Synopsis (chapter 13 and 14)

Synopsis (chapter 13 and 14)

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ElEvEnth Edition

Marianne Moody Jennings Arizona State University

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

its lEgal, Ethical, and global EnvironmEnt


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© 2018, 2015 Cengage Learning®

ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced or distributed in any form or by any means, except as permitted by U.S. copyright law, without the prior written permission of the copyright owner.

Library of Congress Control Number: 2016948642

ISBN: 978-1-337-10357-2

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Business: Its Legal, Ethical, and Global Environment , 11e Marianne Moody Jennings

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Part 1 1 Business: Its Legal, Ethical, and Judicial Environment 1

1 Introduction to Law 2

2 Business Ethics and Social Responsibility 24

3 The Judicial System 72

4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 102

Part 2 139 Business: Its Regulatory Environment 139

5 Business and the Constitution 140

6 Administrative Law 178

7 International Law 218

8 Business Crime 248

9 Business Torts 294

10 Environmental Regulation and Sustainability 328

Part 3 363 Business Sales, Contracts, and Competition 363

11 Contracts and Sales: Introduction and Formation 366

12 Contracts and Sales: Performance, Remedies, and Collection 410

13 Product Advertising and Liability 448

14 Business Competition: Antitrust 486

15 Business and Intellectual Property Law 520

Part 4 553 Business Management and Governance 553

16 Management of Employee Conduct: Agency 554

17 Governance and Structure: Forms of Doing Business 592

18 Governance and Regulation: Securities Law 634

19 Management of Employee Welfare 680

20 Management: Employment Discrimination 728

Appendices A-1 A The United States Constitution A-1 B The Foreign Corrupt Practices Act (Excerpts) A-12 C The Uniform Commercial Code (Excerpts)* A-15 D Dodd-Frank (Wall Street Reform and Consumer

Financial Protection Act) Key Provisions A-20 E The Securities Act of 1933 and the Securities Exchange

Act of 1934 (Excerpts) A-23 F Sarbanes-Oxley Key Provisions (Excerpts) A-28 G The Copyright Act (as Amended) (Excerpts) A-31 H Title VII and the Civil Rights Act (Employment

Provisions) (Excerpts) A-34 I The Americans with Disabilities Act (Excerpts) A-37

Glossary G-1 Table of Cases T-1 Table of Products, People, and Companies T-11 Index I-1

Brief Contents


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Preface xv About the Author xxvi Acknowledgments xxviii

1 Introduction to Law 2

1-1 Definition of Law 3

1-2 Classifications of Law 3 1-2a Public versus Private Law 3 1-2b Criminal versus Civil Law 4 1-2c Substantive versus Procedural Law 4 1-2d Common versus Statutory Law 4 1-2e Law versus Equity 5

1-3 Purposes of Law 6 1-3a Keeping Order 6 1-3b Influencing Conduct 6 1-3c Honoring Expectations 6 1-3d Promoting Equality 6 1-3e Law as the Great Compromiser 7

1-4 Characteristics of Law 7 1-4a Flexibility 7 1-4b Consistency 7 1-4c Pervasiveness 7

1-5 The Theory of Law: Jurisprudence 12 1-5a The Theory of Law: Positive Law 12 1-5b The Theory of Law: Natural Law 12 1-5c The Theory of Law: The Protection of

Individuals and Relationships 12 1-5d The Theory of Law: The Social Contract 12

1-6 Sources of Law 13 1-6a Constitutional Law 13

1-6b Statutory Law at the Federal Level 14 1-6c Statutory Law at the State Level 15 1-6d Local Laws of Cities, Counties, and

Townships 16 1-6e Private Laws 16 1-6f Court Decisions 16

1-7 Introduction to International Law 17 1-7a Custom 17 1-7b Treaties 18 1-7c Private Law in International

Transactions 18 1-7d International Organizations 18 1-7e The Doctrines of International Law 18 1-7f Trade Law and Policies 18 1-7g Uniform International Laws 19 1-7h The European Union 19

Summary 20

Questions and Problems 21

2 Business Ethics and Social Responsibility 24

2-1 What Is Ethics? 26 2-1a “It’s Just Not Right!” 26 2-1b Normative Standards: How We Behave to

Keep Order 26 2-1c Line-Cutting and Ethics 27

Part 1 Business: Its Legal, Ethical, and Judicial Environment 1

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Contents v

2-2 What Is Business Ethics? 28 2-2a Ethical Standards: Positive Law and Ethics 29 2-2b Ethical Standards: Natural Law and Ethics 31 2-2c Ethical Standards: Moral Relativism and Ethics 31 2-2d Ethical Standards: Religion and Ethics 31

2-3 What Are the Categories of Ethical Dilemmas? 31 2-3a Taking Things That Don’t Belong to You 31 2-3b Saying Things You Know Are Not True 32 2-3c Giving or Allowing False Impressions 32 2-3d Buying Influence or Engaging in Conflict of

Interest 33 2-3e Hiding or Divulging Information 34 2-3f Taking Unfair Advantage 34 2-3g Committing Acts of Personal Decadence 35 2-3h Perpetrating Interpersonal Abuse 35 2-3i Permitting Organizational Abuse 35 2-3j Violating Rules 36 2-3k Condoning Unethical Actions 36 2-3l Balancing Ethical Dilemmas 36

2-4 Resolution of Business Ethical Dilemmas 37 2-4a Blanchard and Peale 37 2-4b The Front-Page-of-the-Newspaper Test 38 2-4c Laura Nash and Perspective 38 2-4d The Wall Street Journal Model 39 2-4e Other Models 39

2-5 Why We Fail to Reach Good Decisions in Ethical Dilemmas 39 2-5a “Everybody Else Does It” 39 2-5b “If We Don’t Do It, Someone Else Will” 39 2-5c “That’s the Way It Has Always Been Done” 40 2-5d “We’ll Wait until the Lawyers Tell Us It’s

Wrong” 40 2-5e “It Doesn’t Really Hurt Anyone” 41 2-5f “The System Is Unfair” 41 2-5g “I Was Just Following Orders” 41 2-5h “You Think This Is Bad, You Should

Have Seen . . .” 42 2-5i “It’s a Gray Area” 42

2-6 Social Responsibility: Another Layer of Business Ethics 43 2-6a Ethical Postures for Social Responsibility 43

2-7 Why Business Ethics? 45 2-7a Personal Accountability and Comfort: Business

Ethics for Personal Reasons 45

2-8 Importance of Ethics in Business Success and the Costs of Unethical Conduct 51 2-8a Ethics as a Strategy 53 2-8b The Value of a Good Reputation 55 2-8c Leadership’s Role in Ethical Choices 56

2-9 Creation of an Ethical Culture in Business 58 2-9a The Tone at the Top and an Ethical Culture 58 2-9b Dodd-Frank, Sarbanes-Oxley, Sentencing, and

an Ethical Culture 58 2-9c Reporting Lines: An Anonymous Ethics Line

for an Ethical Culture 59 2-9d Developing an Ethics Stance 59 2-9e Being Careful about Pressure and Signals 61

2-10 Ethical Issues in International Business 61

Summary 68

Questions and Problems 69

3 The Judicial System 72

3-1 Types of Courts 73 3-1a Trial Courts 73 3-1b Appellate Courts 73

3-2 How Courts Make Decisions 73 3-2a The Process of Judicial Review 73 3-2b The Doctrine of Stare Decisis 75

3-3 Parties in the Judicial System (Civil Cases) 77 3-3a Plaintiffs 77 3-3b Defendants 77 3-3c Lawyers 77 3-3d Judges 79 3-3e Name Changes on Appeal 79

3-4 The Concept of Jurisdiction 79

3-5 Subject Matter Jurisdiction of Courts: The Authority over Content 80 3-5a The Federal Court System 80 3-5b The State Court Systems 86 3-5c Judicial Opinions 88 3-5d Venue 88

3-6 In Personam Jurisdiction of Courts: The Authority over Persons 90 3-6a Ownership of Property within the State 90 3-6b Volunteer Jurisdiction 90 3-6c Presence in the State 90 3-6d Internet Companies and Long-Arm

Jurisdiction 94

3-7 The International Courts 95 3-7a Jurisdictional Issues in International Law 96 3-7b Conflicts of Law in International Disputes 96

Summary 98

Questions and Problems 99

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vi Contents

4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 102

4-1 What Is Alternative Dispute Resolution? 103

4-2 Types of Alternative Dispute Resolution 103 4-2a Arbitration 103 4-2b Arbitration Procedures 106 4-2c Mediation 108 4-2d Medarb 108 4-2e The Minitrial 108 4-2f Rent-a-Judge 109 4-2g Summary Jury Trials 109 4-2h Early Neutral Evaluation 109 4-2i Peer Review 110

4-3 Resolution of International Disputes 110

4-4 Litigation versus ADR: The Issues and Costs 111 4-4a Speed and Cost 111 4-4b Protection of Privacy 111 4-4c Creative Remedies 111 4-4d Judge and Jury Unknowns 112 4-4e Absence of Technicalities 113

4-5 When You Are in Litigation 113 4-5a How Does a Lawsuit Start? 113 4-5b The Complaint (Petition) 115 4-5c The Summons 117 4-5d The Answer 119 4-5e Seeking Timely Resolution of the Case 119 4-5f How a Lawsuit Progresses: Discovery 121 4-5g Resolution of a Lawsuit: The Trial 125

4-6 Issues in International Litigation 131

Summary 134

Questions and Problems 134

5 Business and the Constitution 140

5-1 The U.S. Constitution 141 5-1a An Overview of the U.S. Constitution 141 5-1b Articles I, II, and III—the Framework for

Separation of Powers 141 5-1c Other Articles 142 5-1d The Bill of Rights 143

5-2 The Role of Judicial Review and the Constitution 143

5-3 Constitutional Limitations of Economic Regulations 143 5-3a The Commerce Clause 143 5-3b Constitutional Standards for Taxation of

Business 149

5-4 State versus Federal Regulation of Business— Constitutional Conflicts: Preemption and the Supremacy Clause 152

5-5 Application of the Bill of Rights to Business 156 5-5a Commercial Speech and the First Amendment 156 5-5b First Amendment Protection for Advertising 156 5-5c First Amendment Rights and Profits from

Sensationalism 158 5-5d First Amendment Rights and Corporate Political

Speech 159 5-5e Eminent Domain: The Takings Clause 164 5-5f Procedural Due Process 169 5-5g Substantive Due Process 170 5-5h Equal Protection Rights for Business 171

5-6 The Role of Constitutions in International Law 171

Summary 173

Questions and Problems 173

Part 2 Business: Its Regulatory Environment 139

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Contents vii

6 Administrative Law 178

6-1 What Are Administrative Agencies? 179

6-2 Roles of Administrative Agencies 180 6-2a Specialization 180 6-2b Protection for Small Business 182 6-2c Faster Relief 182 6-2d Due Process 182 6-2e Social Goals 183

6-3 Laws Governing Administrative Agencies 183 6-3a Administrative Procedures Act 183 6-3b Freedom of Information Act 183 6-3c Federal Privacy Act 184 6-3d Government in the Sunshine Act 185 6-3e Federal Register Act 186

6-4 The Functions of Administrative Agencies and Business Interaction 186 6-4a Providing Input When Agencies Are

Promulgating Regulations 186 6-4b Formal Rulemaking 186 6-4c Proactive Business Strategies in Regulation 204 6-4d Informal Rulemaking 204

6-5 Business Rights in Agency Enforcement Action 205 6-5a Licensing and Inspections 205 6-5b Prosecution of Businesses 207 6-5c Beginning Enforcement Steps 207 6-5d Consent Decrees 207 6-5e Hearings 207 6-5f Administrative Law of Appeals 209

6-6 The Role of Administrative Agencies in the International Market 210

Summary 212

Questions and Problems 213

7 International Law 218

7-1 Sources of International Law 219 7-1a International Law Systems 219 7-1b Nonstatutory Sources of International Law 220 7-1c Statutory Sources of International Law 221 7-1d Treaties, Trade Organizations, and Controls

on International Trade 222

7-2 Trust, Corruption, Trade, and Economics 227 7-2a Foreign Corrupt Practices Act (FCPA) 227

7-3 Resolution of International Disputes 232

7-4 Principles of International Law 232 7-4a Act of State Doctrine 232 7-4b Sovereign Immunity 232 7-4c Protections for U.S. Property and Investment

Abroad 235 7-4d Repatriation 237 7-4e Forum Non Conveniens, or “You Have the Wrong

Court” 237 7-4f Conflicts of Law 237

7-5 Protections in International Competition 238 7-5a The International Marketplace and Monetary

Issues: The Disclosure Role of Banks 238 7-5b Antitrust Laws in the International

Marketplace 240 7-5c Protections for Intellectual Property 242 7-5d Criminal Law Protections 242

Summary 244

Questions and Problems 244

8 Business Crime 248

8-1 What Is Business Crime? The Crimes within a Corporation 249 8-1a Financial Fraud: Employees Manipulating

Earnings Numbers 249 8-1b Marketing Missteps: Sales Zeal and

Crimes 250 8-1c Friendly Fire: Employee Theft 250

8-2 What Is Business Crime? The Crimes against a Corporation 252

8-3 Who Is Liable for Business Crime? 253

8-4 Federal Laws Targeting Officers and Directors for Criminal Accountability 254 8-4a White-Collar Crime’s Origins and History 254 8-4b Sarbanes–Oxley (SOX) 255 8-4c Honest Services Fraud 256 8-4d Financial Services Crimes and Reforms 256 8-4e Other Business Crimes and White-Collar

Liability 257

8-5 The Penalties for Business Crime 257 8-5a New Penalties and New Processes 257 8-5b Corporate Integrity Agreements (CIAs) 257

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viii Contents

8-5c Criminal Indictments of Corporations on Common Law Crimes 259

8-5d Shame Punishment 259 8-5e New and Higher Penalties for Corporate

Crime 262 8-5f Corporate Sentencing Guidelines: An Ounce of

Prevention Means a Reduced Sentence 262 8-5g Corporate Board Criminal Responsibility 263

8-6 Elements of Business Crime 265 8-6a Mens Rea, Scienter, or Criminal Intent 265 8-6b Mens Rea, Conscious Avoidance, and Corporate

Officers 267 8-6c Actus Reus 268

8-7 Examples of Business Crimes 268 8-7a Theft and Embezzlement 268 8-7b Obstruction of Justice 268 8-7c Computer Crime 269 8-7d Internet Crime 271 8-7e Criminal Fraud 274 8-7f Commercial Bribery 274 8-7g Racketeer Influenced and Corrupt

Organizations (RICO) Act 275 8-7h Business Crime and the USA Patriot Act 277 8-7i Additional Federal Crimes 279 8-7j State Crimes 279

8-8 Procedural Rights for Business Criminals 279 8-8a Fourth Amendment Rights for Businesses 279 8-8b Exceptions to the Warrant Requirement 281 8-8c Fifth Amendment Rights for Businesses 283

8-9 Business Crime and International Business 287

Summary 289

Questions and Problems 290

9 Business Torts 294

9-1 What Is a Tort? Roots of Law and Commerce 295 9-1a Tort Versus Crime 295 9-1b Types of Torts 295

9-2 The Intentional Torts 296 9-2a Defamation 296 9-2b Contract Interference 304 9-2c False Imprisonment 304 9-2d Intentional Infliction of Emotional Distress 305 9-2e Invasion of Privacy 305

9-3 Negligence 308 9-3a Element One: The Duty 308 9-3b Element Two: Breach of Duty 311 9-3c Element Three: Causation 314 9-3d Element Four: Proximate Cause 315 9-3e Element Five: Damages 319 9-3f Defenses to Negligence 319

9-4 New Verdicts on Tort Reform 321 9-4a Strict Liability 322

Summary 323

Questions and Problems 324

10 Environmental Regulation and Sustainability 328

10-1 Common Law Remedies and the Environment 329 10-1a Nuisances 329 10-1b NIMBYs and Nuisances 329

10-2 Statutory Environmental Laws: Air Pollution Regulation 332 10-2a Early Legislation 333 10-2b 1970 Amendments to the Clean Air Act:

New Standards 333 10-2c 1977 and 1990 Amendments 333 10-2d New Forms of Control: EPA Expansion

Through Administrative Procedures 333 10-2e New Forms of Control: EPA and Climate

Change, Nee Global Warming 334 10-2f New Forms of Control: EPA and Small

Businesses 335 10-2g New Forms of Control: EPA and Economic

Forces 336

10-3 Statutory Environmental Law: Water Pollution Regulation 336 10-3a Early Legislation 336 10-3b Present Legislation 336 10-3c Other Water Legislation 337

10-4 Statutory Environmental Law: Solid Waste Disposal Regulation 338 10-4a Early Regulation 338 10-4b CERCLA and the Superfund 339 10-4c New Developments Under CERCLA 343 10-4d CERCLA and Brownfields 344

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Contents ix

10-5 Statutory Law: Environmental Quality Regulation 345

10-6 Statutory Law: Other Federal Environmental Regulations 347 10-6a Surface Mining 347 10-6b The Fracking Issue 347 10-6c Noise Control 347 10-6d Pesticide Control 347 10-6e OSHA 347 10-6f Asbestos 347 10-6g Endangered Species 348 10-6h State Environmental Laws 351

10-7 Enforcement of Environmental Laws 352 10-7a Parties Responsible for Enforcement 352 10-7b Criminal Sanctions and Penalties for

Violations 352 10-7c Group Suits: The Effect of Environmentalists 356

10-8 International Environmental Issues 356 10-8a The EU and Environmentalism 356 10-8b ISO 14000 356 10-8c LEED Certification 357

Summary 359

Questions and Problems 359

11 Contracts and Sales: Introduction and Formation 366

11-1 What Is a Contract? 367

11-2 Sources of Contract Law 367 11-2a Common Law 368 11-2b The Uniform Commercial Code 368

11-3 Types of Contracts 372 11-3a Bilateral Versus Unilateral Contracts 372 11-3b Express Versus Implied Contracts

(Quasi Contracts) 372 11-3c Void and Voidable Contracts 374 11-3d Unenforceable Contracts 374 11-3e Executed Versus Executory Contracts 374

11-4 Consumer Credit Contracts 375 11-4a Discrimination in Credit Contracts 375 11-4b Subprime or Predatory Lending 376 11-4c Credit Disclosures 377 11-4d Controlling Credit Card Contracts 377

11-5 Formation of Contracts 378 11-5a Offer 378 11-5b Acceptance: The Offeree’s Response 390 11-5c E-Commerce and Contract Formation 391

11-5d Consideration 394 11-5e Contract Form: When a Record Is Required 395 11-5f Writing and E-Commerce: The Uniform

Electronic Transactions Act 398

11-6 Issues in Formation of International Contracts 402 11-6a CISG—UCC for the World 402 11-6b The Payment Issues in International

Contracts 403 11-6c Risk in International Contract Performance:

Force Majeure 405

Summary 406

Questions and Problems 407

12 Contracts and Sales: Performance, Remedies, and Collection 410

12-1 Defenses in Contract Formation 411 12-1a Capacity 411 12-1b Misrepresentation 414 12-1c Fraud or Fraudulent Misrepresentation 415 12-1d Consumer Credit Contracts and Rescission

Rights 417

Part 3 Business Sales, Contracts, and Competition 363

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x Contents

12-1e Subprime Lending Representations and Disclosures 419

12-1f Duress 419 12-1g Undue Influence 419 12-1h Illegality and Public Policy 420

12-2 Contract Performance 426 12-2a When Performance Is Due 426 12-2b Standards for Performance 428 12-2c E-Commerce: Payment Performance Has

Changed 429 12-2d When Performance Is Excused 429 12-2e Finding a Way to End Obligations Under the

Contract 433

12-3 Nonperformance and Nonpayment—The  Collection Remedies 433 12-3a Making Sure the Billing Is Accurate 433 12-3b Collection—Fair Standards for Obtaining

Payment 434 12-3c Suits for Enforcement of Debts 437 12-3d The End of the Line on Enforcement of Debts:

Bankruptcy 437 12-3e Is There a Cost to Breaching a Contract:

Creditor Reports on Nonpaying Debtors 438

12-4 Contract Remedies for Nonperformance 441

12-5 Third-Party Rights in Contracts 442

12-6 International Issues in Contract Performance 443 12-6a Assuring Payment 443 12-6b Assuring Performance: International

Peculiarities 443

Summary 444

Questions and Problems 445

13 Product Advertising and Liability 448

13-1 Development of Product Liability 449

13-2 Advertising as a Contract Basis for Product Liability 449 13-2a Express Warranties 449 13-2b Federal Regulation of Warranties and

Advertising 453

13-2c Content Control and Accuracy 453 13-2d FTC Control of Performance Claims 454 13-2e FTC Control of Celebrity

Endorsements 456 13-2f FTC Control of Bait and Switch 458 13-2g FTC Control of Product Comparisons 458 13-2h FTC Remedies 460 13-2i Ad Regulation by the FDA and Other Federal

Agencies 460 13-2j Professional Ads 460

13-3 Contract Product Liability Theories: Implied Warranties 460 13-3a The Implied Warranty of

Merchantability 461 13-3b The Implied Warranty of Fitness for a

Particular Purpose 464 13-3c Eliminating Warranty Liability by

Disclaimers 464 13-3d Privity Standards for UCC Recovery 466

13-4 Strict Tort Liability: Product Liability Under Section 402A 466 13-4a The Requirement of Unreasonably Dangerous

Defective Condition 467 13-4b Reaching the Buyer in the Same

Condition 471 13-4c The Requirement of a Seller Engaged in a

Business 473 13-4d Negligence: A Second Tort for Product

Liability 473 13-4e Privity Issues in Tort Theories of Product

Liability 473

13-5 Defenses to Product Liability Torts 474 13-5a Misuse or Abnormal Use of a

Product 474 13-5b Contributory Negligence 475 13-5c Assumption of Risk 475

13-6 Product Liability Reform 478

13-7 Federal Standards for Product Liability 478 13-7a Consumer Product Safety

Commission 478

13-8 International Issues in Product Liability 479

Summary 481

Questions and Problems 481

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Contents xi

14 Business Competition: Antitrust 486

14-1 What Interferes with Competition? Covenants Not to Compete 487

14-2 What Interferes with Competition? An Overview of the Federal Statutory Scheme on Restraint of Trade 491 14-2a What Types of Activities Do the Federal Laws

Regulate? 492

14-3 Horizontal Restraints of Trade 493 14-3a Monopolization 493 14-3b Price-Fixing 496 14-3c Divvying Up the Markets 501 14-3d Group Boycotts and Refusals to Deal 502 14-3e Free Speech and Anticompetitive Behavior 502 14-3f Subtle Anticompetitive Behavior: Interlocking

Directorates 503 14-3g Merging Competitors and the Effect on

Competition 503

14-4 Vertical Trade Restraints 503 14-4a Resale Price Maintenance 504 14-4b Monopsony 508 14-4c Sole Outlets and Exclusive Distributorships 508 14-4d Customer and Territorial Restrictions 509 14-4e Tying Arrangements 509 14-4f Price Discrimination 511 14-4g Vertical Mergers 513

14-5 What Are the Penalties and Remedies for Anticompetitive Behavior? 513 14-5a Criminal Penalties 513 14-5b Equitable Remedies 514 14-5c Private Actions for Damages 514

14-6 Antitrust Issues in International Competition 514

Summary 516

Questions and Problems 516

15 Business and Intellectual Property Law 520

15-1 What Can a Business Own? Intangible Property Rights 521

15-2 Patents 521 15-2a The Types and Length of Patents 522 15-2b What You Can Patent: Patentability 522 15-2c The Patent Process 523 15-2d What a Patent Does 523 15-2e The Remedies for Patent Infringement 524

15-3 Copyrights 525 15-3a What Is a Copyright and What Does It

Protect? 525 15-3b The Rights of Copyright Holders Against

Third-Party Infringers 526 15-3c How Long Does a Copyright Run? 528 15-3d Rights of a Copyright Holder 529

15-4 Trademarks 533 15-4a What Are Trademarks? 533 15-4b What Are the Legal Protections for

Trademarks? 534 15-4c Enforcing Trademarks and the Risk of

Going Generic 534 15-4d Trade Names 535 15-4e What Are the Rights When a Trademark or

Trade Name Is Misused? 535 15-4f Trade Dress 538 15-4g Cyber Infringement 538

15-5 Trade Secrets 540 15-5a What are Trade Secrets? 540 15-5b How are Trade Secrets Protected? 541 15-5c Criminal Penalties for Theft of Trade

Secrets 541

15-6 International Intellectual Property Issues 542 15-6a Patent Protection 542 15-6b Trademark Protection 542 15-6c Copyrights in International

Business 543 15-6d Differing International Standards 543

15-7 Enforcing Business Property Rights 544 15-7a Product Disparagement 544 15-7b Palming Off 545 15-7c Misappropriation 545

Summary 548

Questions and Problems 548

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xii Contents

16 Management of Employee Conduct: Agency 554

16-1 Names and Roles: Agency Terminology 555 16-1a Agency 555 16-1b Principals 555 16-1c Agents 556 16-1d Employers and Employees: Master–Servant

Relationships 556 161e Independent Contractors 556 16-1f Agency Law 556

16-2 Creation of the Agency Relationship 557 16-2a Express Authority 557 16-2b The Record 557 16-2c Capacity 557 16-2d Implied Authority 558 16-2e Apparent Authority 559 16-2f Ratification 561

16-3 The Principal–Agent Relationship 562 16-3a The Agent’s Rights and Responsibilities 562 16-3b The Principal’s Rights and

Responsibilities 569

16-4 Liability of Principals for Agents’ Conduct: The Relationship with Third Parties 570

16-4a Contract Liability 570 16-4b Liability of Principals for Agents’ Torts 572

16-5 Termination of the Agency Relationship 577

16-6 Termination of Agents under Employment at Will 577

16-6a The Implied Contract 578 16-6b The Public Policy Exception 580 16-6c Handling Employee Termination

Disputes 584

16-7 Agency Relationships in International Law 585

Summary 588

Questions and Problems 588

17 Governance and Structure: Forms of Doing Business 592

17-1 Sole Proprietorships 593 17-1a Formation 593 17-1b Sources of Funding 593 17-1c Liability 593 17-1d Tax Consequences 594 17-1e Management and Control 594 17-1f Transferability of Interest 594

17-2 Partnerships 594 17-2a Formation 594 17-2b Sources of Funding 599 17-2c Partner Liability 600 17-2d Tax Consequences in Partnerships 601 17-2e Management and Control 601 17-2f Transferability of Interests 603 17-2g Dissolution and Termination of the

Partnership 603

17-3 Limited Partnerships 604 17-3a Formation 604 17-3b Sources of Funding 605 17-3c Liability 605 17-3d Tax Consequences 606 17-3e Management and Control 606 17-3f Transferability of Interests 606 17-3g Dissolution and Termination of a Limited

Partnership 607

17-4 Corporations 607 17-4a Types of Corporations 607 17-4b The Law of Corporations 608 17-4c Formation 608 17-4d Capital and Sources of Corporate Funds 610 17-4e Liability Issues 611 17-4f Corporate Tax Consequences 613 17-4g Corporate Management and Control:

Directors and Officers 614

Part 4 Business Management and Governance 553

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Contents xiii

17-4h Corporate Management and Control: Shareholders 621

17-4i The Dissolution of a Corporation 624

17-5 Limited Liability Companies 625 17-5a Formation 625 17-5b Sources of Funding 625 17-5c Liability 625 17-5d Tax Consequences 627 17-5e Management and Control 627 17-5f Transferability of Interest 627 17-5g Dissolution and Termination 628

17-6 Limited Liability Partnerships 628 17-6a Formation 629 17-6b Sources of Funding 629 17-6c Liability 629 17-6d Tax Consequences 629 17-6e Management and Control 629 17-6f Transferability 629 17-6g Dissolution and Termination 629

17-7 International Issues in Business Structure 629

Summary 630

Questions and Problems 631

18 Governance and Regulation: Securities Law 634

18-1 History of Securities Law 635

18-2 Primary Offering Regulation: The 1933 Securities Act 635 18-2a What Is a Security? 635 18-2b Regulating Primary Offerings:

Registration 636 18-2c Regulating Primary Offerings:

Exemptions 637 18-2d What Must Be Filed: Documents and

Information for Registration 642 18-2e Violations of the 1933 Act 643

18-3 The Securities Exchange Act of 1934 654 18-3a Securities Registration 654 18-3b Emerging Growth Companies (EGCs) and

1934 Act Exemption 654 18-3c Periodic Filing Under the 1934 Act:

Those Alphabet Reports 654 18-3d The 1934 Act Antifraud Provision: 10(b) 655 18-3e Insider Trading and Short-Swing Profits 665 18-3f Regulating Voting Information 666

18-3g Shareholder Rights in Takeovers, Mergers, and Consolidations 668

18-4 State Securities Laws 671

18-5 International Issues in Securities Laws 673

Summary 675

Questions and Problems 676

19 Management of Employee Welfare 680

19-1 Wage and Hours Protection 681 19-1a The Fair Labor Standards Act 681 19-1b The Equal Pay Act of 1963 688

19-2 Workplace Safety 688 19-2a The Occupational Safety and Health Act 688 19-2b OSHA Responsibilities 688 19-2c Employee Impairment and Testing Issues 690

19-3 Employee Pensions, Retirement, and Social Security 690 19-3a Social Security 690 19-3b Private Retirement Plans 692 19-3c Unemployment Compensation 693

19-4 Workers’ Compensation Laws 695 19-4a Employee Injuries 695 19-4b Causation and Worker’s Compensation 696 19-4c Fault Is Immaterial 696 19-4d Employees versus Independent

Contractors 696 19-4e Benefits 696 19-4f Forfeiture of the Right of Suit 697 19-4g Third-Party Suits 697 19-4h Administrative Agency 697 19-4i Insurance 697 19-4j Problems in Workers’ Compensation

Systems 699

19-5 Statutory Protections of Employees Through Labor Unions 700 19-5a The Norris–LaGuardia Act of 1932 700 19-5b The Wagner Act 700 19-5c The Taft–Hartley Act: The Labor-Management

Relations Act of 1947 700 19-5d The Landrum–Griffin Act: The Labor-

Management Reporting and Disclosure Act of 1959 700

19-5e Union Organizing Efforts and Social Media 701

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xiv Contents

19-5f Employers Are Accountable for Employee Electronic Content 701

19-5g Employer Monitoring: What is Legal? 701 19-5h Employers’ Right of Access to

Employee E-Mails 704 19-5I E-Mail and NLRA Issues 705 19-5j The Unionization Process 706 19-5k Union Contract Negotiations 710 19-5l Protected Concerted Activities 711 19-5m Unfair Employee Practices 711 19-5n Employer Rights 712 19-5o Right-to-Work Laws 712 19-5p Economic Weapons of Employers 713

19-6 International Issues in Labor 715 19-6a Immigration Laws 715 19-6b Working Conditions and International Labor

Law 718 19-6c Sample International Standards 718 19-6d The Risks of International Suppliers 719 19-6e New Trends in Managing International Wage

and Safety Standards 720

Summary 722

Questions and Problems 724

20 Management: Employment Discrimination 728

20-1 History of Employment Discrimination Law 729

20-2 Employment Discrimination: Title VII of the Civil Rights Act 731 20-2a Application of Title VII 731 20-2b Employment Procedures Covered 731

20-3 Theories of Discrimination Under Title VII 731 20-3a Disparate Treatment 731 20-3b Disparate Impact 734 20-3c Pattern or Practice of Discrimination 737

20-4 Specific Applications of Title VII 738 20-4a Sex Discrimination 738 20-4b Religious Discrimination 746 20-4c Racial Discrimination 749

20-5 Antidiscrimination Laws and Affirmative Action 749 20-5a What Is Affirmative Action? 750 20-5b Who Is Required to Have Affirmative Action

Programs? 750 20-5c Affirmative Action Backlash: The Theory of

Reverse Discrimination 750

20-6 The Defenses to a Title VII Charge 751 20-6a Bona Fide Occupational Qualification 751 20-6b Seniority or Merit Systems 752 20-6c Aptitude and Other Tests 752 20-6d Misconduct 752

20-7 Enforcement of Title VII 755 20-7a Steps in an EEOC Case 755 20-7b Remedies Available Under Title VII 756

20-8 Other Antidiscrimination Laws 756 20-8a Age Discrimination in Employment Act

of 1967 756 20-8b Equal Pay Act of 1963 758 20-8c Communicable Diseases in the

Workplace 758 20-8d Rehabilitation Act of 1973 759 20-8e Americans with Disabilities Act 759 20-8f The Family and Medical Leave Act 760

20-9 The Global Workforce 761

Summary 764

Questions and Problems 764

Appendices A-1

A The United States Constitution A-1

B The Foreign Corrupt Practices Act (Excerpts) A-12

C The Uniform Commercial Code (Excerpts)* A-15

D Dodd-Frank (Wall Street Reform and Consumer Financial Protection Act) Key Provisions A-20

E The Securities Act of 1933 and the Securities Exchange Act of 1934 (Excerpts) A-23

F Sarbanes-Oxley Key Provisions (Excerpts) A-28

G The Copyright Act (as Amended) (Excerpts) A-31

H Title VII and the Civil Rights Act (Employment Provisions) (Excerpts) A-34

I The Americans with Disabilities Act (Excerpts) A-37

Glossary G-1 Table of Cases T-1 Table of Products, People, and Companies T-11 Index I-1

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A Different World, but the Same Issues The seventh edition of this book was published amidst the fallout from the legal, ethical, and, too often, financial collapses of Enron, WorldCom, Adelphia, Health- South, Parmalat, Arthur Andersen, Kmart, and others. With Sarbanes–Oxley on the books and new regulatory demands on corporations, we thought perhaps we had turned the corner. But the eighth edition was published as Wall Street and the economy were reeling from the fallout of a subprime mortgage market operating under regulatory radar without a great deal of disclosure on portfolio risk. When the ninth edition was published, the SEC had just settled a civil suit it brought against Goldman Sachs for allegedly selling securities to clients it was betting against as a short-seller in a scheme that saw its profits reach double-digit billions. Goldman paid a fine of $550 million. In late 2009, Goldman’s CEO, Lloyd Blank- fein, uttered the same words that Jeffrey Skilling did in 2000: “We are doing God’s work.” At press time of the tenth edition, there were questions about the fairness of the scrutiny of taxpayers by an administrative agency, the Internal Revenue Service, and the Justice Department’s tapping of phones of news corporations. Book publishers signed antitrust consent decrees for agreeing to fix prices in order to compete with Amazon. A factory in Bangladesh, that produced clothing for U.S. retailers, collapsed, killing over 600 employees, a collapse that was caused by noncompliance with safety and code standards. Now, as this 11th edition is pub- lished the EPA has tightened regulations so much that two major coal companies have gone out of business. The Veterans Administration is trying to recover from a program that was designed to reduce queue times for patients but resulted in patients dying. A pharmaceutical company raised its prices on one prescription drug by 5,000%, and Apple has a monitor because it was found guilty of being the master mind behind publishers fixing prices on their electronic books. The raisin farmers had a major victory in the U.S. Supreme Court that will change forever government price and supplies controls on raisin. And insider trading remains in the news, for both convictions and the reversals of those convictions as courts sort through the question, “When exactly does insider trading occur?”

The patterns of business behavior that push the envelope of law and ethics continue. Two of the leaders in the New York legislature were convicted on cor- ruption charges, companies from Embrauer to GlaxoSmithKline, and even FIFA faced charges and investigations under the Foreign Corrupt Practices Act. Charges against FedEx for alleged shipping of controlled substances were dismissed because there was no proof that anyone knew what was in the packages. Blue Bell ice cream was shut down for four months because of the presence of listeria in its plants. The FCC was deluged with comments on a proposed rule that would have allowed cell phone use on airplanes. In response to the outcry from flight atten- dants, passengers, and pilots, the FCC did not promulgate the rule. The issues of law and ethics are still at the forefront of business, sports, and government. It has become a tall order just to keep up with all the events!

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These companies and organizations and their employees and executives certainly could have benefited from understanding and keeping at the fore- front of their decision processes the basics of law and ethics! The legal and eth- ical environments of business are center stage. Several editions ago, Congress made massive regulatory reform a reality with the passage of the Sarbanes– Oxley legislation on corporate governance, accounting regulation, and crim- inal penalties. But the SEC missed some large market schemes, so Congress passed Dodd-Frank with new directives to the SEC on financial reports, dis- closures, and primary offerings. The continuing reliance on new credit mecha- nisms resulted in a central agency, the Consumer Protection Bureau, handling all forms of consumer credit. Business is even more international, and changes, such as Brexit (Great Britain’s decision to withdraw from the EU), mean more changes in trade, regulation, and tariffs. FCPA cases have expanded and there is increasing cooperation among countries to address money-laundering schemes and the problems of world leaders hiding funds in accounts around the world.

The world and business continue to change and grow, but law and ethics have retained their role and importance. In fact, now more than ever, we need to understand the legal and ethical issues that affect our businesses and our lives. The knowledge base and even the questions in law and ethics remain the same, but the underlying facts have changed. For example, we still debate the social responsibility role of business. Now we raise that issue in the context of whether companies should use inversions, or reverse acquisitions, by foreign companies to reduce their effective tax rates. We continue to delve into the pros and cons of sending production to other countries. We still have the question of when a contract is formed, but now we face that question with “point and click” technology rather than faxes and letters. We continue to be concerned about our privacy as consumers, but now we wonder who really has access to our Facebook page. We still wonder about the extent of copyright law. The file-sharing programs have never quite gone away and the film industry now litigates the downloading of copyrighted films. The world is different, but law and ethics form the constant framework into which we fit the issues of the day. In the materials that follow, you have the chance to understand the marvelous stability of this framework and the ease with which you can apply it to this very different world. Be sure to look for descriptions of the new structure as well as the continuing features in the book, such as the “Consider” tutorials, the ethics issues, and the Business Strategy application exercises.

Building the Bridge: Applying Legal and Ethical Reasoning to Business Analysis I gave my students a midterm exam—a review of Netflix and its various business issues, including the cost of rights, issues in film production, and problems with obtaining subscriptions. These students are in the second year of their master’s degree studies. They have been trained in economics, marketing, management, and finance. But as they completed their analysis of this fast-growing darling of the stock market, they had an epiphany. A company can get the finance issues right, have the right brand appeal and great offerings, and even yield terrific subscription sales. However, it can all fall apart over the legal issues. What if the estimates on subscriptions released with earnings reports are overly optimistic?

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What if something goes wrong in shooting one of their original production films? Does insurance cover them? Who pays the costs of a late finish on those promised films? What about international copyrights? What happens when copyright hold- ers do not want their films licensed internationally? They are very capable busi- ness students. However, they did not realize until this midterm exam how much of business turns on anticipating the legal issues and getting them resolved cor- rectly. And they also realized that all of our discussions of ethics and social respon- sibility had a role in doing business. TANSTAAFL—“there ain’t no such thing as a free lunch” when it comes to international business. There are costs associated with tapping into a seemingly boundless market of subscribers. And those costs come from legal issues, which, if handled poorly, can affect a company’s value and tarnish its brand name.

Why couldn’t these students see the interconnection and critical roles of law and ethics in business until this case for their midterm? It was not for lack of expo- sure to the law. I taught my course “by the book,” so to speak. Students could recite the components of a valid contract, rattle off the requirements for bankruptcy, and recall from memory the antitrust statutes. Yet, I was coming to realize, this rote knowledge was not enough. One of my best former students, who had gone on to medical school, came to me perplexed about her office lease. She said that the complex in which she wanted to open her practice had a “no advertising” policy. In fact, she said that when she toured the premises with a leasing agent, the leasing agent turned to her and said, “You’re not one of those doctors who advertises, are you? Because if you are, we can’t lease to you. We have a policy against it.” One of my best students, who knew the antitrust statutes well, could not apply them to her everyday business. Worse, perhaps, she could not recognize when to apply these statutes: She did not see the antitrust implications of the agent’s statements nor the problems with the physicians in the complex taking such an approach to screening tenants.

I have reached the conclusion that there have always been shortcomings in the standard approach to teaching business students law and ethics. Students were not ignorant of the law; rather, they simply lacked the necessary skills to recognize legal and ethical issues and to apply their knowledge of law and ethics to business decision making. As instructors, we were not integrating legal and ethical reason- ing with business analysis. My conclusion led me to develop my own materials for classroom use and eventually led to the publication of the first edition of this book. Now in its eleventh edition, Business: Its Legal, Ethical, and Global Environment brings to the classroom the most integrated approach to learning law and ethics available in the market today. Throughout every chapter and in every feature, stu- dents and instructors are continually reminded of how various legal and ethical principles apply in business contexts. For all areas of law and ethics, this book answers the question: How does this concept affect a business? This book builds a bridge for the student between knowledge of law and ethics and application of both in business. My 39 years of teaching law and ethics finally brought this realization: Business ethics is not easily grasped nor practiced in business because we depersonalize ethical issues. If we just allow the company or organization to make the decision, our ethics are not in question; the companies’ are. The ethical issues in the book require students to bring ethical issues into their lives, their cir- cumstances, their world. This feature also forces them to answer this question in a wide variety of contexts: “If it were you, and you were faced with the dilemma and required to make a decision, what would you do?”

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Strengthening the Bridge: New Content, Business Applications, and Learning Aids For the eleventh edition, Business: Its Legal, Ethical, and Global Environment has undergone further refinement. New content has been added, outdated content has been removed, new business applications have been integrated into every chapter, and the learning aids have been modified and refocused to help students under- stand and apply legal and ethical concepts.

New Content

The eleventh edition of Business: Its Legal, Ethical, and Global Environment continues to meet its goal of helping students with their understanding of how law and ethics apply to the business world. The organizational structure, based on feedback from those who use the text, has been changed. The four parts remain, but there is a new mix of topics and chapters in those four parts. Part 1 offers the student an overview of the legal, ethical, and judicial environments of business. Part 2 covers the regu- latory environments of business, including environmental regulation and sustain- ability. Part 3 covers all aspects of sales, contracts, and competition. Part 4 covers business management and corporate governance, and this newly restructured sec- tion covers all issues related to employees, boards, agents, and how to keep all of these groups coordinated while taking legal and ethical actions. Cyber law is now integrated into every chapter so that it can be covered in contracts (formation), employment (right of employee privacy in e-mails), and criminal law (everything from industrial espionage to spamming).


Business Ethics and Social Responsibility (Chapter 2) offers new examples and insights on the application of ethics to business decision making. Chapter 2 is chock full of the examples the last two years have netted—including GM’s engine switch guilty plea and VW’s use of emissions defeating software. A new biogra- phy focuses on Captain Sullenberger who landed an airplane safely in a river and offers his perspectives on how we know the right thing to do in moments of pres- sure. Ethics coverage is also integrated throughout all chapters.

Business Applications Biography

Each chapter contains a biography. Biographies provide students with business history through the study of individuals and companies involved with the area of law and ethics covered in the chapter. For example, Chapter 1 has a biography on Uber, the company that shook up the world of cab transportation. Chapter 4 has a new biography on a legal battle between a small business and its production of parts for another company’s tabletop game including the tools used in that litigation, and the pro bono work of lawyers in helping a small business in Games Workshop v. Chapterhouse. Chapter 19 provides the story of the death of an orca whale trainer at Sea World and the resulting investigations and backlash that Sea World experienced. Chapter 15 gives a biography of Mattel and its Bratz dolls and its long intellectual property battle over who had the idea for the dolls.

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For the Manager’s Desk

Each chapter also contains at least one “For the Manager’s Desk” feature. These readings provide students the opportunity to see how business interrelates with ethics and law. The readings feature topics tackled by publications such as Wall Street Journal, Harvard Business Review, Corporate Finance Review, and the American Business Law Journal. This feature offers the latest best practices as well as data from academic studies and insights from that research. For example, the Chapter 8 “For the Manager’s Desk” discusses who ends up going to prison for business crimes and how long their sentences last. Chapter 19’s feature deals with the recent series of cases brought by interns for lack of pay and excessive hours as well as the Department of Labor’s proposed responses. Chapter 13 discusses how to manage celebrity tweets when they are your spokesperson, i.e., what can Kim Kardashian tweet about an anti-nausea drug she was using during her pregnancy that will not run afoul of FDA restrictions? Chapter 15’s Manager’s Desk discusses the prob- lems with a trademark or trade name that is offensive.

Learning Aids . . . and the Law

Each chapter contains a popular feature to further integrate law and ethics with the other “silos” of business. The “. . . and the Law” feature puts law and ethics in the context of economics, human resources, public policy, strategy, finance, and other areas to illustrate the ways knowledge of the where and how for the fit of law and eth- ics can help make better managers and better decisions. For example, Chapter 20’s “HR and the Law” discusses the dangers and conflicts office romances produce and how managers can deal with those issues. Chapter 1 includes a discussion of the FIFA corruption scandal how the issues were investigated and the problems involved in an NGO. Chapter 8’s “Strategy and the Law” takes a look at what corporations charged with a crime should do and the options for pleas available with the Justice Department. Chapter 14’s “Social Responsibility and the Law” discusses the possible anticompetitive effects of organizations such as Common Code for the Coffee Community and the Bioplastic Feedstock Alliance. These features apply the principles from business disciplines to understand more fully the depth and breadth of management issues.

Case Headlines

Every court case has a case headline that summarizes what issues are involved in the case. Chapter 7 has a new case on the actions of the Russian tax authorities involving Yukos, an international oil company, and the resulting impact in the mar- ket and has this title, “When Putin Affects the Value of Oil Stock.” In Chapter 8, a new case on criminal intent, whether the owner of a salvage yard was aware of his contamination of water, has this intriguing case title, “Mordechay’s Sump Pump and Mens Rea. In Chapter 6, the case Hornbeck Offshore Services, L.L.C. et al. v Salazar deals with an issue of whether agency action was arbitrary and capricious in issu- ing a moratorium on offshore drilling, and the case title is “Drilling Down to the Facts Supporting a Rule.” The vivid one-line description and colorful facts of the case, a common thread throughout the case choices in the text, help students inter- nalize the rules and lessons about not destroying evidence for a potential lawsuit.

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Chapter Openings and the “Consider. . . “ Feature

Chapters begin with an opening problem, titled “Consider. . .”, which presents a legal dilemma relevant to the chapter’s discussion and similar to those business managers need to handle. These are revisited and answered in the body of the chapter. For example, Chapter 6 has a new chapter opening “Consider. . . “on a proposed regulation on the use of cell phones on airplanes and then walks that issue through the full regulatory process. In addition to this Consider problem opening, each chapter also has quotes, data, humor, or insights to pique reader interest about the chapter topics.

Chapter Summary

Each chapter concludes with a summary that reinforces the major concepts of the chapter. Each summary is constructed around the key questions introduced at the start of the chapter and key terms presented throughout the chapter.

Business Strategy Applications

Each chapter has a business strategy connection designed to help students understand where law and ethics fit in developing effective business strat- egies. For example, in Chapter 13 there is a new business strategy on the problems with highway guard rails and the litigation brought about by a competitor who reported changes in the guard rail design that had not been cleared with the federal government. Chapter 5 has a strategy feature that dis- cusses who gives money in politics, how much, and why. Chapter 8’s strategy feature discusses the components of an effective compliance program. The Chapter 12 strategy deals with how restaurants are coping with no-shows in their reservations and their contract rights when someone makes a reserva- tion but never shows up.

Organization and Features: A Structure to Guide Students to Reasoning and Analysis The classic features have been updated and strengthened. The organization has been retained to continue to meet student needs in the classroom.


The four parts in the book serve to organize the materials around four basic areas: (1) understanding the legal environment, (2) understanding the regulatory envi- ronment, (3) dealing with sales, contracts and competition, and (4) management and governance. Every chapter integrates international and ethical topics.

Part 1 In four chapters, Part 1 offers an introduction to law, an introduction to business ethics and the judicial system, and a discussion of litigation and alternative dispute resolution. Part 1 provides students with a foundation in law and ethics as well as legal and ethical reasoning, necessary for the areas of law in the chapters that follow. By being brief (four chapters), Part 1 offers instructors an early and logical break for exams.

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Part 2 In six chapters, Part 2 covers the regulatory environment of business, including the following topics: constitutional law, administrative and international law, busi- ness crimes and business torts, and environmental regulation. At the completion of Parts 1 and 2, students have a grasp of the legal system, ethical boundaries, and the laws that affect business operational decisions.

Part 3 The five chapters in Part 3 present students with the legal and ethical issues sur- rounding contracts, sales, and competition. Part 3 includes the following topics: contract formation and performance (including coverage of consumer issues); product liability; intellectual property; trade restraints; and business competition and antitrust. From the negotiation of price to the collection of accounts, this seg- ment of the book covers all aspects of selling business products and services. This section is structured so that the contracts discussion precedes the complexities of property and competition.

Part 4 The five chapters in Part 4 discuss business management and governance. Topics include the management of employees, from agency law to employment regulation to employee rights to issues in discrimination. Part 4 also includes the governance issues of business structure and management, including financing and securities law issues. This section covers the issues of running, managing, and financing a business.

Woven throughout all the chapters are cyber law issues, as marked by margin icons, and featuring discussions of everything from e-mail privacy to the problems of hacking.


Court Cases Edited court language cases provide in-depth points of law, and many cases include dissenting and concurring opinions. Case questions follow to help students under- stand the points of law in the case and think critically about the decision. The courts have been active since the last edition, and many 2015–2016 case decisions are pre- sented throughout the book. Students will be able to study Donald Trump’s claim for defamation when a writer misstated his net worth. Can a company avoid Foreign Cor- rupt Practices Act violations when it has its agent appointed a government official in another country? What happens when a young man saves his Pepsi points to claim a Harrier Jet that he sees in a Pepsi spoof ad for “Pepsi stuff”? Does he get his jet?

Consider . . . “Consider . . .” problems, along with “Ethical Issues” and “Business Planning Tips,” have been a part of every chapter since the first edition. The “Consider . . .” features, often based on real court cases, ask students to evaluate and analyze the legal and ethical issues discussed in the preceding text. Because these issues are integrated into the text, students must address and think critically about these issues as they encounter them. Through interactive problems, students learn to judge case facts and determine the consequences. Moreover, answers to all of these opening “Consider. . .” features are referenced in the text and clearly marked. There are more “Consider. . . “ features throughout each chapter. Chapter 3 has a new “Consider . . . “

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on whether Katy Perry could be sued in Missouri for her alleged infringement of a Missouri songwriter’s song. Chapter 12 has a new consider on whether a mistake on the total square footage in a property is grounds for setting aside a contract for purchase of that property.

“Consider . . . ” brings the most current topics into the book and the classroom.

Thinking, Applying, and Answering: “Consider . . . ” Tutorials—A Guide for Reasoning One “Consider . . . ” per chapter is solved for the students in a methodical walk- through that helps them understand how to apply the legal principles or case prec- edent that they have just studied. The facts of the case or hypothetical are presented and the students are asked to recall what they have just learned. Next, students are walked through applying those principles to the current facts. Finally, they are given the answer and the reason that answer is consistent with their thinking and applying.

Ethical Issues The “Ethical Issues” feature appears in every chapter and presents real-world ethical problems for students to grapple with. “Ethical Issues” help integrate coverage of ethics into every chapter. The ethical issues also include personal and real-life exam- ples that help students relate to the pervasive nature of ethical dilemmas that they do and will continue to face. Chapter 6 includes the U.S. Supreme Court case revers- ing the bribery conviction of former Virginia governor Bob McDonnell and his wife, followed by an ethics issue that asks students to review whether their taking of vaca- tions, a Rolex, clothing, and help with a wedding from a donor crossed ethical lines. Chapter 12 includes an ethical issue that asks students to evaluate students who accept an employment offer and then renege because a better one came along.

Business Planning Tips Students are given sound business and legal advice through “Business Planning Tips.” With these tips, students not only know the law but also know how to antic- ipate issues and ensure compliance. How to make your property safer, how to conduct an interview without violating the Americans with Disabilities Act, and how to train employees to preserve documents and potential evidence if custom- ers make claims.

Cyberlaw Cyberlaw has been integrated throughout the book. Most chapters also include a segment on cyberlaw. These chapter-by-chapter materials, marked by an icon, give students the chance to see how new technology fits into the existing legal framework.

Exhibits Exhibits include charts, figures, and business and legal documents that help highlight or summarize legal and ethical issues from the chapter. With the credit and financial market reforms, securities law reforms on stock offerings, and the changes in criminal penalties, many of the charts are either new or updated.

End-of-Chapter Problems Many end-of-chapter problems have been updated and now focus more on actual cases. There are new chapter problems throughout the book of varied lengths for different instructor needs.

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The Informed Manager: Who Should Use This Book? With its comprehensive treatment of the law, integrated business applications, and full-color design, Business: Its Legal, Ethical, and Global Environment is well suited for both undergraduate and MBA students. The book is used extensively in under- graduate education programs around the country. In addition, this edition has been class-tested with MBA students, and it is appropriate for MBA and executive education programs.

A Note on AACSB Standards

The strong presence of ethics, social responsibility, international law and issues, and the integration of other business disciplines make the book an ideal fit for meeting AACSB standards and curriculum requirements. The AACSB standards emphasize the need for students to have an understanding of ethical and global issues. The eleventh edition continues with its separate chapter on ethics as well as ethical issues and dilemmas for student discussion and resolution in every chapter. The separate chapter on international law continues its expanded cover- age from the last edition, and each chapter has a segment devoted to international law issues. The eleventh edition includes readings on expanded international law enforcement cooperation, the challenges of ethics and law in international busi- ness, the role of lawyers in other countries, and attitudes outside the United States on insider trading and antitrust laws.

This edition presents students with the legal foundation necessary for busi- ness operations and sales but also affords the students the opportunities to analyze critically the social and political environments in which the laws are made and in which businesses must operate. An examination of the lists of companies and individuals covered in the biographies, and of the publications from which the “For the Manager’s Desk” readings are based on, demonstrates the depth of back- ground the eleventh edition offers in those areas noted as critical by the AACSB. The materials provide a balanced look at regulation, free enterprise, and the new global economy.

Supplements Business: Its Legal, Ethical, and Global Environment offers a comprehensive and well- crafted supplements package for both students and instructors.


MindTap™ is a fully online, highly personalized learning experience combining readings, multimedia, activities, and assessments into a singular Learning Path. Instructors can personalize the Learning Path by customizing Cengage Learning resources and adding their own content via apps that integrate into the MindTap framework seamlessly with Learning Management Systems.

We have heard that business law instructors want to help students Prepare for class, Engage with the course concepts to reinforce learning, Apply these concepts in real-world scenarios, and use legal reasoning and critical thinking to Analyze business law content. Accordingly, our MindTap product provides a four-step

Preface xxiii

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Learning Path designed to meet these critical needs while also allowing instructors to measure skills and outcomes with ease.

• Prepare: Business Law Ebook and Worksheets – help students prepare for class with interactive guided reading & chapter review questions that can be completed prior to class so that class time can be spent applying the concepts.

• Engage: Video Activities – engage students using real-world scenarios that bring business law to life and help students make connections with real work situations. Includes comprehension questions for practice and assignable gradeable homework.

• Apply: Brief Hypothetical Scenarios – These short fictional scenarios, help students spot the issue and apply the law and concepts that they’ve learned. These are great questions for exam preparation.

• Analyze: Legal Reasoning – Promote deeper critical thinking and legal reasoning by using these case problem questions to help improve critical thinking skills.

Every item in the Learning Path is assignable and gradable. This gives instructors the knowledge of class standings and concepts that students may be finding difficult. Additionally, students gain knowledge about where they stand— both individually and compared to the highest performers in class.

To view a demo video and learn more about MindTap, please visit

Case Collection

Now, within MindTap, instructors can search Case Collection—a library of cases from previous editions of different Cengage textbooks—by relevant criteria and then incorporate those cases in the learning path for students.

This exciting repository allows instructors to personalize their course and truly engage students, helping them to reach higher levels of critical thinking.

• Easily search by topic, and then refine the search by subtopic, to find case examples of a specific legal concept.

• Search by court or state to bring a local flavor or interest to the classroom. • Enjoy over 1500 cases at your fingertips. All new edition omitted cases will be

added every year, allowing the archive to continually grow.

Mix and match cases from all textbooks, whether you are currently using it in class or not. This allows you to provide longer cases with more information from other resources, which is especially helpful if your text didn’t show the court’s decision.

Weekly Ethics and Law Updates. Available at, the weekly updates contributed by the author offer at least 12 current events per month for discussion and analysis. The update features new decisions, new statutes, new reg- ulations, new ethical dilemmas, and a host of examples and cites to current period- icals. The eleventh edition includes references to these updates in the text.

Instructor’s Manual. The Instructor’s Manual, written by the author, provides the following for each chapter: a detailed outline; answers to “Considers . . . ”,

xxiv Preface

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“Ethical Issues,” case problems, and the end-of-chapter Questions and Problems; briefs of all cases; summaries of key features; supplemental readings; and interac- tive/cooperative learning exercises.

PowerPoint® Lecture Review Slides. Developed by the author, these PowerPoint slides consist of lecture outlines and select tables and figures used in the book. The slides are available for use by students as an aid to note taking, and by instructors for enhancing their lectures.

Test Bank. The Test Bank for instructors includes more than 2,000 questions in true/false, multiple-choice, and essay format. The questions vary in levels of diffi- culty, and meet a full range of tagging requirements, including AACSB standards.

Cognero. Cengage Learning Testing Powered by Cognero is a flexible, online system that allows you to:

• author, edit, and manage Test Bank content from multiple Cengage Learning solutions

• create multiple test versions in an instant • deliver tests from your LMS, your classroom or wherever you want

Start right away! Cengage Learning Testing Powered by Cognero works on any operating system or browser.

• No special installs or downloads needed • Create tests from school, home, the coffee shop—anywhere with Internet


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• Simplicity at every step. A desktop-inspired interface features drop-down menus and familiar, intuitive tools that take you through content creation and management with ease.

• Full-featured test generator. Create ideal assessments with your choice of 15 question types (including true/false, multiple choice, opinion scale/ likert, and essay). Multi-language support, an equation editor, and unlim- ited metadata help ensure your tests are complete and compliant.

• Cross-compatible capability. Import and export content into other systems.

KnowNOW Blog. Included inside MindTap, this is a professor ’s dream—a daily blog on eye-catching legal issues that allow students the opportunity to engage in discussion and really master concepts because of the nature of the subject matter. Insider trading is something that may not grab their attention until you share with them the story of the famous Notre Dame football player, Rudy, who settled pump-and-dump charges by the SEC. And a breached sale of fabric contract sounds like a dull session unless you are able to use the Lululemon problem—the company made thousands of yoga pants with the fab- ric only to discover through customer complaints that the fabric was see-through and those customers wanted their money back. Even antitrust law comes to life when you use the merger of Corona with Bud Light to cover market share and monopoly power.

Preface xxv

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About the Author

Professor Marianne Jennings is an emeritus professor of legal and ethical studies in business from the W.P. Carey School of Business at Arizona State University. She was named professor of the year in the College of Business in 1981, 1987, 2000, and 2010 and was the recipient of a Burlington Northern teaching excellence award in 1985. She served as director of the Joan and David Lincoln Center for Applied Eth- ics at ASU from 1995–1999. From 2006–2007, she served as the faculty director for the MBA Executive Program. She continues to teach graduate courses in business ethics and ethical culture at ASU and other colleges around the country.

Professor Jennings has authored hundreds of articles in academic, professional and trade journals. She was given best article awards by the institute of Internal Auditors and the Association of Government Accountants in 2001 and 2004. In 2006, her article, “Ethics and Investment Management: True Reform,” was selected by the United Kingdom’s Emerald Management Review from 15,000 articles in 400 journals as one of the top 50 articles in 2005. She was named one of the Top 100 Thought Leaders by Trust Across America in 2010. In 2012 she was named one of the 100 Most Influential People in Business Ethics by Ethisphere magazine. She served on the board of directors for Arizona Public Service (now Pinnacle West Capital Corporation), the owner of the Palo Verde Nuclear Station, from 1987 through 2000. She served on the boards of Zealous Capital Corporation from 1996- 1998 and the Center for Children with Chronic Illness and Disability at the Uni- versity of Minnesota. She served as chair of the Bonneville International Advisory Board for KHTC/KIDR from 1994-199. She was appointed to the board of advi- sors for the Institute of Nuclear Power Operators in 2004. In 2015 she was named an affiliated scholar with the Center for the Study of Economic Liberty at Arizona State University.

Currently she has six textbooks and monographs in circulation. The ninth edi- tion of her textbook, Case Studies in Business Ethics, and the eleventh edition of her textbook, Business: lts Legal, Ethical and Global Environment will be published in January 2017. Her first textbook, Real Estate Law, had its 11th edition published in January 2016. Her text, Anderson’s Business and the Legal Environment had its 23rd edition published in January 2016.

Her book, Business Strategy for the Political Arena, was selected in 1985 by Library Journal as one of its recommended books in business/government rela- tions. 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. A Business Tale was also a finalist for two other literary awards for 2004. In 2000, her book on corporate governance was published by the New York Times MBA Pocket Series. Professor Jennings’ 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 book, The Seven Signs of Ethical Collapse is used by auditors in advance detection of fraud and is a primer on corpo- rate culture, including analysis of board efficacy. Her books have been translated into five languages.

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She is a contributing editor for the Real Estate Law Journal and New Perspectives. She served on the Board of Editors for the Financial Analysts Journal from 2007– 2012. She served as editor-in-chief of the Journal of Legal Studies Education during 2003–2004. During 1984-85, she served as then-Governor Bruce Babbitt’s appoin- tee to the Arizona Corporation Commission. In 1999 she was appointed by then- Governor Jane Dee Hull to the Arizona Commission on Character.

Her columns have been syndicated around the country, and her work has appeared in the Wall Street Journal, the Chicago Tribune, the New York Times, Washington Post, and the Reader’s Digest. A collection of her essays, Nobody Fixes Real Carrot Sticks Anymore, first published in 1994 is still being published. She was given an Arizona Press Club award in 1994 for her work as a feature columnist. She has been a commentator on business issues on All Things Considered for National Public Radio. She served as chair of the Bonneville International Advisory Board for KHTC/KIDR from 1994–1997 and was a weekly commentator on KGLE during 1998. She has appeared on CNBC, CBS This Morning, the Today Show, and CBS Evening News.

Professor Jennings earned her undergraduate degree in finance and her J. D. from Brigham Young University. She has done consulting work for law firms, government agencies, businesses and professional groups including AES, AICPA, Allstate, Amgen, AstraZeneca, Bell Helicopter, Blue Cross Blue Shield, Boeing, Bristol-Myers Squibb, Certified Financial Analysts Institute, CoBank, Coca-Cola, Department of Energy, Department of Interior, Dial Corporation, DuPont, Hy-Vee Foods, IBM, Institute of Internal Auditors, Mattel, Motorola, Southern California Edison, Pfizer, Raytheon, Tenet, Toyota, U.S. Navy, Veterans Administration, and VIAD.

Personal: Married since 1976 to Terry H. Jennings, Maricopa County Attorney’s Office Deputy County Attorney; five children: Sarah, Sam, and John, and the late Claire and Hannah Jennings.

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By its eleventh edition, a book has evolved to a point of trademark characteristics. This book is known for its hands-on examples and readings for business manag- ers. That trademark evolves because of the efforts of many. They are the reviewers and adopters of the text who provide ideas, cases, and suggestions for improve- ment and inclusion, and I thank them all.

Any edition of a book bears the mark of the editors who work to design, refine, market, and produce it. Seven editions ago, Rob Dewey saw potential for the book and applied his enthusiasm and market insights to mold a somewhat ugly duck- ling into a four-color swan. The book also carries the imprimatur of Steve Silver- stein, who confronted me with a profound question, “Why can’t those in business see these ethical dilemmas when they are in the midst of them?” His question forced me back to the drawing board and resulted in the more personal ethical dilemmas. Vicky True, now in Rob’s role, understands the needs of instructors because of her intense road schedule, holds a keen sense of market direction, and offers the insights of both to help to shape this new edition. Kristen Meere, new as the editor for this edition, came into the work with little lead time and picked up the baton and ran with me as we worked through a tight schedule. Kris Tabor has been with me since the first edition, helping with word processing, IMs, study guides, test banks, and venting. We mark 30 years of a terrific partnership with this edition.

This book also carries the unmistakable liveliness of an author who shares her life with helpful and delightful children and one tolerant husband. Since the first edition of this book, I have added four children to our first, witnessed two grad- uate from college, one from law school, grieved over the loss of two, and seen the others grow up all too quickly in a household in which these words, “Mom, the UPS guy is here with page proofs,” made up their first sentences. They now sim- ply witness me hovering over my computer from dawn’s light until I fall asleep on the keyboard. My children and my husband, collectively my family, are the most charming people I know. They have brought me stories, pop culture, and good sense with their, “Uh-oh, here we go!” when their mother finds outrage in yet another ethical lapse in business. Even from their now–globally dispersed posi- tions, they call and ask, “How’s the writing going?” Their vibrancy is found in the color and charm of these pages. I am grateful for their unanimous and unwavering support for my work. Finally, I am grateful to my parents who taught me through their words and examples of the importance and rewards of ethics and hard work.

Marianne Moody Jennings

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1 Business: Its Legal, Ethical, and Judicial Environment

Simply stated, you cannot run a successful business without knowing the law. What is legal? Where can I find the laws I need to know? How do I make decisions about legal conduct that is ethically troublesome

to me? What if I have a disagreement with a customer, employee, or

shareholder? How and where can I resolve our differences?

This portion of the book explains what law is, where it can be found,

how it is applied, and how legal disputes are resolved. But beyond

the legal environment of a business, there are the ethical issues. Just

because what you are doing is legal does not mean it is ethical. And

why should a manager make ethical choices and behave honorably in

business? Law and ethics are inextricably intertwined. A commitment to

both is part of a sustainable business model.

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Introduction to Law1 Most people understand the law through personal experiences. Some are exposed to law through traffic tickets. Others encounter the law when a problem arises with a landlord or lease. Many wonder about their rights when search engines and other Internet companies gather information about them without their realizing such efforts were ongoing. Facing income reductions in tough economic times, many wonder what their rights are when collectors call or file suit. Their understanding of the law may be limited by the anger they feel about an annoying collection agent, their e-mail being scanned or a traffic tick- et. However, without traffic laws, the roads would be a study in survival of the fittest. The law is your source of assurance that you have rights when it comes to collection agency actions. Each day businesses find and face legal and ethical issues in everything from privacy rights on Facebook to proper documentation of employees’ citizenship.

The types of laws and the penalties for violating them vary from state to state and from city to city, but, however much they vary, laws exist everywhere and at every level of government. Indeed, law is a universal, necessary foundation of an orderly society. Law helps maintain order, imposing on us certain minimum standards of conduct. When we fall short of those standards, we risk penalties. Law is made up of rules that control people’s conduct and their interrelationships. Traffic laws control not only our conduct when we are driving but also our rela- tionships with other drivers using the roads. In some instances, traffic laws give other drivers a right-of-way, and we are liable to them for any injuries we cause by not following those laws.

This chapter offers an introduction to law. How is law defined? What types of laws are there? What are the purposes and characteristics of law? Where are laws found, and who enacts them?

Update For up-to-date legal news, go to

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1-1 Definition of Law Philosophers and scholars throughout history have offered definitions of law. Aristotle, the early Greek philosopher, wrote that “the law is reason unaffected by desire” and “law is a form of order, and good law must necessarily mean good order.” Oliver Wendell Holmes Jr., a U.S. Supreme Court justice of the early twen- tieth century, said, “[L]aw embodies the story of a nation’s development through many centuries.” Sir William Blackstone, the English philosopher and legal scholar, observed that law was “that rule of action which is prescribed by some superior and which the inferior is bound to obey.” Black’s Law Dictionary defines law as “a body of rules of action or conduct prescribed by the controlling authority, and having legal binding force.”1 Law has been defined at least once by every phi- losopher, statesman, and police officer.

Law is simply the body of rules governing individuals and their relationships. Most of these rules become law through a recognized governmental authority. Laws give us basic freedoms, rights, and protections. Law also offers a model of conduct for members of society in their business and personal lives and gives them certainty of expectation. Plans, businesses, contracts, and property ownership are based on the expectation that the law will provide consistent protection of rights. Without such constancy in legal boundaries, society would be a mass of chaos and confusion.

1-2 Classifications of Law 1-2a public versus private Law

Public law includes those laws enacted by some authorized governmental body. State and federal constitutions and statutes are all examples of public laws, as are the state incorporation and partnership procedures, county taxation statutes, and local zoning laws.

This country’s planted thick with laws from coast to coast . . . and if you cut them down . . . d’you really think you could stand upright in the winds that would blow then? A MAn for All SeASonS, Act I

Consider . . . 1.1 John Yates, a commercial fisherman, caught undersized red grouper in federal waters in the Gulf of Mexico. To prevent federal authorities from confirming that he had harvested undersized fish, Yates ordered a crew member to toss the suspect fish into the sea. Yates was charged with, and convicted of, violating 18 U.S.C. § 1519,

“Whoever knowingly alters, destroys, mutilates, con- ceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation . . . or

any case filed . . . or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.”

Mr. Yates says that the statute applies to financial records and not fish. The statute was passed after Enron collapsed and its financial records and audit papers had been shredded to deter such actions by businesses. Who decides whether the law applies to hurling fish overboard? What should the court decide?

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4 part 1 Business: Its Legal, Ethical, and Judicial Environment

Private law, on the other hand, is developed between two individuals. For exam- ple, landlords usually have regulations for their tenants, and these regulations are private laws. Homeowners’ associations have developed an important body of pri- vate law that regulates everything from the type of landscaping for homes in a sub- division to whether homeowners can erect basketball hoops in their driveways. The terms of a contract are a form of private law for the contracting parties. Although the requirements for forming and the means for enforcing that contract may be a matter of public law, the terms for performance are the private law the parties agree to as the rules for governing their relationships. Employer rules in a corporation are also examples of private law; as long as those rules do not infringe any public rights or violate any statutory or constitutional protections, those rules define a private law relationship between employer and employee. For example, most companies now have Twitter and Facebook policies that limit the type of information and comments employees can post about their employers in social media outlets. Interestingly, both state legislatures and the U.S. Congress have proposed legislation that would con- trol employer restrictions on employees’ posts. Public law is being changed to reflect technological areas that are not yet addressed in employment law.

1-2b Criminal versus Civil Law

A violation of a criminal law is a wrong against society. A violation of a civil law is a wrong against another person or persons. Criminal violations have penalties such as fines and imprisonment. When you run a red light, you have committed a criminal violation and owe society a penalty, such as a fine or imprisonment. Vio- lations of civil laws, on the other hand, require restitution: someone who violates a civil law must compensate the harmed party. If you do run a red light and strike and injure a pedestrian, your criminal case is society’s remedy. The civil wrong in the same action requires you to pay damages to that pedestrian.

If you drive while intoxicated, you are breaking a criminal law and are subject to a fine, jail term, or license suspension. If you have an accident while driving intoxicated, you commit a civil wrong against anyone you injure. People who are injured as a result of your driving while intoxicated can file a civil suit against you to recover for injuries to their persons and property (cars).

Other differences also distinguish civil laws from criminal laws and their enforcement. For example, different rights and procedures are used in the trials of criminal cases (see Chapter 8 for more details).

1-2c Substantive versus procedural Law

Substantive laws are those that give rights and responsibilities. Procedural laws provide the means for enforcing substantive rights. For example, if Zeta Corpo- ration has breached its contract to buy 3,000 microchips from Yerba Corporation, Yerba has the substantive right to expect performance and may be able to collect damages for breach of contract by bringing suit. The laws governing how Yerba’s suit is brought and the trial process are procedural laws. Procedural laws are also used in criminal cases, such as grand jury proceedings or arraignments and pleas (see Chapter 8 for more information).

1-2d Common versus Statutory Law

The term common law has been in existence since 1066, when the Normans con- quered England and William the Conqueror sought one common set of laws for

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Chapter 1 Introduction to Law 5

governing a then-divided England. The various customs of each locality were con- glomerated so that all fiefdoms could operate under a “common” system of law. The common law came about as judges in different areas settled disputes in similar ways by consulting their fellow judges on their previous decisions before making decisions. This principle of following other decisions is referred to as stare decisis, meaning “let the decision stand.” This process of legal reasoning is still followed today. The courts use the judicial decisions of the past in making their judgments in order to provide the consistency and constancy of the law.

As much of an improvement as it was, the common law was still just uncod- ified law. Because of increased trade, population, and complexities, the common law needed to be supplemented. As a result, statutory law, which is passed by some governmental body and written in some form, was created.

Today, in the United States, we have common law and statutory law. Some of our common law still consists of principles from the original English common law. For example, how we own and pass title to real property are areas largely devel- oped from English common law. The body of common law continues to grow, however: the judicial system’s decisions constitute a form of common law that is used in the process of stare decisis. Courts throughout the country look to other courts’ decisions when confronted with similar cases.

Statutory law exists at all levels of government—federal, state, county, city, borough, and town. Our statutory law varies throughout our nation because of the cultural heritages of various regions. For example, the southwestern states have marital property rights statutes—often referred to as community property laws—that were influenced by the Spanish legal system implemented in Mexico. The northeastern states have different marital property laws that were influenced by English laws on property ownership. Louisiana’s contract laws are based on French principles because of the early French settlements there.

1-2e Law versus equity

Equity is a body of law that attempts to do justice when the law does not provide a remedy, when the remedy is inadequate, or when the application of the law is terribly unfair. Equity, which originated in England, came into being because the technicalities of the common law often resulted in unresolved disputes or unfair resolutions. The monarchy allowed its chancellor to hear those cases that could not be resolved in the common law courts; eventually, a separate set of equity courts developed that were not bound by rigid common law rules. These courts could get more easily to the heart of a dispute. Over time, they developed remedies not available under common law. Common law, for example, usually permitted only the recovery of monetary damages. Courts of equity, on the other hand, could issue orders, known as injunctions, prohibiting certain conduct or ordering certain acts. The equitable remedies available in the courts of chancery were gradually com- bined with the legal remedies of the common law courts so that now parties can have their legal and equitable remedies determined by the same court.

Today’s courts award equitable remedies when the legal remedy of money damages would be inadequate. For example, the copyright infringement cases brought by the recording and motion picture industries sought injunctions against the individuals and companies that provided the technological means for making unauthorized individual copies of movies and songs. The record companies, the movie producers, and the artists could never be adequately compensated with

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6 part 1 Business: Its Legal, Ethical, and Judicial Environment

money for these forms of infringement because the continued activity caused the loss of their exclusive copyrights. The remedy that they sought and were given were injunctions that, within certain parameters, ordered a halt to the sites and programs that facilitated the unauthorized downloading of copy- righted materials.

1-3 Purposes of Law 1-3a Keeping Order

Laws carry some form of penalty for their violation. Violations of securities laws carry a fine or imprisonment or both. Violations of civil laws also carry sanctions. If an employer discriminates against you by refusing to give you a raise or promo- tion because of your age, gender, or race, you can seek money damages. A driver who injures another while driving intoxicated can be prosecuted but must also pay for the damages and the costs of the injuries the other person experiences. These civil and criminal penalties for violations of laws prevent feuds and the use of primitive methods for settling disputes, such as force.

During the summer of 2016, a number of U.S. cities experienced protests and riots because of concerns about particular police officers’ conduct. These cities imposed curfews in order to bring quiet to the city streets as well as preventing damages to and looting of businesses. A simple curfew law helped to bring order to those cities.

1-3b Influencing Conduct

Laws also influence conduct in a society. For example, securities laws require com- panies to make certain disclosures about those securities before they can be sold to the public. The antitrust laws passed in the early twentieth century prohibited some methods of competition, such as price fixing, and limited others, such as mergers (see Chapter 14). These types of laws continue to change the way busi- nesses operate. For example, Google recently agreed to stop restricting its advertis- ers from working with other search engines.

1-3c Honoring expectations

Businesses commit resources, people, and time to ventures, expansion, and product development with the expectation that the contracts for those commitments will be honored and enforced according to existing law. Investors buy stock with the knowledge that they will enjoy some protection of that investment through the laws that regulate both the securities themselves and the companies in which they have invested. Laws allow prior planning based on the protections inherent in the law.

1-3d promoting equality

Laws have been used to achieve equality in those aspects of life in which equality is not a reality. For example, the equal-right-to-employment acts (see Chapter 20) were passed to bring greater equality to the job market. The social welfare pro- grams of state and federal governments were created to further the cause of eco- nomic justice. The antitrust laws attempt to level the playing field for the free enterprise system to operate efficiently.

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Chapter 1 Introduction to Law 7

1-3e Law as the Great Compromiser

A final and important purpose of law is to act as the great compromiser. Few people, groups, or businesses agree philosophically on how society, business, or government should be run. Law serves to mesh different views into one united view so that all parties are at least partially satisfied. When disputes occur, the courts apply the law to the parties’ situation in an attempt to strike a compromise between two opposing views. The U.S. Supreme Court has provided compromises for the rights of businesses to be involved in the political process and make dona- tions to candidates (see Chapter 5). In the relationship between freedom of speech and advertising regulation, the law serves as the mediator.

1-4 Characteristics of Law 1-4a Flexibility

As society changes, the law must change with it. When the United States was an agricultural nation, the issues of antitrust, employment discrimination, and secu- rities fraud rarely arose. However, as the United States became an industrialized nation, those areas of law expanded, and they continue to expand today. As the United States further evolves into a technological and information-based society, still more areas of law will be created and developed. Computer fraud and iden- tity theft, for example, were unknown issues 35 years ago; today, both state and federal laws address these issues through criminal statutes (see Chapter 8). The introduction of document attachments and electronic signature programs required the courts to re-examine how offers and acceptances of contracts are made, with electronic signatures now legislatively sanctioned as having the same force and effect as signatures on paper (see Chapter 11).

Circumstances change through technology, sociology, and even biology. The law must address those changes. What are the rights of copyright holders when an Internet company creates a system that allows users to post videos that are copy- righted? With billions of users and millions of videos, how do we protect copy- righted materials?

1-4b Consistency

Although the law must be flexible, it still must be predictable. Law cannot change so suddenly that parties cannot rely on its existence or protection. Being able to predict the outcome of a course of conduct allows a party to rely on a contract or dissuades a party from the commission of a crime. For a contract, a judicial remedy can be ordered for breach or non-performance; for a crime, a prescribed punish- ment is the result.

1-4c pervasiveness

The law must be pervasive and cover all necessary areas, but at the same time, it cannot infringe on individual freedoms or become so complex that it is difficult to enforce. For example, laws cover the formation, operation, and dissolution of corporations. Laws govern corporate management decisions on expanding, devel- oping, and changing the nature of the corporation. Laws also ensure that share- holders’ rights are protected. The corporation has great flexibility in management, as long as it stays within these legal boundaries.

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8 part 1 Business: Its Legal, Ethical, and Judicial Environment

In the following case, the U.S. Supreme Court was a deeply divided court on a statutory interpretation question, a question that touched on many of the pur- poses of law. The majority and dissenting opinions show the struggle courts face as they try to honor the law’s dual purposes of keeping order while preserving rights. Case 1.1 is briefed in Exhibit 1.1. A brief is a tool used by lawyers, law stu- dents, and judges to help them summarize a case and focus on its facts and the key points of the decision by the court. The Yates case answers the questions posed in the “Consider . . .” problem at the beginning of the chapter.

Yates v. U.S. 135 S.Ct. 1074 (2015)

Hurling Fish Overboard the Miss Katie: Obstruction of Justice?

Case 1.1


On August 23, 2007, the Miss Katie, a commercial fish- ing boat, was six days into an expedition in the Gulf of Mexico. Her crew numbered three, including Yates, the captain. Engaged in a routine offshore patrol to inspect both recreational and commercial vessels, Officer John Jones of the Florida Fish and Wildlife Conservation Commission decided to board the Miss Katie to check on the vessel’s compliance with fishing rules. Because he had been deputized as a federal agent by the Nation- al Marine Fisheries Service, Officer Jones had authority to enforce federal, as well as state, fishing laws.

Upon boarding the Miss Katie, Officer Jones noticed three red grouper that appeared to be under- sized hanging from a hook on the deck. At the time, federal conservation regulations required immediate release of red grouper less than 20 inches long. Offi- cer Jones instructed Yates to keep the undersized fish segregated from the rest of the catch until the ship returned to port. After Jones departed, Yates instead told a crew member to throw the undersized fish overboard. For this offense, Yates was charged with destroying, concealing, and covering up undersized fish to impede a federal investigation, in violation of 18 U.S.C. § 1519:

“Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investi- gation or proper administration of any matter with- in the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter

or case, shall be fined under this title, imprisoned not more than 20 years, or both.”

Yates was convicted but moved to dismiss the charges, arguing that §1519’s reference to “tangible object” means objects used to store information, such as computer hard drives, not fish. The District Court denied Yates’s motion, and a jury found him guilty. The Eleventh Circuit affirmed the conviction, concluding that §1519 applies to the destruction or concealment of fish because, as objects having phys- ical form, fish fall within the dictionary definition of “tangible object.” Yates, who was sentenced to 30 days in jail and three years of supervised proba- tion as well as carrying a felony conviction for life, appealed.


GINSBURG, Justice Although dictionary definitions of the words “tangi- ble” and “object” bear consideration in determining the meaning of “tangible object” in §1519, they are not dispositive. Whether a statutory term is unambiguous “is determined [not only] by reference to the language itself, [but also by] the specific context in which that language is used, and the broader context of the statute as a whole.”

Section 1519’s position within Title 18, Chapter 73, further signals that §1519 was not intended to serve as a cross-the-board ban on the destruction of physical evidence. Congress placed §1519 at the end of Chapter 73 following immediately after pre-existing specialized provisions expressly aimed at corporate fraud and financial audits.

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Chapter 1 Introduction to Law 9

The contemporaneous passage of §1512(c)(1), which prohibits a person from “alter[ing], destroy[ing], mutilat[ing], or conceal[ing] a record, document, or other object . . . with the intent to impair the object’s integrity or availability for use in an official proceed- ing,” is also instructive.

Use of traditional tools of statutory interpretation to examine markers of congressional intent within the Sarbanes–Oxley Act and §1519 itself thus call for rejec- tion of an aggressive interpretation of “tangible object.”

Having used traditional tools of statutory inter- pretation to examine markers of congressional intent within the Sarbanes–Oxley Act and §1519 itself, we are persuaded that an aggressive interpretation of “tan- gible object” must be rejected. It is highly improbable that Congress would have buried a general spoliation statute covering objects of any and every kind in a provision targeting fraud in financial record-keeping.


ALITO, Justice, Concurring [T]hough the question is close, traditional tools of statutory construction confirm that John Yates has the better of the argument. Three features of 18 U.S.C. § 1519 stand out to me: the statute’s list of nouns, its list of verbs, and its title. Although perhaps none of these features by itself would tip the case in favor of Yates, the three combined do so. Start with the nouns. Sec- tion 1519 refers to “any record, document, or tangible object.”

[T]he term “tangible object” should refer to some- thing similar to records or documents. A fish does not spring to mind—nor does an antelope, a colonial farm- house, a hydrofoil, or an oil derrick. All are “objects” that are “tangible.” But who wouldn’t raise an eyebrow if a neighbor, when asked to identify something similar to a “record” or “document,” said “crocodile”?

[My] analysis is influenced by §1519’s title: “Destruction, alteration, or falsification of records in Federal investigations and bankruptcy.” (Emphasis added.) This too points toward filekeeping, not fish. Titles can be useful devices to resolve “‘doubt about the meaning of a statute.’” The title is especially valu- able here because it reinforces what the text’s nouns and verbs independently suggest—that no matter how other statutes might be read, this particular one does not cover every noun in the universe with tangible form.

KAGAN, Justice Dissenting with Justices SCALIA, KENNEDY, AND THOMAS

If none of the traditional tools of statutory interpre- tation can produce today’s result, then what accounts

for it? The plurality offers a clue when it emphasizes the disproportionate penalties §1519 imposes if the law is read broadly. Section 1519, the plurality objects, would then “expose[ ] individuals to 20-year prison sentences for tampering with any physical object that might have evidentiary value in any federal investiga- tion into any offense.” That brings to the surface the real issue: overcriminalization and excessive punish- ment in the U.S. Code.

Now as to this statute, I think the plurality some- what—though only somewhat—exaggerates the mat- ter. The plurality omits from its description of §1519 the requirement that a person act “knowingly” and with “the intent to impede, obstruct, or influence” federal law enforcement. And in highlighting §1519’s maxi- mum penalty, the plurality glosses over the absence of any prescribed minimum. (Let’s not forget that Yates’s sentence was not 20 years, but 30 days.) Congress presumably enacts laws with high maximums and no minimums when it thinks the prohibited conduct may run the gamut from major to minor. That is assuredly true of acts obstructing justice. Most district judges, as Congress knows, will recognize differences between such cases and prosecutions like this one, and will try to make the punishment fit the crime. Still and all, I tend to think, for the reasons the plurality gives, that §1519 is a bad law—too broad and undifferentiated, with too-high maximum penalties, which give pros- ecutors too much leverage and sentencers too much discretion. And I’d go further: In those ways, §1519 is unfortunately not an outlier, but an emblem of a deeper pathology in the federal criminal code.

But whatever the wisdom or folly of §1519, this Court does not get to rewrite the law. “Resolution of the pros and cons of whether a statute should sweep broadly or narrowly is for Congress.” If judges dis- agree with Congress’s choice, we are perfectly entitled to say so—in lectures, in law review articles, and even in dicta. But we are not entitled to replace the statute Congress enacted with an alternative of our own design.

I respectfully dissent.


1. Explain what Mr. Yates did and why.

2. Describe the terms used in the statute at issue and the history of the statute.

3. Why does the dissent think the majority made the decision it did?

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10 part 1 Business: Its Legal, Ethical, and Judicial Environment

Exhibit 1.1 Sample Case Brief

Name of case: Yates v. U.S. Court: U.S. Supreme Court Citation: 135 S.Ct. 1074 (2015) Parties and their roles: United States (respondent/prosecutor); John L. Yates (petitioner/defendant) Facts: John Yates, a commercial fisherman, caught undersized red grouper in federal waters in the Gulf of

Mexico. To prevent federal authorities from confirming that he had harvested undersized fish, Yates ordered a crew member to toss the suspect fish into the sea. Yates was charged with obstruction of justice through destruction of the small red-grouper fish.

Issues: Is the release of fish back into the sea obstruction of justice? Lower court decision: Yates was convicted and appealed. His conviction was upheld. He appealed to the U.S. Supreme Court. Decision: A split court held that the fish were not “tangible objects” for purposes of the obstruction of justice

statute. The court held that the statute was passed to cover files and electronic records and not tangible objects such as fish. The conviction was reversed.

Reasoning: The court held that the statute was passed in the wake of financial and ethical collapses in companies and was not intended to have generic application. It was directed at electronic files and documentation, not tangible objects such as fish.

