in the case, how could you discover such information about this potential juror, and what are your options for excluding him from selection? [Rick Lyman, “For the Ryder Trial, a Hollywood Script,” New York Times, November 3, 2002, SL-1]

13. What is the difference between the role of a trial court and the role of an appellate court? What functions do they perform, and how do they perform them?

14. Martha Simms is the plaintiff in a contract suit she has brought against Floral Supply, Inc., for its failure to deliver the green sponge Martha needed in

Chapter 2 The Court System and Dispute Resolution 37

building the floral designs she sells to exclusive home decorators. Martha had to obtain the sponge from another supplier and was late on seven deliveries. One of Martha’s customers has been called by Martha’s lawyer as a witness and is now on the witness stand, testifying about Martha’s late performance and the penalty she charged. The lawyer for Floral Supply knows that Martha’s customer frequently waives penalties for good suppliers. How can Floral Supply’s lawyer get that information before the jury?

38 Part 1 The Legal and Social Environment of Business

Chapter 3


A. What is Business Ethics?





B. Why is Business Ethics Important?





C. How to Recognize and Resolve Ethical Dilemmas



Each day businesspeople work together on contracts and projects. Theircompletion of the work is partially the result of the laws that protect contractrights. Much of what businesspeople do, however, is simply a matter of their word. Executives arrive at a 9:00 A.M. meeting because they promised they would be

there. An employee meets a deadline for an ad display board because she said she would.

Business transactions are completed through a combination of the values of the parties

and the laws that reflect those values and the importance of one’s word in business.

This chapter takes you behind the rules of law to examine the objectives in

establishing rules for business conduct. Both social forces and business needs

contribute to the standards that govern businesses and their operations.

A. WHAT IS BUSINESS ETHICS? Ethics is a branch of philosophy dealing with values that relate to the nature of human conduct and values associated with that conduct. Balancing the goal of profits with the values of individuals and society is the focus of business ethics. Some economists make the point that insider trading is an efficient way to run that market. To an economist, inside information allows those with the best information to make the most money. This view ignores some issues: What about those who trade stock who do not have access to that information? Is the philosophy fair to them? What will happen to the stock market if investors perceive there is not a level playing field? In the U.S. Supreme Court decision United States v O’Hagan1

on insider trading, Justice Ruth Ginsburg noted, “Investors likely wouldn’t invest in a market where trading based on misappropriated nonpublic information is unchecked.” The field of business ethics deals with the balance between society’s values and the need for businesses to remain profitable.

1. The Law as the Standard for Business Ethics Philosophers debate the origin of moral and ethical standards as well as which of those standards should be applied. One view of ethics is simply following what codified or positive law requires. The test of whether an act is legal is a common moral standard used frequently in business. Codified law, or law created by governmental authority, is used as the standard for ethical behavior. Absent illegality, all behavior is ethical under this simple standard. The phrase “AS IS,” on a contract (see Chapter 25 for further discussion), means by law that there are no warranties for the goods being sold. For Example, if a buyer purchases a used car and the phrase “AS IS” is in the contract, the seller has no legal obligation, in most states, if the transmission falls apart the day after the buyer’s purchase. Following a positive law standard, the seller who refuses to repair the transmission has acted ethically. However, ethical standards are different.We know there was no legal obligation to fix the transmission, but was it fair that the car fell apart the day after it was purchased?

1 521 US 657 (1997).

ethics–a branch of philosophy dealing with values that relate to the nature of human conduct and values associated with that conduct.

business ethics–balancing the goal of profits with values of individuals and society.

positive law– law enacted and codified by governmental authority.

40 Part 1 The Legal and Social Environment of Business

2. The Notion of Universal Standards for Business Ethics Another view of ethics holds that standards exist universally and cannot be changed or modified by law. In many cases, universal standards stem from religious beliefs. In some countries today, the standards for business are still determined by religious tenets. Natural law imposes higher standards of behavior than those required by positive law and they must be followed even if those higher standards run contrary to codified law. For Example, in the early nineteenth century when slavery was legally permissible in the United States, a positive law standard supported slavery. However, slavery violates the natural law principle of individual freedom and would be unethical. Civil disobedience is the remedy natural law proponents use to change positive law.

Former Supreme Court Justice Sandra Day O’Connor, who was second in her class at Stanford Law School (the late Chief Justice William Rehnquist was first), was offered a job as a receptionist for a law firm while her male classmates were hired as attorneys. At that time, no law prohibited discrimination against women, so law firms’ hiring practices, using only a positive law standard, were ethical. However, if the natural law standard of equality is applied, the refusal to hire Sandra O’Connor as a lawyer, a position for which she was qualified, was a violation of the natural law principle of equality and unethical.

3. The Standard of Situational Business Ethics or Moral Relativism

Situational ethics or moral relativism is a flexible standard of ethics that considers circumstances and motivation before attaching the label of right or wrong to conduct. The classic example of moral relativism: Would it be unethical to steal a loaf of bread to feed a starving child? A question a Florida court faced was whether to go forward with the prosecution for arson of a man who set fire to an abandoned property in his neighborhood that was used as a crack-cocaine house. In both cases, the law has been broken. The first crime is theft, and the second crime is arson. Neither person, either the bread thief or the arsonist, denied committing the crime. The issue in both cases is not whether the crime was committed but whether the motivation and circumstances excuse the actions and eliminate the punishment. An employee embezzles money from her employer because she is a single parent trying to make ends meet. Was her conduct unethical? The conduct is illegal, but moral relativism would consider the employee’s personal circumstances in determining whether it is ethical.

Businesses use moral relativism standards frequently in their international operations. Bribery is illegal in the United States, but, as many businesses argue, it is an accepted method of doing business in other countries.2 The standard of moral relativism is used to allow behavior in international business transactions that would be a violation of the law in the United States. For Example, Google and other Internet service providers have agreed to do business in China despite the

2 The United States, Mexico, Korea, and most of the countries in the European Union have joined together and signed a resolution denouncing bribery, specifically noting that its practice is neither legally nor culturally accepted in their nations.

natural law–a system of principles to guide human conduct independent of, and sometimes contrary to, enacted law and discovered by man’s rational intelligence.

civil disobedience– the term used when natural law proponents violate positive law.

situational ethics–a flexible standard of ethics that permits an examination of circumstances and motivation before attaching the label of right or wrong to conduct.

moral relativism– takes into account motivation and circumstance to determine whether an act was ethical.

Chapter 3 Business Ethics, Social Forces, and the Law 41

restrictions the Chinese government places on the use of the Internet and the content of search engines. Such restrictions in the United States would be an unconstitutional violation of our First Amendment. In China, however, government control of information is legal. Google and others testified before Congress that some entry, however restricted, was better for the Chinese people than no access at all. Their decision weighed the conflicting values and concluded that they would use the standard of honoring the law of China despite the censorship.

4. The Business Stakeholder Standard of Behavior Businesses have different constituencies, referred to as stakeholders, often with conflicting goals for the business. Shareholders, for example, may share economists’ view that earnings, and hence dividends, should be maximized. Members of the community where a business is located are also stakeholders in the business and have an interest in preserving jobs. The employees of the business itself are stakeholders and certainly wish to retain their jobs. Balancing the interests of these stakeholders is a standard used in resolving ethical dilemmas in business.

As Figure 3-1 indicates, stakeholder analysis requires a view of an issue from different perspectives in the light of day. Stakeholder analysis requires measure- ment of the impact of a decision on various groups but also requires that public

Corrupt Climates: Good or Bad for Business?

As you examine the following list of countries, those in the column labeled “Least Corrupt” (countries in which gov- ernment officials are least likely to accept bribes) and those in the column marked

“Most Corrupt” (countries in which gov- ernment officials are most likely to accept bribes), can you comment on the business climates in them?

Least Corrupt (Least Likely to Accept Bribes) Most Corrupt (Most Likely to Accept Bribes)

• Denmark • Luxembourg • Somalia • Zimbabwe

• New Zealand • Austria • Myanmar • Uzbekistan

• Sweden • Hong Kong • Iraq • Turkmenistan

• Singapore • Germany • Haiti • Kyrgyzstan

• Finland • Norway • Afghanistan • Cambodia

• Switzerland • Ireland • Sudan • Venezuela

• Iceland • United Kingdom • Guinea • Sierra Leone

• Netherlands • Belgium • Chad • Guinea-Bissou

• Australia • Japan • Equatorial Guinea • Gambia

• Canada • USA • Congo, Democratic Republic • Congo Republic

*From 2008 Transparency International annual survey,

stakeholders– those who have a stake, or interest, in the activities of a corporation; stakeholders include employees, members of the community in which the corporation operates, vendors, customers, and any others who are affected by the actions and decisions of the corporation.

stakeholder analysis– the term used when a decision maker views a problem from different perspectives and measures the impact of a decision on various groups.

42 Part 1 The Legal and Social Environment of Business

disclosure of that decision be defensible. The questions provide insight in a variety of situations and ethical dilemmas. For example, if a lender gives a loan to a debtor without checking income, the lapse seems harmless. But, suppose someone purchases that loan believing the debtor met the standards and the lender verified income. The debtor defaults on the loan. The purchaser has to write down or write off the loan. If enough loans that were not documented go into default, you create the kind of ripples in the real estate and stock markets that occurred in late 2008. Stakeholder analysis helps you to see that the decisions we make in business are not made in isolation or limited in their impact.

In other ethical dilemmas, a business faces the question of taking voluntary action or simply complying with the law. Some experts maintain that the shareholders’ interest is paramount in resolving these conflicts among stakeholders. Others maintain that a business must assume some responsibility for social issues and their resolution. Economist Milton Friedman expresses his views on resolving the conflicts among stakeholders as follows:

A corporate executive’s responsibility is to make as much money for the shareholders as possible, as long as he operates within the rules of the game. When an executive decides to take action for reasons of social responsibility, he is taking money from someone else—from the stockholders, in the form of lower dividends; from the employees, in the form of lower wages; or from the consumer, in the form of higher prices. The responsibility of the corporate executive is to fulfill the terms of his contract. If he can’t do that in good conscience, then he should quit his job and find another way to do good. He has the right to promote what he regards as desirable moral objectives only with his own money.3

Many businesses feel an obligation to solve social problems because those problems affect their stakeholders. For example, programs such as flextime, job sharing, and telecommuting as work are not legal requirements but voluntary options businesses offer their employees to accommodate family needs. These

FIGURE 3-1 Guidelines for Analyzing a Contemplated Action










3 “Interview: Milton Friedman,” Playboy, February 1973. Ó1973 Playboy.

Chapter 3 Business Ethics, Social Forces, and the Law 43

options are a response to larger societal issues surrounding children and their care but may also serve as a way to retain a quality workforce that is more productive without the worry of poor child care arrangements.

Some businesses are also involved in their communities through employees’ volunteer work and companies’ charitable donations. For example, Bill Gates, the CEO of Microsoft who is ranked as the richest man in the United States, in 2003 pledged $3 billion for fighting AIDS and providing childhood vaccine programs around the world. In 2008, corporations gave a total of $15.6 billion to charity. Overall charitable giving in the United States in 2008 reached over $300 billion for the first time. Many companies also provide support for employees to participate in volunteer programs in their communities.

B. WHY IS BUSINESS ETHICS IMPORTANT? Ethics and values represent an important part of business success. Business ethics is important for more than the simple justification that “it’s the right thing to do.” This section covers the significance of ethics in business success.

5. The Importance of Trust Capitalism succeeds because of trust. Investors provide capital for a business because they believe the business will provide a return on their investment. Customers are willing to purchase products and services from businesses because they believe the businesses will honor their commitments to deliver quality and then stand behind their product or service. Businesses are willing to purchase equipment and hire employees on the assumption that investors will continue to honor their commitment to furnish the necessary funds and will not withdraw their promises or funds. Business investment, growth, and sales are a circle of trust. Although courts provide remedies for breaches of agreements, no economy could grow if it were

Rapper Lil Wayne used lyrics from the Rolling Stones’ 1965 song, “Playing With Fire,” in his “Playing With Fire” song that was part of his The Carter III CD. Abkco Music filed an infringement suit against Lil Wayne for using the lyrics after it had denied him permission. Abkco was going to grant permission to Lil until it read all of the song’s lyrics, described as “explicit, sexist, and offensive.” The

suit was settled when Lil Wayne agreed to remove the song from the CD and from iTunes. The Rolling Stones did not seek damages, only that the song be removed. Why did Abkco and the Rolling Stones take this position? Who are the stakeholders? Are there any constitutional issues here?

Source: Ethan Smith, “Rapper to Pull Song in Copyright Fight,” Wall Street Journal, January 30, 2009, B8.

44 Part 1 The Legal and Social Environment of Business

based solely on positive law and court-mandated performance. It is the reliance on promises, not the reliance on litigation, that produces good business relationships.

6. Business Ethics and Financial Performance Studies centering on a business’s commitment to values and its financial performance suggest that those with the strongest value systems survive and do so successfully. According to the book Building and Growing a Business Through Good Times and Bad by Louis Grossman and Marianne Jennings,4 an in-depth look at companies with 100 years of consistent dividends produced a common thread: the companies’ commitment to values. All firms studied had focused on high standards for product quality, employee welfare, and customer service.

Poor value choices do have an effect on financial performance. A study of the impact of just breaches of federal law by companies showed that for five years after their regulatory or legal misstep, these companies were still struggling to recover the financial performances they had achieved prior to their legal difficulties.5

Over the past five years, there have been devastating stories of companies’ fates after ethical lapses. After Enron announced that it would restate its income because it had been spinning off its debt obligations into off-the-book-entities, its price per share dropped from $83 on January 14, 2001, to $0.67 on January 14, 2002.6 By the time former Enron CEO Jeffrey Skilling and its former chairman, the late Kenneth Lay, were convicted of multiple federal felonies, Enron stock was trading at $0.15 per share, a figure that was up four cents from the pre-verdict value of $0.11. Columbia Health Care’s share price dropped 58 percent and it experienced a 93 percent drop in earnings after it was charged with overbilling for Medicare reimbursements. Its share price dropped from $40 to $18. The nation’s largest hospital chain had to spin off 100 hospitals and has paid record fines to settle the charges.7 When the subprime lender New Century Financial announced that it was finally writing down all the subprime loans it had made that had gone into default but that it had been concealing, it was forced to declare bankruptcy because it was insolvent. On January 1, 2007, New Century had $1.75 billion in market capitalization, but by the middle of March, that figure was $55 million and its stock was delisted by the New York Stock Exchange.

Insurance broker Marsh & McLennan paid $850 million to former clients to settle price-fixing charges brought by then- New York Attorney General Eliot Spitzer. The 134-year-old company saw a drop in both its earnings (64 percent) and its share price (40 percent).8 The financial crunch resulted in 3,000 employees losing their jobs. AIG, the insurance giant, paid $1.64 billion, the largest penalty ever by a U.S. company, to settle charges that it smoothed its earnings over time. The fine came after the company was forced to reduce its reported earnings by $1.3 billion.9 The company also issued an apology as part of the settlement: “Providing incorrect information to the investing public and regulators was wrong and is

4 Greenwood Press (2002). 5 Melinda S. Baucus and David A. Baucus, “Paying the Piper: An Empirical Examination of Longer-Term Financial

Consequences of Illegal Corporate Behavior,” 40 Academic Management Journal 129 (1997). 6 From stock price chart, 7 Lucette Lagnado, “Columbia/HCA Warns of Profit Decline,” Wall Street Journal, September 10, 1987, A3. 8 Ian McDonald, “After Spitzer Probe, Marsh CEO Tries Corporate Triage,” Wall Street Journal, August 29, 2005 A1, A5. 9 Ian McDonald and Liam Pleven, “AIG Reaches Accord with Regulators, Stock Rises But May Still Be a Bargain,” Wall

Street Journal, February 10, 2006, C1, C4.

Chapter 3 Business Ethics, Social Forces, and the Law 45

against the values of our current leadership and employees.”10 Its $73 share price dropped to $50 before the financial reporting allegations were settled. But AIG continued to underestimate its needed reserves and losses for the subprime mortgage market it had insured. By the fall of 2008, AIG had to be rescued by the federal government with a funds bailout. The company continues to struggle as its dependence on federal funding draws attention to all of its activities.

7. The Importance of A Good Reputation Richard Teerlink, the CEO of Harley-Davidson, once said, “A reputation, good or bad, is tough to shake.11 A breach of ethics is costly to a firm not only in the financial sense of drops in earnings and possible fines. A breach of ethics also often carries with it a lasting memory that affects the business and its sales for years to come. For Example, the Peanut Corporation of America had to declare bankruptcy in 2009 after government officials discovered that its plant was the source of salmonella poisonings among those customers who had eaten peanut products that used Peanut Corporation’s product as their base. Records showed that Peanut Corporation continued to produce the product even after salmonella warnings and questions arose. The company’s name and image became so damaged that it could not continue to make sales. When an ethical breach occurs, businesses lose that component of trust important to customers’ decisions to buy and invest.

8. Business Ethics and Business Regulation: Public Policy, Law, and Ethics

When business behavior results in complaints from employees, investors, or customers, laws or regulations are often used to change the behavior. For Example, the bankruptcy of Lehman Brothers, the near-collapse of Bear Stearns, and the losses

In March 2009, after it received govern- ment assistance, AIG announced the pay- ment of $100 million in bonuses to various executives and managers in the company. There was a great hue and cry from regulators, legislators, and the public. How- ever, AIG maintained it was contractually obligated to pay the bonuses. For a time, AIG had to cover

its name on its New York office building because of public protests. The executives who received the bonuses received death threats. Evaluate the ethical issues related to the bonus payments. Evaluate the ethical issues in the public response to those bonuses. Be sure to discuss AIG’s argument

on the legal requirements for the bonuses.

10 Gretchen Morgenson, “AIG Apologizes and Agrees to $1.64 Billion Settlement,” New York Times, February 10, 2006, C1, C5.