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Ethical Issues

Evaluate the ethics of Mr. Yates in hurling the fish back after the federal agent told him to retain them.

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Consider . . . 1.2 Andrew B. Katakis received a letter from his bank informing him that federal inves- tigators had subpoenaed his bank records. On September 3, 2010, Katakis purchased, downloaded, and installed a program called DriveScrubber on his home computer, a Dell. DriveScrubber places deleted infor- mation into free space on the computer. DriveScrubber actively overwrites all data in the free space of a hard drive. Once a file is

overwritten by DriveScrubber, it is impossi- ble to retrieve it.

Katakis’s business partner, Steve Swanger, kept two computers at their office. Katakis told Swanger that he wanted to install a “scrubber program” on their computers and that there was “nothing wrong with us cleaning our computers.” The Swanger Dell had 4,000 e-mails on it, and Katakis began deleting them. After seeing that it would

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Chapter 1 Introduction to Law 11

take a long time for the e-mails to be delet- ed, Katakis went home. When he returned to the office on Monday, Swanger noticed that almost all of the e-mails on his Dell had been deleted from his e-mail in-box.

The government seized the computers in its investigation of an alleged bid-rigging scheme. When examining Swanger’s Dell, the government discovered ten incriminat- ing e-mails that implicated Katakis. Katakis was either a sender or recipient of all ten e-mails. Swanger was also either the sender or recipient of all ten e-mails. The e-mails were discovered in the deleted items folder in Swanger’s e-mail. Metadata attached to the e-mails showed that Katakis had re- ceived and opened all of them. However, Katakis had deleted the e-mails, and the government expert believed that Katakis had destroyed them using DriveScrubber. However, because the e-mails were part of an Exchange e-mail program, deleted e-mails simply go into a deleted mail folder and are not subject to DriveScrubber over- write. Still, the government never found the e-mails on the Katakis computer. Katakis was charged with obstruction of justice for destroying electronic documents. What should the court do with the case? Based on what you learned in the Yates case, was this obstruction of justice? U.S. v. Katakis, 800 F.3d 1017 (9th Cir. 2015).

THINK: Before answering this prob- lem, review the opinions in the Yates case. Recall the following.

1. According to the majority, the statute applies to the destruction of docu- ments or electronic records. a. The e-mails were electronic records. b. The e-mails were missing.

2. The e-mails were relevant to the bid-rigging investigation and charges.

3. The e-mails were not covered by the DriveScrubber program that Katakis installed.

APPLY: The e-mails are covered by the obstruction statute because the court care- fully outlined what was included in and cov- ered by the statute and electronic records are part of the coverage.

ANSWER: However, what is different about this case from the Yates case is that the proof does not connect Katakis with de- struction of the e-mails. There must be some form of a record, but there must also be destruction, and the experts in the case in- dicated that DriveScrubber would not have automatically destroyed the e-mails because they were in an Exchange folder, not the computer free space over which DriveScrub- ber writes. Circumstantial evidence does not provide the connection between the missing records and Katakis. The case was dismissed.

Re: the Cover-Up vs. the Crime For the Manager’s Desk

One of the important lessons of the Yates case is for those who run businesses to understand that when inspectors or offi- cers find violations in their operations, the worst thing to do is to attempt to conceal the evidence. Concealment or obstruction always reach felony levels. The fines and imprisonment, as with §1519, can be as high as 20 years. Once caught, the best

approach is, in consultation with a lawyer, to determine your rights and options. However, undertaking the destruction of documents, records, or fish only brings greater penalties. If the statutes are excessive or unfair, there is always the appeal of the sentence itself, but the issue will be the fairness of the sen- tence and not a felony conviction for the act of obstruction.

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12 part 1 Business: Its Legal, Ethical, and Judicial Environment

1-5 The Theory of Law: Jurisprudence Law is the compromise of conflicting ideas. Not only do people differ in their thinking on the types of specific laws, they also differ on the theory behind the law or the values a legal system should try to advance or encourage. Many can agree on the definition of law and its purposes but still differ on how those purposes are best accomplished. The incorporation of theories or values into the legal process is, perhaps, what makes each society’s laws different and causes law to change as society changes its values. These different theories or value bases for law are found in an area of legal study called jurisprudence, a Latin term meaning “wis- dom of the law.” In many cases, how the law should work is unclear. Conflicting philosophical views often come together in litigation. Judges and lawmakers must struggle to do the best good for the most members of society.

1-5a the theory of Law: positive Law

There are some who see law as simply written orders that we must keep. Known as the positive law school of thought, those who subscribe to it believe that the crit- ical part of the law is obedience so that we can have an orderly society.

1-5b the theory of Law: Natural Law

Another theory of jurisprudence is that of natural law, a theory that holds that we have certain rights that cannot be taken away by law. The United States of Amer- ica’s form of government was grounded in the natural law theorists’ views that we have certain unalienable rights that cannot be taken away by any law. Any law that purports to take away those rights is invalid and must be challenged, either through the courts or through civil disobedience. An example would be slavery. While slavery was legal in the United States and other countries for many years, it was constantly met with dissent, disobedience, and eventually civil war. Natural law trumped the positive law, and slavery was eliminated because it was a viola- tion of natural law, and laws were changed to make it illegal.

1-5c the theory of Law: the protection of Individuals and Relationships

Justice Oliver Wendell Holmes, in “Natural Law,” his famous essay written in 1918 at the height of World War I, rejected the notion of natural law. His essay began with the famous phrase, “The life of the law has not been logic; it has been expe- rience.” Holmes’s opinion is that our interactions with each other constitute the foundation of law.

If I do live with others they tell me what I must do if I wish to remain alive. If I do live with others they tell me what I must do and abstain from doing various things or they will put the screws to me.2

In other words, the law is what keeps the peace among us, and should we choose to ignore it, those around us will take control and bring us into compliance.

1-5d the theory of Law: the Social Contract

Roscoe Pound, another legal philosopher and dean of Harvard Law School for 20 years, had a different view of jurisprudence from Justice Holmes. His view was that law exists as the result of those who happen to be in power, that there is a type

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Chapter 1 Introduction to Law 13

of social contract that we mutually honor. In 1941, Pound wrote his famous credo, called “My Philosophy of Law.”

I think of law as in one sense a highly specialized form of social control in a developed politically organized society—a social control through the systematic and orderly application of the force of such a society. Moreover, it operates through a judicial process and an administrative process, which also go by the name of law. . . .3

Apply the theories of jurisprudence to the following situations.

1. Major General Antonio M. Taguba led an investigation of the conduct of U.S. soldiers in the Abu Ghraib prison in Iraq. The 54-page report documented brutal treatment of Iraqi prisoners, tor- ture, and humiliation, all in violation of either the Geneva Convention for the treatment of prisoners of war or the standards of the Red Cross. General Taguba referred to the treatment of the prisoners as consisting of “egregious acts and grave violations of interna- tional law.”4 One of the findings of the report is that the soldiers serving as prison guards had little training. General Taguba recommended training for soldiers in when to disobey orders. A fellow officer said of General Taguba, “If you want the truth; he’s going to tell you the truth. He’s a stand-up guy.”5

General Taguba’s father was Staff Sergeant Tomas Taguba, a man who fought in the Battle of Bataan and was taken prisoner by the Japanese. He

escaped from prison there and joined the fighters in Japan who opposed the government.

Based on these brief descriptions of these two men, what philosophy of law do you think they would follow?

2. A supervisor has ordered an employee to inflate the company’s earnings for the quarter so that their unit can meet their goals and attain their bonuses. Must the employee obey?

3. Is a businessperson who believes the tax system to be unconstitutional justified in refusing to pay taxes? How will society react to such a position?

4. Is there any example of a law that is accepted by everyone in society? What about the laws against speed- ing? What happens, according to the philosophers, when there is no common agreement on what the law should be?

5. Refer back to the Yates case. What school of thought on jurisprudence do you think Mr. Yates followed?

Consider . . . 1.3

1-6 Sources of Law Laws exist in different forms at every level of government. As discussed earlier, law exists not only in statutory form but also in its common law form through judi- cial decisions. Statutory law exists at all levels of government. Statutes are written laws enacted by some governmental body with the proper authority—legislatures, city governments, and counties—and published and made available for public use and knowledge. These written statutes are sometimes referred to as codified law, and their sources, as well as constitutions, are covered in the following sections.

1-6a Constitutional Law

The U.S. Constitution and the constitutions of the various states are unique forms of law. Constitutions are not statutes because they cannot be added to, amended,

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14 part 1 Business: Its Legal, Ethical, and Judicial Environment

or repealed with the same ease as can statutes. Constitutions are the law of the peo- ple and are changed only by lengthier and more demanding procedures than those used to repeal statutes.

Constitutions tend to protect general rights, such as speech, religion, and prop- erty (see Chapter 5 for a more complete discussion). They also provide a frame- work for all other forms of laws. The basic rights and protections afforded in them cannot be abridged or denied by the other sources of law. In other words, a stat- ute’s boundaries are formed by constitutionally protected rights. Exhibit 1.2 is an illustration of the sources of law; constitutional law is at the base of the pyramid diagram because of its inviolate status.

1-6b Statutory Law at the Federal Level

Congressional Law Congress is responsible for statutory law at the federal level. The laws passed by Congress become part of the United States Code (U.S.C.). Examples of such laws are the 1933 and 1934 Securities Acts (see Chapter 18), the Sherman Act and other antitrust laws (see Chapter 14), the Equal Employment Opportunity Act (see Chap- ter 20), the National Labor Relations Act (see Chapter 19), the Truth-in-Lending Act (see Chapter 11), the USA Patriot Act (see Chapters 8 and 18), and the Internal Revenue Code (see Chapter 19).

Statutes from the U.S.C. are referenced or cited by a standard form of legal short- hand, often referred to as a cite or citation. The number of the title is put in front of “U.S.C.” to tell which volume of the Code to go to. For example, “15 U.S.C.” refers to Title 15 “of the U.S. Code (Title 15 happens to cover securities). There may be more than one volume that is numbered “15,” however. To enable you to find the

Exhibit 1.2 Sources of Law

Private Law

City or Borough Ordinances

County Ordinances

State Administrative Regulations

State Legislative Enactments

State Constitutions

Federal Administrative Regulations

Federal Legislative Enactments

C ou

rt D

ec is

io ns

C ourt D


Court Decisions

U.S. Constitution

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Chapter 1 Introduction to Law 15

volume you need, the reference or cite has a section (§) number following it. This section number is the particular statute referenced, and you must look for the vol- ume of Title 15 that contains that section. For example, the first volume of Title 15 contains §§ 1–11. A full reference or cite to a United States Code statute looks like this: 15 U.S.C. §77. When a U.S.C. cite is given, the law cited will be a federal law passed by Congress.

executive Orders Executive orders are laws of the executive branch of the federal government and deal with those matters under the direct control of that branch. For example, on his second day in office, President Barack Obama issued an executive order prohibit- ing the use of waterboarding in questioning military combatants who are in U.S. custody. In 2015, President Obama issued an executive order that increased back- ground checks on private gun sales, including those sales at gun shows.

Federal administrative Regulations The federal government has administrative agencies that serve the functions of promulgation of rules (called regulations) for developing specifics such as forms and time requirements for carrying out the legislative enactments of Congress, in addition to enforcing both the laws and regulations (see Chapter 6 for more details). Examples of federal agencies include the Environmental Protection Agency (EPA), the Equal Employment Opportunity Commission (EEOC), and the Securities and Exchange Commission (SEC).

Federal regulations are found in the Code of Federal Regulations (CFR), a set of paperback volumes that is published once each year. A citation from the CFR has a structure similar to that of a U.S.C. cite. For example, 12 C.F.R. §226 is volume 12 of the CFR, and §226 is a section that deals with credit disclosure rights.

1-6c Statutory Law at the State Level

As noted on p. 13–14, each state has its own constitution. State constitutions cannot circumvent or cancel any of the rights afforded under the U.S. Constitution. These state constitutions provide the authority for the state statutory law structure.

Legislative Law and State Codes Each state has its own code containing the laws passed by its legislature. State codes contain the states’ criminal laws, laws for incorporation, laws governing partnerships, and contract laws. Much of the law that affects business is found in these state codes. Some of the laws passed by the states are uniform laws, which are drafted by groups of businesspeople, scholars, and lawyers in an effort to make interstate business less complicated. For example, the Uniform Commercial Code (UCC), which has been adopted in 49 states, governs contracts for the sale of goods, commercial paper, security interests, and other types of commercial transactions. Having this uniform law in the various states gives businesses the opportunity to deal across state lines with some certainty. Other uniform acts passed by many state legislatures include the Uniform Partnership Act (Revised), the Uniform Res- idential Landlord and Tenant Act, the Model Business Corporation Act, and the Uniform Probate Code.

State administrative Law Just as at the federal level, state governments have administrative agencies with the power to pass regulations dealing with the statutes and powers given by the

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16 part 1 Business: Its Legal, Ethical, and Judicial Environment

state legislatures. For example, most states have an agency to handle incorpora- tions and the status of corporations in the state. Most states also have a tax agency to handle income or sales taxes in the state.

1-6d Local Laws of Cities, Counties, and townships

In addition to federal and state statutes, local governments can pass ordinances or statutes within their areas of power or control. For example, cities and counties have the authority to handle zoning issues, and the municipal code outlines the zoning system and whatever means of enforcement and specified penalties apply. These local laws govern lesser issues, such as dog licensing, curfews, and loiter- ing. However, local governments are often responsible for national legal trends. For example, city and county bans on Styrofoam containers have resulted in the transformation of the fast-food industry by the use of new types of containers. City ordinances often affect national companies, and the companies make changes nationwide to comply with local ordinances.

1-6e private Laws

Private laws are a final source of written law and are found, for example, in con- tracts and landlord regulations. These private laws are enforceable provided they are not inconsistent with rights and protections afforded under the other sources of law (see Chapters 3 and 4).

1-6f Court decisions

Looking at Exhibit 1.2, you can see that all of the sources of law just covered are surrounded in the pyramid by the term “Court Decisions.” Often the language in a statute is unclear, or perhaps whether the statute or ordinance applies in a particu- lar situation is unclear. When these ambiguities or omissions occur in the statutory language, courts provide interpretation or clarification of the law when disputing parties bring suit. These court decisions are then read along with the statutory lan- guage in order to give a complete analysis of the scope and intent of the statute. The Yates case is an example of how laws are interpreted and applied as factual twists arise.

Strategy for Small Businesses and Legal Issues

Business Strategy

From the Yates case and the extent of the sources of law, it is easy to see that a small businessman landed in a great deal of legal difficulty. In fact, his court battle began in 2011 and did not end until the 2015 U.S. Supreme Court decision. It also took two years, from the boat inspection in 2009 until 2011, for the criminal charges to be brought against him. How does a small business keep up with legal issues and potential

pitfalls? Small businesses are not always able to have lawyers on call or following all the potential pitfalls they might face. To ensure that they are keeping abreast of the law, changes, and development in their busi- ness areas, many small businesses belong to trade associations. Those associations provide members with information about court decisions, pending legislations, and cautions about business practices. ©

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Chapter 1 Introduction to Law 17

1-7 Introduction to International Law Business is global. Companies headquartered in Japan have factories in the United States, and U.S. firms have manufacturing plants in South America and subcontrac- tors and suppliers in China. Trade and political barriers to economic development no longer exist. Businesses must be adept at trading across country boundaries, and such trade requires an understanding of international law.

International law is not a neat body of law like contract law or the UCC. Rather, it is a combination of the laws of various countries, international trade customs, and international agreements. Article 38(1) of the Statute of the International Court of Justice (a court of the United Nations that countries consent to have resolve dis- putes) is a widely recognized statement of the sources of international law:

(a) international conventions, whether general or particular, establishing rules expressly recognized by the contesting states;

(b) international custom as evidence of a general practice accepted as law;

(c) the general principles of law recognized by civilized nations;

(d) judicial decisions and the teachings of the most highly qualified publicists of the various nations, as subsidiary means for the determination of rules of law.

1-7a Custom

Every country has its boundaries for allowable behavior, and these boundaries are unwritten but recognized laws. The standards of behavior are reflected in state- ments made by businesspeople and government officials. Custom develops over time and through repeated conduct. For example, working conditions in factories around the world have improved over the past 20 years not through changes in laws but through the business custom of inspections, monitors, and transparent disclosure of supply chain resources. Business custom is now one of assuming responsibility for the conditions in factories that supply parts and labor for goods produced around the world.

In addition to operations, businesses must develop a knowledge of and sen- sitivity to individual country customs related to negotiations and relationships. For example, unlike the United States, most countries do not offer a warranty pro- tection on goods and instead follow a philosophy of caveat emptor, “Let the buyer beware.” Other countries also do not recognize the extensive rules of insurance and risk followed here with respect to the shipment of goods. Multinational firms must make provisions for protection of shipments in those countries with differ- ent standards. Differing laws can affect product content and quality. For example, lead-based paint is not permitted for use on children’s toys in the United States, but in China, at one point, lead-based paint was standard in toy production. A toy manufacturer must learn to specify legal standards for suppliers because custom and laws in that country may find the suppliers assuming the same standards they use apply to production for businesses outside their country.

At one time, the customs of China with respect to intellectual property, most particularly computer software, lagged behind those of Europe and the United States. Chinese custom was to separate infringement into two categories: ordinary acts and serious acts. Ordinary infringement was not regarded as a legal issue and requires only that the party apologize, destroy the software, and not engage in infringement again. Courts were rarely involved in ordinary infringement cases.

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18 part 1 Business: Its Legal, Ethical, and Judicial Environment

However, the U.S. government demanded more protection for its copyright hold- ers by imposing trade sanctions, and China eventually agreed to revise its customs and laws to afford protection. In this case, China’s customs had to be changed to provide protection similar to that afforded in other countries.

1-7b treaties

A treaty is an agreement between or among nations on a subject of international law signed by the leaders of the nations and ratified by the nations’ governing bodies. In the United States, treaties are ratified by the Senate and are included in the pyramid (Exhibit 1.2) as federal legislative enactments.

Treaties can be between two nations—bilateral treaties—or multilateral trea- ties—those that are made among several nations. Other treaties, recognized by almost all nations, are called general or universal treaties. Universal treaties are a reflection of widely followed standards of behavior. For example, the Geneva Convention is a universal treaty covering the treatment of prisoners of war. The Vienna Convention is a universal treaty covering diplomatic relations. The Warsaw Convention is a treaty that addresses issues of liability for injuries to passengers and property during inter- national air travel. For more discussion on trade treaties, see Chapter 7.

1-7c private Law in International transactions

Those businesses involved in multinational trade and production rely heavily on private law to ensure performance of contractual obligations. Even though each country has a different set of laws, all of them recognize the autonomy of parties in an international trade transaction and allow the parties to negotiate contract terms that suit their needs, as long as none of the terms is illegal. Party autonomy allows firms to operate uniformly throughout the world if their contracts are recognized as valid in most countries. For example, most international trade contracts have a choice-of-law clause whereby the parties decide which country’s law will apply to their disputes under the contract.

1-7d International Organizations

Some international organizations provide the means for facilitating multinational commercial transactions. For example, the World Trade Organization (WTO) (see Chapter 7 for more details) provides a Dispute Settlement Body (DSB), a forum for resolving trade disputes related to multilateral treaties.

1-7e the doctrines of International Law

There are a number of principles of international law that are widely accepted and honored by most countries. These include the act of state doctrine, a theory that protects governments from reviews of their actions by courts in other coun- tries. In any action in which the government of a country has taken steps to con- demn or confiscate property, the courts of other countries will not interfere (see Chapter 7 for a full discussion of this and other doctrines of international law).

1-7f trade Law and policies

The importance of trade laws, tariffs, and policies has increased directly with the rising numbers of international business transactions. Chapter 7 provides addi- tional details on trade laws, tariffs, restrictions, and trade agreements.

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Chapter 1 Introduction to Law 19

1-7g Uniform International Laws

Because trade barriers have been largely eliminated, contracts have been and are being formed between and among businesses from virtually all nations. How- ever, not all nations have the same approach to contracts. Indeed, some nations have no contract laws or commercial codes. In an attempt to introduce uniformity in international contract law, the United Nations developed its Contracts for the International Sale of Goods (CISG), which has been adopted widely and allows businesses to opt in or out of its application in adopting countries. Similar to the UCC (see Chapter 11), the CISG has provisions on contract formation, perfor- mance, and damages. More information on the CISG can be found in Chapters 7, 11, and 12.

1-7h the european Union

Once referred to as the Common Market and later known as the European Com- munity (EC), the European Union (EU) is a tariff-free group of European coun- tries that have joined together to enjoy the benefits of barrier-free trade. Formed in 1992, the single economic community requires member nations to subscribe to the same monetary standard, the elimination of immigration and customs controls, universal product and job safety standards, uniform licensing of professionals, and unified taxation schedules. The EU has been experiencing tension because of the weaker economies of some of its members and the need for other members to provide economic support for failing government finances. Great Britain’s vote to withdraw (Brexit) from the EU in 2016 signals more tension and change. More details on the governance of the EU can be found in Chapter 7.

Re: When Worldwide Soccer Involves Bribery

For the Manager’s Desk

The scandal erupted around the world as Interpol and law enforcement agents from Europe and the United States descended on the offices of FIFA, the World Cup soccer organization. The agents were there to seize records and computers because of allega- tions of an international bribery scandal in the organization that had existed for years and funneled millions to individual leaders in the organization.

The case was representative of a new approach of cooperation among nations for curbing bribery, money laundering, and securities fraud. Working together,

multinational task forces focus on activ- ities and then together bring charges against individuals in their own countries.

FIFA is an NGO (non-governmental organization) that is still subject to the standards that OECD nations have adopted for curbing bribery. The result of the coop- eration in the investigation is the indict- ment of leaders, their resignations, and the end of the excessive payments that teams and cities vying for the World Cup were paying in exchange for FIFA favors and award of contracts.

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20 part 1 Business: Its Legal, Ethical, and Judicial Environment


Uber has become the little company that could. In a brilliant recognition of the costs of intra-city transportation, Uber offered customers who had been tied to cabs or public transportation a service of car transportation without the high cost. Staffed by independent contractors who use their own cars, San Francisco–based Uber has expanded worldwide to 300 cities in 60 countries.

However, one lawyer observed, “A lot of these start-ups initially don’t think much about regulation. They do things first, then ask questions.”6 For example, Uber did not understand the power of taxi drivers. In Paris, the company was met with pro- tests by taxi drivers who were lobbying city officials to impose a 15-minute wait time on Uber drivers. That is, they wanted to require Uber to wait 15 minutes before picking up a passenger to give the taxis a chance to pick up the waiting passenger. France has charged two Uber executives with “deceptive commercial practices.”

In the United States, the Depart- ment of Labor has been pushing to have Uber drivers classified as employ- ees, something that would increase Uber’s costs because of benefits and wage taxes. Many cities have been resistant to Uber infiltration and have required cab licensing or restricted Uber to rides within the city and not from the airports.

Uber has learned that it must work with regulators in order to establish a relationship and prevent the types of restrictions it has experienced at the local, state, and federal levels. In Munich, Uber has been working with city officials in order to obtain permission to operate under existing laws there. Uber main- tains that its goal is to provide low-cost transportation in a system in which there are monopolies held by cabs that charge high rates. Filling that niche seems to be working except for the regulatory challenges.

Uber: the Importance of Law in a developing Business

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s u m m a r y How is law defined?

• Law is a form of order. Law is the body of rules of society governing individuals and their relationships.

What types of laws are there?

• Public law—codified law; statutes; law by government body

• Private law—rules created by individuals for their contracts, tenancy, and employment

• Civil law—laws regulating harms and carrying damage remedies

• Criminal law—laws regulating wrongful conduct and carrying sentences and fines

• Statutory law—codified law

• Common law—law developed historically and by judicial precedent

• Substantive laws—laws giving rights and responsibilities

• Procedural laws—laws that provide enforcement rights

What are the purposes of law?

• Keep order; influence conduct; honor expectations; promote equality; offer compromises

What are the characteristics of law?

• Flexibility; consistency; pervasiveness

• Jurisprudence—theory of law

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Chapter 1 Introduction to Law 21

Where are laws found and who enacts them?

• Constitution—document that establishes structure and authority of a government

• Federal statutes—laws passed by Congress: the U.S. Code

• State statutes—laws passed by state legislatures, including uniform laws on contracts and business organizations

• Ordinances—local laws passed by cities, counties, and townships

What are the sources of international law?

• Customs—the standards of conduct and norms in a country

• Treaties—agreements between and among nations regarding their political and commercial relationships

• Private law—party autonomy recognized in all nations

• International doctrines—widely accepted principles of law followed in most countries

• European Union—group of nations working collectively for uniform laws and barrier-free trade

• Uniform laws—Contracts for the International Sale of Goods (CISG)

Q u e s t i o n s a n d P r o b l e m s 1. Bryant Gunderson is a sole proprietor with a successful bungee-jumping business. He is consid- ering incorporating his business. What levels and sources of law would affect and govern the process of incorporation?

2. Jeffrey Stalwart has just been arrested for ticket scalping outside the Great Western Forum in Los Angeles. Jeffrey sold a ticket to a Taylor Swift con- cert to an intense fan for $1,200; the face value of the ticket was $48. Ticket scalping in Los Angeles is a mis- demeanor. Will Jeffrey’s court proceedings be civil or criminal?

3. The U.S. Golf Association put a new rule (effective January 1, 2016) that prohibits players from anchoring their putters to their chests. Tim Clark, a golfer from South Africa, who has won ten championships, anchors his putter to his chest and reacted, “We are not going to roll over and just accept this. We have been put in a position where we have to fight for our livelihoods.”7

Explain what source of law is involved. How can the rule be challenged? Where would the golfers go to court?

4. Define and contrast the following: a. Civil law and criminal law b. Substantive law and procedural law c. Common law and statutory law d. Private law and public law

5. During the 2001 baseball season, Barry Bonds, a player with the San Francisco Giants, hit 73 home runs in one season, a new record that went beyond the 72 set by Mark McGwire in 2000. Mr. Bonds made

his record-breaking home run in San Francisco. When he hit the home run, the ball went into the cheap seats. All agree that Alex Popov had his glove on the home-run ball. However, Patrick Hayashi ended up with the ball.

Mr. Popov filed suit alleging that Mr. Hayashi assaulted Mr. Popov in order to get the ball. A substan- tial amount of videotape shows Mr. Popov’s “glov- ing” of the ball. Mr. Popov says the ball belongs to him because he held that ball in a “Sno-cone position” and others wrested it from his control.

Mark McGwire’s ball from his record-breaking home run sold for $3 million. The battle for the Bonds home-run ball carries high financial stakes. What areas of law will be involved in the judge’s determination of who gets the baseball? (Peter Page, “Ownership of His- toric Baseball Is in Extra Innings,” National Law Journal, November 12, 2001.)

6. They call them “floating bacchanals.” Offshore from Florida and California cities, sunseekers take their rafts and boats and tie them together as they share adult bev- erages, music, swimming, and the sun. However, after a day of floating, many involved in the floating com- munity are so drunk that they cannot get their rafts and boats back to shore. In addition, safety patrols have difficulties gaining access to take action when there are arguments. What level of law could be directed to con- trol these types of activities? Where would those laws be promulgated?

7. Around 5:00 a.m. on January 1, 2004, Matthew Schmucker, who was 18 at the time, was traveling alone in a horse and buggy near the intersection of Indiana

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22 part 1 Business: Its Legal, Ethical, and Judicial Environment

State Road 37 and Notestine Road in Harlan, Indiana. He was intoxicated at the time and failed to stop at an inter- section, thereby colliding with the side of a 2003 Dodge Stratus carrying David Candon and Monica Young, who is now paralyzed from the neck down as a result of the accident. Schmucker was charged with being a minor in possession of alcohol and failing to stop at a through- way. Candon, Young, and their children, who were in the car at the time of the auto/buggy collision, brought suit against Schmucker. Schmucker declared bankruptcy and asked to be discharged from his obligations to Candon and Young. Candon and Young argued that the injury was a “willful and malicious injury by a vessel” under the bankruptcy code and was thus a nondischargeable debt. Schmucker said a horse and buggy is not a vessel. Discuss the role of the court in this case. What would the court look to in making its decision? What is the impact of the court’s decision on the ability of the family to recover for injuries? [Young v Schmucker, 409 B.R. 477 (N.D. Ind. 2008)]

8. Ms. Paris Hilton, a well-known celebrity with a ubiq- uitous presence on television and in People magazine, had her driver’s license suspended by the state of Cal- ifornia because of driving under the influence (DUI) or while intoxicated (DWI). She was then pulled over by officers for DUI while driving with a suspended license. Following a hearing on the second traffic stop, a judge sentenced Ms. Hilton to 45 days in jail for failure to honor the terms of her DUI probation, including driving while intoxicated.

List all the types of laws that apply to Ms. Hilton in her situation and also where the specific California laws would appear on the pyramid of the sources of law. If Ms. Hilton asked for a pardon or commutation of her sentence by the governor of California, would the law allow it?

9. Classify the following subject matters as substantive or procedural laws:

a. Traffic law on speeding b. Small claims court rules c. Evidence d. Labor law e. Securities

10. The New York Attorney General began an investi- gation of Monster Energy Drinks (Monster Beverage), Pepsi’s AMP (PepsiCo), and 5-Hour Energy Drinks (Living Essentials) to determine whether the compa- nies were adequately disclosing the amount of caf- feine in their drinks. The investigation focuses on the fact that there are other ingredients in the drinks, such as black tea extract and guarana, that are disclosed on the labels of the drinks, but the labels don’t disclose that there may be additional caffeine in the additional ingredients.

The Food and Drug Administration (FDA) has already issued a warning about combining these energy drinks with alcohol consumption because of several resulting deaths. In addition, the Department of Health and Human Services (HHS) has issued a report warning about the negative health impact of excessive caffeine consumption. The report documented data from emergency room physicians about young people requiring emergency room treatment because of con- sumption of alcohol and energy drinks. Neither agency has, however, taken any action against the makers of these drinks.

List all of the applicable layers of law involved in this energy drink situation. What statutory interpreta- tions do you think there will have to be as a result of the investigation? (Nelson D. Schwarz, “New York State Is Investigating Energy Drink Makers,” New York Times, August 29, 2012, p. B1.)

Economics, Ethics & the Law The Cost of Corporate Wrongdoing

Read and analyze “Paying the Piper: An Empirical Examination of Longer-Term Financial Consequences of Illegal Corporate Behavior,” 40 Academy of Manage- ment Journal 129 (1997), by Melissa S. Baucus and David A. Baucus. Then answer the following questions.

a. What financial impact does illegal corporate behavior have on a company?

b. How long does a company feel the impact of illegal behavior?

c. How does the market react to illegal corporate behavior?

d. What are the financial costs of violating the law?

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Chapter 1 Introduction to Law 23

n ot e s 1. Reprinted with permission of Thomson Reuters.

2. Oliver Wendell Holmes, “Natural Law,” 32 Harvard Law Review 40 (1918). Copyright © 1918 by The Harvard Law Review Association.

3. From My Philosophy of Law by Roscoe Pound. © 1941 West Publishing Corporation. Reprinted with permission of West Group.

4. Douglas Jehl, “Head of Inquiry on Iraq Abuses Now in Spotlight,” New York Times, May 11, 2004, A1, A12.

5. Id.

6. Mark Scott, “The Bumps in Uber’s Fast Lane,” New York Times, July 8, 2015, p. B1.

7. Steve DiMeglio, “Golf Rule Could Go to Court,” USA Today, May 22, 2013, p. 1C.

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Business Ethics and Social Responsibility2 If we were to make a list of the headlines of the past 20 years, we would realize that we have been through two stock market and economic collapses, scan- dals with performance-enhancing drugs in sports, car manufacturers falsifying car emissions through software programs, food producers knowingly selling salmonella-contaminated products, and mortgage foreclosures based on robo signatures. We would find fake courses for student-athletes at universities and cheating scandals in high schools, colleges, and on the SAT exams. And then we would recall that bank traders were rigging currency exchange rates even as CEOs were convicted for knowingly violating safety standards. We witnessed the largest Ponzi scheme in the history of the world, one that was masterminded by the former chairman of NASDAQ. World soccer offices were raided one morn- ing because of a multicountry bribery investigation. And a new book explains the rules for young people beginning their business careers with Rule #176 being, Don’t steal more than $3.00 of office supplies per quarter.

What happened to ethics? Is doing business just a matter of lying and getting away with it? Does anybody really care about ethics in business now? Has soci- ety drifted, and is business conduct just a reflection of changing ethical norms? And what does it mean to be ethical in our lives and in business? This chapter dis- cusses these questions and answers several others: What is ethics? How does ethics affect me? What is business ethics? Why is business ethics important? What ethical standards should a business adopt? How do employees recognize ethical dilemmas? How are ethical dilemmas resolved? How does a business create an ethical atmosphere?

Update For up-to-date news on ethical issues, go to

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The chapter’s opening “Consider . . .” teaches us that often we look at what com- panies and business executives say and do and the fact that the companies are doing well and assume that they must all have high ethical standards. The quotes are ironic because these individuals and/or their companies then crossed the ethi- cal lines they touted as standards.

We look at these individuals’ behaviors and wonder why they thought they could get away with their poor ethical choices or why they believed they were immune from the laws and our ethical standards. We like to think of ourselves as so different from those who cross ethical and/or legal lines. But all of them were col- lege graduates, nearly all with business degrees. All of them were respected by their friends and were active in community projects and institutions. These individuals were “good” people, but they lost sight of personal ethics, business ethics, and the importance of ethics in success. Before they committed their business crimes, the worst that could have been said about many white-collar criminals who are serving six-month to 25-year prison sentences is that they had parking and speeding tickets. Keeping ethics with us, in life and in business, can help us avoid the kinds of mis- takes that so many bright and capable businesspeople have made. But, we wonder, what are ethics? How do we know when we have them? How do we keep them when we face pressures, whether on an important exam or in meeting the quarterly numbers or our sales quota at work? This chapter answers these questions.

Goodness is the only investment that never fails. Henry D. THoreau Walden, “Higher Laws”

Of all the passions, the passion for the Inner Ring is most skillful in making a man who is not yet a very bad man do very bad things. C.S. LewiS “The Inner Ring”

A bad reputation is like a hangover. It takes a while to get rid of, and it makes everything else hurt. JameS PreSTon Former CEO, Avon

There is a big difference between what we have the right to do and what is right. Hon. JuSTiCe PoTTer STewarT Associate Justice, U.S. Supreme Court, 1958–1981

P = f(x) The probability of an ethical outcome is a direct function of the amount of money involved; the more money, the less likely the ethical outcome. CFa inSTiTuTe

Consider . . . 2.1 1. Who said, “I have done absolutely nothing


2. What CEO said, “In today’s regulatory environ- ment, it’s virtually impossible to violate the rules. It’s impossible for a violation to go undetected, certainly not for a considerable period of time”?

3. What CEO said, “We are the good guys. We are on the side of angels”?

4. Who said, “Go after the men who seek out prostitutes”?

5. Who said, “It’ll give me a chance to show my innocence”?

6. What company had a 64-page, award-winning code of ethics?*

*ANSWERS: 1. Former Illinois governor Rod Blagojevich, charged with attempting to fill President Obama’s Senate seat in exchange for favors and perks and convicted of lying to the FBI. 2. Bernie Madoff, former CEO of Bernard L. Madoff Investment Securities LLC, a firm that perpetrated a $50 billion Ponzi scheme. 3. Jeffrey Skilling, former CEO of Enron, and Lloyd Blankfein, CEO of Goldman Sachs. 4. Former New York governor Eliot Spitzer, in 2004, when he was establishing a task force as New York attorney general to halt prostitution in New York. Mr. Spitzer resigned when his long-standing relationship with a call girl was uncovered in a sting operation. 5. John Kinnucan, former owner of Broadband Research LLC, a Wall Street analyst firm, who later entered a guilty plea to all charges of insider trading. 6. Enron.

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26 part 1 Business: Its Legal, Ethical, and Judicial Environment

2-1 What Is Ethics? When we learn that the employees and administrators in the Veterans Administra- tion were falsifying the length of patient queues for medical care in order to ensure their bonuses and good performance evaluations, we label that conduct “uneth- ical.” When we read about underinflated footballs in the NFL, we use the term unethical. When we discover the young CEO of a company has raised the price on a life-saving drug 5,000%, we feel that something is just not right. Uber charges a $10 cancellation fee if you do not cancel within five minutes after the driver accepts. But 15 minutes after you have accepted, the Uber driver is not there, so you take a cab because you do not want to be late. Uber drivers could simply stay in one place or be deliberately late and make money from cancellations. Or the Uber driver cancels, and you have to make a last-minute reservation, something that ups your fare. Again, drivers could game this policy to make money. “This is not fair” is our response.

2-1a “It’s Just Not Right!”

We read about these types of situations in the newspaper each day. From politics to journalism to business to our favorite sports and Hollywood icons, references to ethics run through the stories. But we also face ethical dilemmas ourselves. Two students purchase tickets at a theater to see Star Wars: The Force Awakens, and when they emerge from the theater, they realize they are in an open area with access to other theaters. If they wanted to, they could slip into The Revenant or another movie without paying for another ticket. “Who’s to know?” they might think. “Hollywood makes too much money anyway.” “It doesn’t really hurt anyone.” These thoughts are similar to those that may have run through the minds of the VA administrators, the quarterback and the CEO who did not analyze the risk factors in their conduct. Although we may believe we are different from business execu- tives and others involved in scandals, we all face ethical dilemmas each day. Do I tell the clerk that he gave me too much change? Do I tell the lender on my loan application that my salary was just cut 25%? Do I go back to pay for the laundry detergent that slipped through on the bottom of my cart? Do I do what my boss says when he tells me to write a fake review online for our company’s services? Do I tell a potential buyer of my car about the hairline crack in the engine block? Do I tell my clients that I am selling off the investments I am trying to get them to buy?

The fact pattern changes slightly. The parties’ names and the subject matter vary, but the ethical issues are the same. Some conduct is more harmful, such as those situations in which a criminal statute is violated. Still, regardless of the law, we look at the conduct of VA employees, the quarterback, the students in the the- ater, the company employee writing reviews, and the seller of the car, and we con- clude, “It’s just not right!” We probably agree that they all behaved unethically. We may not be able to zero in on what bothers us about their conduct, but we know an ethics violation, or an ethical breach, when we see one.

2-1b Normative Standards: How We Behave to Keep Order

But what do we mean when we say that someone has acted unethically? Ethical standards are not the standards of the law. In fact, they are a higher standard. Sometimes referred to as normative standards in philosophy, ethical standards are the generally accepted rules of conduct that govern society. Ethical rules are both

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Chapter 2 Business Ethics and Social Responsibility 27

standards and expectations for behavior, and we have developed them for nearly all aspects of life. For example, no statute in any state makes it a crime for someone to cut in line in order to save the waiting time involved by going to the end of the line.1 But we all view those who “take cuts in line” with disdain. We sneer at those cars that sneak along the side of the road to get around a line of traffic as we sit and wait our turn. We resent those who tromp up to the cash register in front of us, ignoring the fact that we were there first and that our time is valuable too.

2-1c Line-Cutting and ethics

If you have ever resented a line-cutter, you understand ethics and have applied ethical standards in life. Waiting your turn in line is a societal expectation. “Wait- ing your turn” is not an ordinance, a statute, or even a federal regulation. “Waiting your turn” is an age-old principle developed because it was fair to proceed with first in time, first to be served. “Waiting your turn” exists because large groups wait for the same road, theater tickets, or fast food at noon in a busy downtown area. We recognize that lines ensure order and that waiting your turn is the just way to allocate the limited space and time allotted for the traffic, the tickets, or the food. “Waiting your turn” is an expected but unwritten behavior that plays a criti- cal role in an orderly society.

So it is with ethics. Ethics consists of those unwritten rules we have developed for our interactions with each other. These unwritten rules govern us when we share resources or honor contracts. “Waiting your turn” is a higher standard than the laws passed to maintain order. Those laws apply when individuals use physi- cal force or threats to push to the front of the line. Assault, battery, and threats are forms of criminal conduct for which the offenders can be prosecuted. But the law does not apply to the stealthy line-cutter who simply sneaks to the front, perhaps using a friend and a conversation as a decoy. No laws are broken, but the notions of fairness and justice are offended by one individual putting him or herself above others and taking advantage of others’ time and position.

Because line-cutters violate the basic procedures and unwritten rules for line formation and order, they commit an ethical breach. We don’t put line-cutters in jail, but we do refer to them as unethical. Other examples of unethical behavior also carry no legal penalty. A married person who commits adultery does not com- mit the type of crime that lands you in jail but does create a breach of trust with his or her spouse. We do label their conduct with adjectives such as unfaithful and even use a lay term to describe adultery: cheating.

Speaking of cheating, looking at someone else’s paper during an exam is not a criminal violation. If you cheat on a test, your professor may sanction you and your college may impose penalties, but the county attorney will not prosecute you for cheating. Your conduct is unethical because you did not earn your standing and grade under the same set of rules applied to the other students. Just like the line-cutter, your conduct is not fair to those who spent their time studying. Your cheating is unjust because you are getting ahead using someone else’s work.

These examples of cutting in line, committing adultery, and cheating on exams bring certain common adjectives to our minds: “That’s not fair!” “That was dishonest!” “That was unjust!” You have just defined ethics for yourself. Ethics is more than com- mon, or normative, standards of behavior. Ethics is honesty, fairness, and justice. The principles of ethics, when honored, ensure that the playing field is level and that we earn our achievements by using our own work and ideas. Being ethical means being honest and fair in our interactions with each other, whether personally or in business.

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28 part 1 Business: Its Legal, Ethical, and Judicial Environment

2-2 What Is Business Ethics? Many have referred to “business ethics” as an oxymoron. The little jibe suggests that it is impossible to be in business and be ethical. Some see the pursuit of profit as being at odds with ethics. However, the term business ethics is actually a complex one with many layers of meaning. The first layer consists of basic values (covered in the following section), such as being honest, keeping promises, and not taking things that do not belong to you. Another layer consists of notions of fairness (also covered in the next section), such as how we treat others, including customers and employees who report to us. Still a third layer consists of issues related to how a business interacts with the community, the environment, and its neighbors.

For the Manager’s Desk

Re: a State of the Union on academic ethics

Ethics is not so difficult to understand, but it is difficult to practice. Data are available on the ethics of everyone from school-age chil- dren to graduate school students. In 1992, the Josephson Institute found that 61% of high school students reported that they had cheated at least once during a school year. By 2008, that number had risen slightly to 64% but then fell to 49% in 2012.2 Accord- ing to the Center for Academic Integrity, about 75% of college students confess that they have cheated in some way in college.3

The rate for graduate students is 50%. They describe taking notes and answers into exams, copying others’ work, downloading and buying term papers from the Internet, and not contributing to team projects but still receiving credit for them. Graduate students at Columbia University extended

the time clock for an online exam. Harvard Business School candidates tapped into the school’s admission database. Thirty-four students at Duke’s Fuqua Business School faced discipline for collaborating on a take- home exam. Several New York high school students faced criminal charges related to a cheating conspiracy on SAT exams. One student took the exam for 20 students, who paid him an average of $2,500 for his efforts at scholastic identity deception. Sixty-four students at Dartmouth were accused of cheating in a course called “Sports, Eth- ics, and Religion.” The students were using handheld clickers for other students to make it seem as if those students were in class doing the work when, in fact, they were absent. Attendance and participation were 15% of the students’ grades in the class.

Why do we worry about ethics in school? What is the point of teaching young peo- ple to be honest? Why do we impose penalties for cheating? How does cheat- ing affect those who do not cheat? What are some of the long-term consequences

if those who cheat are permitted to pass courses, graduate with honors, and pur- sue careers in their fields? What happens when the 75% of those who admit cheat- ing in college reaches 100%?

Consider . . . 2.2

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Chapter 2 Business Ethics and Social Responsibility 29

The three layers of business ethics bring back into the purely quantitative models of business the elements of a fair playing field. Business ethics involve the study of fairness and ethical standards amidst the pressure of earning a profit and providing returns to shareholders and others who have invested in the business.

A business faces the special problem of having to develop ethical standards for a group of people who work together toward the common goal of profit for the firm. Individuals in the group have personal ethical standards, but too often employees find that the ethical standards imposed by managers at the top of a company result in possible harm to those at the bottom or to others outside the firm. An employee may feel compelled to resolve the conflict between loyalty to an employer and the performance of an illegal or unethical act ordered by that employer by simply following the employer’s direction. In other words, in devel- oping standards of business ethics, an employee has personal economic interests in continuing employment that may compromise personal ethical standards. Businesses face the additional challenges of developing business standards that are consistent with individual standards and helping employees understand that their personal standards of honesty and fairness need not be different at work. To accomplish this meshing, business managers should understand the various sources of ethical standards.

2-2a ethical Standards: positive Law and ethics

Ethical standards can be derived from different sources, and ethicists often debate the origins of these standards. One theory is that our ethical standards are the

Ethical Issues

The stories abound. Footballs are baked, microwaved, and placed in the dryer— actions that supposedly make the footballs more pliant, easier to hold, easier to pass, and easier to send farther. The Colorado Rockies place their baseballs in a humidor because if the baseballs dry out, they travel farther, especially when they are playing in the mile-high city of Denver. Phil Jackson and Bill Bradley have confessed to deflating basketballs, and, of course, Tom Brady is suspected of deflating the Patriots’ foot- balls. If you have fake crowd noise in an arena, it can psyche out the opposition.

And the pros are not alone. The Jackie Robinson West Little League team out of Chicago, Illinois, won the national Lit- tle League championship in August 2014. However, after the team won the title, the League discovered that the team had

falsified boundaries in order to get some ringers onto the team and also falsified documents to qualify other players. Jackie Robinson West was stripped of its nation- al title as its leader stated, “For more than 75 years, Little League has been an organization where fair play is valued over the importance of wins and losses.”4 The announcement said that although adults were responsible for the conduct and not the kids, the League was still obligated to preserve the “integrity” of the game: “For more than 75 years, Little League has been an organization where fair play is valued over the importance of wins and losses.”5

Are all of these examples cheating? Are the behaviors ethical? Are all of these ways to gain an advantage in the game? What if the rules do not explicitly prohibit what is being done in each of these cases?

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30 part 1 Business: Its Legal, Ethical, and Judicial Environment

same as actual or positive law and that our ethical decisions are made simply upon the basis of whether an activity is legal. Positive law, or codified law, establishes one standard for ethical behavior. But compliance with positive law is not always ethical. For example, one of the most frequently asked questions about the 2008 financial crisis is, “How come no one has been convicted of any crimes?” The fed- eral government brought several cases against fund managers and analysts in an attempt to attain convictions. However, the juries returned acquittals in the cases. In one of the cases, the jury sent the judge a note along with its acquittal that read, “This verdict should not deter the SEC from continuing to investigate the financial industry, review current regulations and modify existing regulations as necessary.” The jury found that there was no criminal conduct because there was no violation of the law, but they called the conduct “appalling.” The financial crisis acquittals illustrate that ethical and legal standards are not the same. Conduct may be legal but not ethical.

Reprinted with permission of Jim Brown (c) 1991.

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Chapter 2 Business Ethics and Social Responsibility 31

2-2b ethical Standards: Natural Law and ethics

Others believe that our ethical standards are derived from a higher source and that they are universal. Often labeled natural law, this school of ethical thought sup- ports the notion that some standards do not exist because of law (and, indeed, may exist despite laws). For example, as discussed in Chapter 1, at one time the United States permitted slavery. Even though the positive law allowed the activity and the standard of positive law considered slave ownership ethical, natural law dictated that the deprivation of others’ rights was unethical.

2-2c ethical Standards: Moral Relativism and ethics

Moral relativism (also called situational ethics) establishes ethical standards accord- ing to the situation in which the dilemma is faced. Violation of the law, for exam- ple, is permitted if you are stealing to provide food for your starving family. Under moral relativism, adultery is justified when you are caught in an unhappy mar- riage, as is the business situation in which you engage in lying to avoid offending a coworker or a customer. Bribery is illegal in the United States, and most compa- nies even have firm policies against accepting gifts, because doing so may create conflicts of interest, but some companies still use a relativist approach and argue that being competitive in international markets is different. They adhere to a phi- losophy of “When in Rome, do as the Romans do,” following the standards and customs in a given country even though those same behaviors in the United States would be unacceptable and even illegal.

2-2d ethical Standards: Religion and ethics

A final source of moral standards is religious beliefs or divine revelation. The source of standards can be the Bible, the Koran, or any inspired book or writing that is the cornerstone of a religion or faith and believed to have resulted from divine revelation.

2-3 What Are the Categories of Ethical Dilemmas?

Regardless of the root or source of a company’s or individual’s ethical standards, certain categories of conduct involve ethical issues. The following 12 categories were developed and listed in Exchange, the magazine of the Brigham Young Uni- versity School of Business.

2-3a taking things that don’t Belong to You

Everything from the unauthorized use of the Pitney-Bowes postage meter at your office for mailing personal letters to exaggerations on travel expenses to the down- loading of music from the Internet without authorization to not working your required hours at your job but accepting full pay as if you had belongs in this cat- egory of ethical violations. A CFO (chief financial officer) of a large electric util- ity reported that, after taking a cab from LaGuardia International Airport to his midtown Manhattan hotel, he asked for a receipt. The cab driver handed him a full book of blank receipts and drove away. Apparently, the problem of accurately reporting travel expenses involves more than just employees.

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32 part 1 Business: Its Legal, Ethical, and Judicial Environment

2-3b Saying things You Know are Not true

A salesperson who tells a potential customer that a product carries a “money-back guarantee” when the salesperson knows that only an exchange is possible has said something that is not true, committed an ethical breach and possibly a violation of the law, and misled the customer. If a car dealer assures a customer that a car has not been in an accident and it has, an ethical breach has occurred. If a homeowner tells a buyer that a home has not had any water damage when, in fact, the base- ment had been flooded, this false statement is an ethical breach too.

2-3c Giving or allowing False Impressions

An urban legend that has circulated among marketing departments around the country is the story of an infomercial that offered two CDs with the hits of the 1980s on them. The infomercial emphasized over and over again, “All songs by original artists.” Even the CDs carried the line, “All songs by original artists.” When pur- chasers read the label with a closer eye and listened to the CDs, they discovered that all the songs were performed by one group, a group called “The Original Art- ists.” While technically true, the advertising left a false impression with customers who assumed they would be buying songs as performed by the recording artists who made the songs popular.

Ethical Issues

The temptation is remarkable. The run is long. The body screams, “No more!” So, it happened again in the New York City Marathon for 2008. Cheating on this form of a physical final examina- tion became international news when, in 1979, Boston Marathon runner and winner Rosie Ruiz combined her running with a hitch on the train to earn first place. She repeated the ploy in the 1980 Boston Marathon, when her creative approach was discovered.

The New York Road Runners Club, the sponsors and managers of the New York City Marathon, disclosed multiple subway riders in their 2008 race on the eve of the 2009 Marathon with the hope of encourag- ing the 42,000 runners to go the distance, the real distance. For 2008, there were 71 runners disqualified from the race, 46 of them for taking the subway in order to go the distance. The club discovers these free-riders when it investigates what it believes to be extraordinary times for run- ners who have not been able or should not

have been able to achieve their recorded times. In at least two situations, the run- ners who took the subway also took first place in their age categories and deprived the real winners of their Tiffany trophies as well as the thrill of quaffing the elixir of victory on the day of the marathon. The real winners in these age categories from 2008 were not notified of their victories until July 2009 because of the time the investiga- tions take.

A spokesperson from the Road Run- ners Club said that the greatest temptation in the race comes when the runners enter Manhattan via the Queensboro Bridge. That entry to the city is close to Central Park and the finish line, but the race first takes a turn there for another 10 miles into Harlem and the Bronx. Most cheaters simply skip those boroughs and head right into Central Park and the finish line.

Are there any laws that govern this situ- ation with the runners? Discuss the ethical issues of the runners. Is anyone really hurt if runners cheat?

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Chapter 2 Business Ethics and Social Responsibility 33

2-3d Buying Influence or engaging in Conflict of Interest

A company awards a construction contract to a firm owned by the father of the state attorney general while the state attorney general’s office is investigating that company. A county official who has the responsibility for selecting the contractor who will build the county’s new baseball stadium travels around the country at the contractor’s expense to view existing stadium sites. The county official should see as many sites and samples of work as there are bidders on the new stadium, but when the contractors pay, there is an ethical issue. A physician researcher whose work was funded by Coca-Cola concluded that the major influence in childhood obesity was lack of exercise, not enough sleep, and too much television. Other experts believe that soft drinks, such as those produced by Coca-Cola, are a major contributor to childhood obesity. The issue of the $29 million for the research com- ing from Coca-Cola resulted in questions about the study and its conclusions.

Those involved in these conflict situations such as these often protest, “But I would never allow that to influence me.” That they have to insist they are not or would not be influenced is evidence of the conflict. Whether the conflict can or will influence those it touches is not the issue, for neither party can prove conclu- sively that a quid pro quo was not intended. The possibility exists, and it creates suspicion.

Dr. Drew Pinsky, the host of a cable health show, recommended GlaxoSmithKline’s antidepressant Wellbutrin to physicians and patients but did not disclose that he re- ceived $275,000 from Glaxo-SmithKline for “services related to Wellbutrin.” Dr. Drew, as he is known on television, participated in town hall meetings, published writings, and hosted multimedia activities that tout- ed the benefits of Wellbutrin. When asked about his failure to disclose the payments, Dr. Drew said that all of his commentary and writing were consistent with his clinical experience and that, “how does a doctor choose one specific antidepressant medi- cation for a certain patient from the many excellent medications available? The vast majority of doctors attending my lectures stated that they felt I answered this ques- tion and did so in an unbiased and scien- tifically sound manner.” Is there a conflict of interest? Did Dr. Drew manage the con- flict correctly? Is there any significance to Dr. Drew’s statement that doctors felt that he answered their questions in a scientific and unbiased manner?

(Jeanne Whalen, “‘Dr. Drew’ Was Paid by Glaxo,” Wall Street Journal, July 5 2012, B3.)

Steps for Analyzing Ethical Dilemmas and Case Studies in Business

1. Make sure you have a grasp of all the available facts.

2. List any information you would like to have but don’t and what assumptions you would have to make, if any, in resolving the dilemma.

3. Take each person involved in the dilemma and list the concerns they face or might have. Be sure to consider the impact on those not specifically mentioned in the case. For example, product safety issues don’t involve just engineers’ careers and company profits; shareholders, customers, customers’ families, and even communities supported by the business are affected by a business decision on what to do about a prod- uct and its safety issue.

Consider . . . 2.3

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34 part 1 Business: Its Legal, Ethical, and Judicial Environment

4. Develop a list of resolutions for the problem. Apply the various models for reaching this resolution. As you apply the various models to the dilemma, you may find additional insights for questions 1, 2, and 3. If the breach has already occurred, consider the possible remedies and develop sys- temic changes so that such breaches do not occur in the future.

5. Evaluate the resolutions for costs, legalities, and impact. Try to determine how each of the parties will react to and be affected by each of the resolu- tions you have proposed.

6. Make a recommendation for the actions that should be taken.

Some Help for You on the Dr. Drew Case

THINK: To help in your analysis, consid- er the following list of the parties affected by this dilemma.

• GlaxoSmithKline—the company’s credibility is affected by Dr. Drew’s conduct, recommendations, and disclosures.

• The doctors who listened to Dr. Drew’s recommendations without knowing about his compensation.

• The patients who asked for or used the drug Wellbutrin without knowing about Dr. Drew’s conflict.

• Other drug manufacturers whose drugs may have been more appro- priate or worthy of recommendation but were not mentioned because of Dr. Drew’s loyalty to Wellbutrin and GlaxoSmithKline.

APPLY: To further assist you in your analysis, consider the following categories:

• Conflict of interest: Dr. Drew had an obligation to disclose his financial interest in promoting the drug. Those who listened to his analysis, read his recommendations, or used the drug deserved to know before they made their decision that he did have a finan- cial interest.

• Giving or allowing false impressions: Dr. Drew gave the impression of being a detached clinician who had pre- scribed the drug and had patients who benefited, but he did not disclose that he was paid by GlaxoSmithKline for his work in recommending the drug.

ANSWER: Because the conduct has already occurred, your role becomes one of recommendation. You need to provide a recommendation that affords protection to all the parties listed as affected by the con- duct. For example, to protect the credibility of the pharmaceuticals, the companies and their experts need to develop a policy on accepting compensation, as well as one for disclosures of these programs of compen- sation. These policies may require not only disclosure but also prohibitions on certain types of conduct (such as doctors receiving stock ownership in the pharmaceutical com- panies) if the conflict seems too difficult to overcome. Two approaches can be taken in regard to a conflict of interest: (1) don’t do it, or (2) disclose the conflict to those affected. Sometimes disclosure is insufficient and one party must not engage in the conduct. Regulators may force these new standards on physicians and pharmaceutical firms.

2-3e Hiding or divulging Information

Taking your firm’s product development or trade secrets to a new place of employ- ment constitutes an ethical violation: divulging proprietary information. Failing to disclose the results of medical studies that indicate that your firm’s new drug has significant side effects is an ethical violation: hiding information that the product could be harmful to purchasers.

2-3f taking Unfair advantage

One of the areas the Federal Communications Commission continues to investigate and assess fines for is Wi-Fi blocking. When hotels host major company meetings

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Chapter 2 Business Ethics and Social Responsibility 35

or trade associations, suppliers and vendors often pay fees to participate in those meetings. Hotels often scramble or blocks these vendors’ access to their own hot spots or Wi-Fi services so that they are forced to pay for access to the hotel’s Wi-Fi, something that is an extra and expensive fee. The vendors and suppliers are pay- ing for their own Wi-Fi, but the hotel is blocking that access in order to collect fees for something they already have.

Eagle Gate College hired an admission consultant from Stevens-Henager College named Janna Miller. Ms. Miller hired others from Stevens-Henager to join her at Eagle Gate. Those who came along to join Ms. Miller also brought along lists of potential students for recruiting purposes. Those lists of potential students are very valuable to for-profit colleges because of the need for new students. In addition, the information

left behind at Steven-Henager was altered so that the database of potential recruits could not be reached due to incorrect phone numbers and/or e-mails. Stevens-Henager could not contact the potential students from their own data base.

Are there ethical issues in this situa- tion? Or is this just competition? [Stevens-Henager College v Eagle Gate Col- lege, 248 P.3d 1025 (Utah 2011)]

Consider . . . 2.4

2-3g Committing acts of personal decadence

While many argue about the ethical notion of an employee’s right to privacy, it has become increasingly clear that personal conduct outside the job can influence performance and company reputation. During 2012, a number of CEOs and the former head of the CIA, General David Petraeus, had to resign their positions because of affairs with employees or extramarital affairs. The CEOs’ personal con- duct created tension within their companies and resulted in loss of respect from the employees. For General Petraeus, his role as the chief executive for the orga- nization protecting national security was in jeopardy because the affair with a younger woman left him vulnerable to threat and also meant he was not comply- ing with the agency standards that applied to all employees. Personal conduct by those who are in leadership positions affects organizational reputation, morale, and credibility.

2-3h perpetrating Interpersonal abuse

A manager sexually harasses an employee. Another manager is verbally abusive to an employee. Still another manager subjects employees to humiliating correction in the presence of customers. In some cases, laws protect employees. But at the heart of this category is unfair treatment.

2-3i permitting Organizational abuse

Many multinational firms, such as Walmart, Ikea, Apple, and Nike, have faced issues of organizational abuse. The unfair treatment of workers in international operations appears in the form of child labor, demeaning wages, excessive work- ing hours, and factory safety standards. Even though a business cannot change the culture of another country, it can perpetuate—or alleviate—abuse through its operations there.

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36 part 1 Business: Its Legal, Ethical, and Judicial Environment

2-3j Violating Rules

Many rules, particularly those in large organizations that tend toward bureaucracy from a need to maintain internal controls or follow lines of authority, seem burden- some to employees trying to serve customers and other employees. However, those rules do serve a purpose and should be followed so that harms are avoided. For example, Yale University senior Michele Dufault was killed in a lab accident when her hair was caught in a lathe in the machinery lab. The physics and astronomy major did not follow the simple safety rule of tying your hair back before begin- ning work with the heavy equipment. She was also working in the lab at 2:30 a.m., a time when there were no people near the lab, and she violated a basic safety stan- dard of not working alone around the large machines. Sometimes these rules seem superfluous and we feel that we have more expertise and experience and need not follow them. However, there is an ethical issue here in that as a student she had agreed to follow the safety rules of the lab and the university. Not following those rules was a breach of that promise. As a result of Ms. Default’s accident, Yale and other colleges and universities have revamped their rules, enforcement, and train- ing to encourage compliance.

2-3k Condoning Unethical actions

In this breach of ethics, the wrong results from the failure to report the wrong. What if you witnessed a fellow employee embezzling company funds by forging his signature on a check that was supposed to be voided? Would you report that violation? A winking tolerance of others’ unethical behavior is in itself unethical. Suppose that as a product designer, you were aware of a fundamental flaw in your company’s new product—a product predicted to catapult your firm to record earnings. Would you pursue the problem to the point of halting the distribution of the product? Would you disclose what you know to the public if you could not get your company to act? The German auto manufacturer Volkswagen revealed that its engineers had installed emissions test–defeating software, and while many engineers and employees were aware of the illegal conduct, no one spoke up about the problem or objected. One former employee of Lehman Brothers, whose sales efforts and structuring of securities investments “helped lead to the demise of the bank he loved and to an economic unraveling worldwide[,] confessed, ‘I have blood on my hands.’”6 His remorse comes from his failure to speak up and raise his concerns about the ethical issues he saw even as he was rewarded for his work.

2-3l Balancing ethical dilemmas

In some situations, the answers are neither right nor wrong; rather, the situations present dilemmas to be resolved. For example, Google has struggled for years with its decision to do business in the People’s Republic of China because of known human rights violations and censorship by the government there. Its eventual decision was to remain in China despite the government’s censorship of its search engine there. Other companies debated whether to do business in South Africa when that country’s government followed a policy of apartheid. In some respects, the presence of these companies would help by advancing human rights and, cer- tainly, by improving the standard of living or communications for at least some international operations workers. On the other hand, their presence could help such governments sustain themselves by enabling them to point to economic suc- cesses despite human rights violations.

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Chapter 2 Business Ethics and Social Responsibility 37

2-4 Resolution of Business Ethical Dilemmas So far, you know what business ethics is and you have a list of the areas that cover most ethical dilemmas. But if you were faced with an ethical dilemma, how would you resolve it? The resolution of ethical dilemmas in business is often difficult, even in firms with codes of ethics and cultures committed to compliance with ethical models for decision making. Managers need guidelines for making ethical choices. Several prominent scholars in the field of business ethics have developed models for use as guides in difficult situations. This section covers those models.

2-4a Blanchard and peale

The late Dr. Norman Vincent Peale and management expert Kenneth Blanchard offer three questions that managers should ponder in resolving ethical dilemmas: “Is it legal?” “Is it balanced?” “How does it make me feel?” If the answer to the first question, “Is it legal?,” is no, for business ethics purposes, your ethical anal- ysis is done. While there is room for conscientious objection to many laws on an ethical basis, a manager is not given the authority to break the law, and agencies such as the Internal Revenue Service (IRS) and the Securities Exchange Commis- sion (SEC) are not known for helping companies ease their consciences through refusals to pay taxes or file required securities disclosures and reports. The Hewlett-Packard board hired private investigators to determine the source of leaks about its board meetings, activities, and decisions. The investigators hired (actually a subcontractor of a contractor) used a technique known as “pretexting” in the trade. They posed as others in order to obtain access to phone records of directors and reporters to determine who was calling who, an activity prohibited by a California statute.7 Eventually, the investigators as well as some within the company, including HP’s ethics officer, were charged with violations. These man- agers failed to stop when the answer to the question of legality was “no.”

Answering the second question, “Is it balanced?,” requires a manager to step back and view a problem from other perspectives—those of other parties, owners, shareholders, or the community. For example, an M&M/Mars cacao buyer was able to secure a low price on cacao for his company because of pending govern- ment takeovers and political disruption. M&M/Mars officers decided to pay more for the cacao than the negotiated figure. Their reason was that someday their com- pany would not have the upper hand, and then they would want to be treated fairly when the price became the seller’s choice.

Answering “How does it make me feel?” requires a manager to do a self- examination of the comfort level of a decision. Some decisions, though they may be legal and may appear balanced, can still make a manager or employee uncomfort- able. For example, Gil Meche, a pitcher for the Kansas City Royals, was entitled to $12 million in compensation for his final contract year with the Royals. However, his shoulder and arm had significant pain from years of pitching, and he opted not to have surgery for repairs. Under the terms of his contract, all he had to do was report for spring training and the season and go through the motions of rehabili- tation. Mr. Meche retired because he said, “When I signed my contract, my main goal was to earn it. Once I started to realize I wasn’t earning my money, I felt bad. I was making a crazy amount of money for not even pitching. Honestly, I didn’t feel I deserved it. I did not want to have those feelings again.”8 Known as the element of conscience, this test for ethics requires businesspeople to find the source of their discomfort in a particular dilemma or proposed decision.

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38 part 1 Business: Its Legal, Ethical, and Judicial Environment

2-4b the Front-page-of-the-Newspaper test

One simple ethical model requires only that a decision maker envision how a reporter would describe a decision on the front page of a local or national newspa- per. When Salomon Brothers illegally cornered the U.S. government’s bond mar- ket, the BusinessWeek headline read, “How Bad Will It Get?” Nearly two years later, a follow-up story on Salomon’s crisis strategy was headlined “The Bomb Shelter That Salomon Built.” During the aftermath of the bond market scandal, the interim chairman of Salomon, Warren Buffett, told employees, “Contemplating any busi- ness 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.”9

There are other examples, such as that involving the investigation of the Vet- erans Administration for its falsification of patient queues for treatment: “V.A. Officials Acknowledge Link between Delays and Patient Deaths.”10 You will be productive at work after reading this headline: “Secret Service May Have Turned ‘Lazy,’ Panetta Says.”11

When Wall Street firms were reporting multi-billion-dollar losses due to their highly leveraged portfolios of risky instruments, the headline on the cover of For- tune magazine read, “What Were They Smoking?” (November 26, 2007). The head- line test helps us to put our decisions into a longer-term perspective.

2-4c Laura Nash and perspective

Business ethicist Laura Nash has developed a series of questions that business man- agers should ask themselves as they evaluate their ethical dilemmas. One of the ques- tions is, “How would I view the issue if I stood on the other side of the fence?” For example, in 1993, federal guidelines required meat to be cooked to 140 degrees Fahr- enheit. At that time, however, the state of Washington proposed imposing a higher temperature requirement of 155 degrees. Burger King cooked its hamburgers to 160 degrees, and Wendy’s, Hardee’s, and Taco Bell cooked their meat to 165 degrees.

Health and food industry experts supported a minimum cooking temperature of 155 degrees to be certain E. coli bacteria are eliminated. Jack-in-the-Box followed the legal minimum of 140 degrees. Would you want that information as a consumer? Given the trend toward higher temperatures and the pending regulation, would you want your meat cooked to a higher temperature? Although the cooking temperature was legal, an ethical issue arises in continuing to follow only the law when health experts are concerned about the adequacy of the law. Jack-in-the-Box did, in fact, experience an E. coli outbreak: one child died, and 300 other customers became ill.12

Other questions in the Nash model include these: “Am I able to discuss my decision with my family, friends, and those closest to me?” “What am I trying to accomplish with my decision?” “Will I feel as comfortable about my decision over time as I do today?” The Nash model forces managers to seek additional perspec- tives as decisions are evaluated and implemented. For example, when the late William Aramony served as the CEO of United Way, he enjoyed such perks as an annual salary of close to $400,000, flights on the Concorde, and limousine service. Even though these benefits were about the same as those of other CEOs managing comparable assets, it would still be difficult to justify such benefits to a donor who earns $22,000 a year and has pledged 5% of it to United Way.

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Chapter 2 Business Ethics and Social Responsibility 39

2-4d The Wall Street Journal Model The Wall Street Journal model for resolution of ethical dilemmas consists of compli- ance, contribution, and consequences. Like the Blanchard–Peale model, any pro- posed conduct must first be in compliance with the law. The next step requires an evaluation of a decision’s contributions to the shareholders, the employees, the community, and the customers. For example, furniture manufacturer Herman Miller, in a decision that was prescient in relation to the sustainability initiatives of today, decided both to invest in equipment that would exceed the requirements for compliance with the 1990 Clean Air Act and to refrain from using rain forest woods in producing its signature Eames chair. The decision was costly to the shareholders at first, but ultimately they, the community, and customers enjoyed the benefits.

Finally, managers are asked to envision the consequences of a decision, such as whether headlines that are unfavorable to the firm may result. The initial conse- quence of Miller’s decisions was a reduction in profits because of the costs of the changes. However, the long-term consequences were the respect of environmental regulators, a responsive public committed to rain forest preservation, and Miller’s long-standing recognition as one of America’s top 20 corporate citizens.

2-4e Other Models

Of course, much simpler models for making ethical business decisions are avail- able. One stems from Immanuel Kant’s categorical imperative, loosely similar to the Golden Rule: “Do unto others as you would have them do unto you.” Treating others or others’ money as we would want to be treated is a powerful evaluation technique in ethical dilemmas. (See Exhibit 2.4 and p. 63 for more discussion.)

2-5 Why We Fail to Reach Good Decisions in Ethical Dilemmas

Very often, we look at the harmful conduct of corporate executives and won- der, “Where were their minds, and what were they thinking when they decided to engage in such bad behavior?” Often those involved did not walk through the steps in resolving ethical dilemmas discussed earlier. But they probably also slipped into rationalizations rather than analysis. The following sections provide a list and summary of each of the frequent statements of rationalization that we use to avoid facing ethical dilemmas (see Exhibit 2.1).

2-5a “Everybody Else Does It”

When former Tour de France winner (now stripped of those titles) Lance Arm- strong admitted that he had used performance-enhancing drugs throughout his career, he said, “I looked up the word ‘cheat’ in the dictionary and decided it didn’t apply, given that it meant ‘to gain an advantage on a rival or foe.’ I didn’t view doping that way. I viewed it as a level playing field.”13 “Everybody else does it” is a rationalization, but it is not an analysis of the ethical issues involved in conduct.

2-5b “If We Don’t Do It, Someone Else Will”

The rationalization of competition is one that finds us reasoning that if someone is going to do it and make money, it might as well be us. For example, a friend asks if

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40 part 1 Business: Its Legal, Ethical, and Judicial Environment

he can pay you for the use of your subway pass, a pass that says it is nontransfer- able. You could easily say, “If I don’t do it, he will just get someone else to do it, so I might as well benefit.” The fact that others may engage in unethical conduct does not require you to join them. Think through the consequences if we relied on this notion that they are going to do it anyway, so we might as well participate. There is an impact on the sale of tokens, the ability to trust pass-holders, and the overall revenues of the transportation system if everyone participates in such a sharing program.

2-5c “that’s the Way It Has always Been done”

Corporate or business history and business practices are not always sound. The fact that for years nothing has changed in a firm may indicate the need for change and an atmosphere that invites possible ethical violations. For example, when the New Orleans Saints bounty program was uncovered by the NFL, a program under which some players were able to double their salaries by taking out certain players or inflicting physical injuries on players in exchange for cash bonuses, the players all said that they came into the culture that had always done this kind of thing. They also said that they knew it was a mistake, but because it was accepted behav- ior in their organizations, they did it anyway.

2-5d “We’ll Wait until the Lawyers tell Us It’s Wrong”

Lawyers are trained to provide only the parameters of the law. In many situations, they offer an opinion that is correct in that it does not violate the law. Whether the conduct they have judged as legal is also ethical is a different question. Allowing law and lawyers to control a firm’s destiny ignores the opportunity to make wise and ethical choices. For example, the SEC has given very little guidance to com- panies and lawyers about when they need to disclose health issues of their CEOs. So, when the CEO of United Airlines had a heart attack, the company disclosed the heart attack and the interim plans for who would be running the company. However, the company did not disclose until after the surgery was completed that the CEO had a heart transplant. The airline had come through a rough time with its previous CEO resigning after questions emerged about his close relationships

Exhibit 2.1 the Language of Rationalization

“Everybody else does it.”

“If we don’t do it, someone else will.”

“That’s the way it has always been done.”

“We’ll wait until the lawyers tell us it’s wrong.”

“It doesn’t really hurt anyone.”

“The system is unfair.”

“I was just following orders.”

“You think this is bad, you should have seen . . .”

“It’s a gray area.”

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Chapter 2 Business Ethics and Social Responsibility 41

with New Jersey transit authorities and requests for additional gates at the New- ark airport. In light of an ongoing investigation, a new CEO was appointed, but his heart attack came within weeks of his taking over the helm. Struggling with stock price and transition issues, the information was not as forthcoming. The SEC rules do not mandate disclosure, but the ethical issues in this situation are different. (See Chapter 18 for more information on required disclosures.)

2-5e “It doesn’t Really Hurt anyone”

When we are the sole rubbernecker on the freeway, traffic remains unaffected. But if everyone rubbernecks, we have a traffic jam. If all of us made poor ethical choices, we would cause significant harm. A man interviewed after he was arrested for defrauding insurance companies through staged auto accidents remarked, “It didn’t really hurt anyone. Insurance companies can afford it.” The second part of his statement is accurate. The insurance companies can afford it—but not with- out cost to someone else. Such fraud harms all of us because we must pay higher premiums to allow insurers to absorb the costs of investigating and paying for fraudulent claims.

2-5f “the System Is Unfair”

Often touted by students as a justification for cheating on exams, this rationaliza- tion eases our consciences by telling us we are cheating only to make up for defi- ciencies in the system, yet just one person cheating can send ripples through an entire system. The credibility of grades and the institution come into question as students obtain grades through means beyond the system’s standards. In countries in which corruption is a way of life and government employees award contracts and rights to do business on the basis of payments rather than on the merits of a given company or its proposal, the bribery only results in greater unfairness within and greater costs to those countries. Many economists have noted that a country’s businesses and economy will not progress without some fundamental assurance of trust that comes through a belief that there is a level playing field where the quality of products and services matter.

2-5g “I Was Just Following Orders”

In many criminal trials and disputes over responsibility and liability, managers disclaim their responsibility by stating, “I was just following orders.” Sometimes, individuals should not follow the directions of supervisors because they have been asked to do something illegal or immoral. Judges who preside over the criminal trials of war criminals often remind defendants that an order is not necessarily legal, ethical, or moral. Values require us to question or depart from orders when others will be harmed or wronged. In the days prior to the financial collapse of MF Global, employees were asked to transfer funds from clients’ accounts in order to cover hedging losses, something that is prohibited by law. During the investiga- tion, the employees said that they did what they were ordered to do. However, the result was significant losses for their customers. The same scenario has emerged in the Volkswagen emissions scandal as employees noted that disobedience was not an option in their culture. When the allegations of prisoner abuse in Iraq emerged, along with photos, one of the first defenses raised by lawyers for the soldiers being court-martialed for their role in the abuses was, “I was just following orders.” Sometimes following orders is not the ethical thing to do.

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42 part 1 Business: Its Legal, Ethical, and Judicial Environment

2-5h “You think this Is Bad, You Should Have Seen . . .”

This rationalization finds employees looking back at earlier times and remind- ing others that the company’s safety policies or accounting practices used to be much worse. At one company, when some employees objected to backdating contracts to slip the earnings into the quarter, some employees reassured them by saying, “At least we’re not using the 35-day month we used to use to meet targets.”

2-5i “It’s a Gray area”

The gray area is a comfort level for us when we are in the midst of an ethical dilemma. Once we enter the gray area, we have a fine line that crosses into ille- gality and also an opportunity to explore an issue beyond bare legal require- ments. An attorney for former HP general counsel Ann Baskins says that Ms. Baskins realized after the fact that she should have focused on questioning whether the pretexting was ethical, not just on whether it was legal. “She regrets that she did not do so.”14 Kevin Hunsaker, a deputy general counsel and chief ethics officer, asked internal HP security employees about the legality of the pretexting operations, and one responded, “I think it’s on the edge, but above board.” Hunsaker responded with what have become the infamous words in the investigation: “I shouldn’t have asked.” “On the edge” and “in a gray area” often land us in legal difficulty and controversy. Even though many of the charges were dismissed or reduced, five individuals, including Mr. Hunsaker, were charged with criminal misconduct in the HP pretexting case, and the com- pany paid a $14 million fine to settle the charges.

Ethical Issues

Indy driver Danica Patrick gave an interview to Sports Illustrated writer and radio host Dan Patrick, a transcript of which follows.

Dan: If you could take a perfor- mance-enhancing drug and not get caught, would you do it if it allowed you to win Indy?

Danica: Well then it’s not cheating, is it? If nobody finds out?

Dan: So you would do it?

Danica: Yeah, it would be like finding a grey area. In motorsports we work in the grey areas a lot. You’re trying to find where the holes are in the rule book.

After the interview, in an interview with USA Today, Ms. Patrick indicated that she was just joking. The head of the USADA (U.S. Anti-Doping Agency) called the inter- view “totally irresponsible” and added, “Although joking about the use of danger- ous and unhealthy drugs that cheaters use to rob clean athletes of their dreams is no laughing matter.”

Identify the rationalizations in Ms. Patrick’s statements. Why do you think she answered the questions as she did? Was the joke still an ethical issue?

Sources:, http://www.sportsillustrated, accessed June 2, 2009; Eddie Pells, AP wire story, June 2, 2009. ©

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Chapter 2 Business Ethics and Social Responsibility 43

2-6 Social Responsibility: Another Layer of Business Ethics

So far in this chapter we have covered two layers of business ethics: the basic cat- egories and notions of fairness. A third layer of ethics focuses on relationships and conflicts among relationships.

In some ethical dilemmas in business, the interests of the shareholders might be different from the interests of the employees. Lower wages bring higher prof- its and returns, at least temporarily, to shareholders, but is shipping work over- seas to countries where the wages are low or work conditions unhealthy taking unfair advantage? In this third layer of business ethics, we look at the interests of those who are affected by business decisions, often called the stakeholders of the business. For example, suppose the business discovers that its air pollution control equipment is not state-of-the-art technology and that, although no laws are being violated, more pollution is being released than is necessary. To correct the problem, its factory must be shut down for a minimum of three months. The pollution will harm the air and the community, but the shutdown will harm the workers and the shareholders. The business must consider the needs and interests of all its stake- holders in resolving the ethical dilemma it faces. Much discussion and disagree- ment continue to surround this particular issue. In the following interview excerpt, economist Milton Friedman offers a different perspective on this ethical dilemma.

Q: Quite apart from emission standards and effluent taxes, shouldn’t corporate officials take action to stop pollution out of a sense of social responsibility?

Milton Friedman: I wouldn’t buy stock in a company that hired that kind of leadership. 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 a 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. If, on the other hand, the executives of U.S. Steel undertake to reduce pollution in Gary for the purpose of making the town attractive to employees and thus lowering labor costs, then they are doing the stockholders’ bidding. And everyone benefits: The stockholders get higher dividends; the customer gets cheaper steel; the workers get more in return for their labor. That’s the beauty of free enterprise. . . . To the extent that pollution caused by the U.S. Steel plant there is confined to that city and the people there are truly concerned about the problem, it’s to the company’s advantage to do something about it. Why? Because if it doesn’t, workers will prefer to live where there is less pollution, and U.S. Steel will have to pay them more to live in Gary, Indiana.15

2-6a ethical postures for Social Responsibility

Often, decisions in dilemmas that involve stakeholders depend on the overall attitude of a company and its perspective on the role of business in society. The ethical perspective of a business often sets the tone for its operations and employ- ees’ choices. Historically, the philosophical debate over the role of business in society has evolved into four schools of thought on ethical behavior based on the responses to two questions: (1) Whose interest should a corporation serve?

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44 part 1 Business: Its Legal, Ethical, and Judicial Environment

(2) To whom should a corporation be responsive in order to best serve that inter- est? These questions have only two answers—“shareholders only” and “the larger society”—and the combination of those answers defines the school of thought. The following discussion is summarized in Exhibit 2.2.

Inherence According to the inherence school of thought, managers answer only to sharehold- ers and act only with shareholders’ interests in mind. This type of manager would not become involved in any political or social issues unless it was in the sharehold- ers’ best interests to do so, provided the involvement did not backfire and cost the firm sales. Milton Friedman’s philosophy, as previously expressed, is an exam- ple of inherence. To understand how a business following the inherence school of thought would behave, consider the issue of a proposed increase in residen- tial property taxes for school funding. A business that subscribes to the inherence school would support a school tax increase only if the educational issue affected the company’s performance and only if such a position did not offend those who opposed the tax increase.

enlightened Self-Interest According to this school of thought, the manager is responsible to the shareholders but serves them best by being responsive to the larger society. Enlightened self-in- terest is based on the view that, in the long run, business value is enhanced if busi- ness is responsive to the needs of society. In this school, managers are free to speak out on societal issues without the constraint of offending someone, as in inher- ence. Businesses would anticipate social changes and needs and be early advocates for change. For example, many corporations today have instituted job sharing, child-care facilities, and sick-child care in response to the changing structure of the American family and workforce. Others have instituted wellness and fitness pro- grams to improve employees’ health and reduce medical and insurance costs. This responsiveness to the needs of the larger society should also be beneficial to share- holders because it enables the business to retain a quality workforce.

the Invisible Hand The invisible hand school of thought is the opposite of enlightened self-interest. According to this philosophy, business ought to serve the larger society, and it

Exhibit 2.2 Social Responsibility of Corporations



Inherence Shareholders only Shareholders only

Enlightened self-interest Shareholders only Larger society

Invisible hand Larger society Shareholders only

Social responsibility Larger society Larger society

Source: Adapted with permission of American Business Law Journal, from Daryl Hatano, “Should Corporations Exercise Their Freedom of Speech Rights?” 22 American Bus.L.J. 165 (1984).

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Chapter 2 Business Ethics and Social Responsibility 45

does this best when it serves the shareholders only. Such businesses allow gov- ernment to set the standards and boundaries for appropriate behavior and simply adhere to these governmental constraints as a way of maximizing benefits to their shareholders. They become involved in issues of social responsibility or in polit- ical issues only when society lacks sufficient information on an issue to make a decision. Even then, their involvement is limited to presenting data and does not extend to advocating a particular viewpoint or position. This school of thought holds that it is best for society to guide itself and that businesses work best when they serve shareholders within those constraints.

Social Responsibility In the social responsibility school of thought, the role of business is to serve the larger society by responding to society’s needs as a first priority. A business follow- ing this school of thought would advocate full disclosure of product information to consumers in its advertising and would encourage political activism on the part of its managers and employees on all issues, not just those that affect the corporation. These businesses adhere to the belief that their sense of social responsibility con- tributes to their long-term success.

2-7 Why Business Ethics? Now that you have background on the types of ethical issues businesses face, background on social responsibility, and a framework for analysis of ethical issues, you may still be skeptical: “But why should a business worry about these things beyond just complying with the law? Why not just maximize under the system?” Some compelling reasons promote choosing ethical behavior, as discussed in the following sections.

2-7a personal accountability and Comfort: Business ethics for personal Reasons

Before looking at business data on the value of ethics, it is important to realize that the choices we make in our business lives must still feel personally comfort- able. And it would be misleading to say that every ethical business is a profitable business. First, not all ethical people are good managers or possess the neces- sary skills for making a business a success, but many competent businesspeople have suffered for being ethical, and many others seem to survive despite their lack of ethics. Despite his conviction and jail term related to junk bond sales in the 1980s, Michael Milken decades later earned a $50 million fee for helping Ted Turner negotiate a merger with Time Warner.16 Many whistle-blowers, although highly respected, have been unable to find employment in their industries. If ethi- cal behavior does not guarantee success, then why have ethics? The answer has to do with personal ethics applied in a business context. One investment banker who worked on Drexel Burnham’s trading desk during the Michael Milken days of that firm and who is now chairman of GoldTree Asset Management said, “Just to be able to sit on the desk and see the calls start at 4:15 in the morning, Boesky and Perelman and Diller and Murdoch.”17 But Mr. Wagner said that he took not just the memories of the power of Drexel with him but a powerful lesson as well: “There’s a difference between being very competitive and can-do, and winning at all costs. All costs is costly.”

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46 part 1 Business: Its Legal, Ethical, and Judicial Environment

Business ethics is really nothing more than a standard of personal behavior applied to a group of people working together to make a profit. Some people are ethical because it enables them to sleep better at night. Some people are ethical because of the fear of getting caught. But being personally ethical is a justifica- tion for business ethics—it is simply the correct thing to do. Bowen McCoy’s “The Parable of the Sadhu” focuses on business ethics for personal reasons.

For the Manager’s Desk

Re: the parable of the Sadhu

[In 1982], as the first participant in the new six-month sabbatical program that Morgan Stanley has adopted, I enjoyed a rare oppor- tunity to collect my thoughts as well as do some traveling. I spent the first three months in Nepal, walking 600 miles through 200 villages in the Himalayas and climbing some 1,20,000 vertical feet. On the trip my sole Western companion was an anthropol- ogist who shed light on the cultural patterns of the villages we passed through.

During the Nepal hike, something occurred that has had a powerful impact on my thinking about corporate ethics. Although some might argue that the expe- rience has no relevance to business, it was a situation in which a basic ethical dilemma suddenly intruded into the lives of a group of individuals. How the group responded I think holds a lesson for all organizations no matter how defined.

The Sadhu

The Nepal experience was more rugged and adventuresome than I had anticipated. Most commercial treks last two or three weeks and cover a quarter of the distance we traveled.

My friend Stephen, the anthropologist, and I were halfway through the 60-day Himalayan part of the trip when we reached the high point, an 18,000-foot pass over a crest that we’d have to traverse to reach the village of Mukinath [sic], an ancient holy place for pilgrims.

Six years earlier I had suffered pulmo- nary edema, an acute form of altitude sick- ness, at 16,500 feet in the vicinity of Everest

base camp, so we were understandably concerned about what would happen at 18,000 feet. Moreover, the Himalayas were having their wettest spring in 20 years; hip- deep powder and ice had already driven us off one ridge. If we failed to cross the pass, I feared that the last half of our “once in a lifetime” trip would be ruined.

The night before we would try the pass, we camped at a hut at 14,500 feet. In the photos taken at the camp, my face appears wan. The last village we’d passed through was a sturdy two-day walk below us, and I was tired.

During the late afternoon, four backpack- ers from New Zealand joined us, and we spent most of the night awake, anticipating the climb. Below we could see the fires of two other parties, which turned out to be two Swiss couples and a Japanese hiking club.

To get over the steep part of the climb before the sun melted the steps cut in the ice, we departed at 3:30 a.m. The New Zealanders left first, followed by Stephen and myself, our porters and Sherpas, and then the Swiss. The Japanese lingered in their camp. The sky was clear, and we were confident that no spring storm would erupt that day to close the pass.

At 15,500 feet, it looked to me as if Stephen were shuffling and staggering a bit, which are symptoms of altitude sickness. (The initial stage of altitude sickness brings a headache and nausea. As the condition worsens, a climber may encounter diffi- cult breathing, disorientation, aphasia, and paralysis.) I felt strong, my adrenaline was flowing, but I was very concerned about my ultimate ability to get across. A couple of our


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Chapter 2 Business Ethics and Social Responsibility 47


porters were also suffering from the height, and Pasang, our Sherpa sirdar (leader), was worried.

Just after daybreak, while we rested at 15,500 feet, one of the New Zealanders, who had gone ahead, came staggering down toward us with a body slung across his shoulders. He dumped the almost naked, barefoot body of an Indian holy man—a sadhu—at my feet. He had found the pilgrim lying on the ice, shivering and suffering from hypothermia. I cradled the sadhu’s head and laid him out on the rocks. The New Zealander was angry. He wanted to get across the pass before the bright sun melted the snow. He said, “Look, I’ve done what I can. You have porters and Sherpa guides. You care for him. We’re going on!” He turned and went back up the mountain to join his friends.

I took a carotid pulse and found that the sadhu was still alive. We figured he had probably visited the holy shrines at Muk- inath [sic] and was on his way home. It was fruitless to question why he had chosen this desperately high route instead of the safe, heavily traveled caravan route through the Kali Gandaki gorge. Or why he was almost naked and with no shoes, or how long he had been lying in the pass. The answers were not going to solve our problem.

Stephen and the four Swiss began strip- ping off outer clothing and opening their packs. The sadhu was soon clothed from head to foot. He was not able to walk, but he was very much alive. I looked down the mountain and spotted below the Japanese climbers marching up with a horse.

Without a great deal of thought, I told Stephen and Pasang that I was concerned about withstanding the heights to come and wanted to get over the pass. I took off after several of our porters who had gone ahead.

On the steep part of the ascent where, if the ice steps had given way, I would have slid down about 3,000 feet, I felt vertigo. I stopped for a breather, allowing the Swiss to catch up with me. I inquired about the sadhu and Stephen. They said that the sadhu was fine and that Stephen was just behind. I set off again for the summit.

Stephen arrived at the summit an hour after I did. Still exhilarated by victory, I ran down the snow slope to congratulate him.

He was suffering from altitude sickness, walking fifteen steps, then stopping, walking fifteen steps, then stopping. When I reached them, Stephen glared at me and said: “How do you feel about contributing to the death of a fellow man?”

I did not fully comprehend what he meant.

“Is the sadhu dead?” I inquired. “No,” replied Stephen, “but he surely

will be!” After I had gone, and the Swiss had

departed not long after, Stephen had remained with the sadhu. When the Jap- anese had arrived, Stephen had asked to use their horse to transport the sadhu down to the hut. They had refused. He had then asked Pasang to have a group of our porters carry the sadhu. Pasang had resisted the idea, saying that the porters would have to exert all their energy to get themselves over the pass. He had thought they could not carry a man down 1,000 feet to the hut, reclimb the slope, and get across safely before the snow melted. Pasang had pressed Stephen not to delay any longer.

The Sherpas had carried the sadhu down to a rock in the sun at about 15,000 feet and had pointed out the hut another 500 feet below. The Japanese had given him food and drink. When they had last seen him he was listlessly throwing rocks at the Japa- nese party’s dog, which had frightened him.

We do not know if the sadhu lived or died.

For many of the following days and eve- nings Stephen and I discussed and debated our behavior toward the sadhu. Stephen is a committed Quaker with deep moral vision. He said, “I feel that what happened with the sadhu is a good example of the break- down between the individual ethic and the corporate ethic. No one person was willing to assume ultimate responsibility for the sadhu. Each was willing to do his bit just so long as it was not too inconvenient. When it got to be a bother, everyone just passed the buck to someone else and took off. Jesus was relevant to a more individualist stage of society, and how do we interpret his teaching today in a world filled with large, impersonal organizations and groups?”

I defended the larger group, saying, “Look, we all cared. We all stopped and


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48 part 1 Business: Its Legal, Ethical, and Judicial Environment


gave aid and comfort. Everyone did his bit. The New Zealander carried him down below the snow line. I took his pulse and suggest- ed we treat him for hypothermia. You and the Swiss gave him clothing and got him warmed up. The Japanese gave him food and water. The Sherpas carried him down to the sun and pointed out the easy trail toward the hut. He was well enough to throw rocks at a dog. What more could we do?”

“You have just described the typical affluent Westerner’s response to a problem. Throwing money—in this case food and sweaters—at it, but not solving the funda- mentals!” Stephen retorted.

“What would satisfy you?” I said. “Here we are, a group of New Zealanders, Swiss, Americans, and Japanese who have never met before and who are at the apex of one of the most powerful experiences of our lives. Some years the pass is so bad no one gets over it. What right does an almost naked pilgrim who chooses the wrong trail have to disrupt our lives? Even the Sherpas had no interest in risking the trip to help him beyond a certain point.”

Stephen calmly rebutted, “I wonder what the Sherpas would have done if the sadhu had been a well-dressed Nepali, or what the Japanese would have done if the sadhu had been a well-dressed Asian, or what you would of done, Buzz, if the sadhu had been a well-dressed Western woman?”

“Where, in your opinion,” I asked instead, “is the limit of our responsibility in a situation like this? We had our own well-be- ing to worry about. Our Sherpa guides were unwilling to jeopardize us or the porters for the sadhu. No one else on the mountain was willing to commit himself beyond cer- tain self-imposed limits.”

Stephen said, “As individual Christians or people with a Western ethical tradition, we can fulfill our obligations in such a situation only if (1) the sadhu dies in our care, (2) the sadhu demonstrates to us that he could undertake the two-day walk down to the vil- lage, or (3) we carry the sadhu for two days down to the village and convince someone there to care for him.”

“Leaving the sadhu in the sun with food and clothing, while he demonstrated hand- eye coordination by throwing a rock at a dog, comes close to fulfilling items one and two,”

I answered. ?“And it wouldn’t have made sense to take him to the village, where the people appeared to be far less caring than the Sherpas, so the third condition is impractical. Are you really saying that, no matter what the implications, we should, at the drop of a hat, have changed our entire plan?”

The Individual versus the Group Ethic

Despite my arguments, I felt and continue to feel guilt about the sadhu. I had literally walked through a classic moral dilemma without fully thinking through the conse- quences. My excuses for my actions include a high adrenaline flow, a superordinate goal, and a once-in-a-lifetime opportunity—factors in the usual corporate situation, especially when one is under stress.

Real moral dilemmas are ambiguous, and many of us hike right through them, unaware that they exist. When, usually after the fact, someone makes an issue of them, we tend to resent his or her bringing it up. Often, when the full import of what we have done (or not done) falls on us, we dig into a defensive position from which it is very dif- ficult to emerge. In rare circumstances we may contemplate what we have done from inside a prison.

Had we mountaineers been free of physical and mental stress caused by the effort and the high altitude, we might have treated the sadhu differently.? Yet isn’t stress the true test of personal and corporate values? The instant decisions executives make under pressure reveal the most about personal and corporate character. Among the many questions that occur to me when pondering my experience are: What are the practical limits of moral  imagination and vision? Is there a collective or institutional ethic beyond the ethics of the individual? At what level of effort or commitment can one discharge one’s ethical responsibilities?

Not every ethical dilemma has a right solution. Reasonable people often disagree; otherwise there would be no dilemma. In a business context, however, it is essential that managers agree on a process for deal- ing with dilemmas.

The sadhu experience offers an inter- esting parallel to business situations. An immediate response was mandatory. Failure


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Chapter 2 Business Ethics and Social Responsibility 49


to act was a decision in itself. Up on the mountain we could not resign and submit our résumé to a headhunter. In contrast to philosophy, business involves action and implementation—getting things done. Man- agers must come up with answers to prob- lems based on what they see and what they allow to influence their decision-making processes. On the mountain, none of us but Stephen realized the true dimensions of the situation we were facing.

One of our problems was that as a group we had no process for developing a consen- sus. We had no sense of purpose or plan. The difficulties of dealing with the sadhu were so complex that no one person could handle it. Because it did not have a set of preconditions that could guide its action to an acceptable resolution, the group reacted instinctively as individuals. The cross-cultural nature of the group added a further layer of complexity. We had no leader with whom we could identify and in whose purpose we believed. Only Stephen was willing to take charge, but he could not gain adequate sup- port to care for the sadhu.

Some organizations do have a value system that transcends the personal values of the managers. Such values, which go beyond profitability, are usually revealed when the organization is under stress. Peo- ple throughout the organization generally accept its values, which, because they are not presented as a rigid list of command- ments, may be somewhat ambiguous. The stories people tell, rather than printed mate- rials, transmit these conceptions of what is proper behavior.

For twenty years I have been exposed at senior levels to a variety of corporations and organizations. It is amazing how quickly an outsider can sense the tone and style of an organization and the degree of toler- ated openness and freedom to challenge management.

Organizations that do not have a her- itage of mutually accepted, shared val- ues tend to become unhinged during stress, with each individual bailing out for himself. In the great takeover battles we have witnessed during past years, com- panies that had strong cultures drew the wagons around them and fought it out, while other companies saw executives,

supported by their golden parachutes, bail out of the struggles.

Because corporations and their mem- bers are interdependent, for the corporation to be strong the members need to share a preconceived notion of what is correct behavior, a “business ethic,” and think of it as a positive force, not a constraint.

As an investment banker I am continual- ly warned by well-meaning lawyers, clients, and associates to be wary of conflicts of interest. Yet if I were to run away from every difficult situation, I wouldn’t be an effec- tive investment banker. I have to feel my way through conflicts. An effective manager can’t run from risk either; he or she has to confront and deal with risk. To feel “safe” in doing this, managers need the guidelines of an agreed-on process and set of values within the organization.

After my three months in Nepal, I spent three months as an executive-in-residence at both Stanford Business School and the Center for Ethics and Social Policy at the Graduate Theological Union at Berkeley. These six months away from my job gave me time to assimilate twenty years of busi- ness experience. My thoughts turned often to the meaning of the leadership role in any large organization. Students at the seminary thought of themselves as antibusiness. But when I questioned them they agreed they distrusted all large organizations, including the church. They perceived all large orga- nizations as impersonal and opposed to individual values and needs. Yet we all know of organizations where people’s values and beliefs are respected and their expressions encouraged. What makes the difference? Can we identify the difference and, as a result, manage more effectively?

The word “ethics” turns off many and confuses more. Yet the notions of shared values and an agreed-on process for dealing with adversity and change—what many people mean when they talk about corpo- rate culture—seem to be at the heart of the ethical issue. People who are in touch with their own core beliefs and the beliefs of others and are sustained by them can be more comfortable living on the cutting edge.

At times, taking a tough line or a deci- sive stand in a muddle of ambiguity is the only ethical thing to do. If a manager is


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50 part 1 Business: Its Legal, Ethical, and Judicial Environment

indecisive and spends time trying to figure out the “good” thing to do, the enterprise may be lost.

Business ethics, then, has to do with authenticity and integrity of the enterprise. To be ethical is to follow the business as well as the cultural goals of the corporation, its owners, its employees, and its custom- ers. Those who cannot serve the corporate vision are not authentic business people and, therefore, are not ethical in the busi- ness sense.

At this stage of my own business experi- ence I have a strong interest in organization- al behavior. Sociologists are keenly studying what they call corporate stories, legends, and heroes as a way organizations have of transmitting the value system. Corporations such as Arco have even hired consultants to perform an audit of their corporate culture. In a company, the leader is the person who understands, interprets, and manages the corporate value system. Effective managers are then action-oriented people who resolve conflict, are tolerant of ambiguity, stress, and change, and have a strong sense of pur- pose for themselves and their organizations.

If all this is true, I wonder about the role of the professional manager who moves from company to company. How can he or she quickly absorb the values and culture of different organizations? Or is there, indeed, an art of management that is totally trans- portable? Assuming such fungible managers do exist, is it proper for them to manipulate the values of others?

What would have happened had Ste- phen and I carried the sadhu for two days back to the village and become involved with the villagers in his care? In four trips to Nepal my most interesting experiences occurred in 1975 when I lived in a Sher- pa home in the Khumbu for five days recovering from altitude sickness. The high point of Stephen’s trip was an invitation to participate in a family funeral ceremony in Manang. Neither experience had to do with climbing the high passes of the Himalayas. Why were we so reluctant to try the lower path, the ambiguous trail? Perhaps because we did not have a leader who could reveal the greater purpose of the trip to us.

Why didn’t Stephen with his moral vision opt to take the sadhu under his

personal care? The answer is because, in part, Stephen was hard-stressed physically himself, and because, in part, without some support system that involved our involuntary and episodic community on the mountain, it was beyond his individual capacity to do so.

I see the current interest in corporate culture and corporate value systems as a positive response to Stephen’s pessimism about the decline of the role of the individ- ual in large organizations. Individuals who operate from a thoughtful set of personal values provide the foundation of a corporate culture. A corporate tradition that encour- ages freedom of inquiry, supports personal values, and reinforces a focused sense of direction can fulfill the need for individuality along with the prosperity and success of the group. Without such corporate support, the individual is lost.

That is the lesson of the sadhu. In a complex corporate situation, the individual requires and deserves the support of the group. If people cannot find such support from their organization, they don’t know how to act. If such support is forthcoming, a person has a stake in the success of the group, and can add much to the process of establishing and maintaining a corporate cul- ture. It is the management’s challenge to be sensitive to individual needs, to shape them, and to direct and focus them for the benefit of the group as a whole.

For each of us the sadhu lives. Should we stop what we are doing and comfort him; or should we keep trudging up toward the high pass? Should I pause to help the derelict I pass on the street each night as I walk by the Yale Club en route to Grand Central Station? Am I his brother? What is the nature of our responsibility if we consid- er ourselves to be ethical persons? Perhaps it is to change the values of the group so that it can, with all its resources, take the other road.

Discussion Question

Consider the closing questions Mr. McCoy poses. How do they apply to you personally and to businesses?

Source: Reprinted by permission of Harvard Business Review. From “The Parable of the Sadhu,” by Bowen H. McCoy, May–June 1997. Copyright © 1997 by Harvard Business School Publishing Corporation; all rights reserved.


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Chapter 2 Business Ethics and Social Responsibility 51

2-8 Importance of Ethics in Business Success and the Costs of Unethical Conduct

As you learn in other disciplines, from economics to management, business is driven by the bottom line. Profits control whether the firm can obtain loans or gain investors and serve as the sole indicator of the firm’s success—and, in most cases, its employees’ success as well. Indeed, business firms can be defined as groups of people working together to obtain maximum profits. The pursuit of the bottom line, however, can occasionally distort the perspective of even the most conscien- tious among us. The fear of losing business and, consequently, losing profits and capital support can persuade people to engage in conduct that, although not ille- gal, is unethical. But those who pursue only the bottom line fail to recognize that a successful business is more like a marathon than a sprint, requiring that ethical dilemmas be resolved with a long-term perspective in mind. Indeed, those firms that adhere to ethical standards perform better financially over the long run. A 2010 study indicates that if companies are not ever-vigilant in adhering to ethical standards, they slip into illegal activity and destroy their profitability, often to the point of bankruptcy.18

The Tylenol tampering incident of 1982 offers one of the most telling exam- ples of the rewards of being ethical. When Tylenol capsules were discovered to have been tainted with deadly poison, Tylenol’s manufacturer, McNeil Consumer

Ethical Issues

In 2006, David Sharp, 34, from Britain, was not handling a climb to Mt. Everest well. He was a victim of oxygen deprivation and eventually collapsed on the ground. Forty other climbers passed him by, and, unable to move, Mr. Sharp froze to death. Those who passed him by indicated that the con- ditions are rugged and that climbers know going in that they may have to pay the ultimate price.

Lincoln Hall, 50, from Australia, was discovered by an American guide after he had spent a night on the freezing moun- tainside. The MyHeroProject describes Mr. Hall’s condition as follows: “He was sit- ting on the trail with his jacket around his waist, wearing no hat or gloves. The group stopped to investigate and found he was suffering from symptoms of edema, frost- bite and dehydration. He was alone and hallucinating; and generally incoherent in his responses to their offers of help. He

was without any of the proper equipment for survival in such conditions. Apparently, Mr. Hall had collapsed the previous day on his way down from the summit.”

Mr. Dan Mazur and his team aban- doned their climb and stayed with Mr. Hall until rescuer sherpas could come to help. Mr. Hall’s team assumed that he was dead and had called his wife the evening before to tell her.

In the years since 1953, 3,000 climbers have made it to the Everest summit, but 200 climbers have died. A climb with a guide costs about $60,000. What do you think makes the difference in the decision process between those who stop to help and those who continue their climbs?

Source: Adapted from Alan Cowell, “Adventurers Change. Danger Does Not,” New York Times, June 4, 2006, p. WK 5.

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52 part 1 Business: Its Legal, Ethical, and Judicial Environment

Products Company, a subsidiary of Johnson & Johnson, followed its code of ethics, which required it to put the interests of the consumer first. In what many financial analysts and economists considered to be a disastrous decision and a dreadful mis- take, McNeil recalled all Tylenol capsules from the market—31 million bottles with a retail value of about $100 million. A new and safer form of a noncapsule Tylenol caplet was developed, and within a few months Tylenol regained its majority share of the market. The recall had turned out to be neither a poor decision nor a finan- cial disaster. Rather, the company’s actions enhanced its reputation and served to create a bond between Tylenol and its customers that was based largely on trust and respect for the integrity of the company and the product. Johnson & Johnson and McNeil enjoyed decades of goodwill and deferential treatment arising from their recall. The two companies had a near immunity from questions about their products and practices until 2010, when the companies’ conduct differed substan- tially from the 1982 recall. In 2010, the FDA found metal particles in the company’s liquid Infants’ Tylenol. That can happen in production, but the key is to stop pro- duction, issue a recall, and confess. Instead, however, one officer resigned, and the FDA levied penalties against McNeil over its lack of cooperation, mishandling of materials, lax documentation, and failure to follow up on customer complaints.18

An April 2010 FDA site visit to one plant found violations of the agency’s good manufacturing processes. One violation was releasing seven batches of cherry- flavored Infants’ Tylenol after the employees had found the metal from processing pistons in the product. Not only did McNeil not issue a recall, it did not even notify the government about the issue. The result of these decisions has been declining profits, federal monitoring, and a loss of trust by consumers.

Nestlé provides another example of the consequences for poor ethical choices, consequences that can span generations. Nestlé has endured many consumer boy- cotts since the early 1970s as a result of its intense—and what came to be perceived by the public as exploitative and unethical—marketing of infant formula in then–Third World nations, where the lack of sanitation, refrigeration, and education led to serious health problems in infants given the formula. In 1989, nearly 20 years after the infant formula crisis, Nestlé’s new “Good Start” formula was slow in market infiltration and, because of continuing consumer resistance, did not perform as well as its qual- ity and innovativeness would have predicted. Nestlé has never gained the market share or reputation its quality product deserves. As the Nestlé experience illustrates, a firm’s reputation for ethical behavior is the same as an individual’s reputation: it takes a long time to gain, but it can be lost instantly as the result of one bad choice.

BP, the oil and natural gas company, was performing well, with operations in 100 countries, 96,000 employees, and nearly 24,000 retail service stations around the world. As the second-largest oil company in the world and one of the world’s 10 largest corporations, BP had also been a perennial favorite of NGOs and environ- mental groups. For example, Business Ethics named BP the world’s most admired company and one of its top corporate citizens. Green Investors named BP its top company because of BP’s continuing commitment to investment in alternative energy sources. But BP had issues percolating as it gained these recognitions. In 2005, an explosion at one of BP’s refineries, located in Texas City, Texas, resulted in the death of 15 employees and injuries to 170 others. Both an internal investigation and a government report indicated that the accident would have been avoidable if the company had not cut maintenance costs at the expense of safety. The accident followed on the heels of charges that the company’s traders were manipulating the price of propane in the markets by holding back on supplies.

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Chapter 2 Business Ethics and Social Responsibility 53

Also, the company’s oil fields at Prudhoe Bay, Alaska, burst in 2006, resulting in a 267,000-gallon oil spill on pristine Alaskan tundra.20 Industry standards require “smart-pigging” (ultrasonic checking) of pipelines every five years to detect weak- nesses or corrosion. At the time of the March 2006 spill, BP disclosed that it had not done smart-pigging on the Prudhoe Bay line since 1998 and that the pipes had not been cleaned since 1992. The BP field manager at Prudhoe Bay said, follow- ing the spill, “If we had it to do over again, we would have been pigging those lines.”21 The line had to be closed down, and again an internal report revealed that the cost-cutting drive at BP affected the decisions in the oil fields. Following the oil spill, BP’s stock price fell more than 15% in three months.

Oil production dropped 75%, and BP spent $1 billion to fix the Texas refinery. One expert noted at that time that it would take years for BP to recover financially and even longer to restore its credibility with the market and regulators. That pre- scient remark has proved to be even truer after BP’s Deepwater Horizon well in the Gulf of Mexico sprung a “leak” and began gushing oil in April 2010. The evi- dence of compromises on well construction and rig safety was so overwhelming that BP has paid an unprecedented $62 billion in fines and compensation following a guilty plea to environmental and safety violations.

In 2005, a GM employee sent the following e-mail to other employees related to an ignition switch problems that had been previously pointed out by test drivers:

“We have a serious safety problem here. I am thinking big recall. I was driving 45 mph when I hit the pothole and the car shut off, and I had a car behind me that swerved around me. I don’t like to imagine a customer driving their kids in the back seat, on I75, and hitting a pothole in rush hour traffic.”22

GM did not make the information public or issue a recall. Its inaction resulted in the company settling with the federal government to pay a $900 million fine for withholding information from regulators and failure to issue a recall or notify its customers or dealers of the problem. The civil lawsuits by the families of those who were killed in accidents related to the ignition switch are still pending.

The poor ethical choices of the aforementioned firms resulted in tremendous financial setbacks and, in some cases, destruction. The core values of a firm give it long-standing profitability. “The Tony Bennett Factor” offers some insight into longevity, profitability, and values.

2-8a ethics as a Strategy

Ethical behavior not only increases long-term earnings but also enables businesses to anticipate and plan for social needs and cultural changes that require the firm or its product to evolve. One of the benefits of a firm’s ethical behavior and par- ticipation in community concerns is the goodwill that such involvement fosters. Conversely, the absence of that goodwill and consequent loss of trust can mean the destruction of the firm.

Blue Bell ice cream, one of the largest ice cream brands in the United States, issued massive recalls over listeria contamination that resulted in three deaths and at least 10 illnesses. Criminal investigations began because of the presence of liste- ria in its plants. Blue Bell recalled all of its products in 23 states in April 2015 and did not ship products again until August 2015. Just the allegations that Blue Bell did not follow practices recommended by both government regulators and indus- try groups damaged the brand. But reports by Fortune that Blue Bell found listeria at the plant in 2013 but did not take the appropriate steps to correct the problem

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54 part 1 Business: Its Legal, Ethical, and Judicial Environment

For the Manager’s Desk

Re: the tony Bennett Factor

I had blocked out the background noise offered courtesy of MTV and my teenager, but I glanced up and saw Tony Bennett. My parents raised me on Tony Bennett LPs back in the ’50’s. “I Left My Heart in San Francisco” enjoyed hours of play in Tyrone, Pa. And here he was back, “Tony Bennett Unplugged.” Mr. Bennett has not changed. Yet his success has spanned generations. Suddenly my work with a colleague, Prof. Louis Grossman, had new meaning. We had been studying business longevity, trying to determine what makes some businesses survive so successfully for so long.

Prof. Grossman and I began our study when we spotted a 1982 full-page ad in this newspaper placed by Diamond Match Co. The ad touted the company’s 100 years of consistent dividend payments. Today’s standards tell us that quarters of dividend payments would be stellar. What kind of company was this? Were there others?

We discovered seven other industrial firms that could boast of making at least an annual dividend payment for a string of 100 years or more: Scovill, Inc.; Ludlow Corp.; Stanley Works; Singer Co.; Pennwalt, Inc.; Pullman, Inc.; and Corning Glass Works. Pullman, Ludlow and Stanley had unbroken chains of a century of quarterly dividend payments as well.

Mr. Bennett and our eight companies have survival in common. These survivors’ tools make management theories of today seem trite. They had no shifting paradigms. No buzzwords.

Mr. Bennett recognized his strength as a balladeer and stuck with it, through every- thing from the Beatles to Hootie and the Blowfish. Although each of our companies recognized the importance of diversification, they all held fast to a WBAWI—or “what business are we in?”—philosophy. They knew their strengths, developed strong mar- ket presences based on those strengths, and never forgot their roots. Mr. Bennett

never performed without singing “I Wanna Be Around.” Singer never left its sewing machines. Pullman never deserted its train cars. Diamond held on to its matches.

The firms diversified only when their strengths allowed. Scovill began as a brass button manufacturer and backed into brass manufacturing because it knew brass. Scovill bought Hamilton Beach because Hamilton Beach was a major brass pur- chaser. Scovill understood this customer’s business.

Other companies have forgotten the WBAWI lesson and paid the price. Sears abandoned its catalog, insurance and real estate businesses and now struggles to find a retail presence. IBM has suffered for not understanding its business was the work- place, not mainframe computers. Its Lotus takeover shows it may recognize the PC as the workplace.

All Mr. Bennett needs are a microphone and a pianist to make music. All eight of our companies were low-cost producers. All eight were cost conscious. Scovill executive vice presidents with worldwide responsibil- ities shared a secretary. Spartan company headquarters were the rule for these firms. There were barely six-figure salaries for executives. By contrast, IBM’s Louis Gerst- ner hired an executive chef at $120,000 just last month.

Mr. Bennett has used the same musi- cal arranger for nearly 30 years. Our eight companies’ management team histories are in direct contrast to the executive recruiting practices in vogue today. Scovill, found- ed during the Jefferson administration in 1803, had only 12 CEOs during its 100-year dividend run. Three of the companies (Sing- er, Stanley and Diamond) had CEOs who served for more than 40 years. Seven of the companies never had a CEO serve for fewer than 10 years. They were not afraid of home-grown management. Their officers and CEOs came up through the ranks.


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Chapter 2 Business Ethics and Social Responsibility 55

(Continued)Management succession is found in all eight companies.

Perhaps this information demonstrates the importance of continuity and stabili- ty. The executives appreciated the tension between short-term results and long-term performance, but the short term did not control decision making. Donald Davis, chairman and CEO of Stanley Works, put it this way: “The tension is always there. One of the top management’s toughest jobs really is to mediate between the two viewpoints—short-term profit results now versus investment for future development.”

Mr. Bennett did and does spend time on the road in concert, in direct contact with audiences—no mega-tours, just constant gigs. And a full century before we heard of customer service, these firms sent their sales forces and vice presidents alike out on the road to talk directly with customers. They had interesting marketing studies: one- on-one feedback. Sales calls, follow-ups, replacements, and refunds allowed them to remain in the customers’ minds and good graces.

One officer said it best: “Anyone can read the monthly financial reports: What we need to do is to interpret them so we can spot trends. We call on customers, on suppliers, we look at the bottom line of course, but we know how that line reached the bottom.”

Mr. Bennett has never made a bad recording or disappointed during a live

performance. Our eight firms had strong commitments to integrity. Their mantra was: “If there’s integrity, there will be quality and profits.” Their integrity man- ifested itself in more than just quality. Frederick T. Stanley, founder of Stanley Works, spoke of the intricate balance between automation and employees: “Machines are no better than the skill, care, ingenuity and spirit of the men who operate them. We can achieve perfect harmony when shortening of an operation provides mutual advantages to the work- man and the producers.” Ethics before its time. Re-engineering done correctly in the 1800s. Nothing at the expense of the customer or the employee.

Our firms were no less remarkable than Mr. Bennett and his success with Generation X—his third generational con- quest. The sad part of their stories is what happened following the takeover battles of the ’80’s. But that is a story for another time. For now, it is reassuring to realize that cost-consciousness, focus, custom- er service, home-grown management and integrity are keys to longevity. Today’s man- agement fads seem as shallow as Ice T (aka Ice-T) and Madonna. There is a simple Tony Bennett factor in success that makes today’s fads much easier to debunk and infinitely easier to question.

Source: “The Tony Bennett Factor?,” by Marianne M. Jennings, from The Wall Street Journal, June 26, 1995, p. A12.

or make disclosures caused further fallout: “The FDA released inspection reports showing that the company had found the bacteria in its Oklahoma plant, on sur- faces such as floors and catwalks, on 17 occasions beginning in March 2013.”23

The shutdown cost the company $200 million, 1,450 jobs, and the loss of its 6.4% market share.

2-8b the Value of a Good Reputation

A reputation, good or bad, stays with a business or an individual for a long time. Richard Teerlink, the former CEO of Harley-Davidson, has said, “A reputation, good or bad, is tough to shake.” Once a company makes poor ethical choices, it carries the baggage of those choices despite successful and sincere efforts to reform. Salt Lake City struggled to regain its credibility as the trials from the brib- ery allegations surrounding its winning the bid for the 2002 Winter Olympics

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56 part 1 Business: Its Legal, Ethical, and Judicial Environment

progressed and companies withdrew sponsorships. Businesses were, at that time, unsure about the reputations and trustworthiness of those running the Salt Lake City Olympic operations. It took new leadership and a commitment to high ethi- cal standards from Mitt Romney, who went on to become a two-term governor of Massachusetts and presidential candidate in 2008 and 2012, to restore confidence in the Salt Lake City 2002 Winter Olympics.

2-8c Leadership’s Role in ethical Choices

George Fisher, the former CEO of Motorola and Kodak, has defined leadership as the ability to see around corners. In other words, a leader sees a problem before it becomes a legal issue or liability and fixes it, thus saving company time and money. All social, regulatory, and litigation issues progress along a timeline. As the issue is brought to the public’s attention, either by stories or by the sheer mag- nitude of the problem, the momentum for remedies and reforms continues until behavior is changed and regulated. Ethical choices afford firms opportunities to take positions ahead of the curve. Firms can choose to go beyond the law and per- haps avoid regulation that might be costly or litigation that can be devastating. For example, the issues relating to the problems with asbestos dust in the lungs of asbestos workers and installers were clear in the 1930s. More studies needed to be done, but there was sufficient evidence to justify lung protection for workers and the development of alternative forms of insulation. However, the first litiga- tion relating to asbestos and asbestos workers did not arise until 1968. For that 30-year period, those in the business of producing and selling asbestos insulation products had the opportunity to take preventive actions. They chose to wait out the cycle. The results were a ban on asbestos and litigation at levels that forced the largest producer, Johns-Manville (now Manville), into bankruptcy. Leadership choices were available in the 1930s for offering warnings, providing masks, and developing alternative insulators. Johns-Manville chose to continue its posture of controlling information releases and studies. The liability issue progressed to a point of no choice other than bankruptcy and reorganization.

Every business regulation that exists today controls business conduct in an area that was once not subject to control but, rather, provided an opportunity for busi- nesses to self-regulate by making good value choices. Problems resulting from a lack of candor in payday loans and in the so-called subprime loan market have surfaced at all levels of our economy. “We made so much money, you couldn’t believe it. And you didn’t have to do anything. You just had to show up”24 was the comment of Kal Elsayed, a former executive at New Century Financial, a mort- gage brokerage firm based in Irvine, California. With his red Ferrari, Mr. Elsayed enjoyed the benefits of the growth in the subprime mortgage market. However, those risky debtors, whose credit histories spelled trouble, defaulted on their loans. New Century Financial declared bankruptcy under the weight of its portfolio of $39.4 billion in subprime loans. “Subprime mortgage lending was easy until the market changed” is the hindsight comment of mortgage brokers and analysts. And the Wall Street instruments tied to those mortgages carried the defaults throughout the economy. The mortgage lending market is now greatly controlled and limited by state and federal regulations. Wall Street firms not under federal controls are nevertheless subject to increased regulation.25

Ethical choices give businesses the freedom to make choices before regulators mandate them. Breaches of ethics bring about regulation and liability with few

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Chapter 2 Business Ethics and Social Responsibility 57

opportunities to choose and less flexibility. The notions of choices and leadership are diagrammed in Exhibit 2.3, which is explained in the following discussion. Every issue progresses along a cycle that begins with a latency phase, in which the indus- try is aware of a problem. The use of private information about consumers’ buying patterns was well known in the marketing industry, but few consumers were aware of that use. The awareness stage begins when the popular press reports on an issue and raises questions. Once the public has knowledge of a problem, it responds by demanding assurance that the problem either is resolved or is not really an issue— or by calling for reform. The activism stage is one in which members of the public ask for either voluntary or regulatory reform. If voluntary reform is not forthcom- ing, those affected may sue or lobby for reform or both. For example, a group of parents, police officers, and shareholders protested Time Warner’s production of “Cop Killer,” a song by the rap music artist Ice T (a.k.a. Ice-T). The public outcry was strong both in the press and at Time Warner’s shareholder meeting. Congress was considering holding hearings on record labels and record content. Time Warner eventually made a choice to voluntarily withdraw the song, later in the regulatory cycle when public outcry was strong but still in time to avert regulation.

During 2004, the public again became active in demanding changes in the con- tent of entertainment when Janet Jackson and Justin Timberlake’s performance at the halftime show at the Super Bowl resulted in partial nudity on prime-time television. In 2007, CBS Radio and MSNBC pulled the Don Imus show because of questionable comments he made. Entertainment and television executives undertook voluntary controls to prevent government controls. The televised Acad- emy Awards are now on a five-second delay so that any mishaps can be edited out before broadcast. Some artists are not permitted to appear on awards shows because of their past behaviors on similar shows. Voluntary self-control averts government regulation.

Exhibit 2.3 Leadership and ethics: Making Choices before Liability and Regulation



E th ic s


Latency Awareness Activism



Source: Adapted from James Frierson, “Public Policy Forecasting: A New Approach,” SAM Advanced Management Journal, Spring 1985, pp. 18–23.

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58 part 1 Business: Its Legal, Ethical, and Judicial Environment

Few people realize one aspect of the Tylenol poisonings case (noted earlier in the chapter), which is that the issue of tamper-proof packaging had been a concern in the industry long before the poisonings involving Tylenol occurred. Those in the industry were concerned that packaging that did not signal unauthorized entry so that a buyer could spot tampering could open the door to the tragedy that even- tually occurred. However, no one in the industry, despite knowledge of this issue, took steps to create tamper-proof packaging. The law did not require such a step, additional costs were associated with the packaging and retooling production, and some were worried that they would be at a competitive disadvantage if their prod- ucts were harder to use than those that did not have the tamper-proof packages. By not solving the problem voluntarily, companies faced unpleasant results: first, the tragedy of the deaths, and, second, additional regulations and costs imposed as the government required tamper-proof packaging.

2-9 Creation of an Ethical Culture in Business 2-9a the tone at the top and an ethical Culture

Employees work under the pressures of meeting quarterly and annual goals and can make poor choices if the company’s priority with respect to values and eth- ics is not made clear. Employees must see that those who evaluate and pay them really do care about ethics. Employees are convinced that ethics is important when they see officers comply with all of the provisions in the company code of ethics. They see the right tone at the top when ethical employees are rewarded and uneth- ical conduct is punished. The tone at the top comes from actions by officers and executives who show they “walk the talk” about ethics.

2-9b dodd-Frank, Sarbanes-Oxley, Sentencing, and an ethical Culture

Following the collapses of Enron, WorldCom, and other companies noted in the chapter’s opening “Consider . . . ,” Congress passed the most extensive reforms of corporate governance and financial reporting since the enactment of the 1933 and 1934 securities laws following the 1929 stock market crash. Following the 2008 financial markets collapse and the bankruptcies of many financial firms, Congress added additional reforms through what is called the Dodd-Frank Act (Wall Street Reform and Consumer Financial Protection Act; see Chapters 17 and 18 for more information on these two statutes). Although both statutory reforms impose many requirements on accountants, lawyers, directors, and officers, they also increased criminal penalties and empowered the Federal Sentencing Commission to exam- ine the types of things companies could do that would improve the ethical culture, thereby reducing the risk of misconduct and earning sentence reductions for com- panies that attempt to create an ethical culture but still have an ethical or legal lapse.

The Federal Sentencing Commission has determined that factors such as the following would be helpful in setting the tone of the company:

• A code of ethics • Training for employees in the code and in ethics • A means for employees to report misconduct anonymously • Follow up on reports employees make on misconduct

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Chapter 2 Business Ethics and Social Responsibility 59

• Action by the board, including follow-up and monitoring, on complaints and reports made by employees

• Self-reporting and investigation of legal and ethical issues • Sanctions and terminations for those within the company who violate the law

and company rules, including officers • A high-ranking officer, with the ability to communicate with the CEO and

board, who is responsible for the code of ethics and ethics training in the company

The guidelines for company practices incorporate the factors most experts agree are critical to setting an ethical culture in a company.

2-9c Reporting Lines: an anonymous ethics Line for an ethical Culture

An anonymous reporting line is a minimum requirement for companies working to achieve and maintain an ethical culture. The reporting line can be received inter- nally, or, in best-practices companies, the report goes out to a third-party contractor who then keeps track of the issue and its progress toward resolu- tion within the company. In addition to encouraging employees to discuss issues with their supervisors, anonymous reporting allows employees to raise issues without the fear and concern that might deter them from reporting to a supervisor. Under the sentencing guidelines, companies that can show they fostered an atmosphere of education and discussion in which employees were encouraged to come forward will fare much better in terms of fines and other punishments if any missteps occur. Many com- panies have developed ethical news bulletins to offer employees examples of and guidelines on ethical dilemmas. DuPont delivers an ethics bulletin to employees through its e-mail system. Blue Cross Blue Shield has given employees Slinky toys for their desks with the hotline reporting number on them so that as employees think and perhaps use the Slinky to relieve pressure and stress, they will be reminded to report any problems. The federal gov- ernment has an ethics encyclopedia online for its employees to use. The encyclopedia is filled with examples of government employees’ misconduct and the sanctions they received.

2-9d developing an ethics Stance

Both individuals and firms should decide up front what types of conduct they would never engage in and be certain that the rules are in writing, that everyone understands the rules, and that the rules will be enforced uniformly. Individuals can vary in their responses to various ethical dilemmas. For example, a woman who had taken $12,000 from her employer was terminated imme- diately upon the company’s discovery of the embezzlement. At the company’s next board meeting, the board members discussed the issue and had varying views. One director felt that taking something that does not belong to you is wrong and that ter- mination was the appropriate action. Another director said that

If an organization wants its code of ethics to be followed, used, understood, and relied upon, the key steps are the following:

1. Develop a code of ethics with input from employees, vendors, suppliers, and others who deal with your organization.

2. Have a ceremony of sorts to roll out the code. For example, in the Arizona State University MBA program, the code of academic integrity is printed on banners, and students come and sign the banners as evidence of their com- mitment. The Facebook posts generate further publicity for the code. The food at the ceremony draws participants to the session.

3. Train everyone on what’s in the code of ethics. Have the code of ethics up on an internal site for easy access and have examples and explanations available there.

4. Integrate the principles of the code into strategy, planning, operations, and community activities.

5. Make sure reporting mechanisms are clear, available, and responsive when employees raise issues and questions.

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60 part 1 Business: Its Legal, Ethical, and Judicial Environment

the ethical CultureBusiness Strategy

A strategic pyramid can help in understand- ing how to implement an ethical culture. At the base of the pyramid are the facial trappings of ethics: codes. Even Enron had a 64-page, award-winning code of ethics. Some companies have progressed beyond annual training seminars to regular ethics scenarios circulated throughout the compa- ny for employees to consider and discuss before the ethics office offers its insights and guidance on the hypothetical or reali- ty-based scenario that has been presented. Some companies regularly report to employ- ees on number of ethics questions/reports, the investigations, and the outcomes (with- in the bounds of privacy constraints). For example: “The ethics office investigated 323 matters and employee disciplinary action was taken in 175 of those matters. The form of discipline included terminations, warnings, loss of bonus [and whatever other sanctions were imposed].” The purpose of this data-based feedback is to let employees know, particularly those who reported anon- ymously and wish to remain anonymous, of

the ethics office activity, the results of inves- tigations, and, perhaps most importantly, the enforcement.

The next layer involves compensation for and recognition of the role of individuals’ moral development and the differing roles employees play in terms of organizational behavior parameters in moving the com- pany toward ethical behavior and an ethical culture.

The final or top layer, and the area con- quered by so few companies, requires lead- ership at the executive level and dramatic shifts in both internal and external policies and behaviors of the company. Exploring these top two layers can provide ethics offi- cers and ethics programs within companies with the next step in the evolution of not just “best practices in ethics programs,” but in the creation of an ethical culture.

Source: Adapted from Marianne M. Jennings, “Taking Ethics Programs to the Next Level: Why CFOs Are Critical,” Corporate Finance Review 10, no. 3 (2005), pp. 38–42. Reprinted by permission of Thomson Reuters.

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Leadership by Example

Company Policies and Compensation Systems

Reward Ethical and Moral Behavior

Ethics Codes Ethics Training: Annual/Scenarios


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Chapter 2 Business Ethics and Social Responsibility 61

his remedy would be determined by whether the money was taken all at once or over a period of time. Another director said that his remedy would be determined according to why the employee took the money. Still another director noted that perhaps the employee did not understand that this type of action is wrong. The directors varied in their views on ethics. One is pragmatic—it is simply wrong. Another applies a relative approach—why did she take the money?

Knowing where you stand as a company sends clear signals to employees. Knowing where you stand as an individual sends clear signals for the behavior of those around you. Taking a position on a set of values helps a company avoid the either/or conundrum in which tough situations are boiled down to something such as, “Either we release this product now with its flaws and meet the deadline and start getting earnings, or we don’t and the company collapses.” A value-based decision is one that says, “We as a company do not cheat our customers with poorly designed or manufactured products, and we don’t hurt them with defective ones. Because of that value, we retool quickly to correct the problem and get the product out there as soon as possible.” With this value-based decision, the com- pany also makes a good business decision, for it has chosen to avoid the often-de- structive costs of releasing a defective product despite knowledge of that defect. The GM engine switch case discussed earlier represents the destructive costs of deciding not to take action based on values but, rather, taking action based only on immediate costs.

2-9e Being Careful about pressure and Signals

Doing the right and ethical thing often gets lost in the pressures employees felt with respect to goals and number quotas. These types of signals create a pressured environment in which employees fall into ethical lapses that often lead to illegal behavior. Just the disparity between the amount of time devoted to discussion of results versus ethics is a signal. For example, most employees will say that they discuss performance goals every day and then add, “Without fail, we sign off on the ethics policy once each year!” The signal, however unwitting, is that perfor- mance matters most.

In the subprime mortgage meltdown that affected so many Wall Street invest- ment houses, there were clear differences between the firms that collapsed and those that survived. Stan O’Neal at Merrill Lynch, a company that led the pack with over $25 billion in losses and an eventual takeover, was an indefatigable “numbers guy” who took Merrill Lynch from its position of being a safe, trading house to a leveraged player, and O’Neal expected employees to produce results. One Merrill Lynch executive noted the pressure: “It got to the point where you didn’t want to be in the office on Goldman earnings days.” The pressure for goals was so intense that no one really questioned the numbers and how they were get- ting the results. Employees called operations meetings “staged.” The result was Merrill Lynch’s demise, even as employees became concerned but were pressured to just keep going despite the clear consequences.

2-10 Ethical Issues in International Business The global market presents firms with more complex ethical issues than they would experience if operations were limited to one country and one culture. Moral standards vary across cultures. In some cases, cultures change and evolve to allow

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62 part 1 Business: Its Legal, Ethical, and Judicial Environment

conduct that was not previously acceptable. For example, tipping hospital employ- ees is common practice in some countries. In the United States, such behavior could be illegal in the case of government-run hospitals.

In many executive training seminars for international business, executives are taught to honor customs in other countries and to “Do as the Romans do.” Employees are often confused by this direction.

A manager for a U.S. title insurer provides a common example. He com- plained that if he tipped employees in the United States, such as employees at public recording agencies, for their expediting property filings, the manager would not only be violating the company’s code of ethics but could be charged with violations of the Real Estate Settlement Procedures Act and state and federal antibribery provisions. Yet that same type of practice is permitted, recognized, and encouraged in other countries as a cost of doing business. Paying a regula- tory agency in the United States to expedite a licensing process would be bribery of a public official. Yet many businesses maintain that they cannot obtain such authorizations to do business in other countries unless such payments are made. So-called grease or facilitation payments are permitted under the Foreign Corrupt Practices Act (see Chapter 7), but legality does not necessarily make such pay- ments ethical.

An inevitable question arises when custom and culture clash with ethical stan- dards and moral values adopted by a firm. Should the national culture or the com- pany code of ethics prevail? Typical business responses to the question of whether cultural norms or company codes of ethics should control decisions in international business operations are the following: Who am I to question the culture of another country? Who am I to impose U.S. standards on all the other nations of the world? Isn’t legality the equivalent of ethical behavior? The attitude of businesses is one that permits ethical deviations in the name of cultural sensitivity. Many businesses fear that the risk of offending those in other countries is far too high to impose U.S. ethical standards on the conduct of business in other countries.

Part of the misunderstanding about ethics in international business on the part of U.S.-based businesses is that ethical standards in the United States vary significantly from the ethical standards in other countries. Operating under this misconception can create a great deal of ethical confusion among employees. Stra- tegically, businesses and their employees are more comfortable when they oper- ate under uniform standards. What is known as the “Golden Rule” in the United States actually has existed for some time in other religions and cultures and among philosophers. Exhibit 2.4 offers a list of how this simple rule is phrased in different writings. The principle is the same even if the words vary slightly.

The successful operation of commerce depends on the ethical roots of busi- ness. A look at the three major parties in business explains this point. These parties are the risk-takers, the employees, and the customers. Risk-takers—those furnish- ing the capital necessary for production—are willing to take risks on the assump- tion that customers will judge their products as valuable. Employees are willing to offer production input, skills, and ideas in exchange for wages, rewards, and other incentives. Consumers and customers are willing to purchase products and services as long as they receive value in exchange for their furnishing, through payment, costs, and profits to the risk-takers and employees. To the extent that the interdependency of the parties in the system is affected by factors outside of their perceived roles and control, the intended business system does not function on its underlying assumptions.

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Chapter 2 Business Ethics and Social Responsibility 63

Although the roots of business have been described as primarily economic, this economic system cannot survive without recognition of some fundamental values. Some of the inherent—indeed, universal—values built into our capitalis- tic economic system, as described here, are as follows: (1) the consumer is given value in exchange for the funds expended, (2) employees are rewarded accord- ing to their contribution to production, and (3) the risk-takers are rewarded for their investment in the form of a return on that investment. Exhibit 2.5 depicts this relationship. Everyone in the system must be ethical. An economic system is like a four-legged stool. If corruption seeps into one leg, the economic system is off balance. In international business, often the government slips into corrup- tion, with bribes controlling which businesses are permitted to enter the country and who is awarded contracts in that country. In the United States, the wave of reforms at the federal level since 2008 was the result of perceived corruption in the financial markets that resulted in a lack of transparency.

To a large extent, all business is based on trust. The tenets for doing business are dissolved as an economy moves toward a system in which one individual can control the market in order to maximize personal income.

Suppose, for example, that the sale of a firm’s product is determined not by perceived consumer value but, rather, by access to consumers, which is controlled by government officials. That is, your company’s product cannot be sold to con- sumers in a particular country unless and until you are licensed within that coun- try. Suppose further that the licensing procedures are controlled by government officials and that those officials demand personal payment in exchange for your company’s right to even apply for a business license. Payment size may be arbi- trarily determined by officials who withhold portions for themselves. The basic values of the system have been changed. Consumers no longer directly determine the demand.

Beyond just the impact on the basic economic system, ethical breaches involv- ing grease payments introduce an element beyond a now-recognized component

Exhibit 2.4 a possible Uniform Standard for ethical Choices

Categorical imperative: How would you want to be treated?

Would you be comfortable with a world with your standards?

Christian principle: The Golden Rule

And as ye would that men should do to you, do ye also to them likewise. (Luke 6:31)

Thou shalt love . . . thy neighbor as thyself. (Luke 10:27)

Confucius: What you do not want done to yourself, do not do to others.

Aristotle: We should behave to our friends as we wish our friends to behave to us.

Judaism: What you hate, do not do to anyone.

Buddhism: Hurt not others with that which pains thyself.

Islam: No one of you is a believer until he loves for his brother what he loves for himself.

Hinduism: Do nothing to thy neighbor which thou wouldst not have him do to thee.

Sikhism: Treat others as you would be treated yourself.

Plato: May I do to others as I would that they should do unto me.

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64 part 1 Business: Its Legal, Ethical, and Judicial Environment

in economic performance: consumer confidence in long-term economic perfor- mance. Economist Douglas Brown has described the differences between the United States and other countries in explaining why capitalism works here and not in all nations. His theory is that capitalism depends on an interdependent sys- tem of production. For economic growth to proceed, consumers, risk-takers, and employees must all feel confident about the future, about the concept of a level playing field, and about the absence of corruption. To the extent that consumers, risk-takers, and employees feel comfortable about a market driven by these basic assumptions, the investment and commitments necessary for economic growth via capitalism will be made. Significant monetary costs are incurred by business systems based on factors other than customer value, as discussed earlier. In devel- oping countries where “speed” or grease payments are required and corrupt gov- ernment officials are in control, the actual money involved may not be significant in terms of the nation’s culture. Such activities and payments introduce an element of demoralization and cynicism that thwarts entrepreneurial activity when these nations most need risk-takers to step forward.

Bribes and guanxi (gifts) in China given to establish connections with the Chi- nese government are estimated at 3% to 5% of operating costs for companies, totaling an estimated $5 billion of China’s foreign investment. But China incurs costs from the choices government officials make in return for payments. For example, guanxi are often used to persuade government officials to transfer gov- ernment assets to foreign investors for substantially less than their value. Chinese government assets have fallen more than $50 billion in value during the same period of economic growth, primarily because of the large undervaluation by government officials in these transactions with foreign companies. China’s econ- omy was adrift because of this underlying corruption. Economic progress suffers because of graft.

Exhibit 2.5 the Interdependence of trust, Business, and Government

R eg

ul at

io n/

Fa ir

ne ss Fairness A

ssum ptio


Return on Investment


Protection Protection




Quality/ Dependency





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Chapter 2 Business Ethics and Social Responsibility 65

Perhaps Italy and Brazil provide the best examples of the long-term impact of corruption in foreign business practices. Although the United States, Japan, and Great Britain have had scandals such as the savings and loan failures, political corruption, and insurance regulation, these forms of misconduct do not indicate corruption that pervades entire economic systems. The same cannot be said about Italy. Elaborate connections between government officials, the Mafia, and business executives were unearthed in the 1990s. As a result, half of Italy’s cabinet resigned at one time, and hundreds of business executives were indicted. It has been esti- mated that the interconnections of these three groups cost the Italian government $200 billion, as well as compromising the completion of government projects. Italy is known for its 40-year freeway project. In over 40 years of work, it has not been able to complete a single highway designed to connect the northern and southern parts of the country.

Transparency International publishes an annual index of perceptions of corruption. Business executives are asked to rank

countries on a scale from 1 to 10, with 10 being the least corrupt. The results for 2015 are as follows.

Consider . . . 2.5

Why do you think the index appears as it does? Do you see a correlation between economic development or its absence and corruption?

Source: Reprinted from CORRUPTION PERCEPTION INDEX LIST. Copyright © Transparency International. All Rights Reserved. Used with permission. For more infor- mation, visit


• Denmark • Finland • Sweden • New Zealand • Norway • Switzerland • Singapore • Canada • Germany • Luxembourg • United Kingdom • Australia • Iceland • Belgium • Austria • United States • Hong Kong • Ireland • Japan • Uruguay • Qatar

• Somalia • Korea (North) • Afghanistan • Sudan • South Sudan • Angola • Libya • Iraq • Guinea Bissau • Venezuela • Haiti • Yemen • Turkmenistan • Syria • Eritrea • Uzbekistan • Zimbabwe • Cambodia • Burundi • Myanmar

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66 part 1 Business: Its Legal, Ethical, and Judicial Environment

In Brazil, during the 1980s, the level of corruption led to a climate of murder and espionage. Many foreign firms elected not to do business in Brazil because of so much uncertainty and risk—beyond the normal financial risks of international investment. Why send an executive to a country where officials may use force when soliciting huge bribes?

Brazil continues to be saddled with ongoing corruption issues. In 2016, its president as well as many CEOs of major businesses were charged with crimes related to public corruption. But this wave of corruption charges is nothing new for Brazil. The Wall Street Journal offered an example of how Brazil’s corruption has damaged the country’s economy despite growth and opportunity in sur- rounding nations. The governor of the northeastern state of Paraiba in Brazil, Ronaldo Cunha Lima, was angry because his predecessor, Tarcisio Burity, had accused Mr. Lima’s son of corruption. Mr. Lima shot Mr. Burity twice in the chest while Mr. Burity was having lunch at a restaurant. The speaker of Brazil’s Senate praised Mr. Lima for his courage in doing the shooting himself as opposed to sending someone else. Mr. Lima was given a medal by the local city council and granted immunity from prosecution by Paraiba’s state legislature. No one spoke for the victim, and the lack of support reflected a culture controlled by self- interest that benefits those in control. Unfortunately, these self-interests preclude economic development.

Economists in Brazil document hyperinflation and systemic corruption. A São Paulo businessman observed, “The fundamental reason we can’t get our act together is we’re an amoral society.” This businessperson probably understands capitalism. Privatization that has helped the economies of Chile, Argentina, and Mexico cannot take hold in Brazil because government officials enjoy the benefits of generous wages and returns from the businesses they control. The result is that workers are unable to earn enough even to clothe their families, 20% of the Brazilian population lives below the poverty line, and crime has reached the level of nightly firefights. Brazil’s predicament occurred over time, as graft, collusion, and fraud became entrenched in the government-controlled economy.26


U.S. Air pilot, Captain Chesley “Sully” Sullenberger refers to it as, “That Day.” “That day” was January 15, 2009 when a flock of geese hit one of the engines of his A320 flight taking off from LaGuardia airport in New York City. He felt the lag as his mind raced through the possibil- ities of diverting to Teterboro or turning around to LaGuardia. He made his deci- sion and glided the plane onto the Hudson River. Everyone survived. In recounting “that day” with the Smithsonian’s Air and Space magazine, Sully described his deci- sions and actions:

The way I describe this whole experi- ence—and I haven’t had time to reflect on it sufficiently—is that everything I had done in my career had in some way been a preparation for that moment. There were probably some things that were more important than others or that applied more directly. But I felt like everything I’d done in some way contributed to the outcome.27

Captain Sullenberger’s experience and reflections sum up how it works when we face those life-defining,

Chesley “Sully” Sullenberger: preparation for the Moment When Something Goes Wrong

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Chapter 2 Business Ethics and Social Responsibility 67

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career-defining, and organization-de- fining ethical dilemmas. Everything we do up until those critical decision points is the preparation. Captain Sullenberg- er described his preparation as includ- ing training, handbooks, participation in NTSB investigations, observations, and reading and studying about flights, crash- es, engines, and all things related to air travel. Captain Sullenberger’s preparation translates across to preparing ourselves for those defining ethical moments.

Preparation: The Formal Ethical Infrastructure

Just like airlines have their training and handbooks for pilots, organizations have their have their codes of ethics, hand- books, and training. And organizations lack- ing these formal ethical infrastructures are not giving their employees a critical aspect of preparation. Captain Sullenberger also noted how well trained the crew members were. He said that he could hear the crew members through the cabin door after he made the announcement about the emer- gency landing. In unison they were repeat- ing to the passengers, “Heads down. Stay down.” He said it was comforting for him to know that everyone was on the same page. Everyone knew what to do and what to say. The training kicked in.

When it comes to ethical dilemmas, employees should all be on the same page. Training should give them the methods to raise questions and report issues and the language to use when confronted by a supervisor asking them to cross an ethical line. When everyone has been exposed to the same training, repeated regularly, crisis

situations find them relying on what has been drilled into the culture.

Preparation: Studying the Missteps

Captain Sullenberger indicated that he par- ticipated with NTSB in investigations and studies of crashes in order to learn. So it is with ethics. Unless and until we study the situations in which people make mis- takes, we continue along the cheery path of believing that nothing could possibly go wrong in our organization because we have the formal ethical infrastructure of training and a good code. Sully knew that his first priority was getting the nose of the aircraft down because so many previous crashes resulted from attempted landings with the noses of the aircraft up. That knowledge was critical to the safe water landing.

So it is with ethics. Unless employees understand what it feels and looks like for ethics to go south, they will not make good decisions in averting an ethical crisis. There are common factors that precede ethical crises. For example, in Enron, HealthSouth, Madoff, Finova, Fannie Mae, and other companies, unprecedented performance preceded the ethical collapse. In the recent- ly announced Volkswagen issue of the installation of software to shut off emis- sions controls except during emissions testing, there were questions about how VW was achieving such low emissions. In fact, California regulators raised questions about the phenomenal emissions perfor- mance of the cars two years before VW made its announcement of the deception. Studying what crashes look and feel like helps employees to spot the signs and raise questions or take actions to avert damage.

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68 part 1 Business: Its Legal, Ethical, and Judicial Environment

S u m m a r y What is ethics?

• Behavior beyond the law

• Day-to-day nature of ethics

What is business ethics?

• Ethical standards—normative standards of behavior set by culture

• Ethical standards—standards of behavior set by nat- ural law

• Ethical standards—moral relativism; moral stan- dards by situation

• Ethical standards—religion and ethics

What are the categories of ethical dilemmas in business?

• Taking things that don’t belong to you

• Saying things you know are not true

• Giving or allowing false impressions

• Buying influence or engaging in conflict of interest

• Hiding or divulging information

• Taking unfair advantage

• Committing acts of personal decadence

• Perpetrating interpersonal abuse

• Permitting organizational abuse

• Violating rules

• Condoning unethical actions

• Balancing ethical dilemmas

How do employees resolve ethical dilemmas?

• Blanchard and Peale

• Front-page-of-the-newspaper test

• Wall Street Journal and stakeholders

• Laura Nash and perspective

• Categorical imperative

Why do we fail to reach good ethical decisions?

• “Everybody else does it.”

• “If we don’t do it, someone else will.”

• “That’s the way it has always been done.”

• “We’ll wait until the lawyers tell us it’s wrong.”

• “It doesn’t really hurt anyone.”

• “The system is unfair.”

• “I was just following orders.”

• “You think this is bad, you should have seen . . . ”

• “It’s a gray area.”

What is social responsibility and how does a business exercise it?

• Positive law—codified law

• Inherence—serves shareholders’ interests

• Enlightened self-interest—serves shareholders’ inter- ests by serving larger society

• Invisible hand—serves larger society by serving shareholders’ interests

• Social responsibility—serves largest society best by serving larger society

Why is business ethics important?

• Profit

• Leadership

• Reputation

• Strategy

How does a business create an ethical atmosphere?

• Tone at the top

• Dodd-Frank and corporate sentencing guidelines

• Code of ethics

• Reporting hotlines

• Ethical posture and developing an ethical stance

What are the ethical issues in international business?

• Corruption issues

• Economic systems and ethics

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Chapter 2 Business Ethics and Social Responsibility 69

Q u e S t i o n S a n d P r o b l e m S 1. E. & J. Gallo, the world’s largest winery, announced that it would stop selling its Thunderbird and Night Train Express wines in the Tenderloin, the skid row of San Francisco, for six months. Gallo took the action after meeting with an activist group called Safe and Sober Streets, which has asked grocers to remove the high- alcohol wine from the district, where citizens say drunks create a menace. One retailer in the district said, “If I don’t sell this, I will have to close my doors and go home.”

Discuss the actions of E. & J. Gallo and the dilemma of the retailers in the district. Be sure to discuss the type of philosophy each of them holds with respect to social responsibility and ethical dilemmas.

2. Paul Backman is the head of the purchasing depart- ment for L. A. East, one of the “Baby Bells” that came into existence after the divestiture of AT&T. Mr. Backman and his department purchase everything for the company, from napkins to wires for equipment lines.

S. C. Rydman is an electronics firm and has been a major supplier for L. A. East since 1984. Rydman is also the cosponsor of an exhibit at Wonder World, a theme park in Florida.

Rydman’s vice president and CFO, Gunther Fromme, visited Mr. Backman in his office on April 3, 2004. Rydman had no bids pending at that time, and Mr. Fromme told Mr. Backman that he was there “for goodwill.” Mr. Fromme explained that Rydman had a block of rooms at Wonder World because of its exhibit there and that Mr. Backman and his group could use the rooms at any time, free of charge.

Should Mr. Backman and his employees use the block of rooms? Why or why not?

3. David Tovar served a Walmart’s vice president of communication and had always put on his credentials and résumé that he had received a degree in art from the University of Delaware. He had gone through the gradu- ation ceremonies and assumed that all requirements were met. However, he was notified that he was a “couple of credit hours short.” He did not take the steps to address the shortage and continued to carry the credential. He was under consideration for a promotion, but when Bloomberg News broke the story about problems with his degree, he was terminated. What was the ethical category here? Was termination an appropriate remedy? Discuss the ethical issues.

4. Kenneth Branch was an employee with Lockheed Martin in 1996. At that time Lockheed Martin was com- peting head-to-head with the Boeing Company for a government contract worth $5 billion. Mr. Branch inter- viewed for a job in Boeing’s rocket division in 1996 and began employment at Boeing in January 1997.28

The government awarded the contract to Boeing. An internal investigation by Boeing revealed that Mr. Branch and his supervisor, William Erskine, had thou- sands of pages of proprietary documents from Lockheed Martin, including detailed information about Lockheed Martin’s costs and specifications for the rocket contract. Boeing turned over 11 boxes of documents to Lockheed in 2003, some of which were marked “Proprietary.”

Applying the model on steps for analyzing ethi- cal dilemmas and case studies in business you learned in the “Consider . . .” feature, determine whether there were any ethical breaches in Boeing’s conduct.

The author has performed consulting work for Boeing on changing its ethical culture. Why is this disclosure important in this text? Why is this disclosure important to you?

5. During the 2013 presidential inauguration, a contro- versy arose: Did Beyoncé lip-sync the national anthem? No definitive answer was offered by those involved. What was clear was that the National Marine Band did not play during her performance, that a tape was played, and that those in charge of the event felt a live perfor- mance was too risky because the singer had not had the opportunity to rehearse with the band prior to her perfor- mance. Are there any ethical issues here? Does this action fit into any of the ethical categories? Could you offer any advice to those involved about the ethical issues?

6. Richard M. Scrushy, the former CEO of Health- South and now a convicted felon (bribery), was the subject of a probation hearing. Prosecutors said that Mr. Scrushy was trying to leave the country in February 2007 via his 92-foot yacht, the Chez Soiree. The yacht journey was nixed when bad weather hit the Alabama coast. Mr. Scrushy pro- tested the allegations, testifying that he had permission to travel to South Florida as part of a vacation that had been approved for him and his family (including going to Dis- ney World). He said he did not tell the probation officer about the trip to Miami because her questions were not spe- cific enough: “I can’t answer the question unless she asks me.”29 The federal magistrate said that Mr. Scrushy was being “coy” with his probation officers. Discuss whether Mr. Scrushy breached any ethical standards with his con- duct and interpretation of the terms of his probation.

7. The NCAA sanctioned Syracuse University after releasing a 94-page report that found that the director of basketball operations and other staff members had bas- ketball players’ passwords and used the players’ e-mail accounts to pretend to be the players in communication with the players’ professors. The report also found that players received checks and that the drug policy was lax. After an eight-year investigation, the NCAA took away

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70 part 1 Business: Its Legal, Ethical, and Judicial Environment

12 scholarships, gave the basketball coach a nine-game suspension, and took away 108 victories of the coach, a sanction that takes the coach from the number 2 win- ningest coach in history to number 6. While Syracuse acknowledged the violations, Syracuse Chancellor Kent Syverud responded with the following:

“We believe the NCAA’s investigation of Syracuse University has taken longer than any other investigation in NCAA history. The entire process has taken close to eight years and involved a review of conduct dating back to 2001. By comparison, the investigation into the fixing of the 1919 World Series took two months and the 2007 investigation of steroid use in baseball took 21 months. However, we hope everyone will agree that eight years is too long for an investigation and that a more expeditious and less costly process would be beneficial to student- athletes, public confidence in the NCAA enforcement pro- cess, and major intercollegiate athletics in general.”30

How would you characterize the chancellor ’s response and characterization of the NCAA and the investigation?

8. Gold Peak Tea, a Coca-Cola brand, sponsored its “Take the Year Off” contest. The prize was one year off work and $100,000. Entrants were required to submit a video. Theodore A. Scott, a Decatur, Georgia, attorney, won the grand prize based on votes for his video. His video began with him describing how he had missed out with his family because of his career demands and vowed to spend time with his wife, children, and grand- children if he won the prize. He also said that he would drink, of course, iced tea.

After Gold Peak told Mr. Scott that he had won, the company received a tip (and the company will not iden- tify who gave them the tip) that Mr. Scott had gone to, a site that has information on contests and sweepstakes, and made a pitch to voters there. Mr. Scott asked them to vote for him.

When Gold Peak learned of the post, it disqualified Mr. Peak and gave the prize to the next entrant in line. Rule 6B of the “Take the Year Off” contest provides that

contestants were prohibited from obtaining votes by “offering prizes or other inducements to members of the public, vote farming, or any other activity that artificially inflates such finalists’ votes as determined by sponsor in its sole discretion.”

Mr. Scott has defended his action by saying that the people who voted for him were real people and that he did not use robotics or Facebook accounts. An expert on sweepstakes agrees: “In my opinion, that’s not cheating if those are real people who aren’t being induced.” Is Mr. Scott correct? Did he cheat?

9. Heinz Ketchup holds 54% of the U.S. ketchup market, and nine of every 10 restaurants feature Heinz ketchup. However, Heinz has learned that many restaurant owners simply refill Heinz bottles with cheaper ketchup, thereby capitalizing on the Heinz name without the cost. One restaurant owner explains, “It’s just ketchup. The custom- ers don’t notice.” There are no specific health regulations that apply, and owners are not breaking the law by refill- ing the bottles. Do you think this practice is ethical?

10. Gerald Grinstein, the former CEO of Delta Air Lines, refused to take any bonuses, stock options, or extra compensation for 2006 and instead would take only his base salary of $338,000. Grinstein arranged to have $1 bil- lion distributed to about 39,000 nonunionized employees and 1,000 managers within 12 to 15 months after the air- line emerged from bankruptcy. “I’m the dawning of the old age,” was the comment the 74-year-old CEO made when asked why he was taking such an unprecedented step.31 Grinstein is giving up an estimated $10 million. He also added, “Corporate pay packages have gotten out of control. It has become a salary derby out there.” Grinstein still arranged to have bonuses for top executives if they hit certain profit targets and explained, “You have got to have a program that attracts executives but at the same time you’ve got to take care of the relationships with frontline employees.”32 Apply the various schools of social responsi- bility to Mr. Grinstein and decide which he followed. Think about the regulatory cycle’s application to the issue of CEO pay. What do you think regulators will do?

Economics, Ethics & the Law Self-Interest vs. Selfishness

Adam Smith, in what has been called the seminal work on free-market economics, wrote, “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.”33 Self-interest, then, is what Smith believed to be the motivator for eco- nomic engagement and growth. Is there a difference between self-interest and selfishness? Where would social responsibility fit in the Smith view of the rela- tionship between ethics and economics? However,

17 years before writing Wealth of Nations, Smith wrote The Theory of Moral Sentiments and included the follow- ing observation about ethics and business: “How self- ish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others and render their happiness necessary to him though he derives nothing from it except the pleasure of seeing it.”34 What does this quote reveal about Smith’s attitudes toward social responsibility?

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Chapter 2 Business Ethics and Social Responsibility 71

n ot e S 1. There is a misdemeanor statute in Seattle that makes it illegal to cut in line in front of other drivers who are waiting to board a ferry.

2. See

3. Professor Donald McCabe of Rutgers University has conducted surveys on academic integrity for many years. His latest survey involved 4,500 student respondents nationwide. See Center for Academic Integrity at Clemson University,, for more information.

4. Jay Nordlinger, “A Tragic National Pastime,” National Review, March 9, 2015, p. 24.

5. Id.

6. Louise Story and Landon Thomas Jr., “Tales from Lehman’s Crypt,” New York Times, September 12, 2009, p. SB1.

7. Steve Stecklow et al., “Sonsini Defended HP’s Methods in Leak Inquiry,” Wall Street Journal, September 8, 2006, p. A1.

8. Tyler Kepner, “Pitcher Spurns $12 Million, to Keep Self- Respect,” New York Times, January 27, 2011, p. A1.

9. Leah Nathan Spiro, “The Bomb Shelter Salomon Built,” BusinessWeek, September 9, 1991, pp. 78–80.

10. Richard A. Oppell Jr., New York Times, December 18, 2014, p. A17.

11. Susan Page, USA Today, October 6, 2014, p. 4A.

12. Catherine Yang and Amy Barrett, “In a Stew over Tainted Meat,” BusinessWeek, April 12, 1993, p. 36.

13. Jonathan McEvoy, “Career Cheat Still Playing the Game As He Performs Dark Arts for Oprah,” The Daily Mail, January 18, 2013, article-2264334/Lance-Armstrong-interview-He-glinteye-cocky- smirk-Jonathan-McEvoy.html, last visited October 8, 2013.

14. Sue Reisinger, “Runaway Train Hits H-P’s GC,” National Law Journal, December 18–25, 2006, pp. 8–9.

15. From “Interview: Milton Friedman,” Playboy, February 1973. © 1973 Playboy.

16. Mr. Milken was required by the Securities and Exchange Commission to pay a fine for his involvement in the negotiations (see Chapter 18).

17. Mr. Wagner is referring to Ivan Boesky, another financier who served a prison sentence; Ron Perelman, the chairman of Revlon, Inc.; Barry Diller, former chairman of Paramount and Fox and owner of the Home Shopping Network; Rupert Murdoch, the media mogul who now owns Fox. Jenny Anderson, “The Drexel Diaspora,” New York Times, February 6, 2005, 3-1, Money & Business.

18 Yuri Mishina et al., “Why ‘Good’ Firms Do Bad Things: The Effects of High Aspirations, High Expectations, and Prominence on the Incidence of Corporate Illegality,” 53 Academy of Management Journal 701 (2010).

19 Jonathan D. Rockoff, “J&J Lapses Are Cited in Drugs for Kids,” Wall Street Journal, May 27, 2010, p. B1.

20. For complete information about BP’s presence in Alaska and its contribution to the economic base there, go to http://

21. Chris Woodward, Paul Davidson, and Brad Heath, “BP Spill Highlights Aging Oil Field’s Increasing Problems,” USA Today, August 14, 2006, pp. 1B, 2B.

22. Jeff Bennett and Siobhan Hughes, “GM Officials Ignored Alert on Car Stalling,” Wall Street Journal, June 19, 2014, p. B1.

23. Peter Elkind, “How the Ice Cream Maker Blue Bell Blew It,” Fortune, September 25, 2015.

24. Julie Creswell and Vikas Bajas, “A Mortgage Crisis Begins to Spiral, and the Casualties Mount,” New York Times, March 5, 2007, pp. C1, C4.

25. For a summary of the state legislation on predatory lending practices, see Therese G. Franzén and Leslie M. Howell, “Predatory Lending Legislation in 2004,” 60 Business Lawyer 677 (2005).

26. Barnaby J. Feder, “An Abrupt Departure Is Seen as a Harbinger,” New York Times, May 1, 2002, pp. C1, C2.

27. Linda Shiner, “Sully’s Tale,” Air and Space, February 18, 2009, interview-sullys-tale-53584029/#xJyMTVCWUvi7pc7e.99.

28. Anne Marie Squeo and Andy Pasztor, “U.S. Probes Whether Boeing Misused a Rival’s Documents,” Wall Street Journal, May 5, 2003, pp. A1, A7.

29. Andrew Backover, “Report Slams Culture at WorldCom,” USA Today, November 5, 2002, p. 1B.

30. regarding-ncaa-report-72610.

31. Annual report for 1998, posted at http://www.worldcom .com. (Note: Because WorldCom no longer exists, company information can be found only in the Edgar database at http://

32. Bernard Ebbers’s letter to shareholders in the annual report for 1999, posted at (Note: Because WorldCom no longer exists, information about the company can be found only in the Edgar database at http://www.sec. gov.)

33. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Book 1, Chapter 2, Paragraph 2, Edited by Edwin Cannan. Chicago: University of Chicago Press, 1976. Accessed online March 5, 2010, at / library/Smith/smWN.html.

34. The Theory of Moral Sentiments (1759). Part 1, Section 1, Chapter 1, Paragraph 1, Edited by D. D. Raphael and A. L. Macfie. Oxford: Clarendon Press; New York: Oxford University Press, 1976. Accessed online March 5, 2010, at http://www.

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The Judicial System3 Our introduction to law included discussions of statutory law and common law. With so many statutes at so many levels, you perhaps might think that statutory law is a complete source of law. However, sometimes statutes need interpretation. Someone must determine when, how, and to whom statutes apply. Statutory law is not even half of all the law. The bulk of the law is found in judicial decisions. These decisions contain statutory interpretations and common law. This chapter covers the parties involved in these decisions, as well as the courts that make them—what they decide, when they can decide, and how those decisions are made.

Update For up-to-date legal news, go to

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3-1 Types of Courts All U.S. court systems include two different types or levels of courts: trial courts and appellate courts.

3-1a trial Courts

A trial court is the place in the judicial system where the facts of a case are presented. This court is where the jury sits if the case is a jury trial. Here the evidence and witnesses are presented and the first decision in the case is made, by either judge or jury. The procedures for trials and trial courts are covered in Chapter 4.

3-1b appellate Courts

At least one other court, an appellate court, reviews the conduct during the trial of the judge, the lawyers, the witnesses, and the jury. This process of review helps assure that the lower court applied the law correctly and followed the rules of procedure. Further, this review system provides uniformity. In some appeals, the appellate court issues published opinions, which can then be referred to and used as resources in deciding future cases. However, in many cases the appellate court issues unpublished opinions. Unpublished opinions have become a controversial issue, and although no law prohibits citing such opinions, a cite should always make clear that the opinion is an unpublished one.

3-2 How Courts Make Decisions 3-2a the process of Judicial Review

Appellate courts do not hold trials. Rather, they review what has been done by trial courts to determine whether the trial court, also referred to as the lower court, made an error in applying the substantive or procedural law in the case through the process of judicial review.

The atmosphere in the appellate court is different from that of the trial court. No witnesses, no jury, and no testimony play a role. No new evidence is considered; only the evidence presented at trial is reviewed. The court reviews a transcript of

Hard Candy is a Florida company that sells nail polish and women’s cosmetics throughout the United States. The singer Madonna owns a company called Hard Can- dy Fitness that was created in Delaware and operates out of California. Hard Candy Fitness operates fitness centers throughout the world and sells a line of exercise gear under the company name. Hard Candy filed suit

against Hard Candy Fitness, Madonna, and her holding companies for trademark infringement. Madonna, a California resident, was only in Florida for two concerts and did not sell any of her company’s products while there or mention the centers or their products at her concerts. Can a Florida court force Madonna to defend the suit in Florida?

Consider . . . 3.1

For as thou urgest justice, be assured thou shalt have justice, more than thou desirest. Portia The Merchant of Venice, Act IV, Scene I

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74 part 1 Business: Its Legal, Ethical, and Judicial Environment

the trial along with all the evidence presented at trial to determine whether an error was made.

In addition to the transcript and evidence, each of the parties to a case can pres- ent the appellate court with a brief, which is a summary of the case and the legal issues being challenged on appeal. The appellate brief is each side’s summary of why the trial court decision or procedures were correct or incorrect. The parties make their arguments for their positions in the brief and support them with stat- utes and decisions from other cases. The brief serves as a summary of the major points of error the parties allege occurred during the trial. This type of brief, called an appellate brief, is very detailed. In fact, many refer to “briefs” as a misnomer because they are generally quite lengthy. Note that these briefs differ from the case brief presented in Exhibit 1.1.

Many appellate courts permit the attorneys for the opposing parties to make timed oral arguments in their cases. An oral argument is a summary of the points that have been made in each party’s brief. The judge can also ask questions of the attorneys at that time. At the trial level, one judge makes all decisions. At the appel- late level, more than one judge reviews the actions of the lower court in a case. The typical number is three, but, in the case of state supreme courts and the U.S. Supreme Court, the full bench of judges on the court hears each case. For example, in U.S. Supreme Court decisions, all nine justices review the cases before the Court unless they have recused (disqualified) themselves because of some conflict.

The panel of appellate judges reviews the case and the briefs, hears the oral argument, and then renders a decision. The decision in the case could be unani- mous or could be a split vote, such as 2 to 1. In the case of a split vote, a justice who is not in the majority will frequently draft a dissenting opinion, which is the judge’s explanation for a vote different from that of the majority.

Checking for error A reversible error is one that might have affected the outcome of the case or influ- enced the decision made. Examples of reversible errors include the refusal to allow some evidence to be admitted that should have been admitted, the refusal to allow a particular witness to testify, and misapplication of the law.

When a reversible error has been made, the appellate court reverses the lower court’s decision. However, in some cases, the appellate court will also remand the case, which means the court sends the case back to the trial court for further pro- ceedings. For example, when the court orders a reversal because some evidence should have been admitted that was not, the case is remanded for a new trial with that evidence admitted (i.e., allowed).

If the appellate court does not find a reversible error, it simply affirms the deci- sion of the lower court. The fact that a decision has been affirmed does not mean no mistakes were made at the trial; rather, it means that none of the mistakes was a reversible error. The appellate decision is written by a member of the court who has voted with the majority. The decision explains the facts and the reasons for the court’s reversal, remand, or affirmation.

In some appellate cases, the court will modify the decision of a lower court. The full case is neither reversed nor affirmed; instead, a portion or portions of the case are reversed or modified. For example, a trial court verdict that found a defen- dant negligent might be affirmed, but the appellate court could also hold that the damages awarded were excessive. In this type of decision, the case is remanded for a redetermination of damages at the trial court level.

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Chapter 3 The Judicial System 75

Statutory Interpretation In addition to checking for error, appellate courts render interpretations of statutes. Often, statutes seem perfectly clear until a new factual situation not covered by the statute arises.

3-2b the doctrine of Stare Decisis Judicial review by appellate courts of lower court decisions provides the database for the doctrine of stare decisis, a Latin term meaning “let the decision stand.” The decisions of the appellate courts are written and often published so that they may be analyzed, reviewed, and perhaps applied in the future.

Setting precedent When reviewing the decisions of lower courts, courts examine their own previous decisions, along with decisions of other courts on the same topic. This process of examining other decisions for help in a new case uses case precedent, which is the doctrine of stare decisis. Judges examine all prior cases in the same area of law or related to a statute to determine whether the issue has already been decided and, if so, whether the current case should be decided in the same way. Following case precedent does not mean similar cases will be decided identically; several factors influence the weight given to precedent.

the Quality of precedent Where the case originated is one of the factors that influence the use of precedent in a case. In federal courts, precedent from other federal courts is strongest when the case involves federal issues.

In state courts, prior decisions within a particular state’s own court system are given greater weight than decisions from other states’ courts. One state’s courts are not obliged to follow the precedent of another state’s courts; they are free to examine it and use it, but, as with all precedent, it is not a mandatory requirement to follow another state’s decisions.

the purposes of precedent The purposes of precedent are the same as the purposes of law. Law offers some assurance of consistency and reliability. The judiciary recognizes these obligations in applying precedent. Stability and predictability are necessary in the way law functions. No exact formula applies when deciding a case, but consistency is a key element in the use of precedent.

In addition to consistency, however, judges must remember the law’s need for flexibility. As new twists in facts arise and technology develops, the judiciary must adapt the law to those changes. For example, the courts have issued a number of decisions on copyright infringement in this era of YouTube and segments of mov- ies and TV shows being reproduced and posted there.

the Interpretation of precedent Using precedent involves more than just finding similar cases. Every case decision has two parts. One is the actual rule of law, which technically is the precedential part. However, judges never offer just a rule of law in a case. The rule of law is given at the end of the case decision after a full discussion of reasoning and prece- dent. This discussion is called the dicta of the case, which includes case precedent of benefit to each party. In some instances, the rule of law may benefit one party while the dicta benefit the other party.

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76 part 1 Business: Its Legal, Ethical, and Judicial Environment

A dissenting opinion is dicta and is often quoted in subsequent cases to urge a court to change existing precedent. Application of precedent is not a scientific pro- cess, and it often leaves much room for interpretation and variation.

Then a third-year law student, Andrew Rausa was spending July 4 with some friends on the porch or stoop area of one of the brown- stone homes in Brooklyn, New York. The area in front of the brownstone is enclosed in a fence with a gate entry. Mr. Rausa and his friends were also enjoying several rounds of beer. Two police officers came by, noted the group inside the wrought-iron fence, and cited them all for drinking in public. Mr. Rau- sa looked up the code section on his phone and found that a public place for purposes of the “no drinking in public” code provision was defined as:

[one] to which the public or a substantial group of persons has access, including, but not limited to a park, sidewalk, or beach.

There are exceptions for neighborhood block parties and events covered by per- mits. The group of friends decided to fight the violations because they did not want them to be part of their permanent records. How should the court interpret the code provision? Consider the following questions in interpretation. What if you were drink- ing in your house, but your front door was open? A window?

Consider . . . 3.2

When precedent Is Not Followed Precedent may not be followed for several reasons. Some of those reasons have already been given: the precedent is from another state, or the prece- dent is interpreted differently because of the dicta in that precedent. Precedent is also not followed when the facts of cases can be “distinguished,” which means that the context of the facts in one case is different enough from those in other cases that the precedent cannot be applied. For example, suppose that a court decided that using roadblocks to stop motorists to check for drunk drivers is constitutional. Another court then decides that using roadblocks just to check for drivers’ licenses is not constitutional. The first case can be distinguished because of the purpose of the roadblocks: to prevent a hazard- ous highway condition. The court may not see the same urgency or safety issue in roadblocks used for checking for drivers’ licenses. The precedent can be distinguished.

The theories of law discussed in Chapter 1 may also control whether precedent is applied. Courts struggle with issues of fact and law and with changes in society as they apply precedent and consider modifications.

For example, a court may not follow a precedent because of an ethical reason or because of the need to change the law on the basis of what is moral or what is right. A precedent may also be abandoned on an economic theory; in this case, the court changes the law to do the most good for the most people. For example, a factory may be a nuisance because of the noise and pollution it creates, and ample case law probably supports shutting down the factory as a nuisance. However, the factory may also be the town’s only economic support, and its shutdown will mean unemployment for virtually the whole town. In balancing the economic fac- tors, the nuisance precedent may not be followed or it may be followed in only a modified way.

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Chapter 3 The Judicial System 77

3-3 Parties in the Judicial System (Civil Cases) 3-3a plaintiffs

Plaintiffs are the parties who initiate a lawsuit and are seeking some type of recov- ery. In some types of cases, those who initiate the court action are called petitioners (such as in an action for divorce). Plaintiffs file their suits in the appropriate court, and this filing step begins the litigation process.

3-3b defendants

Plaintiffs seek recovery from defendants, who are named in the suit as having committed some violation of the law or the rights of the plaintiff. Another name for a defendant is respondent.

3-3c Lawyers

In most cases, each of the parties is represented by a lawyer. Lawyers have other functions besides representing clients in a lawsuit. Many lawyers offer “preven- tive” services. Lawyers draft contracts, wills, and other documents to prevent legal problems from arising. One role that lawyers play is advising clients in advance in order to minimize clients’ legal problems and costs.

The attorney–client relationship is a fiduciary one that carries a protected privi- lege. The attorney is expected to act in the best interests of the client and can do so without the fear of having to disclose the client’s thoughts and decisions. The attor- ney–client privilege keeps the relationship confidential and assures that others (even an adversary in a lawsuit) have limited access to lawyer–client conversations. One of the key areas of discussion and debate, under Sarbanes-Oxley (SOX), related to corpo- rate lawyers’ duty to report fraud and other financial misdeeds of their client compa- nies. Lawyers were concerned about the need for client confidentiality, and regulators and investors were concerned that lawyers have remained silent as financial frauds have been ongoing in companies. Under the law, lawyers are not required to blow the whistle on their clients, but they are required to take steps to notify the audit commit- tee and board about misconduct and ultimately resign if the conduct is not changed and rectified. (For more details of the role of general counsel, the privilege, and audi- tors’ responsibilities regarding financial fraud, refer to Chapters 8, 17, and 18.)

Under the American Bar Association’s Model Rules for Professional Responsibil- ity, attorneys are obligated to represent clients with persuasive force. An attorney who agrees to represent a client must represent that client to the best of the lawyer’s ability. Because of the privilege, many lawyers know that their clients actually did commit a crime or breach a contract. However, the client’s confession to an attorney is confi- dential. Even with knowledge of a client’s guilt, an attorney must represent the client in a manner that gives the client all rights and protections under the law. There is a difference between a client’s confession to a crime and the proof required for convic- tion of that crime. A lawyer’s obligation is to see that the other side meets its burdens and responsibilities in proving a case against the client. Lawyers do represent guilty people. Their role is to, as many lawyers phrase it, “keep the system clean.” Protect- ing the rights of the guilty is required in order to ensure that the rights of the inno- cent are also preserved. However, lawyers are not required to remain silent under the privilege if a client is about to commit a crime. A lawyer representing a client accused of murder cannot disclose that the client confessed. However, a lawyer whose client vows to kill someone must make a disclosure in order to prevent a crime.

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78 part 1 Business: Its Legal, Ethical, and Judicial Environment

Lawyers and their titles and roles vary from country to coun- try. Great Britain and most of Canada have solicitors and barristers. Solicitors prepare legal documents, give legal advice, and represent clients in some of the lesser courts. Barristers are the only “lawyers” who can practice before higher courts and administrative agencies. Quebec and France have three types of lawyers: the avocat, who can practice before the higher courts and give legal advice; the notaire, who can handle real property transactions and estates and can pre- pare some legal documents; and the juriste (legal counselor), who can give advice and prepare legal documents. In Germany, a law- yer who litigates is called Rechtsanwalt, and a lawyer who advises clients but does not appear in court is called Rechtsbeistand. Japan has only one class of lawyers, called Bengosh, but does have the Shiho-Soshi, a type of advanced notary with the authority to incor- porate companies, prepare documents, and create wills. In Italy, the two types of lawyers—whose roles are similar to those in the dual British system—are avocati and procuratori.