11 David K. Wright, The Harley-Davidson Motor Co.: An Official Ninety-Year History (Milwaukee: Motorbook International, 1993).

46 Part 1 The Legal and Social Environment of Business

at Merrill Lynch and AIG in 2008-2009 all resulted from the subprime mortgage financial derivative investment market, a market that had previously been a relatively regulation-free environment. The companies had billions of dollars of exposure because of their sales and purchases of financial instruments that were tied to the subprime mortgage market that ultimately resulted in high rates of foreclosure and nearly worthless loans. Congress, the Securities and Exchange Commission (SEC), and the Federal Reserve all stepped in to regulate virtually all aspects of mortgage transactions, including the lenders and others who were involved in packaging the loans into financial products.

Confusion among consumers about car leasing and its true costs and the fees applicable at the end of the lease terms caused the Federal Reserve to expand its regulation of credit to car leases. Figure 3-2 depicts the relationships among ethics, the social forces of customers and investors, and the laws that are passed to remedy the problems raised as part of the social forces movement.

From the nutrition facts that appear on food packages to the type of pump at the gas station, government regulation of business activity is evident. Legislation and regulation are responses to activities of businesses that are perfectly legal but raise questions of fairness that cause customer and investor protests.

Businesses that act voluntarily on the basis of value choices often avoid the costs and the sometimes arbitrariness of legislation and regulation. Voluntary change by businesses is less costly and is considered less intrusive.

Businesses that respond to social forces and the movements of the cycle of societal interaction often gain a competitive advantage. Businesses that act irresponsibly and disregard society’s views and desire for change speed the transition from value choice to enforceable law. Businesses should watch the cycle of social forces and follow trends there to understand the values attached to certain activities and

FIGURE 3-2 The Endless Cycle of Societal Interaction





Chapter 3 Business Ethics, Social Forces, and the Law 47

responses. These values motivate change either in the form of voluntary business activity or legislation. All values that precipitate change have one of several basic underlying goals. These underlying goals are discussed in the following sections.

(A) PROTECTION OF THE STATE. A number of laws exist today because of the underlying goal or value of protection of the state. Laws that condemn treason are examples of laws passed to preserve the government of the state. Another less dramatic set of laws offering protection to the state are the tax codes, which provide authority for collecting taxes for the operation of government facilities and enforcement agencies. The U.S Patriot Act and airport security regulations are also examples of government programs and regulations created with the protection and security of the state as the goal.

(B) PROTECTION OF THE PERSON. A second social force is protection of the person. From the earliest times, laws have been developed to protect the individual from being injured or killed. Criminal laws are devoted to protection of individuals and their properties. In addition, civil suits permit private remedies for wrongful acts toward people and their property. Over time, the protection of personal rights has expanded to include the rights of privacy and the protection of individuals from defamation. Contract rights are protected from interference by others. Laws continue to evolve to protect the reputations, privacy, and mental and physical well- being of individuals.

Ethics, Trust, and Markets

The cover of Fortune magazine from May 14, 2001, featured a picture of Wall Street financial analyst Mary Meeker and the words, “Can we ever trust again?”* The inside story focused on the relationship of underwriters, analysts, and brokerage houses with the high-tech companies whose stocks they were touting and selling. They had continued to pump the virtues of stock shares they knew had overinflated prices. When the dot-com market bubble burst, the losses to shareholders were cata- strophic. The analysts, underwriters, and brokers had not violated the law. Those in the financial markets had too much at stake to be honest with investors.

In 2002, when companies beyond the dot-coms, such as Enron, WorldCom, and Tyco, experienced write-downs for some fairly creative accounting prac- tices gone awry, the market once again looked at

analysts, wondering how they had failed to catch the accounting issues. The cover of Fortune read, “In Search of the Last Honest Analyst.”**

During 2007, Fortune ran a cover with the pictures of the CEOs of the major Wall Street investment firms (such as Merrill

Lynch, Bear Stearns, and Lehman Brothers) who had managed to lose trillions of investors’ pension and 401 (k) plans to risky investments in subprime mortgages that were marketed as low-risk investments. The cover’s headline asked, “What Were They Smoking?”***

What do the covers of this business magazine convey about the importance of trust and its role in markets?

* “Can We Ever Trust Again?” Fortune, May 14, 2000 (cover).

** “In Search of the Last Honest Analyst,” Fortune, June 10, 2002 (cover).

*** Cover, Fortune, November 26, 2007.

48 Part 1 The Legal and Social Environment of Business

(C) PROTECTION OF PUBLIC HEALTH, SAFETY, AND MORALS. Food-labeling regulations are an example of laws grounded in the value of protecting the safety and health of individuals. Food and restaurant inspections, mandatory inoculation, speed limits on roadways, mandatory smoke detectors and sprinkler systems in hotels, and prohibitions on the sale of alcohol to minors are all examples of laws based on the value of safety for the public. Zoning laws that prohibit the operation of adult bookstores and movie theaters near schools and churches are examples of laws based on moral values.

(D) PROTECTION OF PROPERTY: ITS USE AND TITLE. Someone who steals another’s automobile is a thief and is punished by law with fines and/or imprisonment. A zoning law that prohibits the operation of a steel mill in a residential area also provides protection for property. A civil suit brought to recover royalties lost because of another’s infringement of one’s copyrighted materials is based on federal laws that afford protection for property rights in nontangible or intellectual property (see Chapter 10). Laws afford protection of title for all forms of property. The deed recorded in the land record is the legal mechanism for protecting the owner’s title. The copyright on a software program or a song protects the creator’s rights in that intellectual property. The title documents issued by a department of motor vehicles afford protection of title for the owner of a vehicle.

Those who have title to property are generally free to use the property in any manner they see fit. However, even ownership has restrictions imposed by law. A landowner cannot engage in activities on his property that damage another’s land or interfere with another’s use of land. A business may operate a factory on its real property, but if the factory creates a great deal of pollution, adjoining landowners may successfully establish it as a nuisance (see Chapter 49) that interferes with their use and enjoyment of their land. The law affords remedies for such a nuisance that might include an injunction, or court order, limiting the hours of the factory’s operation or requiring scrubbers on the emissions towers.. Environmental laws also emerged as regulation of land use in response to concerns about legal, but harmful, emissions by companies.

(E) PROTECTION OF PERSONAL RIGHTS. The desire for individual freedom to practice religion and to enjoy freedom from political domination gave rise to the colonization of the United States and, eventually, the American Revolution. The desire for freedom from economic domination resulted in the free enterprise philosophy that exists in the United States today. Individual freedoms and personal rights continue as a focus of value discussions followed by legislation if those individual rights are violated.

(F) ENFORCEMENT OF INDIVIDUAL INTENT. When we voluntarily enter into a contract, we have a responsibility to fulfill the promises made in that agreement. Principles of honesty and the honoring of commitments are the ethical values at the heart of the parties’ conduct in carrying out contracts. If, however, the parties do not keep their promises, the law does enforce transactions through sets of rules governing requirements for them. For Example, the law will carry out the intentions of the parties to a business transaction.

Chapter 3 Business Ethics, Social Forces, and the Law 49

Laws exist to honor the intent of parties because not all commitments are fulfilled voluntarily. The law may impose requirements that a transaction or agreement be in writing to ensure that the intent of the parties is adequately documented and fulfilled (see Chapter 17). The law may also place restrictions on honoring intentions. A contract to commit a murder may be evidenced by intent and fully documented in writing. However, the intent of the parties will not be honored because of the social values manifested in the protection of individuals and individuals’ rights and safety.

(G) PROTECTION FROM EXPLOITATION, FRAUD, AND OPPRESSION. Many laws have evolved because businesses took advantage of another group. The law has given some groups or individuals protection because of excesses by businesses in dealing with them. Minors, or persons under legal age (see Chapter 14), are given special protections under contract laws that permit them to disaffirm their contracts so they are not disadvantaged by excessive commitments without the benefit of the wisdom of age and with the oppressive presence of an adult party.

The federal laws on disclosure in the sales of securities and shareholder relations (see Chapters 45 and 46) were developed following the 1929 stock market crash when many investors lost all they had because of the lack of candor and information by the businesses in which they were investing.

(H) FURTHERANCE OF TRADE. Some laws are the result of social forces seeking to simplify business and trade. Installment sales and credit transactions, and their accompanying laws and regulations, have made additional capital available for businesses and provided consumers with alternatives to cash purchases. The laws on checks, drafts, and notes have created instruments used to facilitate trade.

(I) PROTECTION OF CREDITORS AND REHABILITATION OF DEBTORS. Society seeks to protect the rights of creditors and to protect them from dishonest or fraudulent acts of debtors. Statutes that make it a fraud for a debtor to conceal property from a creditor also protect creditors. Mortgages, security interests, and surety relationships (see Chapters 32, 34, and 49) are mechanisms created by law to provide creditors the legal mechanisms for collecting their obligations.

When collection techniques became excessive and exploitative, new laws on debtors’ rights were enacted. Debtors’ prisons were abolished. Congress mandated disclosure requirements for credit contracts. The Fair Debt Collections Practices Act (see Chapter 33) limited collection techniques. The remedy of bankruptcy was afforded debtors under federal law to provide them an opportunity to begin a new economic life when their existing debts reached an excessive level and could no longer be paid in a timely fashion (see Chapter 35).

(J) STABILITY AND FLEXIBILITY. Stability is particularly important in business transac- tions. When you buy a house, for example, you want to know not only what the exact meaning of the transaction is under today’s law but also that the transaction will have the same meaning in the future.

Because of the desire for stability, courts will ordinarily follow former decisions unless there is a strong reason to depart from them. Similarly, when no former case bears on the point involved, a court will try to reach a decision that is a logical

50 Part 1 The Legal and Social Environment of Business

extension of some former decision or that follows a former decision by analogy rather than strike out on a new path to reach a decision unrelated to the past.

The typical modern statute, particularly in the area of business regulation, often contains an escape clause by which a person can “escape” from the operation of the statute under certain circumstances. For Example, a rent control law may impose a rent ceiling, that is, a maximum rent a landlord can charge a tenant. The same law may also authorize a higher charge when special circumstances make it just and fair to allow such an exception. For example, the landlord may have made expensive repairs to the property or taxes on the property may have increased substantially.


Business managers often find themselves in circumstances in which they are unclear about right and wrong and are confused about how to resolve the dilemmas they face. A recent survey showed that 98 percent of all Fortune 500 companies have codes of ethics designed to help their employees recognize and resolve ethical dilemmas. Nearly 90 percent of those firms provide their employees some form of training in ethics.12 Almost 80 percent of companies now have an ethics officer. These codes of ethics provide employees information about categories of behavior that constitute ethical breaches. Regardless of the industry, the type of business, or the size of the company, certain universal categories can help managers recognize ethical dilemmas. Figure 3-3 provides a list of those categories.

9. Categories of Ethical Behavior (A) INTEGRITY AND TRUTHFULNESS. Mark Twain once wrote, “Always tell the truth. That way you don’t have to remember anything.” As discussed earlier, trust is a key component of business relationships and of the free enterprise system. Trust begins

FIGURE 3-3 Categories of Ethical Behavior







12 Survey of the Society for Human Resource Management and Ethics Resource Center (2005).

Chapter 3 Business Ethics, Social Forces, and the Law 51

with the belief that honesty is at the heart of relationships. Many contract remedies in law are based on the failure of the parties to be truthful with each other. If you purchase a home that has been certified as termite free but you discover termites in the home shortly after you move in, someone has not been truthful. If you also discover that two termite inspections were conducted and that the first one, which revealed there were termites, was concealed from you, your trust in both the sellers and their exterminators is diminished.

An assurance that a seller has the expertise to handle your project is important in building that relationship. If you discover later that the seller lacks the expertise, you are harmed by the delay and possible poor work that has been done. Investors become skeptical when offerings do not carry with them a very basic level of honesty in their disclosures. Honesty is necessary for the wheels of commerce to turn.

Integrity is the adherence to one’s values and principles despite the costs and consequences. For Example, an executive contracted with a variety of companies to sell his hard-to-find computer components. When he was approached by one of his largest customers to break a contract with a small customer, the executive refused. The customer assured the executive it would be his last order with the company if he did not get more components. Despite facing the threat of losing a multimillion- dollar customer, the executive fulfilled his promises to the small purchasers. The executive kept his word on all of his contracts and demonstrated integrity.

(B) PROMISE KEEPING. If we examine the types of things we do in a day, we would find that most of them are based on promises. We promise to deliver goods either with or without a contract. We promise to pay the dentist for our dental work. We promise to provide someone with a ride. Keeping those promises, regardless of whether there is a legal obligation to do so, is a key component of

Lying to Get into a Top School

The University of California at Berkeley has implemented a new step in its admis- sion process. The Haas School of Business has begun running background checks on students who have applied to determine whether the information in their applica- tions is correct. The Wharton School implemented a similar procedure and charges appli- cants a $35 fee for these background checks.

Of the 100 students admitted to Berkeley in the fall of 2003, 5 students were found to have offered false information on their admissions applications. The most

common type of false information was the job titles they held, and the second most common type was their number of years of work experience. Haas admissions officers indicated that had the students not lied, they otherwise met the GMAT score and GPA standards for admission to Haas.

What risk do the students take in lying on their applications? What are the long-term consequences?

Source: “Cheaters Don’t Make the Grade at Berkeley Business School,”, March 14, 2003, AP wire reports.

integrity– the adherence to one’s values and principles despite the costs and consequences.

52 Part 1 The Legal and Social Environment of Business

being an ethical person and practicing ethical business. Keeping promises is also evidence of integrity.

The issue of employee downsizing is debated with the underlying question of whether the downsized employees had a promise from their company of continued employment. As we consider stakeholder analysis the ethical issue surrounding the question is whether there are promises to others who are at risk. Weren’t shareholders promised a return on their investment? Weren’t suppliers promised payment? In many circumstances, the question is not whether a promise will be kept but rather which promise will be kept. The strategic issue is whether businesses should make commitments and promises in circumstances that create a very thin margin of profit and perhaps even thinner margin for error. Over the long term, the importance of a company’s keeping its promises to all stakeholders translates into its reputation.

(C) LOYALTY—AVOIDING CONFLICTS OF INTEREST. An employee who works for a company owes allegiance to that company. Conduct that compromises that loyalty is a conflict of interest. For Example, suppose that your sister operates her own catering business. Your company is seeking a caterer for its monthly management meetings. You are responsible for these meetings and could hire your sister to furnish the lunches for the meetings. Your sister would have a substantial contract, and your problems with meal logistics would be solved. Nearly all companies have a provision in their codes of ethics covering this situation. An employee cannot hire a relative, friend, or even her own company without special permission because it is a conflict of interest. Your loyalty to your sister conflicts with the loyalty to your employer, which requires you to make the best decision at the best price.

Image, Morals, and Cereal

Olympic champion Michael Phelps was photographed apparently smoking a bong pipe at a party at the University of South Carolina. When the picture made its way onto the Internet, the companies that carry Mr. Phelps’s image for their products were listed on the Internet. Those companies include the following:

● Kellogg’s

● Subway*

● Speedo

● Visa

● Omega

● PureSport

● 505 Games*

● Mazda (China only)

After the picture appeared, Kellogg’s canceled its contract with Mr. Phelps. What legal right would a company have to cancel its agreement with Mr. Phelps? What is a “morals clause” and how is it used?

* Indicates that endorsement was signed after the Olympics.

conflict of interest– conduct that compromises an employee’s allegiance to that company.

Chapter 3 Business Ethics, Social Forces, and the Law 53

A conflict of interest arises when a purchasing agent accepts gifts from suppliers, vendors, or manufacturers’ representatives. The purchasing agent has introduced into the buy-sell relationship an element of quid pro quo, or the supplier’s expectation that the gift will bring about a return from the agent in the form of a contract. Some companies have zero tolerance for conflicts and establish a complete prohibition on employees accepting any gifts from suppliers and manufacturers. For Example, Wal-Mart buyers are not permitted to accept even a cup of coffee from potential merchandise suppliers, and Amgen’s buyers can go out to dinner with a supplier only if Amgen pays.

(D) FAIRNESS. In business transactions in which the buyer was not told about the crack in the engine block or the dry well on the property, a typical response is “That’s not fair. I wouldn’t have bought it if I’d known.” A question often posed to the buyer in response is “Wouldn’t you have done the same thing?” We feel differently about such situations, depending on whether we are the victims of unfairness or whether we hold the superior knowledge in the transaction. The ethical standard of fairness requires both sides to ask these questions: “How would I want to be treated? Would this information make a difference to me?” Imposing our own standards and expectations on our own behavior in business transactions produces fairness in business.

(E) DOING NO HARM. Imagine selling a product that your company’s internal research shows presents significant health dangers to its users. Selling the product without disclosure of the information is unfair. There is the additional ethical breach of physical harm to your customers and users. Ford designed and sold its Pinto with a fundamental flaw in the placement of the car’s gas tank. Rear-end collisions in which a Pinto was involved resulted, even at very low speeds, in fires that engulfed the car so quickly that occupants could not always escape from it. An internal memo from engineers at Ford revealed that employees had considered doing an analysis of the risk of the tanks versus the cost of redesign but never did. The late Peter Drucker’s advice on ethics for businesses is primum non nocere, or “above all, do no harm.” Such a rule might have helped Ford.

(F) MAINTAINING CONFIDENTIALITY. Often the success of a business depends on the information or technology that it holds. If the competitive edge that comes from the business’s peculiar niche or knowledge is lost through disclosure, so are its profits. Employees not only owe a duty of loyalty to their employers, but they also owe an obligation of confidentiality. Employees should not use, either personally or through a competitor, information they have obtained through their employer’s work or research. Providing customer lists or leads is a breach of employees’ obligation of confidentiality.

In addition, managers have responsibilities regarding their employees’ privacy. Performance evaluations of individual employees are private and should never be disclosed or revealed, even in one-on-one conversations outside the lines of authority and the workplace.

primum non nocere–above all do no harm.