For the Manager’s Desk

Re: the privilege of Lawyers

To whom does the attorney–client privilege belong? An attorney who is employed as general counsel for a corporation, or a lawyer representing that corporation in a particular matter, owes a duty to the corporation. The cor- poration, in those circumstances, is the client. Employees are not. The privilege, therefore, applies to corporate client communications. Even though officers and employees provide the attorney with the information about what the corporation did, the lawyer does not rep- resent those officers and employees. In most situations, the interests of the officers and employees are the same as those of the cor- poration, and a lawyer can work closely with the officers and employees to represent the corporation. However, in some circumstanc- es the corporation’s interests are different from those of the employees. For example, suppose that a general counsel for a corpo- ration learned that its officers had engaged in price-fixing. (See Chapter 8 for more discus- sion of criminal prosecutions of officers of a corporation and Chapter 14 for discussion of price-fixing and antitrust violations.) The gen- eral counsel would discuss the issue with the board (see Chapters 17 and 18) and perhaps

conclude that it is best to disclose what has happened to the Justice Department. The officers involved might object, but they are not protected by any privilege with the cor- poration’s attorney. The attorney is protecting a client, the company, by disclosing the mis- conduct and perhaps providing assurance that the board was unaware of the price-fixing, which would then reduce any penalties the company might be required to pay.

The issue of client confidentiality also exists when employees discuss information, issues, and possible legal claims with cor- porate counsel. For example, in Schaeffer v Gregory Village Partners, L.P., 78 F. Supp. 3d 1198 (N.D. Cal. 2015), the general counsel talked with a consultant for the company who was handling corporate communications about contamination of neighboring homeowners’ property. The consultant received confidential information about the situation, and in litigation the homeowners tried to force the consultant to testify. The court held that the consultant was the equivalent of an employee and disclo- sure of information did not waive the privilege because employees can discuss issues with corporate counsel without fear of disclosure.

Be careful to protect your lawyer–client privilege. Business letters and memos to lawyers should be marked as privileged and include limitations on access to those letters and memos. If you reveal information to someone other than your lawyer, you may lose your privilege on that information. Holding a conversation or meeting with your lawyer with others present may cost you your privilege, too. Privileged communications should be with your lawyer(s) only.

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Chapter 3 The Judicial System 79

3-3d Judges

Judges control the proceedings in a case and, in some instances, the outcome. Trial judges control the trial of a case, from presiding over the selection of a jury to rul- ing on evidence questions. (See Chapter 4 for more details on trial procedures.) Appellate judges review the work of trial court judges. They do not actually hear evidence. Rather, they review the record of the case to determine whether there has been reversible error.

Judges are selected in various ways throughout the country. Some judges are elected to their offices. Some states have merit appointment systems wherein judges are appointed on the basis of their qualifications. In some states, judges are appointed by elected officials subject to the approval of the legislature. In some states with appointed judges, the judges are put on the ballot every other year (or at some other interval) for retention; voters in these states do not decide whom they want as judges but do decide whether they want to keep them once they are in office. Federal judges are appointed for life by the president with Senate approval.

3-3e Name Changes on appeal

The lawyers and the parties stay in the “game” even after a case is appealed. However, the names of the parties do change on appeal. The party appealing the case is called the appellant. Some courts also call the party appealing a case the petitioner. The other party (the one not appealing) is called the appellee or respondent.

Some states change the name of the case if the party appealing the case is the defendant. For example, suppose that Smith sues Jones for damages in a car acci- dent. The name of the case at trial is Smith v Jones. Smith is the plaintiff, and Jones is the defendant. If Smith wins the case at trial and Jones decides to appeal, Jones is the appellant, and Smith is the appellee. In some courts, the name of the case on appeal becomes Jones v Smith. Other courts leave the case name the same but still label Jones the appellant and Smith the appellee.

3-4 The Concept of Jurisdiction Courts are found at every level of government, and every court handles a different type of case. In order for a court to decide or try a particular case, both parties to the case and the subject matter of the case must be within the established powers of the court. The established powers of a court make up the court’s jurisdiction. Juris means law, and diction means to speak.

Jurisdiction is the authority or power of a court to speak the law. Some courts can handle bankruptcies, whereas others may be limited to traffic vio- lations. Some courts handle violations of criminal laws, whereas others deal only with civil matters. The subject matter of a case controls which court has jurisdiction. For example, a case involving a federal statute belongs in a fed- eral district court by its subject matter; however, federal district courts are found in every state. In personam jurisdiction, or jurisdiction over the person, controls which of the federal district courts will decide the case. Determining which court can be used is a two-step process; subject matter and in personam jurisdiction must fit in the same court.

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80 part 1 Business: Its Legal, Ethical, and Judicial Environment

3-5 Subject Matter Jurisdiction of Courts: The Authority over Content

The two general court systems in the United States are the federal court system (see Exhibit 3.1) and the state court system.

3-5a the Federal Court System

the trial Court of the Federal System The federal district court is the general trial court of the federal system. However, federal district courts are limited in the types of cases they can hear; that is, their subject matter jurisdiction is limited. Federal district courts can hear three types of cases: those in which the United States is a party, those that involve a federal ques- tion, and those that involve diversity of citizenship.

Jurisdiction When the United States Is a party Any time the U.S. government is a party in a lawsuit, it will want to be tried in its own court system—the federal system. The United States is a party when it brings suit or when it is the defendant named in a suit. For example, many busi- nesses have brought suit against the Department of Health and Human Services, a federal agency, regarding the constitutionality of that agency’s rules related to the implementation of Obama Care, the nickname given to national health care reform. Because an agency of the federal government is the defendant in the case, the federal district court has exclusive jurisdiction over the suits.

Federal Jurisdiction for a Federal Question The federal district court also has jurisdiction over cases involving federal ques- tions. For example, if a business is suing for treble damages (a remedy of three times the amount of damages experienced) under the federal antitrust laws

Exhibit 3.1 the Federal Court System

*For example, the Federal Trade Commission (FTC) or the National Labor Relations Bureau (NLRB).

U.S. Supreme Court

U.S. Courts of Appeals

Federal District Courts

Specialty Courts

U.S. Claims Court

Administrative Agencies


U.S. Court of International


Bankruptcy Court

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Chapter 3 The Judicial System 81

(see Chapter 14) the case involves a federal question and may be brought in fed- eral district court. A suit charging a violation of the Equal Protection Clause of the U.S. Constitution (see Chapter 5 for more details) also involves a federal question and can be brought in federal district court. Prosecutions for federal crimes also involve federal questions, and the United States will be a party as the prosecutor; these criminal cases are tried in federal district court.

Many federal questions can also be heard by a state court. For example, most state constitutions include the same Fifth Amendment protections included in the U.S. Constitution. A plaintiff often has a choice between federal and state court, and the decision to proceed in one forum as opposed to the other may be a strate- gic one based on the nature of the case, rules of procedure, and other factors related to differences between the two court systems.

Jurisdiction by diversity Most of the civil cases in federal district court are not there because they are federal questions or because the United States is a party. Most civil cases are in federal district court because the plaintiff and defendant are from different states and their case involves damage claims in excess of $75,000. Cases in which the parties are from different states qualify for diversity of citizenship status, and federal district courts have the authority to hear these diversity cases. That authority is not exclu- sive; a state court can also hear diversity cases as long as neither party chooses to exercise the right to a federal district court trial. In diversity cases, state and fed- eral courts have concurrent jurisdiction. Concurrent jurisdiction means that two courts have the authority to hear a case. By contrast, exclusive jurisdiction means that only one court has the authority to hear the case. For example, federal dis- trict courts have exclusive jurisdiction over cases in which the United States has charged an individual or corporation with a federal crime.

Federal courts decide controversies among citizens of different states for rea- sons that go back to fears about state court judges giving preferential or favorable treatment to citizens of their state, as opposed to nonresident parties. If the case is held in one side’s state court, that side might have an unfair advantage or built-in prejudice because of the location of the court.

When corporations are parties to suits, the diversity issue is more complex. The citizenship of a corporation can be its state of incorporation or the state in which its principal office is located. This citizenship test is used for subject matter juris- diction. The citizenship test for in personam jurisdiction has been greatly expanded.

It is important to understand that when a federal court tries a case on the basis of diversity, it is simply trying the case under the same state laws but without the local prejudice that might exist in a state court. In other words, federal courts do not rule under a different set of laws; they simply apply the state law in a different setting.

Limited Jurisdiction: the Special trial Courts of the Federal System Not all cases in which the United States is a party or in which a federal question is involved are decided in federal district courts. The federal system also has spe- cialized trial courts to handle limited matters. For example, the jurisdiction of the Tax Court in the federal system is limited to tax issues. If you challenge the Internal Revenue Service because it would not allow one of your deductions, your case would be heard in Tax Court. The bankruptcy courts make up a well-used lim- ited court system within the federal system and have exclusive jurisdiction over all bankruptcies. No other court can handle a bankruptcy or bankruptcy issues, and bankruptcy courts do not handle any other type of trial or suit.

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82 part 1 Business: Its Legal, Ethical, and Judicial Environment

The U.S. Claims Court is another specialized federal court: it handles disputes that involve government contracts and other claims against the federal govern- ment, such as eminent domain issues. (See Chapter 5 for more discussion of emi- nent domain and “takings.”)

The U.S. Court of International Trade is a specialized court that focuses on international trade transactions regulated by federal agencies in various ways and also on customs issues.

Another court that is often discussed along with the federal system is the Indian Tribal Court. This court, the court of the Native American nations, has exclusive jurisdiction over criminal and civil matters on the reservations. Indian tribal courts are unique because of their limited jurisdiction and their exclusivity, which arises from their sovereign nature.

the Structure of the Federal district Court System Each state has at least one federal judicial district. The number of federal districts in each state is determined by the state’s population and caseload. States such as Wyoming and Nevada have only one federal district each, whereas states such as Illinois and New York have many. The number of courts and judges in each federal district is also determined by the district’s population and caseload. Even in those states with just one district, the district has several judges and multiple courtrooms for federal trials. Ninety-four federal districts serve the 50 states, the District of Columbia, Puerto Rico, Guam, the Virgin Islands, and the Northern Mariana Islands.

the Importance of Federal district Court decisions The subject matter of cases that qualify for federal district court jurisdiction is important. These cases involve the interpretation of federal statutes and often the resolution of constitutional issues. Because of the importance of these decisions, the opinions of federal district judges are published in a reporter series called the Federal Supplement, which reprints most opinions issued by federal district judges in every federal district. (Decisions of the Court of International Trade are also found in the Federal Supplement.) Cases in the Federal Supplement provide excellent precedent for interpretation and application of federal statutes. In addition to the system for citing statutes (see Chapter 1), a specific system is used for citing case opinions. Such a sys- tem is necessary so that precedent can be found easily for use in future cases.

All case cites consist of three elements: an abbreviation for the reporter, the vol- ume number, and the page number. The abbreviation for the Federal Supplement is “F. Supp.” or, for the second series, after volume 999, “F. Supp. 2d,” or, the third series, “F. Supp. 3d.” The volume number always appears in front of the abbre- viation, and the page number appears after it. A formal cite includes in parenthe- ses the federal district in which the case was decided and the year the case was decided. A sample federal district court cite of a case that dealt with an eminent domain question looks like this:

Sansotta v Town of Nags Head, 97 F. Supp. 3d 713 (E.D.N.C. 2014)

This method of uniform citation not only helps ease the burden of research but also provides an automatic way to know where a case came from and how it can be used.

the appellate Level in the Federal System Cases decided in federal district court and the specialized trial courts of the federal system can be appealed. These cases are appealed to the U.S. Courts of Appeals (formerly called the U.S. Circuit Courts of Appeals).

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Chapter 3 The Judicial System 83

Structure. All of the federal district courts are grouped into federal circuits according to their geographic location. Exhibit 3.2 is a map that shows the 13 fed- eral circuits. Note that 11 of the circuits are geographic groupings of states; the twelfth circuit is the District of Columbia, and the thirteenth is a nongeographic circuit created to handle special cases, such as those involving patent disputes and issues and appeals from the Court of Claims and Court of International Trade. Some scholars and members of Congress have proposed creating a fourteenth cir- cuit by dividing the very large Ninth Circuit.

Each circuit has its own court of appeals. The office of the court’s clerk is located in the city named in each of the federal circuits in Exhibit 3.2. The number of judges for each of the federal circuits varies according to caseload. However, most cases are heard by a panel of three of the circuit judges. It is rare for a case to be heard en banc (by the “whole bench,” meaning all the judges in that circuit). One of the more famous cases to be heard en banc following a three-judge panel deci- sion involved a father’s challenge to his child being required to recite the Pledge of Allegiance because the phrase “under God” was in the pledge: Elk Grove Unified School Dist. v Newdow, 292 F.3d 597 (9th Cir. 2002) and 313 F.3d 500 (9th Cir. 2002) with en banc rehearing denied, 328 F.3d 466 (9th Cir. 2003).1

Procedures. The U.S. Courts of Appeals are appellate courts and operate by the same general procedures discussed earlier in the chapter. An appeal consists of a

Exhibit 3.2 the 13 Federal Judicial Circuits



























































3 6










Puerto Rico

Virgin Islands

D.C. Circuit

Federal Circuit



Washington, D.C.

Washington, D.C.

Legend Circuit boundaries

State boundaries

District boundaries

Location of U.S. Court of Appeals


Maryland Delaware

New Jersey


Connecticut Rhode Island Massachusetts

New Hampshire

New York


Northern Mariana Islands


New York


District of Columbia Washington, D.C. Richmond

New Orleans



St. Louis

Denver San


Source: Administrative Ofˆce of the United States Courts.













New Mexico





So. Dakota

No. Dakota Minnesota




Georgia Alabama

So. Carolina

No. Carolina

Virginia W. Va.





Indiana Illinois





Source: A dministrative Office of the U.S. Courts.

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84 part 1 Business: Its Legal, Ethical, and Judicial Environment

record of the trial in the court below (here, the federal district court), briefs, and possible oral argument. The standard for reversal is reversible error. Because the right of appeal is automatic, the appellate courts have tremendous caseloads. A full opinion is not given in every case. In the cases that are affirmed, the opinion may consist of that one word. Other decisions are issued as memorandum opinions for the benefit of the parties but not for publication.

Opinions. The opinions of the U.S. Courts of Appeals are published in the Fed- eral Reporter. The system of citation for these cases is the same as for federal dis- trict court opinions. The abbreviation for the Federal Reporter is “F.” (or sometimes “F.2d” or “F.3d”; the “2d” means the second series, which was started after the first “F” series reached volume 300, and this series is now followed by a third series— “F.3d”). A formal cite includes in parentheses the federal circuit and date of the decision. A sample U.S. court of appeals cite, the appeal of a case challenging the constitutionality of Obama Care mandates on coverage follows:

Little Sisters of the Poor Home for the Aged, Denver, Colo. v Burwell 794 F.3d 1151 (10th Cir. 2015)

the U.S. Supreme Court A decision by a U.S. court of appeals is not necessarily the end of a case. One more appellate court is part of the federal system—the U.S. Supreme Court. However, the Supreme Court’s procedures and jurisdiction are slightly different from those of other appellate courts.

Appellate Jurisdiction and Process. The Supreme Court handles appeals from the U.S. courts of appeals. This appeal process, however, is not an automatic right. The Supreme Court must first decide whether a particular case merits review. That decision is announced when the Court issues a writ of certiorari for those cases it will review in full. The Supreme Court, in its writ, actually makes a preliminary determination about the case and whether it should be decided. Only a small num- ber of cases appealed to the Supreme Court are actually heard. In 1945, 1,460 cases were appealed to the Court. By 1960, that number had grown to 2,313. Now the number averages about 7,000 each year with fiscal year 2012 (the latest year avail- able from the Court), having 7,713 cases. The court grants certiorari in about 100 cases and hears oral arguments and issues written opinions in about 70 to 80 cases. All of the Supreme Court opinions issued in one year total about 5,000 pages, including the majority, concurring, and dissenting opinions.

The court grants writs of certiorari in cases as a matter of discretion. Certiorari may be granted because of a conflict among the circuits about the law, such as the differ- ing decisions among the circuits on the constitutionality of Obama Care, or because the case presents a major constitutional issue, such as with corporate political dona- tions. This writ of certiorari procedure also applies to other sources of appellate cases, such as those coming up through state supreme courts, which can be appealed to the U.S. Supreme Court. For example, in 2015, the U.S. Supreme Court granted certiorari in a case in order to clarify the relationship between state arbitration waiver statutes and the Federal Arbitration Act (DirectTV, Inc. v Imburgia, 136 S.Ct. 463 (2015)). The plaintiff in the case, DirectTV, was granted certiorari because it argued that the Fed- eral Arbitration Act superseded any state law that allowed consumers to opt out of arbitration. The U.S. Supreme Court granted certiorari for purposes of clarifying the federal law and preemption issues on mandatory arbitration clauses.

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Chapter 3 The Judicial System 85

The U.S. Supreme Court also acts as a trial court (called a court of original juris- diction) in certain cases. When one state is suing another state, the U.S. Supreme Court becomes the states’ trial court. For example, the water dispute among Cali- fornia, Arizona, Colorado, and Nevada has been tried over a period of years by the U.S. Supreme Court. The Court also handles the trials (on espionage charges, for example) of ambassadors and foreign consuls.

Structure. The U.S. Supreme Court consists of nine judges, who are nominated as justices to the Court by the president and confirmed by the Senate. The appoint- ment is for life. A president who has the opportunity to appoint a Supreme Court justice is shaping the structure of the Court and the resulting decisions. U.S. Supreme Court justices are often labeled “conservative” or “liberal.” The makeup of the bench controls the philosophy and decisions of the Court.

Opinions. Because the Court is the highest in the land, its opinions are precedent for every other court in the country. The importance of these opinions has resulted in three different volumes of reporters for U.S. Supreme Court opinions. The first is the United States Reports (abbreviated “U.S.”). These reports are put out by the U.S. Government Printing Office and are the official reports of the Court. Because these reports are often slow to be published, two private companies also publish opin- ions in the Supreme Court Reporter (abbreviated “S. Ct.”) and the Lawyer’s Edition

For the Manager’s Desk

The following chart, organized by federal cir- cuits, shows the percentage of lower court

decisions the U.S. Supreme Court reversed in 2014.

CIRCUIt CaSeS takeN CaSeS ReveRSed ReveRSaL Rate

1st 1 0 0%

2nd 1 1 100%

3rd 3 3 100%

4th 6 3 50%

5th 8 6 75%

6th 5 4 80%

7th 3 3 100%

8th 8 7 88%

9th 16 10 63%

10th 4 3 75%

11th 5 5 100%

D.C. Federal Circuit 6 5 83%

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86 part 1 Business: Its Legal, Ethical, and Judicial Environment

(abbreviated “L. Ed.” or “L. Ed. 2d”). The three-part cite for Citizens United v Federal Election Com’n (the Court’s decision on corporate speech during elections) follows:

558 U.S. 310 (2010) 130 S.Ct. 876 (2010) 175 L. Ed. 2d 753 (2010)

3-5b the State Court Systems

Although each state court has a different structure for its court system and the courts may have different names, the basic structure in each state is similar to the federal system. Exhibit 3.3 provides a diagram of a sample state court system.

State trial Courts Each state has its own general trial court. This court is usually called a circuit, dis- trict, county, or superior court. It is the court in which non-diversity civil cases are heard and state criminal cases are tried.

In addition to its general trial court, each state also has its own group of “lesser courts.” They are courts with limited jurisdiction and are comparable to the spe- cialty courts of the federal system. For example, most states have a small claims court in which civil cases with minimal damage claims are tried. In a true small claims court, attorneys are not used. Parties represent themselves before a judge. Such a setting offers parties the chance to have a judge arrive at a solution without the expense of attorneys. The amount recoverable in small claims court is indeed small: $200 to $25,000 is the typical range.

Most states also have a lesser court that allows the participation of lawyers but limits the amount that can be recovered. The idea is to take the burden of lesser cases away from the usually overburdened general trial courts. These courts are called justice of the peace courts or county courts.

Most cities also have their own trial courts, which are limited in their jurisdiction to the trial of lesser crimes, such as violations of city ordinances. Many states call these courts traffic courts because city ordinances involve so many traffic regulations.

Exhibit 3.3 typical State Court System

Trials de novo

City Courts

Probate Courts

Justice of the Peace or

County Courts

Small Claims Courts

General Trial Courts (Circuit, District, County)

State Courts of Appeals

State Supreme Courts

Lesser Courts

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Chapter 3 The Judicial System 87

In addition to these courts, some states have specialized courts to handle mat- ters that are narrow in their application of law but frequent in occurrence. For example, although probating (processing) a will and an estate involves narrow issues of law, the supply of this type of case is constant. Many states have special courts to handle this and related matters, such as guardianships for incompetent persons.

Many of the lesser courts allow appeals to a general state trial court for a new trial (trial de novo) because not all judges in these lesser courts are lawyers, and constitutional protections require a right of de novo appeal in those situations.

State appellate Courts State appellate courts serve the same function as the U.S. courts of appeals. The court system provides an automatic right of review in these courts. Some states have two appellate-level courts to handle the number of cases being appealed. The opinions of these courts are reported in the state’s individual reporter, which contains the state’s name and some indication that an appellate court decided the case. For example, state appellate decisions in Colorado are reported in Colorado Appeals Reports (abbreviated “Colo. App.”). These opinions are also reported in a regional reporter. All states are grouped into regions, and opinions of state appel- late courts are grouped into the reporter for that region. Exhibit 3.4 presents the various regions and state groupings. For example, Nevada is part of the Pacific region, and its appellate reports are found in the Pacific Reporter (abbreviated “P.,”

Exhibit 3.4 National Reporter System Regions

paCIFIC (p. oR p.2d)

NoRthWeSteRN (N.W. oR N.W.2d)

NoRtheaSteRN (N.e. oR N.e.2d)

SoUtheaSteRN (S.e. oR S.e.2d)










New Mexico










North Dakota

South Dakota


Southwestern (S.W. or S.W.2d)









(New York)


Atlantic (A. or A.2d)



District of Columbia



New Hampshire

New Jersey


Rhode Island



North Carolina

South Carolina


West Virginia

Southern (So. or So.2d)





Note: California and New York each have their own reporter system. Source: The national reporter system was developed by West Publishing Company. Reprinted with permission of West Publishing Company.

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88 part 1 Business: Its Legal, Ethical, and Judicial Environment

“P.2d,” or “P.3d”). The following is a sample regional reporter cite, a case that deals with UCC warranties:

Wyman v Ayer Properties, 11 N.E.3d 1074 (Mass. 2014).

State Supreme Courts State supreme courts are similar in their function and design to the U.S. Supreme Court. These courts do not hear every case because the right of appeal is not auto- matic. These supreme courts have some discretion in deciding which cases they will hear. State supreme courts also act as trial courts in certain types of cases and so are also courts of original as well as appellate jurisdiction. For example, if two counties within a state have a dispute, the state supreme court would take the trial to ensure fairness. A state supreme court’s decision is not necessarily the end because there is the possibility of an appeal to the U.S. Supreme Court if the case also involves a federal question or an issue of constitutional rights.

The opinions of state supreme courts are significant and are reported in the regional reporters discussed earlier. Many states also have their own reporters for state supreme court opinions. For example, California has the California Reporter. The state supreme court reporters are easily recognized because their abbrevia- tions are the abbreviation of each state’s name. The following is the cite from the California decision on the arbitration clause that the U.S. Supreme Court eventu- ally heard and decided:

DirectTV, Inc. v Imburgia 170 Cal. Rptr. 3d 190 (Cal. 2014)

3-5c Judicial opinions

Although the published opinions of the courts just discussed vary in their places of publication, the format is the same. Exhibit 3.5 shows a sample page from a reporter, with each part of the excerpt identified. Opinions are reported consis- tently in this manner so that precedent can be found and used easily through the research keys highlighted at the beginning.

3-5d venue

The concept of jurisdiction addresses the issue of which court system has the authority to try a case. The concept of venue addresses the issue of the location of the court in the system. For example, a criminal case in which a defendant is charged with a felony can be tried in any of a state’s general trial courts. Heavy media coverage, however, may result in a judge’s changing the venue of a case from the place where the crime was committed to another trial court in an area where there is less publicity about the case and it is easier to obtain an impar- tial jury. However, the bar is a tall one for establishing the need for a change of venue. In Skilling v U.S., 561 U.S. 358 (2010), the U.S. Supreme Court held that the daily and ongoing coverage of Enron’s collapse and the role of former CEO Jef- frey Skilling in that collapse were not enough to require that Mr. Skilling’s trial for criminal fraud be moved from Houston, where the company was headquartered, to another federal court in Texas or outside the state.

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Chapter 3 The Judicial System 89

Exhibit 3.5 Sample page of a Case in a National Reporter

Chapter 3 The Judicial System 93

CASTEEL v STATE Cite as 131 P.3d 1 (Nev. 2006)

Dion Fabion CASTEEL, Appellant, v

The STATE of Nevada, Respondent. No. 42436.

Supreme Court of Nevada. March 30, 2006.

Rehearing Denied May 17, 2006. Reconsideration en banc Denied

June 12, 2006. Background: Defendant was convicted in the Eighth Judicial District Court, Clark County, Joseph T. Bonaventure, J., of 10 counts of sexual assault of a minor and 12 counts of use of a minor under age of 14 in production of pornography. He appealed. Holdings: The Supreme Court, Maupin, J., held that: 1. consent to search of apartment given

by defendant’s live-in girlfriend authorized police ofŽcers to search apartment;

2. girlfriend had authority to consent to ofŽcers’ search of defendant’s gym bag;

3. trial court’s Žndings supported its conclusion that defendant was not in custody for Miranda purposes when he was interrogated by ofŽcer; but

4. defendant could be convicted only of four counts of use of a minor under age of 14 in production of pornography.

AfŽrmed in part, reversed in part, and remanded.

1. Searches and Seizures 177 Consent to search of apartment given

by defendant’s live-in girlfriend autho- rized police ofŽcers to search apartment; girlfriend had equal control over apart- ment, which she shared with defendant. U.S.C.A. Const.Amend. 4.

2. Criminal Law 1139 Appellate court reviews the lawfulness

of a search de novo because such a review requires consideration of both factual circumstances and legal issues. U.S.C.A. Const.Amend. 4.

3. Searches and Seizures 177 A warrantless search is valid if police

ofŽcers acquire consent from a cohabitant who possesses common authority over the property to be searched. U.S.C.A. Const.Amend. 4.

4. Searches and Seizures 186 Defendant’s live-in girlfriend had

authority to consent to police ofŽcers’ search of his gym bag, which was located in closet inside apartment that he shared with girl- friend; girlfriend gave ofŽcers valid consent to search apartment, and defendant appar- ently took no special steps to secure privacy interest in gym bag and did not deny girl- friend all access to apartment, given that both girlfriend and minor victim knew con- tents of gym bag and knew that it could be found in closet. U.S.C.A. Const.Amend. 4.

5. Searches and Seizures 177 A warrantless search is valid based on

the consent of one occupant, despite the physical presence of the nonconsenting occupant. U.S.C.A. Const.Amend. 4.

Philip J. Kohn, Public Defender, and Sharon G. Dickinson and Jordan S. Savage, Deputy Public Defenders, Clark County, for Appellant.

George Chanos, Attorney General, Carson City; David J. Roger, District Attorney, James Tufteland, Chief Deputy District Attorney, and Ross J. Miller, Deputy District Attorney, Clark County, for Respondent.



In this appeal, we hold that a warrant- less search of a residence is valid based on the consent of one occupant where the other occupant fails to object. We also resolve questions concerning custody for purposes of Miranda v Arizona.1 Finally, we conclude that only 4 counts of production of child pornography may stand because the State failed to prove production depict- ing separate sexual performances.

case name

decision issue

research tool

docket number

decision of the court


case name

case cite

judge deciding case

attorneys for parties


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90 part 1 Business: Its Legal, Ethical, and Judicial Environment

3-6 In Personam Jurisdiction of Courts: The Authority over Persons

Once the proper court for the subject matter in a case is determined, only half the job is done. For example, a case may involve a million-dollar claim between citizens of different states, in which case a federal district court has subject matter jurisdiction over the parties. So which of the 94 federal district courts will hear the case? The case will be heard by the federal district court with in personam jurisdiction over the parties. Subject matter jurisdiction is one issue; the other jurisdictional issue is power over the parties involved in the case.

The various criteria for determining in personam jurisdiction are examined here and are outlined in Exhibit 3.6.

3-6a ownership of property within the State

A party who owns real property in a state is subject to the jurisdiction of that state’s courts for litigation related to that property. Actually, this type of jurisdiction gives the court authority over the person because the person owns a thing in the state. Technically, this type of jurisdiction through property ownership is called in rem jurisdiction.

3-6b volunteer Jurisdiction

A court has jurisdiction over a person who agrees to be subject to that court. In some contracts, for example, the parties agree that any lawsuits will be brought in the seller’s state. The seller’s state courts then have jurisdiction over that volunteer buyer. Most Internet contracts have a venue clause.

3-6c presence in the State

The third and final way a state court can take jurisdiction is by the “presence” of a party in the state, which is determined by different factors.

Residence Individuals are present in a state if they have a residence in that state. Differ- ent definitions of residency are used for tax and election laws, but the require- ment here is simply that the person live in the state some time during any given year.

Corporations are residents of the states in which they are incorporated. A cor- poration is also a resident, for purposes of judicial jurisdiction, of any state in which it has a business office with employees.

“Minimum Contacts” Both corporations and residents can be subject to a state court’s jurisdiction if they have “minimum contacts” in that state. The standard for minimum contacts is a fairness standard, which was established by the U.S. Supreme Court in Inter- national Shoe v Washington, 326 U.S. 310 (1945). This decision requires states to notify out-of-state defendants of a suit and determine that those defendants have some contact with the state. Such contact can come through the voluntary acts

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Chapter 3 The Judicial System 91

of shipping products or advertising products or services in the state. The courts look at the extent of involvement in the state as a standard for fairness. However, fairness does not require an office or an employee in the state. These standards for in personam jurisdiction are more liberal than the citizenship requirements for diversity actions.

Long-arm Statutes: the tools of Minimum Contacts In order to follow the Supreme Court’s ruling on fairness, all of the states have adopted long-arm statutes. These statutes are appropriately named: they give courts the power to extend their “arms of jurisdiction” into other states. For exam- ple, suppose that Zeta Corporation is incorporated in Ohio and has its manufac- turing plant there. Zeta ships its glass baking dishes to every state in the country, although it has no offices anywhere except in Ohio. Joan Berferd, who lives in Alabama, is injured when one of Zeta’s baking dishes explodes. Can the Ala- bama courts allow Berferd to file suit there and require Zeta to come to Alabama to defend the suit? Yes, because a long-arm statute is fair if it covers businesses shipping products to the state. Zeta entered the Alabama market voluntarily and must be subject to the Alabama courts. Long-arm statutes generally cover busi- nesses with offices in the state, businesses shipping products into the state, and businesses that cause a tort to be committed in that state.

Hard Candy, LLC v Hard Candy Fitness (Case 3.1) deals with a long-arm issue and provides an answer for the chapter’s opening “Consider …”

Exhibit 3.6 personal Jurisdiction





Business Of�ce

Minimum Contacts

Standards of Justice and Fair Play

Products in State

Marketing Plan

Long Arm Statute

Ownership of Property within the State

Volunteer Jurisdiction

Presence in the State


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92 part 1 Business: Its Legal, Ethical, and Judicial Environment

Hard Candy, LLC v Hard Candy Fitness 106 F. Supp. 3d 1231 (S.D. Fla. 2015)

A Hard Decision on Madonna’s Hard Candy Fitness Company

Case 3.1


Hard Candy is a Florida limited liability company with its principal place of business in Hollywood, Florida, that began with “Hard Candy” nail polish in 1995. Around that time, Hard Candy filed a U.S. trademark application for the nail polish. Some time later, they filed other applications under the name “Hard Candy” for cosmetics, including lipstick, lip liner, and mascara. Hard Candy’s products are sold in Wal-Mart retail stores and on Wal-Mart’s website. Since 1997, Hard Candy has also operated a website at www.hardcandy. com, on which Hard Candy currently displays its prod- ucts with a link to Wal-Mart’s website.

Hard Candy Fitness (HCF) is a network of luxury fitness clubs operated by Hard Candy Fitness, LLC (“HCF”), a Delaware limited liability company with its principal place of business in California. HCF’s clubs are located worldwide, but there has never been a club in Florida. NEV Hard Candy Fitness, LLC (“NEV-HC”) (a Delaware limited liability company) and MGHCandy (a Delaware limited liability company and owner of HCF) with its principal place of business in California, along with New Evolution Ventures, LLC (“NEV”) (a Delaware limited liability company with its principal place of business in California), are businesses associ- ated with Madonna Louise Ciccone, popularly known as Madonna.

Ciccone (a resident of New York) has Guy Oseary (a resident of California) as MGHCandy’s “senior man- agement representative.” Additionally, Oseary and Sara Zambreno have provided personal management services to Ciccone since around 2005, first as employ- ees of Guyo Entertainment, Inc., and later in affiliation with third-party Live Nation. Although in some cir- cumstances Oseary and Zambreno must consult with Ciccone before making decisions on her behalf, as a general matter both have considerable discretion to manage Ciccone’s affairs without her input.

In November 2008, NEV filed with the U.S. Patent and Trademark Office for use of the mark “Hard Candy Fitness” for “[h]ealth club services.” The “Hard Candy Fitness” mark was used for the first time over two years later. On October 12, 2011, MGHCandy granted HCF a license to use the mark “Hard Candy Fitness” in connection with the operation of fitness clubs, the sale

of related products, and the marketing and promotion of the clubs and products. In May 2014, MGHCandy assigned to HCF its rights in the unregistered mark “Hard Candy” for use on clothing, bags, jewelry, athletic gear, and accessories. All of these companies, Ciccone, Oseary, and Zambreno are the Defendants.

Hard Candy filed suit in Florida for infringement of the Hard Candy Marks by Hard Candy Fitness through the clubs, the apparel, the website, and the Hard Candy Fitness DVD, entitled Addicted to Sweat.

Madonna and her companies (Defendants) filed a motion to dismiss or, in the alternative, to transfer venue to the Northern District of California.


ALTONAGA, District Judge The Florida long-arm statute recognizes two kinds of per- sonal jurisdiction over a nonresident defendant: specific jurisdiction and general jurisdiction. The statute confers specific jurisdiction over a non-resident defendant if the claim asserted against the defendant arises from the defen- dant’s forum-related contacts (i.e., contacts with Florida). The statute expressly provides a defendant’s contacts may be based not only on the defendant’s personal activities, but also on the actions of the defendant’s agents. Hard Candy relies on this agency theory of jurisdiction.

To establish a defendant is “carrying on business” under the Florida long-arm statute, “the activities of the defendant must be considered collectively and show a general course of business activity in the state for pecuniary benefit. Relevant factors in this analy- sis include “the presence and operation of an office in Florida . . . , the possession and maintenance of a license to do business in Florida . . . , the number of Florida clients served . . . , and the percentage of overall revenue gleaned from Florida clients.”

The Defendants conduct significant business in this District by selling Hard Candy Fitness products and services here, both in stores and via the internet; MGH- Candy “actively participates in all of HCF’s decisions related to the use of the mark ‘Hard Candy,’ and the aesthetics of the mark and the products.” [MGHCandy, Ciccone,] and Oseary approve and control all aspects of the use of the mark “Hard Candy,” including the

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Chapter 3 The Judicial System 93

“artistic content,” aesthetics and images related to the use of the mark. Their approval and control rights spe- cifically include the Addicted to Sweat DVD—from its creation, sale and marketing, to the content and cover— the locations for new fitness centers, and the scope of “Hard Candy Fitness” branded services and products, including apparel, sunglasses, bags, t-shirts and more.

“Generally, a foreign parent corporation is not subject to the jurisdiction of a forum state merely because a subsidiary is doing business there.” A sub- sidiary’s contacts may, however, be imputed to the foreign parent, and therefore potentially subject the parent to personal jurisdiction, “if the subsidiary is merely an agent through which the parent company conducts business in a particular jurisdiction or [the subsidiary’s] separate corporate status is formal only and without any semblance of individual identity.” This agency theory of personal jurisdiction is “not . . . limited to a parent-subsidiary relationship,” but rather may extend to other relationships, such as the relation- ship between members of a limited liability company and the company.

The fact the parent approves major policy decisions of the subsidiary and establishes the subsidiary’s goals and directives is not sufficient to render the subsidiary merely a formality. Similarly, operational control does not exist simply because the parent monitors the sub- sidiary and advises it when necessary.

According to Richard Feldstein, who provides business and accounting services to MGHCandy and Ciccone, MGHCandy was formed for the following purposes: (1) allowing Ciccone and Oseary to hold ownership interests in MGHCandy; (2) fulfilling obli- gations and receiving benefits pursuant to the HCF Operating Agreement; (3) facilitating the transfer of intellectual property rights to HCF; and (4) engaging in other necessary and incidental activities.

The limited purposes for which MGHCandy was formed reflect the limited role MGHCandy plays in HCF.

Ciccone provided input regarding: “(1) the individ- ual names used for the DVDs in the set; (2) the DVD descriptions included on the back of the DVD covers; (3) the wording of the quote attributed to Ciccone on the cover of the DVDs; and (4) the title that should be given to the dancer in the DVD, Nicole Winhoffer.” Ciccone also selected the final DVD cover artwork as well as the final color scheme and layout (including images) for the rest of the DVD artwork. Ciccone also viewed a “sizzle reel” highlighting portions of the DVD’s content, but she never viewed the entire DVD. Ciccone was “only concerned with [her own] image on the cover of the DVD,” and she did not otherwise take part in any approval process regarding how the DVD was advertised, presented, or sold.

When they do discuss HCF-related matters, the issues are “more aesthetic, approving a color of some- thing in a gym, approving flooring.” Indeed, Ciccone approved certain HCF merchandise, including shirts, sunglasses, water bottles, a gym bag, and a pen.

In 2012 and 2013, Live Nation and one of Ciccone’s business entities collaborated to produce a worldwide concert tour. As part of the arrangement, Live Nation— not Ciccone—scheduled and produced the concerts and manufactured and sold merchandise with the “Hard Candy” mark. In late November 2012, Ciccone per- formed two of those concerts in Miami, Florida, but she did not promote HCF or HCF-related goods or services at her concerts, nor did she attend a special event held in Miami around the time of her concerts to promote the ATS DVD. Ciccone has not directly sold concert tickets or merchandise in connection with the concerts she has performed with Live Nation over the past five years.

Strictly construing the Florida long-arm statute, and making all reasonable inferences in favor of Hard Candy, the Court finds the Defendants’ Florida contacts relating to the asserted causes of action are too tenuous to support specific jurisdiction over the Defendants.

The reach of general jurisdiction under the Florida long-arm statute “extends to the limits on personal juris- diction imposed by the Due Process Clause of the Four- teenth Amendment. . . . Corporations are considered “at home” in their place of incorporation and principal place of business. Corporations may be subject to the exercise of general jurisdiction in other places as well, but the Due Process Clause imposes a high standard: “the inquiry . . . is not whether a foreign corporation’s in-forum contacts can be said to be in some sense ‘continuous and system- atic,’ it is whether that corporation’s ‘affiliations with the State are so ‘continuous and systematic’ as to render [it] essentially at home in the forum State.’” Defendants, MGHCandy, LLC, Guy Oseary, and Madonna Louise Ciccone are dismissed from this action. The request to transfer this case to a different venue is granted.


1. Develop a chart showing the various companies involved along with the people and locations for doing business.

2. Explain when Madonna was in Florida and why her presence was not enough to allow jurisdiction.

3. What kinds of activities would have subjected Madonna and her companies and agents to Florida jurisdiction?

4. Why do you think it is so important for Hard Candy to have Madonna and one of her compa- nies as defendants?

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94 part 1 Business: Its Legal, Ethical, and Judicial Environment

3-6d Internet Companies and Long-arm Jurisdiction

One of the active areas of in personam jurisdiction involves the question of when companies that do business solely over the Internet can be required to travel to a state to defend a lawsuit that is the result of their sales of goods in that state. In making the determination of jurisdiction, courts look at five factors: (1) the nature and quality of the contacts with the state, (2) the quantity of contacts with the state, (3) the relation of the suit to the contacts, (4) the interest of the state in allowing its residents to recover, and (5) the convenience of the parties. These factors are

Ethical Issues

Evaluate the ethics of Hard Candy Fitness in its infiltration of the Florida market using the similar name.

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Strategic Geography on Courts and higher damages

Business Strategy

Not all states have the same laws, not all jurors see issues the same way, and not all courts are as fussy about experts and evidence as others. Businesses must know where to go, court-wise, in order to maxi- mize the results of their litigation.

Companies that purchase patents and file suit against large corporations for infringement have favored the Eastern Dis- trict of Texas (Tyler and Marshall, Texas) for their suits for the past decade because those who live in this area (including lawyers and jurors) believe in patents in the same way they believe in oil and gas rights. If you find it, you own it, and all the rights and royalties that come with that ownership. Most cases filed there are settled because everyone involved understands the area dynamics. If a case does go to trial, the verdicts are Texas-size. Versata Software

recovered $345 million from SAP following a patent infringement trial held in Marshall, Texas. That verdict is the 10th largest in pat- ent infringement history. When Microsoft lost its Eastern District of Texas court case to I4i, it paid $200 million in damages.

There are also geographical differences in how product liability cases are viewed. Philadelphia, Pennsylvania, is a favorite for product liability plaintiffs because the court there is known for its “rocket docket” (fast-moving cases) and because Pennsyl- vania places no limits on damage claims in product liability suits.

Businesses and individuals have learned to choose their courts’ locations very care- fully. As seen in these examples, geography matters in results.

Source: Susan Decker, “A Crackdown on Patently Absurd Lawsuits,” BusinessWeek, May 14–20, 2012, 33. ©

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Chapter 3 The Judicial System 95

applied differently, but Internet immunity seems to be winning the day. For exam- ple, in Sioux Transportation, Inc. v XPO Logistics, LLC, 2015 WL 9412930 (D. Ark. 2015), the court refused to allow personal jurisdiction over an out-of-state com- pany whose employee had posted allegedly defamatory information about the plaintiff company on an industry website.

3-7 The International Courts The decisions of international courts provide precedent for parties involved in international trade. However, one of the restrictions on international court decisions is that the decision binds only the immediate parties to the suit on the basis of their factual situation. International courts do not carry the enforce- ment power or authority of courts in the U.S. federal and state systems. They are consensual courts and are used only when the parties agree to use them.

The International Court of Justice (ICJ) is the most widely known international court. It was first established as the Permanent Court of International Justice (PCIJ) in 1920 by the League of Nations. In 1945, the United Nations (UN) changed the name and structure of the court. The ICJ is made up of judges, no more than two of whom can be from the same nation, who are elected by the General Assembly of the UN. The court has been described as having contentious jurisdiction, which is

Marcus Gray brought suit in Missouri against Kathryn Elizabeth Hudson, aka Katy Perry, for her alleged infringement of his gospel song, “Joyful Noise,” with her song, “Dark Horse.” “Joyful Noise” was written and published five years prior to Ms. Perry’s song.

Ms. Perry is a resident of California and has been to Missouri twice for concerts. “Dark Horse” can be purchased on a web- site established by Ms. Perry’s business- es, and the website has many customers in Missouri. Ms. Perry has challenged the Missouri federal court’s jurisdiction over her for purposes of the suit. What should the court do?

Steps for Analyzing This Case Study


1. Determine how much of a presence Ms. Perry had in Missouri.

2. List the contacts she had with Missouri.

3. Determine whether there will be any suit or remedy if the case must be moved to California.

APPLY: Ms. Perry did travel to Missouri for a concert. Ms. Perry and her compa- nies do sell CDs and songs for download- ing through her website to residents of Missouri. However, Ms. Perry does not have a continuing presence in Missouri and does not have offices there. The Hard Candy case from earlier in the chapter pro- vides guidance on this issue. If the case is not heard in Missouri, Mr. Gray will have to pursue the case in California, and he may not have the means to pursue the case there.

ANSWER: The facts of this case do not provide a sufficient basis for granting ju- risdiction over Ms. Perry. She cannot be required to come to Missouri to defend the suit. [Gray v Hudson, 2015 WL 4488143 (E.D. Mo. 2015)]

Consider . . . 3.3

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96 part 1 Business: Its Legal, Ethical, and Judicial Environment

to say that the court’s jurisdiction is consensual: when a dispute occurs, the parties can agree to submit the dispute to the ICJ.

In addition to the ICJ, other international courts include the European Union’s Court of Justice of European Communities and the European Court of Human Rights, as well as the Inter-American Court of Human Rights. Jurisdiction in these courts is also consensual.

The decisions of these courts and decisions from individual countries’ courts dealing with international law issues can be found in International Law Reports.

In recent years, London’s Commercial Court, established more than 100 years ago, has become a popular forum for the resolution of international com- mercial disputes. Over half the cases in this court involve foreign enterprises. Some companies choose London’s Commercial Court as the forum for their dis- putes for several reasons, even though neither they nor their transactions have any connection with England. First, the court has the advantage of being a neu- tral forum. Second, for U.S. firms, the use of the English language in the court is important. Third, the court has a wide range of experience in international dis- putes, from shipping contracts to joint trading ventures. Fourth, the judges on the court were all once commercial litigators themselves and bring their depth of experience to the cases. Fifth, the court is known for its rapid calendar, mov- ing cases along quickly. Major cases are heard within one year from the ser- vice of summons. Finally, the court has used a variety of creative remedies. The Commercial Court has issued pretrial injunctions to freeze assets, and its ties to the English government afford the injunctions international recognition. Per- haps the most famous of the Commercial Court’s cases is its handling of the 20 class actions against Lloyd’s of London.

3-7a Jurisdictional Issues in International Law

The jurisdiction of courts within a particular country over businesses from other countries is a critical issue in international law. A common subject in international disputes is whether courts in the United States, for example, can require foreign companies to defend lawsuits within the United States.

3-7b Conflicts of Law in International disputes

The courts and judicial systems of countries around the globe vary, as do the procedural aspects of litigation. For example, Japan has no discovery process that permits the parties to examine each other ’s documents and witnesses prior to trial (see Chapter 4 for more details on discovery and the Japanese court system), and the United States permits lawyers to collect contingency fees and also permits broader tort recovery than would be available in most other countries.

Because of liberal discovery and recovery rules in the United States, many plaintiffs injured in other countries by products manufactured by U.S.-based firms want to bring suit in the United States to take advantage of our judicial system’s processes and rules. However, the California Supreme Court has ruled in Stangvik v Shiley, Inc., 819 P.2d 14 (Cal. 1991), that if a plaintiff’s home coun- try provides an adequate forum for a dispute, the case cannot be brought in the United States. The suit involved family members of various patients who had died when their heart valves, manufactured by Shiley of Irvine, Califor- nia, failed. The decision of the California Supreme Court required the plaintiffs

With national and international business transactions becoming so frequent, many con- tracts now include “fo- rum selection” claus- es. These portions of a contract stipulate that if litigation is required, a particular court in a particular state or country will have jurisdiction over both parties. For example, a franchisor might have the forum selection clause provide that all litigation by franchi- sees would be in the state and city where the franchisor’s prin- cipal office is located. Checking a contract carefully for these clauses will enable you to decide, before signing, whether you want to agree to travel to another state or country if litigation be- comes necessary.

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Chapter 3 The Judicial System 97

Biographythe Judges and their Words

The judges who handle trials and appeals often find themselves dealing with seri- ous statutory interpretations and legal issues even as they are faced with whim- sical factual patterns. Below are some sample excerpts from judicial opinions that illustrate the tall order judges have in managing their courtrooms and in issuing their wisdom, precedent, and decisions.

That golfers do not always hit their golf balls straight is a matter of common knowledge; it is a fact that needs no supporting evidence, a principle that needs no citation of authority. Geddes v Mill Creek Country Club, Inc., 751 N.E.2d 1150 (Ill. 2001)

A child’s belief in Santa Claus or Spi- derman does not make the child’s testimony about his real-life experi- ences unreliable. Harris v Thompson, 698 F.3d 609 (7th Cir. 2012)

When confronted with a situation involving a juror who appears to have fallen asleep during trial, counsel has a duty to bring the matter to the attention of the trial court and the trial court has a duty to awaken the juror. Mathis v State, S.E.2d 308 (Ga. 2013)

Discharge of sworn juror based on purported misconduct, because other jurors had complained that juror emitted a foul body odor and was flatulent, was improper, where trial court failed to conduct inquiry, especially where defense counsel objected. People v Westbrook, 576 N.Y.S.2d 372 (N.Y. App. Div. 1991)

Juror note sent during delibera- tions, asking for the opportunity to thank all concerned for privilege of serving, mentioning breakup of her marriage and her view that the male lawyer who sat in second chair at the prosecution table was a “Cutie,” and asking to be given that lawyer’s telephone number when trial was over, did not require the juror’s disqualification; trial judge inter- viewed the juror in counsel’s pres- ence, explained to her that the note was inappropriate, and obtained her assurance that nothing, including her favorable impression of a prose- cutor, would prevent her from being fair to both sides. People v Lewie, 953 N.E.2d 760 (N.Y. 2011)

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to return to their home countries, where the recovery would be substantially less. The courts have continued to favor litigation in the home country of the plaintiffs despite hardships. Martinez v E.I. DuPont Nemours and Company, 86 A.3d 1102 (Del. 2014), and Auffret v Capitales Tours, S.A., 2013 WL 1749895 (Cal. App. 2013).

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98 part 1 Business: Its Legal, Ethical, and Judicial Environment

What is the judicial process?

• Judicial review—review of a trial court’s decisions and verdict to determine whether any reversible error was made

• Appellate court—court responsible for review of trial court’s decisions and verdict

• Brief—written summary of basis for appeal of trial court’s decisions and verdict

• Reversible error—mistake by trial court that requires a retrial or modification of a trial court’s decision

• Options for appellate court:

• Reverse—change trial court’s decision

• Remand—return case to trial court for retrial or reexamination of issues

• Affirm—uphold trial court’s decisions and verdict

• Modify—overturn a portion of the trial court’s verdict

• Stare decisis—Latin for “let the decision stand”; doctrine of reviewing, applying, and/or distin- guishing prior case decisions

• Case opinion—written court decision used as precedent; contains dicta or explanation of rea- soning and, often, a minority view or dissenting opinion

Who are the parties in the judicial system?

• Plaintiffs/petitioners—initiators of litigation

• Defendants/respondents—parties named as those from whom plaintiff seeks relief

• Lawyers—officers of the court who speak for plaintiffs and defendants

• Attorney–client privilege—confidential protections for client conversations

• Appellant—party who appeals lower court’s decision

• Appellee—party responding in an appeal

What factors decide jurisdiction?

• The power of the court to hear cases

• Subject matter jurisdiction—authority of court over subject matter

• Jurisdiction over the parties: in personam jurisdiction

• Voluntary

• Through property

• Presence in the state: minimum contacts

• Residence

• Business office

What are the courts and court systems?

• Federal court system

• Federal district court—trial court in federal system; hears cases that involve a federal ques- tion, the United States as a party, or a plaintiff and defendant from different states (diversity of citizenship) and $75,000 or more at issue; opinions reported in Federal Supplement

• Limited jurisdiction courts—bankruptcy courts, court of claims

• U.S. Courts of Appeals—federal appellate courts in each of the circuits; opinions reported in Federal Reporter

• U.S. Supreme Court—highest court in United States; requires writ of certiorari for review; acts as trial court (original jurisdiction) for suits involving states and diplomats

• State court system

• Lesser courts—small claims, traffic courts, justice of the peace courts

• State trial courts—general jurisdiction courts in each state

• State appellate courts—courts that review trial court decisions

• State supreme courts—courts that review appel- late court decisions

• International courts

• Voluntary jurisdiction

• International Court of Justice—UN court; contentious (consensual) jurisdiction; reported in International Law Reports

• London Commercial Court—voluntary court of arbitration

s u m m a r y

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Chapter 3 The Judicial System 99

1. The brokerage firm of E. F. Hutton was charged with federal criminal violations of interstate funds transfers. In reviewing the case, the lawyers for the government discovered internal memoranda from and between branch managers in several states that outline a process for check kiting (a literal stringing together of checks and deposits) that enabled E. F. Hutton to earn interest on phantom deposits. Where will the case be tried? Which court system? Which court? Why?

What are the lawyers’ obligations with respect to the documents? What is the company’s obligation? If you were a manager at E. F. Hutton, would you voluntarily disclose the documents to the government?

2. Pharmaceutical manufacturer Merck experienced litigation over its drug Vioxx because of customers who say they had cardiovascular side effects from taking the anti-arthritis pain drug. Merck faced 9,500 lawsuits that a federal judge ruled could not be tried as class actions because of the different health issues among the plain- tiffs who were bringing the suits against Merck. A jury in a federal court in New Orleans cleared Merck of any responsibility for the death of Richard Irvin, a Florida resident who had a fatal heart attack one month after he began to take Vioxx. In 2005, Merck won one state court verdict in New Jersey and lost another state court trial in Texas. Why would some of the cases be tried in state court and some in federal court? Explain the differing decisions.

3. N-the-Water Publishing, Inc. dba Still N the Water Publishing produces hip-hop and rap music through sampling, the process of copying portions of prior mas- ter sound recordings directly onto new sound recordings and then rapping on top of the new sound recording. Bridgeport Music is the owner of the copyright for the music that Still N the Water has used for its rap and hip- hop song productions. Bridgeport is headquartered in Nashville, Tennessee, and Still N the Water is part of a series of record companies based in Florida and Texas. Bridgeport brought suit against Still N the Water in fed- eral district court in Tennessee. Under Tennessee’s long- arm statute, jurisdiction may be asserted on “any basis not inconsistent with the constitution of this state or of the United States.” [Tenn. Code Ann. § 20–2–214(a)(6)] Still N the Water sells CDs in all 50 states, with sales spread equally among the states and marketing plans for each of the states.

Can Still N the Water be required to come to Tennes- see to defend the lawsuit? [Bridgeport Music, Inc. v Still N The Water Pub, 327 F.3d 472 (6th Cir. 2003); cert. denied 540 U.S. 948 (2003)]

4. Troy Francis was driving his 2005 Mitsubishi Lancer automobile—equipped with a Bridgestone Potenza tire— on the Melvin Evans Highway on St. Croix on February 9, 2008. Francis lost control of the vehicle when the tread on the Potenza tire allegedly separated, causing the vehi- cle to leave the road and overturn. As a result, Francis suffered fractures of the neck, ribs, and forearm; a brain injury; lacerations; and disfigurement. Francis filed suit against Bridgestone for strict liability and negligence, alleging that Bridgestone negligently manufactured, engineered, designed, marketed, tested, or failed to test the tire.

Bridgestone Corporation is a Japanese corporation with its principal place of business in Tokyo, Japan. Bridgestone challenged the Court’s personal jurisdiction over it. Bridgestone argued that it does not do business in the Virgin Islands and that it does not have contacts with the Virgin Islands that would allow the Court to exercise personal jurisdiction.

Does the court have jurisdiction? Is there jurisdiction if your products end up in a particular country? How would the tires have ended up on the car? Suppose that Francis was on vacation and driving a rental car but lives in Florida. Could Florida exercise jurisdiction over the case? What would Francis have to show? [Francis v Bridgestone Corporation, 2013 WL 5276365 (D.C.V.I. 2013)]

5. Determine which court(s) would have jurisdiction over the following matters:

a. The sale of securities without first registering them with the Securities and Exchange Commis- sion, as required under 15 U.S.C. § 77 et seq.

b. A suit between a Hawaiian purchaser of sun- screen lotion and its California manufacturer for severe sunburn that resulted $65,000 in medical bills

6. Where will the following cases be tried? a. A will contest that challenges the validity of a will b. A suit by a homeowner against his building con-

tractor for $1.5 million for the failure to provide termite protection on the home the contractor built

c. A suit by a defense contractor against the U.S. Army for nonpayment on drones delivered to Iraq

7. The following rule appears in State University’s cur- rent catalog:

A course in which a grade of C or better has been earned may not be repeated. The second entry will not be counted in earned hours or grade point index for graduation.

Q u e s t i o n s a n d P r o b l e m s

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100 part 1 Business: Its Legal, Ethical, and Judicial Environment

Rod took his business math course and earned a C. Not satisfied with his grade but unaware of the catalog regulation, Rod took the math course again and this time earned a D. The registrar has entered the D grade in Rod’s cumulative average. Rod objects based on the catalog rule, but the registrar says the rule applies only if a higher grade is earned. What should Rod do? Should the grade count?

8. Patricia Baker was a passenger aboard a Royal Carib- bean Cruise Lines ship. She had purchased a ticket to participate in a mock pirate ship excursion tour in the Cayman Islands from E & H Cruises, a Cayman Islands corporation. While boarding the E & H mock pirate ship, Ms. Baker fell and was injured. She brought suit in Flor- ida federal district court against both Royal Caribbean and E & H to recover for her injuries. E & H moved to dismiss the suit because it did not do business in the United States and was not subject to U.S. courts. Ms. Baker argues that she bought the pirate excursion ticket in Florida, so E & H was doing business in the United States. Is she correct? Can E & H be required to come to the United States to defend the suit? [E & H Cruises, Ltd. v Baker, 88 So.3d 291 (Fla. App. 2012)]

9. The words “I’ve fallen and I can’t get up!” were part of a TV commercial for a device whose marketing was directed at the elderly and whose appeal was that the device was hooked to communication links with emer- gency care providers. In fact, the device provided a link,

but not a direct link, to a 911 number; some interlink delay would occur in notifying emergency personnel. The devices, worn around the neck, were in fact a means of effecting communication when the wearer could not get to a phone. However, the device was not directly linked to a 911 number.

Officials in Arizona brought charges against the com- pany for deceptive advertising. Standards in Arizona require proof only that someone could be misled by the commercials; actions against advertisers do not require proof that someone was actually misled. The devices have been a help to many people, bringing assistance to those who would otherwise, because of temporary or permanent mobility impairment, be unable to call for help. Officials in other states did not find the ads mis- leading. Does Arizona have jurisdiction?

If you were an official for the company, would you change all of your ads or modify only those in Arizona? Were the ads unethical?

10. Janice Burns purchased a crockpot from Cooking, Inc. The handles on the crockpot were designed poorly and were too small for lifting. When Janice tried to lift it from the cooking element, the pot slipped, and she was severely burned when the food fell on her legs and feet. Janice has $85,000 in medical bills plus loss of income and pain and suffering. Janice lives in Illinois. Cooking, Inc. is a Delaware corporation based in New Jersey. In which court could Janice file suit? Which state?

Ethics & the Law The Dismissal of a Lawyer

Timothy J. Mayopoulos was the general counsel for Bank of America (B of A) until shortly before its merger/acquisition of Merrill Lynch was approved by B of A shareholders. Mr. Mayopoulos was fired from his position on the day he met with the board, and the board was told that Merrill Lynch had heretofore undisclosed losses that had not been disclosed to B of A shareholders. He was escorted out of the Charlotte, North Carolina, B of A headquarters by security per- sonnel and was not permitted to return to his office and collect his belongings. The merger was approved, and the shareholders brought suit for the bank’s failure to disclose the full scope of the Merrill Lynch losses.

Mr. Mayopoulos gave testimony to New York Attorney General Andrew Cuomo, the official who had been investigating whether information about the

scope of the losses was withheld prior to the share- holder vote on the Merrill Lynch merger/acquisition. Mr. Mayopoulos, however, declined to disclose to Mr. Cuomo’s office the content of the advice he gave to the bank, citing legal ethics rules.

Mr. Cuomo asked B of A to waive “the privilege” because its refusal was hindering his office’s ability to investigate what happened in the days leading up to the merger/acquisition. B of A initially refused to waive its attorney–client privilege. However, when an SEC investigation began, the bank waived the privilege and then settled the SEC case for a $150 million fine. The shareholder litigation was settled for $2.43 billion.

B of A’s then CEO, Kenneth D. Lewis, testified that Mr. Mayopoulos was fired because B of A had more executives than it needed following the merger.

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Chapter 3 The Judicial System 101

Mr. Mayopoulos went on to become general counsel for Fannie Mae and ultimately its CEO, but, in an ironic note, Mr. Mayopoulos who lived in Charlotte, North Caro- lina, continued to live on the same street as Mr. Lewis fol- lowing his termination. The neighborhood block parties during the summer of 2009 must have been tense.

What is the lawyer–client privilege, and when does it apply? Does it apply to general counsel as well as to outside counsel? When is the privilege waived? Why do you think Mr. Mayopoulos stood so firm on his refusal

to answer questions about what happened in the days leading up to the merger and his termination? What do you think really happened in the lead-up to the merger?

For More Information Louise Story, “Bank Firing of Counsel Is Examined,” New York Times, September 9, 2009, p. C1.

Dan Fitzpatrick, “New York Nears Charges on Merrill Deal,” Wall Street Journal, September 9, 2009, p. C1.

n ot e 1. The U.S. Supreme Court ruled that Mr. Newdow lacked standing to challenge the “under God” clause in the pledge of allegiance because he was not the custodial parent of his

daughter. [542 U.S. 1 (2004)] The other cites for this case are 124 S.Ct. 2301(2004) and 159 L.Ed.2d 98(2004).

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Managing Disputes: Alternative Dispute Resolution and Litigation Strategies4 The study of business regulation to this point has involved an overview of ethics, law,  and the courts responsible for enforcing, interpreting, and applying the law. This chapter focuses on disputes and answers the following questions: How can businesses best resolve disputes? What strategies should a business follow if litigation is inevitable? How do courts proceed with litigation?

Update For up-to-date news on law, ethics, and economics, go to

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4-1 What Is Alternative Dispute Resolution? Alternative dispute resolution (ADR) offers parties alternative means of resolving their differences outside actual courtroom litigation and the costly preparation for it. ADR ranges from informal options, such as a negotiated settlement between the CEOs of companies, to the formal, written processes of the American Arbitration Associa- tion (AAA). These processes may be used along with litigation or in lieu of litigation.

4-2 Types of Alternative Dispute Resolution 4-2a arbitration

Nature of arbitration Arbitration is the oldest form of ADR and was once the most popular form of ADR, but its increasing costs and time commitment have found businesses and lawyers labeling it “no different from litigation.”1 As of 2012, arbitration cases were down, and motions to set aside arbitration awards or obtain exemptions from mandatory arbitration clauses were up.2 Mandatory arbitration clauses have even been abandoned by the American Institute of Architects (AIA), a pioneer in ADR that had the mandatory clauses in its model contract from 1888 through 2010. The AIA has moved to mandatory mediation. Bank of America has elim- inated mandatory arbitration from its credit card, bank account, and auto loan contracts. The Consumer Financial Protection Bureau has proposed eliminating arbitration in consumer credit contracts. Because of this shift in ADR, arbitration is no longer the preferred method for business dispute resolution.

The one remaining area of growth in arbitration is through state courts, which, in order to encourage ADR, now impose mandatory arbitration in all cases involv- ing amounts below a certain dollar limit, generally $25,000 to $50,000. In Arizona, these mandatory arbitration proceedings are arbitrated by lawyers in the state, who are required to accept such assignments on a rotating basis either for a fee or as part of their pro bono activities. Such mandatory arbitration requirements have reduced the civil caseloads in many states by as much as 50%.

Binding vs. Nonbinding vs. Mandatory arbitration An agreement to submit to arbitration is an enforceable clause in consumer and commercial contracts. The parties may also agree to submit to arbitration after

Pulte Homes was developing a subdivision when its grading of the land resulted in flooding of the proper- ty of adjoining landowners. The landowners brought suit against Pulte. A special master found that Pulte had deleted relevant e-mails and that its lawyers had

removed documents from a stack of documents the landowners’ lawyer had selected to copy while the land- owners’ lawyers went to lunch. What happens when parties do not disclose all evidence? Are there sanctions for destroying evidence?

Consider . . . 4.1

If I were asked where I place the American aristocracy, I should reply without hesitation that it occupies the judicial bench and bar. Alexis de Tocqueville


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104 part 1 Business: Its Legal, Ethical, and Judicial Environment

their dispute arises even though they do not have such a clause in their contract. Arbitration can be binding or nonbinding. Binding arbitration means that the decision of the arbitrators is final. Appeals of the decision are limited (see dis- cussion that follows). Nonbinding arbitration is a preliminary step to litigation. If one of the parties is not satisfied with the result in the arbitration, the case may still be litigated.

A contract can also require arbitration, something known as mandatory arbi- tration. Under mandatory arbitration, the parties cannot choose court action first. Mandatory arbitration clauses have been a focus of court challenges. However, the Federal Arbitration Act (FAA) permits mandatory arbitration in consumer contracts and has been upheld by the U.S. Supreme Court. [Green Tree Financial Corp. v Randolph, 531 U.S. 79 (2000)] Arbitration clauses can be set aside if they are included in a contract due to misrepresentation or fraud. Case 4.1, College Park Pentecostal Holiness Church v General Steel Corp., deals with an issue of whether an arbitration clause can be set aside.

College Park Pentecostal Holiness Church v General Steel Corp. 847 F. Supp. 2d 807 (D. Md. 2012)

When a Church Gets Snookered into a Building and Arbitration

Case 4.1


In December 2006, Pastor Jamil Kahn of the College Park Pentecostal Church (plaintiff) discussed by phone with Christopher Davis, an employee of General Steel Corporation (Defendants), the possible construction of a building on the Church’s property in College Park, Maryland. Davis told Pastor Kahn that General Steel would provide a “turnkey” building ready for occupancy and would handle all zoning, design, site planning, and general contracting work. General Steel faxed the contract to Kahn on January 11, 2007.

The cover page of the contract, which was marked “Urgent,” stated that the contract had to be signed that day and directed Kahn to initial the “CONDITIONS” page before faxing the document back to General Steel. The contract outlined the Church’s “STEEL BUILD- ING SPECIFICATIONS,” and farther down the page, in small block print, the contract stated, “. . .  ALL DISPUTES SHALL BE ARBITRATED PURSUANT TO PARAGRAPH 6 OF THE CONDITIONS PAGE.” Para- graph 6 provided:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be resolved by arbitration before the Judicial Arbiter Group, Inc. in Denver, Colorado. Any challenge relating to the entire agreement or any subpart thereto, arbitration of any controversy, and confirmation of any arbitration award

shall be only in Denver, Colorado. Any such challenge that relates to whether claims are arbitrable shall obli- gate the challenging party to pay the attorney’s fees and costs of defense to the non-challenging party. The party initiating arbitration shall advance all costs thereof. This agreement shall be governed by and interpreted in accordance with the laws of the State of Colorado. The Federal Arbitration Act shall govern the interpretation, enforcement, and proceedings pursuant to the arbitra- tion clause in this agreement.

On January 12, Pastor Kahn sent General Steel a check for $45,000 as a deposit. In January 2008, Pastor Kahn signed a “Building Change Order,” which added a mezzanine level to the planned building, and sent General Steel another check for $50,000. Due to the increased price of the mezzanine, however, the parties later executed a second Change Order that restored the original design of the building. General Steel never returned the $50,000.

Following payment of the deposits, General Steel informed the Church that they would provide no assistance with site planning, zoning, or construction and would only supply materials for the building. The Church demanded return of the deposits, claiming it had no intention of entering into a “materials only” contract, but General Steel refused. The Church filed suit for breach of contract.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 105

General Steel filed a motion to dismiss the suit and refer the case to arbitration, but the court requested more information in order to determine the validity of the arbitration clause, given the obvious distance, cost, and inconvenience to the Church of having to arbitrate in Colorado.

JUdiCial OpiNiON

MESSITTE, Judge Under Colorado law, an arbitration clause, as with any clause in a contract, may be invalidated if it is deemed unconscionable.

Defendants advance two arguments why the arbi- tration clause in this case should be enforced as writ- ten, neither of which the Court finds persuasive. In its supplemental brief, the Church specifically attacked the “enforceability of the arbitration clause” as “part of a multiple part analysis” that courts use in exam- ining “such issues as venue under the principle of forum non-convenience [sic].” [T]he Church assert- ed the hardship of “litigating and/or arbitrating in Colorado.” The Church’s assets included a savings account totaling $32,736.00 and a checking account, after deducting outstanding liabilities, consisting of $2,319.00. The Church received an income of approxi- mately $24,000.00 per month in donations but incurred approximately per month in $20,000.00 expenses. [T] he Judicial Arbiter Group in Denver, Colorado would charge on average $395.00 per hour for an arbitrator’s services. The Church estimated that an arbitrator would spend between twenty-six to thirty-six hours resolving this case—consisting of two days of hearings and 10 additional hours of work—for an arbitrator’s fee of approximately $14,220.00. Additional costs of arbitration would include the cost of retaining Colora- do counsel and transportation and housing expenses for a minimum of three days for at least two individ- uals representing the Church. To date, the Church’s Maryland counsel has charged only expenses for his legal representation, and has stated that he is unable to devote the time necessary to handle arbitration in Colorado. The Church has contacted several attorneys in Denver, all of whom indicated that it would take some 50 hours to handle the arbitration and draft a post-hearing memorandum. These attorneys reported on average a fee of $325.00 per hour, which would bring their fees to a total of about $17,500.00. As for travel and accommodations expenses for two Church representatives, those may be estimated at $700.00 and $1,275.00, respectively, a total of $1,975.00. Given an approximate total cost of $33,695.00 to arbitrate in

Colorado, arbitrating the dispute would effectively eliminate all of the Church’s remaining assets and likely jeopardize its continued existence. The cost of arbitration that the Church would incur if Defendants’ arbitration clause were fully enforceable can only be described as unconscionable.

Fully cognizant that Colorado public policy “strong- ly favors the resolution of disputes through arbitra- tion,” the Court concludes that some terms of the clause are indeed unconscionable and therefore unenforceable.

It is readily apparent that the arbitration clause was part of a standardized agreement executed by parties of unequal bargaining strength. General Steel sent Pas- tor Kahn the front and back of its [purchase agreement] and pressured him to sign and return it the same day he received it. The terms and conditions of the contract, including the arbitration clause, were not subject to negotiation. According to General Steel’s website, it is a “worldwide leader” in the steel building industry with “years of building design experience.” See General Steel, In contrast, from all appearances neither Kahn nor the Church possessed the least business sophistication, including experience with contracts or in the field of construction generally. Additionally, Khan conducted his discussions with Defendants without the benefit of counsel, and signed the Purchase Agreement as the Church’s representative again without the benefit of counsel. This factor weighs heavily against enforceability of the forum selection clause.

It is also clear that the Church had little time to read and familiarize itself with the Purchase Agreement before signing it. Kahn received the contract on Jan- uary 11, 2007 and was obliged to execute the contract and return it on the same day he received it. [T]he same day turn-around hardly gave the Church the opportu- nity to appreciate the significance of its terms, especial- ly the potential onerousness of having to arbitrate in Colorado should it find it necessary to challenge any aspect of Defendants’ performance.

The Court is hard pressed to conclude that it is commercially reasonable to require the representatives of a financially modest church to travel three-quarters of the way across the country to arbitrate its claims, pay Defendants’ attorneys’ fees and costs if it challenges arbitrability (whether the challenge is successful or not), and advance all costs of arbitration.

The Court [must] examine the terms of the arbitra- tion clause and determine whether they are substan- tively unfair. The Court has done so and concludes that most of the provisions are clearly lopsided in favor of Defendants. The Court finds no reason to


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106 part 1 Business: Its Legal, Ethical, and Judicial Environment

challenge the bona fides of the designated arbitrator, the Judicial Arbiter Group, Inc. But the fact remains that General Steel is located in Lakewood, Colorado. The Church is located in College Park, Maryland, over 1,400 miles away. And again, if the Church merely undertakes to challenge enforcement of any aspect of the arbitration clause, it must “pay the attorney’s fees and costs of defense to the non-challenging party,” i.e., Defendants, whether the Church prevails on the point or not.

Perhaps more important, the Church is apparently obliged to “advance all costs thereof.” In other words, even if the Church were to obtain a favorable out- come through arbitration, it would still be obligated to put forward Defendants’ fees and costs and the arbitrator’s fees and costs. Nothing in the contract allows for deferral of payments or shifting fees and costs to the losing party. Courts have expressed concern about fee-splitting provisions in arbitration clauses that require an aggrieved party to pay even one half of an arbitrator’s fees.

Defendants’ argument that hiring new counsel might not be necessary, the implication being that the Church could either appear without counsel, or that current Maryland counsel, presumably out of the goodness of his heart, could offer his services without charge, is altogether fatuous. This case is far too com- plex for the Church members to handle by themselves, and their counsel has already voiced his understand- able unwillingness to handle the arbitration in Colorado pro bono. Defendants’ contention that if Colorado counsel were needed, the Church has overestimated the average hourly rate and ignored the possibility of contingency fee arrangements, is also fatuous. Even $250.00 rather than $325.00 per hour would result in a significant sum over the projected 50 hours of attorney time. Moreover, it is highly unlikely that any Colo- rado counsel worth his or her salt would be willing to sign onto this case on a contingency basis. Finally, Defendants’ suggestion that “telephonic appearances or preservation depositions” might suffice ignores the fact that they would be clearly weak substitutes for live appearances.

The Church alleges, and Defendants have yet to deny, that the latter’s representative told Kahn that

General Steel would provide a “turnkey” building ready for occupancy and would handle all zoning, design, site planning, and general contracting work, a representation the Church maintains was totally false when made.

Finally, it does not pass notice that Defendants’ sales practices have been seriously called into ques- tion in other jurisdictions. The Church asserts that Defendants have yet again engaged in sharp dealings. Perhaps so, perhaps not. What is undisputed, however, is that as a result of signing the contract with General Steel and making the required deposits, the Church has lost $95,000, which Defendants claim is non- refundable, including—incredibly—the $50,000 depos- it the Church made for a change Defendants agree was duly cancelled.

This case involves more than just a disparity of bar- gaining strength and a “‘simple old-fashioned bad bar- gain.’” This is a case where “no decent, fair[-]minded person would view the ensuing result” of enforcement of the arbitration provisions “without being possessed of a profound sense of injustice. . . .”

Accordingly, the Court will excise the uncon- scionable provisions of the arbitration clause. The Court will STRIKE those portions of the arbitration clause (1)  designating “the Judicial Arbiter Group, Inc. in Denver, Colorado,” as the sole arbitrator for any controversy or claim; (2) declaring that “Denver, Colorado” is the only place where any challenge relat- ing to the agreement; (3) compelling the party that challenges arbitrability “to pay the attorney’s fees and costs of defense to the non-challenging party;” and (4) requiring the party “initiating arbitration” to “advance all costs thereof.”

The Court will direct that the arbitration go for- ward, but that it be held in this District, minus the described unconscionable provisions.


1. What does the court find was unconscionable about the contract and negotiations?

2. What is severed from the contract and why?

3. How will the case now proceed?

4-2b arbitration procedures

Once the parties agree to arbitrate, they usually notify the AAA (, which, for a fee, will handle all the steps in the arbitration. The AAA is the largest ADR provider in the country for commercial disputes, and the National Arbitra- tion Forum is the largest for consumer contracts.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 107

The parties submit names for arbitration, and a mutually agreeable arbitrator or panel is appointed. A hearing date is set at a mutually agreeable time. Between the time the date is set and the actual hearing, the parties have the responsibility of gathering their evidence and necessary witnesses. The parties are, in effect, doing their preparation or discovery (see pp. 120–125). The parties can also request that the other party bring certain documents to the hearing. Some arbitrators are given subpoena power in certain states; that is, they have the power to require the pro- duction of documents or to have a witness testify.

The parties need not have lawyers but have the right to use one under AAA rules. AAA rules require notification to the other parties about the use and iden- tity of counsel. Although the atmosphere is more relaxed, an arbitration hearing parallels a trial. Each of the parties has the opportunity to present evidence and witnesses. Each has the right to cross-examination and a closing statement. Some of the emotion of a trial is missing because, although emotional appeal influences juries, an expert arbitrator is not likely to be swayed by it. After the close of the hearing, the arbitrator has 30 days to make a decision.

In binding arbitration, the arbitrator’s award is final. The award and decision cannot be changed, modified, or reversed. Only the parties can agree to have the case reopened; the arbitrator cannot do so. The courts are strict in their hands-off policy on private arbitration decisions that result from the parties’ contractual agreement to submit to arbitration. The grounds for setting aside an arbitration finding under federal law are (1) the award resulted from corruption, fraud, or undue influence; (2) partiality or corruption occurred among the arbitrators; (3) the arbitrators were guilty of misconduct, which prejudiced the rights of one of the parties; or (4) the arbitrators exceeded their powers.

Re: Understanding the Disillusionment with ADR

For the Manager’s Desk

The issues lawyers raise about arbitration include the following:

• Increasingly, arbitrations are as time-consuming and costly as trials.

• Too many arbitrators are allowing extensive discovery.

• Some arbitrators are requiring $40,000 retainers just for agreeing to begin hearing a case.

• The panel of arbitrators may consist of people who, while knowledgeable in their fields, are beholden to the industry, such as an engineer siding with an engineer defendant.

Some businesses are revisiting their mandatory arbitration clauses because they are looking at some of the arbitration deci- sions and saying, “Maybe the court system isn’t so bad—at least you get due process at some point.”

The concern of many lawyers and court administrators is the loss of common law and statutory interpretation when too many cases opt for the ADR route, which does not include published decisions or rationale.

What are the theoretical benefits of arbi- tration? What are its drawbacks?

Sources: Leigh Jones, “Gotcha Game,” National Law Journal, February 11, 2011, p. 1; Michael Orey, “The Vanishing Trial,” BusinessWeek, April 30, 2007, pp. 38–39.

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108 part 1 Business: Its Legal, Ethical, and Judicial Environment

Nicholas Sharp and Barry and Rhonda Downey own adjacent tracts of land, and for almost eight years, they have been en- gaged in litigation over land and easement rights. One tract of land involved in the dis- pute was landlocked and the other was not, with the main issue being whether there was an easement for the landlocked prop- erty and where that easement would be located. At the end of the eight years, they agreed to submit their issues for binding arbitration.

The arbitrator reached a decision that resulted in the granting of an implied ease- ment to one owner but not to the owner of the landlocked property. The arbitrator found that the landlocked property did not need an implied easement. Further, the arbitrator’s decision on the location of the easement

resulted in an easement that was not actually connected on the land. When one party moved for the court to set aside the decision of the arbitrator as an “arbitrary, irrational decision in manifest disregard of the law,” the court agreed and stated that “While parties to arbitration agree to accept the arbitrator’s interpretation of the law, this does not mean that they agree to per- mit the arbitrator to fabricate the law from whole cloth.” [Sharp v Downey, 13 A.3d 1 (Md. App. 2010)] The case was appealed to the Maryland Supreme Court on the grounds that an arbitration award cannot be set aside when there are factual issues that could have influenced the arbitrator’s deci- sion. What should the Maryland Supreme Court do? [Downey v Sharp, 51 A.3d 573 (Md. 2012)]

Consider . . . 4.2

4-2c Mediation

Other forms of ADR are readily available and relatively inexpensive, especially when compared to arbitration. Mediation is one such alternative. Mediation is a process in which both parties meet with a neutral mediator who listens to each side explain its position. The mediator is trained to get the parties to respond to each other and their concerns. The mediator helps break down impasses and works to have the parties arrive at a mutually agreeable solution. Unlike an arbi- trator, the mediator does not issue a decision; the role of the mediator is to try to get the parties to agree on a solution. Mediation is completely confidential. What is said to the mediator cannot be used later by the parties or their lawyers if litigation becomes necessary. Mediation does not require that the parties be represented by lawyers. Mediation is not binding unless the parties have agreed to be bound by the decision.

4-2d Medarb

Mediation arbitration (medarb) is a recent creation in which the arbitrator begins by attempting to negotiate between the two parties. If the arbitrator is unable to reach a settlement, the case proceeds to arbitration with the same party serving as arbi- trator. One percent of the AAA’s cases each year are decided by a medarb process.

4-2e the Minitrial

In a minitrial, the parties have their lawyers present the strongest aspects of their cases to senior officials from both companies in the presence of a neutral advisor or a judge with experience in the field. At the end of the presentations by both parties, the neutral advisor can provide several forms of input, which are controlled by the parties. The advisor may be asked to provide what his or her judgment would be

Mediation has been a popular form of dis- pute resolution among business-to-business (B2B) e-commerce companies. Amazon. com and eBay have used mediation regu- larly in the resolution of disputes.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 109

in the case, or the advisor may be asked to prepare a settlement proposal based on the concerns and issues presented by the parties. Minitrials are more adver- sarial than mediation, but they are confidential, and the input from a neutral but respected advisor may help bring the parties together. A minitrial is not binding.

4-2f Rent-a-Judge

Many companies and individuals are discovering that the time that elapses between the filing of a lawsuit and its resolution is too great to afford much relief. As a result, a kind of private court system, known as rent-a-judge, is developing in which parties may have their case heard before someone with judicial experience without waiting for the slower process of public justice. These private courts are like “Judge Judy” without the television cameras. The parties pay filing fees and pay for the judges and courtrooms. These private courts also offer less expensive settlement conferences to afford the parties a chance at mediation prior to their private hearing. This and the other methods of ADR previously discussed offer the opportunity to obtain final dispositions of cases more quickly and at less cost.

4-2g Summary Jury trials

Under this relatively new method of ADR, the parties are given the opportunity to present summaries of their evidence to a judge and jurors. The jurors then give an advisory verdict to start the settlement process. If the parties are unable to agree on a settlement, a formal trial proceeds. This means of resolution gives the parties an idea of a jury’s perception and assists in setting guidelines for settlement. A summary jury trial occurs late in the litigation process, after the costs of discovery have been incurred. It can, however, save the expense of a trial.

4-2h early Neutral evaluation

Early neutral evaluation requires another attorney to meet with the parties, receive an assessment of the case by both sides, and then provide an evaluation of the

Re: Southwest airlines and Creative dispute Resolution

For the Manager’s Desk

In 1991, Dallas-based Southwest Airlines began a marketing campaign using the slogan “Just Plane Smart.” Greenville-based Stevens Aviation had been using the slogan “Plane Smart” to market its airline service business. Following posturing by lawyers, Kurt Herwald, the chairman of Stevens Aviation, called Herb Kelleher, then chair- man of Southwest Airlines, and offered to arm wrestle for the rights to the slogan. Mr. Kelleher rented a wrestling auditorium, sold tickets to the event, and offered the

proceeds to charity. Mr. Kelleher, then 61, lost to Mr. Herwald, then 38, who is also a weightlifter. Mr. Herwald said, “Just to show sympathy for the elderly and that there’s no hard feelings, we’ve decided to allow Southwest Airlines to continue using our slogan.” After the event, a commentator noted, “Not only did the companies save a court battle that would have taken years and cost several hundred thousand dollars, they gained loads of free publicity. They also made donations to charities.”

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110 part 1 Business: Its Legal, Ethical, and Judicial Environment

merits of the case. The attorney, who is either a paid consultant or a volunteer through the state bar association, renders an opinion on the resolution of the case. The idea in this method of resolution is to encourage settlement. Because early neutral evaluation occurs before the discovery phase of the case, it can save time and money if the parties are able to settle.

4-2i peer Review

Peer review has become popular particularly for disputes between employers and employees and is used by Darden Industries (Red Lobster, Olive Garden), TRW Inc., Rockwell International Corp., and Marriott International, Inc. Peer review, which is generally conducted within three weeks of demand, is a review by coworkers of the action taken against an employee (demotion, termination, discipline). These panels of fellow employees (one chosen by management, one chosen by the employee, and one chosen randomly) can take testimony, review documents, and make decisions that can include an award of damages.

Employers say that sometimes their decisions are reversed in peer review, but Darden Industries indicates that peer review has reduced employee litigation and legal fees. Of the 100 disputes handled each year in peer review, only 10 proceed to litigation.

Experiments in the use of peer review for customers, contractors, and physi- cians are ongoing around the country. Many see the perception of fairness as an important quality that has resulted in the growth of the use of peer review.

4-3 Resolution of International Disputes Arbitration has been used in the international business arena since 1922. The Inter- national Chamber of Commerce (ICC) is a private organization that handles arbi- tration cases from parties in 139 countries. In 2014, the Arbitration Court of the ICC handled 791 requests for arbitration and issued 459 arbitration awards. Most requests for ICC arbitration come from 139 countries, and the typical subject mat- ters are trade transactions, contracts, intellectual property, agency, and corporate law. The following statistics were taken from the ICC’s annual report for 2014, the latest data available.

• Arbitrators of 79 different nationalities were appointed or confirmed under the ICC Rules.

• Hearings were held in 57 different countries. • The amount in dispute exceeded $1 million (U.S.) in 77.5% of new cases.

The ICC process is similar to that discussed earlier for the AAA. The award of the ICC is final, and payment must be made at the location of the hearing.

The ICC also provides mediation, referred to as conciliation, services. In con- ciliation, the court assigns an expert to work with the parties to try to achieve a settlement of the case.

In addition to the ICC, the World Bank has established the International Cen- ter for Settlement of Investment Disputes (ICSID). The ICSID is an arbitral organi- zation created specifically to hear disputes between investors and the nations in which they have made investments. This arbitration forum was created because of investors’ fears that the courts of the nation in which they have invested may favor the government of that nation.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 111

The AAA created the International Centre for Dispute Resolution (ICDR), with offices in New York City, Dublin, and Mexico City, to provide an international AAA service for global U.S.-based companies that face contract and other types of disputes in their international operations. The ICDR has partnering agreements with ADR organizations in 92 countries, including the AAA, and uses those part- nerships to manage disputes that occur primarily in other countries. The United Nations Commission on International Trade Law (UNCITRAL) adopted a Model Law for Arbitration that deals with where arbitration should be held (the parties can decide) and which country’s laws should apply.

4-4 Litigation versus ADR: The Issues and Costs 4-4a Speed and Cost

Speed and cost are two compelling reasons businesses turn to ADR to resolve dis- putes. Costs of ADR have increased substantially over the past five years, and the speed has slowed down considerably.

4-4b protection of privacy

Whatever matter is in dispute can be kept private if referred directly to ADR, which means that no public court documents are available for examination. Even when a suit is filed, the negotiated settlement achieved through alternative means can be kept private to protect the interests of the parties. When Dillard’s, a national department store chain, and Joseph Horne Company, a department store based in Pittsburgh, were litigating over Dillard’s conduct in a Horne’s takeover, the parties’ dispute centered on whether Dillard’s was conducting due diligence in obtaining access to Horne’s facilities and records or whether Dillard’s was actually running the stores in an attempt to drive down the acquisition price. The business press reported on the litigation and the underlying dispute. The information was not flattering to either party. Dillard’s was portrayed as a large firm taking advan- tage of a small chain and engaging in unethical conduct when it was supposed to be obtaining just financial information prior to finalizing the acquisition (a pro- cess called due diligence). Horne’s was portrayed as naive and inept. Dillard’s and Horne’s settled the dispute, and both agreed to keep the terms of the settlement confidential. As a result, the public litigation ended, and the focus on alleged mis- conduct changed because of the settlement and its private nature.