54 Part 1 The Legal and Social Environment of Business

10. Resolving Ethical Dilemmas Recognizing an ethical dilemma is perhaps the easiest part of business ethics. Resolution of that dilemma is more difficult. The earlier section on stakeholders offers one model for resolution of ethical dilemmas (see Figure 3-1). Other models have been developed to provide managers analytical methods for resolving dilemmas in a timely fashion.

(A) BLANCHARD AND PEALE THREE-PART TEST. Dr. Kenneth Blanchard, author of books on the One-Minute Manager, and the late Dr. Norman Vincent Peale developed a model for evaluating ethical breaches that is widely used among Fortune 500 companies.13 To evaluate situations, ask the following three questions: Is it legal? Is it balanced? How does it make me feel?

In answering the questions on legality, a manager should look to positive law both within and outside the company. If the proposed conduct would violate antitrust laws, the manager’s analysis can stop there. If the proposed conduct would violate company policy, the manager’s analysis can stop. In the field of business ethics, there is little room for civil disobedience. Compliance with the law is a critical component of a successful ethics policy in any company.

Piggybacking on Wireless Networks

A new issue that has evolved because of technology could require legal steps to stop it. People are “piggybacking” or tapping onto their neighbors’ wireless Internet connection. The original subscri- ber pays a monthly fee for the service, but without security, people located in the area are able to tap into the wireless network, which bogs down the speed of the service. Once limited to geeks and hackers, the practice is now common among the ordinary folk who just want free Internet service.

One college student said, “I don’t think it’s stealing. I always find people out there who aren’t protecting their connection, so I just feel free to go ahead and use it.”* According to a recent survey, only about 30 percent of

the 4,500 wireless networks onto which the surveyors logged were encrypted.

An apartment dweller said she leaves her connection wide open because “I’m sticking it to the man. I open up my network, leave it wide open for anyone to jump on.” One of the users of another’s

wireless network said, “I feel sort of bad about it, but I do it anyway. It just seems harmless.” She said that if she gets caught, “I’m a grandmother. They’re not going to yell at an old lady. I’ll just play the dumb card.”

Some neighbors offer to pay those with wireless service in exchange for their occasional use rather than paying a wireless company for full-blown service. However, the original subscribers do not really want to run their own Internet service.

Do you think we need new legislation to cover this activity? What do you think of the users’ statements? Is their conduct legal? Is it ethical?

13 Kenneth Blanchard and Norman Vincent Peale, The Power of Ethical Management (New York: William Morrow, 1986).

* Michael Marriott, “Hey Neighbor, Stop Piggybacking on My Wire- less,” New York Times, March 5, 2006, A1, A23.

Chapter 3 Business Ethics, Social Forces, and the Law 55

The second question on balance forces the manager to examine the ethical value of fairness. Perhaps the decision to downsize must be made, but couldn’t the company offer the employees a severance package and outplacement assistance to ease the transition?

The final question of the Blanchard and Peale model is conscience based. Although some managers may employ any tactics to maximize profits, this final question forces a manager to examine the physical impact of a decision: Does it cause sleeplessness or appetite changes? Personalizing business choices often helps managers to see the potential harm that comes from poor ethical choices.

(B) THE FRONT-PAGE-OF-THE-NEWSPAPER TEST. This simple but effective model for ethical evaluation helps a manager visualize the public disclosure of proposed conduct. When he temporarily took over as the leader of Salomon Brothers after its bond-trading controversy, Warren Buffett described the newspaper test as follows:

Contemplating any business act, an employee should ask himself whether he would be willing to see it immediately described by an informed and critical reporter on the front page of his local paper, there to be read by his spouse, children, and friends. At Salomon, we simply want no part of any activities that pass legal tests but that we, as citizens, would find offensive.14

(C) LAURA NASH MODEL. In her work, business ethicist Laura Nash has developed a series of questions to help businesspeople reach the right decision in ethical dilemmas. These are her questions: Have you defined the problem accurately? How would you define the problem if you stood on the other side of the fence? How did this situation occur in the first place? What is your intention in making this decision? How does the intention compare with the probable results? Whom could your decision or action injure? Can you discuss your decision with the affected parties? Are you confident that your position will be as valid over a long period of time as it seems now? Could you discuss your decision with your supervisor, coworkers, officers, board, friends, and family?

The Nash model requires an examination of the dilemma from all perspectives. Defining the problem and how the problem arose provides the business assistance in avoiding the dilemma again. For Example, suppose that a supervisor is asked to provide a reference for a friend who works for her. The supervisor is hesitant because the friend has not been a very good employee. The ethical dilemma the manager believes she faces is whether to lie or tell the truth about the employee. The real ethical dilemma is why the supervisor never provided evaluation or feedback indicating the friend’s poor performance. Avoiding the problem in the future is possible through candid evaluations. Resolving the problem requires that the supervisor talk to her friend now about the issue of performance and the problem with serving as a reference.

One final aspect of the Nash model that businesspeople find helpful is a question that asks for a perspective on an issue from family and friends. The problem of groupthink in business situations is very real. As businesspeople sit together in a room and discuss an ethical dilemma, they can persuade each other to think the same way. The power of consensus can overwhelm each person’s concerns and values. There is a

14 Janet Lowe, Warren Buffett Speaks: Wit and Wisdom from the World’s Greatest Investor (New York: Wiley, 1997).

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certain fear in bringing up a different point of view in a business meeting. Proper perspective is often lost as the discussion centers around numbers. Therefore, bringing in the views of an outsider is often helpful. For example, when McNeil, the manufacturer of Tylenol, faced the cyanide poisonings from contaminated capsules sold in the Chicago area, it had to make a decision about the existing Tylenol inventory. It was clear to both insiders and outsiders that the poison had not been put in the capsules at McNeil but after delivery to the stores. Despite the huge numbers involved in the recall and the destruction of inventory, the McNeil managers made the decision easily because they viewed the risk to their own families, that is, from the outside. From this standpoint, the issue became a question of human life, not of numbers.15

(D) WALL STREET JOURNAL MODEL. The Wall Street Journal presented a simple, three- prong test for resolving ethical dilemmas known as the three-C model: (1) Will this conduct be in compliance with the law? (2) What contribution does this decision make to the shareholders? To the community? To the employees? (3) What are the consequences of this decision? This model requires an examination of the impact of a choice, which then produces a different perspective on a course of conduct.

Burger King, Coke, and Numbers

Coca-Cola has admitted that it paid a consultant $10,000 to drive up the de- mand for its Frozen Coke beverage being test-marketed in Burger Kings in the Rich- mond, Virginia, area. The consultant used the money to make donations to Boys and Girls Clubs. The clubs then provided meal coupons to the children in exchange for them doing their homework. The impressive demand that resulted from the Richmond area test market led Burger King to invest $65 million to put the machines in restaurants around the country. However, the demand was not what it had been falsely alleged to be, and the result is that, following a six-week investigation by a law firm hired by the Coca-Cola board, Coca-Cola admitted that the marketing studies were inflated.

The board investigation followed an allegation in a lawsuit filed by a former employee, Matthew Whitley. Whitley was terminated following his questioning of an expense claim by the consultant and his resulting investigation that produced an internal memo describ- ing the consultant’s work on driving up the demand.

Coca-Cola also issued an earnings resta- tement of $9 million based on an inves- tigation of those allegations. The Wall Street Journal was following the Whitley lawsuit when the underlying issues emerged, and it reported the marketing scheme.* Coca-Cola settled with Burger

King by paying $21 million. Was this conduct ethical? Was it fraud? What does

Mr. Whitley’s termination say about the company? Does he have protection? Why do you think the marketing managers decided to involve the consultant and report the false demand? What effect does this incident have on Burger King’s relationship with Coke? How do you think the story played on the front page of the Wall Street Journal?**

15 “Brief History of Johnson & Johnson” (company pamphlet, 1992).

* Chad Terhune, “Coke Employees Acted Improperly in Marketing Test,” Wall Street Journal, June 18, 2003, A3, A6;Sherri Day, “Coke Confirms Product Test Was Rigged,” New York Times, June 18, 2003, C1, C10.

** Marianne Jennings, one of the authors of this text, has done consulting work for Coca-Cola since this incident. Why is this disclosure important?

Chapter 3 Business Ethics, Social Forces, and the Law 57

For Example, Sears paid $475 million in fines and penalties for its unauthorized collection of debts from debtors who were in bankruptcy or had debts discharged in bankruptcy. Such collection beyond what the law allows did not comply with the law.16 The contribution to the company was more collections and hence more cash, but the consequences were the large fine and the damage to Sears’s reputation for putting its interests above the law and above the interests of other creditors who conducted themselves within the limits of the bankruptcy law. Sears may have resented the fact that debtors had not paid, but the company was not justified in taking the law into its own hands or profiting at the expense of other creditors.

Breaking Away (1979) (PG)

In this story about “cutters” (a nickname for natives of Bloomington, Indiana), a recent high school graduate trains to be a first-class bike rider. He idolizes the Italian world racing team and enters an Indiana race to have the opportunity to compete with them. He does well in the race and manages to catch up and keep pace with the Italian team. As he rides alongside his idols, one of the members of the Italian team places a tire pump in his spoke. His bike crashes, he loses the race and is injured. He becomes disillusioned. Is this experience like business? Do unethical tactics get you ahead? Do nice guys finish last? Are there sanctions for unethical conduct?

Jaws (1975) (PG 13)

The movie that shot Steven Spielberg to directorial legend brings us the classic business dilemma of what to do when you have a high-risk/low-probability event that you know about but about which the public has no knowledge. Do you stop? But what about the economic losses?

Hoosiers (1986) (PG)

Often called the “greatest sports movie ever made,” this story of a coach with a history and a small-town team presents several life-defining ethical moments. In one, with advancement to the finals on the table, Coach Norman Dale grapples with whether he should allow one of his injured players to continue when he has no depth on his bench. What do you do when your values are in conflict?

The Family Man (2000) (PG 13)

Nicolas Cage plays a Wall Street billionaire who is suddenly given a suburban life in New Jersey with all of its family life and financial constraints. He is forced to examine who he really is and what is important.

You can view a clip of these movies and others that illustrate business law concepts at the LawFlix site, located at

16 Leslie Kaufman, “Sears Settles Suit on Raising of Its Credit Card Rates,” New York Times, March 11, 1999, C2.

58 Part 1 The Legal and Social Environment of Business



Business ethics is the application of values and standards to business conduct and decisions. These values originate in various sources from positive (codified) law to natural law to stakeholder values. Business ethics is important because trust is a critical component of good business relationships and free enterprise. A business with values will enjoy the additional competitive advantage of a good reputation and, over the long term, better earnings. When businesses make decisions that violate basic ethical standards, they set into motion social forces and cause the area of abuse to be regulated, resulting in additional costs and restrictions for business. Voluntary value choices by businesses position them for a competitive advantage.

The categories of ethical values in business are truthfulness and integrity, promise keeping, loyalty and avoiding conflicts of interest, fairness, doing no harm, and maintaining confidentiality.

Resolution of ethical dilemmas is possible through the use of various models that require a businessperson to examine the impact of a decision before it is made. These models include stakeholder analysis, the Blanchard and Peale test, the front- page-of-the-newspaper test, the Laura Nash model, and the Wall Street Journal model.

LEARNING OUTCOMES After studying this chapter, you should be able to clearly explain:

A. WHAT IS BUSINESS ETHICS? LO.1 Define business ethics

See the discussion of the definition, balancing the goal of profits with the values of individuals and society, on p. 40.

B. WHY IS BUSINESS ETHICS IMPORTANT? LO.2 Discuss why ethics are important in business

See “The Importance of Trust” on p. 44. See “Business Ethics and Financial Performance” on p. 45. See “The Importance of a Good Reputation” on p. 46.

C. HOW TO RECOGNIZE AND RESOLVE ETHICAL DILEMMAS LO.3 Describe how to recognize and resolve ethical dilemmas

See “Integrity and Truthfulness” on p. 51 See“Promise Keeping” on p. 52 See “Loyalty—Avoiding Conflicts of Interest” on p. 53. See “Fairness” on p. 54. See “Doing No Harm” on p. 54. See “Maintaining Confidentiality” on p. 54. See “Resolving Ethical Dilemmas” on p. 55. See “Blanchard and Peale Three-Part Test” on p. 55.

Chapter 3 Business Ethics, Social Forces, and the Law 59

See “The Front-Page-of-the-Newspaper Test” on p. 56. See “Laura Nash Model” on p. 56. See “Wall Street Journal Model” on p. 57.


business ethics civil disobedience conflict of interest ethics

integrity moral relativism natural law positive law

primum non nocere situational ethics stakeholder analysis stakeholders

QUESTIONS AND CASE PROBLEMS 1. Marty Mankamyer, the president of the United States Olympic Committee

(USOC), resigned in early February 2003 following reports in The Denver Post that indicated she had demanded a commission from a fellow real estate broker in the Colorado Springs area, the home of the USOC, who had sold property to Lloyd Ward, the CEO of the USOC. Mr. Ward had purchased a 1.3-acre lot in Colorado Springs for $475,000 and had paid the listing broker, Brigette Ruskin, a commission. Ms. Mankamyer allegedly demanded a portion of the commission from Ms. Ruskin, and Ms. Ruskin sent her a check. Ms. Mankamyer had shown Mr. Ward and his wife properties in the area when they were being considered for the job and when he was considering taking the job. However, Mrs. Ward indicated that Ms. Mankamyer did not identify herself as a real estate agent and that she assumed that Ms. Mankamyer was showing the properties as a “goodwill gesture.”17 What conflicts of interest do you see here?

2. Ann Elkin, who works for Brill Co., has been sent out to conduct two customer evaluations, which have gone much more quickly than Ann anticipated. Her supervisor does not expect Ann back until after lunch. It is now 10:30 A.M., and Ann would like to run some personal errands and then go to lunch before returning to work at 1:00 P.M. Should Ann take the time? Would you? Why or why not? Be sure to consider the categories of ethical values and apply one or two models before reaching your conclusion.

3. Fred Sanguine is a New York City produce broker. Ned Santini is a 19-year-old college student who works for Sanguine from 4:00 A.M. until 7:00 A.M. each weekday before he attends classes at Pace University. Fred has instructed Ned on the proper packing of produce as follows: “Look, put the bad and small cherries at the bottom. Do the same with the strawberries and blueberries. Put the best fruit on top and hide the bad stuff at the bottom. This way I get top dollar on all that I sell.” Ned is uncomfortable about the instructions, but, as he explains to his roommate, “It’s not me doing it. I’m just following orders. Besides, I need the job.” Should Ned just follow instructions? Is the manner in

17 Richard Sandomir, “U.S. Olympic Chief Resigns in a Furor Over Ethics Issues,” New York Times, February 5, 2003, A1, C17; Bill Briggs, Realtor Waving Red Flag,, February 4, 2003.

60 Part 1 The Legal and Social Environment of Business

which the fruit is packed unethical? Would you do it? Why or why not? Is anyone really harmed by the practice?

4. Alan Gellen is the facilities manager for the city of Milwaukee and makes all final decisions on purchasing items such as chairs, lights, and other supplies and materials. Alan also makes the final decisions for the award of contracts to food vendors at event sites. Grand Beef Franks has submitted a bid to be one of the city’s vendors. Alan went to school with Grand Beef’s owner, Steve Grand, who phones Alan and explains that Grand Beef owns a condominium in Maui that Alan could use. Steve’s offer to Alan is: “All it would cost you for a vacation is your airfare. The condo is fully stocked with food. Just let me know.” Should Alan take the offer? Would you? Be sure to determine which category of ethical values this situation involves and to apply several models as you resolve the question of whether Alan should accept the invitation.

5. Television network CNBC and other television networks have been working to develop policies for their business correspondents and guests on their business shows because of a practice known as pump-and-dump, the practice of a Wall Street professional or network business correspondent appearing on television to tout a particular stock as being a good buy. Often, unbeknown to the viewing audience, the guest or correspondent promoting the stock has a large holding in it and, after the television show runs and the stock price creeps up, sells his or her interest at a higher price than would have been possible before the show on which the person raved about the stock. What category of ethical issue exists here? If you were a network executive, what would you do to remedy the problem? Could the government regulate such practices? What kind of regulation could it impose?

6. Adam Smith wrote the following in The Theory of Moral Sentiments:

In the practice of the other virtues, our conduct should rather be directed by a certain idea of propriety, by a certain taste for a particular tenor of conduct, than by any regard to a precise maxim or rule; and we should consider the end and foundation of the rule, more than the rule itself.18

Do you think Adam Smith adhered to positive law as his ethical standard? Was he a moral relativist? Does his quote match stakeholder analysis? What would his ethical posture be on violating the law?

7. A new phenomenon for admissions to MBA programs is hiring consultants to help applicants hone their applications. About 20 percent of those who apply to the top MBA programs have hired consultants at a cost of $150 to $200 per hour to help them say and do the right things to be admitted. The total cost for most who use a consultant is $5,000. The consultants help with personal essays and applications. One admissions officer points out that one function of the consultant is to draw out and emphasize skills that the applicant may not see as important. For example, playing the piano is looked upon favorably because it shows discipline and focus. However, admissions committees are becoming adept at spotting the applications via consultant because, as the faculty describe

18 Adam Smith, The Theory of Moral Sentiments (Arlington House, 1969; originally published in 1769).

Chapter 3 Business Ethics, Social Forces, and the Law 61

it, these essays and applications have a certain “sameness” to them. The Fuqua School at North Carolina suggests that students simply call the admissions office and get comparable advice for free. Is it ethical to use an admissions consultant? When would you cross a line in using the consultant on the essay?