4-4c Creative Remedies

Often, without the constraints of court jurisdiction and the restraints of legal boundaries, a creative remedy can be crafted that helps both sides. For example, Intel, a computer chip manufacturer, experienced ongoing disputes with employ- ees who left the company to begin their own businesses with products and in areas that would compete with Intel. Intel’s concern was whether the departing employ- ees were taking with them technology that had been developed at and belonged to Intel. Using only the courts, Intel would have found itself in lengthy, expensive, and complex litigation over engineering and developmental issues. Such litigation is costly not only in a monetary sense but also to the morale of employees charged with product development. Constant legal battles with former employees are not healthy for a corporate image within a company or from the outside.

Businesses such as Intel have now taken litigation strategy to a prevention stage. Intel and other firms, particularly those in high-tech and product development fields, now offer departing employees a partner- ship if they are leaving to start their own firms. The company provides a sort of incu- bator for the departing employee to get start- ed in business. The company is an investor and will share in the returns the new prod- uct brings. The strategy here: why try to beat them in litigation when you can join them with an investment?

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112 Part 1 Business: Its Legal, Ethical, and Judicial Environment

After filing suit against one group of employees, Intel agreed, along with the former employees, to have an expert oversee the former employees’ work in their business. The expert would have knowledge of Intel’s product development efforts that the employees had been involved with and would agree to notify all sides if the new company was infringing on any of Intel’s patents. The expert agreed to oversee the new company’s work for one year, at which point technology would make obsolete anything developed by the former employees while they were still at Intel. This creative solution permitted the former employees to operate their business, but it also provided Intel officials with the reassurance that their intellec- tual property was not being taken.

4-4d Judge and Jury Unknowns

Even though a good case and preparation are often offered as explanations for vic- tory in a lawsuit, many good cases are lost despite excellent preparation. Various unknowns characterize all forms of litigation and ADR. The unknowns are judges, juries, and arbitrators and their perceptions and abilities. Research shows that 80% of all jurors make up their minds about a case after only the opening statements in a trial have been made. Further research has shown that juries use their predeter- mined ideas in reaching a verdict. Finally, research shows that juries employ hind- sight bias in their deliberation processes; that is, juries view the outcome of a set of facts and conclude that one party should have done more. Knowing that someone was injured often clouds our ability to determine whether that person should have been able to prevent the injury.

They deliberated for 21 days. The jury that was charged with determining whether three lawyers had committed fraud tried to reach a verdict on the 150 counts, but just could not meet minds. The United States, Canada, and some places in Australia are the last great hold-outs on unanimous ver- dicts. The three lawyers were from one of the world’s top law firms, Dewey LeBeouf, and were charged with accounting fraud and other crimes related to inflating the firm’s revenues so as to avoid loans being called and a resulting bankruptcy.

There were four jurors who could not bring themselves to find criminal activity. While the jurors believed that what the law- yers did was wrong, they were not prepared to convict them. Jury research shows that if nine of the 12 jurors are in agreement, they can persuade three hold-outs. However,

with four favoring acquittal, there is strength in the group and a willingness to stand firm. They hung in there for 21 days of delibera- tion, one that ranks as one of the longest in history. However, the juror finally came out and surrendered to the judge—they could not reach a verdict.

The complexity of the case is also part of a recipe for a hung jury. If the case and the alleged counts are confusing, jurors tend to go with defendants because they are unwilling to make a mistake that may be the result of their confusion. As federal district judge, Jed S. Rakoff advis- es, “Keep it simple. A jury that under- stands the basics can reason through to a verdict.”

Source: James B. Stewart, “Deadlock in the Dewey Case Exposes the Jury System’s Flaws,” New York Times. November 6, 2015, p. B1.

For the Manager’s Desk

Re: The Deadlocked Jury and Why

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 113

Exhibit 4.1 Benefits of adR versus litigation

litiGatiON adR

Technical discovery rules

Judicial constraints of precedent

Remedies limited (by law and precedent)


Public proceeding

Control by lawyers


Strict procedures/timing

Judge/jury unknowns

Those who can afford to stay in win

Judicial enforcement tools

Open lines of communication

Parties can agree to anything

Creative remedies permitted

Parties set timetable


Control by parties (or mediator/arbitrator)

Expertise of arbitrator/mediator

More flexibility

Parties select mediator/arbitrator

Positions examined for validity

Enforcement by good faith

Based on information about juries, many businesses opt for a trial in which a judge, not a jury, renders a decision. However, research with judges has demon- strated that even their case judgments are affected by predetermined ideas and hindsight bias, although to a lesser extent than those of jurors. “The Deadlocked Jury and Why” provides background information on the risks that juries pose for businesses in litigation.

4-4e absence of technicalities

Under ADR, the parties have the opportunity to tell their stories. The strict pro- cedural rules and evidentiary exclusions do not apply in these forums, and many companies feel more comfortable because ADR seems to be more of a search for the truth than a battle of processes. A mediator can serve as a communication link between the parties and help them focus on issues and concerns. As one mediator described ADR, “If you’ve done your job . . . everyone goes home with big smiles.”

Exhibit 4.1 provides a list of the benefits of ADR versus litigation.

4-5 When You Are in Litigation At times, a business must face litigation and ADR is not possible. This portion of the chapter explains the language, process, and strategies of civil litigation.

4-5a How does a lawsuit Start?

Lawsuits are based on feelings. Whether rights have actually been violated and what damages were caused as a result are the questions addressed through the trial process. The only restriction on the filing of a suit is that the plaintiff’s claim of right must be based on some statutory law or common law.

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114 part 1 Business: Its Legal, Ethical, and Judicial Environment

Re: a Checklist for When to litigate

Business Strategy


Every lawsuit costs time and money. Costs of litigation include but by no means end with attorneys’ fees, and other significant costs are often not considered before a business decides to become embroiled in a legal battle.

Legal Costs

The total legal fee must be considered in every case of possible litigation. A lawyer should be required to give an estimate of fees for any suit before the suit begins. The estimate should always include discovery costs. . . .

Time Costs (Hidden Downtime)

Litigation costs time as well as money. Indeed, in many cases, the loss of time can be more devastating to a firm than the financial loss. If a firm takes part in major litigation, chances are that its officers and possibly its directors will be involved in depositions, other forms of pretrial discov- ery and paperwork, and eventually in the trial itself.

Image Costs

If a lawsuit attracts the attention of the media, a firm may incur money and time costs stemming from public relations. Someone must be available to explain the firm’s position to reporters and perhaps initiate an affirmative campaign to minimize negative publicity about the suit.

Capital Costs

Auditors require that pending litigation be listed in the financial reports of the compa- ny. Ongoing litigation that carries the poten- tial for great financial loss to a business can have a negative effect on the firm’s financial rating and the ability to raise capital.

Costs of Alternatives to Litigation

The costs of litigation should be compared with the costs of alternatives to litigation. (See discussion of alternatives.)

Costs of Not Litigating

There are costs for litigating, but there are also costs for not litigating. If the stakes are high enough, litigation may be worth pursu- ing regardless of the expense. For example, if a suit challenges the land records and thus the title to the land on which the business is located, the cost of not responding to the suit may be the loss of the property and the expense of reestablishing the business at another site. In a trademark or trade name suit, the cost may be a product or company name or label. In a patent infringement case, the failure to sue an infringer may undermine a company’s sales and its exclu- sivity in the marketplace.

Public Relations Issues

Litigation is not a private matter. In every city, at least one reporter is assigned to the clerk’s office in the state and federal courts for the purpose of checking on suits filed.

Many an electric bill goes unpaid simply because it is not good public relations for a utility company to appear in the newspapers and on television as the “bad guy” when a retired widow explains that the big power company has just filed suit because she has no money to pay her bill. . . .

Jury Appeal

When considering the effects of publicity on a case, a company should also consider the closely related matter of jury appeal. In some cases, it will not matter how correct a business may be, how much of a remedy the law provides, or how wrong the other side is; the jury will simply side with the “little guy,” and the business will have no chance of succeeding in the courtroom. For example, the Arthur Murray Dance Studios once fully litigated a case in which a man who had been severely injured in a car accident and was unable to complete the lessons in his contract with Arthur Murray (some 2,734 lessons, for which he had paid $24,812.40) sought to recover his pay- ments on the grounds that performance had

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 115

become impossible. It is difficult to build jury appeal into such a case.

Discussion Questions

1. List the factors you should consider as you make a decision to litigate.

2. At the awards show for the Academy of Motion Picture Arts and Sciences (Academy), a character dressed as Snow White appeared in the opening musical number and sang with actor Rob Lowe. Walt Disney, Inc., had not given the Academy permission to use

the Snow White likeness, a trademarked Disney character. If you were the Walt Disney Corporation, would you sue the Academy?

3. List concerns you would have as an employer litigating a sexual harassment case.

Source: Frank Shipper and Marianne Jennings, Avoiding and Surviving Lawsuits: The Executive Guide to Strategic Legal Planning for Business, Jossey- Bass Publishing, Inc., pp. 59–73. Copyright © 1989. Excerpted and reprinted with permission of the authors.

People begin lawsuits. The judicial system does not unilaterally undertake the enforcement of civil rights. Individuals must assume responsibility for protecting their rights. The judicial system determines what and whose rights have been violated.

Although procedures vary from state to state, the following sections offer a general discussion of the procedures involved in a civil lawsuit. Exhibit 4.2 sum- marizes the trial process.

4-5b the Complaint (petition)

The first step in a lawsuit is the filing of a document called a complaint or petition. The plaintiff must file the petition or complaint within certain time limits each state has for filing suit. These time limits are called statutes of limitations. They vary depending on the type of rights involved in a suit. The typical statute of limitations for personal injuries is two years; the typical limitation for contracts is four years.

Exhibit 4.2 the trial process



Pretrial Work


Posttrial Work

Complaint (followed by service of summons), answer, counterclaims, cross-claims

Interrogatories, depositions, requests for production, requests for admission

Motions, pretrial conference

Motions, appeal


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116 part 1 Business: Its Legal, Ethical, and Judicial Environment

Exhibit 4.3 Sample Complaint

) ) ) ) ) ) ) ) ) ) ) ) )

Reed C. Tolman, Esq. (006502) TOLMAN & OSBORNE, PC. 1400 E. Southern, Suite 625 Tempe, Arizona 85282 Attorneys for Plaintiffs



CRAIG CONNER and KATHY CONNER, husband and wife, individually and on behalf of their minor son, CASEY CONNER,



CARMEN A. CHENAL and THOMAS K. CHENAL, wife and husband,


For their complaint, plaintiffs allege:

1. Plaintiffs and defendants are residents of Maricopa County, Arizona. 2. This Court has jurisdiction over the subject matter under the Arizona Constitution, Art. 6, § 14. 3. Casey Conner is the minor son of Craig and Kathy Conner. 4. Carmen A. Chenal and Thomas K. Chenal are wife and husband. At all times relevant hereto, Carmen A. Chenal was acting for

and on behalf of the marital community of which she is a member. 5. On or about July 20, 1990, defendant Carmen A. Chenal was driving her motor vehicle in the vicinity of Primrose Path and Cave

Creek Road in Carefree, Arizona. At the time, Casey Conner was a passenger in the back seat of defendants’ vehicle, a 1976 Mercedes, ID No.11603312051326.

6. At all times relevant hereto, defendant Carmen A. Chenal had a duty to care properly for the safety of Casey Conner. That duty included the responsibility to place Casey in an appropriate and functioning seat belt.

7. Prior to the accident that resulted in injuries to Casey Conner, Carmen A. Chenal knew that the right rear door of her vehicle was damaged and not functioning properly.

8. Despite the duty Carmen A. Chenal had to care properly for the safety of Casey Conner, and despite her knowledge of a malfunctioning right rear door, Carmen A. Chenal negligently failed to place Casey in an appropriate and functioning seatbelt and negligently and carelessly operated her vehicle in such a way that the right rear door opened and allowed Casey to be ejected from the vehicle while the vehicle was in operation.

9. Carmen A. Chenal’s failure to exercise reasonable care for the safety of Casey and the failure to operate her vehicle in a careful and safe manner proximately caused Casey to suffer personal injuries.

10. As a result of Casey Conner’s injuries, he has experienced physical and psychological suffering, and his parents have incurred medical and other expenses, as well as lost earnings.

WHEREFORE, plaintiffs request judgment against defendants for compensatory damages in an amount to be determined at trial.


COMPLAINT (Tort—Motor Vehicle)

By:   ________________________________ Reed C. Tolman 1400 E. Southern Suite 625 Tempe, Arizona 85282

DATED: this ——— day of July, 1992. TOLMAN & OSBORNE

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 117

A complaint is a general statement of the plaintiff’s claims. For example, if a plaintiff is suing for a breach of contract, the complaint must describe the con- tract, when it began, and what the defendant did that the plaintiff says is a breach. Exhibit 4.3 shows a sample complaint in a suit over a car accident.

The complaint need not have every detail described in it. The standard for a valid complaint is that it must be definite enough in its description of what hap- pened for the defendant to understand why the suit has been brought.

All complaints must establish the subject matter jurisdiction of the court (see Chapter 3 for a discussion of this concept). For example, for a federal district court action, the complaint would have to allege either diversity of citizenship between the parties and a damage claim of more than $75,000 or that a federal question is involved.

In some cases, the complaint is filed by a group of plaintiffs who have the same cause of action against one defendant. These types of suits, called class action suits, are typically filed in antitrust cases, shareholder actions against corpora- tions, and employment discrimination cases. The class action suit enables a group of plaintiffs to share one lawyer and minimize litigation expenses while at the same time preserving their individual rights. Perhaps the most widely publicized type of class action lawsuit is the suit that results when a large jet airliner crashes and causes multiple deaths and injuries. All the plaintiffs were injured in the same event, and the defendant then litigates once with a group of plaintiffs.

Another form of class action suit is the derivative suit, in which shareholders sue a corporation to recover damages for actions taken by the corporation. (See Chapter 17 for more information.)

The final paragraphs of a complaint list the damages or remedies the plaintiff wants. The damages may be a legal remedy, such as money, in which case a dollar amount is specified. The plaintiff may seek an equitable remedy, such as specific performance in the case of an action for breach of contract. Specific performance is an order of the court requiring a defendant to perform on a contract. In some cases, the plaintiffs just want the defendants to stop violating their rights. In those com- plaints, plaintiffs ask for injunctions, which are court orders requiring the defen- dant to stop doing the act complained of. In an action for nuisance, for example, an injunction orders the defendant to stop engaging in the conduct that causes the nuisance or orders the defendant to comply with a law or a previous decision. As another example, an injunction could order a website to stop infringement of copy- right music or material.

4-5c the Summons

The complaint or petition of the plaintiffs is filed with the clerk of the appropriate court—that is, the court with subject matter jurisdiction, in personam jurisdiction, and venue. The defendant, however, will not know of the suit just because it is filed. The second step in a lawsuit is serving the defendant with a copy of the com- plaint and a summons, which is a legal document that tells the defendant of the suit and explains the defendant’s rights under the law. Those rights include the opportunity to respond and the grant of a limited amount of time for responding. Exhibit 4.4 shows a sample summons.

A summons must be delivered to the defendant. Some states require that the defendant be given the papers personally. Other states allow the papers to be given to some member of the defendant’s household or, in the case of a business, to an agent of that business. (See Chapter 16 for a discussion of an agent’s authority to receive the papers notifying the business of a lawsuit.)

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118 part 1 Business: Its Legal, Ethical, and Judicial Environment

Exhibit 4.4 Sample Summons

YOU ARE HEREBY SUMMONED and required to appear and defend, within the time applicable, in this action in this court. If served within Arizona, you appear and defend within 20 days after the service of the Summons and Complaint upon you, exclusive of the day of service. If served out of the State of Arizona—whether by direct service, by registered or certi†ed mail, or by publication you shall appear and defend within 30 days after the service of the Summons and Complaint upon you is complete, exclusive of the day of service. Where process is served upon the Arizona Director of Insurance as an insurer’s attorney to receive service of legal process against it in this state, the insurer shall not be required to appear, answer or plead until expiration of 40 days after date of such service upon the Director. Service by registered or certi†ed mail without the State of Arizona is complete 30 days after the date of receipt by the party being served. Service by publication is complete 30 days after the date of †rst publication. Direct service is complete when made. Service upon the Arizona Motor Vehicle Superintendent is complete 30 days after †ling the Af†davit of Compliance and return receipt or Of†cer’s Return. RCP 4; ARS §§ 20-222, 28-502, 28-503.

Copies of the pleadings †led herein may be obtained by contacting the Clerk of Superior Court, County, located at Arizona. RCF 4.1 (e).

SUMMONS (Continued on Reverse Side)

YOU ARE HEREBY NOTIFIED that in case of your failure to appear and defend within the time applicable, judgment by default may be rendered against you for the relief demanded in the Complaint.

YOU ARE CAUTIONED that in order to appear and defend, you must †le an Answer or proper response in writing with the Clerk of this Court, accompanied by the necessary †ling fee, within the time required, and you are required to serve a copy of any Answer or response upon the Plaintiffs’ attorney. RCP 10(D); ARS 12-311; RCP5.

The name and address of plaintiffs’ attorney is:

Name: Address: City, State, Zip: Telephone: State Bar Code: Client:





1-1 ©LawForms 10-92 1-93

1-1 ©LawForms 11-67, 3-84, 1-93

Method of Service: Private Process Service Sheriff or Marshall Personal Service Registered/Certified Mail (out of State)

SIGNED AND SEALED this date:__________________________

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Clerk

By . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deputy Clerk



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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 119

The summons is delivered by an officer of the court (such as a sheriff or magis- trate) or by private firms licensed as process servers. Once the defendant is served, the server must file an affidavit with the court to indicate when and where the service was made. In rare circumstances, courts allow service of process by mail or by publishing the summons and complaint. These circumstances, however, are limited and are carefully supervised by the courts.

4-5d the answer

The parties’ positions in a case are found in the pleadings. The complaint or peti- tion is a pleading. The defendant’s position is found in the answer, another plead- ing in a case. The defendant must file an answer within the time limits allowed by the court or risk default. The time limits are typically 20 to 30 days for filing an answer to the complaint. A failure to answer, or a default, is like a forfeit in sports: the plaintiff wins because the defendant failed to show up. The plaintiff can then proceed to a judgment to collect damages.

The defendant’s answer can do any or all of several different things. The defen- dant may admit certain facts in the answer. Although it is rare for a defendant to admit the wrong alleged by the plaintiff, the defendant might admit parts of the plaintiff’s complaint, such as those that establish jurisdiction and venue. If the plaintiff already has correct venue, fighting that issue is costly, and admitting juris- diction is a way to move on with the case. If, however, the court lacked in personam jurisdiction over the defendant, the defendant could deny the jurisdiction. (See Chapter 3 for more discussion of in personam jurisdiction.)

A denial is a simple statement in the answer whereby the defendant indicates that the allegation is denied. An answer might also include a statement that the defendant does not know enough to admit or deny the allegations in the complaint and might include a demand for proof of those allegations.

An answer might also include a counterclaim, with which the defendant, in effect, countersues the plaintiff, alleging a violation of rights and damages against the plaintiff. The plaintiff must respond to the counterclaim using the same answer process of admitting or denying the alleged wrong. Exhibit 4.5 shows a sample answer.

The answer must be filed with the clerk of the court and a copy sent to the plaintiff. With the exception of amendments to these documents, the pleadings are now complete.

4-5e Seeking timely Resolution of the Case

The fact that a suit has been filed does not mean that the case will go to trial. A great majority of suits are disposed of before trial because of successful motions to end them. Motions are requests to the court that it take certain action. Motions usually involve filed documents and include citations to precedent that support granting the motion. Often the judge will have the attorneys present oral argu- ments for and against the motion, after which the court then issues a ruling on the motion. For example, in 2012, a federal judge quickly dismissed Lance Arm- strong’s suit against the USADA as it prepared to take disciplinary action against Mr. Armstrong because the complaint had no legal cause of action but was only a “a lengthy and bitter polemic against the named defendants.” Following Mr. Arm- strong’s admissions of the use of performance-enhancing drugs, the judge’s rapid dismissal proved prescient.

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Exhibit 4.5 Sample answer

Grand, Canyon & Rafts 12222 W. Camelback Phoenix, Arizona 555-5555 Attorneys for Defendant



CRAIG CONNER and KATHY CONNER, ) husband and wife, individually ) and on behalf of their minor ) son, CASEY CONNER, )

) Plaintiffs, )

) v. )

) CARMEN A. CHENAL and THOMAS K. CHENAL, wife and husband,

) ) )

Defendants. ) ____________________________________)

For their answer, defendants respond to plaintiffs’ complaint as follows:

1. Admit paragraph one. 2. Admit paragraph two. 3. Have no knowledge to admit or deny paragraph three. 4. Have no knowledge to admit or deny paragraph four. 5. Admit paragraph five. 6. As for paragraphs 6 through 10, inclusive of plaintiffs’

complaint, defendants have no knowledge of the statements alleged and deny all statements made therein.



Defendents deny any and all parts of plaintiffs’ complaints not specifically mentioned herein.

DATED: this day of August, 1992. Grand, Canyon & Raft

By: ____________________________________________ Robert C. Canyon 12222 W. Camelback Phoenix, Arizona

Motion for Judgment on the pleadings Either in the answer or by separate motion, a defendant can move for judgment based just on the content of the pleadings. The theory behind a motion for judg- ment on the pleadings is that the plaintiff has no cause of action even if everything

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 121

the plaintiff alleges is true. For example, a plaintiff could file suit claiming the defendant is an annoying person, but unless the defendant is annoying to the extent of invading privacy or not honoring contracts, the plaintiff has no right of recov- ery. The defendant in this case could win a motion for judgment on the pleadings because the law (perhaps unfortunately) does not provide a remedy for annoying people. A denial of a motion for judgment on the pleadings does not imply victory for the plaintiff. It simply means that the case will proceed with the next steps.

Motion to dismiss A motion to dismiss can be filed any time during the proceedings but usually is part of the defendant’s answer. Such a motion can be based on the court’s lack of subject matter or in personam jurisdiction. Again, if the case is not dismissed, it does not mean that the plaintiff wins; it just means that the case will proceed to the next steps and possibly trial.

Motion for Summary Judgment A motion for summary judgment has two requirements. Summary judgment is appropriate only when (1) the moving party is entitled to a judgment under the law and (2) no issues of fact remain disputed. Actions brought on the basis of motor vehicle accidents, for example, always involve different witnesses’ testimonies and variations in facts. These types of cases cannot be decided by summary judgment. In other cases, however, the parties do not dispute the facts but differ on the appli- cations of law. Consider, for example, a dispute involving a contract for the repair of a computer, including service and parts. Different laws govern contractual pro- visions for services and provisions for goods. The parties do not dispute the facts: they agree goods and services are covered in the contract. At issue is the question about which law applies, and a summary judgment appropriately will resolve it. A suit may involve other factual disputes about contract performance, but the partial summary judgment will determine which contract law will apply.

4-5f How a lawsuit progresses: discovery

Trials in the United States are not conducted by ambush. Before the trial, the parties engage in a mandatory process of mutual disclosure of all relevant documents and other evidence. This court-supervised process of gathering evidence is called dis- covery. Under procedural rules that govern discovery, the parties must provide to each other lists of witnesses, all relevant documents, tangible evidence, and state- ments related to the case. Under the old discovery rules, the expense and difficulty of discovery techniques often meant that the search for the truth was a cat-and- mouse game won by those with the most funds. Armed with the evidence from a full-disclosure approach, the parties to a case are more prepared—and perhaps more inclined—to negotiate a settlement. Discovery rules provide for sanctions (penalties) for not turning over relevant documents at the start of a case. Sanctions can include fines against the party who withheld the evidence, findings of con- tempt against the lawyers (including fines), and the exclusion of responses to the withheld evidence. The following sections cover the traditional tools of discovery.

Requests for admissions and interrogatories A request for admissions asks the other side to admit a certain fact. Interrogato- ries ask questions about facts. The parties have some incentive to admit the facts requested if they are true because if these facts are denied and then proved at trial, the party who had to prove those true facts can recover the costs of proof. Requests

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for admissions request the other party to admit that a document is authentic. For example, the parties might have a dispute about the amount due under a contract but should be willing to admit that they signed the contract and that it is authentic. These requests for admission reduce the length of trials.

depositions Depositions are the oral testimony of parties or witnesses that are taken under oath but outside the courtroom and before the trial. They can be taken long before a trial and help preserve a witness’s or party’s recollection. Depositions are also helpful in determining just how strong a case is. It is far better to discover damag- ing information in a deposition than to have surprises at trial.

Requests for production A request for production requires the other side to produce requested documents. For example, if a business is suing to recover lost profits, the defendant will prob- ably want to request the income statements and perhaps the income tax returns of that business in order to prepare for the presentation of damages issues at trial. A request for production can include medical records as well as tangible evidence. In Kroger Co. v Walters (Case 4.2), the destruction of physical evidence is an issue in a case that provides an answer to the opening “Consider …”

Pulte Home Corporation v Simerly 746 S.E.2d 173 (Ga.App. 2013)

Fooling Around with Documents and E-Mails: Costs and Consequences

Case 4.2


In January 2004, Pulte purchased property to develop sin- gle-family residences for what would become the Notting Hill and Fieldstone subdivisions. The Pulte Development discharged water into Harris Creek and was located upstream of the properties owned by Tim and Adele Simerly and Richard and Susan Trent (Plaintiffs). Pulte had purchased the property from Macauley Properties, which previously hired Lowe Engineering to complete a hydrology and storm-water management study. The Lowe Study was completed in January 2004, and Pulte relied upon the study to design and construct its devel- opment. The Lowe Study recommended that storm water discharges from future developments could be controlled with the construction of a weir on Harris Creek, which consisted of a partial wall across the creek, above Drew Campground Road located within Fieldstone.

Pulte began mass grading and other land-disturbing activities at Fieldstone in March 2004. Shortly thereafter, excessive amounts of storm water, dirt, sediment, and development debris were discharged into Harris Creek and ultimately into the ponds located on the Simerly and Trent properties. Investigations revealed that the discharged sediment and pollutants were caused by

Pulte’s activities upstream and its failure to install and maintain erosion control devices required by law. The Pulte Development also caused a dramatic increase in the rate and flow of storm-water discharge into Harris Creek that caused flooding to the Simerly and Trent properties. During a subsequent study, it was discovered that the weir was inadequate to control the storm-water discharge from the Pulte Development because the Lowe Study, upon which Pulte had relied for storm-water manage- ment, was based upon flawed assumptions and analysis.

The Simerlys and Trents sued Pulte Home Corpo- ration for trespass, nuisance, negligence, negligence per se, riparian rights, unjust enrichment, and eject- ment based on the company’s actions in causing excess storm water and sediment to enter the Simerlys’ and Trents’ properties.

The jury found in favor of the Simerlys, Trents, and Lawsons (collectively, the “Plaintiffs”) and awarded them $2.49 million in damages and attorney fees. The court had found evidence of spoliation by Pulte and excluded certain exculpatory evidence from the trial because of a finding of Pulte’s counsel’s misconduct. The trial court also allowed evidence of Pulte’s conduct during discov- ery in its determination of attorney fees. Pulte appealed.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 123

JUdiCial OpiNiON

MILLER, Judge During litigation, the trial court found that Pulte had engaged in spoliation by deleting emails relevant to the litigation, and enjoined Pulte from engaging in further destruction of evidence. The trial court had appointed a Special Discovery Master to oversee compliance with the court’s injunction and to resolve other discovery issues, including the attempted recovery of spoliated evidence through a computer forensic investigation. The Special Discovery Master issued a report outlining that the computer forensic investigation revealed that Pulte had engaged in further spoliation of electronic evidence after the trial court’s order and recommended that Pulte be sanctioned for its violations. The trial court adopted the Special Discovery Master’s report and recommendation.

The Special Discovery Master also informed the trial court that the Simerlys’ counsel and Pulte’s counsel had provided conflicting statements relating to Pulte’s removal of discovery documents during a May 2009 document review at Pulte’s offices. At a subsequent hearing before the trial court, Simerlys’ counsel, Michael Carvalho, testi- fied that he and an associate attorney, Christine Westberg, had a scheduled document review at Pulte’s offices in May 2009. Carvalho testified that during the document review, he had stacked a number of documents in a pile that were deemed relevant in order to copy them. Before

taking a break for lunch, Carvalho informed Pulte’s coun- sel that they planned to copy the documents in the stack. When Carvalho returned from lunch, he noticed that the stack of documents was smaller. Carvalho testified that he asked Pulte’s counsel about the missing documents, and she told him that she took the documents because they were privileged. Following the hearing, the trial court found that Pulte’s counsel had taken documents during the document review.

The trial court allowed Carvalho to testify about spoliation during the May 2009 document review, and would [not] allow Pulte to benefit from its discovery violations.

Plaintiffs were forced to undergo unnecessary trou- ble and expense to prosecute their claims in this case, and the evidence [of the spoliation] was properly admit- ted as it related to the issue of attorney fees.



1. Explain what the Special Master found about Pulte’s behavior in the case.

2. What are the consequences when one side attempts to withhold or destroy evidence?

3. What management lessons should be learned and applied from this case?

The obstruction of justice trial against the accounting firm of Arthur Andersen found the prosecution using the following types of evidence:

• Testimony from partners, employees, and consultants with Andersen

• E-mails among Andersen partners, employees, and consultants; both saved and deleted e-mails were intro- duced into evidence

• A videotape of a partner making a pre- sentation to employees on the pending SEC investigation in which he urged employees to get rid of excess files so that “nosy plaintiffs’ lawyers” wouldn’t be able to find damaging evidence

• The statistics on the e-mail deletions by Andersen employees, including the peak in e-mail deletions following the presen- tation that was shown on video and the instruction to get rid of unnecessary files

• The articles clipped and saved by Andersen employees relating to Enron and SEC investigations

What would the government need to show to establish that Andersen had engaged in spoliation through their e-mail deletions?

THINK: In the Pulte case, the court found that the e-mails were destroyed after the court had ordered the company to stop destruction and that the documents were removed before the plaintiffs’ lawyers could copy them and all this was done during discovery in the case.

APPLY: What is different in this Andersen situation? What is the same?

ANSWER: The evidence shows that the An- dersen employees had been briefed on at least the investigations, a likely source of lit- igation. With the investigations pending, the destruction of e-mails and other documents at that time meets the test for spoliation, even though litigation had not actually begun.

Consider . . . 4.3

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124 part 1 Business: Its Legal, Ethical, and Judicial Environment

limitations on discovery Discovery has the general limitation of relevance. Only things that are evidence or could lead to the discovery of evidence are discoverable. However, discovery also has a specific limitation. Discovery cannot require the production of work product, which consists of the attorney’s legal research, comments or reactions to a witness, thoughts, analysis, and case or trial strategy. Discovery affords the parties the right to know all the evidence (if it asks for it), but it does not give them the right to know how that evidence will be used or what legal precedent supports a party’s position.

Certain evidence in cases is not discoverable. Communications between law- yers and their clients is protected by a privilege and, except in certain limited cir- cumstances, cannot be discovered or used by the opposition. (See Chapter 3 for a complete discussion of privilege.)

Cyberlaw and discovery Businesses are required to preserve their business records. Smartphones create problems because smartphones can be configured in different ways, sometimes with very limited archiving capability. In certain configurations, a message deleted can be lost forever. There are programs that permit hackers to download every- thing from a smartphone in about 30 seconds. There is a risk of everything from corporate espionage to the loss of privilege on documents that become public via hackers or theft.

Companies should develop policies on the use of smartphones by executives, policies that cover the following:

• Configuration of smartphones, access, and archiving. For example, the exec- utive branch of the federal government has configured the smartphones of government officials so that the messages are archived (as required by law for government business) and then stored by a contractor who then manages and indexes the messages so that they are not lost.

• The requirement of a password for access to the phone. • No sharing your passwords with others. • If your smartphone is lost, notify the IT staff immediately so that they can

take protective and preventive action.

Ethical Issues

Evaluate the ethics of the Andersen employees and the lawyers in the Pulte case. Why do you think they followed orders to destroy the e-mails and other documents so willingly? Is “I was just following orders” a defense in criminal and civil cases? Is it a justification for conduct?

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 125

• Topics that should and should not be discussed on social media and smartphones.

• Discussion of risks of social media and smartphone communication. • Deletion of messages on smartphones.

4-5g Resolution of a lawsuit: the trial

If a case is not settled (and many are settled literally on the courthouse steps), the trial begins.

the type of trial—Jury or Nonjury Occasionally, the parties agree not to have a jury trial and instead have a trial to the court. In these cases, the judge acts as both judge and jury—both running the trial and determining its outcome. In highly technical cases, it is sometimes better for both sides to have a knowledgeable judge involved than to try to explain the complexities of the case to a jury of laypersons.

If the parties do not agree on a nonjury trial, then certain types of cases carry a constitutional right to a trial by jury. The Seventh Amendment of the U.S. Constitu- tion covers the jury requirement in civil trials:

In suits at common law, where the value in controversy shall exceed twenty dollars, the right of trial by jury shall be preserved, and no fact tried by a jury shall be otherwise re-examined in any court of the United States other than according to the rules of common law.

Although this right is limited to what existed at common law at the time the U.S. Constitution was adopted, many states have expanded the right under their state constitutions. The absolute right to a jury exists in criminal cases as covered in Article III and the Fifth and Sixth Amendments of the U.S. Constitution.

The size of a jury varies; some states require only six jurors. A jury may have 12 to 18 members, which include alternates, particularly in long trials, to ensure that a panel of 12 participates fully in the trial.

the trial—Jury Selection The pool of potential jurors and the selection of those jurors are resolved before trial. Usually, voting lists, alone or combined with other lists (e.g., rosters of licensed drivers), are used as pools for potential jurors. People on these lists are randomly notified of a period of time during which they should report for jury duty. Many states excuse from jury duty certain individuals, such as doctors and emergency workers, because of the needs they serve in society. Students are often excused if they are summoned for duty during the semester because of their pecu- liar obligations and time limitations on completing classes. Judges also usually have the power to excuse certain individuals who would experience hardship if they were required to serve. For example, a sole proprietor of a service business would have no income during the time of jury service and would probably be excused on a hardship basis.

Many more jurors than are actually needed are summoned to serve. These extra numbers are required because all the parties to a dispute participate in the selection of a jury. Once a pool is available, the court begins the process of voir dire, which determines whether a potential juror is qualified to serve. Most states have jurors complete a questionnaire on general topics so that the selection process can

When in doubt, don’t. That is, if you have any question about litiga- tion or an investigation, do not destroy e-mails, documents, or tangible evidence.

Every company should have a docu- ment retention and file purging policy. Employ- ees should follow the timelines on retention and destruction. Even when the designated time for destruction has arrived, any doubt about pending litiga- tion, investigations, or regulatory issues means the documents should be retained.

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126 part 1 Business: Its Legal, Ethical, and Judicial Environment

move quickly. The questionnaire covers personal information—age, occupation, and so on. The questionnaire might also ask whether the person has ever been a juror, a party to a lawsuit, or a witness.

A juror can be removed from a jury panel for two reasons. First, a juror can be removed for cause, which means the juror is incapable of making an impar- tial decision in the case. If a juror is related to one of the attorneys in the case, for example, the juror would be excused for cause. Some jurors reveal their biases or prejudices, such as racial prejudice, in the questionnaire they are required to complete. Others may express strong feelings of animosity toward the medical profession. Clearly, the removal of such jurors for cause in cases involving civil rights and malpractice suits, respectively, is an important part of trial strategy.

Sometimes a juror cannot be excused for cause but an attorney feels uncom- fortable about the juror or the juror’s attitudes. In these circumstances, the law- yer issues a peremptory challenge, which excuses the juror. The peremptory challenge is the attorney’s private tool. However, the use of peremptory chal- lenges is limited. All states have a statute or court rule limiting the number of peremptory challenges an attorney may use in a trial. The U.S. Supreme Court ruled that the use of peremptory challenges is subject to some limitations. The Court indicated that such a challenge cannot be based on either race or gen- der. If the trial judge suspects that either of these factors may have induced one of the lawyers to seek a peremptory challenge, the lawyer will be required to produce a plausible explanation for the use of the peremptory challenge that is unrelated to race or gender.

Winona Ryder was arrested for shoplift- ing from Saks Fifth Avenue. The charges against her included theft and burglary for taking $5,600 in merchandise from Saks’s Beverly Hills store.

The jury selection process in the trial uncovered the fact that Peter Guber, a Holly- wood executive who was in charge of three films that starred Ms. Ryder (Bram Stoker’s Dracula, The Age of Innocence, Little Wom- en), was among the pool of jurors. When questioned by the judge, Mr. Guber assured

him that he could be impartial in judging the evidence. Mr. Guber was allowed to remain on the jury.

What argument could the prosecution have made against keeping Mr. Guber? What argument could the defense have made against Mr. Guber? What process could each side have used to have him removed from the jury?

Source: Rick Lyman, “For the Ryder Trial, a Holly- wood Script,” New York Times, November 3, 2002, p. SL-1.

Consider . . . 4.4

Jury selection is an art and a science. Jury consulting firms specialize in pro- viding data to attorneys for jury selection. These firms do thorough checks of the potential jurors’ backgrounds (including through their Facebook pages and even the types of bumper stickers on their cars) and offer statistics on the reactions of certain economic and social groups to trials and trial issues. Much about a case at trial is uncontrollable, but jury selection is a part of the process that, with thorough preparation, can increase the likelihood of desired results by ensuring an optimally favorable jury panel.

Jury or trial consultants perform jury profiles, find surrogate juries, and often conduct mock trials. The use of trial consultants has increased dramatically since

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 127

Re: Jury Selection in High-profile Cases

For the Manager’s Desk

Even though the criminal rape charges against him were eventually dismissed, NBA basketball star Kobe Bryant’s trial still had progressed to the point of jury selec- tion. As part of the voir dire questions for the potential Bryant jurors, the 276 jury panelists were asked the following as part of their 82-question background sheet:

• What are your feelings about the sexual assault laws in Colorado?

• Do you think that people who make a lot of money are treated better by our court system than other people?

• Have you ever been afraid of or had any negative experience with an African American individual?

• In your opinion, in general do African Americans in our society experience

(check one): a great deal of racial discrimination; some amount of racial discrimination; or no racial discrimination?

• How do you feel about interracial relationships?

• Do you have particularly strong feel- ings about, or have you or anyone close to you ever been affected by or involved in, a situation of marital infidelity? [At the time of the alleged rape, Mr. Bryant was married and had one child.]

• Which of the following best describes your opinion of profession- al basketball players: very positive; positive; negative; very negative?

the 1970s, and membership in the American Society of Trial Consultants has grown from 19 members in 1982 to 500 members today. Jury consultants are now the norm rather than the exception in trials. In many civil cases, the attitudes about the subject matter of the case can have an impact on the way the jury decides the case. See the “Biography” feature at the end of the chapter for a discussion of the use of consultants in a gaming case.

the trial process

Opening Statements and Burden of Proof. It is often difficult to piece together all the witnesses and evidence in a trial. A lengthy trial may leave the jurors confused. The attorney for each party, therefore, is permitted to make an opening statement that summarizes what that party hopes to prove and how it will be proved. Most attor- neys also mention the issue of burden of proof, which controls who has the respon- sibility for proving what facts. Although the plaintiff has the burden of proving a case, the defendant has the burden of proving the existence of any valid defenses. Various standards are used for meeting the burden of proof. In criminal cases, the standard is proof beyond a reasonable doubt. In civil cases, the standard is proof by a preponderance of the evidence, or more likely than not.

Presentation of the Case and Evidence. Because the plaintiff has the burden of proof, the plaintiff presents his or her case and evidence first. The attorney for the plain- tiff decides the order of the witnesses; questioning of these witnesses under oath is

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called direct examination. Although the defense cannot present witnesses during this part of the trial, it can question the plaintiff’s witnesses after their direct examination is completed. The defense questioning of plaintiff witnesses is called cross-examination, after which the plaintiff may again pose questions to clarify under redirect examination.

By the end of the case, the plaintiff must show enough evidence to estab- lish a prima facie case, one in which the plaintiff has offered some evidence on all the elements required to be established for recovery. Although the evidence may be subjected to credibility questions and challenged by defense evidence, some proof is required for each part of the claim. If the plaintiff does not meet this standard, the defendant can and may make a motion for a directed ver- dict. This motion for a directed verdict is made outside the jury’s hearing and argued to the judge. If it is not granted, the trial proceeds with the defendant’s case.

The defendant then has the same opportunity to present witnesses and evi- dence. Throughout the trial, the judge will apply the rules of evidence to deter- mine what can and cannot be used as evidence. All trials have some form of witness testimony. However, tangible evidence is also often presented. In a con- tracts case, for example, a great deal of paper evidence—letters, memos, and cost figures—is likely.

(1) Expert Testimony. One of the evidentiary issues that has been debated and litigated over the past few years is the use of expert testimony in cases. The issue the courts face is determining whether the expert’s testimony reflects scientific knowledge or whether the testimony is contrived for the trial (often called “junk science”). In Daubert v Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993), the U.S. Supreme Court provided guidance for the standards judges should use in determining whether the studies and testimony of experts and their experiments and analysis should be allowed as evidence in a case.3 One expert, who was testifying in a suit against Merrell Dow (defendant) about birth defects allegedly caused by pregnant women’s use of the anti-nausea drug Bendectin, filed an affidavit in the case stating that the use of Bendec- tin during the first trimester had not been shown to be a risk factor for birth defects. On the other hand, eight experts for the plaintiff parents in the case concluded, based on animal and epidemiological studies, that Bendectin can cause birth defects. The court ruled that the decision to admit the expert’s evi- dence must be based on an examination of the study methodology as well as whether the expert’s work had been subjected to peer review, the means that academics use for testing the validity of new studies and theories. The court noted that studies developed for purposes of the litigation require higher lev- els of scrutiny than studies that existed under the expert’s work prior to the litigation. However, the expert’s work does not require general acceptance and still will be subject to the scrutiny of the opposing parties’ experts as well as the rigor of cross-examination. For example, in U.S. v Parra, 402 F.3d 752 (7th Cir. 2005), a DEA agent could offer testimony about the usual behaviors of drug suspects based on his extensive experience. The agent may not be a PhD psychologist, but the judge can establish through voir dire of the expert the extent and scope of qualifications.

(2) Hearsay Testimony. The forms and types of evidence that can be used at trial are subject to some restrictions. Most people are familiar with the hearsay rule of

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 129

evidence. Hearsay is evidence offered by a witness who does not have personal knowledge of the information being given but just heard it from someone else. For example, suppose that Arkansas Sewing and Fit Fabric are involved in contract litigation. Fit Fabric says there was no contract. Arkansas Sewing has a witness who overheard the president of Fit Fabric talking to someone on a plane saying he had a contract with Arkansas Sewing but had no intention of performing on it. The witness’s testimony of the airplane conversation is hearsay and cannot be used to prove the contract existed. The reason for the hearsay rule is to keep evidence as reliable as possible. The person testifying about the hearsay may not know of the circumstances or background of the conversation and is testifying only to what someone else said.

Closing Arguments and the Jury’s Role. Once the evidence is presented and the parties are finished with their cases, the parties have one final “go” at the jury. The parties are permitted to make closing arguments, which review the presented evidence, highlight the important points for the jurors, and point out the defects in the other side’s case. After the cases and clos- ing arguments are presented, the jurors are given their instructions. These instructions tell the jurors what the law is and how to apply the law to the facts presented. The instructions are developed by the judge and all the attorneys in the case.

Jury deliberations are done privately; they cannot be recorded, and no one can attend the deliberations except the jurors. Jurors can, but are not required to, dis- cuss what happened during the deliberations after they are ended and a decision is returned to the court.

The U.S. Supreme Court has ruled that jury verdicts need not be unanimous. A state can adopt a rule that requires only a simple majority or three-fourths of the jury to agree on a verdict. In those states requiring unanimous verdicts, it is not unusual for juries to be unable to agree on a verdict. The jurors have then reached a deadlock, which is called a hung jury. If a trial results in a hung jury, the case can be retried.

The result of jury deliberations is the verdict. The verdict is given to the judge and is usually read by the judge’s clerk.

Karsten Manufacturing Corporation filed suit against the Professional Golf Associa- tion (PGA) because the PGA had proposed a ban of Karsten’s U-groove Ping brand clubs from professional play. Karsten hired Richard Smith, then an Arizona State Uni- versity finance professor, to develop an eco- nomic model to correlate professional and consumer usage. Professor Smith’s model showed that if pros play with Ping clubs, a proportionate number of duffers will play with them. If the pros cannot use Ping

clubs, Karsten is out of business because amateur golfers will not purchase Karsten products. Professor Smith said he conduct- ed valid regression analysis. The attorney for the PGA, Larry Hammond, called it “junk science” that interferes with the real issues in the case. Should the Smith model be ad- mitted? Does it make a difference that the model was developed only for the case? Does it make a difference that Professor Smith’s consulting firm was paid more than $1 million for the model?

Consider . . . 4.5

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130 part 1 Business: Its Legal, Ethical, and Judicial Environment

post-trial proceedings Even after the verdict, the case is not over. The losing party can make several motions to get around the verdict. One such motion is for a new trial, wherein the attorney argues the need and reason for a new trial to the judge.

For the Manager’s Desk

Re: the Jurors Who Get Online during trial

Social media has become a court man- agement problem. Jurors have gotten online during deliberations to do their own research. Jurors have posted messages on Twitter and Facebook about their expe- riences, issues, questions, and observa- tions during trial. The conduct has become so pervasive that courts now include a discussion of these issues in their jury handbooks that are distributed to every potential juror. The instructions in the book- let and admonitions to jurors need to add one additional caution: jurors should not be communicating by e-mail with the witness- es or lawyers. For example, in Tennessee v Smith, 418 S.W.2d 38 (Tenn. 2013), a juror sent the following note to a doctor who had testified during a criminal trial:

Scott Mitchell: “A-dele!! I thought you did a great job today on the witness stand . . . I was in the jury . . . not sure if you recognized me or not!! You really explained things so great!!”

Adele Maurer Lewis: “I was thinking that was you. There is a risk of a mistrial if that gets out.”

Scott Mitchell: “I know . . . I didn’t say anything about you . . . there are 3 of us on the jury from Vandy and one is a phy- sician (cardiologist) so you may know him as well. It has been an interesting case to say the least.”

Three of the jurors (including Scott Mitchell) worked at the Vanderbilt

University hospital, where Dr. Adele Lewis, the medical examiner for the county and a witness for the prosecution in the case, had done her medical training. None of the jurors had been questioned during voir dire about working at Vanderbilt, but the jurors had been instructed not to speak to any of the parties, attorneys, or witnesses in the case. They were instructed to say nothing if they saw any of these persons in the court facilities until the case was concluded.

The court held that the trial judge should have notified all the parties and then held a hearing to determine the impact of the com- munication, including questioning the juror, Mr. Mitchell, to determine the impact of the interaction on the case and deliberations. The court noted,

Even though technology has made it easier for jurors to communicate with third parties and has made these com- munications more difficult to detect, our pre-internet precedents provide appropriate principles and procedures to address extra-judicial communi- cations, even when they occur on social media websites and applica- tions such as Facebook. Accordingly, we will apply the same principles and procedures.

The technology has facilitated juror com- munication and made it more difficult to see, the standards are the same, and the court must still supervise and question.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 131

Another motion after the verdict, one that a judge is less likely to grant, is a motion for a judgment NOV. NOV stands for non obstante veredicto, which means “notwithstanding the verdict.” In other words, the moving attorney is asking the trial judge to reverse the decision of the jury. The basis for granting a judg- ment NOV is that the jury’s verdict is clearly against the weight of the evidence. Occasionally, juries are swayed by the emotion of a case and do not apply the law properly. It is, however, a strong show of judicial authority for a judge to issue a judgment NOV, and they are rare.

Even if no motions are granted, the case still may not be over; it can go to an appellate court for review. Such an appeal must be done within a speci- fied time limit in each state. Here the trial has come full circle to the principle of judicial review and stare decisis. Exhibit 4.6 summarizes the steps in civil litigation.

4-6 Issues in International Litigation As noted earlier, international courts have no enforcement powers. They serve as avenues for voluntary mediation. However, courts in each nation in which a firm is doing business would have jurisdiction over that firm in the nation’s court sys- tem. In a recent infringement dispute over Mattel’s “Barbie” and the French doll “Sindy,” the parties litigated in London, where both firms were doing business and the dolls were selling well.

Among the critical questions that arise in international litigation are the following: Which set of laws applies? What court is the appropriate forum for a lawsuit that involves citizens of different countries? For example, many non–U.S. citizens who are injured in their own countries by products made by U.S. firms will generally be able to recover more under the product liability and tort laws of the United States. The U.S. Supreme Court issued a 9–0 deci- sion in a tragic accident case involving a U.S. citizen traveling in Austria. In OBB Personenverkehr A.G. v Sachs, 136 S.Ct. 390 (2015), Carol P. Sachs, of Berke- ley, California, filed suit against an Austrian entity because she was injured in an accident that occurred as she tried to board a moving train in Innsbruck, Austria. As a result of injuries sustained, Ms. Sachs had to have both of her legs amputated. Ms. Sachs filed suit in the United States against OBB Per- sonenverkehr (OBB), which operates a railway that carries nearly 235 million passengers each year on routes within Austria and to and from points outside Austria. OBB—along with 29 other railways throughout Europe—is a member of the Eurail Group. In reversing the Ninth Circuit, 737 F.3d 584 (2013), the court noted that the essence of Ms. Sach’s claims was at the point of her injury, which was in Austria. The sale of the ticket, which was done through a U.S. entity in the United States, was not involved in her injuries. She can pursue her remedies, but only in Austria.

A similar ruling was made with respect to the 2,500 victims of the Union Car- bide gas leak in Bhopal, India. Some of the victims filed suit in the United States because the law and damages provisions here afforded them much greater relief. Their suit was dismissed to India, and the court added that Union Carbide would be required to submit to the jurisdiction of Indian courts and to follow discovery rules of the United States.

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132 part 1 Business: Its Legal, Ethical, and Judicial Environment

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 133

Biography Games Workshop v Chapterhouse

Studios: a tabletop Gamers’ Battle with Jury Selection Help

Benson Green, a jury consultant with Douglas Green and Associates, was perus- ing a tabletop game blog when he came across a post about Games Workshop (GW) filing suit against Chapterhouse, a company of two people who started a business in a garage based on their tabletop gaming hobby. GW is a company based in England and sells science-fiction and fantasy products based on a “dys- topian fictional universe known as ‘War- hammer 40,000.’” Its products include miniature war game figures and parts, books, computer games, and an annual convention.

Chapterhouse, founded in 2008, sold what is known as “bit parts” for the tabletop game such as shoulder pads, shields, weapons, and alternative heads for figures. GW was suing Chapter- house for almost $500,000 for copyright infringement.

After reading about the suit, Mr. Green called Chapterhouse to wish the two “good luck” and learned that the two could not afford an attorney. Mr. Green contacted Lawyers for Creative Arts (LCA), an organization of lawyers who provide pro bono services for artists, actors, authors, and so on. LCA was able to obtain Winston and Strawn to represent Chap- terhouse. The case involved two motions for summary judgment and eventually went to trial. [Games Workshop Limited v Chapterhouse Studios, LLC, 2013 WL 1340559 (N.D. Ill.)] The issues at trial cen- tered on whether there was infringement on specific tabletop figures and icons such

as Blood Ravens, Chaplain, Exorcist, Flesh Tearers, Howling Griffons, Celestial Lions, and Lightning Claw.

Mr. Green and his firm donated over 1,000 hours to the case, including recruiting a mock jury to review the case in advance of the trial. Mr. Green’s firm also provided assistance with jury selection. Following a two-week trial and two days of jury deliberation, Chap- terhouse won on 111 of the 160 infringe- ment claims. Chapterhouse did have to pay damages ($25,000), but the parties reached a settlement on the damages. [Games Workshop Limited v Chapter- house Studios, LLC, 2012 WL 5949105 (N.D. Ill.)] Chapterhouse was permitted to continue its garage-based business, but with fewer products and not using the GW terms.

The case served as a national exam- ple of pro bono work as well as the first experience for the lawyers in the case in using jury consultants. For small business owners, the case is instruc- tive on the complexity of litigation as well as the importance of understand- ing production of a product that corre- sponds to the products of another firm. The case has also served as precedent in circumstances in which one compa- ny is creating parts for the pieces in a tabletop game developed by another company; that is, what is fair use of trademarked items? And licensing the right to make the parts might not have been a bad idea. (See Chapter 15 for more information.)

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134 part 1 Business: Its Legal, Ethical, and Judicial Environment

s u m m a r y How can businesses resolve disputes?

• Alternative dispute resolution (ADR)—means of resolving disputes apart from court litigation

Types of ADR:

• Arbitration—hearing with relaxed rules of evidence

• Mediation—third party acts as go-between

• Conciliation—international term for mediation

• Medarb—combination of mediation and arbitration

• Minitrial—private judge and courtroom; shortened trial

• Rent-a-judge—disputes resolved by hired judge

• Summary jury trial—advisory verdict by jurors in a mock trial

• Early neutral evaluation—third-party evaluation before litigation proceeds

• International Chamber of Commerce (ICC)— voluntary international court that offers arbitration in international disputes

What strategies should businesses follow if litigation is inevitable?

• Evaluate cost, including the unknowns such as jury reaction

• Consider privacy and creative remedies

How do courts proceed with litigation?

• Complaint—plaintiff’s statement of a case

• Summons—document to serve defendant with lawsuit

• Answers—defendant’s response to complaint

• Statute of limitations—time limit for filing suit

• Discovery—advance disclosure of evidence in case

• Production—obtain and produce document

• Deposition—questioning of witnesses under oath

• Interrogatories—information questions to other party

• Admissions—acknowledgment of facts in a case

• Trial—court proceeding for hearing evidence

• Voir dire—jury selection method to screen for bias

• Opening statements—frame by parties’ lawyers of the case

• Plaintiff’s case—facts for proving complaint presented

• Defendant’s case—defenses to allegations presented

• Evidence—testimony and documents presented in the case; no hearsay

Q u e s t i o n s a n d P r o b l e m s 1. Craig Walters slipped and fell on a piece of banana in the meat department of a Kroger store and landed on his left hip and left elbow. Initially, Walters did not expe- rience pain or other symptoms. Peyton Kelley, the store co-manager, came to the scene, and concluded that some- thing “mushy” and smelling like banana caused the fall. Kroger had video cameras that would have filmed both the fall as well as the regularity of cleanup in the aisles of the store. Kelley, however, did not retain the video films and allowed them to be automatically purged after the 17-day automatic preservation period. Walters filed suit and recovered over $1.6 million, partly because the jury was permitted to assume that there would have been negative evidence on the purged videos. Kroger filed an appeal objecting to that assumption about the purged vid- eos. What happens when a business destroys evidence? [Kroger Co. v Walters, 735 S.E.2d 99 (Ga. App. 2012)]

2. In the Johns-Manville asbestos litigation, Samuel Greenstone, an attorney for 11 asbestos workers, settled their claims for $30,000 and a promise that he would not “directly or indirectly participate in the bringing of new actions against the Corporation.” The 1933 case settle- ment was documented in the minutes of Johns-Manville’s board meeting. Could the information in the minutes be used in later litigation against Johns-Manville? How could a plaintiff’s attorney obtain the information? Do you feel Mr. Greenstone made an ethical decision in his agreement? Wasn’t his loyalty to his 11 clients and his obligation to obtain compensation for them? Would you have agreed to the no-further-participation-in-a-law- suit clause? Would you, if you had been an executive at Johns-Manville, have supported the clause?

3. Suppose that your company had received a letter complaint about one of the prescription drugs that it sells.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 135

The customer and his physician have complained that there were cardiovascular effects from use of the drug over the past 12 months. You know about the complaint, and you also have e-mails from one of your friends in the company, a research scientist who was in your fraternity in college, that indicate he sees some cardiovascular side effects from the same drug. If you deleted the e-mail, would it be spoliation?

What would be required to prove spoliation in this case?

4. After she was found guilty of obstruction of justice and conspiracy (see Chapter 8), lawyers for Martha Stew- art filed a motion for a new trial on the grounds that a juror on the case had possible undisclosed bias. The defense lawyers pointed out that juror Chappel Har- tridge had checked “No” on the juror questionnaire when asked whether he had been accused of, charged with, or convicted of a crime. The lawyers for Ms. Stewart filed an affidavit from a former girlfriend of Mr. Hartridge’s who indicated that he had been arrested and arraigned on charges of assaulting her. Mr. Hartridge’s former girlfriend ultimately dropped the charges against him. What bias do you think Ms. Stewart’s lawyers alleged? Are they right? Should the juror have been eliminated for cause? [U.S. v Stewart, 317 F. Supp. 2d 432 (S.D.N.Y.2004)]

5. A discrimination suit by a former flight attendant against Atlantic East Airlines is going to trial. Jury selec- tion has begun. An executive from Atlantic East notices that a member of the potential juror panel was a flight attendant responsible for pregnancy leave reforms among airline flight attendants during the early 1980s. This potential juror is no longer a flight attendant and is raising two small children at home. The executive informs Atlantic East’s lawyer. Can the lawyer do any- thing to prevent the woman from sitting on the jury?

6. Applegate is in litigation with Magnifium over a con- tract breach. Applegate has been approached by a former janitor for Magnifium who can testify regarding con- versations about the contract between Magnifium exec- utives. The janitor heard them when the executives had stayed late at work and he was cleaning. Can Applegate use the statements at trial?

7. Robert Joiner began work as an electrician in the Water & Light Department of Thomasville, Georgia, in 1973. Mr. Joiner worked with and around electrical transformers that contained a fluid. In 1983, the city of Thomasville discovered that this fluid contained poly- chlorinated biphenyls (PCBs), a substance considered hazardous. Mr. Joiner was diagnosed with lung cancer in 1991 and filed suit against General Electric, the man- ufacturer of the transformers, for negligence and product liability.

Mr. Joiner had been a smoker, his parents were smokers, and his family had a history of lung cancer.

Mr. Joiner offered expert testimony on studies involving the injection of PCB into the stomachs of infant mice and resulting cancer. The experts had no epidemio- logical studies on PCB exposure. Should the expert testi- mony be admitted? [General Electric Co. v Joiner, 522 U.S. 136 (1997)]

8. Dr. John Sutter, a pediatrician, agreed with a number of other physicians to provide medical care for individu- als insured with Oxford Health Plans. Oxford agreed to pay the physicians according to the terms of a contract all the physicians signed. The contract provided for arbitra- tion of any disputes between Oxford and the physicians. Dr. Sutter was not paid in a timely fashion and filed an arbitration claim. However, other physicians wished to join him in the claim for a sort of class action arbitration. Is that possible under arbitration? Who should make that decision about allowing other doctors to join in on the claim of lack of timely payment? [Oxford Health Plans, LLC v Sutter, 133 S.Ct. 2064 (2013)]

9. The SEC investigation of Tyco International for pos- sible securities law violations produced several e-mails. The e-mails focused on two concerns about the company: accounting improprieties and the use of company funds by then-CEO Dennis Kozlowski. The e-mails were writ- ten by outside lawyers from the firm of Wilmer Cutler to former Tyco General Counsel Mark Belnick. The e-mails are as follows.

March 23, 2000: E-mail from a Wilmer Cutler Partner, Lewis Liman, to Mark Belnick

There are payments to a woman whom the folks in finance describe to be Dennis’s girlfriend. I do not know Dennis’s situation, but this is an embarrassing fact.

(Note: The payments were later verified as being made from the Key Employee Loan Account to Karen  Mayo, who subsequently became Karen Kozlowski, who divorced Mr. Kozlowski while he was in prison.)

May 25, 2000: E-mail from a Wilmer Cutler Part- ner, William McLucas, to Mark Belnick

We have found issues that will likely interest the SEC; creativeness is employed in hitting the forecasts.

There is also a bad letter from the Sigma people just before the acquisition confirming that they were asked to hold product shipment just before closing. . . .

(This e-mail also went on to suggest that there was, in regard to Tyco’s financial reports, “something funny which is likely apparent if any decent accountant looks at this.”)

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136 part 1 Business: Its Legal, Ethical, and Judicial Environment

Although Mr. McLucas and Mr. Liman could not comment because of attorney–client privilege, others indicate that they followed up on the e-mails and asked officials at Tyco to correct the concerns and problems raised in the e-mails.

Are the e-mails privileged? How did the SEC gain access to them? Can they be used as evidence? Are they discoverable? (Laurie P. Cohen and Mark Maremont, “E-Mails Show Tyco’s Lawyers Had Concerns,” Wall Street Journal, December 27, 2002, pp. C1, C5)

10. In October 1995, Saint Clair Adams applied for a job at Circuit City Stores, Inc., a now-defunct national retailer of consumer electronics. Mr. Adams signed an employ- ment application that included the following provision.

I agree that I will settle any and all previously unasserted claims, disputes or controversies arising out of or relating to my application or candidacy for employment, employment and/ or cessation of employment with Circuit City, exclusively by final and binding arbitration before a neutral Arbitrator. By way of example only, such

claims include claims under federal, state, and local statutory or common law, such as the Age Discrimination in Employment Act, Title VII of the Civil Rights Act of 1964, as amended, including the amendments of the Civil Rights Act of 1991, the Americans with Disabilities Act, the law of contract and the law of tort.

Mr. Adams was hired as a sales counselor in Circuit City’s store in Santa Rosa, California.

Two years later, Mr. Adams filed an employ- ment discrimination lawsuit against Circuit City in state court, asserting claims under California’s Fair Employment Act. Circuit City filed suit in the U.S. District Court seeking to stop the state court action and to compel arbitration under the FAA. Mr. Adams says the arbitration clause violates his statutory rights for protection against employment discrimination and that he has the right to go to court, not arbitration. Who is correct? Can Mr. Adams be required to submit to arbitration? [Circuit City Stores, Inc. v Adams, 532 U.S. 105 (2001)]

Economics, Public Policy & the Law

Japan’s Changing Legal System Many businesspeople have argued that too many lawyers and lawsuits hurt the United States in the competitive international market. However, Japan is a country that has been moving toward the U.S. model for the role of lawyers in the judicial system even as it preserves some limitations on the standards for civil recovery and the types of recoveries available in those cases.

Lifting Limits on the Number of Lawyers Prior to 2000, in order to become a bengoshi (law- yer) in Japan, an individual had to win a slot at the Legal Training and Research Institute. This government-run school accepted only 2% of the 35,000 annual applicants. As a result, only 400 new bengoshi were added each year to Japan’s bar. How- ever, in 2000, the government allowed the opening of private law schools that are operated in a manner similar to those in the United States. With more slots available for education, there are now 29,000 law- yers in Japan, a more-than-double increase from the 14,336 lawyers there in 1992. There is also increased

competition among lawyers. Japan now permits lawyer advertising. Japanese law firms are also now permitted to merge with other firms to increase the services offered and compete effectively.

Limits on Recovery Japanese courts allow recovery only for actual losses. There is no recovery for mental anguish. Class actions are rare in Japan, and it is very difficult to get a court’s approval to go forward with such a suit. The Toyota recall of so many cars in the sudden-acceleration issues of 2010 resulted in great activity in Japanese courts for class actions and recovery.

Costs to Plaintiffs Plaintiffs are required to pay money to their lawyers up front. The amount required is 8% of the recovery sought plus the nonrefundable filing fee.

Limits on Damage Awards Judges, not juries, determine damages, and even in wrongful death cases, the damages may not include punitive damages.

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Chapter 4 Managing Disputes: Alternative Dispute Resolution and Litigation Strategies 137

Encouragement of Settlement and Cultural Disdain for Confrontation In Japan, a cultural pride exists in being able to resolve disputes outside the courtroom; those who must lit- igate are looked down upon. However, the Japanese culture and judicial system are moving toward the use of litigation as a means of correcting company behav- iors. One financial analyst concluded that litigation is good as he discussed the Toyota issues: “Toyota has been arrogant. It’s good that lawsuits are taking place now so Toyota will go through soul-searching.


1. Should the United States move more toward some of the rules of the Japanese litigation system as

Japan moves toward ours? Why or why not? Are there benefits to the openness of one and the limit- edness of the other? What are they?

2. In the English court system, the loser pays court costs and the costs of the other party involved in the litigation. Should such a rule be adopted in the United States? For all cases? Would you be less will- ing to pursue a case for yourself or your company if you knew that you would be required to pay if you lost the case?

Sources: Michele Galen et al., “Guilty,” BusinessWeek, April 13, 1992, pp. 60–66; ABA Report on International Lawyers (1990); Yuka Hayashi, “Japanese Culture Shifting on Suits,” Wall Street Journal, February 23, 2010, p. A4. © Ron and Joe/

n ot e s 1. Alan Dabdoub and Trey Cox, “Which Costs Less: Arbitration or Litigation?,” Inside Counsel, December 6, 2012, http://www -or-litigation. In fact, the study concludes that arbitration is higher in costs as well as in attorneys’ fees.

2. Leigh Jones, “Gotcha Game,” National Law Journal, February 4, 2011, p. A1.

3. Michael Gottesman, the attorney who argued the Daubert case in the U.S. Supreme Court on behalf of the plaintiffs,

confirmed that his client’s name is pronounced “dow-burt.” Michael Gottesman, “Admissibility of Expert Testimony after Daubert: The ‘Prestige’ Factor,” 43 Emory Law Journal 867 (1994). During oral argument, the justices of the Supreme Court mispronounced the name as “dough-bear.” Mr. Gottesman chose the wise course of not correcting the justices. You now know something that Supreme Court justices do not.

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2 Business: Its Regulatory Environment

A business is regulated by everything from the U.S. Constitution to the rules of the Consumer Product Safety Commission. Managers must know codified law, as well as the law that develops as cases are

litigated and new issues of liability arise. The regulatory environment of

business includes penalties for criminal conduct and punitive damages

for knowingly causing injuries to customers. Part 2 describes the laws

that regulate businesses and business operations, including tort and

environmental law, the sanctions that are imposed for violation of these

laws, and the manner in which businesses can make compliance with

the law a key part of their values.

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Business and the Constitution5 The U.S. Constitution is a remarkable document. It was drafted by a group of independent states more than 220 years ago in an attempt to unify the states into one national government that could function smoothly and efficiently with- out depriving those independent states of their rights. The fact that it has sur- vived so many years with so few changes indicates the flexibility and foresight built into the document.

This chapter covers the application of the U.S. Constitution to business and answers several questions: What are the constitutional limitations on business regulation? Who has more power to regulate business—the states or the federal government? What individual freedoms granted under the Constitution apply to businesses?

Update For up-to-date legal and ethics news, go to

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Congress passed the Patient Protection and Afford- able Care Act (also known as Obama Care) in order to increase the number of Americans covered by health insurance and decrease the cost of health care. One key provision in the law is the individual mandate, which requires most Americans to maintain “minimum es- sential” health insurance coverage. Attorneys gener- al and businesses from several states challenged this

requirement (and other provisions of the law) as being unconstitutional under the Commerce Clause. From a series of federal decisions from the courts below, some finding the law constitutional and others not, the affect- ed parties appealed to the U.S. Supreme Court. What does the Commerce Clause have to do with this law? Is the law constitutional?

Consider . . . 5.1

5-1 The U.S. Constitution 5-1a an Overview of the U.S. Constitution

Although virtually all constitutional issues and all court decisions on those issues are complicated and detailed, the U.S. Constitution itself is a simple and short document. Contained within it is the entire structure of the federal government, its powers, the powers of the states, and the rights of all citizens. The exact language of the U.S. Constitution is presented in Appendix A.

5-1b articles I, II, and III—the Framework for Separation of powers

The first three articles of the U.S. Constitution set up the three branches of the federal government. Article I establishes the legislative branch. The two houses of Congress—the House of Representatives and the Senate—are created, their method of electing members is specified, and their powers are listed.

Article II creates the executive branch of the federal government. The office of president along with its qualifications, manner of election, term, and powers are specified.

Article III establishes the judicial branch of the federal government. This arti- cle creates only the U.S. Supreme Court and establishes its jurisdiction. Congress, however, is authorized to establish inferior courts, which it has done in the form of federal district courts, specialized federal courts, and U.S. courts of appeals (see Chapter 3, Exhibit 3.1).

The first three articles establish the nature of the federal government as involv- ing the separation of powers. Each of the branches of government is given unique functions that the other branches cannot perform, but each branch also has curb- ing powers on the other branches through the exercise of its unique powers. For example, the judicial branch cannot pass laws, but it can prevent a law passed by Congress from taking effect by judicially interpreting the law as unconstitutional. The executive branch does not pass legislation but has veto power over legislation

Some men look at constitutions with sanctimonious reverence, and deem them like the ark of the covenant, too sacred to be touched. . . . I am certainly not an advocate for frequent and untried changes in laws and constitutions. . . . But . . . laws and institutions must go hand in hand with the progress of the human mind. Thomas Jefferson

The history of the United States has been written not merely in the halls of Congress, in the Executive offices and on the battlefields, but to a great extent in the chambers of the Supreme Court of the United States. Charles Warren

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142 part 2 Business: Its Regulatory Environment

passed by Congress. The executive branch has responsibility for foreign relations and treaty negotiation. However, those treaties do not take effect until the Senate ratifies them. In 2015, the ratification of the Obama treaty with Iran became a politi- cally charged issue in the Senate. This system of different powers that can be used to curb the other branches’ exercise of power is called a system of checks and balances.

The drafters of the U.S. Constitution designed the federal government this way to avoid the accumulation of too much power in any one branch of government. In Nixon v Administrator of General Services, 433 U.S. 425 (1977), the Supreme Court held that former President Nixon was required to turn over to Congress any records and materials of the executive branch that were relevant to the congressional inquiry into the Watergate scandal (a break-in at the Democratic Party’s national headquarters that was masterminded by members of the Nixon administration). In NLRB v. Noel Canning, 134 S.Ct. 2550 (2014), the Supreme Court declared that President Obama’s interim appointments to the National Labor Relations Board were invalid and would have to be redone with Senate approval. In Clinton v Jones, 520 U.S. 681 (1997), the Supreme Court ruled that even the president is subject to the laws of the land and is accountable for civil wrongs alleged by private citizens. In the case, Paula Corbin Jones alleged that Mr. Clinton had sexually harassed her while he was governor of Arkansas. The Court ruled that, “. . . even the sovereign is subject to God and the law.”

5-1c Other articles

Article IV deals with states’ interrelationships. Article V provides the procedures for constitutional amendments. Article VI is the Supremacy Clause (discussed later in this chapter), and Article VII simply provides the method for state ratifica- tion of the Constitution.

For the Manager’s Desk

Re: the president, Justice alito, Congress, and the Balance of powers

During President Obama’s State of the Union address on January 27, 2009, he made reference to Citizens United v Fed- eral Election Commission, 558 U.S. 310 (2010) (see pp. 162–164). The decision dealt with the constitutionality of portions of the McCain–Feingold campaign and campaign contributions law. The president made the following statements about the decision:

With all due deference to separation of powers, last week the Supreme Court reversed a century of law that, I believe, will open the floodgates for special inter- ests, including foreign corporations, to spend without limit in our elections.

Well I don’t think American elections should be bankrolled by America’s most powerful interests, or worse, by foreign entities. They should be decided by the American people, and that’s why I’m urging Democrats and Republicans to pass a bill that helps to right this wrong.

Following the statement, U.S. Supreme Court Justice Alito could be seen (as he was picked up by the cameras) shaking his head and mouthing what appears to be “not true” or “definitely not true.”

What can be done with regard to the decision? Who was right on what the decision did—Mr. Obama or Justice Alito? (See p. 160.)

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Chapter 5 Business and the Constitution 143

5-1d the Bill of Rights

In addition to the seven articles, the U.S. Constitution 27 has amendments, the first 10 of which are the Bill of Rights. Although these rights originally applied only to federal procedures, the Fourteenth Amendment extended them to apply to the states as well. These amendments establish rights ranging from freedom of speech (First Amendment) to the right to a jury trial (Sixth Amendment) to protection of privacy from unlawful searches (Fourth Amendment) to due process before depri- vation of property (Fifth Amendment). The amendments as they apply to busi- nesses are covered later in this chapter and in Chapter 8.

5-2 The Role of Judicial Review and the Constitution

The Supreme Court and its decisions are often in the news because the cases decided by the Court are generally significant ones that provide interpretations of the U.S. Constitution and also define the extent of the rights we are afforded under it. The role of the U.S. Supreme Court is to decide what rights are provided by the general language of the U.S. Constitution. For example, the Fifth Amendment guarantees that we will not be deprived of our life, liberty, or property without “due process of law.” Due process of law, interpreted by the courts many times now, includes such rights as the right to a hearing before a mortgage foreclosure, or at least the right of notice before property is sold after repossession as a result of nonpayment of the underlying debt.

The First Amendment protects the simple right to freedom of speech, but the Supreme Court has been faced with issues such as whether restrictions on member- ship in student clubs at state universities are an infringement of the First Amend- ment.1 The Fourth Amendment, the “privacy amendment,” protects us from warrantless searches. This general idea has been analyzed in the context of garbage taken from cans waiting for pickup on the street and unannounced inspections of company workplaces by OSHA regulators (see Chapter 19 for more information on OSHA—the Occupational Safety and Health Administration).

The U.S. Supreme Court has the responsibility of determining the extent and scope of the rights and protections afforded by the U.S. Constitution. In addition, the Supreme Court plays the unique role of reviewing the actions of the other branches of government. The Court is a crucial part of the checks-and-balances system set up in our Constitution. As noted in the “For the Manager’s Desk” (see p. 142), the court recently dealt with the issue of the constitutionality of legislation passed by Congress.

5-3 Constitutional Limitations of Economic Regulations

5-3a the Commerce Clause

The Commerce Clause is found in Article I, Section 8, Part 3, of the U.S. Constitu- tion and provides Congress with the power “[t]o regulate Commerce with foreign Nations, and among the several States.” Although the language is short and sim- ple, the phrase “among the several states” has created much controversy. The clause limits Congress to the regulation of interstate commerce. The regulation of local and

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144 part 2 Business: Its Regulatory Environment

intrastate commerce is left to the states. Defining interstate commerce has been the task of the courts. The standards are defined from two perspectives: federal regula- tion of state and local commerce and state and local regulation of interstate commerce.

Standards for Congressional Regulation of State and Local Business activity The issue, as defined by the U.S. Supreme Court, is whether the situation involves sufficient interstate contact or effects for the application of federal standards. The Constitution gives Congress authority to regulate interstate matters and vests all the remaining regulatory authority in the states.

The U.S. Supreme Court initially gave a very narrow interpretation to the scope of the Commerce Clause. In the beginning of the Court’s interstate commerce jurisprudence, federal regulation applied to commercial activity if the commercial activity had a “direct and immediate effect” on interstate commerce. In 1918, the Court ruled that manufacturing was not “commerce” (because it was solely intra- state) and struck down an act of Congress that attempted to regulate goods man- ufactured in plants using child labor. [Hammer v Dagenhart, 247 U.S. 251 (1918)] During the 1930s, Congress and President Roosevelt bumped heads with the Court many times in their attempts to legislate a recovery from the Depression. The Court consistently refused to validate federal legislation dealing with manufactur- ing, operations, and labor. [Schechter Poultry v United States, 295 U.S. 495 (1935); Carter v Carter Coal, 298 U.S. 238 (1936)] Roosevelt refused to accept a judicial road- block to his legislation and initiated his court-packing plan to increase the number of members of the court with Roosevelt appointees.

The Court responded in NLRB v Laughlin Steel, 336 U.S. 460 (1940), by ruling that intrastate activities, even though local in character, may still affect interstate com- merce and thus be subject to federal regulation. The “affectation” doctrine expanded the authority of the federal government in regulating commerce. In the words of the Court, “If it is interstate commerce that feels the pinch, it does not matter how local the squeeze” (336 U.S. at 464). The Commerce Clause has had a critical role in the elimination of discrimination because the Court’s liberal definition of what consti- tutes interstate commerce has permitted the application of federal civil rights laws to local economic activities. However, some recent refinements limit federal authority. For example, in U.S. v Lopez, 514 U.S. 564 (1995), the court held that the Gun-Free School Zones Act of 1990, 18 U.S.C. § 922(q)(1)(A), which made it a federal crime to knowingly possess a firearm in a school zone, exceeded Congress’s authority under the Commerce Clause because Congress was not regulating any form of commerce through the law but imposing criminal sanctions on a local activity. Because there was no commerce or economic activity involved, federal authority to regulate was limited by the Commerce Clause. Congress has the authority to regulate in those areas where what they are regulating substantially affects interstate commerce. Likewise, in U.S. v Morrison, 529 U.S. 598 (2000), the Court struck down the federal Violence Against Women Act because the law, which provided for a federal cause of action for women who had been assaulted, did not deal with any underlying economic activity and the Court held that allowing Congress to regulate the right to file suit for criminal activity would allow Congress to use the Commerce Clause to completely obliterate the Con- stitution’s distinction between national and local authority.

National Federation of Independent Business v Sebelius (Case 5.1) is a landmark case that also limits the scope of federal power under the Commerce Clause but expanded other federal powers, including that of taxation (see discussion of taxa- tion powers on p. 149).

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Chapter 5 Business and the Constitution 145

National Federation of Independent Business v Sebelius 132 S.Ct. 2566 (2012)

Mandating Health Insurance under the Commerce Clause

Case 5.1


Congress passed the Patient Protection and Affordable Care Act (also known as Obama Care) in order to increase the number of Americans covered by health insurance and decrease the cost of health care. One key provision in the law is the individual mandate, which requires most Americans to maintain “minimum essen- tial” health insurance coverage. Attorneys general from several states, along with businesses, challenged this requirement (and other provisions of the law) as being unconstitutional under the Commerce Clause. From a series of federal court decisions below, some finding the law constitutional and others not, the affected par- ties appealed and the Supreme Court granted certiorari. Their cases were consolidated for the court’s review.


ROBERTS, Chief Justice The Constitution grants Congress the power to “regu- late Commerce.” (Art. I, § 8, cl. 3.) The power to regulate commerce presupposes the existence of commercial activity to be regulated. If the power to “regulate” something included the power to create it, many of the provisions in the Constitution would be superflu- ous. For example, the Constitution gives Congress the power to “coin Money,” in addition to the power to “regulate the Value thereof.” And it gives Congress the power to “raise and support Armies” and to “provide and maintain a Navy,” in addition to the power to “make Rules for the Government and Regulation of the land and naval Forces.” If the power to regulate the armed forces or the value of money included the power to bring the subject of the regulation into existence, the specific grant of such powers would have been unnecessary. The language of the Constitution reflects the natural understanding that the power to regulate assumes there is already something to be regulated.

Our precedent also reflects this understanding. As expansive as our cases construing the scope of the commerce power have been, they all have one thing in common: They uniformly describe the power as reach- ing “activity.” It is nearly impossible to avoid the word when quoting them.

The individual mandate, however, does not reg- ulate existing commercial activity. It instead compels individuals to become active in commerce by purchas- ing a product, on the ground that their failure to do so affects interstate commerce. Construing the Commerce Clause to permit Congress to regulate individuals precisely because they are doing nothing would open a new and potentially vast domain to congressional authority. Every day individuals do not do an infinite number of things. In some cases they decide not to do something; in others they simply fail to do it. Allowing Congress to justify federal regulation by pointing to the effect of inaction on commerce would bring countless decisions an individual could potentially make within the scope of federal regulation, and—under the Gov- ernment’s theory—empower Congress to make those decisions for him.

Indeed, the Government’s logic would justify a mandatory purchase to solve almost any problem. To consider a different example in the health care market, many Americans do not eat a balanced diet. That group makes up a larger percentage of the total population than those without health insurance. The failure of that group to eat a healthy diet increases health care costs more than the failure of the uninsured to purchase insurance. Those increased costs are borne in part by failure of that group to have a healthy diet increases health care costs, to a greater extent than other Amer- icans who must pay more, just as the uninsured shift costs to the insured. Congress addressed the insurance problem by ordering everyone to buy insurance. Under the Government’s theory, Congress could address the diet problem by ordering everyone to buy vegetables.

People, for reasons of their own, often fail to do things that would be good for them or good for society. Those failures—joined with the similar failures of others— can readily have a substantial effect on interstate com- merce. Under the Government’s logic, that authorizes Congress to use its commerce power to compel citizens to act as the Government would have them act.

That is not the country the Framers of our Consti- tution envisioned. James Madison explained that the Commerce Clause was “an addition which few oppose and from which no apprehensions are entertained.”

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146 part 2 Business: Its Regulatory Environment

The Federalist No. 45, at 293. While Congress’s authori- ty under the Commerce Clause has of course expanded with the growth of the national economy, our cases have “always recognized that the power to regulate commerce, though broad indeed, has limits.” The Government’s theory would erode those limits, per- mitting Congress to reach beyond the natural extent of its authority, “everywhere extending the sphere of its activity and drawing all power into its impetuous vortex.” The Federalist No. 48, at 309 (J. Madison). Congress already enjoys vast power to regulate much of what we do. Accepting the Government’s theory would give Congress the same license to regulate what we do not do, fundamentally changing the relation between the citizen and the Federal Government.

[There were other issues covered in the 106-page opinion. The complicated decision resulted in the lower court decisions being both affirmed and reversed, but the individual mandate was declared unconstitutional under the Commerce Clause but constitutional as a tax.]


1. What was missing that the Court indicated was needed in order to find that the mandate was constitutional?

2. What was the purpose of the court’s discussion of a healthy diet?

3. What sources does the court rely on for constitu- tional interpretation?

Ollie’s Barbecue is a family-owned restau- rant 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 sta- tions. The restaurant caters to a family and white-collar trade, with a takeout service for “Negroes.” (Note: The court uses this term in the opinion on the case.)

In the 12 months preceding the pas- sage of the Civil Rights Act, the restaurant purchased locally approximately $150,000 worth of food, $69,683 or 46% 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 accommodations since its original 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?

THINK: What did the Sebelius case require for the Commerce Clause to allow

Congressional action on intrastate activi- ties? If Congress was to have the authority to regulate seemingly intrastate activities, there had to be some underlying economic activity, and, whatever that economic activity was, it had to have some relation to or an impact on interstate activity.

APPLY: What is different about Ollie’s Barbecue’s activities and the federal health care law?

Ollie’s Barbecue is a commercial enter- prise involved in producing and selling food. This is economic activity, and the Sebelius case discussed that Congress was not au- thorized to regulate inactivity, which is what the mandate did.

Ollie’s has an impact on interstate commerce because it orders goods in in- terstate commerce, and it serves travelers who are moving from state to state. The Civil Rights Act prohibited discrimination in public places, and Congress was regulat- ing economic activity. The activity involved interstate shipment of goods.

ANSWER: Congress had the authority under the Commerce Clause to pass the Civil Rights Act and have it apply to intra- state businesses such as Ollie’s Barbecue.

[Katzenbach v McClung, 379 U.S. 294 (1964)]

Consider . . . 5.2

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Chapter 5 Business and the Constitution 147

Standards for State Regulation of Interstate Commerce The Commerce Clause also deals with issues beyond those of federal power. The interpretation of the clause involves how much commerce the states can regulate without interfering in the congressional domain of interstate commerce. In answer- ing this question, the courts are concerned with two factors: (1) whether federal regulation supersedes state involvement and (2) whether the benefits achieved by the regulation outweigh the burden on interstate commerce. These two factors are meant to prevent states from passing laws that would give local industries and businesses an unfair advantage over interstate businesses. In some circumstances, however, the states can regulate interstate commerce. Those circumstances occur when the state is properly exercising its police power.

What Is the Police Power? The police power is the states’ power to pass laws that promote the public welfare and protect public health and safety. Regulation of these primary concerns is within each state’s domain. It is, however, inevitable that some of the laws dealing with public welfare and health and safety will burden interstate commerce. Many of the statutes that have been challenged constitution- ally have regulated highway use. For example, some cases have tested a state’s power to regulate the length of trucks on state highways. [Raymond Motor Trans- portation v Rice, 434 U.S. 429 (1978)] In Bibb v Navajo Freight Lines, Inc., 359 U.S. 520 (1959), the Supreme Court analyzed an Illinois statute requiring all trucks using Illinois roads to be equipped with contour mudguards. These mudguards were supposed to reduce the amount of mud splattering the windshields of other driv- ers and preventing them from seeing. Both cases revolved around the public safety purpose of the statutes.

The Balancing Test. A statute is not entitled to constitutional protection just because it deals with public health, safety, or welfare. Although the courts try to protect the police power, that protection is not automatic. The police power is upheld only so long as the benefit achieved by the statute does not outweigh the burden imposed on interstate commerce. Each case is decided on its own facts. States present evi- dence of the safety benefits involved, and the interstate commerce interests pres- ent evidence of the costs to and effects on interstate commerce. The question courts must answer in these constitutional cases is whether the state interest in public health, welfare, or safety outweighs the federal interest in preventing interstate commerce from being unduly burdened. In performing this balancing test, the courts of course examine the safety, welfare, and health issues. However, the courts also examine other factors, such as whether the regulation or law provides an unfair advantage to intrastate or local businesses. For example, a prohibition on importing citrus fruits into Florida would give in-state growers an undue advantage.

Courts also examine the degree of the effect on interstate commerce. State stat- utes limiting the length of commercial vehicles would require commercial truck lines to buy different trucks for certain routes or in some cases to stop at a state’s border to remove one of the double trailers being pulled. Such stops can have a substantial effect on interstate travel. On the other hand, a state law that requires travelers to stop at the border for a fruit and plant check is not as burdensome: only a stop is required, and the traveler would not be required to make any further adjustments. Also, the state’s health interest is great; most fruit and plant checks are done to keep harmful insects from entering the state and destroying its crops. In the Bibb case, the courts found that the evidence of increased safety was not per- suasive enough to outweigh the burden on interstate commerce.

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148 part 2 Business: Its Regulatory Environment

Another question courts answer in their analysis is whether the state could accomplish its health, welfare, or safety goal in any other way with less of a bur- den on interstate commerce. Suppose a state has a health concern about having milk properly processed. One way to cover the concern is to require all milk to be processed in state. Such a regulation clearly favors that state’s businesses and imposes a great burden on out-of-state milk producers. The same result, however, could be produced by requiring all milk sellers to be licensed. The licensing pro- cedure would allow the state to check the milk-processing procedures of all firms and accomplish the goal without imposing such a burden on out-of-state firms. In Rowe v New Hampshire Motor Transport Association (Case 5.2), the court dealt with a state’s regulation of tobacco products delivered into the state.

Rowe v New Hampshire Motor Transport Ass’n 552 U.S. 364 (2008)

Minors, Maine, and Motor Transport of Tobacco

Case 5.2


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 becom- ing addicted to tobacco. The federal district court granted summary judgment for the shippers, and the court of appeals affirmed. The state of Maine appealed.


BREYER, Justice The provision requires the carrier to check each ship- ment for certain markings and to compare it against the Maine attorney general’s list of proscribed shippers. And it thereby directly regulates a significant aspect of the motor carrier’s package pickup and delivery ser- vice. In this way it creates the kind of state-mandated regulation that the federal Act pre-empts.