8. Oprah Winfrey named James Frey’s autobiographical book, A Million Little Pieces, to her television book club. The impact of the book’s inclusion in the Oprah Book Club was the sale of 10 million copies, making it the fastest-selling book in the club’s history. The book allegedly addressed Mr. Frey’s addictions and recovery. However, on January 8, 2006, the Web site The Smoking Gun found significant and multiple discrepancies between Frey’s accounts of his life experiences in the book and what really happened. For example, Frey wrote that he spent 87 days in prison. In reality, he spent 3 hours. When the discrepancies initially emerged, Ms. Winfrey defended Mr. Frey, saying the book was the “essential truth” about his life. She also called the controversy “much ado about nothing.”

The public reaction was different, and Ms. Winfrey had Mr. Frey on her show, or, as some critics labeled it, “had him into the woodshed.” Ms. Winfrey told Mr. Frey, “I feel really duped. You betrayed millions of readers. Why would you lie?”

In the week following his Oprah appearance, Mr. Frey sold 50,000 copies of A Million Little Pieces, but the publisher for his next book canceled his contract. However, Mr. Frey rebounded and found another publisher for a book released in 2008. Was there truthfulness in his book? Mr. Frey said the book was a “creative novel memoir” that had not been intended to be autobiographical. Does this clarification help? Were Mr. Frey’s actions ethical? Evaluate Ms. Winfrey’s initial response.

9. The state of Arizona mandates emissions testing for cars before drivers can obtain updated registrations. The state hires a contractor to conduct the emissions tests in the various emissions-testing facilities around the state. In October 1999, the Arizona attorney general announced the arrest of 13 workers at one of the emissions-testing facilities for allegedly taking payoffs of between $50 to $200 from car owners to pass their cars on the emissions tests when those cars fell below emissions standards and would not have been registered. Nearly half of the staff at the emissions facility were arrested.

Why is it a crime for someone working in a government-sponsored facility to accept a payment for a desired outcome? Do the payoffs to the workers really harm anyone?

10. The president and athletic director at the University of California at Los Angeles (UCLA) fired the school’s basketball coach because an expense form he had submitted for reimbursement had the names of two students he said had joined him for a recruiting dinner. The students had not been to the dinner. The coach was stunned because he had been at UCLA for eight years and had established a winning program. He said, “And to throw it all away on a meal?” Do you agree with the coach’s assessment? Was it too harsh to fire him for one inaccurate expense form? Did the coach commit an ethical breach?

62 Part 1 The Legal and Social Environment of Business

11. A new trend is emerging in health insurance: premium increases based on claims. It is common practice in the auto insurance industry, for example, for insurers to revisit your premium each year and adjust it based on factors such as your driving record or number of accidents. However, health insurers have generally evaluated their insured’s health only once, at the outset, when issuing a policy. The reevaluation of health and premiums was a practice that ended in the 1950s because the insurers feared regulators would impose limitations on premiums. At least one health insurer, however, has begun to evaluate the health of its insureds annually and to adjust policy premiums accordingly. Even without examination of insureds, some insurers have increased the insureds’ premiums based simply on the nature of their claims for the year and the possibility that more claims will arise. Those who are healthy are in favor of this annual review. Perceiving themselves as the equivalent of good drivers, they want to pay less when they stay healthy. The health discount is, in their minds, the equivalent of the safe driver discount. However, those who are less healthy argue that people buy insurance so it will be there when they need it, and the coverage should apply without regard to claims. Consider the ethical issues in this type of pricing for health insurance.

12. David A. Vise, a Pulitzer Prize winner and a reporter for the Washington Post, wrote the book The Bureau and the Mole. When the book hit the market, Mr. Vise purchased 20,000 copies via Barnes &, taking advantage of both free shipping offered by the publisher and a discounted initial price. Mr. Vise’s book had already hit the New York Times’ bestseller list in the week before the purchases. He used the books he purchased to conduct online sales of autographed copies of the books, and then returned 17,500 books and asked for his money back. However, that return of 17,500 books represented more books than a publisher generally runs for a book. Mr. Vise said that he did not intend to manipulate the market or profit from the transactions. He said his only intent was to “increase awareness of The Bureau and the Mole.” Mr. Vise’s editor offered to pay Barnes & Noble for any expenses it incurred. Was it ethical to do what Mr. Vise did? Was he within his rights to return the books? What are his remedies? Does Barnes & Noble have any rights?

13. Suzy Wetlaufer, editor of the Harvard Business Review, interviewed former General Electric CEO Jack Welch for a piece in the business magazine. In December 2001, she asked that the piece be withdrawn because her objectivity might have been compromised. Those at the magazine did another interview and published that interview in the February issue of the magazine. Editorial director of the magazine, Walter Kiechel, who supervised Ms. Wetlaufer, acknowledged as true a report in the Wall Street Journal about an alleged affair between Ms. Wetlaufer and Mr. Welch and that Mr. Welch’s wife had called to protest the article’s objectivity. Mr. Welch refused to confirm or deny an affair with Ms. Wetlaufer, who was divorced. Some staff members asked that Ms. Wetlaufer resign from her $277,000-per-year job, but she refused. Their objections were that she compromised her journalistic integrity. Mr. Kiechel, on

Chapter 3 Business Ethics, Social Forces, and the Law 63

the other hand, noted that she did “the right thing in raising her concerns.”19

About six weeks later, Ms. Wetlaufer did resign from her position as editor, announcing that she would be spending time with her four children. Do you think there was a conflict of interest because of the affair between Welch and Wetlaufer?20 Note: Mr. Welch and Ms. Wetlaufer have married and have written a book together. They now write a semiweekly column for BusinessWeek magazine.

14. Piper High School in Piper, Kansas, a town located about 20 miles west of Kansas City, experienced national attention because of questions about students and their term papers for a botany class. Christine Pelton, a high school science teacher, had warned students in her sophomore class not to use papers posted on the Internet for their projects. When their projects were turned in, Ms. Pelton noticed that the writing in some of the papers was well above the students’ usual quality and ability. She found that 28 of her 118 students had taken substantial portions of their papers from the Internet. She gave these students a zero grade on their term paper projects with the result that many of the students were going to fail the course for that semester. The students’ parents protested, and the school board ordered Ms. Pelton to raise the grades. She resigned in protest. She received a substantial number of job offers from around the country following her resignation. Nearly half of the high school faculty as well as its principal announced their plans to resign at the end of the year. Several of the parents pointed to the fact that there was no explanation in the Piper High School handbook on plagiarism. They also said that the students were unclear about what could be used, when they had to reword, and when quotations marks were necessary. The annual Rutgers University survey on academic cheating has revealed that 15 percent of college papers turned in for grades are completely copied from the Internet. Do you think such copying is unethical? Why do we worry about such conduct? Isn’t this conduct just a function of the Internet? Isn’t it accepted behavior?

15. Pharmaceutical companies, faced with the uphill battle of getting doctors to take a look at their new products, have created complex systems and programs for enticing doctors to come, sit, and absorb information about the new products. Following is a list of the various type of benefits and gifts that drug companies have given doctors over the past few years to entice them to consider prescribing their new offerings:

● An event called “Why Cook?” in which doctors were given the chance to review drug studies and product information at a restaurant as their meals were being prepared—they could leave as soon as their meals were ready, and they were treated to appetizers and drinks as they waited

● Events at Christmas tree lots where doctors can come and review materials and pick up a free Christmas tree

● Flowers sent to doctors’ offices on Valentine’s Day with materials attached

19 Del Jones, “Editor Linked with Welch Finds Job at Risk,” USA Today, March 5, 2002, 3B. 20 Ms. Wetlaufer and Mr. Welch were engaged to be married after Mr. Welch divorced Jane Welch.

64 Part 1 The Legal and Social Environment of Business

● Manicures as they study materials on new drugs

● Pedicures as they study materials on new drugs

● Free car washes during which they study materials

● Free books with materials enclosed

● Free CDs with materials attached

● Bottles of wine with materials attached

● Events at Barnes & Noble where doctors can browse and pick out a book for themselves for free as long as they also take some materials on a new drug

Some doctors say that they can enjoy dinner on a drug company as often as five times per week. The American Medical Association (AMA) frowns on the “dine-and-dash” format because its rules provide that dinners are acceptable only as long as the doctors sit and learn something from a featured speaker. The AMA also limits gifts to those of a “minimal value” that should be related to their patients, such as note pads and pens with the new drug’s name imprinted on them. The chairman of the AMA Committee on Ethics says the following about gifts, “There are doctors who say, ‘I always do what’s best for my patients, and these gifts and dinners and trips do not influence me.’ They are wrong.”21

In which category of ethical issues do these gifts fall? Do you think doctors act ethically in accepting gifts, meals, and favors? The Food and Drug Adminis- tration recently issued rules about such favors and perks. Why?

21 Chris Adams, “Doctors on the Run Can ‘Dine ‘n’ Dash’ in Style in New Orleans,” Wall Street Journal, May 14, 2001, A1, A6.

Chapter 3 Business Ethics, Social Forces, and the Law 65



A. The U.S. Constitution and the Federal System



B. The U.S. Constitution and the States




C. Interpreting and Amending the Constitution




D. Federal Powers



E. Constitutional Limitations on Government






This chapter introduces you to the powers of government and to theprotections that you have for your rights. The Constitution of the UnitedStates establishes the structure and powers of government but also the limitations on those powers. This Constitution forms the foundation of our legal



By establishing a central government to coexist with the governments of the individual states, the U.S. Constitution created a federal system. In a federal system, a central government has power to address national concerns, while the individual states retain the power to handle local concerns.

1. What a Constitution is A constitution is the written document that establishes the structure of the government and its relationship to the people. The U.S. Constitution was adopted in 1789 by the 13 colonies that had won their independence from King George.1

2. The Branches of Government The U.S. Constitution establishes a tripartite (three-part) government: a legislative branch (Congress) to make the laws, an executive branch (the president) to execute or enforce the laws, and a judicial branch (courts) to interpret the laws. The national legislature or Congress is a bicameral (two-house) body consisting of the Senate and the House of Representatives. Members of the Senate are popularly elected for a term of six years. Members of the House of Representatives are popularly elected for a term of two years. The president is elected by an electoral college whose membership is popularly elected. The president serves for a term of four years and is eligible for reelection for a second term. Judges of the United States are appointed by the president with the approval of the Senate and serve for life, subject to removal only by impeachment because of misconduct. (See Chapter 2 for a discussion of the federal court system.)

B. THE U.S. CONSTITUTION AND THE STATES The Constitution created certain powers within the national government that would have been exercised by the individual states, which are given their powers by the people of the state. Figure 4-1 illustrates the delegation of powers. Likewise, the states, as the power-granting authorities, reserved certain powers for themselves.

1 To examine the U.S. Constitution, go to and click on “Founding Documents,” or refer to Appendix 2.

federal system– the system of government in which a central government is given power to administer to national concerns while individual states retain the power to administer to local concerns.

constitution–a body of principles that establishes the structure of a government and the relationship of the government to the people who are governed.

tripartite– three-part division (of government).

legislative branch– the branch of government (e.g., Congress) formed to make the laws.

executive branch– the branch of government (e.g., the president) formed to execute the laws.

judicial branch– the branch of government (e.g., the courts) formed to interpret the laws.

bicameral–a two-house form of the legislative branch of government.

Chapter 4 The Constitution as the Foundation of the Legal Environment 67

3. Delegated and Shared Powers (A) DELEGATED POWERS. The powers given by the states to the national government are described as delegated powers. Some of these delegated powers are given exclusively to the national government. For example, the national government alone may declare war or establish a currency.

(B) SHARED POWERS. The powers delegated to the national government that may still be exercised by the states are shared powers. For Example, the grant of power to the national government to impose taxes did not destroy the state power to tax. In other cases, a state may provide regulation along with, but subject to the supremacy of, federal law. For Example, regulation of the use of navigable waterways within a state is an example of joint state and federal regulation.

4. Other Powers (A) STATE POLICE POWER. The states possess the power to adopt laws to protect the general welfare, health, safety, and morals of the people. This authority is called the police power. For Example, states may require that businesses be licensed with state agencies to protect persons dealing with the business. State exercise of the police power may not unreasonably interfere with federal powers.

FIGURE 4-1 Governments of the United States













delegated powers–powers expressly granted the national government by the Constitution.

shared powers–powers that are held by both state and national governments.

police power– the power to govern; the power to adopt laws for the protection of the public health, welfare, safety, and morals.

68 Part 1 The Legal and Social Environment of Business

(B) PROHIBITED POWERS. The Constitution also prohibits both states and the federal government from doing certain things. For Example, neither states nor the national government may adopt ex post facto laws, which make criminal an act that has already been committed but was not criminal when it was committed. Laws that increase the penalty for an act already committed above the penalty in force when the act was committed are also ex post facto laws.

5. Federal Supremacy Federal law bars or preempts conflicting state regulation when a federal law regulates that particular subject. Federal law also preempts state action when congressional intent to regulate exclusively can be inferred from the details of congressional regulation. Preemption means that the federal regulatory scheme is controlling.

(A) EXPRESS FEDERAL REGULATION. The Constitution and statutes passed by Congress are the supreme law of the land. They cancel out any conflicting state law.2 When a direct conflict exists between federal and state statutes, federal law prevails.

In some cases, however, no obvious conflict occurs because the federal statute covers only part of the subject matter. In such cases, the question becomes whether a state law can regulate the areas not regulated by Congress or whether the partial regulation made by Congress preempts, or takes over, the field so as to preclude state legislation.

The Folk Singer Who Staged a Protest against Preemption

FACTS: Diana Levine, a folk singer from Vermont, suffered from migraine headaches. She was being administered Wyeth Labora- tory’s Phenergan through a drip IV. Either because the IV needle entered Levine’s artery or the drug escaped from the vein into her surrounding tissue, Ms. Levine developed gangrene. Doctors amputated her right hand and eventually her forearm. Levine could no longer work as a professional musician. Levine filed suit

against both the clinic that administered the drug and Wyeth. She was awarded $7.4 million and Wyeth appealed on the grounds that the FDA approval of the drug preempted state tort suits by patients.

DECISION: In a 6 to 3 decision that departed from past precedent on preemption, the U.S. Supreme Court held that federal regulation did not preempt Levine’s state tort suit against Wyeth. Wyeth argued that it could not change the label to warn against IV use of Phenergan without FDA approval—and the FDA had approved the drug as safe for use. The Court held that Wyeth could move to change the label with the FDA in a timely fashion and that federal regulation did not preempt responsible follow-up by manufacturers with regard to their drugs. [Wyeth v Levine, 129 S Ct 1187 (2009)]3

2 U.S. Const., Art VI, cl 2. Cuomo v Clearinghouse Ass’n, LLC, 129 S Ct 2710 (2009). 3 For an earlier decision that concluded differently on another preemption case involving medical and FDA issues, see

Riegel v Medtronic, 552 US 312 (2008).

ex post facto law–a law making criminal an act that was lawful when done or that increases the penalty when done. Such laws are generally prohibited by constitutional provisions.

preemption– the federal government’s superior regulatory position over state laws on the same subject area.

Chapter 4 The Constitution as the Foundation of the Legal Environment 69

(B) SILENCE OF CONGRESS. In some situations, the silence of Congress in failing to cover a particular subject area indicates that Congress does not want any law on the matter. However, when national uniformity is essential, the silence of Congress generally means that the subject has been preempted for practical reasons by Congress and that no state law on the subject may be adopted.

(C) EFFECT OF FEDERAL DEREGULATION. The fact that the federal government removes the regulations from a regulated industry does not automatically give the states the power to regulate that industry. If under the silence-of-Congress doctrine the states cannot regulate, they are still barred from regulating after deregulation. For Example, deregulation of banks in the 1980s did not mean that the states could step in and regulate those banks.4


The Constitution as it is interpreted today has changed greatly from the Constitution as originally written. The change has been brought about by interpretation, amendment, and practice.

6. Conflicting Theories Shortly after the Constitution was adopted, conflict arose over whether it was to be interpreted strictly, so as to give the federal government the least power possible, or broadly, so as to give the federal government the greatest power that the words would permit. These two views may be called the bedrock view and the living- document view, respectively.

In the bedrock view, or strict constructionist or originalist view, the purpose of a constitution is to state certain fundamental principles for all time. In the living- document view, a constitution is merely a statement of goals and objectives and is intended to grow and change with time.

Whether the Constitution is to be liberally interpreted under the living- document view or narrowly interpreted under the bedrock view has a direct effect on the Constitution. For the last century, the Supreme Court has followed the living-document view. This view has resulted in strengthening the power of the federal government, permitting the rise of administrative agencies, and expanding the protection of human rights.

One view is not selected to the exclusion of the other. As contradictory as these two views sound, the Constitution remains durable. We do not want a set of New Year’s resolutions that will soon be forgotten. At the same time, we know that the world changes, and therefore, we do not want a constitution that will hold us tied in a straitjacket of the past.

In terms of social forces that make the law, we are torn between our desire for stability and our desire for flexibility. We want a constitution that is stable. At the same time, we want one that is flexible.

4 New York v Trans World Airlines, 556 NYS2d 803 (1990). See also footnote 2 and the Cuomo case from 2009.

bedrock view–a strict constructionist interpretation of a constitution.

living-document view– the term used when a constitution is interpreted according to changes in conditions.

70 Part 1 The Legal and Social Environment of Business

7. Amending the Constitution The U.S. Constitution has been amended in three ways: (1) expressly, (2) by interpretation, and (3) by practice. Figure 4-2 illustrates these three methods of amendment.

(A) CONSTITUTIONAL METHOD OF AMENDING. Article V of the Constitution gives the procedure to be followed for amending the Constitution. Relatively few changes have been made to the Constitution by this formal process, although thousands of proposals have been made. Since the time of its adoption, there have been only 27 amendments to the Constitution.

(B) AMENDMENT BY JUDICIAL INTERPRETATION. The U.S. Supreme Court has made the greatest changes to the written Constitution by interpreting it. Generally, interpretation is used to apply the Constitution to a new situation that could not have been foreseen when the written Constitution was adopted.