Maine replies that the regulation will impose no significant additional costs upon carriers. But even were that so (and the carriers deny it), Maine’s reply is off the mark. As with the recipient-verification provi- sion, the “deemed to know” provision would freeze in place and immunize from competition a service-related

system that carriers do not (or in the future might not) wish to provide. To allow Maine to insist that the car- riers provide a special checking system would allow other States to do the same. And to interpret the federal law to permit these, and similar, state requirements could easily lead to a patchwork of state service-deter- mining laws, rules, and regulations.

That state regulatory patchwork is inconsistent with Congress’ major legislative effort to leave such decisions, where federally unregulated, to the compet- itive marketplace. And to allow Maine directly to reg- ulate carrier services would permit other States to do the same. Given the number of States through which carriers travel, the number of products, the variety of potential adverse public health effects, the many differ- ent kinds of regulatory rules potentially available, and the difficulty of finding a legal criterion for separating permissible from impermissible public health- oriented regulations.

In this case, the state law is not general, it does not affect truckers solely in their capacity as members of the general public, the impact is significant, and the connection with trucking is not tenuous, remote, or peripheral. The state statutes aim directly at the car- riage of goods, a commercial field where carriage by commercial motor vehicles plays a major role. The state statutes require motor carrier operators to perform cer- tain services, thereby limiting their ability to provide incompatible alternative services; and they do so sim- ply because the State seeks to enlist the motor carrier operators as allies in its enforcement efforts.

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Chapter 5 Business and the Constitution 149

Congressional Regulation of Foreign Commerce The Commerce Clause also grants Congress the power to regulate foreign com- merce. The case of Gibbons v Ogden, 9 Wheat. 1 (1824), defined foreign commerce as any “commercial intercourse between the United States and foreign nations.” This power to regulate applies regardless of where the activity originates and where it ends. For example, many international trade transactions begin and end in the city of New York. Although the paperwork and delivery of the goods may be solely within one state (here within one city), the foreign commerce power is not restricted by intrastate standards. If the transaction involves foreign commerce, congressional regulation applies (such as customs controls and fees) regardless of the place of transaction.

5-3b Constitutional Standards for taxation of Business

Article I, Section 8, Paragraph 1, of the Constitution gives Congress its powers of taxation: “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises. . . .” In addition, the Sixteenth Amendment to the Constitution gives this power: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

The U.S. Supreme Court has consistently upheld the authority of Congress— and local governments as well—to impose taxes. However, one area in taxation still results in considerable litigation. This area involves state and local taxation of interstate commerce. Interstate businesses are not generally exempt from state and local taxes just because they are interstate businesses. However, the taxes imposed on these businesses must meet certain standards.

First, the tax cannot discriminate against interstate commerce. A tax on milk could not be higher for milk that is shipped in from out of state than for milk pro- duced within the state.

Second, the tax cannot unduly burden interstate commerce. For example, a tax on interstate transportation companies that is based on the weight of their

Maine adds that it possesses legal authority to prevent any tobacco shipments from entering into or moving within the State, and that the broader authority must encompass the narrower authority to regulate the manner of tobacco shipments.

But even assuming purely for argument’s sake that Maine possesses the broader authority, its conclusion does not follow. To accept that conclusion would per- mit Maine to regulate carrier routes, carrier rates, and carrier services, all on the ground that such regulation would not restrict carriage of the goods as seriously as would a total ban on shipments.

And it consequently would severely undermine the effectiveness of Congress’ pre-emptive provi- sion. Indeed, it would create the very exception that we have just rejected, extending that exception to all other products a State might ban. We have explained why we do not believe Congress intended that result.

Finally, Maine says that to set aside its regulations will seriously harm its efforts to prevent cigarettes from falling into the hands of minors. The Solicitor General denies that this is so. He suggests that Maine, like other States, can prohibit all persons from providing tobacco products to minors; that it can ban all non-face-to-face sales of tobacco; that it might pass other laws of general applicability; and that it can, if necessary, seek appro- priate federal regulation.

For these reasons, the judgment of the Court of Appeals is affirmed.


1. What is the effect of the Maine law, if allowed to stand, on interstate carriers?

2. If this law is constitutional, what would happen to interstate carriers and their activities within particular states?

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150 part 2 Business: Its Regulatory Environment

trucks as measured upon entering and leaving the states would be a burden- some tax.

Third, some connection—“a sufficient nexus”—between the state and the busi- ness being taxed must be established. The business must have some activity in the state, such as offices, sales representatives, catalog purchasers, or distribution systems.

Finally, the tax must be apportioned fairly. Apportionment prevents having businesses taxed in all 50 states for their property. Apportionment also avoids the unjust result of having businesses pay state income tax on all their income in all 50 states. Their income and property taxes must be apportioned according to the amount of business revenues in each state and the amount of property located in that state. General Motors does not pay an inventory tax to all 50 states on all of its inventory, but it does pay an inventory tax on the inventory it holds in each state. A significant decision on tax apportionment is New Mexico Taxation and Revenue Department v LLC (Case 5.3).

CASE 5.3 New Mexico Taxation and Revenue Department v. LLC, 283 P.3d 298 (N.M. App. 2012) and brick and mortar combo retailers: taxing?

FaCtS LLC ( is a Delaware cor- poration that sells books, movies, and other media over the Internet. In 2006, the New Mexico Taxation and Revenue Department (the Department) assessed gross receipts tax against on its sales to New Mexico residents during a period from January 1998 through July 2005. protested the assessment, and a hearing officer granted summary judgment to, finding that it lacked a substantial nexus with the State of New Mexico, and therefore it could not constitutionally be required to pay the tax. The Depart- ment appealed, and the Court of Appeals held that had a substantial nexus with the state. appealed.


CHÁVEZ, Justice This case presents the question of whether an out-of- state internet retailer (, which has no physical presence in New Mexico other than through stores owned by a sister corporation, Barnes & Noble Book- sellers, Inc. (Booksellers), is subject to New Mexico gross receipts tax on its sales to New Mexico residents without offending the federal Commerce Clause.

The Commerce Clause has been interpreted not only as an affirmative grant of power to Congress, but also as a limitation on state actions that interfere with interstate commerce. [Quill Corp. v N.D. ex rel. Heit- kamp, 504 U.S. 298 (1992)]

In the absence of specific federal authorization, the Commerce Clause allows a state to tax an actor in inter- state commerce “when the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State.” Of these requirements, the only issue in this case is in the substantial nexus. If’s actual sales have a substantial nexus with New Mexico, New Mexico may constitutionally tax those sales.

A vendor that has a physical presence in the taxing state has a substantial nexus with the state. The key dis- tinction is “between mail-order sellers with [a physical presence in the taxing] State and those . . . who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business.” The facts in Quill Corp. concern a vendor that did not have a physical presence in the taxing state of North Dakota and Quill Corp. sold its products by mail; it had no offices, employees, or significant proper- ty in North Dakota. Therefore, the U.S. Supreme Court

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Case 5.3

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Chapter 5 Business and the Constitution 151

held that the company lacked a substantial nexus with North Dakota, and North Dakota could not require the company to pay a use tax to the state on its sales. The Court explained that there is a “safe harbor for vendors ‘whose only connection with customers in the [taxing] State is by common carrier or the United States mail.’ . . . In this case, the parties agree that itself has no employees or property in New Mexico, but that is not the end of our inquiry.

Although had no property in New Mexico, Booksellers performed activities in New Mexico for’s benefit. Booksellers operated three stores in New Mexico during the audit period. and Booksellers are separate corporations, but they share a parent company, Barnes & Noble, Inc., which owned 100% of Booksellers and between 40% and 100% of throughout the audit period. During the audit period, Booksellers displayed’s web address on gift cards (usable at either Booksellers or that they sold in stores during part of the audit period, providing with advertising. Booksellers sold memberships in a loyalty program that also gave customers a discount at, and Booksellers shared customers’ email addresses with

In addition, and Booksellers both used Barnes & Noble trademarks. A reasonable inference is that consumers would likely have thought of the two corporations as one company. Because of customers’ association of Booksellers with, benefitted from brand loyalty established by local branches of Booksellers.’s parent company recognized the benefits of such custom- er associations in a filing with the Securities and Exchange Commission during the audit period, in which it wrote that “the Barnes & Noble trade name . . . is a strong motivating factor in attracting customers, especially with regard to the post-early adopter market of consumers who have yet to make an online purchase.”

We therefore hold that Booksellers’ in-state activi- ties assisted’s efforts to establish and maintain a market in New Mexico.

Even though Booksellers accepted returns of purchases from on the same basis as returns from its competitors, advertised its return policy to customers as follows: “You can return your online purchases of most products to us for a full refund or to any Barnes & Noble Store for an in-store credit.” Near its “Easy Returns” link, also pro- vided a link to a Booksellers store locator. Customers visiting’s website would likely have seen the ability to return items to Booksellers’ stores as a

benefit of purchasing from Nothing on the site suggests that customers could return purchases from or any other competitor on identical terms, even though that was apparently the case.

We recognize that courts in several states have reached a different conclusion, holding that the pres- ence of affiliated brick-and-mortar stores in a state does not create a nexus that would allow the state to tax catalogue or online sales.

We also recognize that one federal district court considered a case almost identical to this one and found no substantial nexus. [St. Tammany Parish Tax Collector v, 481 F. Supp. 2d 575, 582 (E.D.La. 2007)] That court seems to have imposed a standard higher than that required by [the U.S. Supreme Court]. The court does not require Booksellers to act as sales agents for; it requires only that activities performed on’s behalf be “significantly associated with [’s] ability to establish and maintain a market” in New Mexico. Booksellers and presented a single face to the public, so we may infer that Booksellers’ New Mexico locations developed name recognition and loyalty for Booksellers sold gift cards that encouraged customers to shop at, and advertised its connections to Booksellers by offering a store locator and by promoting its return policy. and Booksellers also shared customer data.

We conclude that Booksellers’ presence and activities in New Mexico gave an advantage over its competitors, which helped establish and maintain a market in this state. Because Book- sellers’ activities in New Mexico were significantly associated with’s ability to establish and maintain a market here, had a substantial nexus with the State of New Mexico. Therefore, New Mexico may collect gross receipts tax on’s sales in the state without offending the Commerce Clause of the United States Constitution. Affirmed and remanded.


1. Explain why the Court feels this case is different from other cases in which online retailers have not been taxed.

2. What benefits does an online retailer gain from a physical presence in the state?

3. Were customers of Booksellers and allowed to interchange their business with the two retailers?

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152 part 2 Business: Its Regulatory Environment

5-4 State versus Federal Regulation of Business—Constitutional Conflicts: Preemption and the Supremacy Clause

Although the Constitution has sections that deal with the authority of the federal government and some that deal with state and local governments, some crossovers between state and federal laws still occur. For example, both state and federal governments regulate the sale of securities and both have laws on the sale of real property. Such crossovers create conflicts and a constitutional issue of who has the power to regulate. These conflicts between state and federal laws are governed by Article VI of the Constitution, sometimes called the Supremacy Clause, which provides, “This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land. . . .”

The Supremacy Clause provides that when state and local laws conflict with federal statutes, regulations, executive orders, or treaties, the federal statute, reg- ulation, executive order, or treaty controls the state or local law. However, in a variety of cases, a state law does not directly conflict with the federal law. Some- times, the federal government just has extensive regulations in a particular area. In those areas of extensive federal regulation, the issue of which laws control can be resolved in Congress, which specifies its intent in an act. For example, Congress

Twenty-one states and eight cities have what is commonly called a “jock tax.” These are municipal taxes that were passed pri- marily to obtain revenue from athletes, coaches, trainers, and highly paid entertain- ers when they are present in the city for purposes of earning income. All profession- al sports events and concerts bring revenue from the players and artists in the form of state and municipal income taxes.

Indianapolis Colt player Jeff Saturday challenged the city of Cleveland’s collec- tion of municipal taxes from him. In 2008, the Colts paid Jeff Saturday $3,577,561.11 in compensation and attributed $178,878 (approximately 5% of Mr. Saturday’s total compensation) to a game the Colts played in Cleveland during 2008. The calculation employed the “games played” method of calculation. For example, if the team played 20 games, then 1/20 of the income, or 5%, is allocated to each of the cities involved as the required jock tax. The Colts with- held the allocated Cleveland tax, or $3,594.

However, Mr. Saturday did not travel to the Cleveland game because he stayed in In- dianapolis and participated in rehabilitation for a knee injury, as ordered by the team’s physician.

Mr. and Mrs. Saturday, who filed a joint tax return, applied for a refund from Cleveland. Cleveland refunded $322. The Saturdays appealed to the board of review, which upheld the amount of the payment and the refund. The Saturdays then ap- pealed the refund amount to the Board of Tax Appeals (BTA), and the BTA affirmed the decision of the review board. The Sat- urdays appealed that decision to the Ohio Supreme Court. The city of Cleveland ar- gued that even though Mr. Saturday was not present for the game, there was a part of his salary that was attributable to the playing of the game in Cleveland and was, therefore, taxable. What should the court decide and why? [Saturday v Cleve- land Board of Review, 33 N.E.2d 46 (Ohio 2015)]

Consider . . . 5.3

Know state taxation laws before you decide where to locate a plant, office, or warehouse. For example, Nevada does not have an inven- tory tax, so many man- ufacturers have large warehouse facilities there, including Spiegel and Levi Strauss. Other states have no sales tax but have high property tax rates. Still other states have high sales tax and low income tax rates. Structuring a nationwide business requires an understand- ing of intrastate as well as interstate taxes.

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Chapter 5 Business and the Constitution 153

amazon’s Internet Sales tax Strategy has been very careful about state sales tax issues. The company has even controlled how often employees can travel to certain states so that it does not reach the level of a physical presence for purposes of being subject to sales tax in those states. However, Amazon, along with other Internet retailers, reached an agreement with the states for a type of uniform sales tax application that simplified what had become a complicated sales tax structure during the height of catalog sales. By 2013, Amazon was supporting feder- al legislation, known as the Marketplace Fairness Act, that would require all online retailers with over $1 million in annual revenue to pay state and local taxes on transactions completed on the Internet by any customers located within those taxing

jurisdictions. The costs of computing those taxes and handling audits by sales tax authorities would give Amazon less com- petition because smaller businesses could not maintain the staff or expertise to handle these complexities.

Amazon also established a division with- in its organization that would provide con- tract services to smaller businesses to help them in collecting their sales taxes on Inter- net sales. Amazon’s approach to the confus- ing constitutional standards was to solve the problem with its own legislative proposals and to find a business niche to operate in helping others to solve the problems of tax collection for Internet sales. Amazon worked strategically with government and empha- sized its business strengths to find a solu- tion to a complex and uncertain legal issue.

Business Strategy

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has provided that many federal workplace safety laws can be circumvented by state law as long as the state law provides as much employee protection as the federal laws. In other words, Congress allows the states to regulate the field in some instances and sets the standards for doing so. Most statutes, however, do not include the congressional intent on preemption. Whether a field has been preempted is a question of fact, of interpretation, and of legislative history. The question of preemption is determined on a case-by-case basis using the following questions:

1. What does the legislative history indicate? Some hearings offer clear state- ments of the effect and scope of a federal law.

2. How detailed is the federal regulation of the area? The more regulation there is, the more likely a court is to find preemption. Volume itself indicates con- gressional intent.

3. What benefits exist from having federal regulation of the area? Some matters are more easily regulated by one central government. Airlines fly across state lines, and if each state had different standards, there would be no guarantee of uniform standards. The regulation of aircraft and their routes is clearly better handled by the federal government.

4. How much does a state law conflict with federal law? Is there any way that the two laws can coexist?

Mutual Pharmaceutical Co., Inc. v Bartlett (Case 5.4) deals with a preemption issue.

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154 part 2 Business: Its Regulatory Environment

Mutual Pharmaceutical Co., Inc. v Bartlett 133 S.Ct. 2466 (2013)

An Anti-Inflammatory Drug and an Inflammatory Decision

Case 5.4


In 1978, the FDA approved an anti-inflammatory pain reliever called “sulindac” under the brand name of “Clinoril.” When the patent expired, the FDA approved several generic versions of sulindac for sale, including one developed by Mutual Pharmaceutical (Petitioner). The warnings for Clinoril included the possibility of developing toxic epidermal necrolysis. Karen Bartlett (respondent) took a generic form of sulindac in Decem- ber 2004 and developed an acute case of toxic epidermal necrolysis. Sixty to 65 percent of Ms. Bartlett’s body deteriorated, was burned off, or turned into an open wound. She spent months in a medically induced coma, underwent 12 eye surgeries, and was tube-fed for a year. She is now severely disfigured, has a number of physical disabilities, and is nearly blind.

At the time Ms. Bartlett got her sulindac prescrip- tion, the label did not refer to toxic epidermal necroly- sis but warned that the drug could cause “severe skin reactions” and “fatalities.” Toxic epidermal necroly- sis was listed as a side effect in the package insert. After Ms. Bartlett was suffering from toxic epidermal necrolysis, the FDA did a comprehensive study and recommended that the product label include more explicit warnings about toxic epidermal necrolysis.

Ms. Bartlett sued Mutual in New Hampshire state court, and Mutual removed the case to federal court. Ms. Bartlett initially asserted both failure-to-warn and design-defect claims, but the District Court dismissed her failure-to-warn claim based on her doctor’s “admi[s- sion] that he had not read the box label or insert.” After a two-week trial on a design-defect claim, a jury found Mutual liable and awarded Ms. Bartlett over $21 million in damages. The Court of Appeals affirmed, and Mutual appealed. The U.S. Supreme Court granted certiorari.


ALITO, Justice We must decide whether federal law pre-empts the New Hampshire design-defect claim.

The Supremacy Clause provides that the laws and treaties of the United States “shall be the supreme Law of the Land . . . any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.” “[U]nder

the Supremacy Clause, from which our pre-emption doctrine is derived, any state law, however clearly within a State’s acknowledged power, which interferes with or is contrary to federal law, must yield.”

Federal law prevents generic drug manufacturers from changing their labels. When federal law forbids an action that state law requires, the state law is “without effect.” Because it is impossible for Mutual and other similarly situated manufacturers to comply with both state and federal law, New Hampshire’s warning-based design-defect cause of action is pre-empted with respect to FDA-approved drugs sold in interstate commerce.

The Court of Appeals reasoned that Mutual could escape the impossibility of complying with both its federal- and state-law duties by “choos[ing] not to make [sulindac] at all.” We reject this “stop-selling” rationale as incompatible with our pre-emption jurisprudence. Our pre-emption cases presume that an actor seeking to satisfy both his federal- and state-law obligations is not required to cease acting altogether in order to avoid liability. Indeed, if the option of ceasing to act defeated a claim of impossibility, impossibility pre-emption would be “all but meaningless.”

The dreadful injuries from which products liabil- ities cases arise often engender passionate responses. But sympathy for respondent does not relieve us of the responsibility of following the law.

The dissent accuses us of incorrectly assuming “that federal law gives pharmaceutical companies a right to sell a federally approved drug free from common-law liability.” But we make no such assumption. Rather, we hold that state-law design-defect claims like New Hamp- shire’s that place a duty on manufacturers to render a drug safer by either altering its composition or altering its labeling are in conflict with federal laws that prohibit manufacturers from unilaterally altering drug composi- tion or labeling. The dissent is quite correct that federal law establishes no safe-harbor for drug companies—but it does prevent them from taking certain remedial mea- sures. Where state law imposes a duty to take such reme- dial measures, it “actual[ly] conflict[s] with federal law” by making it “‘impossible for a private party to comply with both state and federal requirements.’“

Finally, the dissent laments that we have ignored “Congress’ explicit efforts to preserve state

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Chapter 5 Business and the Constitution 155

common-law liability.” We have not. Suffice to say, the Court would welcome Congress’ “explicit” resolution of the difficult pre-emption questions that arise in the prescription drug context. That issue has repeatedly vexed the Court—and produced widely divergent views—in recent years.

As the dissent concedes, however, the [federal law’s] treatment of prescription drugs includes nei- ther an express pre-emption clause nor an express non-pre-emption clause. In the absence of that sort of “explicit” expression of congressional intent, we are left to divine Congress’ will from the duties the statute imposes. That federal law forbids Mutual to take actions required of it by state tort law evinces an intent to pre-empt.

Congress [has made the] decision to regulate the manufacture and sale of generic drugs in a way

that reduces their cost to patients but leaves generic drug manufacturers incapable of modifying either the drugs’ compositions or their warnings. Respon- dent’s situation is tragic and evokes deep sympathy, but a straightforward application of pre-emption law requires that the judgment below be reversed.


1. Explain why the extra labeling could not be placed on the generic version of the drug that Ms. Bartlett purchased.

2. Discuss the relationship between state product liability laws and the duty of manufacturers and federal regulation of generic labels.

3. How does the court address the issue of the tragedy of the case?

Samantha T. Reckis was seven years old in late 2003, when she developed toxic epider- mal necrolysis (TEN), a rare but life-threat- ening skin disorder, after receiving multiple doses of Children’s Motrin. Children’s Mo- trin is an over-the-counter (OTC) medication with ibuprofen as its active ingredient that is manufactured and sold by the McNeil–PPC, Inc., whose parent company is Johnson & Johnson.

Lisa and Richard Reckis, Samantha’s parents, claim that Samantha developed TEN as a result of being exposed to the ibuprofen in the Children’s Motrin. They brought suit alleging that the warning la- bel failed to warn consumers adequately

about the serious risk of developing TEN, a life-threatening disease. After a lengthy jury trial, the trial court found for the Reckis family and awarded $63 million in damages to them. Johnson & Johnson (McNeil) appealed on the grounds that the state suit was preempted because the FDA has exclusive authority over drug labels and the Motrin label complied with the FDA requirements. In fact, the FDA had prohibited McNeil from adding any discussion of possible risk of TEN because it was rare and would confuse consumers. What should the court do? [Reckis v Johnson & Johnson, 28 N.E.3d 445 (Mass. 2015)]

Consider . . . 5.4

Ethical Issues

Evaluate the ethics of a generic drug manufacturer using the same label instead of asking for updates when they are aware of risks and harms from usage of the drug.

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156 part 2 Business: Its Regulatory Environment

5-5 Application of the Bill of Rights to Business Certain of the amendments to the U.S. Constitution have particular significance for business, especially the First Amendment on freedom of speech and the Four- teenth Amendment for its issues of substantive and procedural due process and equal protection. The Fourth, Fifth, and Sixth Amendments on criminal procedures also have significance for business; those issues are covered in Chapter 8.

5-5a Commercial Speech and the First amendment

The area of First Amendment rights and freedom of speech is complicated and full of significant cases. The discussion here is limited to First Amendment rights as they apply to businesses. The speech of business is referred to as commercial speech, which is communication used to further the economic interests of the speaker. Advertising is clearly a form of commercial speech.

5-5b First amendment protection for advertising

Until the early 1970s, the U.S. Supreme Court held that commercial speech was different from the traditional speech afforded protection under the First Amend- ment. The result was that government regulation of commercial speech was virtu- ally unlimited. The Court’s position was refined in the 1970s, however, to a view that commercial speech was entitled to First Amendment protection but not on the same level as noncommercial speech. Commercial speech was not an absolute freedom; rather, the benefits of commercial speech were to be weighed against the benefits achieved by government regulation of that speech. Several factors are examined in performing this balancing test.

1. Is a substantial government interest furthered by restricting the commercial speech?

2. Does the restriction directly accomplish the government interest? 3. Is there any other way to accomplish the government interest? Can it be

accomplished without regulating commercial speech? Are the restrictions no more extensive than necessary to serve that interest?

These standards clearly provide authority for regulation of fraudulent adver- tising and advertising that violates the law. For example, if credit terms are adver- tised, Regulation Z requires full disclosure of all terms (see Chapter 11 for more details). This regulation is acceptable under the standards just listed. Further, restrictions on where and when advertisements are made are permissible. For example, cigarette ads are not permitted on television, and such a restriction is valid.

Exhibit 5.1 illustrates the degrees of protection afforded business speech. The overlapping area represents those cases in which the need to disseminate informa- tion conflicts with regulations on ad content or form.

The overlapping area of the diagram shows a shift during the 1970s when cases were introduced that reformed the commercial speech doctrine by limiting restric- tions on professional advertising. In Virginia State Board of Pharmacy v Virginia Cit- izens Consumer Council, Inc., 425 U.S. 748 (1976), the Supreme Court dealt with the issue of the validity of a Virginia statute that made it a matter of “unprofessional conduct” for a pharmacist to advertise the price or any discount of prescription drugs. In holding the statute unconstitutional, the Court emphasized the need for

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Chapter 5 Business and the Constitution 157

the dissemination of information to the public. In a subsequent case, the Court applied the same reasoning to advertising by lawyers. [Bates v State Bar of Arizona, 433 U.S. 350 (1977)]

An evolving area that is part of the overlapping portion of the two circles is that of corporate speech in defense of corporate decisions and policies—speech by corporations that is neither political speech nor advertising but rather explains and defends corporate policies such as animal testing, outsourcing production

Exhibit 5.1 Commercial Speech: First amendment protections and Restrictions

First Amendment

Full Protection of Commercial


Political Speech by


Government Regulation of

Commercial Speech

Business Advertising

Speech on Social Issues and Business Operations:

Nike; Professions

The award-winning film Zero Dark Thirty came under federal investigation when then-acting director of the Central Intelli- gence Agency, Michael Morell, was asked by the Senate Intelligence Committee to provide the Committee with “all informa- tion and documents” that the agency had provided to filmmakers, as well as the re- cords that reflected meetings and discus- sions between employees of the agency and the filmmakers. The reason for the request was the Committee’s statement that it found the movie to be “grossly inac- curate.” The alleged inaccuracies centered on whether information obtained through torture (waterboarding) was key in the kill- ing of Osama bin Laden. The Senate Intel- ligence Committee maintains that “such information was not used in tracking down and killing bin Laden and believes that the film allows viewers to draw that conclusion from the way the story is presented.”

The film’s director, Kathryn Bigelow, told TV host Steven Colbert that she can- celed an appearance on his show because she was “spooked” by the investigation. Christopher Dodd, a former U.S. senator who is now the president of the Motion Pic- ture Association of America, has objected to the investigation, saying, “There could, in my view, be a chilling effect if, in the end of all this, you have a screenwriter or a director called before an investigating committee.”

What type of speech is a film? Is it pro- tected under the First Amendment? What could happen if the government were free to investigate those who express differing views and takes on issues, whether through statements or through art and films?

Sources: Alan Ziebel, “‘Zero Dark Thirty’ Writer Slams Probe,” Wall Street Journal, January 28, 2013, p. B4; Michael Cieply, “Hollywood Makes Case for ‘Zero Dark Thirty,’” New York Times, January 19, 2013.

Consider . . . 5.5

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to other countries, and environmental policies. The issues the companies are dis- cussing have social and political implications, but they relate directly to the cor- poration’s business and/or operations. Can the government regulate this form of speech? Nike, Inc. v Kasky, 539 U.S. 654 (2003), involved a situation in which Nike responded to charges of mistreating and underpaying workers at its foreign pro- duction facilities in numerous ways, such as by sending out press releases, writing letters to the editors of various newspapers around the country, and mailing letters to university presidents and athletic directors. For example, New York Times colum- nist Bob Herbert wrote two columns that were sharply critical of Nike’s conditions in plants throughout Asia. The columns compared then-CEO Philip Knight’s com- pensation 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, double the minimum wage as defined in countries where its products are produced 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 sued Nike for unfair and deceptive practices under California’s Unfair Competition Law and False Advertising Law for alleged false statements in those materials and op-eds.

Nike contended that Mr. Kasky’s suit was absolutely barred by the First Amendment. The trial court dismissed the case. Mr. Kasky appealed, and the Cal- ifornia Court of Appeal affirmed, holding that Nike’s statements “form[ed] part of a public dialogue on a matter of public concern within the core area of expression protected by the First Amendment.”

On appeal, the California Supreme Court reversed and remanded for further proceedings. Nike appealed. The Supreme Court granted certiorari but later dis- missed the case with a per curiam opinion (an unsigned opinion that comes from the majority of the court) that indicated only that certiorari was granted improv- idently. The Court said it would need to have the California authorities issue a decision and penalties in the case before it could be heard. Nike settled the case, so there was never a definitive decision. However, it is likely that the Court would have classified Nike’s efforts as fitting into the territory between advertising and political speech, an area that would enjoy great First Amendment protection.

5-5c First amendment Rights and profits from Sensationalism In the past few years, a number of book publishers and movie producers have pur- sued criminal figures for the rights to tell the stories of their crimes in books, tele- vision programs, and movies. Many of the victims of the crimes and their families have opposed such moneymaking ventures as benefits that encourage the commis- sion of crimes. The state of New York, for example, passed a statute requiring that earnings from sales of such stories be used first to compensate victims of the crimes. Statutes such as the one in New York create dilemmas between First Amendment rights and public policy issues concerning criminal activities. In Simon & Schuster, Inc. v Members of the New York State Crime Victims Board, 502 U.S. 105 (1991), the U.S. Supreme Court addressed the constitutionality of New York’s statute. Simon & Schuster had entered into a contract in 1981 with organized crime figure Henry Hill (who was arrested in 1980) and author Nicholas Pileggi for a book about Mr. Hill’s life, Wiseguy, a book full of colorful details and the day-to-day workings of orga- nized crime, primarily in Mr. Hill’s first-person narrative. Throughout Wiseguy, Mr. Hill frankly admits to having participated in an astonishing variety of crimes.

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Chapter 5 Business and the Constitution 159

Ethical Issues

Orenthal James (O.J.) Simpson was charged with murder in June 1994 in the double homicide of his ex-wife, Nicole Brown Simpson, and her friend Ronald Goldman.

Because Mr. Simpson was charged with a capital crime, he was incarcerated upon being charged. California’s version of the Son of Sam law prevents profits from crimes only after there has been a conviction. Mr. Simpson authored a book, I Want to Tell You, while he was incarcerated and his nine-month trial in progress. Mr. Simpson also signed autographs and sports memorabilia and sold them from the Los Angeles County jail. Mr. Simpson’s cottage industry from jail netted him in excess of $3 million. Could a law that passes consti- tutional muster be implemented to prevent crime-related profits like those Mr. Simpson was able to obtain?

Mr. Simpson was acquitted of the mur- ders. Following his acquittal, prosecutors in the case, Christopher Darden, Marcia Clark, and Hank Goldberg, signed multi-mil- lion-dollar book contracts to write about their experiences during the trial. Alan Dershowitz, the late Johnnie Cochran, and Robert Shapiro, members of the Simpson

defense team, signed six-figure contracts to write books about the trial from the defense perspective. Daniel Petrocelli, the lawyer who represented the Goldmans in their civil suit against Mr. Simpson, also wrote a book, Triumph of Justice: The Final Judgment on the Simpson Saga.

In 2007, a book by Mr. Simpson, If I Did It, was released by the Goldman family. The Goldmans had acquired the rights to the Simpson book because of their $33 million judgment against Mr. Simpson fol- lowing the civil case for wrongful death. They were assigned the rights to the book’s royalties as a means of collecting the judgment. Upon its release, the book soared to number 1 on even as Mr. Simpson was arrested in Las Vegas for his alleged role in a robbery of sports paraphernalia.

Is it moral to profit from a crime and a trial? Are these book contracts a form of making money from the deaths of two people? Many publishers refused to pub- lish If I Did It, and networks refused to air interviews with Mr. Simpson about the book. Would you have declined the book for publication or to air an interview that would have brought in ad revenues?

The book was also a commercial success: within 19 months of its publication, more than 1 million copies were in print. A few years later, the book was converted into a film called Goodfellas, which won a host of awards as the best film of 1990.

When the Crime Victims Board requested that Simon & Schuster turn over all monies paid to Mr. Hill and that all future royalties be payable not to Mr. Hill but to the statutorily prescribed escrow account, Simon & Schuster brought suit main- taining that the so-called Son of Sam law violated the First Amendment. The U.S. Supreme Court agreed and held that the statute was overly broad, would have a chilling effect on authors and publications, and required a redrafting of the statute to tailor its scope more narrowly so it could still accomplish the public purpose.

5-5d First amendment Rights and Corporate political Speech

Not all commercial speech is advertising. Some businesses engage in corporate political speech. Corporate political speech generally takes three forms:

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160 part 2 Business: Its Regulatory Environment

1. Through financial support, such as from employee and political action com- mittee (PAC) donations to political candidates

2. Through financial support, such as party donations 3. Through direct communications and ads about issues, ballot propositions,

and funding proposals (such as bond elections)

For more than a century, both legislators and courts have grappled with the balancing of First Amendment rights and the influence of money in election campaigns. “More than a century ago the ‘sober-minded Elihu Root’ advocated legislation that would prohibit political contributions by corporations in order to prevent ‘the great aggregations of wealth from using their corporate funds, directly or indirectly,’ to elect legislators who would ‘vote for their protection and the advancement of their interests as against those of the public.’” [United States v Automobile Workers, 352 U.S. 567, 571 (1957)] (Elihu root was Secretary of War and Secretary of State 1901–1909.)

As a result, Congress, state legislatures, and the U.S. Supreme Court have all addressed corporate speech in all three of these categories. The first legisla- tive prohibition came in 1907 when the Tillman Act completely banned corpo- rate contributions of “money . . . in connection with” any federal election. Since that time corporations have been banned from making direct political donations to political candidates. In 1925, Congress extended the prohibition of contribu- tions “to include ‘anything of value,’ and made acceptance of a corporate con- tribution as well as the giving of such a contribution a crime” (Federal Corrupt Practices Act, 1925, §§ 301, 313, 43 Stat. 1070, 1074). With corporate donations in tow, Congress realized through several election cycles that union contributions were equally plentiful and as powerful as corporate ones. Congress first restricted union contributions in 1940 with the passage of the Hatch Act. Congress later pro- hibited “union contributions in connection with federal elections . . . altogether” (18 U.S.C. § 610). During the passage of these limitations, PACs began. PACs are independent of corporations and labor unions, although they may be formed by those affiliated with both. For example, Coors Brewing has its corporate PAC, known as the Six Pac. Employees of companies and members of labor unions make donations to their PACs. Other PACs include trade association PACs (such as the American Medical Association and the American Association of Trial Law- yers), cooperative PACs, and PACs formed along ideological lines, such as the Right-to-Life PAC or Emily’s List (Early Money Is Like Yeast, a PAC that supports pro-choice candidates beginning in the early primary stages of an election cycle).

As the Supreme Court has noted in its opinions on the topic of donations, “Money is like water and it always finds an outlet,” and the donations and PAC activity became a concern. As a result, in 1972 and 1974, Congress passed and amended the Federal Election Campaign Act (FECA), which limited individual donations, required reporting and public disclosure of contributions and expen- ditures exceeding certain limits, and established the Federal Election Commission (FEC) to administer and enforce the legislation (2 U.S.C. § 431(8)(A)(i)).

The limitations in FECA were challenged and the U.S. Supreme Court ruled on their constitutionality in Buckley v Valeo, 424 U.S. 1 (1976). The Court struck down the expenditure limitations of the federal law but upheld the $1,000 individual dona- tion limitation (now $2,700 per election cycle) as being sufficiently narrowly tailored to address the corruption concerns without infringing on the speech elements of donation. Individuals remained free to spend as much as they wanted on their own campaigns for federal office. FECA does not apply to state and local elections.

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Chapter 5 Business and the Constitution 161

Where the Money Flows

A look at the following list of top corporate and trade PACs (hard dollars, not including soft dollars) indicates that those businesses whose markets or prices are controlled by

the government are the most active political voices. Why do you think these particular PACs are so active?

Business Strategy

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Top 20 PAC Contributors to Candidates, 2013–2014

paC naMe tOtaL aMOUnt deMOCRatIC

peRCent RepUBLICan-

peRCent National Association of Realtors

$3,822,955 40 52

National Beer Wholesalers Association

$3,213,000 44 56

Honeywell International $3,002,603 44 56

National Auto Dealers Association

$2,805,350 29 71

Lockheed Martin $2,629,750 42 58

American Bankers Association $2,537,375 23 76

AT&T Inc. $2,507,250 40 60

Operating Engineers Union $2,488,462 80 20

Credit Union National Association

$2,470,650 49 51

International Brotherhood of Electrical Workers

$2,440,214 97 3

Blue Cross/Blue Shield $2,363,050 39 61

Northrup Grumman $2,350,750 43 57

National Association of Insurance & Financial Advisors

$2,326,750,000 38 62

American Association for Justice

$2,214,450 96 4

Boeing $2,190,000 42 58

National Rural Electric Cooperative

$2,160,522 28 72

Laborers Union $2,146,749 85 15

Comcast Corporation $2,135,750 48 52

Plumbers/Pipefitters Union $2,124,000 93 7

American Crystal Sugar $2,096,499 56 44

Source: FEC,

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162 part 2 Business: Its Regulatory Environment

In First National Bank of Boston v Bellotti, 435 U.S. 765 (1978), the U.S. Supreme Court developed what has become known as the Bellotti doctrine, which gives cor- porations the same degree of First Amendment protection for their political speech that individuals enjoy in their political speech. Although commercial speech can be regulated, political speech enjoys full First Amendment rights. That is, when a corporation takes a position on a proposed ballot initiative, its right to participate in public discussion of that issue cannot be restricted.

Under FECA, contributions made with funds that are subject to the act’s dis- closure requirements and source and amount limitations are thus known as “fed- eral dollars” or “hard dollars.” Corporations and unions, as well as individuals who had already made the maximum permissible contributions to federal candi- dates, could still contribute “nonfederal money”—also known as “soft money”— to political parties for activities intended to influence state or local elections. The FEC ruled that political parties could fund mixed-purpose activities—including get-out-the-vote drives and generic party advertising—in part with soft money. In 1995, the FEC concluded that the parties could also use soft money to defray the costs of “legislative advocacy media advertisements,” even if the ads mentioned the name of a federal candidate, as long as they did not expressly advocate the candidate’s election or defeat.

The so-called soft money donations became extensive. As a result, Congress passed the Bipartisan Campaign Reform Act of 2002 (BCRA, 2 U.S.C.A. § 431 et seq.). Often referred to as the McCain–Feingold law, Title I of the BCRA regulates the use of soft money by political parties, officeholders, and candidates. The BCRA was immediately challenged by 11 different parties in different federal courts, and the cases were consolidated and eventually heard by the U.S. Supreme Court in McConnell v Federal Election Comm’n, 540 U.S. 93 (2003). The Supreme Court, in a 175 page opinion (including the dissents), upheld most of the then-new law, but the Court was forced to revisit the constitutionality in Citizens United v FEC (Case 5.5), the decision that the president urged Congress to reverse (see p. 142).

Citizens United v Federal Election Commission 558 U.S. 310 (2010)

Hillary: It’s a Movie! It’s a Campaign! It’s Free Speech!

Case 5.5


Citizens United is a nonprofit corporation with an annual budget of about $12 million, most of which comes from donations by individuals.

In January 2008, Citizens United released a film entitled Hillary: The Movie. It is a 90-minute documen- tary about then-Senator Hillary Clinton, who was a candidate in the Democratic Party’s 2008 presidential primary elections. Hillary mentions Senator Clinton by name and depicts interviews with political com- mentators and other persons, most of them quite

critical of Senator Clinton. Hillary was released in theaters and on DVD, but Citizens United wanted to increase distribution by making it available through video-on-demand.

In December 2007, a cable company offered, for a payment of $1.2 million, to make Hillary available on a video-on-demand channel called “Elections ‘08.” Citizens United was prepared to pay for the video- on-demand, and to promote the film, it produced two ten-second ads and one 30-second ad for Hillary. Each ad includes a short (and, in our view, pejorative) state- ment about Senator Clinton, followed by the name of

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Chapter 5 Business and the Constitution 163

the movie and the movie’s website address. Citizens United desired to promote the video-on-demand offer- ing by running advertisements on broadcast and cable television.

BCRA § 203(§441) prohibits any “electioneering communication.” An electioneering communication is defined as “any broadcast, cable, or satellite com- munication” that “refers to a clearly identified candi- date for Federal office” and is made within 30 days of a primary or 60 days of a general election. The Federal Election Commission’s (FEC’s) regulations further define an electioneering communication as a communication that is “publicly distributed.” “In the case of a candidate for nomination for President . . . pub- licly distributed means” that the communication “[c] an be received by 50,000 or more persons in a State where a primary election . . . is being held within 30 days.” Corporations and unions are barred from using their general treasury funds for express advocacy or electioneering communications. They may establish, however, a “separate segregated fund” (known as a political action committee, or PAC) for these purposes. The moneys received by the segregated fund are lim- ited to donations from stockholders and employees of the corporation or, in the case of unions, members of the union.

Citizens United wanted to make Hillary available through video-on-demand within 30 days of the 2008 primary elections. It feared, however, that both the film and the ads would be covered by § 441b’s ban on corporate-funded independent expenditures, thus sub- jecting the corporation to civil and criminal penalties. In December 2007, Citizens United sought declaratory and injunctive relief against the FEC. It argued that (1) § 441b is unconstitutional as applied to Hillary and that (2) BCRA’s disclaimer and disclosure requirements are unconstitutional as applied to Hillary and to the three ads for the movie.

The District Court denied Citizens United’s motion for a preliminary injunction (per curiam) and then granted the FEC’s motion for summary judgment. The court held that § 441b was facially constitutional and that § 441b was constitutional as applied to Hillary because it was “susceptible of no other interpretation than to inform the electorate that Senator Clinton is unfit for office, that the United States would be a dan- gerous place in a President Hillary Clinton world, and that viewers should vote against her.” The court also rejected Citizens United’s challenge to BCRA’s dis- claimer and disclosure requirements. It noted that “the Supreme Court has written approvingly of disclosure provisions triggered by political speech even though the speech itself was constitutionally protected under the First Amendment.” Citizens United appealed to

the U.S. Supreme Court, where the case was argued twice, once before the retirement of Justice David Souter and again following the addition of Justice Sotomayor.


KENNEDY, Justice The narrative [of Hillary] may contain more sugges- tions and arguments than facts, but there is little doubt that the thesis of the film is that she is unfit for the Presidency.

Citizens United argues that Hillary is just “a docu- mentary film that examines certain historical events.” We disagree. The movie’s consistent emphasis is on the relevance of these events to Senator Clinton’s candida- cy for President. The narrator begins by asking “could [Senator Clinton] become the first female President in the history of the United States?” And the narrator reit- erates the movie’s message in his closing line: “Finally, before America decides on our next president, voters should need no reminders of . . . what’s at stake—the well-being and prosperity of our nation.”

Courts, too, are bound by the First Amendment. We must decline to draw, and then redraw, consti- tutional lines based on the particular media or tech- nology used to disseminate political speech from a particular speaker.

The law before us is an outright ban, backed by criminal sanctions. Section 441b makes it a felony for all corporations—including nonprofit advocacy corporations—either to expressly advocate the election or defeat of candidates or to broadcast electioneering communications within 30 days of a primary election and 60 days of a general election. Thus, the following acts would all be felonies under § 441b: The Sierra Club runs an ad, within the crucial phase of 60 days before the general election, that exhorts the public to disapprove of a Congressman who favors logging in national forests; the National Rifle Association pub- lishes a book urging the public to vote for the chal- lenger because the incumbent U.S. Senator supports a handgun ban; and the American Civil Liberties Union creates a Web site telling the public to vote for a Pres- idential candidate in light of that candidate’s defense of free speech. These prohibitions are classic examples of censorship.

Section 441b’s prohibition on corporate indepen- dent expenditures is thus a ban on speech. Were the Court to uphold these restrictions, the Government could repress speech by silencing certain voices at any of the various points in the speech process. If § 441b applied to individuals, no one would believe that it is merely a time, place, or manner restriction on speech.


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164 part 2 Business: Its Regulatory Environment

Its purpose and effect are to silence entities whose voic- es the Government deems to be suspect.

Speech is an essential mechanism of democracy, for it is the means to hold officials accountable to the people.

The First Amendment protects speech and speak- er, and the ideas that flow from each. The Court has recognized that First Amendment protection extends to corporations. This protection has been extended by explicit holdings to the context of political speech. Under the rationale of these precedents, political speech does not lose First Amendment protection “simply because its source is a corporation. . . .” Government lacks the power to ban corporations from speaking.

It is irrelevant for purposes of the First Amendment that corporate funds may “have little or no correlation to the public’s support for the corporation’s political ideas.” All speakers, including individuals and the media, use money amassed from the economic mar- ketplace to fund their speech. The First Amendment protects the resulting speech, even if it was enabled by economic transactions with persons or entities who disagree with the speaker’s ideas.

There is simply no support for the view that the First Amendment, as originally understood, would permit the suppression of political speech by media corporations. The Framers may not have anticipated modern business and media corporations. Yet televi- sion networks and major newspapers owned by media corporations have become the most important means of mass communication in modern times. The First Amendment was certainly not understood to condone the suppression of political speech in society’s most salient media. It was understood as a response to the repression of speech and the press that had existed in England and the heavy taxes on the press that were imposed in the colonies. The great debates between the Federalists and the Anti-Federalists over our founding document were published and expressed in the most important means of mass communication of that era— newspapers owned by individuals.

When Government seeks to use its full power, including the criminal law, to command where a per- son may get his or her information or what distrusted source he or she may not hear, it uses censorship to control thought. This is unlawful. The First Amend- ment confirms the freedom to think for ourselves.

When word concerning the plot of the movie Mr. Smith Goes to Washington reached the circles of Government, some officials sought, by persuasion, to discourage its distribution. [I]t, like Hillary, was speech funded by a corporation that was critical of Members of Congress. Mr. Smith Goes to Washington may be fic- tion and caricature; but fiction and caricature can be a powerful force.

Modern day movies, television comedies, or skits on might portray public officials or public policies in unflattering ways. Yet if a covered transmission during the blackout period creates the background for candidate endorsement or opposi- tion, a felony occurs solely because a corporation, other than an exempt media corporation, has made the “purchase, payment, distribution, loan, advance, deposit, or gift of money or anything of value” in order to engage in political speech. Speech would be suppressed in the realm where its necessity is most evident: in the public dialogue preceding a real elec- tion. Governments are often hostile to speech, but under our law and our tradition it seems stranger than fiction for our Government to make this polit- ical speech a crime. Yet this is the statute’s purpose and design.

“The First Amendment underwrites the freedom to experiment and to create in the realm of thought and speech. Citizens must be free to use new forms, and new forums, for the expression of ideas. The civic dis course belongs to the people, and the Government may not prescribe the means used to conduct it.”

The judgment of the District Court is reversed with respect to the constitutionality of § 441b’s restrictions on corporate independent expenditures.


1. Why does the Court say it cannot be involved in ongoing monitoring of political ads, documenta- ries, and other forms of communication?

2. Why are independent expenditures by corpo- rations different from corporate donations and funding of candidates?

3. Are time restrictions and unflattering portraits grounds for regulating political speech? Why or why not?

5-5e eminent domain: the takings Clause

The right of a governmental body to take title to property for a public use is called eminent domain. This right is established in the Fifth Amendment to the Constitu- tion and may also be established in various state constitutions. Private individuals cannot require property owners to sell their property, but governmental entities

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Chapter 5 Business and the Constitution 165

can require property owners to transfer title for public projects for the public good. The Fifth Amendment provides that “property shall not be taken for a public use without just compensation.” For a governmental entity to exercise properly the right of eminent domain, three factors must be present: public purpose, taking (as opposed to regulating), and just compensation.

public purpose To exercise eminent domain, the governmental authority must establish that the taking is necessary for the accomplishment of a government or public purpose. When eminent domain is mentioned, we think of the use of property for highways and schools. However, the right of the government to eminent domain extends much further. For example, the following uses have been held to constitute pub- lic purposes: the condemnation of slum housing (for purposes of improving city areas), the limitation of mining and excavation within city limits, the declaration of property as a historic landmark, and the taking of property to provide a firm that is a town’s economic base with a large enough tract for expansion. According to the U.S. Supreme Court, the public purpose requirement for eminent domain is to be interpreted broadly, and “the role of the judiciary in determining whether that power is being exercised for a public purpose is an extremely narrow one.” [United States ex rel. TVA v Welch, 327 U.S. 546 (1946)] The Kelo v City of New London case (Case 5.6) was the U.S. Supreme Court decision that changed the eminent domain landscape, as it were.

Kelo v City of New London 545 U.S. 469 (2005)

Yes, Actually, They Can Take That Away From You

Case 5.6


In 1978, the city of New London, Connecticut, undertook a redevelopment plan for purposes of creating a redeveloped area in and around the existing park at Fort Trumbull. The plan sought to develop the related ambience a state park should have, including the absence of pink cottages and other architecturally eclectic homes. Part of the redevelopment plan was the city’s deal with Pfizer Corporation for the location of its research facility in the area. The preface to the city’s development plan included the following statement of goals and purpose:

To create a development that would complement the facility that Pfizer was planning to build, create jobs, increase tax and other revenues, encourage public access to and use of the city’s waterfront, and eventu- ally “build momentum” for the revitalization of the rest of the city, including its downtown area.

The affected property owners, including Susette Kelo, live in homes and cottages (15 total) located in and around other existing structures that would be permitted to stay in the area designated for the proposed new structures (under the city’s economic development plan) that would be placed there primar- ily by private land developers and corporations. The city was assisted by a private, nonprofit corporation, the New London Development Corporation (NLDC), in the development of the economic plan and pilot- ing it through the various governmental processes, including that of city council approval. The central focus of the plan was getting Pfizer to the Fort Trum- bull area (where the homeowners and their properties were located) with the hope of a resulting economic boost that such a major corporate employer can bring to an area.

Kelo and the other landowners whose homes would be razed to make room for Pfizer and the

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166 part 2 Business: Its Regulatory Environment

accompanying and resulting economic development plan filed suit challenging New London’s legal author- ity to take their homes. The trial court issued an injunc- tion preventing New London from taking certain of the properties but allowing others to be taken. The appel- late court found for New London on all the claims, and the landowners (petitioners) appealed.


STEVENS, Justice Two polar propositions are perfectly clear. On the one hand, it has long been accepted that the sovereign may not take the property of A for the sole purpose of trans- ferring it to another private party B, even though A is paid just compensation. On the other hand, it is equally clear that a State may transfer property from one pri- vate party to another if future “use by the public” is the purpose of the taking; the condemnation of land for a railroad with common-carrier duties is a famil- iar example. Neither of these propositions, however, determines the disposition of this case.

The disposition of this case therefore turns on the question whether the City’s development plan serves a “public purpose.” Without exception, our cases have defined that concept broadly, reflecting our long-standing policy of deference to legislative judgments in this field.

In Berman v Parker, 348 U.S. 26, 75 S.Ct. 98, 99 L.Ed. 27 (1954), this Court upheld a redevelopment plan targeting a blighted area of Washington, D.C., in which most of the housing for the area’s 5,000 inhabitants was beyond repair. Under the plan, the area would be con- demned and part of it utilized for the construction of streets, schools, and other public facilities. The remain- der of the land would be leased or sold to private par- ties for the purpose of redevelopment, including the construction of low-cost housing.

The owner of a department store located in the area challenged the condemnation, pointing out that his store was not itself blighted and arguing that the cre- ation of a “better balanced, more attractive communi- ty” was not a valid public use. Writing for a unanimous Court, Justice Douglas refused to evaluate this claim in isolation, deferring instead to the legislative and agency judgment that the area “must be planned as a whole” for the plan to be successful. The Court explained that “community redevelopment programs need not, by force of the Constitution, be on a piecemeal basis—lot by lot, building by building.” “We do not sit to deter- mine whether a particular housing project is or is not desirable. The concept of the public welfare is broad and inclusive. . . . The values it represents are spiritual as well as physical, aesthetic as well as monetary. It is within the power of the legislature to determine that

the community should be beautiful as well as healthy, spacious as well as clean, well-balanced as well as care- fully patrolled. In the present case, the Congress and its authorized agencies have made determinations that take into account a wide variety of values. It is not for us to reappraise them. If those who govern the District of Columbia decide that the Nation’s Capital should be beautiful as well as sanitary, there is nothing in the Fifth Amendment that stands in the way.”

In Hawaii Housing Authority v Midkiff, 467 U.S. 229, 104 S. Ct. 2321, 81 L.Ed.2d 186 (1984), the Court considered a Hawaii statute whereby fee title was taken from lessors and transferred to lessees (for just compensation) in order to reduce the concentration of land ownership. We unanimously upheld the statute and rejected the Ninth Circuit’s view that it was “a naked attempt on the part of the state of Hawaii to take the property of A and transfer it to B solely for B’s private use and benefit.” Reaffirming Berman’s defer- ential approach to legislative judgments in this field, we concluded that the State’s purpose of eliminating the “social and economic evils of a land oligopoly” qualified as a valid public use.

Those who govern the City were not confronted with the need to remove blight in the Fort Trumbull area, but their determination that the area was suf- ficiently distressed to justify a program of economic rejuvenation is entitled to our deference. The City has carefully formulated an economic development plan that it believes will provide appreciable benefits to the community, including—but by no means limited to—new jobs and increased tax revenue. To effectuate this plan, the City has invoked a state statute that specifically authorizes the use of eminent domain to promote economic development. Given the compre- hensive character of the plan, the thorough delibera- tion that preceded its adoption, and the limited scope of our review, it is appropriate for us, as it was in Ber- man, to resolve the challenges of the individual owners, not on a piecemeal basis, but rather in light of the entire plan. Because that plan unquestionably serves a public purpose, the takings challenged here satisfy the public use requirement of the Fifth Amendment.

Petitioners contend that using eminent domain for economic development impermissibly blurs the boundary between public and private takings. Again, our cases foreclose this objection. We cannot say that public ownership is the sole method of promoting the public purposes of community redevelopment projects. It is further argued that without a bright-line rule nothing would stop a city from transferring cit- izen A’s property to citizen B for the sole reason that citizen B will put the property to a more productive


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Chapter 5 Business and the Constitution 167

eminent domain in the post-Kelo World The impact of the Kelo case has been substantial. The decision resulted in back- lash from landowners and paved the way for legislative reforms that restrict eminent domain powers at the state and local levels. Following the Kelo decision and because 80% of the public disapproved of the court’s decision, 45 states have passed some form of limitation on the exercise of eminent domain for economic development either through ballot propositions, constitutional amendments, or legislation.

However, many of those states still allow eminent domain proceedings to eliminate “blight,” with blight carrying a broad definition. Still, Arizona and Florida have placed substantial curbs on the exercise of eminent domain for eco- nomic development purposes. In November 2005, the U.S. House of Represen- tatives passed the Private Property Rights Protection Act of 2005 (also known as House Resolution 4128) by a vote of 376 to 38. The bill died in the Senate. In 2006,

use and thus pay more taxes. Such a one-to-one trans- fer of property, executed outside the confines of an integrated development plan, is not presented in this case. While such an unusual exercise of government power would certainly raise a suspicion that a private purpose was afoot, the hypothetical cases posited by petitioners can be confronted if and when they arise. They do not warrant the crafting of an artificial restric- tion on the concept of public use.

Just as we decline to second-guess the City’s con- sidered judgments about the efficacy of its develop- ment plan, we also decline to second-guess the City’s determinations as to what lands it needs to acquire in order to effectuate the project. “It is not for the courts to over-see the choice of the boundary line nor to sit in review on the size of a particular project area. Once the question of the public purpose has been decided, the amount and character of land to be taken for the proj- ect and the need for a particular tract to complete the integrated plan rests in the discretion of the legislative branch.”

The judgment of the Supreme Court of Connecticut is affirmed.

dISSentInG OpInIOn

O’CONNOR, Justice, joined by Justices SCALIA, THOMAS, and REHNQUIST Under the banner of economic development, all private property is now vulnerable to being taken and trans- ferred to another private owner, so long as it might be upgraded—i.e., given to an owner who will use it in a way that the legislature deems more beneficial to the public—in the process. To reason, as the Court does, that the incidental public benefits resulting from the subsequent ordinary use of private property render economic development takings “for public use” is to

wash out any distinction between private and public use of property—and thereby effectively to delete the words “for public use” from the Takings Clause of the Fifth Amendment. Accordingly I respectfully dissent.

Where is the line between “public” and “private” property use? We give considerable deference to leg- islatures’ determinations about what governmental activities will advantage the public. But were the political branches the sole arbiters of the public-private distinction, the Public Use Clause would amount to little more than hortatory fluff. An external, judicial check on how the public use requirement is interpret- ed, however limited, is necessary if this constraint on government power is to retain any meaning.

Even if there were a practical way to isolate the motives behind a given taking, the gesture toward a purpose test is theoretically flawed. If it is true that incidental public benefits from new private use are enough to ensure the “public purpose” in a taking, why should it matter, as far as the Fifth Amendment is concerned, what inspired the taking in the first place? And whatever the reason for a given condem- nation, the effect is the same from the constitutional perspective— private property is forcibly relinquished to new private ownership.


1. What is different between this case and a case in which property is taken for constructing a freeway?

2. What is the concern of the dissent about the decision?

3. Why does the majority state that the courts should be reluctant to get involved in local government eminent domain activities?

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President George W. Bush signed Executive Order 13406, called “Protecting Prop- erty Rights of the American People,” which prohibited the taking of private prop- erty for purposes of giving economic benefit to another private party.

Ms. Kelo’s home and 15 others were razed. Pfizer merged with Wyeth in 2009 and closed all company operations in New London. The Fort Trumball area has no houses, no research park, and no businesses. However, after Hurricane Irene, in 2010, officials from New London announced that residents could use the Fort Trumball area for dumping their branches and fallen trees. The location that once had Ms. Kelo’s and others’ homes became a landfill and home for feral cats.

In 2015, the mayor of New London announced that the former site of the Kelo home would be turned into a park to “serve as a memorial to all those adversely affected by the city’s use of eminent domain.”2 Justice Richard Palmer of the Con- necticut Supreme Court, who was the swing vote in the Kelo decision, met with Ms. Kelo and explained to her that if he had known then what he knows now, he would have voted differently.

taking or Regulating For a governmental entity to be required to pay a landowner compensation under the doctrine of eminent domain, there must be a taking of the property. Mere reg- ulation of the property does not constitute a taking, as determined by Village of Euclid, Ohio v Ambler Realty Co., 272 U.S. 365 (1926). Rather, a taking must go so far as to deprive the landowner of any use of the property. In the landmark case of Pennsylvania Coal v Mahon, 260 U.S. 393 (1922), the Supreme Court established standards for determining a taking as opposed to mere regulation. At that time Pennsylvania had a statute that prohibited the mining of coal under any land sur- face where the result would be the subsidence of any structure used as a human habitation. The owners of the rights to mine subsurface coal brought suit challeng- ing the regulation as a taking, and the Supreme Court ruled in their favor, holding that the statute was more than regulation and, in fact, was an actual taking of the subsurface property rights.

Because of the vast amount of technology that has developed since that case was decided, many new and subtly different issues affect what constitutes a tak- ing. For example, in some areas, the regulation of cable television companies is an infringement on air rights. Such specialized areas of real estate rights are particu- larly difficult to resolve. In Loretto v Teleprompter Manhattan CATV Corp., 458 U.S. 100 (1982), the U.S. Supreme Court held that the small invasion of property by the placement of cable boxes and wires did constitute a taking, albeit very small, and required compensation of the property owners for this small but permanent occu- pation of their land.

The issue of taking has arisen because of local zoning restrictions on develop- ment. These restrictions focus on beaches, wetlands, and other natural habitats. For example, in Nollan v California Coastal Commission, 483 U.S. 825 (1987), the Nollans sought permission from the California Coastal Commission to construct a home on their coastal lot, where they currently had only a small bungalow. The com- mission refused to grant permission to the Nollans for construction of their home unless they agreed to give a public easement across their lot for beach access. The Supreme Court held that the demand by the commission for an easement was a taking without compensation and, in effect, prevented the Nollans from using their property until they surrendered their exclusive use.3

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Chapter 5 Business and the Constitution 169

Yet another issue that arises in taking occurs when regulations take effect after owners have acquired land but before it is developed. In Lucas v South Carolina Coastal Council, 505 U.S. 1003 (1992), the U.S. Supreme Court declared that ex post facto legislation that prevents development of previously purchased land is a taking. In Lucas, David Lucas purchased for $975,000 two residential lots on the Isle of Palms in Charleston County, South Carolina. In 1988, the South Carolina legislature enacted the Beachfront Management Act, which barred any permanent habitable structures on coastal properties. The Supreme Court held South Carolina was required to compensate Mr. Lucas because his land was ren- dered useless.

Just Compensation The final requirement for the proper exercise by a governmental entity of the right of eminent domain is that the party from whom the property is being taken be given just compensation. The issue of just compensation is difficult to determine and is always a question of fact. Basic to this determination is that the owner is to be compensated for loss and that the compensation is not measured by the gov- ernmental entity’s gain. In United States v Miller, 317 U.S. 369 (1943), the Supreme Court held that in cases where it can be determined, fair market value is the mea- sure of compensation, and in United States ex rel. TVA v Powelson, 319 U.S. 266 (1943), the Supreme Court defined fair market value to be “what a willing buyer would pay in cash to a willing seller.”

Possible problems in applying these relatively simple standards include pecu- liar value to the owner, consequential damages, and greater value of the land because of the proposed governmental project. Basically, the issue of just compen- sation becomes an issue of appraisal, which is affected by all the various factors involved. In determining just compensation, the courts must consider such factors as surrounding property values and the owner’s proposed use.

5-5f procedural due process

Both the Fifth and the Fourteenth Amendments require state and federal govern- ments to provide citizens (businesses included) due process under the law. Proce- dural due process is a right that requires notice and the opportunity to be heard before rights or properties are taken away from an individual or business. Most people are familiar with due process as it exists in the criminal justice system: the right to a lawyer, a trial, and so on (discussed in Chapter 8). However, procedural due process is also an important part of civil law. Before an agency—whether state or federal—can take away a business license, suspend a license, or impose a fine for a violation, it must ensure due process.

Businesses encounter the constitutional protections of due process in their rela- tionships with customers. For example, the eviction of a nonpaying tenant cannot be done unilaterally. The tenant has the right to be heard in the setting of a hearing. The landlord must file an action against the tenant, and the tenant will have the opportunity to present defenses for nonpayment of rent. The Due Process Clause of the U.S. Constitution provides protection for individuals before their property is taken. Property includes land (as in the case of eminent domain, discussed pre- viously), rights of possession (tenants and leases), and even intangible property rights. For example, students cannot be expelled from schools, colleges, or univer- sities without the right to be heard. Students must have some hearing before their property rights with respect to education are taken away.

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170 part 2 Business: Its Regulatory Environment

In Horne v U.S. Department of Agriculture, 132 S.Ct. 2566 (2015), raisin farmers challenged the taking of their raisin crops by the Department of Agriculture in its efforts to stabilize the raisin market. The farmers’ challenge was based on their lack of a hearing for the taking as well as compensation for the loss of their raisin crops and the imposition of penalties if they sell the raisins prohibited by the Depart- ment of Agriculture. The court held that the Fifth Amendment requires that the government pay just compensation when it takes personal property, just as when it takes real property. The government cannot make raisin growers relinquish their raisins without just compensation.

All proceedings designed to satisfy due process requirements must provide notice and the right to be heard and present evidence (see Chapter 6 for more details). If these rights are not afforded, the constitutional right of due process has been denied, and the action taken is rescinded until due process requirements are met. Suppose that OSHA charges a company with safety violations in its plants. Before a fine or order can be imposed, procedural due process requires that the company have the right to be heard and to present evidence on the violations. In court cases, a matter reduced to a judgment entitles the victorious side to collect on that judgment. However, under due process, even the proceedings for collection allow the losing party or debtor to be notified of the proceedings and to be heard.

5-5g Substantive due process

Procedural rules deal with how things are done. All rules on the adjudication of agency charges are procedural rules. Similarly, all rules for the trial of a civil case— from discovery to jury instructions—are also procedural. These rules exist to make sure the substantive law is upheld. Substantive law consists of rights, obligations, and behavior standards. Criminal laws are substantive laws, and criminal proce- dure rules are procedural laws. Substantive due process is the right to have laws

When the Crafts moved into their residence in October 1972, they noticed two separate gas and electric meters and only one water meter serving the premises. The residence had been used previously as a duplex. The Crafts assumed, based on information from the seller, that the second set of meters was inoperative.

In 1973, the Crafts began receiving two bills: their regular bill and another with an ac- count number in the name of Willie C. Craft, as opposed to Willie S. Craft. In October 1973, after learning from a Memphis Light, Gas & Water (MLG&W) meter reader that both sets of meters were running in their home, the Crafts hired a private plumber and electrical contractor to combine the meters into one gas and one electric meter. Be- cause the contractor did not combine the

meters properly, they continued to receive two bills until January 1974. During this time, the Crafts’ utility service was termi- nated five times for nonpayment.

Mrs. Craft missed work several times to go to MLG&W offices to resolve the “dou- ble billing” problem. She sought explana- tions on each occasion but was never given an answer.

In February 1974, the Crafts and other MLG&W customers filed suit for violation of the Due Process Clause. The district court dismissed the case. The court of ap- peals reversed, and MLG&W appealed.

Have the Crafts been given due process?

[Memphis Light, Gas & Water Div. v Craft, 436 U.S. 1 (1978)]

Consider . . . 5.6

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Chapter 5 Business and the Constitution 171

that do not deprive businesses or citizens of property or other rights without justi- fication and reason. The issue of whether a statute was “void for vagueness” and denied due process was a central one in F.C.C. v Fox Television Stations, Inc., 132 S.Ct. 2307 (2012). In the case, which is discussed in Chapter 6, the Supreme Court held that the Federal Communications Commission (FCC) regulations did not give the television networks enough information to understand the standards for the use of expletives on television as well as the limits on momentary nudity. Justice Kennedy wrote, “A fundamental principle in our legal system is that laws which regulate persons or entities must give fair notice of conduct that is forbidden or required.” This requirement of clarity in regulation is essential to the protections provided by the Due Process Clause of the Fifth Amendment.

5-5h equal protection Rights for Business

The Fourteenth Amendment grants citizens the right to the equal protection of the law. Lawmakers, however, are often required to make certain distinctions in legislating and regulating that result in classes of individuals being treated differently.

Such different or disparate treatment is justified only if some rational basis for it is determined. In other words, a rational connection is necessary between the classifications and the achievement of some governmental objec- tive. Most classifications survive the rational basis test. An example of a clas- sification that would not survive is one requiring the manufacturers of soft drinks to use only unbreakable bottles for their product but allowing juice manufacturers to use glass bottles; this classification is irrational. If a public safety concern is raised about glass bottles, it must apply equally to all bever- age manufacturers.

5-6 The Role of Constitutions in International Law

Although the U.S. Constitution is the basis for all law in the United States, not all countries follow a similar system of governance. The incorporation of other systems (such as a constitution or code) depends on a nation’s history, including its colonization by other countries and those countries’ forms of law. The United States and the United Kingdom (and countries established through British colo- nization) tend to follow a pattern of establishing a general set of principles, as set forth in a constitution, and of reliance on custom, tradition, and precedent for the establishment of law in particular legal areas.

In countries such as France, Germany, and Spain (and nations colonized through their influences), a system of law that is dependent on code law exists. These countries have specific codes of law that attempt to be all-inclusive and cover each circumstance that could arise under a particular provision. These nations do not depend on court decisions, and often the application of the law leads to inconsistent results because of the lack of dependence on judicial precedent.

Approximately 78 countries follow Islamic law in some way. When Islamic law is the dominant force in a country, it governs all aspects of personal and business life. The constitutions in these lands are the tenets of the nation’s religion.

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172 part 2 Business: Its Regulatory Environment

Following a boom in cruise ship construc- tion, ships are now looking for ports at which they can dock in order to begin voyages, most of which start in the Unit- ed States. With so many new ships, the companies are trying to establish con- nections with cities that are not ordinari- ly considered for 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 result has been a burden on the facilities and staff at the ports.

Most cruise ship lines are incorporated outside of the United States, do not pay federal income taxes, and are not subject to state income taxes even though the bulk of their passengers come from the United States. (See the section “5-3b Constitution- al Standards for Taxation of Business” earli- er in this chapter.)

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?

Source: Nicole Harris, “Big Cruise Ships Cause Traffic Jams in Ports,” Wall Street Journal, August 20, 2003, pp. B1, B6.

Consider . . . 5.7


As the saying goes, only in New York City. Times Square has individuals dressed as Mickey Mouse, Minnie Mouse, the Cookie Monster, Elmo, and, well, you name it, who make a living by wander- ing around the famous New York City landmark area and offering photo ops to tourists in exchange for tips. However, perhaps in an effort to offer age-specific photo ops, the so-called topless ladies are now omnipresent in Times Square. The topless ladies, also known as desnudas, earned their name because they are wear- ing little except body paint as they offer photo ops with tourists. Recently, photos and videos of the topless ladies with New York City police officers emerged, but the topless ladies explained that the police officers did not tip them: “We’re working. They are working.”4

The photos with the police were the beginning of public ire. Parents with chil- dren expressed concerns—perhaps the street characters  should be isolated in

one area. As a result, New York City Mayor DeBlasio has proposed having some reg- ulation. However, there are constitutional barriers because the desnudas, as well as Elmo and the Cookie Monster, argue that they are afforded the right to artistic expression under the First Amendment.

Under the U.S. Constitution, the gov- ernment is curbed in its regulation of speech, which includes artistic expression. However, the government can still put time and place limitations. There is precedent for such regulation because, for example, street vendors, such as sketch artists, are restricted on the areas they are permitted to use, restrictions that are based on traf- fic, crowding, and other factors that are tied to the city’s role of general health and welfare of city inhabitants. In statistical tracking, Times Square had more than 120 costume characters and 11 “painted ladies” at one time, a statistic that could support restrictions. In addition, there have also been arguments and confrontations

the Cookie Monster in times Square: Free Speech on parade

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Chapter 5 Business and the Constitution 173

when tourists take pictures with the street performers and fail to tip them.

The Times Square Alliance, a group of business owners in the area, has been offering help and advice to tourists on how to handle the characters, explaining that payment is not required regardless of how aggressive the street artists become. The Alliance has asked the city to step in and regulate the characters and/or artists. Mayor DeBlasio has noted that the charac- ters and desnudas are not just involved in expression; they are engaged in business

activities, and the city has the authority to regulate all businesses operating within the city, within the parameters of free speech. The businesses can continue to operate but may be subject to licensing, hours restrictions, or even location limitations. Thanks to his constitutional rights, Cookie Monster will go on in Times Square, but the city has imposed area restrictions. The characters are limited to “activity areas,” which are painted turquoise. The characters can pursue their First Amendment rights, but only in the turquoise areas.

s u m m a r y What is the Constitution?

• U.S. Constitution—document detailing authority of U.S. government and rights of its citizens

What are the constitutional limitations on business regulations?

• Commerce Clause—portion of the U.S. Constitution that controls federal regulation of business; limits Congress to regulating interstate and international commerce

• Intrastate commerce—business within state borders

• Interstate commerce—business across state lines

• Foreign commerce—business outside U.S. boundaries

Who has more power to regulate business—the states or the federal government?

• Supremacy Clause—portion of the U.S. Constitution that defines relationship between state and federal laws

• Taxation—authority to tax interstate businesses

What individual freedoms granted under the Constitu- tion apply to businesses?

• Bill of Rights—first 10 amendments to the U.S. Con- stitution, providing individual freedoms and protec- tion of individual rights

• First Amendment—freedom-of-speech protection in U.S. Constitution

• Commercial speech—ads and other speech by businesses

• Corporate political speech—business ads or posi- tions on candidates or referenda

• Due process—constitutional guarantee against the taking of property or other governmental exercise of authority without an opportunity for a hearing

• Equal protection—constitutional protection for U.S. citizens against disparate treatment

• Substantive due process—constitutional protection against taking of rights or property by statute

Q u e s t i o n s a n d P r o b l e m s 1. A group of smokers (Respondents) brought suit against tobacco producer Altria, alleging that they were misled by the Altria and other cigarette producers’ (Peti- tioners) ads and labels on its cigarettes touting “light” and “low-tar.” By covering filter ventilation holes with

their lips or fingers, taking larger or more frequent puffs, and holding the smoke in their lungs for a longer period of time, smokers of “light” cigarettes unknowingly inhale as much tar and nicotine as do smokers of regular ciga- rettes. “Light” cigarettes are in fact more harmful because

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174 part 2 Business: Its Regulatory Environment

the increased ventilation that results from their unique design features produces smoke that is more mutagenic per milligram of tar than the smoke of regular cigarettes. The smokers argued that the tobacco companies violated the Maine Unfair Trade Practices Act (MUTPA) by fraud- ulently concealing that information and by affirmatively representing, through the use of “light” and “lowered tar and nicotine” descriptors, that their cigarettes would pose fewer health risks.

The District Court entered summary judgment in favor of the tobacco companies on the ground that the state-law claim is preempted by the Federal Cigarette Labeling and Advertising Act. The Court of Appeals reversed that judgment, and the U.S. Supreme Court granted certiorari to review its holding that the Labeling Act neither expressly nor impliedly preempts state law. What should the court decide and why? [Altria Group, Inc. v Good, 555 U.S. 70 (2008)]

2. Mrs. Florence Dolan owned a plumbing and electric supply store on Main Street in Portland, Oregon. Fanno Creek flows through the southeastern corner of Mrs. Dolan’s lot, on which her store is located. She applied to the city for a permit to redevelop her lot. Her plans included the addition of a second structure.

The City Planning Commission granted Mrs. Dolan’s permit but included the following requirement:

Where landfill and/or development is allowed within and adjacent to the 100-year floodplain, the city shall require the dedication of sufficient open land area for greenway adjoining and within the floodplain. This area shall include portions at a suitable elevation for the construction of a pedestrian/bicycle pathway within the floodplain in accordance with the adopted pedestrian/bicycle plan.

Mrs. Dolan maintained that the requirements were a taking of her property because she would be required to reserve a portion of her property for the pedestrian/bike path, and her plans would have to be redone to accom- modate the city’s requirements. The city maintains that its requirements are all simply part of a redevelopment plan for the city and a means of working with the flood- plain created by Fanno Creek. Mrs. Dolan says the city has imposed additional expense and forced her to ded- icate a large portion of her lot to public use. Who is cor- rect? Is Portland taking property from Mrs. Dolan? Is the city required to pay compensation to her? [Dolan v City of Tigard, 512 U.S. 374 (1994)]

3. The Heart of Atlanta Motel, which has rooms avail- able to transient guests, is located on Courtland Street, two blocks from downtown Peachtree Street in Atlanta, Georgia. It is readily accessible to interstate highways 75 and 85 and state highways 23 and 41. The motel does advertise outside Georgia through various national

advertising media, including magazines of national cir- culation; it maintains more than 50 billboards and high- way signs within the state, soliciting patronage for the motel; it accepts convention trade from outside Georgia; and approximately 75% of its registered guests are from out of state.

Prior to passage of Title II of the Civil Rights Act, the motel had followed a practice of refusing to rent rooms to Negroes, and it alleged that it intended to continue to do so. The motel filed suit, challenging Congress for passing this act in excess of its power to regulate com- merce under Article I, Section 8, Part 3, of the Constitu- tion of the United States.

Section 201 of Title II provides, “All persons shall be entitled to the full and equal enjoyment of the goods, services, facilities, privileges, advantages, and accom- modations of any place of public accommodation, as defined in this section, without discrimination or segre- gation on the ground of race, color, religion, or national origin.” Section 201(b) covers four classes of business establishments, each of which “serves the public” and “is a place of public accommodation”: any inn, hotel, motel, or other establishment which provides lodging; (2) any restaurant, cafeteria; (3) any motion picture house; and (4) any establishment which is physically located within the premises of any establishment otherwise covered by this subsection.

Is Title II of the Civil Rights Act constitutional? Is this case different from Ollie’s Barbecue? [Heart of Atlanta Motel, Inc. v U.S., 379 U.S. 241 (1964)]

4. Bruce Church, Inc., is a company engaged in extensive commercial farming in Arizona and California. A provi- sion of the Arizona Fruit and Vegetable Standardization Act requires that all cantaloupes grown in Arizona “be packed in regular compact arrangement in closed stan- dard containers approved by the supervisor.” Arizona, through its agent Pike, issued an order prohibiting Bruce Church from transporting uncrated cantaloupes from its ranch in Parker, Arizona, to nearby Blythe, California, for packing and processing.

It would take many months and $200,000 for Bruce Church to construct a processing plant in Parker. Fur- ther, Bruce Church had $700,000 worth of cantaloupes ready for transportation. Bruce Church filed suit in fed- eral district court challenging the constitutionality of the Arizona statutory provision on shipping cantaloupes. The court issued an injunction against the enforcement of the act on the grounds that it was an undue hardship on interstate commerce. Will the regulation withstand Commerce Clause scrutiny? [Pike v Bruce Church, Inc., 397 U.S. 137 (1970)]

5. Diana Levine, a folk singer from Vermont, suffered from migraine headaches. She was being administered

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Chapter 5 Business and the Constitution 175

Wyeth Laboratory’s Phenergan through an IV drip. Either because the IV needle entered Levine’s artery or the drug escaped from the vein into her surrounding tis- sue, 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 Food and Drug Admin- istration approval of the drug preempted state tort suits by patients. What constitutional provision is involved, and what should the court decide? [Wyeth v Levine, 555 U.S. 555 (2009)]

6. For the past 62 years, Pacific Gas & Electric (PG&E) has distributed a newsletter in its monthly billing enve- lopes. The newsletter, called Progress, reaches more than 3 million customers and contains tips on conservation, util- ity billing information, public interest information, and political editorials.

A group called TURN (Toward Utility Rate Normal- ization) asked the Public Utility Commission (PUC) of California to declare that the envelope space belonged to the ratepayers and that TURN was entitled to use the Progress space four times each year. The PUC ordered TURN’s request, and PG&E appealed the order to the California Supreme Court. When the California Supreme Court denied review, PG&E appealed to the U.S. Supreme Court, alleging a violation of its First Amendment rights. Is PG&E correct? [Pacific Gas & Electric v Public Utility Commission of California, 475 U.S. 1 (1986)]

7. The Minnesota legislature enacted a 1977 statute banning the retail sale of milk in plastic nonreturnable, nonrefillable containers but permitting such sale in other nonrefillable containers, such as paperboard milk car- tons. Clover Leaf Creamery brought suit challenging the constitutionality of the statute under the Equal Protection Clause, alleging that there was no rational basis for the statute. The Minnesota legislature’s purpose in passing the statute was to control solid waste, arguing that plas- tic containers take up more space in solid waste disposal dumps. The Minnesota Supreme Court found evidence to the contrary: the jugs took up less space and required less energy to produce. On appeal to the U.S. Supreme Court, can the statute survive a constitutional challenge? Is there a “rational basis” for the statute? What effect does the evidence to the contrary have on the statute’s constitutionality? [Minnesota v Clover Leaf Creamery, 449 U.S. 456 (1981)]

8. Iowa passed a statute restricting the length of vehi- cles that could use its highways. The length chosen was 55 feet. Semitrailers are generally 55 feet long; double

or twin tracks (one cab pulling two trailers) are 65 feet long. Other states in the Midwest have adopted the 65-foot standard. Consolidated Freightways brought suit, challenging the Iowa statute as an unconstitu- tional burden on interstate commerce. The Iowa statute meant Consolidated could not use its twins in Iowa. The Iowa legislature claims the 65-foot doubles are more dangerous than the 55-foot singles. However, the statute did provide a border exception: Towns and cit- ies along Iowa borders could make an exception to the length requirements to allow trucks to use their city and town roads. Can Iowa’s statute survive a constitutional challenge? Is the statute an impermissible burden on interstate commerce? [Kassel v Consolidated Freightways Corp., 450 U.S. 662 (1981)]

9. In 1989, the city of Cincinnati authorized Discovery Network, Inc., to place on public property freestanding news racks for distributing free magazines that con- sisted primarily of advertising for Discovery Network’s service. In 1990, the city became concerned about the safety and attractive appearance of its streets and side- walks and revoked Discovery Network’s permit on the grounds that the magazines were commercial handbills whose distribution was prohibited on public property by a preexisting ordinance. Discovery Network argues that the prohibition is an excessive regulation of its commer- cial speech and a violation of its rights. The city main- tains the elimination of the news racks decreases litter and increases safety. Is the ban on news racks constitu- tional? [City of Cincinnati v Discovery Network, Inc., 507 U.S. 410 (1993)]

10. Fed up with the warning signals and being outnum- bered on the highways by drivers looking out for one another, police officers and state troopers began issuing tickets to those who send signals and warnings to driv- ers so that they can slow down and avoid being caught going above the speed limit.

On November 17, 2012, a police officer pulled Michael Elli over and issued a citation for “[f]lashing lights on certain vehicles prohibited, warning of RADAR ahead.” Mr. Elli told the judge that he wanted to plead not guilty because he did not believe flashing headlamps violated §375.100 of the Ellisville city code. The judge became agitated and asked Mr. Elli if he had ever heard of “obstruction of justice.”

Mr. Elli then entered a plea of not guilty, and he was ordered to return to court on February 21, 2013. How- ever, Mr. Elli, with the help of the ACLU, filed a civil rights action in federal court. Have Mr. Elli’s rights been violated? Is flashing your headlights a form of speech? What do you think the court decided? [Elli v City of Ellis- ville, 997 F. Supp. 2d 980 (E.D. Mo. 2014)]

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176 part 2 Business: Its Regulatory Environment

Economics & the Law The Perils of Eminent Domain

The bittersweet ending to the Kelo case presents some interesting economic issues. The city spent $87 million razing the homes to make room for the Pfizer project, which failed. Many eminent domain projects for eco- nomic developments do fail as businesses withdraw due to economic factors and other developments.

Consider whether these types of projects are good investments for local governments. Who are the stake- holders in eminent domain cases? Who is affected by the takings? What lessons do we glean about business and government partnerships?

n ot e s 1. Christian Legal Society Chapter of the University of California, Hastings College of the Law v Martinez, 130 S.Ct. 2971 (2010).

2. Ilya Somin, “Lesson from a Little Pink House, 10 Years Later,” Wall Street Journal, June 22, 2015, p. A13.

3. In Koontz v St. Johns River Water Management District, 133 S.Ct. 2586 (2013), the U.S. Supreme Court held that a landowner

could not be required to fund off-site projects in order to obtain land use permits for his property.

4. Patrick McGeehan, “Mayor Says Times Sq.’s Topless Women Should Be Regulated,” New York Times, August 19, 2015, p. A18.

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Administrative Law6 The regulations of administrative agencies at the federal and state levels affect the day-to-day operations of all businesses. From permits to labor regulations, every business is affected. Agencies are the enforcement arm of governments. Created by one of the branches of government, they affect the way businesses operate. This chapter answers the following questions: What is an administra- tive agency? What does it do? What laws govern the operation of administrative agencies? How do agencies pass rules? How do agencies enforce the law?

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6-1 What Are Administrative Agencies? An administrative agency is best defined by what it is not: it is not a legislative or judicial body. An administrative agency is a statutory creation within the executive branch with the power to make, interpret, and enforce laws. Such agencies exist at practically every level of government, and their names vary considerably. Exhibit 6.1 is a list of all the federal administrative agencies.

States also have administrative agencies that are responsible for such things as the licensing of professions and occupations. Architects, contractors, attorneys, accountants, cosmetologists, doctors, dentists, real estate agents, and nurses are all professionals whose occupations are regulated in most states by some adminis- trative agency. Utility and worker compensation regulations are also handled by administrative agencies in each of the states.

All these agencies at every level of government derive their authority from the legislative body responsible for their creation. Congress creates federal agencies, state legislatures create state agencies, and city governments create their cities’ administrative agencies.

The structures of agencies may differ significantly, but most will have an orga- nizational chart to show how different departments operate. Exhibit 6.2 is an organizational chart for the Securities and Exchange Commission (SEC). The SEC consists of five commissioners, six divisions, and 11 regional offices.

Lord’s Prayer 66 words Gettysburg Address 286 words Declaration of Independence 1,322 words Kings James Bible 788,320 Federal regulations on the sale of cabbage 26,911 words Entire Harry Potter series 1,000,000 Internal Revenue Code and Regulation 31,500,000 words (as of 2015 including

statutes and regulations)

THIS TAG NOT TO BE REMOVED EXCEPT BY THE CONSUMER. Modified warning tag (which previously read, “do not reMove under penalty of law”) required on Mattresses The change was made because the agency needed to reduce the number of calls from consumers who were concerned about removing their mattress tags

In December 2013, the Federal Communications Commission (FCC) proposed a rule change that would allow passengers on commercial jet flights to use their cell phones (wireless services) if the airlines agreed to permit their customers to do so. Foreign airlines have already been allowing in-flight use of cell phones. However, flight attendants are concerned about safety issues because passengers will not hear announcements when they are engaged in phone conversations.

Those who fly frequently are concerned about the possibility of being seated next to a “loud” cell phone

users and the resulting agony of a long flight. Flight attendants fear that passengers, agitated by loud cell phone conversations, will experience air rage that will be difficult to manage. On the other hand, cell phone companies are pleased with the possible expansion of usage.

Still, some experts are concerned about high cell phone usage interfering with plane navigation and com- munication systems. What can flight attendants and passengers do to let their concerns be heard? Can the proposed rule be challenged? How do cell phone com- panies offer their support?

Consider . . . 6.1

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180 part 2 Business: Its Regulatory Environment

Exhibit 6.1 Major Federal administrative agencies


Department of Labor

Department of State

Department of Transportation

Department of the Treasury

Selected Independent Agencies

Commodity Futures Trading Commission (CFTC)

Consumer Product Safety Commission (CPSC)

Environmental Protection Agency (EPA)

Equal Employment Opportunity Commission (EEOC)

Federal Aviation Administration (FAA)

Farm Credit Administration (FCA)

Federal Communications Commission (FCC)

Federal Deposit Insurance Corporation (FDIC)

Federal Election Commission (FEC)

Federal Emergency Management Agency (FEMA)

Federal Maritime Commission (FMC)

Federal Mine Safety and Health Review Commission

Federal Reserve System

Federal Trade Commission (FTC)

General Services Administration (GSA)

Interstate Commerce Commission (ICC)

National Aeronautics and Space Administration (NASA)

National Credit Union Administration (NCUA)

National Highway Traffic Safety Administration (NHTSA)

National Labor Relations Board (NLRB)

National Science Foundation (NSF)

National Transportation Safety Board (NTSB)

Nuclear Regulatory Commission (NRC)

Occupational Safety and Health Administration (OSHA)

Overseas Private Investment Corporation (OPIC)

Patent and Trademark Office

Pension Benefit Guaranty Corporation

Securities and Exchange Commission (SEC)

Selective Service System (SSS)

Small Business Administration (SBA)

Tennessee Valley Authority (TVA)

U.S. Postal Service (USPS)

Veterans Administration (VA)

Executive Departments

Department of Agriculture

Department of Commerce

Department of Defense

Department of the Air Force

Department of the Army

Department of the Navy

Department of Education

Department of Energy

Department of Health and Human Services (HHS)

Department of Homeland Security

Department of Housing and Urban Development (HUD)

Department of the Interior

Department of Justice

Note: Some historical agencies are listed here and in CFR for topical and historical purposes. Current agency structures may include absorption of older agencies.