(C) AMENDMENT BY PRACTICE. In practice, the letter of the Constitution is not always followed. Departure from the written Constitution began as early as 1793 when George Washington refused to make treaties as required by the Constitution, by and with the consent of the Senate. Washington began the practice of the president’s negotiating a treaty with a foreign country and then submitting it to the Senate for approval. This practice has been followed since that time. Similarly, the electoral college was originally intended to exercise independent judgment in selecting the president, but it now automatically elects the official candidate of the party that elected the majority of the members of the electoral college.

8. The Living Constitution The living Constitution has the following characteristics.

(A) STRONG GOVERNMENT. One of the characteristics of the new Constitution is strong government. Business enterprises are highly regulated and the economy is controlled through monetary policy.

(B) STRONG PRESIDENT. Instead of being merely an officer who carries out the laws, the president has become the political leader of a party, exerting strong influence on the lawmaking process.

FIGURE 4-2 Amending the U.S. Constitution





*Article V of the U.S. Constitution specifies the procedure for adopting amendments.

Chapter 4 The Constitution as the Foundation of the Legal Environment 71

(C) ECLIPSE OF THE STATES. Under constitutional interpretations, all levels of government have powers that they never possessed before, but the center of gravity has shifted from the states to the nation. When the Constitution was adopted in 1789, the federal government was to have only the very limited powers specified in Article I, Section 8, of the Constitution. Whatever regulation of business was permissible was to be imposed by the states. Today, the great bulk of the regulation of business is adopted by the federal government through Congress or its administrative agencies. As the U.S. economy moved from the local community stage to the nationwide and then international stages, individual states could no longer provide effective regulation of business. Regulation migrated to the central government.

(D) ADMINISTRATIVE AGENCIES. These units of government were virtually unheard of in 1789, and the Constitution made no mention of them. The vast powers of the new Constitution are exercised to a very large degree by administrative agencies. They are in effect a fourth branch of the government, not provided for in the written Constitution. More importantly, the administrative agencies are the ones that come in contact with the majority of businesspersons and citizens.

Agencies have had a significant amount of power delegated to them. The members and heads of the agencies, boards, or commissions are not elected by the voters (see Chapter 6). They are appointed by the president and, at certain levels of appointment in the agency, must be approved by Congress.

D. FEDERAL POWERS The federal government possesses powers necessary to administer matters of national concern.

9. The Power to Regulate Commerce The desire to protect commerce from restrictions and barriers set up by the individual states was a prime factor leading to the adoption of the Constitution of 1789. To protect commerce, Congress was given Article I, Section 8, Clause 3—now known as the commerce clause—the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.”5

Until 1937, the Supreme Court held that this provision gave Congress the power to control or regulate only that commerce crossing a state line, such as an interstate railway train or an interstate telegraph message.

(A) THE COMMERCE POWER BECOMES A GENERAL WELFARE POWER. In 1937, the Supreme Court began expanding the concept of interstate commerce. By 1946, the power to regulate interstate commerce had become very broad. By that year, the power had expanded to the point that it gave authority to Congress to adopt regulatory laws that were “as broad as the economic needs of the nation.”6 By virtue of this broad interpretation, Congress can regulate manufacturing, agriculture, mining, stock

5 For more details on the actual language in the U.S. Constitution, go to and click on “Founding Documents,” or refer to Appendix 2.

6 American Power & Light Co. v Securities and Exchange Commission, 329 US 90 (1946).

commerce clause– that section of the U.S. Constitution allocating business regulation between federal and state governments.

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exchanges, insurance, loan sharking, monopolies, and conspiracies in restraint of trade. The far reach of the interstate commerce power is seen in the Freedom of Access to Clinic Entrances Act,7 which prohibits obstruction of entrances to clinics.8

The case that was the beginning point in the transition of the commerce clause was NLRB v Jones & Laughlin Steel, 301 US 1 (1937). The “affectation” doctrine expanded the authority of the federal government under the commerce clause. At that time, the Court concluded, “If it is interstate commerce that feels the pinch, it does not matter how local the squeeze.”

(B) THE COMMERCE CLAUSE TODAY. Today, judicial review of the commerce clause typically finds some connection between the legislation and congressional authority. However, in the past five years, the U.S. Supreme Court has found some areas Congress may not regulate and has placed some limitations on the commerce clause. These constraints on the commerce clause focus on the nature of the underlying activity being regulated. So long as the federal regulation relates to economic/ commercial activity, it is constitutional. If, however, the underlying activity is not economic and has only an economic impact, the Supreme Court has imposed restrictions on congressional authority under the commerce clause.

(C) THE COMMERCE POWER AS A LIMITATION ON STATES. The federal power to regulate commerce not only gives Congress the power to act but also prevents states from acting in any way that interferes with federal regulation or burdens interstate commerce. For Example, if the federal government establishes safety device regulations for interstate carriers, a state cannot require different devices.

The Commerce Clause Meets Violence

FACTS: Christy Brzonkala filed a suit under the federal Violence Against Women Act (VAWA) after she was raped by two of her fellow students at the Virginia Polytechnic Institute. The VAWA gives women who are the victims of violence a civil rights action against their assailants. The district court dismissed the suit because it found Congress lacked authority under the commerce clause for the VAWA. The court of appeals reversed. Because a lower court

invalidated a federal statute, the Supreme Court granted certiorari.

DECISION: Congress does not have authority under the commerce clause for the VAWA. The Court held that neither the activity regulated by the VAWA nor the settings in which violence against women occur constitute interstate commerce. The VAWA did not regulate either the channels or instrumentalities of interstate commerce and must therefore rely on aggregating activities to show a substantial effect on interstate commerce. Because the commerce clause requires the aggregating of economic activities for substantial effect cases, the VAWA’s underlying conduct of violence was insufficient to survive constitutional scrutiny. [United States v Morrison, 529 US 598 (2000)]

7 18 USC § 248. 8 The act is constitutional. United States v Wilson, 73 F3d 675 (7th Cir 1995), cert denied, 519 US 806 (1996).

Chapter 4 The Constitution as the Foundation of the Legal Environment 73

States may not use their tax power for the purpose of discriminating against interstate commerce, because such commerce is within the protection of the national government. For Example, a state cannot impose a higher tax on goods imported from another state than it imposes on the same kind of goods produced in its own territory.

State regulations designed to advance local interests may conflict with the commerce clause. Such regulations are invalid. A state cannot refuse to allow an interstate waste collector to conduct business within the state on the grounds that the state already has enough waste collectors.

Minors in Maine and a Major Commerce Clause Decision

FACTS: Maine passed a law that prohibited anyone other than a Maine-licensed tobacco retailer from accepting an order for delivery of tobacco. The law required the retailer to arrange for delivery with a special receipt showing that someone over the age of 18 had received and signed for the tobacco products delivered. Out-of-state shippers and tobacco sellers challenged the law as one that favored Maine tobacco retailers. The state of Maine argued that its law was

passed to prevent the public health hazard of minors becoming addicted to tobacco. The federal district court granted summary judgment for the shippers, and the court of appeals affirmed. The state of Maine appealed.

DECISION: In a 9 to 0 decision, the Court held that the Maine law may have been passed with health benefits in mind, but it clearly gave Maine businesses an economic benefit. In addition, other states had managed to fight teen smoking using programs other than discrimination between in-state and out-of-state tobacco retailers. [Rowe v New Hampshire Motor Transport Association, 552 US 364 (2008)]

Whining about Wine

FACTS: Michigan and New York regulate the sale and importation of alcoholic beverages, including wine, through a three-tier distribu- tion system. Separate licenses are required for producers, wholesalers, and retailers. Both New York and Michigan prohibit out-of-state wine producers from selling their wines directly to consumers there. In-state wineries can sell directly to consumers. The impact of the prohibition on the out-of-state wine producers is that they are required to pay

wholesaler fees and thus cannot compete with in-state wine producers on direct-to-consumer sales. The wine producers challenging the New York and Michigan statutes are small wineries that

rely on direct consumer sales as an important part of their businesses. If they did business through wholesalers in the state, the price of their wines would have to be increased to a level that would be noncompetitive.

74 Part 1 The Legal and Social Environment of Business

10. The Financial Powers The financial powers of the federal government include the powers to tax and to borrow, spend, and coin money.

(A) THE TAXING POWER. The federal Constitution provides that “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.”9 Subject to the express and implied limitations arising from the Constitution, the states may impose such taxes as they desire and as their own individual constitutions and statutes permit. In addition to express constitutional limitations, both national and local taxes are subject to the unwritten limitation that they be imposed for a public purpose. Taxes must also be apportioned. A business cannot be taxed for all of its revenues in all 50 states. There must be apportionment of taxes, and there must be sufficient connection with the state.

(B) THE SPENDING POWER. The federal government may use tax money and borrowed money “to pay the debts and provide for the common defence and general welfare of the United States.”10

(C) THE BANKING POWER. The Constitution is liberally interpreted to allow the federal government to create banks and to regulate banks created under state laws. For example, the Federal Reserve System is responsible for this regulatory oversight of banks.


The district court granted summary judgment for the state of Michigan. The Sixth Circuit Court of Appeals reversed on the grounds that the out-of-state restrictions violated the commerce clause. The state of Michigan appealed. In the New York case, the district court found that the out-of-state restrictions violated the commerce clause, and the Second Circuit Court of Appeals reversed and upheld the New York statute as constitutional. The out-of-state wine producers appealed.

DECISION: State laws violate the commerce clause if they treat in-state and out-of-state economic interests differently with the result that one benefits and the other is burdened. The mere fact that a wine producer is not a resident of the state should not foreclose access to markets there. The Michigan statutes prohibiting out-of-state wineries from shipping wine directly to in-state consumers, but permitting in-state wineries to do so if licensed, discriminated against interstate commerce. New York statutes imposing additional burdens on out-of-state wineries seeking to ship wine directly to New York consumers discriminated against interstate commerce. The effect of both statutes was to favor in-state wine producers and create the economic Balkanization that the commerce clause was intended to prevent. Both statutes violated the commerce clause. [Granholm v Heald, 544 US 460 (2005)]

9 U.S. Const., Art 1, § 8, cl 1. To read more of the U.S. Constitution, refer to Appendix 2, or go to and click on “Founding Documents.”

10 U.S. Const., Art 1, § 8, cl 1. See, or Appendix 2.

Chapter 4 The Constitution as the Foundation of the Legal Environment 75


The constitutional limitations discussed in the following sections afford protections of rights for both persons and businesses.

11. Due Process The power of government is limited by both the Fifth and Fourteenth Amendments to the Constitution. Those amendments respectively prohibit the national government and state governments from depriving any person “of life, liberty, or property without due process of law.”11

(A) WHEN DUE PROCESS RIGHTS ARISE. As a result of liberal interpretation of the Constitution, the due process clause now provides a guarantee of protection against the loss of property or rights without the chance to be heard. These amendments also guarantee that all citizens are given the same protections. For Example, the Supreme Court has extended the due process clause to protect the record or standing of a student.12 A student cannot lose credit in a course or be suspended or expelled without some form of a hearing.

A Quill in Your State Means Taxes in the Coffer

FACTS: Quill is a Delaware corporation with offices and warehouses in Illinois, California, and Georgia. None of its employees works or lives in North Dakota, and Quill owns no property in North Dakota.

Quill sells office equipment and supplies; it solicits business through catalogs and flyers, advertisements in national periodicals, and telephone calls. Its annual national sales exceed $200 million, of which almost $1 million are made to about 3,000 customers in North

Dakota. The sixth-largest vendor of office supplies in the state, it delivers all of its merchandise to its North Dakota customers by mail or common carriers from out-of-state locations.

North Dakota requires every “retailer maintaining a place of business in” the state to collect the tax from the consumer and remit it to the state. In 1987, North Dakota amended its statutory definition of the term “retailer” to include “every person who engages in regular or systematic solicitation of a consumer market in the state.” State regulations in turn define “regular or systematic solicitation” to mean three or more advertisements within a 12-month period.

Quill has taken the position that North Dakota does not have the power to compel it to collect a use tax from its North Dakota customers. Consequently, the state, through its tax commissioner, filed this action to require Quill to pay taxes (as well as interest and penalties) on all such sales made after July 1, 1987. The trial court ruled in Quill’s favor.

The North Dakota Supreme Court reversed, and Quill appealed.

DECISION: The Court held that the issue is one of whether the company has intentionally placed itself within a state. Whether it does so with offices and salespeople or deluges the citizens with catalogs is irrelevant. So long as the company has voluntarily placed itself within the state, the taxation is neither unfair nor unconstitutional. [Quill v North Dakota, 504 US 298 (1992)]

11 For more information on the language of the Fifth and Fourteenth Amendments, see the U.S. Constitution in Appendix 2, or go to

12 That is, a student cannot be expelled without a chance to have his or her side of the story reviewed.

due process clause–a guarantee of protection against the loss of property or rights without the chance to be heard.

76 Part 1 The Legal and Social Environment of Business

Because there are so many areas in which due process rights exist and require a chance to be heard, speeding up due process has resulted in the creation of quasi-judicial proceedings. In these types of proceedings, the parties need not go through the complex, lengthy, and formal procedures of a trial (described in Chapter 2). Rather, these proceedings have a hearing officer or administrative law judge (see Chapter 6) who conducts an informal hearing in which the rules of evidence and procedure are relaxed.

For Example, a student taking a grade grievance beyond a faculty member’s decision will generally have his case heard by a panel of faculty and students as established by college or university rules. An employer appealing its unemployment tax rate will have the appeal heard by an administrative law judge.

(B) WHAT CONSTITUTES DUE PROCESS? Due process does not require a trial on every issue of rights. Shortcut procedures, such as grade grievance panels, have resulted as a compromise for providing the right to be heard along with a legitimate desire to be expeditious in resolving these issues.

12. Equal Protection of the Law The Constitution prohibits the states and the national government from denying any person the equal protection of the law.13 This guarantee prohibits a government

Internet and Interstate

Collection of sales tax from Internet stores has been a stickler of an issue for businesses, state revenue officials, and the U.S. Supreme Court. All three were grappling with how to collect, what to collect, and whether anybody had any authority to collect. Internet sales repre- sent a large, untapped source of revenue. A study from the Center for Business and Economic Research at the University of Tennessee estimates the lost tax revenue from untaxed Internet sales as $21 billion in 2008.

The merchants involved fell into several different legal groups in terms of their theories on whether tax was owed and whether they should just pay it, with or without the states having the authority to tax:

1. Those stores with physical presences in states (Wal- Mart and J.C. Penney) that just collected sales tax as if they were collecting it in a store in that state where the Internet purchaser was located

2. Those stores without a physical pre- sence (Amazon) that did collect taxes, particularly in those states known for taking a hard-line approach

3. Those stores without a physical presence that do not collect taxes and maintain that it is unconstitu-

tional to do so

4. Those stores with or without a physical presence that have collected taxes but held them until everyone could figure out the legal status of the companies.

What are the constitutional issues in this taxa- tion question?

Note: filed suit in 2008 challenging New York’s statute that authorized the collection of sales taxes from online company sales to New York residents.

Source: Robery Guy Matthews, “Some States Push to Collect Sales Tax from Internet Stores,” Wall Street Journal, Sept. 30, 2005, B1–B4.

13 U.S. Constitution, Fourteenth Amendment as to the states; modern interpretation of due process clause of the Fifth Amendment as to national government. Congress adopted the Civil Rights Act to implement the concept of equal protection.

quasi-judicial proceedings– forms of hearings in which the rules of evidence and procedure are more relaxed but each side still has a chance to be heard.

Chapter 4 The Constitution as the Foundation of the Legal Environment 77

from treating one person differently from another when there is no reasonable ground for classifying them differently.

(A) REASONABLE CLASSIFICATION. Whether a classification is reasonable depends on whether the nature of the classification bears a reasonable relation to the wrong to be remedied or to the object to be attained by the law. The judicial trend is to permit the classification to stand as long as there is a rational basis for the distinction made.14 Whether a rational basis exists is determined by answering whether the lawmaking body has been arbitrary or capricious.

The equal protection clause is the basis of many of the U.S. Supreme Court’s most complicated decisions. For Example, during the 2000 presidential election, the U.S. Supreme Court faced an issue of equal protection with regard to the challenge then–vice president and presidential candidate Al Gore made to the undervotes in Florida’s ballots. However, then-presidential candidate George W. Bush argued that counting the undervotes in some counties and not in others and applying different standards for counting or not counting the infamous dimpled chads, hanging chads, and other undervotes was unconstitutional because it deprived other Florida voters of equal protection because each vote is intended to count equally. Recounts in only some counties while using varying standards resulted in some counties being given greater weight in Florida’s presidential election. The U.S. Supreme Court agreed in a 7–2 decision that the recounts were unconstitutional on equal protection grounds.15

However, the justices split 5–4 on the correct remedy for the unconstitutional recounts.

(B) IMPROPER CLASSIFICATION. Laws that make distinctions in the regulation of business, the right to work, and the right to use or enjoy property on the basis of race, national origin, or religion are invalid. Also invalid are laws that impose restrictions on some, but not all, persons without any justification for the distinction.16 For Example, a state statute taxing out-of-state insurance companies at a higher rate than in-state insurance companies violates the equal protection clause.17

13. Privileges and Immunities The federal Constitution declares that “the citizens of each state shall be entitled to all privileges and immunities of citizens in the several states.”18 The so-called privileges and immunities clause means that a person going into another state is entitled to make contracts, own property, and engage in business to the same extent as the citizens of that state. For Example, a state cannot bar someone who comes from another state from engaging in local business or from obtaining a hunting or fishing license merely because the person is not a resident of that state.

14. Protection of the Person The Constitution has no general provision declaring that the government shall not impair rights of persons. The Constitution does not mention the phrase

14 Ileto v Glock, Inc., 565 F3d 1126 (CA 9 2009) 15 Bush v Gore, 531 US 98 (2000). 16 Associated Industries of Missouri v Lohman, 511 US 641 (1994). 17 Metropolitan Life Ins. Co. v Ward, 470 US 869 (1985). 18 U.S. Const., Art IV, § 2, cl 1. See and click on “Founding Documents” to access more

language of the Constitution, or see Appendix 2.

privileges and immunities clause–a clause that entitles a person going into another state to make contracts, own property, and engage in business to the same extent as citizens of that state.

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“unalienable right” that was part of the Declaration of Independence.19 However, the Bill of Rights, the first 10 amendments to the Constitution, does provide protections for freedom of speech, jury trials, and freedom of religion and association.20 The Bill of Rights provides for the due process protections discussed earlier as well as those that prohibit unlawful searches and seizures. The Second Amendment provides for the right to keep and bear arms, an issue that has resulted in some conflicting decisions that the U.S. Supreme Court has begun to address.21

During the last six decades, the Supreme Court has been interpreting the rights in these amendments and has been finding constitutional protection for a wide array of rights of the person that are not expressly protected by the Constitution. For Example, judicial interpretations have concluded that the Constitution provides for the right of privacy, the right to marry the person one chooses,22 protection from unreasonable zoning, protection of parental control, protection from discrimination because of poverty, and protection from gender discrimination.23

15. The Bill of Rights and Businesses as Persons The Bill of Rights provides protections for individuals and also for corporations. For Example, the Fourth Amendment (see Chapter 8) provides protections against unreasonable searches. Individuals enjoy that protection in their homes, and corporations enjoy that protection with their files, offices, and business records. Businesses also enjoy freedom of speech protections under the First Amendment. The First Amendment provides that “Congress shall make no law … abridging the freedom of speech …”24

The U.S. Supreme Court has clarified the free speech rights of business through classification of the types of business speech. One form of business or commercial speech is advertising. This form of speech in which businesses tout their products is subject to regulation and restriction on form, content, and placement, and such regulation has been deemed constitutional. (See Chapters 25 and 33 for more information on the regulation of advertising.) However, there are other forms of commercial speech. Businesses do have the right to participate in political processes such as creating political action committees and supporting or opposing ballot initiatives. Businesses often take positions and launch campaigns on ballot initiatives that will affect the taxes they will be required to pay.

19 The term unalienable right is employed in reference to natural right, fundamental right, or basic right. Apart from the question of scope of coverage, the adjective unalienable emphasizes the fact that the people still possess the right rather than having surrendered or subordinated it to the will of society. The word alien is the term of the old common law for transferring title or ownership. Today, we would say transfer and, instead of saying unalienable rights, would say nontransferable rights. Unalienable rights of the people were therefore rights that the people not only possessed but also could not give up even if they wanted to. Thus, these rights are still owned by everyone. It is important to note that the Declaration of Independence actually uses the word “unalienable” when describing the rights eventually placed in the Constitution as Amendments I–X, the Bill of Rights, not “inalienable.”

20 North Coast Women’s Care Medical Group, Inc. v San Diego County Superior Court, 189 P 3d 959 (Ca 2008). 21 District of Columbia v Heller, 128 S Ct 2783 (2008). 22 Akron v Akron Center for Reproductive Health, Inc., 462 US 416 (1983); but see Colorado v Hill, cert granted, 527

US 1068 (2000). For more on commercial speech, see Greater New Orleans Broadcasting Association, Inc., v U.S. 527 US 173 (1999) and U.S. v Philip Morris USA Inc., 566 F3d 1095 (CA DC 2009).

23 In some cases, the courts have given the due process and equal protection clauses a liberal interpretation in order to find a protection of the person, thereby making up for the fact that there is no express constitutional guarantee of protection of the person. Davis v Passman 442 US 228 (1979) (due process); Orr v Orr, 440 US 268 (1979) (equal protection).

24 To read the full language of the First Amendment, go to Appendix 2, or to and click on “Founding Documents.”

Chapter 4 The Constitution as the Foundation of the Legal Environment 79

Banks Are People Too: First Amendment Political Speech

FACTS: Massachusetts had passed a statute that prohibited businesses and banks from making contributions or expenditures for the purpose of influencing or affecting the vote on any question submitted to the voters other than one materially affecting any of the property, business, or assets of the corporation. The statute also stated that taxation ballot questions did not materially affect the property, business, or assets of the corporation. The statute carried

a fine of up to $50,000 for the corporation and $10,000 and/or one-year imprisonment for corporate officers.

First National Bank and other banks and corporations wanted to spend money to publicize their views on an upcoming ballot proposition that would give the legislature the right to impose a graduated tax on individual income. Frances X. Bellotti, the attorney general for Massachusetts, told First National and the others that he intended to enforce the statute against them. First National and the others brought suit to have the statute declared unconstitutional, and First National appealed.

DECISION: The worth of speech is not determined by the source. The First Amendment provides protection to all forms of speech. Further, neither the Court nor the Constitution is in a position to restrict the speech of corporations on the grounds that the speech is not about business. That corporate advertising on ballot issues may be influential is not grounds for restricting the ability to advertise on political issues and social concerns. The regulation was also determined to be selective in that it would limit corporate participation on ballot initiatives but placed no controls on lobbying for legislation. The purpose of the regulation was not compelling nor sufficiently narrowly drawn to justify its constitutionality. [First National Bank of Boston v Bellotti, 435 US 765 (1978)]

Sweating It Out on Free Speech

In 1996, Nike was inundated with alle- gations about its labor practices in shoe factories around the world. Nike re- sponded to the negative reports and allegations with a series of releases, advertisements, and op-ed pieces in newspapers around the country. New York Times columnist Bob Herbert wrote two col- umns that were sharply critical of Nike’s conditions in plants throughout Asia. The columns compared then- CEO Philip Knight’s compensation with the $2.20 per day wages of Nike workers in Indonesia.

After the columns appeared, CEO Knight wrote a letter to the editor in response to them. In that letter, he wrote, “Nike has paid, on average, dou- ble the minimum wage as defined in countries where its products are pro- duced under contract. History shows

that the best way out of poverty for such countries is through exports of light manufactured goods that provide the base for more skilled production.”*

Marc Kasky filed suit against Nike in California, alleging that the op-ed pieces and letters in response

80 Part 1 The Legal and Social Environment of Business

The Candidate (1972) (PG)

The movie depicts an idealist running for office who finds himself caught in the political process of fundraising, image-building, and winning. A number of scenes with speeches, fundraising, and principles in conflict provide excellent discussion issues with respect to government structure, the First Amendment, and campaign contributions.

Check out LawFlix at to access movie clips that illustrate business law concepts.


to negative op-ed pieces about Nike violated the False Advertising Act of California. The act permits state agencies to take action to fine corporate violators of the act as well as to obtain remedies such as injunctions to halt the ads.

Nike challenged the suit on the grounds that such an interpretation and application of the advertising regulation violated its rights of free speech. The lower court agreed with Kasky and held that the advertising statute applied to Nike’s defense of its labor practices, even on the op-ed pages of newspapers. The California Supreme Court, 45 P.3d 243 (Cal. 2002),

ruled that Nike could be subject to regulatory sanctions for false advertising. Nike appealed to the U.S. Supreme Court. Should Nike’s editorial be protected by the First Amendment? Discuss where this type of speech fits.

The opinion handed down in this case is only one sentence: “The writ of certiorari is dismissed as im- providently granted.” 539 US 654 (2003). Is this letter protected speech?

*Roger Parloff, “Can We Talk?” Fortune, September 2, 2002, 102–110.



The U.S. Constitution created the structure of our national government and gave it certain powers. It also placed limitations on those powers. It created a federal system with a tripartite division of government and a bicameral national legislature.

The national government possesses some governmental powers exclusively, while both the states and the federal government share other powers. In areas of conflict, federal law is supreme.

Chapter 4 The Constitution as the Foundation of the Legal Environment 81

The U.S. Constitution is not a detailed document. It takes its meaning from the way it is interpreted. In recent years, liberal interpretation has expanded the powers of the federal government. Among the powers of the federal government that directly affect business are the power to regulate commerce; the power to tax and to borrow, spend, and coin money; and the power to own and operate businesses.

Among the limitations on government that are most important to business are the requirements of due process and the requirement of equal protection of the law. In addition, government is limited by the rights given to individuals such as freedom of speech, freedom of religion, and equal protection. The equal protection concept of the U.S. Constitution prohibits both the federal government and the state governments from treating one person differently from another unless there is a legitimate reason for doing so and unless the basis of classification is reasonable.

LEARNING OUTCOMES After studying this chapter, you should be able to clearly explain:

A. THE U.S. CONSTITUTION AND THE FEDERAL SYSTEM LO.1 Describe the U.S. Constitution and the Federal System

See the discussion of the tripartite (three-part) government on p. 67.

B. THE U.S. CONSTITUTION AND THE STATES LO.2 Explain the relationship between the U.S. Constitution and the States

See the discussion of the federal system on p. 67. See Figure 4-1 for an illustration of the delegation of powers.

C. INTERPRETING AND AMENDING THE CONSTITUTION LO.3 Discuss interpreting and amending the Constitution

See the discussion of the bedrock and constructionist views on p. 70.

D. FEDERAL POWERS LO.4 List and describe the significant federal powers

See the discussion of the commerce power on p. 72. See the discussion of the taxing power on p. 76. See the discussion of the banking power on p. 77.

E. CONSTITUTIONAL LIMITATIONS ON GOVERNMENT LO.5 Discuss constitutional limitations on governmental power

See the discussion of the Bill of Rights on p. 79. See the discussion of the Fourth Amendment on p. 79. See the discussion of due process on p. 77. See the For Example discussion of a student taking a grade grievance beyond a faculty member’s decision on p. 77.


bedrock view bicameral commerce clause

constitution delegated powers due process clause

ex post facto laws executive branch federal system

82 Part 1 The Legal and Social Environment of Business

judicial branch legislative branch living-document view police power

preemption privileges and immunities

clause quasi-judicial proceedings

shared powers tripartite

QUESTIONS AND CASE PROBLEMS 1. Federal law requires most interstate truckers to obtain a permit that reflects

compliance with certain federal requirements. The 1965 version of the law authorized states to require proof that a truck operator had such a permit. By 1991, 39 states had demanded such proof, requiring a $10 per truck registration fee and giving each trucker a stamp to affix to a multistate “bingo card” carried in the vehicle. Finding this scheme inefficient and burdensome, Congress created the current Single State Registration System (SSRS), which allows a trucking company to fill out one set of forms in one state, thereby registering in every participating state through which its trucks travel.

A subsection of Michigan’s Motor Carrier Act imposes on truck companies operating in interstate commerce an annual fee of $100 for each self-propelled motor vehicle operated by or on behalf of the motor carrier. The American Truckers Association (ATA) and others challenged the $100 fee as preempted by the extensive federal regulation of interstate trucking and trucking companies. The ATA and others appealed to the U.S. Supreme Court. What should the U.S. Supreme Court do? Be sure to discuss what portion of the Constitution applies to this issue. [American Trucking Associations, Inc. v Michigan Public Service Com’n, 545 US 429]

2. J.C. Penney, a retail merchandiser, has its principal place of business in Plano, Texas. It operates retail stores in all 50 states, including 10 stores in Massachusetts, and a direct mail catalog business. The catalogs illustrated merchandise available for purchase by mail order. The planning, artwork, design, and layout for these catalogs were completed and paid for outside of Massachusetts, primarily in Texas, and Penney contracted with independent printing companies located outside Massachusetts to produce the catalogs. The three major catalogs were generally printed in Indiana, while the specialty catalogs were printed in South Carolina and Wisconsin. Penney supplied the printers with paper, shipping wrappers, and address labels for the catalogs; the printers supplied the ink, binding materials, and labor. None of these materials was purchased in Massachusetts. Printed catalogs, with address labels and postage affixed, were transported by a common carrier from the printer to a U.S. Postal Service office located outside Massachusetts, where they were sent to Massachusetts addressees via third- or fourth-class mail. Any undeliverable catalogs were returned to Penney’s distribution center in Connecticut.

Purchases of catalog merchandise were made by telephoning or returning an order form to Penney at a location outside Massachusetts, and the merchandise was shipped to customers from a Connecticut distribution center. The Massachusetts Department of Revenue audited Penney in 1995 and assessed a use tax, penalty, and interest on the catalogs that had been shipped into Massachusetts.

Chapter 4 The Constitution as the Foundation of the Legal Environment 83

The position of the department was that there was a tax due of $314,674.62 on the catalogs that were used by Penney’s Massachusetts customers. Penney said such a tax was unconstitutional in that it had no control or contact with the catalogs in the state. Can the state impose the tax? Why or why not? [Commissioner of Revenue v J.C. Penney Co., Inc., 730 NE2d 266 (Mass)]

3. Alfonso Lopez, Jr., a 12th-grade student at Edison High School in San Antonio, Texas, went to school carrying a concealed .38-caliber handgun and five bullets. School officials, acting on an anonymous tip, confronted Lopez. Lopez admitted that he had the gun. He was arrested and charged with violation of federal law, the Gun-Free School Zones Act of 1990. Lopez moved to dismiss his indictment on the grounds that the provision of the Gun-Free School Zones Act with which he was charged was unconstitutional in that it was beyond the power of Congress to legislate controls over public schools. The district court found the statute to be a constitutional exercise of congressional authority.

Lopez was found guilty and sentenced to two years in prison. He appealed and challenged his conviction on the basis of the commerce clause. The Court of Appeals agreed with Lopez, found the Gun-Free School Zones Act an unconstitutional exercise of congressional authority, and reversed the conviction. The U.S. Attorney appealed. Who should win at the U.S. Supreme Court and why? [United States v Lopez, 514 US 549]

4. The University of Wisconsin requires all of its students to pay, as part of their tuition, a student activity fee. Those fees are used to support campus clubs and activities. Some students who objected to the philosophies and activities of some of the student clubs filed suit to have the fees halted. What constitutional basis do you think they could use for the suit? [Board of Regents of Wisconsin System v Southworth, 529 US 217]

5. The Crafts’ home was supplied with gas by the city gas company. Because of some misunderstanding, the gas company believed that the Crafts were delinquent in paying their gas bill. The gas company had an informal complaint procedure for discussing such matters, but the Crafts had never been informed that such a procedure was available. The gas company notified the Crafts that they were delinquent and that the company was shutting off the gas. The Crafts brought an action to enjoin the gas company from doing so on the theory that a termination without any hearing was a denial of due process. The lower courts held that the interest of the Crafts in receiving gas was not a property interest protected by the due process clause and that the procedures the gas company followed satisfied the requirements of due process. The Crafts appealed. Were they correct in contending that they had been denied due process of law? Why or why not? [Memphis Light, Gas and Water Division v Craft, 436 US 1]

6. Alexis Geier was injured in an accident while driving a 1987 Honda Accord that did not have passive safety restraints. When her Honda Accord was manufactured, the U.S. Department of Transportation required passive safety restraints on some, but not all, vehicles. Geier and her parents filed suit against Honda for its negligence in not equipping the Honda Accord with a driver’s- side airbag. Geier alleged that because Honda knew of the safety standard but

84 Part 1 The Legal and Social Environment of Business

did not voluntarily comply with it (it was not required to do so under the federal regulations), it was negligent under state negligence standards for liability and should be held liable. The district court granted Honda summary judgment based on Honda’s argument that safety requirements for cars were set exclusively by the federal government. The Court of Appeals affirmed, and Geier appealed. What would be the effect of a decision that requires a car company to comply with state-by-state standards of negligence? Would a state court finding of negligence be a constitutional exercise of state power? Should the U.S. Supreme Court affirm or reverse the summary judgment for Honda? [Geier v American Honda Motor Co., 529 US 1913]

7. Montana imposed a severance tax on every ton of coal mined within the state. The tax varied depending on the value of the coal and the cost of production. It could be as high as 30 percent of the price at which the coal was sold. Montana mine operators and some out-of-state customers claimed that this tax was unconstitutional as an improper burden on interstate commerce. Decide. [Commonwealth Edison Co. v Montana, 453 US 609]

8. Ollie’s Barbecue is a family-owned restaurant in Birmingham, Alabama, specializing in barbecued meats and homemade pies, with a seating capacity of 220 customers. It is located on a state highway 11 blocks from an interstate highway and a somewhat greater distance from railroad and bus stations. The restaurant caters to a family and white-collar trade, with a take-out service for “Negroes.” (Note: This term is used by the Court in its opinion in the case.) In the 12 months preceding the passage of the Civil Rights Act, the restaurant purchased locally approximately $150,000 worth of food, $69,683 or 46 percent of which was meat that it bought from a local supplier who had procured it from outside the state. Ollie’s has refused to serve Negroes in its dining accommoda- tions since opening in 1927, and since July 2, 1964, it has been operating in violation of the Civil Rights Act. A lower court concluded that if it were required to serve Negroes, it would lose a substantial amount of business. The lower court found that the Civil Rights Act did not apply because Ollie’s was not involved in “interstate commerce.” Will the commerce clause permit application of the Civil Rights Act to Ollie’s? [Katzenbach v McClung, 379 US 294]

9. Ellis was employed by the city of Lakewood. By the terms of his contract, he could be discharged only for cause. After working for six years, he was told that he was going to be discharged because of his inability to generate safety and self-insurance programs, because of his failure to win the confidence of employees, and because of his poor attendance. He was not informed of the facts in support of these conclusions and was given the option to resign. He claimed that he was entitled to a hearing. Is he entitled to one? Why or why not? [Ellis v City of Lakewood, 789 P 2d 449 (Colo. App.)]