Legislators begin the creation of an administrative agency with the recogni- tion of a problem and the passage of a law designed to remedy the problem. The enacted law gives the overview—what the legislature wants to accomplish and the penalties for noncompliance with the law. The law may also establish an adminis- trative agency with the power to adopt rules to deal with the problems of enforce- ment of the statute. The law, referred to as an enabling act, gives the agency the power to deal with the issues and problems the act addresses.

6-2 Roles of Administrative Agencies 6-2a Specialization

Administrative agencies are specialists in their particular areas of law, and this type of specialization is needed because of both the complexities of law and the areas of regulation. For example, securities regulation involves both the com- plexity of financial reporting and the underlying technical accounting rules. The SEC has a special division headed by its chief accountant, and that division deals with all current and evolving accounting and financial reporting issues. The peo- ple who work as staff members in these agencies are chosen for their knowledge

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Chapter 6 Administrative Law 181

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182 part 2 Business: Its Regulatory Environment

and experience, which helps them provide protection for the public as well as an understanding of the issues members of the regulated industries face.

6-2b protection for Small Business

An individual or competitor who finds a false advertisement in a newspaper would probably not take the time or effort to bring a private suit to collect dam- ages for the false advertisement. But an agency created to oversee truth in advertis- ing would undertake routine enforcement against such advertisements, affording small business competitors and consumers the protection and rights they might not otherwise have.

6-2c Faster Relief

If enforcement of all government regulations depended on court hearings, courts would be backlogged and the goals of swift action and enforcement defeated. Administrative agencies help expedite investigations and enforcement and pen- alties for violations. In addition, administrative agencies serve as review boards for granting licenses. License and permit applications can be processed far more quickly than they could be handled legislatively.

6-2d due process

Administrative agencies provide the opportunity to be heard, a form of due pro- cess before property, rights, or income is taken. Goldberg v Kelly, 397 U.S. 254 (1970), was the seminal judicial decision responsible for creating administrative agency procedures that provide timely due process. In Goldberg, the Supreme Court ruled that before a benefit (such as aid to dependent children) could be taken away, the agency must present its evidence and allow those who have been receiving the aid an opportunity to respond.

Administrative hearings provide citizens and businesses with a process for see- ing the evidence against them and presenting their side of the story (see Chapter 5 for more insight on due process). For example, the raisin growers had a victory in the U.S. Supreme Court when they successfully challenged the raisin market con- trols of the Department of Agriculture. The Hornes argued that the Fifth Amend- ment requires that the government pay just compensation when it takes personal property, just as when it takes real property. [Horne v Dept. of Agriculture, 135 S.Ct. 2419 (2015)]

The Department of Agriculture had implemented its Marketing Order Regu- lating the Handling of Raisins Produced from Grapes Grown in California. The Marketing Order regulates raisin supply through the oversight of the Raisin Administrative Committee (“RAC”), which sets an annual “reserve tonnage” requirement, a percentage of the overall crop. The remaining raisins are “free ton- nage” and can be sold on the open market. The reserved raisins are diverted from the market to smooth the peaks of the raisin supply curve. Reserved raisins are released when supply is low. The RAC adapts the reserves annually to address changing market conditions. But the growers have their tonnage taken away with- out a hearing or even input on the value of that excess tonnage. The lower courts held that the program was the taking of personal property and that the raisin growers were entitled to due process.

The U.S. Supreme Court agreed, and the Department of Agriculture will have to modify the program to provide compensation as well as the opportunity for

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Chapter 6 Administrative Law 183

growers to be heard regarding any disputes in valuation. Other federal agencies with similar price-support programs will need to re-examine their processes as well because of the decision and its due process implications.

6-2e Social Goals

Some experts see administrative agencies as a means for accomplishing social goals that might otherwise be delayed or debated until no resolution could be reached. For example, the Environmental Protection Agency is assigned the goal of creating a cleaner environment. If Congress had to debate every permit for a factory or rule on discharges, the goal might be lost in the political arena. Further, having judicial review and determination of these issues would result in a delay that might make the goal moot. Administrative agencies can function independently of the judicial and legislative branches. Often, these agencies are created in response to a pressing social issue. For example, the Department of Homeland Security was established to combine several agencies to allow more coordinated responses to terrorism, such as the attacks on the World Trade Center and Washington, D.C., in 2001, as well as natural disasters. The goal was a more centralized means of information distribution and relief.

6-3 Laws Governing Administrative Agencies Apart from their enabling acts, administrative agencies are also subject to some general laws on the functioning of agencies. This section covers those laws.

6-3a administrative procedures act

This act was the first to deal with administrative agency procedures. It was passed in 1946 after some agencies had been in existence long enough for some standard procedures to be established. The Administrative Procedures Act (APA) requires agencies to follow certain uniform procedures in making rules (those procedures are covered later in this chapter). The APA has been amended a number of times by the Freedom of Information Act, the Federal Privacy Act, and the Government in the Sunshine Act, among others.

6-3b Freedom of Information act

The Freedom of Information Act (FOIA) allows access to certain information fed- eral agencies possess and requires that the agencies publicly disclose their pro- cedures and decisions. The types of procedures that must be publicly disclosed relate to agencies’ structures: where the central and regional offices are located and which office or office division will respond to requests for information. Agen- cies must also publish their rules, regulations, procedures, policy statements, and reports.

Some agency information, not published but available to the public, can be obtained by an FOIA request, which must be written and must describe the doc- uments sought. For example, you could request the results of the Federal Trade Commission’s study of coaching programs for college entrance exams. The agency can charge for time and for copying costs in processing the request, although these charges must be published and applied uniformly to all requests. Agencies can waive fees for nonprofit public interest groups.

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184 part 2 Business: Its Regulatory Environment

If an agency wrongfully refuses to supply the information requested, the party requesting it can bring a court action to enforce the request, with all costs paid by the agency.

Some information is exempt from FOIA requests. Those who would be affected by the release of government information can file what are known as “reverse FOIA suits.” These suits seek injunctions to stop the release of government infor- mation on the basis of the FOIA exemptions. The nine categories of exemptions include, for example, requests that would reveal private information about indi- viduals, such as government workers’ personnel records. In some cases, families have an interest in protecting the privacy of loved ones. For example, when Sea World animal trainer Dawn Brancheau was killed by a killer whale during a show at the company’s Florida facility, there were numerous pictures taken by OSHA as part of its investigation into the facility’s compliance with federal safety stan- dards. Ms. Brancheau’s family brought suit to stop the public release of the photos because they were “death-scene materials.” However, there is no such exemption under the FOIA. [Brancheau v Secretary of Labor, 2011 WL 4105047 (M.D.Fla.)]

Businesses often file reverse FOIA suits seeking injunctions. Businesses usually base their reverse FOIA suits on the trade secret exemption. Trade secrets cover a very broad spectrum, including information such as pricing, formulas, and cus- tomer lists. However, the U.S. Supreme Court held in Chrysler Corp. v Brown, 441 U.S. 281 (1979), that the right to stop or grant disclosure rests with the agency and not with the party who supplied the information to the agency.

The exemptions can evolve through legislative additions and clarifications. For example, in 2013, New York passed legislation that prevents government agencies from releasing the names and addresses of gun owners in the state. The effect of the release of that information was that certain police officers’ home addresses became known to criminals who then threatened the officers and also caused thieves to target homes that were revealed by the releases to not have firearms.

6-3c Federal privacy act

In 1974, Congress passed the Federal Privacy Act (FPA) to reduce exchanges of information between agencies about persons (individuals and businesses).

The recordings of 9-1-1 calls have long been subject to FOIA requests by newspapers and television stations. However, the con- tent of those calls often reveals private in- formation or discloses health information about individuals who have not committed a criminal wrong. For example, in 2011, the release of a 9-1-1 call made by friends of actress Demi Moore from her residence as they sought help revealed the actress to be in a disoriented and under-the-influence state, in other words, an unflattering por- trait of a person at an emotional and physi- cal low in her life. However, the recording,

obtained by news outlets, also revealed that agencies involved with the call were slow to respond and confused about jurisdic- tion in the case. Legislation was proposed to ban the public release of these types of calls when there was no criminal behavior. However, opponents of the bill pointed out that the purpose of FOIA requests is of- ten to allow the public to hold government agencies, whether police or administrative agencies, accountable for their conduct and decisions. Discuss whether there should be an exemption or the FOIA should apply to such circumstances.

Consider . . . 6.2

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Chapter 6 Administrative Law 185

The FPA prohibits federal agencies from communicating any records to another agency or person without first obtaining the consent of the person whose record is being communicated. The FPA protects all records about individuals who might be in the possession of the agency, including medical and employment histories.

Because law enforcement agencies would have a difficult time trying to conduct investigations if they had to get permission from the individuals being investigated in order to obtain information, law enforcement agencies are exempt from the FPA. Congress can also obtain information without consent. Routine agency tasks are also exempt from the prior permission requirement. For example, employees of the SEC need constant access to information about stock sales by corporate directors so that the SEC can perform its role of preventing insider trading. Because of ter- rorist attacks, some exchanges of information among federal agencies were broad- ened by the USA Patriot Act.

6-3d Government in the Sunshine act

The Government in the Sunshine Act is often called an open meeting law. Its purpose is to require prior public notice of meetings of those agencies with heads appointed by the president. All the agencies with the word commission in their names have agency heads appointed by the president.

This open meeting law applies only to meetings between or among agency heads. For example, when the commissioners of the FTC meet together, that meet- ing must be public and held only after there has been prior notice. Staff members can hold meetings in private without giving notice. Meetings on law enforcement investigations are also exempt.

Ethical Issues

In 1997, the Internal Revenue Service (IRS) disciplined employees who, out of curiosity, were looking up tax returns of famous people. The employees were not working on the taxpayers’ returns. They were not obtaining information for investigations; they were simply checking to see who made how much income. The IRS fired 23 employees, disciplined 349, and provid- ed counseling for 472. During 1996 and 1997, the IRS investigated 1,515 cases of snooping among its 102,000 employees. By 2007, the number of snooping investiga- tions was increasing by about 400 per year, with employee disciplinary actions taken in about one-half of the cases. About 60 cases per year are referred for criminal prosecu- tion of employees. By 2012, the IRS had

implemented an audit program that tracked employee searches of records to detect access in comparison to the employees’ work assignments and whether the files of individual taxpayers that employees pulled up were related to the audit or review functions that they had been assigned. The report concluded that the tracking was deficient in determining authorization for the employees to access certain files and needed to be improved.

Is this practice so bad? What is wrong with just looking at data accessible at work? The IRS employees said they did not disclose the data and therefore didn’t violate federal privacy laws. Are ethics and laws the same thing?

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186 part 2 Business: Its Regulatory Environment

6-3e Federal Register act

Although the Federal Register Act (FRA) is not a part of the APA, its provisions are necessary for all the acts under the APA to work. The FRA created the Federal Register System, which oversees publication of federal agency information. This system provides the means for Sunshine Act notices and publication of agency rules and procedures.

Three publications make up the Federal Register System. The first is the U.S. Government Manual. This publication is reprinted each year and lists all federal agencies and their regional offices along with addresses. In addition, the Manual contains statistics about the agencies and their sizes.

The second publication of the Federal Register Act is the Code of Federal Regulations. (The U.S. Code is covered in Chapter 1.) The Code of Federal Regu- lations contains all the regulations of all the federal agencies. The volumes are in paperback, and the entire Code is republished each year because of tremendous changes in the regulations.

The third publication under the Federal Register System provides a daily update on changes in the regulations. This publication, called the Federal Register, is published every government working day and contains proposed regulations, notices of meetings (under the Government in the Sunshine Act), notices of hear- ings on proposed regulations, and the final versions of amended or new regula- tions. The Federal Register totals about 83,000 pages a year, or about 320 pages every working day.

6-4 The Functions of Administrative Agencies and Business Interaction

Administrative agencies have three functions: promulgating regulations, enforc- ing rules, and adjudicating rules. Businesses will find themselves interacting with agencies in all three areas of operation.

6-4a providing Input When agencies are promulgating Regulations

The legislative function of administrative agencies has two forms: formal rulemaking and informal rulemaking. Some agencies combine them into a type of rulemaking that is a cross between formal and informal—hybrid rulemaking. This section focuses on formal rulemaking.

6-4b Formal Rulemaking

Exhibit 6.3 diagrams the steps involved in formal rulemaking.

Congressional enabling act Congress is responsible for passing statutes designed to remedy a perceived prob- lem that is within federal jurisdiction. As legislation progresses through Congress, constituents have an opportunity to voice their views and concerns about problem areas.

The chapter-opening “Consider . . .” illustrates an agency carrying out a legis- lative mandate. The Patient Protection and Affordable Care Act (“Affordable Care Act” or “Obama Care”) required the FDA to develop and enforce rules of disclosure

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Chapter 6 Administrative Law 187

on sales of food in restaurants. Its proposed rule on disclosure of theater popcorn was part of the agency’s assignment under the enabling act legislation. Section 4205 of the Patient Protection and Affordable Care Act (PPACA) requires that compa- nies with over 20 restaurants or vending machines must post nutrition content for standard menu items and that vending machines must “provide a sign in close proximity to each article of food or the selection button that includes a clear and conspicuous statement disclosing the number of calories contained in the article.” The law took effect immediately when it was declared constitutional (see Chapter 5 for the case decision), but restaurants and grocery stores needed more guidance in terms of what those labels must include. The result was the FDA’s proposed regula- tions in 2011 regarding content and location of the labels and disclosures, as well as details on exemptions from disclosures. Those proposed rules resulted in extensive push-back from those affected and an 18-month-long rulemaking process, which involved a focus on the theater popcorn regulation proposals.

agency Research of the problem Any regulation passed by an administrative agency must have some purpose and evidence to show that the regulation will accomplish the purpose. Rules passed without some study and evidence supporting their need or effectiveness could be challenged as “arbitrary and capricious” (discussed later in this chapter) by the persons or industries affected by the questioned rules.

Agency staff can perform the study, or the agency can hire outside experts to conduct it. The study will examine issues such as whether the regulation will be cost effective. Some regulations may cost billions of dollars for industries to follow. The food-labeling regulations fell into that category. As the costs of disclosure were explored, the FDA granted more and more exemptions because of the impact on businesses, including the cost of lab analysis for determining

Exhibit 6.3 Stages in Formal Rulemaking by administrative agencies

Agency Study and

Research of Need for


Proposed Regulations Published in

Federal Register

Public Comment


Hearings Held


1 2 3 4 5

Modi�cation of Proposed Regulation

Public Comment Period on


Withdrawal of Proposed Regulation

Rule Is Promulgated

Court Challenges

6 7 8 9

Enabling Act by


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188 part 2 Business: Its Regulatory Environment

label information, costs of printing labels, and the prohibitive costs of devel- oping new products, due to new labeling certification, including the barriers to developing lower-calorie or low-fat versions of food products. The agency study focuses not only on monetary costs but also on the problems the regula- tion is trying to correct and the cost of those problems to the individual and to society.

proposed Regulations Based on the needs and costs shown by the completed study, the agency will pub- lish its proposed rules or rule changes in the Federal Register. To be valid, the notice in the Federal Register must contain certain information. If notice is not given or is given improperly, a court can set aside the action taken by the agency and require the rulemaking process to be repeated with proper notice.

Although not required to do so, some agencies provide background informa- tion in the notice so that some history and the function of the rules are given. In addition to publishing the notice of proposed rules in the Federal Register, an

Exhibit 6.4 example of agency Notice of proposed Rulemaking expanding access to Mobile Wireless Services Onboard aircraft

A Proposed Rule by the Federal Communications Commission

aCtION: Proposed Rules

aGeNCY: Federal Communications Commission

SUMMaRY: In this Notice of Proposed Rulemaking (NPRM), the Commission proposes to revise outdated rules and adopt consistent new rules governing mobile communications services aboard airborne aircraft. These rule changes would give airlines, subject to applicable Federal Aviation Administration (FAA) and Department of Transportation (DoT) rules, the choice of whether to enable mobile communications services using an Airborne Access System and, if so, which specific services to enable. The proposed rules would also replace an existing patchwork of regulatory prohibitions on airborne use of mobile services in some, but not all, of the heavily used mobile wireless bands with a consistent regulatory framework that explicitly forbids airborne use of mobile services in those bands unless they are operating on an aircraft equipped with an Airborne Access System.


I. Introduction and Background

II. Discussion

A. Changes to Current Rules Restricting Airborne Mobile Broadband Use

B. Airborne Access Systems

1. Potential Harmful Interference From Uncontrolled Airborne Mobile Devices

2. Benefits of Airborne Access Systems

3. Technical Requirements

C. Airborne Commercial Mobile Use

D. Other Issues

1. Service Below 3,048 Meters (10,000 Feet)

2. Voice Service Onboard Aircraft

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Chapter 6 Administrative Law 189

agency is required under the Regulatory Flexibility Act to publish a notice in the publications of those trades and industries that will be affected by the rule. For example, the regulation governing food labeling was published in both restaurant and grocery association magazines. Exhibit 6.4 is the original proposed FCC rule on the use of cell phones on airplanes.

the public Comment period One of the purposes for publishing proposed rules is to allow the public an opportunity to review and provide input on the proposed rules. The period during which the agency accepts comments on the rule is called the public com- ment period. Under the APA, the public comment period cannot be fewer than 30 days, but most agencies make the public comment period much longer. The FCC cell phone rules were so controversial that the time from the publication of the proposed rule has lasted two years, with the final rule not yet promulgated. Most experts believe that the FCC will find that cell phone usage is safe but will leave their use for phone conversations while in-flight to airline discretion. The FAA permits PED use of cellphones on flights, but does not permit cellular connections.

Private citizens, government officials, industry representatives, business- people, and corporations can all send in comments. With this opportunity, businesses can provide information and express concerns about proposals. A comment to an agency on a proposed rule need not use a formal format; most just appear in letter form. Exhibits 6.5, 6.6, and 6.7 illustrate the types of com- ments that were submitted by companies and organizations to the FCC about

Exhibit 6.5 Comments in Favor of the proposed Rules

Comments by Consumers in Favor of In-Flight Cell Phone Use (there were only 4)

While I respect the members of the commission and the public who are not excited about the ability of individuals to use cell phones on planes, that lack of support is not a sufficient reason to enforce a pointless ban. May I remind you that just recently many people were upset by the fact that blacks and whites may be forced to endure each other presents [sic] in the same restaurant.

However, those complains [sic] fell on def [sic] ears as the government did its duty. To that end, the duty of the government here is not to decide whether or not customers should be allowed to talk on their phones. The issue here is whether or not it is SAFE for passengers to use their phones.


Submit comments on or before February 14, 2014. Submit reply comments on or before March 17, 2014.

Paperwork Reduction Act (PRA) comments should be submitted March 17, 2014.


You may submit comments, identified by WT Docket No. 13-301 or FCC 13-157, by any of the following methods:

Federal Communications Commission’s Web site: Follow the instructions for submitting comments.

Mail: FCC Headquarters, 445 12th St. SW., Washington, DC 20554.

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190 part 2 Business: Its Regulatory Environment

Exhibit 6.6 Comments that Oppose the proposed Rules

Dear FCC

What better use of my extra Christmas card than to ask you to use any influence you have, during the process of allowing my cellular use on planes, to guide airlines towards allowing data but not voice use on flights. Thank you.

“The ground all dusted white, frosted windows spilling light. . . . Everything says welcome home to Christmas.”

Nooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooo ooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooo ooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooooo!

Flying is already expensive, uncomfortable and full of angst caused by late flights, drunk passengers and badly behaved children. Commercial flights will become hell on earth if this becomes legal.

I beg you to please not allow cell phone conversations on airplanes. I predict hundreds, if not thousands of flights per year forced to divert to a quick landing due to physical confrontations between passengers. The sky marshals will have their hands full breaking up fights, either verbal or physical, between passengers. For the sake of sanity in the air, please do notallow [sic] cell phone conversations in the air. Chaos will reign.

No! God no!! Please God, no!!!


Exhibit 6.7 Comments from Various Groups Comment Letters By Groups

From Organized Groups—A Form Comment Letter (Hundreds Submitted)

I oppose the FCC allowing the use of cell phone voice calling on aircraft in flight, except in emergency situations. This isn’t just an issue of comfort or courtesy, it’s one of safety. In cramped airline cabins, passions already run high. Even when people try to talk quietly on mobile phones, they speak more loudly than they expect because of a lack of sidetone and overcompensation for background noise. Loud mobile phone conversations could dramatically increase the prevalence of “air rage,” endangering the lives of passengers and crew.

SMS texting and Internet connectivity are both excellent ways for fliers to stay entertained and in touch with their friends, family and work contacts on the ground. For safety’s sake, the FCC should approve SMS and data use but prohibit voice calls except in emergencies.

From the Association of Flight Attendants

Flight Attendants and passengers are united on this issue—there should be no voice calls in-flight. As first responders in the aircraft cabin, Flight Attendants know that this reckless FCC proposal would have negative effects on aviation safety and security. Repeatedly, studies have shown that a large majority of the American public agrees that voice calls have no place inside the cabin. The FCC should take heed and reverse this nonsensical plan that only stands to benefit a few manufacturers and vendors, and take into consideration the impact it would have on Flight Attendants and the traveling public.

From Members of Congress

Even if the FCC were to find that cell phones on airplanes did not cause any signal interference, airborne cell phone conversations would have other safety implications. It has been demonstrated that people talking on cell phones were much less likely to aid someone in need. Numerous other studies have demonstrated that cell phone conversations are particularly irritating and distracting to people nearby. The combination of these factors could make it much more difficult for crew members to give instructions and count on passenger assistance during an emergency. Altercations between passengers over cell phone use could also result in flight attendants having to act as referees to mitigate “air rage.”

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the proposed cell phone use on aircraft regulations. Comments such as these, along with comments on any other agencies’ proposed regulations, are available through an FOIA request if the agencies have not already made the comments available online.

Other Issues in the Comment Period. Some agencies hold public hearings on pro- posed regulations. The purpose of the hearings is to take input on the proposals and consider additional evidence and factors relevant in promulgating the final version of the rule.

One of the important distinctions between the legislative process and the regulatory rule making process is the nature of the role of those involved. Legislators, such as representatives and senators, can accept campaign contri- butions and meals from lobbyists. However, those who work in administrative agencies fulfill both rulemaking and enforcement roles and cannot accept such gifts. In U.S. v Sun-Diamond Growers of California 526 U.S. 398 (1999), the U.S. Supreme Court held that administrative officials can be prosecuted for criminal bribery if the payments are made in order to persuade agency officials to aban- don or change proposed regulations or actions before the agency. The types of payments that have resulted in bribery convictions of regulatory officials include club memberships [U.S. v Garrido, 713 F.3d 985 (9th Cir. 2013)] or the payment of the regulator’s son’s college tuition [U.S. v McNair, 605 F.3d 1152 (11th Cir. 2010)]. The McDonnell v U.S. case (Case 6.1), deals with the issue of members of executive branch receiving gifts from a constituent who needs agency action.

McDonnell v U.S. 136 S.Ct. 2355 (2016)

The Governor, Supplement Promotion, Some Loans, a Rolex, an Oscar de la Renta Dress, and Ferrari Rides


On November 3, 2009, Robert McDonnell (Defendant/ Appellant), was elected the seventy-first governor of Virginia. When Mr. McDonnell tool office, he was struggling financially. A real estate LLC (Mobo) that he owned with his sister was losing more than $40,000 each year. By 2011, they owed more than $11,000 per month in loan payments. Each year, their loan balance increased, and by 2012, the outstanding balance was nearing $2.5 million. Mr. McDonnell and his wife also had a combined credit card balance exceeding $74,000, which, by September 2010, had grown to $90,000.

Shortly after the election, the McDonnells met Jonnie Williams, the founder and CEO of Virginia- based Star Scientific Inc. Star was close to launching a new product: Anatabloc. For years, Star had been

evaluating the curative potential of anatabine, an alka- loid found in the tobacco plant, focusing on wheth- er it could be used to treat chronic inflammation. Anatabloc was one of the anatabine-based dietary supplements Star developed as a result of these years of evaluation.

The McDonnells had used Williams’s plane during his campaign, and he wanted to thank Williams over dinner in New York. During dinner, Williams ordered a $5,000 bottle of cognac, and the conversation turned to the gown Mrs. McDonnell would wear to the inauguration. Williams mentioned that he knew Oscar de la Renta and offered to purchase Mrs. McDonnell an expensive custom dress. Following this dinner, the McDonnells and Mr. Williams began a relationship depicted in the following chart.

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McDonnell v U.S. 136 S.Ct. 2355 (2016)

The Governor, Supplement Promotion, Some Loans, a Rolex, an The Governor, Supplement Promotion, Some Loans, a Rolex, an Oscar de la Renta Dress, and Ferrari Rides

Case 6.1

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192 part 2 Business: Its Regulatory Environment


October 2010 McDonnell plane ride with Williams on Williams’s plane from California to Virginia.

Williams asked for help in promoting Anatabloc; both agreed to “independent testing in Virginia.”

McDonnell agrees to introduce Williams to Dr. William Hazel, Virginia’s secretary of health and human services.

April 2011 Williams took Mrs. McDonnell on a shopping spree; they lunched and shopped at Bergdorf Goodman and visited Oscar de la Renta and Louis Vuitton stores on Fifth Avenue. Williams bought Mrs. McDonnell dresses and a white leather coat from Oscar de la Renta; shoes, a purse, and a raincoat from Louis Vuitton; and a dress from Bergdorf Goodman. Williams spent approximately $20,000 on Mrs. McDonnell during this shopping spree.

Williams sits with the McDonnells at a political rally in New York City that evening.

April 29, 2011 Williams joined the McDonnells for a private dinner at the Governor’s Mansion.

The discussion at dinner centered on Anatabloc and the need for independent testing and studies. McDonnell was “intrigued that [Star] was a Virginia company with an idea,” and he wanted to have Anatabloc studies conducted within Virginia.

Two days after this private dinner, Mrs. McDonnell received an e-mail via Williams that included a link to an article titled “Star Scientific Has Home Run Potential,” which discussed Star’s research and stock. Mrs. McDonnell forwarded this e-mail to her husband.

May 2, 2011 Mrs. McDonnell and Williams met at the Governor’s Mansion to discuss Anatabloc.

Mrs. McDonnell began explaining her family’s financial woes— thoughts about filing for bankruptcy, high-interest loans, the decline in the real estate market, and credit card debt. Then, according to Williams, Mrs. McDonnell said, “I have a background in nutritional supplements. and I can be helpful to you with this project, with your company. The governor says it’s okay for me to help you and—but I need you to help me. I need you

Williams called McDonnell to “make sure [he] knew about it” and then cut the checks requested by Mrs. McDonnell.

to help me with this financial situation.” Mrs. McDonnell asked to borrow $50,000. Williams agreed to loan the money to the McDonnells. Mrs. McDonnell also mentioned that she and her husband owed $15,000 for their daughter’s wedding reception. Again, Williams agreed to provide the money.


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May 5, 2011 McDonnell met with Secretary Hazel and Chief of Staff Martin Kent to discuss the strategic plan for the state’s health and human resources office.

McDonnell directed his assistant to forward to Hazel the article about Star that Mrs. McDonnell had earlier brought to his attention.

May 23, 2011 Williams delivers two checks for the amounts discussed on May 2: a $50,000 check made out to Mrs. McDonnell and a $15,000 check that was not made out to anyone but was going to the wedding caterers.

May 28, 2011 Mr. McDonnell expressed his gratitude in a May 28 e-mail to Williams: “Johnnie [sic]. Thanks so much for all your help with my family. Your very generous gift to Cailin was most appreciated as well as the golf round tomorrow for the boys. Maureen is excited about the trip to fla to learn more about the products. . . . Have a restful weekend with your family.”

May 29, 2011 McDonnell, his two sons, and his soon-to-be son-in-law spent the day at Kinloch Golf Club in Manakin– Sabot, Virginia. During this outing, they spent more than seven hours playing golf, eating, and shopping.

June 1, 2011 Mrs. McDonnell traveled to Florida at the start of June to attend a Star- sponsored event at the Roskamp Institute. While there, she addressed the audience, expressing her support for Star and its research. She also invited the audience to the launch for Anatabloc, which would be held at the Governor’s Mansion.

June 1, 2011 Mrs. McDonnell purchased 6,000 shares of Star stock at $5.1799 per share, for a total of $31,079.40.

June 2011 Williams then made a “$100,000 in-kind contributor to the McDonnell campaign and the PAC” and flew the McDonnell children to the resort for a PAC retreat. McDonnell and Williams played golf together during the retreat. A few days later, Williams sent golf bags with brand-new clubs and golf shoes to McDonnell and one of his sons.


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July 2011 McDonnell and his family vacationed at Williams’s multi- million-dollar home at Smith Mountain Lake in Virginia. Williams allowed the McDonnells to stay there free of charge. He also paid $2,268 for the McDonnells to rent a boat. Williams provided transportation for the family: the McDonnell children used Williams’s Range Rover for the trip to the home, and Williams paid more than $600 to have his Ferrari delivered to the home for McDonnell to use.

July 31, 2011 McDonnell drove the Ferrari back to Richmond at the end of the vacation. During the three-hour drive, Mrs. McDonnell snapped several pictures of McDonnell driving with the Ferrari’s top down.

Mrs. McDonnell e-mailed one of the photographs to Williams at 7:47 p.m.

July 31, 2011 At 11:29 p.m., after returning from the Smith Mountain Lake vacation, McDonnell directed Secretary Hazel to have his deputy attend a meeting about Anatabloc with Mrs. McDonnell at the Governor’s Mansion the next day.

August 1, 2011 Hazel sent a staffer, Molly Huffstetler, to the meeting, which Williams also attended.

Williams—with Mrs. McDonnell at his side—told Dr. Clore that clinical testing of Anatabloc in Virginia was important to McDonnell. Williams discussed clinical trials at the University of Virginia (“UVA”) and Virginia Commonwealth University (“VCU”),

After the meeting ended, Mrs. McDonnell noticed the Rolex watch adorning Williams’s wrist. She mentioned that she wanted to get a Rolex for McDonnell. When Williams asked if she wanted him to purchase one for McDonnell, she responded affirmatively.

home of the Medical College of Virginia (“MCV”). Then Williams and Mrs. McDonnell met with Dr. John Clore from VCU, who Williams said was “important, and he could cause studies to happen at VCU’s medical school.”

August 2, 2011 Mrs. McDonnell purchased another 522 shares of Star stock at $3.82 per share, for a total of $1,994.04.


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August 13, 2011 McDonnell and one of his sons returned to Kinloch Golf Club. The bill for this golf outing, which Williams again paid, was $1,309.17.

August 14, 2011 Williams purchased a Rolex from Malibu Jewelers in Malibu, California. The Rolex cost between $6,000 and $7,000 and featured a custom engraving: “Robert F. McDonnell, 71st Governor of Virginia.”

Mrs. McDonnell later took several pictures of McDonnell showing off his new Rolex—pictures that were later sent to Williams via text message.

August 30, 2011 Luncheon at Governor’s Mansion. Invitations bore the Governor’s seal and read, “Governor and Mrs. Robert F. McDonnell Request the Pleasure of your Company at a Luncheon.” Invitees included Dr. Clore and Dr. John Lazo from UVA.

McDonnell thanked the attendees for their presence and “talked about his interest in a Virginia company doing this, and his interest in the product.”

Each place setting featured samples of Anatabloc, and Williams handed out checks for grant applications—each for $25,000—to doctors from various medical institutions.

Fall 2011 Star’s president, Paul L. Perito, began to worry that Star had lost the support of UVA and VCU. In the fall of 2011, Perito was working with those universities to file grant applications. During a particular call with UVA officials, Perito felt the officials were unprepared. According to Perito, when Williams learned about this information, “[h]e was furious and said, ‘I can’t understand it. McDonnell and his wife are so supportive of this and suddenly the administration has no interest.’”

December 2011 Mrs. McDonnell sold all of her 6,522 shares of Star stock for $15,279.45, resulting in a loss of more than $17,000.

This allowed McDonnell to omit disclosure of the stock purchases on a required financial disclosure form known as a Statement of Economic Interest (filed on January 16 2012).

January 7, 2012 McDonnell made another golf visit to Kinloch Golf Club, running up a $1,368.91 bill that Williams again paid.

Outing not disclosed, and other golf outings not disclosed on other 2011 golf trips.

January 20, 2012

Mrs. McDonnell purchased 6,672 shares of Star stock at $2.29 per share, for a total of $15,276.88.


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January 2012 Williams discussed the Mobo properties with Mrs. McDonnell, who wanted additional loans.

Williams agreed to loan more money. Mrs. McDonnell was “furious when [Williams] told her that [they were] bogged down in the administration.” Later, Mrs. McDonnell called Williams to advise him that she had relayed this information to McDonnell, who “want[ed] the contact information of the people that [Star] [was] dealing with at [UVA].”

February 3, 2012 Mrs. McDonnell requested another $50,000 loan.

February 6, 2012 Williams writes a check to Mobo on $50,000.

Mrs. McDonnell received an e-mail, as requested by McDonnell, containing the names of the UVA officials with whom Star had been working. She forwarded this list to McDonnell and his chief counsel, Jacob Jasen Eige, on February 9.

February 10, 2012

While riding with McDonnell, Mrs. McDonnell followed up with Eige:

“Pls call Jonnie today [and] get him to fill u in on where this is at. Gov wants to know why nothing has developed w studies after Jonnie gave $200,000. I’m just trying to talk w Jonnie. Gov wants to get this going w VCU MCV. Pls let us know what u find out after we return. . . .”

February 16, 2012

McDonnell e-mailed Williams to check on the status of certificates and documents relating to loans Williams was providing for Mobo.

Six minutes after McDonnell sent this e-mail, he emailed Eige: “Pls see me about anatabloc issues at VCU and UVA. Thx.”

February 2012 Governor’s Mansion reception for the doctors and Star officials. McDonnell, Mrs. McDonnell, Williams, and two doctors went out for a $1,400 dinner on Williams’s dime.

During dinner, the diners discussed Anatabloc. Mrs. McDonnell talked about her use of Anatabloc, and McDonnell asked one of the doctors—a Star consultant— “How big of a discovery is this?”

Mrs. McDonnell invited the two doctors to stay at the Governor’s Mansion for the evening—an offer the doctors accepted.

May 18, 2012 McDonnell sent Williams a text message concerning yet another loan: “Johnnie. Per voicemail would like to see if you could extend another 20k loan for this year. Call if possible and I’ll ask mike to send instructions. Thx bob.”

Twelve minutes later, Williams responded, “Done, tell me who to make it out to and address. Will FedEx. Jonnie.”


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May 18–26, 2012

McDonnell and his family vacationed at Kiawah Island in South Carolina. The $23,000 vacation was a gift from William H. Goodwin Jr., characterized as a personal friend of the McDonnells.

Not disclosed on McDonnell’s 2012 Statement of Economic Interest.

April–July 2012 McDonnell e-mailed and texted Williams about Star stock on four occasions, each coinciding with a rise in the stock price.

July 3, 2012 Williams texts McDonnell: “Johns Hopkins human clinical trials report on Aug. 8. If you need cash let me know. Let’s go golfing and sailing Chatham Bars inn Chatham mass labor day weekend if you can. Business about to break out strong. Jonnie.”

Labor Day weekend 2012

Williams spent more than $7,300 on this vacation for the McDonnells. Williams paid the McDonnells’ share of a $5,823.79 bill for a private clambake.

Also joining in on the weekend excursion was one of the doctors who attended the February health care leaders reception, whom Williams invited in an attempt “to try to help get the Governor more involved.”

December 12, 2012

McDonnell learns of his wife’s repurchase of Star shares:

“[I]t was her money that she had used for this. But I told her, you know, “Listen. If you have this stock, you know, this is”—“again, triggers a reporting requirement for me. I can do it, but I need”—“I just don’t”—“I really don’t appreciate you doing things that really”—“that affect me without”—“without me knowing about it.”

December 25, 2012

Mrs. McDonnell transferred her Star stock to her children as a gift.

Williams gave the McDonnell’s daughter, Jeanine, a $10,000 wedding gift.

Stock need not be disclosed for the 2012 Statement of Economic Interest.


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198 part 2 Business: Its Regulatory Environment

Mr. McDonnell was convicted of conspiracy to commit honest-services wire fraud, three counts of honest-services wire fraud, conspiracy to obtain prop- erty under color of official right, and six counts of obtaining property under color of official right.1 He appealed. The Fourth Circuit affirmed and he appealed. The U.S. Supreme Court granted certiorari.


ROBERTS, Chief Justice (for a unanimous court) The parties agreed that they would define honest

services fraud with reference to the federal bribery statute, 18 U.S.C. § 201. That statute makes it a crime for “a public official or person selected to be a public offi- cial, directly or indirectly, corruptly” to demand, seek, receive, accept, or agree “to receive or accept anything of value” in return for being “influenced in the perfor- mance of any official act.” § 201(b)(2). An “official act” is defined as “any decision or action on any question, matter, cause, suit, proceeding or controversy, which may at any time be pending, or which may by law be brought before any public official, in such official’s offi- cial capacity, or in such official’s place of trust or profit.”

[T]he Government was required to prove that Gover- nor McDonnell committed or agreed to commit an “offi- cial act” in exchange for the loans and gifts from Williams.

The issue in this case is the proper interpretation of the term “official act.” The Government concludes that the term “official act” encompasses nearly any activity by a public official. In the Government’s view, “official act” specifically includes arranging a meet- ing, contacting another public official, or hosting an event—without more—concerning any subject, includ- ing a broad policy issue such as Virginia economic development.

Governor McDonnell, in contrast, contends that statutory context compels a more circumscribed read- ing, limiting “official acts” to those acts that “direct [ ] a particular resolution of a specific governmental deci- sion,” or that pressure another official to do so.

The issue here is whether arranging a meeting, contacting another official, or hosting an event—with- out more—can be a “question, matter, cause, suit, pro- ceeding or controversy,” and if not, whether it can be a decision or action on a “question, matter, cause, suit, proceeding or controversy.”

Although it may be difficult to define the precise reach of those terms, it seems clear that a typical meeting, telephone call, or event arranged by a public official does not qualify as a “cause, suit, proceeding or controversy.”

[W]e conclude that a “question” or “matter” must be similar in nature to a “cause, suit, proceeding or controversy.” Because a typical meeting, call, or event arranged by a public official is not of the same stripe

as a lawsuit before a court, a determination before an agency, or a hearing before a committee, it does not qualify as a “question” or “matter.”

The question remains whether—as the Govern- ment argues—merely setting up a meeting, hosting an event, or calling another official qualifies as a decision or action on any of those three questions or matters. Although the word “decision,” and especially the word “action,” could be read expansively to support the Government’s view, our opinion in United States v. Sun–Diamond Growers of Cal., 526 U.S. 398, 119 S.Ct. 1402, 143 L.Ed.2d 576 (1999), rejects that interpretation.

We recognized that “the Secretary of Agriculture always has before him or in prospect matters that affect farmers, just as the President always has before him or in prospect matters that affect college and professional sports, and the Secretary of Education matters that affect high schools.” But we concluded that the existence of such pending matters was not enough to find that any action related to them constituted an “official act.” It was possible to avoid the “absurdities” of convicting individ- uals on corruption charges for engaging in such conduct, we explained, “through the definition of that term,” i.e., by adopting a more limited definition of “official acts.”

Setting up a meeting, hosting an event, or calling an official (or agreeing to do so) merely to talk about a research study or to gather additional information, however, does not qualify as a decision or action on the pending question of whether to initiate the study. Simply expressing support for the research study at a meeting, event, or call—or sending a subordinate to such a meeting, event, or call—similarly does not qualify as a decision or action on the study, as long as the public official does not intend to exert pressure on another official or provide advice, knowing or intend- ing such advice to form the basis for an “official act.”

Of course, this is not to say that setting up a meet- ing, hosting an event, or making a phone call is always an innocent act, or is irrelevant, in cases like this one. If an official sets up a meeting, hosts an event, or makes a phone call on a question or matter that is or could be pending before another official, that could serve as evidence of an agreement to take an official act.

But conscientious public officials arrange meetings for constituents, contact other officials on their behalf, and include them in events all the time. The basic com- pact underlying representative government assumes that public officials will hear from their constituents and act appropriately on their concerns—whether it is the union official worried about a plant closing or the homeowners who wonder why it took five days to restore power to their neighborhood after a storm. The Government’s position could cast a pall of potential prosecution over these relationships if the union had given a campaign contribution in the past or the homeowners invited


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the official to join them on their annual outing to the ballgame. Officials might wonder whether they could respond to even the most commonplace requests for assistance, and citizens with legitimate concerns might shrink from participating in democratic discourse.

This concern is substantial. White House coun- sel who worked in every administration from that of President Reagan to President Obama warn that the Government’s “breathtaking expansion of public- corruption law would likely chill federal officials’ interactions with the people they serve and thus dam- age their ability effectively to perform their duties.”

Because the jury was not correctly instructed on the meaning of “official act,” it may have convicted Governor McDonnell for conduct that is not unlawful.

For that reason, we cannot conclude that the errors in the jury instructions were “harmless beyond a reasonable doubt.” We accordingly vacate Governor McDonnell’s convictions.



1. Give a summary of what was going back and forth between the McDonnells and Mr. Williams.

2. What was Mr. Williams looking to obtain from Governor and Mrs. McDonnell?

3. Why is the term “official act” important on appeal?

deciding What to do with the proposed Regulation After the comment period is over, the agency has three choices about what to do with the proposed rules. The first choice is simply to adopt the rules. The second choice is to modify the proposed rules and go through the process of public com- ment again. If the modification is minor, however, the APA allows the agency to adopt a modified version of the rule without going through the public comment period again. The final choice of the proposing agency is to withdraw the rule. Some rules have so many comments pointing out their impracticability, inflexi- bility, or prematurity that they are withdrawn from the promulgation process. For example, when the EEOC proposed guidelines on religious harassment in the workplace, including regulations on employees wearing necklaces with crosses on them, business comments and concerns about those guidelines resulted in the U.S. Senate passing a resolution urging the EEOC to drop the guidelines. Reli- gious and business groups flooded the EEOC with more than 100,000 letters of protest. EEOC attorneys advised that banning such personal expression, a form of speech, would result in a flood of First Amendment suits. The EEOC with- drew the proposed rules. EEOC spokesman Mike Widomski explained that “the public outcry and the number of comments that were received” triggered the reversal. Public comments and input have an impact in the regulatory process.

Ethical Issues

Despite what the court concluded in McDonnell v U.S., evaluate the ethics of the McDonnells and Williams’s conduct.

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Court and Legislative Challenges to proposed Rules Even after the rule is promulgated, those who are affected by the rule can chal- lenge the validity of the rules in court. An administrative rule can be challenged on several different grounds.

The Arbitrary and Capricious Standard for Challenging an Agency Action. The first ground on which to challenge an agency rule is that it is arbitrary, capricious, an abuse of discretion, or in violation of some other law. This standard is generally applied to informal rulemaking and simply requires the agency to show evidence to support the proposed rule. Without such evidence, the rule can be held to be arbitrary and capricious. Hornbeck Offshore Services, L.L.C. et al. v Salazar (Case 6.2) addresses the issue of whether an agency’s action is arbitrary and capricious.

Hornbeck Offshore Services, L.L.C. et al. v Salazar 696 F. Supp. 2d 627 (E.D. La. 2010)

Drilling Down to the Facts Supporting a Rule

Case 6.2


Hornbeck and others (plaintiffs) provide services to sup- port offshore oil and gas drilling, exploration, and pro- duction activities in the Gulf of Mexico. Kenneth Salazar is the secretary of the Department of Interior (DOI), a federal agency that includes the Minerals Management.

Following the BP Deepwater Horizon drilling platform explosion on April 20, 2010, and the resulting devastation and unprecedented disaster, President Obama asked DOI to conduct a study to determine what steps needed to be taken to prevent another problem with oil rigs in the Gulf.

DOI did a 30-day study, consulting respected experts from state and federal governments, academic insti- tutions, and industry and advocacy organizations. On May 27, 2010, DOI issued a report that recommended a six-month moratorium on permits for new wells and an immediate halt to drilling operations on the 33 permitted wells in the Gulf of Mexico. The DOI report also stated that “the recommendations contained in this report have been peer-reviewed by seven experts identified by the National Academy of Engineering.” The experts pointed- ly observed this statement was misleading and called it a “misrepresentation.” Although the experts agreed with the safety recommendations contained in the body of the main Report, five of the National Academy experts and three of the other experts publicly stated that they “do not agree with the six month blanket moratorium” on floating drilling. They envisioned a more limited kind of moratorium, but a blanket moratorium was added after their final review and was never agreed to by them. The plaintiffs moved for a preliminary injunction against the DOI moratorium.


FELDMAN, District Judge The Administrative Procedure Act authorizes judi- cial review of final agency action. The APA cautions that an agency action may only be set aside if it is “arbitrary, capricious, an abuse of discretion, or not otherwise in accordance with law.” The reviewing court must decide whether the agency acted within the scope of its authority, “whether the decision was based on a consideration of the relevant factors and whether there has been a clear error of judgment.”

Normally, an agency rule would be arbitrary and capricious if the agency has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.

After reviewing the Secretary’s Report and the Mor- atorium Memorandum, the Court is unable to divine or fathom a relationship between the findings and the immense scope of the moratorium. The Report describes the offshore oil industry in the Gulf and offers many compelling recommendations to improve safety. But it offers no time line for implementation. The Report patently lacks any analysis of the asserted fear of threat of irreparable injury or safety hazards posed by the 33 permitted rigs also reached by the moratorium. It is incident-specific and driven: Deepwater Horizon and BP only. None others. While the Report notes the increase in deepwater drilling over the past ten years and the increased safety risk associated with deepwater drilling,

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Chapter 6 Administrative Law 201

the parameters of “deepwater” remain confused. And drilling elsewhere simply seems driven by political or social agendas on all sides. The Report seems to define “deepwater” as drilling beyond a depth of 1,000 feet by referencing the increased difficulty of drilling beyond this depth; similarly, the shallowest depth referenced in the maps and facts included in the Report is “less than 1,000 feet.” But while there is no mention of the 500 feet depth anywhere in the Report itself, “deepwater” [is now anything] more than 500 feet.

The Court recognizes that the compliance of the 33 affected rigs with current government regulations may be irrelevant if the regulations are insufficient or if MMS, the government’s own agent, itself is suspected of being corrupt or incompetent. Nonetheless, the Secretary’s determination that a six-month moratorium on issuance of new permits and on drilling by the 33 rigs is neces- sary does not seem to be fact-specific and refuses to take into measure the safety records of those others in the Gulf. There is no evidence presented indicating that the Secretary balanced the concern for environmental safety with the policy of making leases available for develop- ment. There is no suggestion that the Secretary consid- ered any alternatives: for example, an individualized suspension of activities on target rigs until they reached compliance with the new federal regulations said to be recommended for immediate implementation.

The Deepwater Horizon oil spill is an unprece- dented, sad, ugly, and inhuman disaster. What seems clear is that the federal government has been pressed by what happened on the Deepwater Horizon into an

otherwise sweeping confirmation that all Gulf deep- water drilling activities put us all in a universal threat of irreparable harm. While the implementation of reg- ulations and a new culture of safety are supportable by the Report and the documents presented, the blanket moratorium, with no parameters, seems to assume that because one rig failed and although no one yet fully knows why, all companies and rigs drilling new wells over 500 feet also universally present an immi- nent danger.

[T]he Court has found the plaintiffs would likely succeed in showing that the agency’s decision was arbitrary and capricious. An invalid agency decision to suspend drilling of wells in depths of over 500 feet simply cannot justify the immeasurable effect on the plaintiffs, the local economy, the Gulf region, and the critical present-day aspect of the availability of domes- tic energy in this country.

The plaintiffs’ motion for preliminary injunction is granted.


1. Why is the problem with the experts’ objections important in determining whether DOI’s morato- rium was arbitrary and capricious?

2. What is the significance of the difference between the factual information in the report and the terms of the moratorium?

3. What does the court see as alternatives to the moratorium?

The Substantial Evidence Standard for Challenging an Agency Action. A second the- ory for challenging an agency’s regulation is that the regulation is unsupported by substantial evidence. This substantial evidence test is applied in the review of formal and hybrid rulemaking. Where the arbitrary and capricious standard simply requires some proof or basis for the regulation, substantial evidence requires that more convincing evidence exist in support of the regulation than against it.

Failure to Comply with the APA in Challenging an Agency Action. A third ground on which to challenge an agency’s regulation involves the rule that a regulation can be set aside if the agency did not comply with the APA requirements of notice, publication, and public comment or input. The procedures for rulemaking must be followed in order for the regulatory process and resulting rules to be valid. An agency that seeks public comment for the purposes of drafting regulations cannot then turn the proposed regulations into agency rules after the comment period. The promulgated rules must be the result of the proceedings.

The Constitutional Standard for Challenging an Agency’s Action. Another basis for challenging a regulation is that the regulation is unconstitutional. Many challenges based on constitutional grounds deal with regulations that give an agency authority to search records or that impose discriminatory requirements

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202 part 2 Business: Its Regulatory Environment

How Companies Respond to Regulations

When companies take federal agencies to court, they do so as a last resort because the companies remain subject to the agen- cy’s regulation after the litigation ends, even when the companies win. Litigation, such as that in the Hornbeck case, is

undertaken only after careful study and some assurance that the companies can win as well as an examination of what is lost if they do not litigate. In this case, the loss of drilling rights was worth the litigation risk.

Business Strategy

for licensing professionals. For example, a requirement of a minimum residency period before allowing an applicant to become licensed in a particular profes- sion has been challenged successfully. Zoning board regulations that discrim- inate against certain classes or races as to the use of property have also been successfully challenged as unconstitutional. Further, broadcasters often depend on freedom of speech—the First Amendment—to challenge new Federal Com- munication Commission (FCC) regulations. For example, in FCC v Fox Television Stations, Inc., 556 U.S. 502 (2009), the court dealt with a problem on television decency standards. During the 2002 Billboard Music Awards, broadcast by Fox Television, the singer Cher exclaimed during an unscripted acceptance speech, “I’ve also had my critics for the last 40 years saying that I was on my way out every year. Right. So f * * * ’em.” At the 2003 Billboard Music Awards, Nicole Richie made the following unscripted remark while presenting an award: “Have you ever tried to get cow s* * * out of a Prada purse? It’s not so f * * * ing simple.” The third incident involved an episode of NYPD Blue, a regular television show broadcast by ABC Television Network in which there was brief nudity in one episode. The FCC found that the networks had broadcast content that violated decency standards and fined them $1.4 million. The networks appealed, and the U.S. Supreme Court held that the standards were unclear and the fines not related to warnings about issues related to decency standards. The Court held that the FCC could have decency standards but that it needed to make them clear to networks before it could fine them for violations. [FCC v. Fox Television 132 S.Ct. 2307 (2012)]

The Ultra Vires Standard for Challenging an Agency’s Action. Another theory for chal- lenging a regulation in court is ultra vires, a Latin term meaning “beyond its pow- ers.” An ultra vires regulation is one that goes beyond the authority given to the agency in its enabling act. Although most agencies stay clearly within their author- ity, if an agency tries to change the substance and purpose of the enabling act through regulation, the regulations would be ultra vires. For example, the intent of

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Chapter 6 Administrative Law 203

The FDA was challenged by tobacco compa- nies for its new rules that require the tobacco companies to put one of the FDA’s 12 picture labels on its packaging. The tobacco com- panies argued that their First Amendment rights were violated by the rules, forcing them to speak in a certain way using govern- ment-mandated materials. The new labels were promulgated by both the FDA and the Department of Health and Human Ser- vices (HHS) pursuant to authority granted by Congress in 2009 under the Family Smoking Prevention and Tobacco Control Act.

Under the law, the following nine textu- al statements were to be included on ciga- rette labels:

WARNING: Cigarettes are addictive.

WARNING: Tobacco smoke can harm your children.

WARNING: Cigarettes cause fatal lung disease.

WARNING: Cigarettes cause cancer.

WARNING: Cigarettes cause strokes and heart disease.

WARNING: Smoking during pregnancy can harm your baby.

WARNING: Smoking can kill you.

WARNING: Tobacco smoke causes fatal lung diseases in nonsmokers.

WARNING: Quitting smoking now greatly reduces serious risks to your health.

The act required that these warnings and graphic labels take up 50% of the cigarette package label and of all cigarette ads.

After publishing the proposed rule and receiving more than 1,700 comments, the FDA published its final rule in June 2011. Explain how the tobacco companies could challenge the rules. Discuss whether the rules will be set aside.

[In re R.J. Reynolds Tobacco Company, et al. v FDA et al., 696 F.3d 1205 (D.C. Cir. 2012);

see also American Meat Institute v. U.S. Dept. of Agriculture, 760 F.3d 18 (D.D.C. 2014) ]

THINK: The arbitrary and capricious and substantial evidence doctrines require that any agency action, whether a promulgation of a rule or its withdrawal, be supported by evidence and APA processes. That process requires some evidence related to the ac- tion taken or rule promulgated. There must be a full public airing of the issues. Whatever labels and disclosures the agency requires must be supported by evidence.

APPLY: In this case study, the court held initially that the use of pictures and con- clusions is a form of interpretation and not really scientifically grounded statements about the health effects of smoking.

ANSWER: The purpose of the APA require- ments is to curb the emotion of the mo- ment and ensure that agencies do not take action without having followed a process for input and before obtaining evidence that the actions taken are necessary. Ini- tially, the court concluded that the FDA had gone too far in its zeal to warn smokers, stepping beyond the science and into emo- tional appeals, noting:

The graphic images here were neither designed to protect the consumer from confusion or deception, nor to increase consumer awareness of smoking risks; rather, they were crafted to evoke a strong emotional response calculated to provoke the viewer to quit or never start smoking.

However, in the second case cited, the court reversed this stance and overruled itself holding that te requirements could be imposed because there was a gov- ernment interest in correcting decep- tion that allowed a mandate for ad and packaging disclosure of purely factual information.

Consider . . . 6.3

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204 part 2 Business: Its Regulatory Environment

the 1933 Securities Act was to provide full disclosure to investors about a securities sale. The SEC could not, on the basis of its authority, pass a rule that eliminated securities registration in favor of an unregulated securities market. In Massachusetts v EPA, 549 U.S. 497 (2007), the court dealt with greenhouse gases as well as their reg- ulation within the context of challenges to the EPA based on ultra vires, substantial evidence, and the administrative regulation process. Uniquely, the agency’s defense was that the actions groups were demanding were ultra vires. However, the court held that the EPA had the authority to regulate anything that involved air quality.

6-4c proactive Business Strategies in Regulation

Some administrative regulations can be eliminated through the use of legislation. In an enabling act called a sunset law, Congress creates an agency for a limited period of time during which the agency must establish its benefits and other justifi- cation for its continuation. The enabling act may provide for an audit to determine effectiveness after the agency has been in existence for two years. Without renewal by Congress, the “sun sets” on the agency, and it is terminated. Some businesses lobby for the creation of sunset agencies to better control the number of agencies and their effectiveness.

Some agencies’ power is controlled through congressional purse strings. With zero-based budgeting, the agency does not automatically receive a budget amount but rather starts with a zero budget each year and then is required to jus- tify all its needs for funds. This type of control gives Congress some say each year in how the agency is operating. For example, the budget could be renewed only on the condition that the agency not promulgate certain regulations opposed by Congress.

6-4d Informal Rulemaking

The process for informal rulemaking is the same as that for formal rulemaking, with the exception that no public hearings are held on the rule. The only input from the public comes in the form of comments, using the same procedures dis- cussed earlier.

The use of snowmobiles in Yellowstone and Grand Teton National Parks was first permit- ted in 1963, and their use has been a topic of ongoing concern because of their impact on park resources. In 2003, the Department of the Interior (DOI) and various groups, in- cluding snowmobile manufacturers and recreationalists as well as environmental groups, reached a settlement allowing 950 snowmobiles per day in Yellowstone, with similar restrictions in Jackson Hole. The 2003 negotiated rule was challenged and ruled arbitrary and capricious because DOI had not performed the requisite studies for the negotiated rules. [Int’l Snowmobile Mfrs. Ass’n v Norton, 340 F. Supp. 2d 1249, 1266 (D.Wyo. 2004)]

In 2004, NPS promulgated a temporary rule that contained a “sunset clause,” pro- viding its snowmobile authorization would expire at the conclusion of the 2006–2007 winter season. The 2004 temporary rule authorized 720 snowmobiles per day in Yellowstone, 50 per day on the Continen- tal Divide Snowmobile Trail, 50 per day on Grassy Lake Road, and 40 per day on Jack- son Lake. [69 Fed. Reg. 65348 (Nov. 10, 2004)] The 2004 temporary rule triggered litigation by opponents in Washington, D.C., and proponents in Wyoming. The temporary rule survived both challenges. [The Fund for Animals v Norton, 390 F. Supp. 2d 12 (D.D.C.2005)]

Consider . . . 6.4

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Chapter 6 Administrative Law 205

6-5 Business Rights in Agency Enforcement Action

Administrative agencies not only make the rules; they enforce them. In so doing, the agencies are also responsible for adjudicating disputes over the scope or inter- pretation of the rules. Exhibit 6.8 is a chart of the steps involved in agency enforce- ment and adjudication.

6-5a Licensing and Inspections

Much of an administrative agency’s role in enforcement is carried out by requiring the submission of certain types of paperwork. Many agencies issue licenses or per- mits as a way to enforce the law. For example, state administrative agencies may require building contractors to be licensed so that their dues can finance a recov- ery fund for the victims of bankrupt or negligent contractors. The idea behind the licensing and permit method of enforcement is to curtail illegal activity up front and also to have records in case problems arise.

Agencies also have the authority to conduct inspections, such as when an agency responsible for restaurant licenses inspects restaurant facilities to check for health code violations. The Occupational Safety and Health Administra- tion (OSHA) at the federal level has the authority to inspect plants to check for

After the 2004 temporary rule ex- pired under the sunset provision, DOI (with NPS) promulgated what it intended to be a permanent rule in 2007. The 2007 rule allowed 540 snowmobiles per day in Yellowstone, 0 per day on the Continen- tal Divide Snowmobile Trail, 25 per day on Grassy Lake Road, and 40 per day on Jackson Lake. The proponents and oppo- nents again filed simultaneous challenges in Wyoming and Washington, D.C. The Washington, D.C., court ruled first, hold- ing the 2007 rule arbitrary and capricious. [Greater Yellowstone Coal v Kempthorne, 577 F. Supp. 2d 183, 210 (D.D.C. 2008)] Although the Washington, D.C., court be- lieved the 2007 rule allowed too many snowmobiles in the parks, the court did not set forth a maximum number of snowmo- biles that could enter the parks while NPS worked to promulgate a new rule. Thereaf- ter, the Wyoming court issued an order stat- ing its disagreement with the Washington, D.C., court’s ruling but declining to issue a ruling contrary to that of the D.C. court. Because the Wyoming court believed the D.C. court’s ruling did not address what

should happen to snowmobiles in the parks while NPS formulated a new rule, the Wyoming court held that the 2004 rule, as the last valid rule, should be reinstated until NPS could promulgate a new rule. While the litigation regarding the 2007 rule was ongoing, NPS began work on a new rule.

The Wyoming court’s ruling reinstating the 2004 rule became the first decision to reach an appellate court. Before the court could issue a decision, NPS published the 2009 rules. The court ruled the case was moot. [Wyoming v U.S. Dep’t of Interior, 587 F.3d 1245, 1247 (10th Cir. 2009)] How- ever, the 2009 rules ended up in the Wyo- ming court, and the court held that those challenging the rules lacked standing be- cause they had not shown that they had standing through economic harm resulting from the snowmobile restrictions. [Wyo- ming v U.S. Dept. of Interior, 674 F.3d 1220 (10th Cir. 2014)]

What should be the next step for those who are affected by the rule who wish to challenge the rule? Suggest some theories for them to use.

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206 part 2 Business: Its Regulatory Environment

Ethical Issues

In 2010, SeaWorld trainer Dawn Brancheau was killed when she was pulled underwater by Tilikum, a whale at the park. OSHA com- pliance officer Lara Padgett participated in the OSHA investigation of Ms. Brancheau’s death. OSHA issued SeaWorld willful viola- tions after concluding its investigation into Ms. Padgett’s death.

In 2014, SeaWorld delivered a com- plaint to the Department of Labor that accused Ms. Padgett of ethics violations in her investigation. The complaint alleges that Ms. Padgett had improper contacts with animal-rights activists as well as the makers of the film, Blackfish, a 2013 Sun- dance Film Festival entry that has been available on CNN and Netflix. The complaint included photos of Ms. Padgett at the Sun- dance premiere as well as with the film’s makers at other times. The complaint also alleged that Ms. Padgett had transferred confidential investigation documents to one of the film’s producers. Ms. Padgett stayed with the film crew while at Sundance,

something the film’s producer said was due to a “housing shortage.”

SeaWorld’s six-page complaint includ- ed 200 pages of exhibits, including some posts from Ms. Padgett on social media such as, “Wow . . . Take that Sea World [sic]!!!! They’ve got to be getting nervous now.” The post was written in July 2013 after Blackfish opened in Europe.

OSHA pledged to look into the allega- tions. SeaWorld’s complaint alleges that Ms. Padgett “violated the Standards of Ethical Conduct for government employ- ees . . . as well as other requirements of federal law.” OSHA’s Office of the Inspec- tor General had begun an investigation in January 2014 when photos of Ms. Padgett with those associated with the film first emerged. One of the photos showed Ms. Padgett with those from the film in a “Char- lie’s Angels” posing with air guns at the New York City premiere of Blackfish.

Relying on Chapter 2, discuss any eth- ical violations you see in the facts alleged.

© iS

to ck

Ph ot

o. co

m /d

an e_

m ar


Exhibit 6.8 Steps for administrative agency enforcement and adjudication

Nonprosecuting: 1. Regulation 2. Licensing 3. Inspections


Consent Decrees

Appeal of Agency Action

1 2 3

4 5 6


Penalties and Sanctions

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Chapter 6 Administrative Law 207

violations of OSHA standards. This power of inspection at unannounced times is an enforcement tool by itself and provides strong incentive to comply with regula- tions. A business can refuse an inspection, but an agency can obtain a warrant and return for a mandatory inspection.

6-5b prosecution of Businesses

Administrative agencies are also given the authority to prosecute violators. These agency prosecutions, however, are not traditional criminal prosecutions; the sanc- tions imposed for agency violations are not jail terms but rather fines, penalties, and injunctions, which are civil penalties, not criminal ones. For example, in the case of false advertising—a violation of Federal Trade Commission (FTC) rules—the agency could impose restitution as a sanction: the violator would have to reimburse all those individuals who bought the product based on false advertising. In some cases, an agency may merely want a violator to stop certain conduct and promise not to engage in that type of conduct again.

6-5c Beginning enforcement Steps

Regardless of the remedy an agency seeks, all action begins when the agency issues a complaint against the violating party. The complaint describes when and what the company did and why it is a violation.

Once a complaint is filed, an agency can negotiate with a party for an order or proceed to a hearing to obtain an order from an administrative law judge. The rem- edies in an order vary according to the type of violation and whether it is ongoing. The FTC could—and typically does—order companies running deceptive ads to stop using the ads and promise not to use them again in the future. These sanc- tions usually come in the form of an injunction, which is a court order that pro- hibits specifically described conduct. Many statutes are unclear about the extent of authority an agency is given in enforcement proceedings and what types of sanc- tions an agency can impose for violations. The authority to assess civil penalties, for example, varies from agency to agency.

6-5d Consent decrees

Rather than go through a hearing and the expense of the administrative process, some companies agree to penalties proposed by an agency. They do so in a docu- ment called a consent decree, which is comparable to a nolo contendere plea in the criminal system. The party does not admit or deny a violation but simply negotiates a settlement with the administrative agency. The negotiated settlement includes the same types of sanctions the agency would have the power to impose if the case went to a hearing. The agency may be willing to give up a little in exchange for the violator’s willingness to settle and save the agency the time and costs of full prose- cution. The consent decree is a contract between the charged party and the regula- tory agency. Exhibit 6.9 provides an example of an FTC consent decree.

6-5e Hearings

If the parties cannot reach an agreement through a consent decree, the question of violations and penalties will go to an administrative hearing, which is quite different from the litigation procedures described in Chapter 4. This type of hearing does not involve a jury. The plaintiff or prosecutor is the administrative agency, represented

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208 part 2 Business: Its Regulatory Environment

Exhibit 6.9 excerpts from an FtC Consent decree

In the matter of the National Media Group, Inc. et al. Consent Order, etc., in regard to Alleged Violation of The Federal Trade Commission Act

This consent order, among other things, requires a King of Prussia, Pa. firm and a corporate officer engaged in the advertising and sale of “Acne-Statin,” an acne “treatment,” to cease disseminating or causing the dissemination of advertisements that represent that Acne-Statin cures acne, eliminates or reduces the bacteria and fatty acids responsible for acne blemishes, and is superior to all other acne preparations and soap for the antibacterial treatment of acne. . . . Additionally, they are required to establish an independent, irrevocable trust account containing sixty thousand dollars ($60,000) to be used to pay half of all requests for restitution by Acne-Statin purchasers; and obligated to conduct and be totally responsible for the administration of the restitution program.

(The original complaint appeared here.)


It is ordered, That respondents, The National Media Group, Inc. a corporation . . . and the corporate respondent’s officers, agents, representatives, and employees . . . do forthwith cease and desist from:

A. Disseminating or causing the dissemination of any advertisement by means of the United States mails or by any means in or affecting commerce . . . which directly or indirectly:

1. Represents that use of Acne-Statin will cure acne or any skin condition associated with acne.

2. Represents that Acne-Statin will eliminate or reduce the bacteria responsible for pimples, blackheads, whiteheads, or other acne blemishes or any skin condition associated with acne.

3. Represents that Acne-Statin will eliminate or reduce the fatty acids responsible for pimples, blackheads, whiteheads, other acne blemishes or any skin condition associated with acne.

4. Represents that Acne-Statin is superior to prescription or over-the-counter antibacterial acne preparations in the treatment of acne.

5. Represents that Acne-Statin is superior to soap in the antibacterial treatment of acne.

It is further ordered, That:

A. Within thirty (30) days of final acceptance of this consent order by the Federal Trade Commission (hereinafter the ”Commission”), respondent, The National Media Group, Inc., shall establish an interest-bearing trust account containing the sum of sixty thousand dollars ($60,000), for the purpose of paying restitution to Acne-Statin purchasers. . . .

by one of its staff attorneys. The defendant is the person or company accused of vio- lating an administrative regulation. The judge is called an administrative law judge (ALJ) at the federal level and is called a hearing examiner or hearing officer in some state-level agencies. The defendant can be represented by an attorney.

An ALJ has all the powers of a judge. He or she conducts the hearing, rules on evidentiary and procedural questions, and administers oaths. The ALJ also has certain unique powers, such as the ability to hold settlement conferences between the parties. The ALJ also has the responsibility of making the decision in the case. That decision is cast in the form of a written opinion that consists of find- ings of facts, conclusions of law, and an order specifying the remedies and sanctions.

The ALJ also has the ethical responsibilities of a trial judge; that is, the judges are prohibited from having ex parte contacts, which are contacts with one side or one of the parties in the dispute without the knowledge of the others. Staff mem- bers of the agency are prohibited from supplying information to the ALJ except when they are witnesses or attorneys in the hearings.

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Chapter 6 Administrative Law 209

Administrative hearings can have as participants more than just the agency and the party charged with a violation. Other parties with an interest in the case can intervene. These intervenors file motions to intervene and are usually per- mitted to do so at any time before the start of a hearing. Typical intervenors are industry organizations: Should the FCC hold hearings on charges against a tele- vision station on the content of ads on the station, the National Association of Broadcasters would probably want to intervene in the hearing.

The rules of evidence and procedure are somewhat relaxed in administrative hearings. Agencies involved in the hearings can issue subpoenas for documents, but the subpoenas can only be enforced by the courts. All of the investigation and adjudication processes of administrative agencies are subject to the constitutional standards of due process, which include the following rights: right to notification of the charges, right to notification of the hearing day, right to present evidence, right to be represented by an attorney, right to an impartial judge, right to a deci- sion based on the law or regulation, and right to cross-examine the witnesses of the agency or intervenors.

6-5f administrative Law of appeals

Once the ALJ has issued a decision, the decision can be appealed. However, the appel- late process in administrative law is slightly different. The first step in an appeal of an ALJ decision is not to a court but to the agency itself. This step gives the agency a chance to correct a bad decision before the courts become involved.

The appeal is to the next higher level in the agency. For example, in the FTC, an appeal of an ALJ’s decision goes to the five commissioners of the FTC for reconsideration.

In some agencies, the structure is such that appeals may be made to more than one person in the structure. Those appealing an ALJ decision, however, must go through all the required lines of authority in the agency before they can go to court. This process is known as exhausting administrative remedies. An appeal made before administrative remedies are completed will be rejected for the failure to exhaust available administrative processes and remedies.

The exhaustion rule does allow some exceptions. A decision by a zoning board to allow construction of a building project could go directly to court because, if the building is started but the decision to allow construction later overruled, the builder is damaged. Alternatively, if the building is not started, other purchasers of the land and the builder are harmed. In other words, fast action is required to maintain all parties’ positions.

If an agency has gone beyond its enabling act, a party can also go directly to court. This matter is more of a challenge to a regulation than it is to the agency’s decision, and direct appeal is therefore permitted.

Finally, an agency decision can be appealed directly to court if exhaustion of administrative remedies would be futile, as evidenced by public statements of officials of the agency. When the FTC was trying to develop rules on children’s TV advertising, for example, a group of interested parties brought a court action to have then-FTC chairman Michael Pertschuk removed from the rulemaking pro- cess because he had indicated strong feelings in the press about his position. It would have been futile to try administrative remedies because the appeal would have been taken to the party they were trying to remove.

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210 part 2 Business: Its Regulatory Environment

A decision of a federal administrative agency is appealed to one of the U.S. courts of appeals (as indicated in Chapter 3). An appellate court can sim- ply affirm an agency action, find that an agency has exceeded its authority, find that an agency has violated the U.S. Constitution, or rule that an agency has acted arbitrarily or that an agency’s decision or action is not supported by the evidence. The Hornbeck case (see Case 6.2 earlier in the chapter) is an example of a court’s reversal of administrative agency action in the area of rulemaking.

Exhibit 6.10 provides a summary of the roles of administrative agencies.

Exhibit 6.10 the Roles of administrative agencies

aCtIVItY StepS paRtIeS ReSULtS Passing rules Rule proposed Agency New rules

Comments Consumers Modified rules

Modification, withdrawal, or promulgation Business



Withdrawn rules

Enforcement Licensing Agency


Inspections Agency

Courts (if warrant is required)


Search and inspection

Complaints Agency Fines



Consent decrees


6-6 The Role of Administrative Agencies in the International Market

The United States wins the award for having the most administrative agencies and regulations. Some businesses have argued that the amount of regulation hinders them in the international marketplace. For example, the readability level of reg- ulations, as shown in Exhibit 6.11, demands much time and energy as companies attempt to interpret and comply with the laws.

Many regulators, legislators, and businesses have advocated elimination and streamlining of existing regulations, as well as careful consideration before new regulations are promulgated.

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Chapter 6 Administrative Law 211

Exhibit 6.11 Various Reading Levels of documents and populations

dOCUMeNtS aNd pOpULatIONS GRade LeVeL 1. Love Story 7.64

2. Reading level of U.S. population over age 65 9.71

3. Playboy 11.46

4. Reading level of general U.S. population 11.68

5. Sports Illustrated 12.82

6. Your Medicare Handbook 14.94

7. ERISA Summary Plan Description 15.29

8. Wall Street Journal 16.34

9. Social Security Handbook 17.51

10. Reading level of lawyers 19.00

11. Albemarle (U.S. Supreme Court ruling) 20.30

12. Occupational Safety and Health Act 30.79

13. Employment Retirement Income Safety Act 32.10

14. Section 18 of the Social Security Act 41.04

Sources: Warren S. Blumenfeld et al., “Readability of an ERISA Summary Plan Description vis-à-vis Intended Readership: An Empirical Test of Local Legal Compliance with a Federal Regulation,” paper presented at the Western American Institute for Decision Science Meeting, Reno, Nevada, March 1979; Warren S. Blumenfeld et al., “Readability of the Real Estate Settlement Procedures Act,” paper presented at the Southeastern Regional Business Law Association Meeting, Chapel Hill, North Carolina, October 1980.

Ethical Issues

Some businesses are able to take advantage of one government’s regulations. For exam- ple, the Energy Policy Act of 1992 requires that toilets installed after the act took effect (1994) use only 1.6 gallons of water rather than the nearly century-old standard of 3.5 gallons. As of 2000, about one-fourth of the nation’s toilets were the 1.6-gallon types.

As homeowners have remodeled bath- rooms and replaced older toilets, they have learned that the 3.5-gallon toilets are no longer sold in the United States. However, just across the U.S./Canadian border near Detroit, Canadian hardware stores are doing a land-office business selling 3.5-gallon tanks to U.S. citizens.

Those who are remodeling, and even some who are building new homes, gener- ally install a $100 toilet from Home Depot in order to pass inspection. They then purchase a Canadian toilet, which costs in the neighborhood of $500 to $1,000 for a standard fixture because the demand is so high, and install it. Plumbing stores all over Canada report sales are brisk. In a survey conducted in May 2000, owners of Cana- dian plumbing stores said that they sell, on average, one toilet per day to U.S. citizens via either direct sale or shipment.

Do the citizens break any laws by what they do? Is what they do ethical?

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212 part 2 Business: Its Regulatory Environment

s u m m a r y What is an administrative agency?

• Administrative agency—statutory entity with the ability to make, interpret, and enforce laws

What laws govern the operation of administrative agencies?

• Administrative Procedure Act—general federal law governing agency process and operations

• Government in the Sunshine Act—federal law requiring public hearings by agencies (with limited exceptions)

• Federal Privacy Act—federal law protecting transfer of information among agencies unless done for enforcement reasons

• Freedom of Information Act—federal law provid- ing individuals with access to information held by administrative agencies (with some exemptions such as for trade secrets)

What do administrative agencies do?

• Rulemaking—process of turning proposed regula- tions into actual regulations; requires public input

• Federal Register—daily publication that updates agency proposals, rules, hearing notices, and so forth

• Code of Federal Regulations—federal government publication of all agency rules

• Licensing—role in which an agency screens businesses before permitting operation

Earl Devaney served as the inspector general (IG) for the Department of Interior (DOI) from 1999 to 2009. He later became the auditor for funds dispersed under the Recovery Act of 2009. Mr. Devaney’s reports as IG were known for their forth- rightness, insights, and color. When the Denver office of the Minerals Manage- ment Service of the DOI received an anon- ymous complaint from an employee in the Denver office that asked the IG to look into “ethical issues” there, Mr. Devaney responded. He found that agency employ- ees were accepting lodging, gifts, alcohol, and other perks from industry executives in exchange for favorable treatment for the companies. Mr. Devaney also found that agency employees were having affairs with industry executives.2 The agency employees defended these relationships as “arm’s length.” Mr. Devaney’s report concluded, “Sexual relationships cannot, by definition, be arm’s length.”

Mr. Devaney spoke truth to power in a way that resulted in reorganization of

the DOI. As a result of his investigation of lobbyist Jack Abramoff on behalf of Indian tribes, DOI secretary Gale Norton resigned. In testimony before Congress on his reports and recommendations, Devaney testified, “Short of a crime, anything goes at the highest level of the Department of Interior. Ethics failures on the part of senior department officials— taking the form of appearances of impro- priety, favoritism and bias—have been routinely dismissed with a promise of not to do it again.”

Mr. Devaney was appointed by Presi- dent Obama to oversee the use of $787 billion in federal money under the Amer- ican Reinvestment and Recovery Act. Mr. Devaney served in the role until 2013 when he retired from government ser- vice. He now serves as a consultant to Oversight Systems, an analytics systems company where he will be advising the company on audit and detection pro- cesses to detect fraud in corporate and government organizations.

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Chapter 6 Administrative Law 213

Q u e s t i o n s a n d P r o b l e m s

1. Florida State University (FSU) was under investi- gation by the NCAA for various types of violations. FSU created a special website where the NCAA and university officials could communicate, send doc- uments, and post transcripts that were part of the investigation. Associated Press (AP) filed a Freedom of Information Act (FOIA) request with FSU for the release of the information on the special website. FSU refused to release the information, maintaining that because the information and documents were posted on a private website, they were not public records and, therefore, not subject to FOIA requests. Applying the principles of law from this chapter as well as what you have learned about precedent and interpretation, decide whether the court granted the FOIA request. [Associated Press v Florida State University Board of Trustees, National Collegiate Athletic Ass’n v Associated Press, 18 So.3d 1201 (Fla. App. 2009)]

2. The Consumer Product Safety Commission is reconsidering a rule it first proposed in 1997 that would require child-resistant caps on household prod- ucts, including cosmetics. When the rule was first pro- posed, it was resisted by the cosmetics industry and abandoned. However, in May 2001, a 16-month-old baby died after drinking baby oil from a bottle with a pull-tab cap.

The proposed rule would cover products such as baby oil and suntan lotion and any products contain- ing hydrocarbons such as cleansers and spot remov- ers. The danger, according to the commission, is simply the inhalation by children, not necessarily the actual ingestion of the products. Five children have died from inhaling such fumes since 1993, and 6,400 children under the age of five were brought into emer- gency rooms and/or hospitalized for treatment after breathing in hydrocarbons. There is no medical treat- ment for the inhalation of hydrocarbons.

Several companies in the suntan oil/lotion industry have supported the new regulations. The head of a con- sumer group has said, “We know these products cause death and injury. That is all we need to know.”3

What process must the CPSC follow to promulgate the rules? What do you think of the consumer group head’s statement? Will that statement alone justify the rulemaking?

3. Because of overcrowded condit ions at the nation’s airports during the late 1960s, the Fed- eral Aviation Administration (FAA) promulgated a regulation to reduce takeoff and landing delays at airports by limiting the number of landing and takeoff slots at five major airports to 60 slots per hour. The airports were Kennedy, LaGuardia, O’Hare, Newark, and National. At National Airport (Washington), 40 of the 60 slots were given to com- mercial planes, and the commercial carriers allocated the slots among themselves until October 1980. In 1980, New York Air, a new airline, requested some of the 40 slots, but the existing airlines refused to give up any. The secretary of transportation, in response and “to avoid chaos in the skies” during the upcom- ing holidays, proposed a rule to allocate the slots at National. The allocation rule was proposed on Octo- ber 16, 1980, and appeared in the Federal Register on October 20, 1980. The comment period was seven days starting from the October 16, 1980, proposal date. The airlines and others submitted a total of 37 comments to the secretary. However, Northwest Airlines filed suit on grounds that the APA required a minimum of 30 days for a public comment period. The secre- tary argued that the 30-day rule was being suspended for good cause (the holiday season). Who is correct? Should an exception be made, or should the FAA be required to follow the 30-day rule? [Northwest Airlines, Inc. v Goldschmidt, 645 F.2d 1309 (8th Cir. 1981)]

• Inspections—administrative agency role of checking businesses and business sites for compliance

How do agencies pass rules?

• Study issue, develop evidence of the need for the rule

• Public comment period—period in rulemaking process when any individual or business can provide input on proposed regulations

• Promulgation—approval of proposed rules by heads of agencies

• Rule must survive challenges based on stan- dards of “arbitrary and capricious,” “substantial evidence,” “ultra vires,” “procedural errors, and constitutionality.”

How do agencies enforce the law?

• Consent decree—settlement (nolo contendere plea) of charges brought by an administrative agency

• Administrative law judge (ALJ)—overseer of hearing on charges brought by administrative agency

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214 part 2 Business: Its Regulatory Environment

4. AAR Airlift Group, Inc., is a civilian contractor that provides services to the Department of Defense (DOD). The United States Transportation Command (USTC) issued a request for proposals (RFP) to pro- cure airlift services for DOD operations in Africa. AAR submitted a proposal and was awarded the contract. USTC received a FOIA request for information about its contracting processes and was going to release the contract terms with AAR. The contract terms included confidential pricing terms and the contract provided that the information in the contract would be con- sidered “confidential and proprietary information.” FOIA Exemption 4 allows the government to with- hold information that is “commercial or financial,” “is obtained from a third party outside the government,” and is “privileged and confidential.” AAR told USTC that all of its contracts with government and private entities are private and confidential and that it does not release its pricing, particularly line-item pricing, because its competitors would gain an unfair advan- tage in the bidding process. AAR filed a reverse FOIA suit asking that the release of its contract and pricing information be stopped by an injunction. What should the court do and why? [AAR Airlift Group, Inc. v United States Transportation Command, 2015 WL 8215522 (D.C. 2015)]

5. Rhonda Kallman founded a company that produces Moonshot 69, a caffeinated beer. Each bottle of beer con- tains about twice as much caffeine as a can of Pepsi. In 2011, Ms. Kallman, along with three other manufactur- ers, was served with a cease-and-desist notice from the FDA to remove the caffeine from her beer or stop sell- ing the product. Ms. Kallman has said that what the FDA is doing is like Prohibition 2010 and that it has no authority to regulate the sale or production of alcohol. She also indicates that Moonshot 69 is not an energy drink like those that are subject to FDA regulation. She says that agencies should regulate and not ban products. What information could you share with Ms. Kallman that would help determine what the FDA is trying to accomplish?

6. San Diego Air Sports Center (SDAS) operates a sports parachuting business in Otay Mesa, California. SDAS offers training to beginning parachutists and facilitates recreational jumping for experienced parachutists. The majority of SDAS jumps occur at altitudes in excess of 5,800 feet.

The jump zone used by SDAS overlaps the San Diego Traffic Control Area (TCA). Although the air- craft carrying the parachutists normally operate out- side the TCA, the parachutists themselves are dropped through it. Each jump must be approved by the air traffic controllers.

In July 1987, an air traffic controller in San Diego filed an Unsatisfactory Condition Report com- plaining of the strain that parachuting was putting on the controllers and raising safety concerns. The report led to a staff study of parachute jumping within the San Diego TCA. In October 1987, representatives of the San Diego Terminal Radar Approach Con- trol (TRACON) facility met with SDAS operators. In December 1987, the San Diego TRACON sent to SDAS a draft letter of agreement outlining agreed-upon procedures and coordination requirements. None- theless, the San Diego TRACON conducted another study between January 14, 1988, and February 11, 1988, and about two months after the draft letter was sent, the San Diego TRACON withdrew it.

SDAS states that the air traffic manager of the San Diego TRACON assured SDAS that it would be invited to attend all meetings on parachuting in the San Diego TCA. However, SDAS was not informed of or invited to any meetings.

In March 1988, the Federal Aviation Administration (FAA) sent a letter to SDAS informing SDAS that “[e]ffec- tive immediately parachute jumping within or into the San Diego TCA in the Otay Reservoir Jump Zone will not be authorized.” The FAA stated that the letter was final and appealable.

SDAS challenged the letter in federal court on grounds that it constituted rulemaking without com- pliance with required APA procedures. Evaluate SDAS’s challenge to the letter by applying administra- tive law and procedure. [San Diego Air Sports Center, Inc. v Federal Aviation Administration, 887 F.2d 966 (9th Cir. 1989)]

7. Hooked on Phonics is a reading program that departs from the current educational reading phi- losophy of “whole-language learning.” The program emphasizes the more traditional reading process of having children sound out letters and combinations of letters. The Federal Trade Commission (FTC) filed a false advertising complaint against Gateway Edu- cational Products, Inc., the owner of the Hooked on Phonics program. The FTC claimed that Gateway’s television claims that those with reading disabil- ities would be helped “quickly and easily” and that Hooked on Phonics could “teach reading in a home setting without additional assistance” were mislead- ing. Gateway does not feel the claims are false, but it does not want to have bad publicity. What advice can you give Gateway on handling the FTC charges?

8. The Thirty Meter Telescope is a project under con- struction in Hawaii under the direction of Cal Tech (2016) and was given a construction permit by the Hawaii Board of Land and Natural Resources. The

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Chapter 6 Administrative Law 215

telescope is being constructed on the state’s tallest mountain, Mauna Kea, and was challenged by a con- servationist group because the mountain is a conser- vation area. The group says that the Board did not follow due process requirements in issuing the permit. The Hawaii Supreme Court revoked the construc- tion permit. Is due process a basis for challenging the actions of an administrative agency? Discuss whether the actions of an agency can be reversed and why. [Mauna Kea Anaina HOU v Board of Land and Natural Resources, 363 P.3d 224 (Haw. 2015)]

9. The Food and Drug Administration (FDA) is con- cerned about laser eye surgery, noting that an indus- try concerned with correcting vision is spawning joint ventures, holding wine-and-cheese seminars to court potential investors, and creating databases of nearsighted consumers. The corrective laser surgery costs $2,000 per eye and is not covered by insurance. Calls to the available 800 numbers have noted some

dissatisfaction among the 700 patients who’ve had the surgery, including complaints of farsightedness. Further, the only regulation the FDA has in the field covers granting laser manufacturers permission to sell their machines to ophthalmologists. The FDA would like to know more and perhaps control some aspects of patients’ care. Describe the steps the FDA must take.

10. Countrywide, the problem mortgage company that was acquired by Bank of America, was once the largest mortgage lender in the country and the big- gest supplier of mortgages to Fannie Mae’s secondary market program. (Fannie Mae has since collapsed.) Countrywide released information that indicated it made additional loans to Fannie Mae officials at favor- able rates. Referred to as the Friends of Angelo group, these officials received favorable rates and expedited service. The following chart shows the officials, their titles at Fannie Mae, and their loan amounts, rates, and terms.

In the last years before the Countrywide problems and Fannie’s collapse, the two firms reached an agree- ment whereby Countrywide would funnel most of its loans to Fannie in exchange for a special rate. At the time they reached the special arrangement, the “Friends of Angelo” program was created. The FOA, as it was known, gave officials an expedited path for processing as well as a one-point reduction in rate. Former Fan- nie Mae vice chair Jamie Gorelick said, “I don’t believe there was any special treatment given.” However, an employee at the time said, “I know 100 percent she went

through the VIP department.” In response, Ms. Gorelick said, “You’d think if somebody was trying to do me a favor, they would tell me they were doing me a favor, and I am unaware of any such treatment. When I did this transaction, I was decidedly a has-been. I had no favor to give.”4

Apply what you know about conflicts of interest to Ms. Gorelick’s responses to the inquiries about her loan. Did former CEO Daniel Mudd have a conflict? What is the relationship of corporate officers to customers? What is the role of regulators? Senators?