10. The Federal Food Stamp Act provided for the distribution of food stamps to needy households. In 1971, section 3(e) of the statute was amended to define households as limited to groups whose members were all related to each other. This was done because of congressional dislike for the lifestyles of unrelated hippies who were living together in hippie communes. Moreno and others

Chapter 4 The Constitution as the Foundation of the Legal Environment 85

applied for food stamps but were refused them because the relationship requirement was not satisfied. An action was brought to have the relationship requirement declared unconstitutional. Is it constitutional? Discuss why or why not. [USDA v Moreno, 413 US 528]

11. New Hampshire adopted a tax law that in effect taxed the income of nonresidents working in New Hampshire only. Austin, a nonresident who worked in New Hampshire, claimed that the tax law was invalid. Was he correct? Explain. [Austin v New Hampshire, 420 US 656]

12. Following a boom in cruise ship construction, the ships are now looking for ports at which they can dock in order to begin voyages, most of which begin in the United States. With so many new ships, the companies are trying to establish connections with cities that are not ordinarily considered cruise ship docks. The companies pursue these alternatives because the traditional docking cities of New York, Seattle, Miami, Los Angeles, and Houston have become crowded with cruise ship traffic. The following issues have arisen:

● Without proper scheduling and departures, cruise ships often end up waiting in the harbor for three to eight hours; as a result, ports such as Tampa, a nontraditional cruise ship port, are experiencing traffic jams of ships waiting to dock.

● The presence of the large boats and the resulting number of tourists cause overwhelming flooding of the often-quaint alternative ports such as Charleston, South Carolina. Charleston residents worry that tourists from the cruise ships flooding their city will result in irreversible destruction of the town’s preserved landmarks and quaint looks.

● Rising water levels in ports such as New Orleans mean that the tall ships cannot clear power lines and have to be redirected to ports nearby that are not prepared, as when New Orleans had to redirect a 2,974-passenger cruise ship to Gulfport, Mississippi.

● The port facilities are not adequate to handle all of the boats, the passengers, and even the ships’ fueling needs.

Most cruise ship lines are incorporated outside of the United States, and they do not pay federal income taxes and are certainly not subject to state income taxes even though the most passengers come from the United States.25 Can the ships be taxed to cover the harbor expenses? Can they be required by states and cities to pay docking fees, or are they internationally exempt companies?

13. A federal statute prohibited granting federal funds to libraries that did not control access to pornographic Internet sites on library computers so that children did not gain access and were not exposed to such sites as they used the public facilities. The American Library Association challenged the prohibition as a violation of First Amendment rights.

Are free speech rights violated with the funding regulation? [U.S. v American Library Association, 539 US 194; lower court decision at 201 F Supp 2d 401]

25 Nicole Harris, “Big Cruise Ships Cause Traffic Jams in Ports,” Wall Street Journal, August 20, 2003, B1–B6.

86 Part 1 The Legal and Social Environment of Business

Chapter 5


A. Power to Regulate Business




B. Regulation of Markets and Competition



C. Power to Protect Business


The government can regulate not just businesses but also businesscompetition and prices. Antitrust legislation and a regulatory scheme helpto ensure that businesses compete fairly. A. POWER TO REGULATE BUSINESS The federal government may regulate any area of business to advance the nation’s economic needs.1 Under the police power, states may regulate all aspects of business so long as they do not impose an unreasonable burden on interstate commerce or any activity of the federal government. (See Chapter 4 for a discussion of the protections and limits of the commerce clause.) Local governments may also exercise this police power to the extent a state permits them to do so.

1. Regulation, Free Enterprise, and Deregulation Milton Friedman, the Nobel economist, has written that government regulation of business interferes with the free enterprise system. Under a true free enterprise system, market forces would provide the necessary protections for airline safety, food purity, and safe drugs through the forces of demand and supply. Sometimes, however, the demand response, or market reaction, to problems or services is not rapid enough to prevent harm, and government regulation steps in to stop abuses. For example, the Federal Trade Commission (FTC) stepped in to curb the tactics and practices of telemarketers when the number of consumer complaints increased dramatically without any industry self-regulation.

There has been some deregulation in certain industries. The collapse of companies such as Lehman Brothers and New Century Financial as well as the financial woes of companies such as Merrill Lynch and Bear Stearns (situations that stemmed from the meltdown of the subprime mortgage markets) have revealed that more oversight is necessary for Wall Street investment firms, financial analysts, and mortgage lenders. Consequently, Congress is in the process of regulating bond rating agencies, the mortgage process, appraisals, and investment banking operations.

2. Regulation of Production, Distribution, and Financing To protect the public from harm, government may prohibit false advertising and labeling, and establish health and purity standards for cosmetics, foods, and drugs. Licenses may be required to be able to deal in certain goods, and these licenses may be revoked for improper conduct or violations of statutes and regulations.2 The government may also regulate markets themselves: the quantity of a product that may be produced or grown and the price at which the finished product may be sold. For example, agricultural products markets and commodities have significant government constraints. Government may also engage in competition with private

1 SKF, USA, Inc. v Customs and Border Protection, 556 F3d 1337 (CA 9 2009). 2 Culver v Maryland Ins. Com‘r, 931 A2d 537 (Md App 2007).

88 Part 1 The Legal and Social Environment of Business

enterprises or own and operate an industry. For Example, the U.S. Postal Service competes directly with UPS and FedEx for the delivery of packages as well as for overnight delivery services.

The financing of business is directly affected by the national government, which creates a national currency and maintains the Federal Reserve banking system. State and other national laws may also affect financing by regulating financing contracts and documents, such as bills of lading and commercial paper.

3. Regulation of Unfair Competition Each of the states and the federal government have statutes and regulations that prohibit unfair methods of competition. Unfair competition is controlled by both statutes and administrative agencies and regulations.

Congress has enacted the Federal Trade Commission Act,3 which makes all “unfair methods of competition … and unfair or deceptive acts or practices”4

unlawful and created the Federal Trade Commission (FTC) to administer the act. The FTC has taken enforcement steps against refusals to sell, boycotts, market restrictions, disparagement of competitors’ products, and unlawful methods of billing and collection. The FTC regulates false and misleading advertising and controls even the statements on packaged foods to ensure that the nutritional content of the food described on the label is accurate For Example, Beech-Nut Baby Food Company paid significant fines in the late 1980s for representing its baby apple juice to actually contain apple juice. The product was made from a very good- tasting chemical concoction, but it had no apple juice. Such misrepresentation on the label was a violation of Section 5 of the Federal Trade Commission Act that prohibits unfair methods of competition. Business missteps, from false advertising to boycotts, constitute unfair methods of competition prohibited under the FTC Act.5


4. Regulation of Prices Governments, both national and state, may regulate prices. Price regulation may be delegated to an administrative officer or agency. Prices in various forms are regulated, including not only what a buyer pays for goods purchased from a store (through controls on price fixing—see discussion that follows) but also through limits on interest rates and rent controls.C P AC P A (A) PROHIBITION ON PRICE FIXING. Agreements among competitors, as well as “every contract, combination … or conspiracy” to fix prices, violate Section 1 of the Sherman Act.6 Known as horizontal price-fixing, any agreements to charge an agreed-upon price or to set maximum or minimum prices between or among competitors are per se—in, through, or by themselves—a violation of the Sherman

3 15 USC § 41 et seq. 4 To review the Federal Trade Commission Act, go to 5 In many states, such a seller would also be guilty of committing a deceptive trade practice or violating a consumer

protection statute. 6 To view the full language of Section 1 of the Sherman Act, see 15 USC § 1.

Chapter 5 Government Regulation of Competition and Prices 89

Act. An agreement among real estate brokers to never charge below a 6 percent commission is price-fixing.7 For Example, in 2001, Christie’s and Sotheby’s auction houses settled an antitrust lawsuit for charging the same commissions for many years.8

(B) PROHIBITED PRICE DISCRIMINATION. The Clayton Act and Robinson-Patman Act prohibit price discrimination.9 Price discrimination occurs when a seller charges different prices to different buyers for “commodities of like grade and quality,” with the result being reduced competition or a tendency to create a monopoly.10

Price discrimination prohibits charging different prices to buyers as related to marginal costs. That is, volume discounts are permissible because the marginal costs are different on the larger volume of goods. However, the Robinson-Patman Act makes it illegal to charge different prices to buyers when the marginal costs of the seller for those goods are the same. Any added incentives or bonuses are also considered part of the price.

Bagging Customers for Having Sales

FACTS: Leegin Creative Leather Products, Inc. designs, manu- factures, and distributes leather goods and accessories under the brand name “Brighton.” The Brighton brand is sold across the United States in over 5,000 retail stores. PSKS, Inc., runs Kay’s Kloset, a Brighton retailer in Lewisville, Texas, that carries about 75 different product lines, but was known as the place in that area to go for Brighton.

Leegin’s president, Jerry Kohl, who also has an interest in about 70 stores that sell Brighton products, believes that small retailers treat customers better, provide customers more services, and make their shopping experience more satisfactory than do larger, often impersonal retailers. In 1997, Leegin instituted the “Brighton Retail Pricing and Promotion Policy,” which banished retailers that discounted Brighton goods below suggested prices.

In December 2002, Leegin discovered that Kay’s Kloset had been marking down Brighton’s entire line by 20 percent. When Kay’s would not stop marking the Brighton products prices down, Leegin stopped selling to the store.

PSKS sued Leegin for violation of the antitrust laws. The jury awarded PSKS $1.2 million in damages and the judge trebled the damages and reimbursed PSKS for its attorney’s fees and costs– for a judgment against Leegin of $3,975,000.80. The Court of Appeals affirmed. Leegin appealed.

DECISION: The Court held that the goal of providing customers with information and service through the smaller boutiques was a competitive strategy that offered consumers choices. It was not a per se violation for Leegin to require minimum prices. Resale price maintenance increases the choices consumers have by providing them with a full-service retailer. Each case on resale price maintenance requires examination of the market and the effect on competition, but it is not automatically anticompetitive. The decision was reversed. [Leegin Creative Leather Products, Inc. v PSKS, Inc., 551 US 877 (2007)]

7 McClain v Real Estate Board of New Orleans, Inc., 441 US 942 (1980). 8 Carol Vogel and Ralph Blumenthall, “Ex-Chairman of Sotheby’s Gets a Year and a Day for Price-Fixing,” New York

Times, April 12, 2002, A26. 9 15 USC §§ 1, 2, 3, 7, 8.

10 15 USC § 13a. To read the full Clayton Act, go to or and plug in “Clayton Act” in a site search.

Clayton Act–a federal law that prohibits price discrimination.

Robinson-Patman Act–a federal statute designed to eliminate price discrimination in interstate commerce.

price discrimination– the charging practice by a seller of different prices to different buyers for commodities of similar grade and quality, resulting in reduced competition or a tendency to create a monopoly.

90 Part 1 The Legal and Social Environment of Business

For Example, offering one buyer free advertising while not offering it to another as an incentive to buy would be a violation of the Robinson-Patman Act. The Clayton Act makes both the giving and the receiving of any illegal price discrimination a crime.

C P AC P A State statutes frequently prohibit favoring one competitor by giving a secret discount when the effect is to harm the competition.11 A state may prohibit either selling below cost to harm competitors or selling to one customer at a secret price that is lower than the price charged other customers when there is no economic justification for the lower price.12 Some state statutes specifically permit sellers to set prices so that they can match competitive prices, but not to undercut a competitor’s prices.13 The issue of state antitrust regulation and wide variations in state laws and decisions prompted the creation of the Antitrust Modernization Commission,

Getting a Piece of the Pie Market

FACTS: Utah Pie Company is a Utah corporation that for 30 years has been baking pies in its plant in Salt Lake City and selling them in Utah and surrounding states. It entered the frozen pie business in 1957 and was immediately successful with its new line of frozen dessert pies—apple, cherry, boysenberry, peach, pumpkin, and mince.

Continental Baking Company, Pet Milk, and Carnation, all based in California, entered the pie market in Utah. When these companies entered the Utah market, a price war began. In 1958 Utah Pie was selling pies for $4.15 per dozen. By 1961, as all the pie companies competed, it was selling the same pies for $2.75 per dozen. Continental’s price went from $5.00 per dozen in 1958 to $2.85 in 1961. Pet’s prices went from $4.92 per dozen to $3.46, and Carnation’s from $4.82 per dozen to $3.30.

Utah Pie filed suit, charging price discrimination. The district court found for Utah Pie. The Court of Appeals reversed, and Utah Pie appealed.

DECISION: There was price discrimination. Pet was selling its pies in Utah through Safeway at prices that were lower than its prices in other markets and also much lower than its own brand pie in the Salt Lake City market. Pet also introduced a 20-ounce economy pie under the Swiss Miss label and began selling the new pie in the Salt Lake market in August 1960 at prices ranging from $3.25 to $3.30 for the remainder of the period. This pie was at times sold at a lower price in the Salt Lake City market than it was sold in other markets. For 7 of the 44 months in question for price discrimination, Pet’s prices in Salt Lake were lower than prices charged in the California markets. This was true even though selling in Salt Lake involved a 30- to 35-cent freight cost.

Also, Pet had predatory intent to injure Utah Pie. Pet admitted that it sent into Utah Pie’s plant an industrial spy to seek information. Pet suffered substantial losses on its frozen pie sales during the greater part of time involved in this suit. Pet had engaged in predatory tactics in waging competitive warfare in the Salt Lake City market. Coupled with the price discrimination, Pet’s behavior lessened competition and violated Robinson-Patman. [Utah Pie Co. v Continental Baking Co., 386 US 685 (1967)]

11 Eddins v Redstone, 35 Cal Rptr 3d 863 (2006). 12 In Weyerhaeuser v Ross-Simons, 549 US 312 (2007), the U.S. Supreme Court ruled that predatory bidding is also a

price discrimination issue. In a monopsony, a buyer tries to control a market by overbidding all its competitors and thereby cornering the market for supplies it needs to produce goods. However, if the bidder is actually just in need of the goods and bids higher for them, there is no anticompetitive conduct.

13 Home Oil Company, Inc. v Sam’s East, Inc., 252 F Supp 1302 (MD Ala 2003).

Chapter 5 Government Regulation of Competition and Prices 91

a group likely to recommend changes in laws and judicial review standards at both the state and federal levels.14

(C) PERMITTED PRICE DISCRIMINATION. Price discrimination is expressly permitted when it can be justified on the basis of (1) a difference in grade, quality, or quantity; (2) the cost of transportation involved in performing the contract; (3) a good- faith effort to meet competition; (4) differences in methods or quantities, i.e., marginal cost differences; (5) deterioration of goods; or (6) a close-out sale of a particular line of goods. The Robinson-Patman Act15 reaffirms the right of a seller to select customers and refuse to deal with anyone. The refusal, however, must be in good faith, not for the purpose of restraining trade.

5. Prevention of Monopolies and Combinations Monopolies and combinations that restrain trade are prohibited under the federal antitrust laws.

(A) THE SHERMAN ACT. The Sherman Antitrust Act includes two very short sections that control anticompetitive behavior. They provide:

[§ 1] 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.

[§ 2] Every person who shall monopolize or attempt to monopolize, or combine or conspire with any other person or persons to monopolize any part of the trade or commerce among the several states, or with foreign nations, shall be deemed guilty of a felony.16C P AC P A

The Sherman Act applies not only to buying and selling activities but also to manufacturing and production activities. Section 1 of the Sherman Act applies to agreements, conduct, or conspiracies to restrain trade, which can consist of price- fixing, tying, and monopolization. Section 2 prohibits monopolizing or attempting to monopolize by companies or individuals.

(B) MONOPOLIZATION. To determine whether a firm has engaged in monopolization or attempts to monopolize, the courts determine whether the firm has market power, which is the ability to control price and exclude competitors. Market power is defined by looking at both the geographic and product markets. For Example, a cereal manufacturer may have 65 percent of the nationwide market for its Crispy Clowns cereal (the product market), but it may have only 10 percent of the Albany, New York, market because of a local competitor, Crunchy Characters. Crispy Clowns may have market power nationally, but in Albany, it would not reach monopoly levels.

14 21st Century Department of Justice Appropriations Authorization Act, Pub. L. No. 107-273, 116 Stat. 1758 (2002), available at

15 15 USC §§ 13, 21. 16 15 USC § 1. Free competition has been advanced by the Omnibus Trade and Competitiveness Act of 1988, 19 USC

§ 2901 et seq.

Sherman Antitrust Act–a federal statute prohibiting combinations and contracts in restraint of interstate trade, now generally inapplicable to labor union activity.

market power– the ability to control price and exclude competitors.

92 Part 1 The Legal and Social Environment of Business

Having a large percentage of a market is not necessarily a monopoly. The Sherman Act requires that the monopoly position be gained because of a superior product or consumer preference, not because the company has engaged in purposeful conduct to exclude competitors by other means, such as preventing a competitor from purchasing a factory. Perhaps one of the best known monopolization cases involved Microsoft. In the case, the Justice Department alleged that because Microsoft had 90 percent of the market for operating systems it had and used monopoly power to control and market

Marsh & McLennan

Marsh & McLennan (MMC) is best known as the world’s largest insurance broker with 43,000 employees in its global operations.* MMC had a different way of achieving growth.

MMC should have been obtaining competing bids on employee insurance plans for the companies it represented. However, MMC developed a “pay-to-play” format for obtaining bids that allowed the insurers and MMC to profit. To be sure (1) that the policies were renewed and (2) that the renewal bonus was a given, MMC had all of its insurers agree to roll over on renewals. For example, if Insurer A was up for renewal, Insurers B and C would submit fake and higher bids that MMC would then take to the corporate client and, of course, recommend renewal at the lower rate. In some cases, MMC did not even have official bids from the competing insurers. MMC sent bids forward that had not even been signed by the insurers who were playing along to receive the same treatment when their renewals came along. Once MCC implemented the “pay-to-play system,” its insurance revenue became 67.1 percent of its revenue.** Com- missions from these arrangements represented one-half of MMC’s 2003 income of $1.5 billion.***

One of the companies to complain about MMC’s practices was Munich RE. One of its e-mails to an MMC executive (whose name was blacked out) wrote, “I am not some Goody Two Shoes who believes that truth is absolute, but I do feel I have a pretty strict ethical code

about being truthful and honest. This idea of ’throwing the quote’ by quoting artificially high numbers in some predetermined arrangement for us to lose is repugnant to me, not so much because I hate to lose, but because it is basically dishonest. And I basically agree with the comments of others that it comes awfully close to collusion and price-fixing.”

Without admitting or denying guilt, MMC settled antitrust charges by agreeing to drop the commission system and pay $850 million to its clients as a means of compensating for what might have been overcharges. MMC also agreed to hire a new CEO. The value of MMC’s shares dropped almost 50 percent within 10 days following the mid-October filing of suit by then New York Attorney General Spitzer against the company.†

MMC’s new CEO fired several senior executives despite the fact that there was no evidence that they had broken the law. When asked why he would fire them, Michael G. Cherkasky, a former district attorney in New York, said, “Freedom from criminal culpability is not our standard for executive leadership.”‡

* Monica Langley and Ianthe Jeanne Dugan, “How a Top Marsh Employee Turned the Tables on Insurers,” Wall Street Journal, October 23, 2004, A1, A9. Some put the number of employees at 60,000. See also Gretchen Morgenson, “Who Loses the Most at Marsh? Its Workers,” New York Times, October 24, 2004, 3–1 (Sunday Business 1) and 9.

** Monica Langley and Ianthe Jeanne Dugan, “How a Top Marsh Employee Turned the Tables on Insurers,” Wall Street Journal, October 23, 2004, A1, A9.

*** Id.

† “The Chatter,” New York Times, November 14, 2004, BU2. ‡ Ian McDonald, “After Spitzer Probe, Marsh CEO Tries Corporate

Triage,” Wall Street Journal, August 29, 2005, A1.

Chapter 5 Government Regulation of Competition and Prices 93

and did so by refusing to sell its operating system to companies that installed Netscape in lieu of or in addition to the Microsoft Explorer browser.17

C P AC P A (C) PRICE-FIXING. The Sherman Act prohibits, as discussed previously, competitors agreeing to set prices. Price-fixing can involve competitors: agreeing to not sell below a certain price, agreeing on commission rates, agreeing on credit terms, or exchanging cost information. Price is treated as a sensitive element of competition, and discussion among competitors has also been deemed to be an attempt to monopolize.

(D) TYING. It is a violation of the Sherman Act to force “tying” sales on buyers. Tying occurs when the seller makes a buyer who wants to purchase one product buy an additional product that he or she does not want.

The essential characteristic of a tying arrangement that violates Section 1 of the Sherman Act is the use of control over the tying product within the relevant market to compel the buyer to purchase the tied article that either is not wanted or could be purchased elsewhere on better terms. For Example, in the Microsoft antitrust case,

Fill It Up: The Price Is Right and Fixed

FACTS: Barkat U. Khan and his corporation entered into an agreement with State Oil to lease and operate a gas station and convenience store owned by State Oil. The agreement provided that Khan would obtain the gasoline supply for the station from State Oil at a price equal to a suggested retail price set by State Oil, less a margin of $3.25 per gallon. Khan could charge any price he wanted, but if he charged more than State Oil’s suggested retail

price, the excess went to State Oil. Khan could sell the gasoline for less than State Oil’s suggested retail price, but the difference would come out of his allowed margin.

After a year, Khan fell behind on his lease payments, and State Oil gave notice of, and began, eviction proceedings. The court had Khan removed and appointed a receiver to operate the station. The receiver did so without the price constraints and received an overall profit margin above the $3.25 imposed on Khan.

Khan filed suit, alleging that the State Oil agreement was a violation of Section 1 of the Sherman Act because State Oil was controlling price. The district court held that there was no per se violation and that Khan had failed to demonstrate antitrust injury. The Court of Appeals reversed, and State Oil appealed.

DECISION: In what was a reversal of prior decisions, the Court held that vertical maximum prices (as in this case in which a retailer was prohibited from charging above a certain amount) are not a per se violation of the Sherman Act. The Court noted that benefits can come from retailers’ not being able to charge above a certain amount. At a minimum, such controls on maximum prices were not an automatic violation of the Sherman Act and need to be examined in light of what happens to competition. In determining whether such prices might affect competition, the Court noted that maximum prices might have an impact on the survival of inefficient dealers, as was the case here. However, encouraging inefficiency is not the purpose of either the market or the laws on anticompetitive behavior. [State Oil v Khan, 522 US 3 (1997)]

17 United States v Microsoft, 253 F3d 34 (CA DC 2001).

tying– the anticompetitive practice of requiring buyers to purchase one product in order to get another.

94 Part 1 The Legal and Social Environment of Business

Microsoft is accused of requiring the purchase and use of its browser as a condition for purchasing its software. The Sherman Act also prohibits professional persons, such as doctors, from using a peer review proceeding to pressure another professional who competes with them in private practice and refuses to become a member of a clinic formed by them.

(E) BUSINESS COMBINATIONS. The Sherman Antitrust Act does not prohibit bigness. However, Section 7 of the Clayton Act provides that “no corporation … shall acquire the whole or any part of the assets of another corporation … 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.” If the Clayton Act is violated through ownership or control of competing enterprises, a court may order the violating defendant to dispose of such interests by issuing a decree called a divestiture order.18

(1) Premerger Notification When large-size enterprises plan to merge, they must give written notice to the FTC and to the head of the Antitrust Division of the Department of Justice. This advance notice gives the department the opportunity to block the merger and thus avoid the loss that would occur if the enterprises merged and were then required to separate.19

For Example, Time Warner was required to notify the Justice Department and seek

Celebrity Issues and Antitrust

Public Interest Corporation (PIC) owned and operated television station WTMV-TV in Lakeland, Florida. MCA Television Ltd. (MCA) owns and licenses syndicated tele- vision programs. In 1990, the two compa- nies entered into a licensing contract for several first-run television shows. With respect to all but one of these shows, MCA exchanged the licenses on a “barter” basis for advertising time on WTMV. However, MCA conditioned this exchange on PIC’s agreeing to license the remaining show, Harry and the Hendersons, for cash as well as for barter. Harry and the Hendersons was what some in the industry would call a “dog,” a show that was not very good that attempted to capitalize on a hit movie. PIC agreed to

this arrangement, although it did not want Harry and the Hendersons. The shows that PIC did want were List of a Lifetime, List of a Lifetime II, Magnum P.I., and 17 other miscellaneous features.

The relationship between the parties was strained over nonpayment, poor

ratings performance of Harry, and other issues. When litigation resulted, PIC alleged that it had been sub- jected to an illegal tying arrangement. PIC requested damages for MCA’s violation of the Sherman Act. What violation do you think occurred?

Source: Adapted from MCA Television Ltd. v Public Interest Corp., 171 F3d 1265 (CA 11 1998).

18 California v American Stores Co., 492 US 1301 (1989). 19 Antitrust Improvement Act of 1976, PL 94-435, § 201, PL 94-435, 90 Stat 1383, 15 USC § 1311 et seq.

divestiture order–a court order to dispose of interests that could lead to a monopoly.

Chapter 5 Government Regulation of Competition and Prices 95

approval for its merger with AOL, which the Justice Department eventually gave. However, when WorldCom proposed its merger with Sprint, the Justice Depart- ment refused approval because it believed this would reduce competition in telecommunications too much.20

(2) Takeover Laws Antitrust laws usually focus on whether the combination or agreement is fair to society or to a particular class, such as consumers. Some legislation aims to protect the various parties directly involved in combining different enterprises. Concern arises that one enterprise may in effect be raiding another enterprise. Congress and four-fifths of the states have adopted takeover laws, which seek to guard against unfairness in such situations. State laws apply only to corporations chartered in their state.

E-mail’s Revelations

In the U.S. Justice Department’s case against Microsoft, a lawyer commented, “The Government does not need to put Mr. Gates on the stand because we have his e-mail and memoranda.” There were 30 million pages of e-mail used as evi- dence in the Microsoft trial.

E-mail provides what is known as a contemporaneous record of events and has the added bonus that, for whatever psychological reason, those communicating with e-mail tend to be more frank and informal than they would be in a memo. E-mail can also contradict a witness’s testimony and serve to undermine credibility. For example, when asked whether he recalled discussions with a subordinate about whether Microsoft should offer to invest in Netscape, Mr. Gates responded in his deposition, “I didn’t see that as something that made sense.” But Mr. Gates’s e-mail included an urging to his subordinates to consider a Netscape alliance: “We could even pay them money as part of the deal, buying a piece of them or something.”

E-mail is discoverable, admissible as evidence, and definitely not private. Employees should follow the

admonition of one executive whose e-mail was used to fuel a million-dollar settlement by his company with a former employee: “If you wouldn’t want anyone to read it, don’t send it in e-mail.”

The impact of e-mail in the Microsoft antitrust case on companies and their e-mail policies was widespread. For exam-

ple, launched a companywide program called “Sweep and Keep,” under which employees were instructed to purge e-mail messages no longer needed for conducting business. offered employees who immediately purged their e-mail free lattes in the company cafeteria. The company had a two-part program. The first portion included instructions on document retention and deletion. The second part of the program was on document creation and included the following warning for employees: “Quite simply put, there are some communications that should not be expressed in written form. Sorry, no lattes this time.”

Source: Adapted from Marianne M. Jennings, Business: Its Legal, Ethical and Global Environment, 8th ed. (Cincinnati, OH:: West Legal Studies in Business, 2009), ch. 16.

20 Rebecca Blumenstein and Jared Sandberg, “WorldCom CEO Quits Amid Probe of Firm’s Finances,” Wall Street Journal, April 30, 2002, A1, A9.

takeover laws– laws that guard against unfairness in corporate takeover situations.

96 Part 1 The Legal and Social Environment of Business

C. POWER TO PROTECT BUSINESS In addition to controlling business combinations, the federal government protects others. By statute or decision, associations of exporters, marine insurance associations, farmers’ cooperatives, and labor unions are exempt from the Sherman Act with respect to agreements between their members. Certain pooling and revenue-dividing agreements between carriers are exempt from the antitrust law when approved by the appropriate federal agency. The Newspaper Preservation Act of 1970 grants an antitrust exemption to operating agreements entered into by newspapers to prevent financial collapse. The Soft Drink Interbrand Competition Act21 grants the soft drink industry an exemption when it is shown that, in fact, substantial competition exists in spite of the agreements.

The general approach of the U.S. Supreme Court has been that these types of agreements should not be automatically, or per se, condemned as a restraint of interstate commerce merely because they create the power or potential to monopolize interstate commerce. It is only when the restraint imposed is unreasonable that the practice is unlawful. The Court applies the rule of reason in certain cases because the practice may not always harm competition.

6. Remedies for Anticompetitive Behavior (A) CRIMINAL PENALTIES. A violation of either section of the Sherman Act is punishable by fine or imprisonment or both at the discretion of the court. The maximum fine for a corporation is $100 million. A natural person can be fined a maximum of $1,000,000 or imprisoned for a maximum term of ten years or both.

(B) CIVIL REMEDIES. In addition to these criminal penalties, the law provides for an injunction to stop the unlawful practices and permits suing the wrongdoers for damages.

(1) Individual Damage Suit Any person or enterprise harmed may bring a separate action for treble damages (three times the damages actually sustained).

(2) Class-Action Damage Suit by State Attorney General When the effect of an antitrust violation is to raise prices, the attorney general of a state may bring a class-action suit to recover damages on behalf of those who have paid the higher prices. This action is called a parens patriae action on the theory that the state is suing as the parent of its people.

21 Act of July 9, 1980, PL 96-308, 94 Stat 939, 15 USC § 3501 et seq.

treble damages– three times the damages actually sustained.

Chapter 5 Government Regulation of Competition and Prices 97

Antitrust (2001) (R)

This movie is based on Bill Gates and Microsoft. Check out LawFlix at to access movie clips that

illustrate business law concepts.



Regulation by government has occurred primarily to protect one group from the improper conduct of another group. The police power is the basis for government regulation. Regulation is passed when the free enterprise system fails to control abuses, as with the recent passage of investment banking regulations. Unfair methods of competition are prohibited.

Prices have been regulated both by prohibiting setting the exact price or a maximum price and discrimination in pricing. Price discrimination between buyers is prohibited when the effect of such discrimination could tend to create a monopoly or lessen competition. Price discrimination occurs when the prices charged different buyers are different despite the same marginal costs. However, resale price maintenance is not illegal per se if the control is for purposes of providing customer service.

The Sherman Antitrust Act prohibits conspiracies in restraint of trade and the monopolization of trade. The Clayton Act prohibits mergers or the acquisition of the assets of another corporation when this conduct would tend to lessen competition or create a monopoly. The Justice Department requires premerger notification for proposed mergers. Violation of the federal antitrust statutes subjects the wrongdoer to criminal prosecution and possible civil liability that can include treble damages.

LEARNING OUTCOMES After studying this chapter, you should be able to clearly explain:

A. POWER TO REGULATE BUSINESS LO.1 State the extent to which government can regulate business

See the For Example discussion of the subprime mortgage market on p. 88 See the Ethics & the Law discussion of Marsh & McLennan on p. 93

98 Part 1 The Legal and Social Environment of Business

B. REGULATION OF MARKETS AND COMPETITION LO.2 Explain what laws regulate the markets and protect competition

See the Utah Pie case on predatory pricing, p. 91 See the Kahn oil case on price controls, p. 94 See the Leegin case on resale price maintenance, p. 90 See the Sports & Entertainment Law feature on tying, p. 95

C. POWER TO PROTECT BUSINESS LO.3 Discuss the powers and remedies available to protect business competition

See Section 6 for a list of the penalties and remedies on p. 97


Clayton Act divestiture order market power

price discrimination Robinson-Patman Act Sherman Antitrust Act

takeover laws treble damages tying

QUESTIONS AND CASE PROBLEMS 1. American Crystal Sugar Co. was one of several refiners of beet sugar in northern

California, and it distributed its product in interstate commerce. American Crystal and the other refiners had a monopoly on the seed supply and were the only practical market for the beets. In 1939, all of the refiners began using identical form contracts that computed the price paid to the sugar beet growers using a “factor” common to all the refiners. As a result, all refiners paid the same price for beets of the same quality. Though there was no hard evidence of an illegal agreement, the growers brought suit under the Sherman Act against the refiners, alleging that they conspired to fix a single uniform price among themselves to hold down the cost of the beets. The growers sued for the treble damages available under the Sherman Act. Can they recover? [Mandeville Island Farms v American Crystal Sugar Co., 334 US 219]

2. A Wisconsin statute prohibits “the secret payment or allowance of rebates, refunds, commissions, or unearned discounts” to some customers without allowing them to all customers on the same conditions when such practices injure or tend to injure competition or a competitor. Kolbe generally gave dealers a 50 percent discount, but it gave Stock Lumber Co. a discount of 54 percent. Other dealers were not informed of this or of the conditions that had to be satisfied to obtain the same discount. Kolbe gave Jauquet, another lumber dealer, only a 50 percent discount and, when asked, expressly stated that it did not give any other dealer a higher discount. When Jauquet learned of the higher discount given to Stock, it brought suit against Kolbe for violation of the Wisconsin statute. Did Kolbe violate the statute? [ Jauquet Lumber Co., Inc. v Kolbe & Kolbe Millwork, Inc., 476 NW2d 305 (Wis App)]

3. The major record companies settled an antitrust suit brought by 40 state attorneys general against them for alleged price-fixing in the sale of CDs. The

Chapter 5 Government Regulation of Competition and Prices 99

record companies agreed to pay $67.4 million to consumers who purchased CDs during the period from 1995 to 2000. The consent decree stipulated that the record companies had required retailers that accepted subsidies from record companies for advertising CDs not to advertise CDs for sale at a price agreed upon in advance. The record companies said that the policy helped keep independent retailers in business because they could not afford to price at Wal-Mart levels. Wal-Mart always advertised CDs for sale at a price below the floor agreed to by the subsidized independent retailers and the record companies. The record companies did not admit any wrongdoing and, in addition to agreeing to the $67.4 million, also agreed to provide 5.5 million CDs to libraries, schools, and nonprofit organizations (worth $75.7 million).22

What antitrust violation were the attorneys general alleging? Is a minimum price a violation of antitrust laws?

4. The Three Tenors (Luciano Pavarotti, Placido Domingo, and Jose Carreras) made a record of their live performances together once every four years. The first two CDs and videos in the series, made by Time Warner, sold millions, with both becoming two of the highest-volume opera recordings in history. However, by the third performance and CD and video, the public demand was not as great, and Time Warner believed the first two releases would cannibalize the sales for the third. As a result, all parties involved in the sales of these CDs and tapes had to agree not to discount the first two performance tapes so that the third would have an opportunity to sell. The Federal Trade Commission (FTC) stumbled across the information on the pricing program when its staff members located a memo on the marketing plan and advertising constraints as it was reviewing documents for the proposed Time Warner/EMI Music merger proposal, a merger that fell through after European officials balked at the idea. The FTC pursued the case, and Time Warner settled the charges by agreeing not to restrain competition or set prices in the future. Is establishing a minimum price a violation of the Sherman Act? Is restricting advertising a violation of the Sherman Act?

5. Hines Cosmetic Co. sold beauty preparations nationally to beauty shops at a standard or fixed-price schedule. Some of the shops were also supplied with a free demonstrator and free advertising materials. The shops that were not supplied with them claimed that giving the free services and materials constituted unlawful price discrimination. Hines replied that there was no price discrimination because it charged everyone the same. What it was giving free was merely a promotional campaign that was not intended to discriminate against those who were not given anything free. Was Hines guilty of unlawful price discrimination? Explain.

6. Moore ran a bakery in Santa Rosa, New Mexico. His business was wholly intrastate. Meads Fine Bread Co., his competitor, engaged in an interstate business. Meads cut the price of bread in half in Santa Rosa but made no price cut in any other place in New Mexico or in any other state. This price-cutting

22 Claudia Deutsch, “Suit Settled over Pricing of Recordings at Big Chains,” New York Times, October 1, 2002, C1, C10; David Lieberman, “States Settle CD Price-fixing Case,” USA Today, October 1, 2002, 3B.

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