NaMe tItLe aMOUNt Rate teRM Franklin Raines Former Chair $982,253 5.125 10 yrs.

Jamie Gorelick Former Vice Chair $960,149 5.000 10 yrs.

Christopher Dodd Chair, Senate Finance Comm. (Oversight for Fannie Mae)

$506,000 4.250 5 yrs.

James Johnson Former CEO $971,650 3.875 5 yrs.

Franklin Raines Former Chair $986,340 4.125 10 yrs.

Daniel Mudd Former CEO $2,965,000 4.250 7 yrs. Source of Data: Real estate records.

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216 part 2 Business: Its Regulatory Environment

Strategy & the Law When Your Product Is Under Regulatory Scrutiny

The Yamaha Rhino is an off-road vehicle that looks like a golf cart with four-wheel drive. Some have called it an all-terrain cycle (ATC) with a front seat and a steering wheel. With the rise in popu- larity over two decades ago of the ATC, increasing numbers of accidents (100 deaths and 100,000 injuries) resulted in extensive federal regulation of the design of ATCs, including the requirement of four wheels (rather than three). The Consumer Product Safety Commission (CPSC) also required extensive training, disclosures, warnings, and prohibitions on children driving ATCs. However, the Rhino is not subject to the ATC regula- tions because it has a steering wheel rather than han- dlebars. The Rhino is also not subject to federal regula- tions for cars because it meets neither the size nor the structure thresholds for autos.

In this regulatory no-man’s-land, the Rhino has emerged as a popular seller. The vehicle weighs 1,100 pounds, costs $11,000, and has been a popular seller since 2003. The 2008 model was the first of the Rhinos to have doors on the side. Owners say the Rhino offers the comfort of a golf cart but the ability to fit on trails as well as on the back of a pickup truck.

However, there have been 30 deaths caused by Rhino accidents, and there are now 200 lawsuits around the country that seek recovery from Yamaha for injuries caused by what the suits claims is the Rhi- no’s defective design. The Rhino is 54.4 inches long but is narrower than any of its competitors (the design’s goal is to allow the Rhino to fit on trails). The cases involve mostly rollover accidents.

Yamaha has always warned its buyers to wear seat belts and helmets when operating the Rhino. In 2006 and 2007, Yamaha sent out stickers to purchas- ers that read, “Abrupt maneuvers or aggressive driv- ing have caused rollovers—even on flat, open areas.” Yamaha also sent out a letter that offered to install doors on doorless Rhinos and extra handholds. The letter also added that drivers should be at least 16 years old.

The death rate for the Rhino (number of deaths in relation to number of vehicles sold per year) is in 10,000.5 However, the actual death rate for 2006, as provided by Yamaha, was 8 in 10,000. Yama- ha said the death rate stat is skewed because you must include the number of hours operated to have the rate mean anything. Yamaha sold 42,000 Rhi- nos in 2007.

Along with other off-road vehicle manufacturers, Yamaha has formed a voluntary trade association group that has the goal of establishing voluntary safety standards. The Recreational Off-Road Vehicle Associa- tion has already proposed changing the generic name of the vehicles to Recreational Off-Highway Vehicle (ROV) from utility terrain vehicle (UTV). Yamaha and other manufacturers say that many accidents are caused by driver error and recklessness.

What are your obligations when you operate in a loophole area of the law? Is Yamaha liable if it com- plied with any regulations and laws that applied? What is the responsibility of a company to report acci- dents related to its product?

n ot e s 1. Mrs. McDonnell was also convicted, but their appeals were handled separately.

2. In 2010, the DOI found similar issues of conflicts in the Minerals Management Office, which was responsible for the Deepwater Horizon well off the coast of Louisiana. The problems emerged after the explosion at that deepwater offshore rig and the resulting oil leak that damaged the coasts of all the Gulf states.

3. Julian E. Barnes, “Safety Caps Are Considered for Cosmetics,” New York Times, October 10, 2001, pp. C1, C8.

4. Glenn R. Simpson, “Countrywide Made Home Loans to Gorelick, Mudd,” Wall Street Journal, September 25, 2008, p. A10.

5. Melanie Trottman and Christopher Conkey, “U.S. Probes Off- Road Vehicles after a String of Accidents,” Wall Street Journal, November 4, 2008, pp. A1, A16.

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International Law7 Shakespeare was ahead of his time when he wrote that “the world is your oys-ter.” Today’s global business environment is the dream of economists, who have fostered the notion of free trade since the publication of Adam Smith’s The Wealth of Nations 250 years ago. Trade barriers are down, resources are flowing, and even the smallest businesses are involved in international trade. Trade across borders, however, involves additional issues and laws and carries risks that do not exist in transactions within nations. Litigation across borders is expensive and complex, so businesses must understand the legal environment of inter- national trade, including contracts, customs and duties, and anti-bribery provi- sions, in order to minimize their legal risks. This chapter helps with understanding the laws that influence international business. What and whose statutes affect businesses in international trade? What international agreements affect global businesses? How do businesses deal with the complexities of international con- tracts, disputes, and differing cultures and legal systems?

Update For up-to-date legal and ethical news, go to

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7-1 Sources of International Law “When in Rome, do as the Romans do” is advice that can be modified for business: When in Rome, follow Roman law. In each country where a business has opera- tions, it must comply with the laws of that nation. Just as each U.S. business must comply with all the tax, employment, safety, and environmental laws of each state in which it operates, each international business must comply with the laws of the countries in which it operates.

7-1a International Law Systems

The various systems of laws can be quite different, and businesses are well advised to obtain local legal counsel for advice on the peculiarities of each nation’s laws. Generally, a nation’s laws are based on one of three types of systems. The United States, like England, has a common law system. Our laws are built on tradition and precedent (see Chapter 1). Not every possible situation is codified; we rely on our courts to interpret and apply our more general statutes and, in many cases, to develop principles of law as cases are presented (as with the common law doctrine of negligence; see Chapter 9).

Other countries rely on civil law or code law. This form of law is the foundation of legal systems in France, Germany, Spain, and other European countries. Code law systems do not rely on court decisions but rely instead on statutes or codes that are intended to cover all types of circumstances and attempt to spell out the law, leaving little need for interpretation.

A third system of law is Islamic law, which is the foundation for laws in some form in 27 countries. Islamic legal systems are based on religious tenets and gov- ern all aspects of life, from appropriate dress in public to remedies for contract

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of our own industry, employed in a way in which we have some advantage. AdAm Smith The Wealth of Nations

“He said that in raising his two children, he would be more upset with one who tattled than one who erred.” Wall Street Journal in reporting on Marcelo Odebrecht’s testimony before a congressional panel in Brazil on whether he was involved in a cartel to control construction bids. Mr. Odebrecht was later arrested on corruption charges in the operation of his multinational, multi-billion-dollar construction firm. Several executives involved in the corruption schemes confessed and tattled.

We didn’t think of the payments as bribes. We thought of them as useful expenditures. ReinhARd SiekAczek Former Siemens employee, after Siemens paid the largest fine in U.S. history for violations of the FCPA

Consider . . . 7.1 Beginning in the fall of 2003, the stock price of Yukos Oil Company, the largest oil company in Russia, dropped precipitously in response to various mea- sures taken by the Russian Federation. In October 2003, the Russian Federation arrested Yukos’s pres- ident, Mikhail Khodorkovsky, and seized his equity holdings in the company. Soon thereafter, the Russian Ministry of Taxation charged Yukos with under- paying the previous years’ taxes by approximately

$27.5 billion and the Russian Federation confiscated Yukos’ primary assets, sending the company into an economic tailspin.

The shareholders brought suit in the United States for the failure of Yukos to disclose its tax strategy as well as the risk of that strategy. Yukos seeks to have the case dismissed because U.S. courts cannot decide issues that involve decisions by the Russian government. What should the court do, and why?

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220 part 2 Business: Its Regulatory Environment

breaches. Many Islamic countries have a combination of civil and Islamic systems that result from the influences of both colonization and Islam.

Before its collapse in the former Soviet Union and Eastern Europe, communism was also classified as a legal system. Now the former communist nations struggle with evolving cultural, market, and governmental systems. Some countries strug- gle with forces trying to restore formerly collapsed entities. For example, Ukraine has experienced the presence of Russian troops as it tries to preserve its indepen- dence from the Putin government and forces.

7-1b Nonstatutory Sources of International Law

Customs and values in a culture often have a controlling effect on negotiations, contracts, and performance in international business. Before doing business in any country, businesses should think through several factors, discussed in the follow- ing sections.

Language Businesspeople should determine which language a particular country prefers for conducting business. Mexico and other Latin American countries are accustomed to doing business in English. In Quebec, Canadian government regulations man- date the use of French in conducting business. English has become the dominant language for contracts, even for contracts among natives of some countries that do not have English as the official language. The trend to English is attributed by some to the Internet. Those in non–English-speaking countries became increas- ingly familiar with English as they interacted on social media and the Internet. One French businessman learned the language so that he could enjoy the English jokes his son e-mailed him. His son was stunned when he visited and found his father so fluent in English following several years of joke exchanges.

environment and technology Technology and business development vary in countries around the world. The process of negotiating and finalizing contracts varies widely in time required for negotiation as well as in how rapidly the parties will be able to verify offers and acceptances (see Chapter 11 on contract formation). Before expanding operations or contracting in any country, a businessperson needs foundational knowledge about the nature of business development and effective communication. For exam- ple, Walmart has experienced significant delays in opening stores in less devel- oped countries because of difficulties with construction authorization and even the availability of transportation routes for delivery of goods and Internet for process- ing sales transactions.

authority Who has negotiating authority is important in a business meeting, and who is sent to a meeting sends a signal about importance in high-context cultures. Lawyers are not considered part of the negotiating team in Japan but are considered critical in the United States. Often, in Asian cultures, the negotiators do not have the author- ity to commit to a deal and must take proposals back to their companies and those who do have authority.

Nonverbal Behavior In the United States, the tendency is to interpret nonverbal behavior differently from the way it is perceived in other cultures. For example, silence during negotiations

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Chapter 7 International Law 221

in the United States creates a compulsion for businesspeople to fill the awkward silence or interpret the silence as a rejection. In Asian cultures, such silence is simply a method of contemplating and considering and does not indicate a rejection.

time Concept The United States is a monochronic nation: time is everything, and the goal of businesspeople is to get the deal done. Other monochronic nations include Great Britain, Germany, Canada, New Zealand, Australia, the Netherlands, Norway, and Sweden. Countries that operate with great flexibility regarding time and negotiate within the context of building a relationship as opposed to completing a deal are called polychronic nations. The remainder of the world operates within this flexi- ble form of time culture.

7-1c Statutory Sources of International Law

Contracts for the International Sale of Goods (CISG) Sometimes referred to as the Vienna Convention, the U.N. Convention on Con- tracts for the International Sale of Goods (CISG) began its development in 1964 as an idea that was later discussed and formulated at the 1980 Vienna Convention. The CISG first became effective in 1988 with its adoption in the United States along with a small group of other countries. Today, CISG has been adopted in 60 coun- tries, with ratification processes under way in many other countries. However, its use is voluntary, even in adopting countries. Businesses can opt out of using the CISG to govern their contracts.

The CISG is designed to provide international contracts the convenience and uniformity that the Uniform Commercial Code provides for contracts across state lines in the United States. Although it includes some differences (see details in Chapters 11 and 12), the CISG is a reflection of the Uniform Commercial Code.

tax Law: International Business Structures that Reduce Rates Under a provision in the Internal Revenue Code (Section 482), a multinational, multitiered company has some flexibility in allocating income between the parent corporation and its subsidiaries. U.S. companies have been able to structure their business and subsidiaries in ways that minimize their U.S. income. For example, U.S. company Pfizer earned 65% of its revenue overseas, but it was being taxed at the 35% U.S. corporate tax rate (the highest corporate tax rate in the world). Pfizer attempted to undergo an inversion, an acquisition by Allergan, an Irish company, in order to reduce its tax rate to 17% to 18%, a significant savings for shareholders as well as a way to add share value. However, the U.S. Secretary of the Treasury stepped in to stop the acquisition by an interpretation of the tax law that would not afford the reduction Pfizer hoped to achieve. However, other companies continue to attempt inversion in order to reduce their U.S. taxes.

Apple, Google, Medtronic, Mylan, and Caterpillar are examples of U.S. com- panies that have used international structures to reduce their tax rates. Burger King purchased Canadian company Tim Horton and reincorporated in Canada to reduce its tax rates. These inversions were so popular that the U.S. government began taxing shareholders on the benefit, at a 33% tax rate, in order to make the arrangements less palatable for U.S. companies. This foreign structure loophole is being closed step-by-step. Some proposals would reduce the U.S. corporate tax rate, while others would allow the corporations to bring back foreign profits into the United States for investment purposes at a 5% or lower rate.

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222 part 2 Business: Its Regulatory Environment

7-1d treaties, trade Organizations, and Controls on International trade

In international trade, a number of treaties, tariffs, and organizations govern and guide international contracts. This section discusses some of the most important ones.

tariffs: Costs of Goods between Countries Whether supported or despised by economists, tariffs and restrictions on trade have existed for as long as trade itself. Duties, quotas, and tariffs have all been used to control the flow of goods over and across national boundaries. Tariffs are fees paid for the import or export of goods. These tariffs add to the cost of the goods and thereby permit individual countries to protect their own industries by import tariffs, which increase the prices for international competitors seeking to enter the country. Export tariffs make it more economical for companies to keep their goods at home. Tariffs are set by individual countries, but treaties between and among countries can result in the elimination of these economic tariffs.

Nontariff Controls over trade Over the past two decades, the United States has used nontariff barriers as a means of enforcing social policies. For example, the United States has a Turtle Tariff, a nontariff barrier that prevents the import of shrimp from countries that do not require turtle excluder devices (TEDs) on their commercial shrimp boats. If the shrimp cannot be verified as being caught using TEDs, then the shrimp cannot come into the United States.

In 2009, Gibson Guitars was raided by federal agents who seized guitars, pallets of wood, and electronic files. The Justice Department had obtained the warrants for seizing evidence that Gibson violated the Lacey Import Act, a federal law that prohibits the importation of “fish or wildlife taken, possessed, transported, or sold in violation of . . . any foreign law.” [16 U.S.C. § 3372(a)(2)(A)] The Justice Depart- ment seized $155,000 in guitars and wood because it alleged that Gibson used wood imported from India that had not been finished by Indian workers. How- ever, Gibson could not use the wood in India because of government regulations there and issues of resulting tariffs for imports from India. Gibson was caught in a loop of noneconomic tariffs. Gibson and the federal government settled the case with Gibson paying a $300,000 fine, making a $50,000 contribution to the National Fish and Wildlife Foundation, and forfeiting wood valued at $261,000 that was seized in the 2009 government raid at Gibson’s Nashville plant. The government

Ethical Issues

When Walgreen’s proposed moving its corporate headquarters outside the Unit- ed States in order to reduce its effective tax rate, under Section 482 of the Internal Revenue Code, the public outcry was so strong that Walgreen’s CEO nixed the plan. A number of U.S. CEOs have asked

Congress as well as the president and the treasury secretary for tax structure reform so that they can afford to compete inter- nationally without having to move facili- ties and operations overseas. Explain the ethical issues in the Section 482 tax-break structure for multinational companies. ©

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returned some of the wood (valued at $155,000) that it had taken from Gibson. The smallest of businesses have to be concerned with nontariff controls that affect their importation of goods or raw materials.

For most of history, these tariff and nontariff limits on trade have been imposed on a nation-by-nation basis. However, new forms of trade agreements are develop- ing, and nations are organizing in larger groups in an attempt to eliminate many of the individually based barriers to trade. The following sections cover these inter- national trade agreements.

the european Union As discussed in Chapter 1, the European Union (EU) was established with the goal of removing barriers to the free movement across borders of goods, people, ser- vices, and capital. The Treaty on European Union (Maastricht Treaty) established the goals of free trade, a single currency, and uniform laws on commerce and secu- rity. Today, for example, the EU handles antitrust violations by companies in any of the EU’s member nations.

In addition to the European Commission, the EU created other institutions to help it carry out its goal of unified European commercial operations. The European Council, which consists of the heads of state of the various members, is the policy- making body and establishes the broad directives for the operation of the EU. The next step below the council is the European Commission, the body charged with implementation of Council policies. At the third level is the European Parliament, an advisory legislative body with some veto powers. Finally, the European Court of Justice (ECJ) is the judicial body created to handle disputes and any violations of regulations and the EU treaty itself. The EU has in place nearly 300 directives that govern everything from health and safety standards in the workplace to the sale of mutual funds across national boundaries. The recent so-called Brexit vote in Great Britain to leave the EU was, in part, in response to what some believe was heavy- handed EU regulation.

Ethical Issues

When the Taliban was in power in Afghan- istan, it banned watching television. The result of the ban was the creation of a substantial market for smuggling television sets into Afghanistan. For example, a Sony TV set smuggled into Pakistan would cost about $400. The legal cost, paying tariffs, would be $440. The same set smuggled into Afghanistan could bring twice as much. Sony gets the same amount, or $220, for every set sold, regardless of where it is sold and what happens to it in terms of its final destination.

The Taliban decided to impose tariffs and taxes on TV sets even as it held to the ban because the ban resulted in the

smuggling market from which they could extract substantial sums.

Do you think Sony had an ethical obliga- tion to not sell to the Taliban? Does it have an ethical obligation to police what happens to its products? What happens when a company profits from a government mak- ing money from its own ban?

Source: Daniel Pearl and Steve Stecklow, “Taliban Banned TV but Collected Profits on Smuggled Sonys,” Wall Street Journal, January 9, 2002, pp. A1, A8. (Note that the source for this ethical issue was an article co-authored by Daniel Pearl, the U.S. journalist who was kidnapped by terrorists who even- tually killed him and shared graphic coverage of the execution.)©

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the WtO In 1994, the General Agreement on Tariffs and Trade (GATT), a multilateral treaty (treaty among more than two nations) (see Chapter 1), was adopted and established the World Trade Organization (WTO). The WTO lists 159 countries as members, including the United States. The WTO is the body charged with the administra- tion and achievement of the GATT objectives. GATT’s primary objectives are trade without discrimination and protection through tariffs. Trade without discrimina- tion is achieved through GATT’s most-favored-nation (MFN) clause. The issue of China’s membership as a most-favored nation was debated extensively, particu- larly in the political and social context of human rights issues in that country, prior to its admission in 2001. Russia was admitted as a member at the end of 2011 on the condition that it would take steps to ensure that its legal system will enforce contract rights.

For the Manager’s Desk

Re: Fighting and Winning: the International threat of pirates

AARRGGGGGG! Shiver me timbers, and all that other Johnny Depp stuff. We have pirates, savvy? The pirates are from Somalia, and they are wreaking havoc on international commerce off the coast of Africa. NATO has sent ships to patrol the African coasts and rescue ships and hostages. However, there are international law issues regarding what is to be done about—and with—the captured pirates.

In a 1718 trial of pirates, Judge Nich- olas Trott ruled, “It is lawful for any one that takes them, if they cannot bring them under some government to be tried, to put them to death.” More recent due process, human rights, and individual country laws require that the pirates receive a trial. How- ever, the questions still remain: How? By whom? Where?

The conduct of pirates violates inter- national norms of behavior, but what spe- cific laws are broken? Who has jurisdiction when the pirates take ships in international waters? The principles of autonomy apply here: what country has the right to try a citizen of another country for crimes not committed in either country?

Trials for pirates were historically han- dled in military tribunals. However, the backlash today against military tribunals

because of treatment of prisoners of war, as well as court rulings that have trans- ferred the cases to civil courts, means that pirates end up being released. Released pirates are free to pirate another day and, perhaps, another sea.

Countries have come up with differ- ent solutions. The British Royal Navy has instructed its military not to detain pirates because such detention violates the pirates’ human rights. Instructions for the French military are to return the pirates to Somalia. The U.S. policy is to return pirates to their home governments, but only if given assur- ances that the pirates will be detained and prosecuted. The civil and political unrest in Somalia often means that groups are able to secure the freedom of the pirates through the use of force against the government. In the meantime, companies doing interna- tional shipments are vulnerable. There were 300 pirate attacks of shipping vessels in 2009, and by 2012, there were 315, includ- ing 28 hijackings. Since 2013, the number of pirate attacks has decreased almost 90% because of onboard private security, increased naval presence, the addition of onshore security forces in vulnerable areas, and best practices for vessels in handling pirate attacks.

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Under MFN status, subscribing countries treat each other equally in terms of import and export duties and charges. Subscribing countries do not give more favorable treatment to one country as opposed to another. Domestic production is protected by tariffs and not through any other commercial measures.

Some exceptions under GATT for regional trading arrangements are under- taken through other treaties, such as the North American Free Trade Agreement and the European Union.

The WTO also established a Dispute Settlement Body (DSB), which is an interna- tional arbitration body created to bring countries together to resolve trade disputes rather than have those nations resort to trade sanctions. If a WTO panel finds that a country has violated the provisions of GATT, it can impose trade sanctions on that country. The sanctions imposed are generally equal to the amount of economic injury the country caused through its violation of GATT. For example, in 2012, the DSB found that the Philippines was charging differential tax rates on domestic versus imported distilled spirits, and government officials there agreed to stop the practice.

the North american Free trade agreement (NaFta) The North American Free Trade Agreement (NAFTA) is a treaty among Canada, the United States, and Mexico that took effect in 1994 and has achieved its goal of eliminating all tariffs among the three countries over a 15-year period.

Products covered under NAFTA include only those that originate in these countries. All goods traded across the boundaries of these countries must carry a NAFTA certificate of origin, which verifies the original creation of the goods in the country from which they are being exported. NAFTA is unlike the EU in that NAFTA focuses only on free trade and does not create a common labor market, governing body, or currency.

prohibitions on trade: Individual Nation Sanctions In some countries, international tensions have resulted in sanctions being imposed, including trade prohibitions. Countries can impose two types of trade sanctions. With primary trade sanctions, companies based in the United States are prohibited from doing business with certain countries. For example, the United States pro- hibited or regulated trade with Iraq since the time of the 1991 Gulf War and lifted those sanctions only over the past few years as the country’s new government took hold. Currently, the United States is lifting the decades-long sanctions against Iran and Cuba. Primary boycotts can be limited to certain categories of goods. Other category restrictions can include extreme limitations, such as limiting trade to food and medical supplies. In some restrictions, the United States prohibits domestic companies from selling certain types of equipment to certain nations. For example, U.S. firms had severe restrictions on selling certain component parts to Iran prior to the 2016 effective date of the U.S./Iran treaty.

The second form of trade prohibition is the secondary boycott, which is a step beyond the primary boycott in that companies from nations doing business with a sanctioned country will also experience sanctions for such an activity. For exam- ple, in 1996, the United States passed the Iran and Libya Sanctions Act (ILSA) as a secondary boycott against two nations on which the United States already had imposed trade restrictions. This law was passed because of active lobbying by the families of those killed when Pan Am Flight 103 exploded over Lockerbie, Scotland, as a result of bombs planted on the flight by Libyan terrorists. Under the secondary boycott trade prohibition, the United States did not grant licenses to permit its financial institutions to loan money to, award government contracts

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to, or allow imports from any company that finances, supplies, or constructs oil procurement in Iran or Libya. Generally, these types of secondary boycotts do not apply retroactively so that companies need not divest themselves of their holdings already invested in these countries. However, no new business is allowed once the act takes effect if the companies wish to continue trading with the United States. With the death of Col. Muammar e-Qaddafi and the fall of his regime in Libya as well as the 2016 treaty with Iran, the United States is lifting the secondary boycotts against these two nations.

the International Monetary Fund (IMF) and the World Bank Created at Bretton Woods, New Hampshire, the International Monetary Fund (IMF) was established following World War II with the goal of expanding inter- national trade through a bank with a lending system designed to bring stability to national currencies. The IMF created the International Bank for Reconstruction and Development (commonly called the World Bank), which allows signing nations to have Special Drawing Rights (SDR) or the ability to draw on a line of credit in order to maintain the stability of their currency.

The idea of the IMF was to enhance and encourage international trade through assurances about monetary stability in various countries. Each time a particular nation, such as Greece or Russia, experiences a difficult economic swing, signifi- cant debate occurs about the use of IMF funds to buoy that nation’s currency so that international trade with that country is not destroyed.

the Hague Convention Although largely thought of as the multilateral treaty that deals with issues of war, the Hague Convention has become increasingly important to businesses because of a 1954 addition that deals with discovery in civil cases across borders. Countries that are signatories to this 1954 treaty agree to cooperate with civil litigation dis- covery requests (see Chapter 4 for more information on discovery), provided that the request is made for documents that are clearly enumerated in the request and that bear a direct connection to the subject matter of the litigation. In other words, a signatory country has the right to refuse to provide the information if the request appears to be part of a fishing expedition to obtain information for reasons other than the litigation itself. As businesses deal with international copyright, patent, and trademark infringement, litigation across borders has become necessary, and cooperation under the Hague Convention Civil Procedure agreement has proven invaluable in obtaining information that can identify the perpetrators who are sell- ing counterfeit and gray-market goods.

the Climate agreements and treaties The Kyoto Protocol, often called the Kyoto Treaty or the global warming treaty, would have required signatory countries to reduce emissions “by at least 5% below 1990 levels.” The United States would have been required to reduce its emissions by at least 7% had it signed the treaty. China, India, and Mexico are excluded from the treaty’s coverage. By the time of the Copenhagen climate summit late in 2009, the Kyoto Treaty was just a bit of history. The nations in attendance were unwilling to commit to its standards. However, in 2015, 200 countries signed on to the Paris Agreement, a multinational compact that includes pledges to reduce carbon emis- sions as well as contribute money to help smaller nations with economic devel- opment. Many provisions are not binding, but the agreement is described as one designed to eliminate the use of fossil fuels.

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the Organization of petroleum exporting Countries (OpeC) The Organization of Petroleum Exporting Countries (OPEC) was a cartel that worked together to control oil supplies and production, prices, and taxes. How- ever, the development of oil and natural gas resources in the United States, Can- ada, and other countries has increased the oil supplies and minimized the pricing controls of OPEC.

7-2 Trust, Corruption, Trade, and Economics Perhaps the greatest activity in multilateral agreements among countries has been in the area of curbing bribes because of their devastating impact on trust and investment, which can stall economic development in a country. In his depar- ture speech as secretary of the U.S. Treasury, Robert Rubin cautioned govern- ment employees to never accept any sort of gift as part of their duties because, he noted, “Corruption and bribery benefit a few at the expense of many.”

7-2a Foreign Corrupt practices act (FCpa)

Perhaps the most widely known criminal statute affecting firms that operate inter- nationally is the Foreign Corrupt Practices Act (FCPA; 15 U.S.C. §§ 78dd-1). The FCPA applies to business concerns that have their principal offices in the United States. It contains anti-bribery provisions as well as accounting controls for these firms and was passed to curb the use of bribery in foreign operations of these companies.

History, purpose, and application of the FCpa First passed in 1977, the FCPA is the result of an investigation by the Securities and Exchange Commission (SEC) that uncovered questionable foreign payments by large stock issuers who were based in the United States. Approximately 435 U.S. corporations made improper or questionable payments totaling $300 million in Japan, the Netherlands, and Korea.

The FCPA prohibits making, authorizing, or promising payments or gifts of money or anything of value to government and NGO officials with the intent to corrupt for the purpose of obtaining or retaining business for or with or directing busi- ness. That one-sentence prohibition has many components, and those components are covered in the following subsections.

What Constitutes a payment under the FCpa? The decisions in cases and Justice Department guidelines have given us the following: cash, country club memberships, excessive comped travel (travel that does not include seminars or presentations and consists of, for example, shop- ping trips to Paris for government officials or their spouses), cash donations to political parties, payment of cell phone or utility bills for government officials, and giving luxury gifts such as sports cars and furs to government officials or their spouses.

In 2012, the Justice Department published its Resource Guide for the Foreign Corrupt Practices Act (FCPA). The 130-page guide, which is available online, includes the kinds of things companies can do that are not prohibited. For exam- ple, the following are not violations of FCPA according to the guide:

1. Small gifts of expressions of gratitude, provided there is transparency in the giving

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2. Small gifts to local charities, provided the gift is consistent with the compa- ny’s general philanthropic goals and is not “large”

3. Wedding gift to a government official (if not too large) 4. Hats, t-shirts, pins, and pens that companies offer at trade show booths that

government officials take 5. Payment of the bar tab for drinks for government officials at a group meeting 6. Payment for travel to the United States for training at a company’s

facility (foreign dignitaries can even take in a baseball game at company expense during such training without the company risking an FCPA violation)

Payments to foreign officials for “facilitation,” often referred to as grease payments, are not prohibited under FCPA so long as these payments are made only to get the officials to do jobs that they might not do ordinarily or would do slowly without some payment. These grease payments can be made for obtaining permits, licenses, or other official documents; processing govern- mental papers, such as visas and work orders; providing police protection and mail pickup and delivery; providing phone service, power, and water supply; loading and unloading cargo or protecting perishable products; and sched- uling inspections associated with contract performance or transit of goods across the country.

the Costs of Slipping on the FCpaBusiness Strategy

In China, the use of a particular phar- maceutical’s prescription drugs is deter- mined by doctors within the nationalized health system. GlaxoSmithKline (GSK) began its path to FCPA violations with what could be called culturally acceptable interaction with the doctors. Holding sem- inars to provide the doctors with infor- mation about GSK drugs is not an FCPA violation, but the seminars grew into trips to Hawaii, with travel, dinner, and enter- tainment provided by GSK. Then shopping sprees were added for spouses. Gifts at the seminars were not unusual. Eventu- ally, GSK was using 700 travel agents all around China to book travel for doctors and then funnel gifts, sexual favors, and cash to the doctors in exchange for their willingness to adopt GSK drugs at their medical facilities.

The program was very successful in increasing sales in China, but it was so large that it began to attract attention. Following an investigation, Chinese authorities arrest- ed a GSK officer in China. GSK was found guilty of bribery in China and paid a $489 million fine. Almost 50 GSK employees were arrested, and five entered guilty pleas and were sentenced to two to four years in prison.

GSK is in the process of changing its business model, including dealing with a 30% reduction in its sales in China. There is reluc- tance on the part of doctors and hospitals to do business with GSK because of fears of government prosecution. Without the semi- nars, travel, and favors, GSK has been left to develop better sales representatives and mar- keting techniques different from giving things away in order to sway doctors. ©

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What Is “Obtaining, Retaining, or directing Business”? The types of activities included under “obtaining, retaining, or directing business” are the following: winning contracts, influencing a procurement process, circum- venting rules in order to get products imported, gaining access to non–public bid information, evading taxes or penalties, influencing the outcome of lawsuits or regulatory actions, obtaining exceptions to regulations, avoiding contract termina- tion, asking regulators or officials to exclude your competitors from their country, evading customs duties, and extending drilling contracts.

Who Is Covered under FCpa? The types of officials covered under the FCPA (to whom gifts may not be directed) include foreign officials, political parties, party officials, candidates for office, and any NGO. Using any person who will transmit the gift or money to one of the other types of people also is prohibited. Changes in 1998 added the NGO coverage so that officials such as those with the United Nations, the Olympics, or the IMF are now covered under the act. The bribery involved in awarding the 2002 Olympics held in Salt Lake City resulted in this expansion of the statute’s coverage. The international 2015 FIFA investigation that resulted in FCPA charges, is another example of an NGO (The International Federation of Association Football) being subjected to the anti-bribery laws. Those charged in the case are current and former officials of FIFA who are accused of accepting payments in exchange for awarding contracts to cities and countries for the World Cup and FIFA licensing rights as well as other soccer events. The indictment alleges that companies paid more than $150 million in bribes to FIFA officials for marketing and licensing rights for the World Cup and related soccer activities.

Use of agents and the FCpa When the FCPA was passed initially, many companies tried to find ways around the bribery prohibitions. Companies would hire for- eign agents or consultants to help them gain business in countries and allowed these “third parties” to act independently. However, many of these consultants paid others who then paid bribes to officials. Under the FCPA, even these types of arrangements can constitute a violation if the consulting fees are high, odd payment arrangements occur, or the company has reason to know of a potential or actual violation. Companies must be able to establish that they have performed “due diligence” in investigating those hired as their agents and consultants in foreign countries. For example, if a U.S. company hired a consultant who charged the company $25,000 in fees and $25,000 in expenses, the U.S. com- pany would be, under Justice Department guidelines, on notice for excessive expenses that could signal potential bribes being paid. These types of expenses are known as red flags for U.S. com- panies. The Justice Department uses this information as a means of establishing intent, even when the company may not know pre- cisely what was done with the funds and what was paid to whom.

the FCpa and “Grease” or Facilitation payments Payments to foreign officials for “facilitation,” often referred to as grease payments, are not prohibited under FCPA so long as these payments are made only to get the officials to do jobs that they might not do ordinarily or would do slowly without some

One of the areas of focus for consultants and education programs on FCPA compli- ance is this question: How can we know if we have FCPA violations in our interna- tional operations? Below is a list of tips for staying on top of FCPA issues.

1. Have frequent audits of international offices with tight controls over the dis- bursement of funds. Who? When? How? How much? Why?

2. Screen any agents, advisers, trans- lators, and others hired to help with negotiations.

3. Monitor payments made to individ- uals, foreign entities, and even compa- nies, such as travel agencies, to deter- mine the purpose for those relationships.

4. Listen when employees raise ques- tions. GSK was warned by an employee before the Chinese government acted but had not followed up quickly enough on the allegations.

5. If a foreign office is awarded a large contract, make a visit and trace the path of the contract and how it was won.

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payment. These grease payments can be made for obtaining permits, licenses, or other official documents; processing governmental papers, such as visas and work orders; providing police protection and mail pickup and delivery; providing phone service, power, and water supply; loading and unloading cargo or protecting per- ishable products; and scheduling inspections associated with contract performance or transit of goods across the country.

penalties for Violation of the FCpa For FCPA anti-bribery violations, corporations face a penalty of $2 million per vio- lation. Individuals (including officers, directors, and shareholders) are subject to $250,000 in fines and up to five years in prison. FCPA accounting violations carry a penalty of $25 million for corporations and up to $5 million in fines and 20 years in prison for individuals. Corporations are not permitted to pay the fines of their employees. Also, under the Alternative Fines Act, the Justice Department can seek to obtain two times the benefit the bribe attempted to gain, known as disgorgement. For example, if a company paid a bribe to obtain a $100 million contract for com- puter services for a foreign government, the potential fine could be two times the amount of profit on that contract, not including the statutory fine provisions.

The Justice Department and the SEC continue a steady stream of FCPA charges. During 2010, FCPA charges peaked at 74. In 2011, there were 48 charges and in 2012 only 23. From 2013 to 2016, there were 41 FCPA cases brought against many large companies, including Johnson Controls, Las Vegas Sands, SAP, Bristol-Meyers Squibb, Avon, Hitachi, Mead-Johnson, Goodyear, and Ralph Lauren.

American Ri, Inc. (ARI), a Houston-based company, exports rice to foreign countries, including Haiti. Rice Corporation of Haiti, a wholly owned subsidiary of ARI, was incor- porated in Haiti to represent ARI’s interests and deal with third parties there. Haiti’s customs officials assess duties based on the quantity and value of rice imported into the country. Haiti also requires busi- nesses that deliver rice there to remit an advance deposit against Haitian sales tax- es, based on the value of that rice. The businesses are then given a credit for the deposit when they file their Haitian sales tax returns. David Kay and Douglas Mur- phy, executives of ARI, were charged with violations of the Foreign Corrupt Practic- es Act (FCPA) for allegedly bribing Haitian officials to accept false bills of lading that reflected total rice imports to be about one- third of actual levels so that ARI would owe less in taxes. Is this type of an arrange- ment a bribe? Does it violate the FCPA? [U.S. v Kay, 359 F.3d 738 (5th Cir. 2004)]

THINK: The FCPA criminalizes payments that are intended to (1) influence a foreign

official to act or make a decision in his official capacity, or (2) induce such an of- ficial to perform or refrain from perform- ing some act in violation of his duty, or (3) secure some wrongful advantage to the payor.

APPLY: Securing reduced taxes and duties on imports through bribery enables ARI to reduce its cost of doing business, thereby giving it an “improper advantage” over ac- tual or potential competitors and enabling it to do more business or remain in a market it might otherwise leave.

ANSWER: Bribing foreign officials to low- er taxes and customs duties certainly can provide an unfair advantage over compet- itors and thereby be of assistance to the payor in obtaining or retaining business. The FCPA applies broadly to payments in- tended to assist the payor, either directly or indirectly, in obtaining or retaining busi- ness for some person, and bribes paid to foreign tax officials to secure illegally re- duced customs and tax liability constitute a type of payment that can fall within this broad coverage.

Consider . . . 7.2

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the FCpa and U.S. Competitiveness One of the long-standing concerns about the FCPA is whether it has placed U.S. businesses at a competitive disadvantage in those countries in which bribery is generally accepted as a way to win contracts and government benefits. However, a survey by the U.S. Government Accounting Office of the companies affected by the FCPA found that the ability of companies from other countries to bribe offi- cials did not give them a competitive advantage. The survey found that U.S. trade increased in 51 of 56 foreign countries after the FCPA went into effect. The increase was attributed to the position adopted by U.S. companies with respect to their competitors—if they could not bribe government officials, they would disclose publicly information about bribes made by any of the companies from other nations.

FCpa and the Organization for economic Cooperation and development (OeCd) The Organization for Economic Cooperation and Development (OECD) is now supportive of the U.S. FCPA and its principles. Member countries have enacted legislation for compliance with its international pact against bribery. The OECD’s 38 members1 now work together to investigate companies’ activities across bor- ders.2 However, only the United States, Germany, Norway, and Switzerland actively enforce their anti-bribery statutes. The British version of the FCPA took effect in July 2011 and has required significant changes in companies in terms of compliance and monitoring payments.

When Congress amended the FCPA to implement the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, the amendments expanded the act’s jurisdiction to cover all U.S. citizens acting out- side the United States and all non-U.S. citizens acting inside the United States. The convention basically adopts the standards of the United States under the FCPA and requires nations signing the agreement to impose criminal penalties, seize profits earned through bribery, and rein in government officials who accept illicit payments by actively prosecuting them along with the companies making the payments.

In 2009, the top aides to Libya’s then leader, the late Col. Muammar e-Qaddafi, held a meeting with 15 executives from global ener- gy companies that had oil operations in Libya. The United States had reopened trade with Libya in 2004 after nearly a decade-long boycott because the Libyan government played a role in the explosion of Pan Am Flight 103 at 34,000 feet over Scotland caused by a bomb onboard the plane.

At the meeting of these executives, the Qaddafi aides asked them to ante up the $1.5 billion Libya was being asked to pay for the compensation of the Pan Am 103 victims’ families. The aides referred to the payments as “signing bonuses” or “consultancy fees” for their companies

being permitted to continue oil operations in Libya.

A State Department 2009 cable con- tained the following warning for U.S. com- panies: “Libya is a kleptocracy in which the regime—either the al-Qadhafi [sic] family itself or its close political allies—has a direct stake in anything worth buying, selling, or owning.” Some of the U.S. companies paid into the $1.5 billion fund; some did not.

Did those who paid violate the FCPA? What strategic issues do you see in the State Department’s warning?

Source: Eric Lichtblau, David Rohde, and James Risen, “Business Payoffs Helped Qaddafis Solidify Control,” New York Times, March 24, 2011, p. A1.

Consider . . . 7.3

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7-3 Resolution of International Disputes As discussed in Chapters 1, 3, and 4, there really is no way to enforce international laws. The International Court of Justice established by the United Nations is a court of voluntary jurisdiction for disputes between nations; it is not a court for the resolution of business disputes between nations. More and more companies and individuals favor arbitration to resolve disputes. The most popular forum chosen for such arbitrations and quasi-trials is London’s Commercial Court, which was founded on March 1, 1895, when it heard its first case, a dispute over the quality of cloth a Flemish manufacturer sold to a London agent. The court was perhaps the first to recognize the role of arbitration in deciding international business disputes; such innovation restored the confidence of business in the settlement of disputes by third parties. The London Commercial Court is viewed as a neutral forum with highly experienced judges who are also experienced commercial litigators.

7-4 Principles of International Law The sources of international law simply serve to govern businesses as they oper- ate in a particular country, and the laws may vary from country to country. How- ever, some principles of international law apply to all countries and people in the international marketplace. The principles of international law do affect the deci- sions and operations of businesses, regardless of the availability of court resolution of rights.

7-4a act of State doctrine

The act of state doctrine gives every sovereign state respect from other sovereign states for its laws, actions, decisions, and policies. The act of state doctrine con- firms the independence of sovereign nations and their courts. No country will intervene in the judicial and legislative processes of another country because those actions are inconsistent with that country’s standards. Courts of one country will not undertake the responsibility of providing their citizens with remedies against another country, even when that other country has violated the rights of a citi- zen of the first country. For example, when Union Carbide’s plant in Bhopal had a high-fatality accident, Union Carbide’s CEO was arrested and taken into custody when he went to Bhopal to ensure appropriate relief efforts. Although his impris- onment would have violated his rights in the United States, the U.S. courts did not intervene in India’s criminal processes. Lawyers for the CEO had to work through the courts of India.

7-4b Sovereign Immunity

The concept of sovereign immunity is based on the notion that each country is a sovereign nation. This status means that each country is an equal with other countries; each country has exclusive jurisdiction over its internal operations, laws, and people; and no country is subject to the jurisdiction of another coun- try’s court system unless it so consents. Our court system cannot be used to right injustices in other countries or to subject other countries to penalties. For exam- ple, in Schooner Exchange v McFaddon, 7 Cr. 116 (1812), a group of American citi- zens attempted to seize the vessel Exchange when it came into port at Philadelphia

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Chapter 7 International Law 233

because the citizens believed that the ship had been taken improperly on the high seas by the French emperor Napoleon and that the ship rightfully belonged to them. The U.S. Supreme Court held that the ship could not be seized because sov- ereign immunity applied, and France could not involuntarily be subjected to the jurisdiction of U.S. courts.

The Foreign Sovereign Immunities Act of 1976 clarified the U.S. government’s position on sovereign immunity and incorporated the Schooner Exchange doctrine. Not only are countries immune, but the act also adds a clarification to the concept of sovereign immunity of sovereign nations for illegal acts. For example, in Argen- tine Republic v Amerada Hess Shipping Co., 488 U.S. 428 (1989), the Supreme Court dismissed a suit brought in a U.S. federal court by a Liberian-chartered commercial ship company against the government of Argentina for its unprovoked and illegal attack on a company ship. The ship was in neutral waters when the war between Great Britain and Argentina broke out over the Falkland Islands. The attack by the Argentine Navy was unprovoked and in clear violation of international law. How- ever, the U.S. Supreme Court clarified that under the Sovereign Immunities Act and principles of international law, all sovereign nations are immune from suits in other countries, even for those acts—like that of Argentina—that are clear viola- tions of international law.

There is a distinction, however, under both the Foreign Sovereign Immuni- ties Act and the courts with respect to the commercial transactions of a sovereign nation. For example, the sale of services and goods, loan transactions, and con- tracts for marketing, public relations, and employment services entered into by a country are, in essence, voluntary agreements that subject that country’s govern- ment to civil suits in another nation’s courts according to the terms of the agree- ment or according to the basic tenets of judicial jurisdiction (see Chapter 3).

The In re Yukos Oil Company Securities Litigation case (Case 7.1) deals with the act of state doctrine as well as sovereign immunity and provides answers for the chapter-opening “Consider . . .”

In re Yukos Oil Company Securities Litigation 2006 WL 3026024 (S.D.N.Y.)

When Putin Affects the Value of Oil Stock

Case 7.1


Yukos is a Moscow-based joint-stock company whose shares trade on the Russian stock exchange. Yukos shares also trade indirectly on multiple European exchanges and over-the-counter in the United States.

Allegedly, Khodorkovsky was part of a select group of Russian business leaders known as “oligarchs” who supported former Russian President Boris N. Yeltsin but were politically opposed to current Russian Presi- dent Vladimir V. Putin.

The Tax Code of the Russian Federation prescribed a maximum income tax rate that incorporated two components: a tax payable to the federal budget and a tax payable to the budget of the taxpayer’s local region. For example, in 2004, the statutory maximum rate was 24%, of which up to 6.5% could be collected by the federal government and up to 17.5% by regional governments. The Tax Code also prescribed a mini- mum rate for taxes payable to regional governments. In 2004, that rate was 13.5%. However, the regional

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234 part 2 Business: Its Regulatory Environment

governments could offer tax benefits to reduce or even eliminate the regional budget liability of certain categories of taxpayers. As a result of this regional variance in the effective income tax rate, taxpayers in the metropolitan regions of the Russian Federation, such as Moscow, paid higher taxes than taxpayers in remote regions, or “ZATOs.”

From 2000 through 2003, Yukos allegedly grossly underpaid its taxes to the Russian Federation by ille- gally taking advantage of the ZATOs’ preferential tax treatment. Yukos allegedly booked oil sales at “well below” market prices to 17 trading companies, all of which were registered within ZATOs. Without taking physical possession, the trading companies sold the oil to customers at market prices and claimed the tax ben- efits of their ZATOs. However, the profits were “fun- neled . . . back to Yukos and Yukos paid taxes only on the initial below-market sales while reaping substantial profits from the [actual] market-price sales.”

The regional trading companies may have received the benefits of ZATO registration illegitimately because “[n]o business was actually conducted by the sham companies in the ZATOs.” This Yukos tax strategy pre- sented enormous risk because it violated Russian law and because the Russian Federation had prosecuted other companies that had acted similarly. Nonetheless, the tax risk was not disclosed in any of the Yuko’s fil- ings with the SEC. Also, what was filed with the SEC was not prepared in conformity with U.S. GAAP or other standards of financial reporting.

At a secret meeting with Khodorkovsky and other oligarchs in 2000, Putin promised not to investigate potential wrongdoing at their companies if the oligarchs refrained from opposing Putin. Nearly three years later, at another such meeting, Khodorkovsky was said to have voiced his opinion that high-level officials in Putin’s government should be ousted. According to the shareholders (plaintiffs), Putin reacted negatively and intimated to Khodorkovsky that the Russian Federa- tion might investigate Yukos’ methods of acquiring oil reserves. Despite Putin’s warnings, Khodorkovsky pub- licly criticized Putin and financed opposition parties.

On October 25, 2003, Russian Federation author- ities arrested Khodorkovsky and charged him with fraud, embezzlement and evasion of personal income taxes. Days later, the Russian Government seized con- trol of Khodorkovsky’s 44% interest in Yukos as secu- rity against the approximately $1 billion he owed in taxes. The Tax Ministry then revealed that it had been investigating Yukos’ tax strategies. The Department of Information and Public Relations of the General Prosecutors Office then announced charges that it had accused Khodorkovsky and others of fraudulently

operating an illegal scheme at Yukos to avoid tax lia- bility through shell company transactions.

On December 29, 2003, the Tax Ministry conclud- ed its audit of Yukos for tax year 2000 and issued a report that Yukos had illegally obtained the benefit of the ZATOs’ preferential tax treatment and owed $3.4 billion to the Russian Federation in back taxes, interest, and penalties for tax year 2000.

As a result, Yukos defaulted on a $1 billion loan from private lenders, and the Russian government con- fiscated Yukos’ assets, including its main production facility and billions of dollars from its bank accounts. The price of Yukos securities “plummeted” in response to these events.

Yukos shareholders (plaintiffs) filed consolidated class actions against Khodorkovsky and others (defen- dants) on July 2, 2004. The U.S. plaintiffs had pur- chased Yukos securities between January 22, 2003, and October 25, 2003. They allege that Yukos, its outside auditor, and certain of its executives and controlling shareholders knowingly concealed the risk that the Russian Federation would take action against Yukos by failing to disclose (1) that Yukos had employed an illegal tax evasion scheme since 2000 and (2) that Khodorkovsky’s political activity exposed the compa- ny to retribution from the current Russian government. The plaintiffs based their claims on the fraud provision, Section 10(b), of the Securities Exchange Act.


PAULEY, District Judge Defendants contend that that this Court must abstain under the act of state doctrine.

Firmly entrenched as a principle of jurispru- dence, the act of state doctrine prevents the courts of the United States from “question[ing] the validity of public acts (acts jure imperii) performed by other sovereigns within their own borders.” The doctrine “has its roots, not in the Constitution, but in the notion of comity between independent sovereigns.” It also venerates the separation of powers within the federal Government by precluding the judiciary from deciding matters of foreign policy that are properly the province of the executive and legisla- tive branches.

Defendants urge this Court to abstain under the act of state doctrine because “[t]he adjudication of this dispute inevitably will require this Court to inquire into the actions and motives of the Russian Govern- ment in imposing confiscatory tax levies, penalties and interest on Yukos.” Implicit in their argument and resplendent in other portions of their motion papers is the notion that the Russian Federation targeted Yukos


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Chapter 7 International Law 235

unforeseeably and that the Tax Ministry’s interpreta- tion of the Russian Federation Tax Code was without precedent.

Defendants have not cited any precedent invoking the act of state doctrine to abstain from adjudicating a securities fraud action. Under the arguments advanced by Defendants, the doctrine would mandate absten- tion from any action in which a foreign corporation is alleged to have concealed conduct deemed illegal by its home country upon a defendant’s mere assertion that the sovereign’s determination was in error. Such an application of the act of state doctrine would effec- tively insulate foreign corporations from a large swath of securities fraud claims by United States investors.

The act of state doctrine does not preclude a court from deciding a case that implicates the motives or justifications of a foreign sovereign’s official act but does not seek to invalidate or circumvent that act. Rather, the doctrine applies only “when a court must decide—that is, when the outcome of the case turns upon—the effect of official action by a foreign sovereign.” The act of state doctrine does not compel abstention from “cases and controversies that may embarrass foreign governments, but merely requires that, in the process of deciding, the acts of foreign sovereigns taken within their own jurisdiction shall be deemed valid.”

The Yukos Defendants contend that “any defense by Yukos beyond the pleadings stage necessarily will involve its claims that it was denied due process, and that it never would have suffered the consequences of having its business confiscated, had the Russian government properly applied Russian law.” However, whether Yukos received due process in Russia is irrel- evant. Neither party in this action seeks to enforce or disturb the actions taken by the Russian Federation. Moreover, in this action, the pertinent loss-causation inquiry concerns Defendants’ alleged misstatements or omissions and the losses suffered by Yukos investors— not the propriety of the Russian Federation’s tax

enforcement and penal actions. The central question is whether Defendants acted with fraudulent intent in withholding information from the investing public. Even if Defendants prevail with their arguments that the Russian Federation’s interpretation of Russian law was untenable, the validity of the Russian Federation’s acts would be unaffected.

Under the act-of-state doctrine, the assessment of the validity of a foreign law is limited to its application within the sovereign’s territory; under the revenue rule, United States courts avoid the application of a foreign sovereign’s tax laws in the United States. Both approaches enable courts to avoid entanglement with questions about the underlying validity of a foreign sovereign’s laws.

Because Plaintiffs here are not asking this Court to enforce the Russian tax judgments, this Court need not evaluate the policies behind the Russian Federation’s tax legislation or the regional variance among effective federal income tax rates which Yukos is alleged to have exploited.

In sum, this Court is not being called on to either invalidate or enforce the Russian Federation’s mea- sures, nor will the validity of those sovereign acts have any bearing on Defendants’ motions to dismiss or on questions likely to affect the merits of this litigation. As such, the act of state doctrine does not warrant abstention.

The case was dismissed on grounds other than the act of state doctrine.


1. Describe how Yukos is alleged to have saved sig- nificant amounts in taxes.

2. Explain what act of the Russian Federation is in question.

3. What are the plaintiffs asking the court to decide? Does that decision require revisiting what the Russian Federation did, and why or why not?

7-4c protections for U.S. property and Investment abroad

expropriation The effect of nationalization is that the private property of citizens and businesses operating in that country can be taken by the government, an act referred to as expropriation. While courts do not interfere with a sovereign’s actions, the effect of expropriation, combined with the act of state doctrine and sovereign immu- nity, has a chilling effect on U.S. investments in foreign countries. To discourage expropriation, the Foreign Assistance Act of 1962 contained what has been called the Hickenlooper Amendment, which requires the president to suspend all forms

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236 part 2 Business: Its Regulatory Environment

of assistance to countries that have expropriated the property of U.S. citizens or regulated the property in such a way as to effectively deprive a U.S. citizen of it (through taxation or limits on use).

Minimizing Expropriation. Many trade treaties that have been negotiated or are being negotiated with other countries contain protections against expro- priation. Some treaties provide U.S. companies and investors with the same levels of protection as the citizens of those countries. For example, if a coun- try affords its citizens due process before taking over private property, U.S. citizens and companies must be afforded those same protections prior to expropriation.

Finally, Congress has created a federal insurer for U.S. investments abroad. The Overseas Private Investment Corporation (OPIC) is an insurer for U.S. investment in those countries where the per capita annual income is $250 or less. OPIC will pay damages for expropriation, inability to convert the currency of the country, or losses from war or revolution.

Consumer protections in other countries depend on those countries’ laws. For example, many U.S. citizens have constructed luxury homes along the coast near Ensenada in Baja California. They did so because the land and construction were so much cheaper than in the United States that they could afford large, luxurious homes. However, the land on which many of the homes

Ethical Issues

PricewaterhouseCoopers is one of the “Big 4” accounting firms in the United States. PwC, as it is known, has had a tax practice in Russia since the time that country changed from communist rule. One of PwC’s clients in Russia was Yukos, a major Russian oil company that is now bankrupt.

Russia’s Federal Tax Service, an agency similar to the IRS in the United States, has filed suit against PwC, alleging that it concealed tax evasion by Yukos for the years 2002–2004. The Tax Service also announced a criminal probe of PwC’s con- duct with regard to its tax services for Yukos. Twenty Tax Service agents searched PwC’s offices in Moscow and questioned PwC employees about the Yukos account. Yukos lost its tax case and has paid $9.2 million in charges for the nonpayment of taxes.

The Russian government eventually brought criminal charges against two

PwC partners in Russia but dropped the charges and all proceedings against PwC in exchange for PwC withdrawing its Yukos audits. During the time that PwC was fac- ing off with the Russian government, there were concerns that it would be forced to reveal client information. In addition, the Russian government held the power to revoke PwC’s license to conduct audits in that country. PwC experienced great pres- sure and had to invoke help from the State Department in trying to preserve its rights and the rights of its client, Yukos, in the Russian proceedings against it.

What issues should a company consid- er before doing business in an economically developing country? What are the risks? Did this ethical dilemma begin long before the Russian government’s demands of PwC? What international law, culture, and ethical issues should a company consider before deciding to do business in another country? ©

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Chapter 7 International Law 237

were located was the subject of 14 years of litigation and more than 60 court decisions over disputed ownership rights. With the Mexican Supreme Court’s decision on landownership, most of the current U.S. owners have been told that they must vacate their homes and leave everything behind. Despite due process and property rights in the United States, the homeowners in Ensenada have no hope as long as the Mexican Supreme Court has declared the law for its country and land.

7-4d Repatriation

Repatriation is the process of bringing back to your own country profits earned on investments in another country. Some nations establish limits on repatriation; busi- nesses can remove only a certain amount of the profits earned from the operations of a business within a country. Repatriation limits are considered acts of state and are immune from litigation in the United States.

7-4e Forum Non Conveniens, or “You Have the Wrong Court” The doctrine of forum non conveniens is a principle of U.S. justice under which cases that are brought to the wrong court are dismissed. The doctrine allows judicial discretion whereby such issues as the location of the evidence, the loca- tion of the parties, and the location of the property that will be used to satisfy any judgment are examined. For example, when the Union Carbide disaster occurred at its Bhopal plant in India, victims and families brought suit against Union Carbide in New York City. A U.S. court of appeals dismissed the case and sent it back to India on the grounds of forum non conveniens. [In re Union Carbide Corp. Gas Plant Disaster, 809 F.2d 195 (2nd Cir. 1987); cert. denied, 484 U.S. 871 (1987)]

7-4f Conflicts of Law

No two countries match in terms of the structure of their legal system or their laws. For example, the law in the United States, codified by the widely adopted Uniform Commercial Code (UCC), is that all contracts and contract relationships are subject to a standard of good faith. In Canada, the good faith exists only if the parties place such a provision in their agreement. Under German law, pro- tections are given not on the basis of good faith but, rather, on the basis of who is the weaker party. Just among these three major commercial powers, laws on contracts are significantly different. The rules on conflicts of law in international transactions are as follows: (1) If the parties choose which law applies, that law will apply, and (2) if no provision is made, the law of the country where the con- tract is performed will be used. Agreeing to and understanding the set of laws to be applied in a contract are critical parts of international transactions. The U.S. Supreme Court held in Carnival Cruise Lines v Shute, 499 U.S. 585 (1991), that, even in consumer types of contracts, the parties can agree on how and where their dis- putes will be resolved and which law will apply as long as the place and law selected bear some relationship to the nature of the contract and its place of per- formance. In that case, the court held that Carnival Cruise Lines could require its passengers to come to its place of business, Miami, to bring suit for any breaches of contract or injuries while sailing on a Carnival ship. The Miami location was not only Carnival’s U.S. place of business but also a major port from which many of its cruises departed.

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7-5 Protections in International Competition Although trade barriers are coming down and a global marketplace is a reality, international competition is still subject to much regulation found in the forms of antitrust laws, protections for intellectual property, and trade treaties.

7-5a the International Marketplace and Monetary Issues: the disclosure Role of Banks

protections for Banks and International Customers: taxes and Shelters Individuals who place large amounts of cash in banks of other countries have been the subject of increasing numbers of audits because their cash assets are in other countries through tax shelters designed to help them avoid taxation on the money when it is first earned. The U.S. government has been indicting and imposing penalties on foreign banks that held these accounts and then refused to disclose who their customers were when tax officials conducted investigations. Most of the banks have entered into settlements and paid fines. Taxpayers and their advisers have settled their cases and paid significant penalties.

protections for Bank Customers: Information Getting information from banks in other countries continues to be problematic for regulatory agencies as well as for businesses that are seeking help in identifying those engaged in commercial activity that affects their products and or ability to sell those products.

U.S. courts can order foreign banks to make account disclosures as part of dis- covery proceedings under what is known as Hague proceedings discussed earlier in the chapter. Tiffany and Company v Andrew (see Case 7.2) provides a look at this

International Ambassador Programs, Inc., is a Washington-based nonprofit organi- zation that arranges tours and informa- tional visits in foreign countries, including Russia. Archpexpo, once a Soviet state enterprise and now a Russian limited partnership, facilitates and expedites tours such as those sponsored by Am- bassador to Russia and the other former Soviet republics.

Archpexpo and Ambassador entered into several agreements relating to tours. An April 1989 agreement provided that “all disputes and differences without recourse to courts of law shall be referred to the arbitration tribunal with the USSR Trade and Industry Chamber for resolution, such resolution acknowledged as final by the parties.”

A dispute arose between the parties when Archpexpo alleged that it had not been paid certain fees due, and Ambassa- dor claimed it was entitled to an offset of $20,000 for refunds it had to give to travel- ers who were dissatisfied with Archpexpo’s service.

Archpexpo filed for arbitration, and Ambassador brought suit in federal district court in the United States. Does the federal district court have jurisdiction? Must Am- bassador submit to arbitration in Russia? What if Ambassador had more than one contract with Archpexpo and some of the contracts contained the arbitration clause and some did not? Would Ambassador then be required to submit to arbitration? [Inter- national Ambassador Programs, Inc. v Arch- pexpo, 68 F.3d 337 (9th Cir. 1995)]

Consider . . . 7.4

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Chapter 7 International Law 239

bank process and the applicable international standards that apply to bank disclo- sure of information for purposes of identifying those who have harmed U.S. com- panies through infringement or counterfeiting of goods.

Tiffany and Company v Andrew 2012 WL 5451259 (S.D.N.Y.)

Looking for Counterfeiters’ Bank Accounts

Case 7.2


Tiffany (plaintiffs) alleges that Andrew and others (defendants) sold counterfeit Tiffany products through several websites hosted in the United States. Andrew accepted payment in U.S. dollars; used PayPal, Inc., to process customers’ credit card transactions; and then transferred the sales proceeds to accounts held by the Bank of China (“BOC”), Industrial and Commercial Bank of China (“ICBC”), and China Merchants Bank (“CMB”) (“Banks”).

Andrew defaulted on the suit, and Tiffany sought discovery from the Banks by serving subpoenas seek- ing the identities of the holders of the accounts into which the proceeds of the counterfeit sales were transferred and the subsequent disposition of those proceeds. The Banks involved all maintained branch offices in the Southern District of New York, and the subpoenas were served on those branch offices.

The Banks responded to the subpoenas by explain- ing that the information sought was all maintained in China and that the New York branches of the Banks lacked the ability to access the requested information. China’s internal laws prohibited the disclosure of the information except under certain conditions. The Banks proposed that the plaintiffs pursue the request- ed discovery pursuant to the Hague Convention.

The court concluded that Tiffany should pursue discovery through the Hague Convention. Tiffany submitted its Hague Convention application to China’s Central Authority in November 2010, and on August 7, 2011, the Ministry of Justice of the People’s Republic of China (“MOJ”) responded by producing some of the documents requested. For each of the Banks, the MOJ produced account opening documents (including the government identification card of the account holder), written confirmation of certain transfers into the accounts, and a list of transfers out of the accounts. With

respect to CMB, the records indicate that all funds in the account were withdrawn through cash trans- actions either at an ATM or through a teller. BOC and CMB each produced documents concerning a single account; ICBC produced documents for three accounts.

In its cover letter, the MOJ noted that it was not producing all documents requested. Specifically, the letter stated, “Concerning your request for taking of evidence for the Tiffany case, the Chinese competent authority holds that some evidence required lacks direct and close connections with the litigation. As the Chinese government has declared at its accession to the Hague Evidence Convention that for the request issued for the purpose of the pre-trial discovery of documents only the request for obtaining discovery of the docu- ments clearly enumerated in the Letters of Request and of direct and close connection with the subject matter of the litigation will be executed, the Chinese compe- tent authority has partly executed the requests which it deems conform to the provisions of the Convention.”

On the grounds that the MOJ’s production is defi- cient, Tiffany moved to enforce the subpoenas previ- ously served on the New York branches of the Banks. The deficiencies Tiffany claims are (1) whether any of the defendants have any additional accounts at the Banks and (2) detailed wire transfer records concerning the deposits into and withdrawals from the CMB and ICBC accounts.


PITMAN, Magistrate Judge The principal issue to be resolved is whether the

Banks’ production through the MOJ has been so limit- ed that resort to the Hague Convention process can be characterized as futile. Although the Banks’ document production has been more limited than it would have been under the Federal Rules of Civil Procedure, I

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240 part 2 Business: Its Regulatory Environment

cannot conclude that it is so limited that the process has been futile.

The Banks, through the MOJ, have unquestionably produced relevant, responsive documents. In addition, although the MOJ took approximately nine months to respond to the Hague Convention request, this period is not inordinately long given the delays inherent in international discovery proceedings. Although I am not aware of any statistical compilations, based on my experience as a Magistrate Judge, China’s nine-month response time is, at most, only slightly longer than the response time I have seen in other cases involving Hague Convention requests; it is not so long that the process can be described as futile.

Second, the scope of the Banks’ production has not been so narrow that resort to the Convention can fairly be described as futile. The account holders’ identities and addresses have been identified as well as transaction histories. Plaintiffs’ argument that addi- tional documents concerning transfers into and out of the accounts will lead to a fuller understanding of the trademark counterfeiting operation is extremely speculative. While I understand plaintiffs’ desire to identify the source of the counterfeit merchandise, the bank transfer information they are seeking will be at, at most, a small step that may or may not lead to that goal. In an effort to frustrate detection and tracing, many domestic transactions in illegal or contraband merchandise are conducted in cash. The possibility that individuals in China who deal in counterfeit trade- marked jewelry follow a similar practice is a further reason to believe that additional bank transaction doc- uments will not provide fruitful information.

Finally, the fact that the MOJ China takes a narrow- er view concerning the appropriate scope of pretrial dis- covery does not render the Hague Convention process futile. The high cost of discovery in federal litigation is well known, and the fact that another sovereign chooses to take a more restrictive view of the appropriate scope of pretrial discovery is not unreasonable. In addition, as

noted above, China is not unique in reserving its right to limit production in response to a Hague Convention request to documents that it considers to bear a direct and close connection with the litigation; many other countries have made the same reservation.

Absent extraordinary circumstances, it would not comport with considerations of “practicality and wise administration of justice” for the courts of one nation as a matter of course to sit in judgment of the adequacy of due process and the quality of justice rendered in the courts of other sovereigns. There can be no room for arrogance or presumption, or for extravagant rules or practices that may encourage insularity or chauvinism rather than respect for comity. It cannot be the proper province of any one judge in any one country, giving expression to the push of a moment or the pull of the immediate case, to promulgate judgments that impose that court’s rule and will across all sovereign borders so as to reach the rest of humankind.

Concluding that the broad scope of Federal Rules discovery is the only fair manner in which to conduct discovery would be “the essence of sanctimonious chauvinism.”

In summary, resort to the Hague Convention here has not proven futile. Although China, pursuant to its reservation of rights under the Convention, has not produced all the documents that would be required under the Federal Rules of Civil Procedure, its produc- tion is sufficient for plaintiffs to continue their investi- gation concerning the counterfeit goods at issue in their subpoenas against the Banks’ New York branches is, therefore, denied.


1. What information was provided by the Chinese government?

2. What did Tiffany hope for?

3. Why will the court not issue subpoenas to the Chinese government?

7-5b antitrust Laws in the International Marketplace

All U.S. firms are subject to the antitrust laws of the United States, regardless of where their operations and anticompetitive behavior may occur. Firms from other countries operating in the United States or engaging in trade that has a substan- tial impact in the United States are also subject to U.S. antitrust laws. These firms are not covered under the act of state doctrine because they are not governmen- tal entities and are engaging in commercial activity. Likewise, U.S. firms that are operating in other countries are subject to those countries’ antitrust laws. For example, several major U.S. corporations have faced stiff antitrust penalties from the EU. In 2013, Microsoft was required to pay a $732 million penalty to the EU

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Chapter 7 International Law 241

for its failure to comply with an earlier EU order on its anticompetitive behav- ior related to its browser. Citing a technical error, Microsoft took full responsibil- ity for its conduct and apologized for failing to give European consumers their choice of Web browsers on about 15 million copies of the Windows 7 operating system that the company had shipped to them. Although Google was able to set- tle its antitrust suit with the U.S. government, it still has to work through the same allegations with the EU. The distinction between the U.S. case and that in the EU is Google’s higher market share because phones in Europe are more likely to run Google’s Android system, something that gives Google 90% of the market in EU nations.

U.S. firms seeking to merge with competitors must obtain approval from both the U.S. Department of Justice and the EU. Microsoft and GE have been limited in their acquisitions in the EU because of EU antitrust provisions. Generally, if the EU does not approve a merger, the firms drop their plans because it is unlikely they will receive approval from the United States.

The converse is also true. Firms outside the United States may enjoy the pro- tections and benefits of our antitrust laws and bring suit for violations if it can be established that the violations they are alleging had a substantial impact on trade in the United States.

The Export Trading Company Act of 1982 carved an exception to the antitrust laws for U.S. firms that combine to do business in international markets. Large U.S. firms that would otherwise be prohibited from merging for anticompetitive reasons are permitted to form export trading companies (ETCs) for the purpose of participating in international trade. The Justice Department approves applications for ETCs in advance, provided the applicants can demonstrate that the proposed joint venture will not reduce competition in the United States, increase U.S. prices, or cause unfair competition. ETCs such as Mobil and Exxon worked together to explore Siberian oil fields in a combination that would otherwise be prohibited both under the antitrust laws and for ongoing operations. These combinations allow effective negotiation of large foreign contracts. ExxonMobil is now one firm, a result of its joint drilling ventures.

In the United States, the U.S. Customs Service is responsible for developing the tariffs according to a tariff schedule and for enforcing the tariffs on imported goods. The tariff is based on the computed value of the goods coming into the country and is computed at the time of their entry. That computed value depends on how the goods are classified under the schedule. For example, if potato chips are classified as bread, they are tariff- or duty-free. If they are clas- sified as snacks, they carry a tariff. [Sabritas v U.S., 998 F. Supp. 1123 (Ct. Int’l Trade 1998)] The federal government has created a specialized court to handle the many disputes that arise over the application of the tariffs and the underly- ing classification of goods.

Competition may also be controlled by import restrictions, a resulting control on trade balance and prices. By limiting the amounts of certain products or prod- ucts from certain countries, supply and demand (and, through economic princi- ples, price) are affected. These nontariff regulations also control competition and the flow of goods across borders.

As noted earlier, some countries also limit exports, particularly of technologies to certain countries that could use them to harm others through, for example, the development of nuclear technology.

Exhibit 7.1 provides a summary of international law principles and doctrines.

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242 Part 2 Business: Its Regulatory Environment

Exhibit 7.1 The Treaties, Principles, and Statutes of International Law

North Atlantic Treaty North Atlantic Treaty Organization (NATO)

Treaty between U.S. and European nations that establishes a deployment of armed forces and security setup in Europe

Foreign Sovereign Immunities Act of 1976 U.S. statute that clarifies the immunity of foreign countries and officials from prosecution for crimes in the United States

Act of state doctrine (expropriation) Recognition of a foreign government’s actions as valid; U.S. courts may not be used to challenge another country’s actions, even toward U.S. citizens

Foreign Assistance Act of 1962 (Hickenlooper Amendment)

Authorization given to president to cut off aid to countries where U.S. citizens’ property has been taken by the government or regulated so as to deprive owner of use

Overseas Private Investment Corporation (OPIC) Federal insurer for U.S. companies’ investments in countries with low per capita income

Expropriation Act of a sovereign state in taking property from its citizens or businesses operating there

Repatriation Bringing back to your own country money earned on investments in other countries

Export Trading Company Act of 1982 Antitrust combination exemption for companies joining to compete in international markets

Maastricht Treaty Agreement that created European Union

General Agreement on Tariffs and Trade (GATT) Agreement among 150 countries to increase trade by reducing tariffs

North American Free Trade Agreement (NAFTA) Agreement among United States, Canada, and Mexico with the goal of tariff elimination

The Iran Threat Reduction and Syria Human Rights Act of 2012

Paris Agreement of 2015

U.S. law that requires company disclosures about business by them and affiliates in Iran and Syria

Agreement among 200 nations for reduction in the use of fossil fuels

7-5c Protections for Intellectual Property

Protections for intellectual property in the international marketplace are constantly undergoing refinements. Worldwide registration for patents, copyrights, and trade- marks are goals that are within reach as the mechanisms for administration are being put into place. Details on international protections are found in Chapter 15.

7-5d Criminal Law Protections

All persons and businesses present within a country are subject to that nation’s regulatory scheme for business as well as to the constraints of the country’s crimi- nal code. Compliance with the law is a universal principle of international business operations. Expulsion, fines, penalties, and imprisonment are all remedies avail- able to governments when foreign businesses break the law in a particular nation.

Often, the complexities of international operations produce layers of business organizations throughout the world. These layers are often necessary for individual countries and proper business structure under the law. The layers of organizations may provide opportunities for laundering of money, concealment of transactions, and

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Chapter 7 International Law 243

other complex transactions that can escape regulatory detection for a time. However, the activities are eventually discovered, and countries are cooperating more to be cer- tain the complexities of international business do not conceal illicit activities.

BiographySiemens: the Company that paid the Largest Fines ever for FCpa Violations

COUNtRY pROdUCt BRIBeS paId date

Russia Medical devices $55 million 2000–2007

Argentina Identity cards project $40 million 1998–2004

China High-voltage transmission lines $25 million 2002–2003

China Metro trains $22 million 2002–2007

Israel Power plants $20 million 2002–2005

Bangladesh Mobile telephone works $5.3 million 2004–2006

Venezuela High-speed trains $16.7 million 2001–2007

Russia Traffic control systems $0.75 million 2004–2006

Vietnam Medical devices $0.5 million 2005

China Medical devices $14.4 million 2003–2007

Nigeria Telecommunications projects €4.2 million 2003

Iraq Power station $1.7 million 2000

Italy Power station €6.0 million 2003

Greece Telecommunications €37 million 2006

Siemens is a German conglomerate that has been in business since 1847. It has three divisions: energy, health care, and industry. Siemens has 428,200 employees and operates in 190 countries. The above chart shows the countries where Siemens paid bribes for contracts in violation of the FCPA. The multination investigation of the company’s bribery activity resulted in Siemens agreeing to pay a fine that was the largest ever paid in the history of the FCPA.

Both the SEC and the U.S. Department of Justice (DOJ) were investigating Siemens. The two agencies concluded that Siemens had paid more than 4,283 bribes totaling $1.4 billion to government officials to secure contracts. The SEC concluded that the bribes resulted in the company obtaining $1.1 billion in profits.

The DOJ and Siemens AG reached an agreement to settle the company’s ongoing

violations. As a result of these violations, Siemens agreed to pay $800 million to the United States, a fine 20 times higher than the largest fine ever collected under the FCPA. Siemens also settled charges with 10 other countries and paid total fines of $5.8 billion. The SEC complaint (www.sec. gov) against Siemens cited the involvement of employees at all levels of the company and a culture that had long been at odds with the FCPA.

The company’s cooperation with the U.S. government since 2006, as well as its efforts to correct the violations, caused government officials to reduce the fine from $2.7 billion to $800 million. Siemens’s efforts to correct its culture included coop- erating with the government, turning over all documents it found, and replacing all but one officer and all board members.

Siemens did follow what is known as “the four-eyes principle” of internal control for the FCPA, meaning all payments required two signatures. How- ever, the company had made so many exceptions to the four- eyes principle that as a practical matter it was not in effect. Rules and processes in com- panies do protect the company. Exceptions should be rare, if ever.

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244 part 2 Business: Its Regulatory Environment

s u m m a r y What laws affect businesses in international trade?

• Foreign Sovereign Immunities Act of 1976

• Foreign Assistance Act of 1962 (Hickenlooper Amendment)

• Overseas Private Investment Corporation (OPIC)

• Export Trading Company Act of 1982

• Contracts for the International Sale of Goods (CISG)

What treaties, agreements, practices, and principles affect international business and trade?

• North Atlantic Treaty

• North Atlantic Treaty Organization (NATO)

• Maastricht Treaty

• General Agreement on Tariffs and Trade (GATT)

• North American Free Trade Agreement (NAFTA)

• International Monetary Fund (IMF)

• Duties, quotas, tariffs—controls on prices and quantities of goods by nations with the goal of balancing imports and exports

• Foreign Corrupt Practices Act (FCPA)—controls on means of accessing governments

• The Iran Threat Reduction and Syria Human Rights Act of 2012

What principles of international law affect business?

• Sovereign immunity—freedom of one country from being subject to orders from another country

• Expropriation; act of state doctrine—recognition by U.S. courts of the actions of other governments as valid despite noncompliance with traditional U.S. rights and procedures

• Repatriation—returning profits earned in other coun- tries to one’s native land

• Conflict of laws—issue as to which country’s law applies in international transactions

• Antitrust issues

• Forum non conveniens—doctrine requiring dismissal of cases that should be heard in another country’s courts

What protections exist in international competition?

• Antitrust laws

• Protections for intellectual property

• Criminal law protections

Q u e s t i o n s a n d P r o b l e m s 1. Tom Welch and Dave Johnson, two officials of the Salt Lake City Olympic Committee, were charged with bribery and racketeering for their alleged role in paying money to and giving rather large gifts to members of the International Olympic Committee (IOC) in order to win the bid for holding the winter Olympics in Salt Lake City in 2002. Salt Lake City did win the bid, but an anonymous letter to the IOC revealed that these types of payments and gifts had been offered. Following an investigation, nine mem- bers of the IOC were removed or resigned and others were sanctioned. The Salt Lake City Olympic Commit- tee removed Mr. Welch and Mr. Johnson and replaced them with Mitt Romney as the head of its committee. Utah declined prosecution under state law, and a fed- eral district court judge dismissed the charges against Mr. Welch and Mr. Johnson. The U.S. Attorney for the case filed an appeal with the tenth circuit federal court of appeals asking that the charges be reinstated. He

noted that the Olympics were an “international” event and mandated federal jurisdiction. He also argued in the brief that the payments, accommodations, and gifts were more than goodwill and amounted to brib- ery in violation of federal law.

Applying the cases and law presented in the dis- cussion on the FCPA, determine whether there was or was not a violation of federal law. What jurisdiction do federal courts have over criminal charges? Describe the appellate process and what an appellate court can do in an appeal such as this. [U.S. v Welch, 327 F.3d 1081, at 1085 (10th Cir. 2003)]

2. Suppose that the government of Brazil took posses- sion of the cacao farms of a chocolate factory owned by a U.S. firm. What rights would the U.S. factory have? What limits exist on those rights?

3. A Philip Morris subsidiary, C. A. Tabacalera National, and a B.A.T Industries subsidiary known

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Chapter 7 International Law 245

as C. A. Cigarrera Bigott entered into a contract with La Fundacion del Nino (the Children’s Foundation) of Caracas, Venezuela. The agreement was signed on behalf of the foundation by the foundation’s presi- dent, who also was the wife of the then–president of Venezuela. Under the terms of the agreement, these two tobacco firms were to make periodic donations to the Children’s Foundation totaling $12.5 million. In exchange, the two firms would receive price con- trols on Venezuelan tobacco, elimination of controls on retail cigarette prices in Venezuela, tax deductions for donations, and assurances that the existing tax rates applicable to tobacco companies would not be increased.

Is the donation to the charity a violation of the FCPA? [Lamb v Philip Morris, Inc., 915 F.2d 1024 (6th Cir. 1990; cert. denied, 498 U.S. 1086 (1995))]

4. In 1973, Chevron and Ecuador signed an agreement allowing Chevron to develop Ecuadorian oil fields in exchange for providing below-market oil to the Ecuador- ian government. The deal was set to expire in 1992, and the parties were unable to agree to an extension. Chevron filed several breach of contract suits against Ecuador. In 1995, Chevron and Ecuador signed a settlement agree- ment conclusively terminating all rights and obligations between the parties. The agreement provided for the con- tinuation of the pending lawsuits.

In 2006, Chevron commenced an international arbitration action before a three-member tribunal based out of The Hague, claiming that Ecuador had violated the contract terms by failing to resolve its lawsuits in a timely fashion. Ecuador objected to the tribunal’s jurisdiction, arguing that it had never agreed to arbitrate with Chevron as well as asserting its sovereign immunity. Who has jurisdiction here? Discuss the sovereign immunity claim. What lessons should companies take away from these types of for- eign contracts? [Chevron v Republic of Ecuador, 795 F.3d 200 (D.C.C. 2015)]

5. James H. Giffen, owner of Mercator Corporation, a New York company, made $78 million in payments to two government officials in Kazakhstan. He was charged with violations of the Foreign Corrupt Prac- tices Act (FCPA). Giffen moved to have the charges dis- missed because he had been named a counselor to the president of Kazakhstan and was immune from pros- ecution under the act of state doctrine. He also asked that the charges be dismissed because any payments he made to the officials were for facilitation and access and were not bribes for contracts with his company. Is he correct? Does the act of state doctrine apply? Did he bribe, or did he facilitate? [U.S. v Giffen, 326 F. Supp. 2d 497 (S.D.N.Y. 2004)]

6. United Arab Shipping Company (UASC) is a corpo- ration formed under the laws of Kuwait. Its capital stock is wholly owned by the governments of Kuwait, Saudi Arabia, the United Arab Emirates, Qatar, Iraq, and Bah- rain. No single government owned more than 19.33% of UASC’s shares, and the corporation was created by a treaty among the owner nations.

Three seamen who were injured while working for UASC brought suit against it in federal district court in the United States. UASC maintains it enjoys sovereign immunity. The seamen claim it is a com- mercial enterprise and not entitled to immunity. Who is correct? [Mangattu v M/V IBN Hayyan, 35 F.3d 205 (5th Cir. 1994)]

7. Smith & Smith, a U.S. computer firm, contracted to install a computer system for Volkswagen in the com- pany’s headquarters in Berlin, Germany. Smith’s con- tract included the following liability limitation: “We are only liable for loss of data which is due to a deliberate action on our part. We are not responsible for lost profits in any event.” The contract had no provisions on choice of law. A crash in the Smith & Smith system caused a loss of 92 days’ worth of financial data. Volkswagen was required to use its auditors to restructure the database at a substantial cost. Smith & Smith says it did nothing deliberate and, therefore, is not liable. Volkswagen cites German law that mandates protection by sellers against such losses and permits recovery of lost profits. U.S. law would honor the Smith & Smith clause. Which law applies? Why?

8. The Western oil firms once were the dominant play- ers in Kazakhstan, a Central Asian country that is rich in oil resources. However, the Justice Department indicted U.S. citizen James Giffen for allegedly making $80 mil- lion in payments to government officials in Kazakhstan on behalf of Mobil and other companies so that the com- panies could obtain drilling rights from the government. Giffen had the touch when it came to getting the oil com- panies access for drilling. Once Giffen was indicted, the Western oil firms’ drilling rights diminished substantially and the presence of Chinese oil firms increased. Many have pointed to this example, with direct causal con- nection between the elimination of U.S. firms and the increased presence of Chinese firms, as evidence that the FCPA puts U.S. firms and the U.S. economy at a distinct disadvantage to those countries that do not take enforce- ment action against bribery. How would you respond to this argument? Discuss the reasons behind the bribery statutes. (Nathan Wardi, “The Bribery Law Bracket,” Forbes, May 24, 2010, p. 70.)

9. The European Union has developed a directive on privacy and e-mail. Nations within the EU are permitted

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246 Part 2 Business: Its Regulatory Environment

to use e-mail for commercial transactions and can exchange information via e-mail. However, businesses from countries outside the EU will not be permitted access to EU business information and EDI systems for contracting purposes unless they can guarantee adequate privacy protections are in place for the data transmitted via e-mail. Most legal experts believe the EU privacy directive applies to all forms of transmissions in business, including commercial contracts and ordering information.

What would happen if a business tapped into an EU business and began entering into transactions without an adequate privacy guarantee? Would there be criminal sanctions? Trade sanctions? How does this directive affect international trade with the EU? The EU has provided that trading privileges can be with- drawn from countries with businesses that violate the privacy standards on e-mail information and data transmission. What happens when trading privileges are withdrawn? Is the EU directive a commercial con- trol of trade?

10. Walid Azab Al-Uneizi was an employee of the Ministry of Defense of Kuwait. Liticia Guzel was an

employee of the Willard Inter-Continental Hotel in Washington, D.C. One of her duties was restocking minibars in guest rooms. Al-Uneizi approached Miss Guzel outside Rooms 610 and 612 and conferred with her about restocking Room 612. After Miss Guzel fin- ished restocking Room 612, Al-Uneizi assaulted and raped her. After the rape, Al-Uneizi gave her a Kuwaiti flag pin. Miss Guzel has brought suit against both Al-Uneizi and the Kuwaiti government, who seek a dis- missal under the act of state doctrine. Should the case be dismissed against both? [Guzel v State of Kuwait, 818 F. Supp. 6 (1993)]

11. When the Barings Bank bankruptcy occurred in 1995, Nick Leeson, the trader responsible for the immense losses the bank experienced after heavy derivative investments, fled to Germany. He was brought back to Hong Kong, the site of his trades, for trial. He is a Brit- ish citizen who was arrested in Germany. Describe all the principles and issues of international law involved in his arrest, return to, and eventual trial in Singapore. (Note: Mr. Leeson has been released from prison and now lives in Ireland.)

Strategy, Ethics, & the Law Why Recovery from Bribery Charges Is So Difficult

The SEC complaint in the Siemens case (see p. 243) notes how many “red flags” the board ignored in the years during which the bribery was occurring. Since 1999, when Germany signed on to the anti-bribery provisions of the OECD, Siemens executives had been concerned about the company’s involvement in bribery around the world. The CEO at the time of the OECD adoption voiced concern to the board about the number of executives who were under investigation by the German government for bribery activities. He asked the board to take protective measures because its members could be held responsible for inaction. Despite his plea, the bribes continued, with support from some board members.

In 2001, the general counsel for the NYSE board notified its board members that in order for the com- pany to meet U.S. standards for its new NYSE listing, it needed to end its practice of having off-the-books accounts for the payment of the bribes. The company

took no steps to investigate or end its practices. The SEC noted there was a stunning lack of internal controls as well as a tone at the top that did not take the FCPA seriously.

What should Siemens have done? Explain the following quote from a Justice Department official: “Crimes of official corruption threaten the integrity of the global marketplace and undermine the rule of law in host countries.”3 What does the quote mean?

Siemens’s new CEO has said that it will take time for the company to recover because it was so depen- dent on such a facile business model. He explains that the company lost the skill sets of negotiating contracts, competing for projects, and submitting effective proposals. What lessons should compa- nies learn from this observation about reliance on bribery?

For more information, the full Siemens complaint can be found at

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Chapter 7 International Law 247

n ot e s 1. The OECD member countries include Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.

2. OECD also has relationships with 70 countries and NGOs.

3. Siri Schubert and T. Christian Miller, “Where Bribery Was Just a Line Item,” New York Times, December 21, 2008, pp. SB1, SB6–7.

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Business Crime8 The term “white-collar crime” was coined by Edwin Sutherland in a speech he gave to the American Sociological Society in 1939. He defined “white-collar crime” as “[c]rime committed by a person of respectability and high social status in the course of his occupation.” Since that time, the term white-collar crime has evolved to include a wide variety of crimes, but it, along with corporate fraud and public corruption, is among the FBI’s top priorities for their criminal investi- gations and prosecution referrals. Everything from sports memorabilia fraud to adoption scams to Medicare fraud are on the list of the scams, operations, and activities that are tackled at the state and federal levels each year.

Every businessperson is expected to know and understand the types and nature of business crimes. This chapter offers that background by answering the following questions: Why does business crime occur? Who is liable for crimes committed by businesses? What penalties are imposed for business crimes? What are the rights of corporate and individual defendants in the criminal justice system?

Update For up-to-date legal and ethical news, go to

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8-1 What Is Business Crime? The Crimes within a Corporation

8-1a Financial Fraud: employees Manipulating earnings Numbers

Many business crimes are committed because companies apply pressure to man- agers and employees to produce results. Economic pressure often leads managers to cross ethical and legal lines. Managers feel compelled to meet earnings goals or to reach incentive bonus plan figures, and then they pass along the pressure they feel to employees. The drive to succeed or present a good earnings record can lead many managers and employees into committing crimes on behalf of the corpora- tion. These crimes might not directly line employee pockets. The business bene- fits, and then employees benefit indirectly through profit sharing, salary increases, bonuses, or just being able to keep their jobs.

For example, in January 2004, Andrew Fastow, the former CFO of the collapsed and bankrupt energy company Enron, entered a guilty plea to two counts of con- spiracy to commit securities and wire fraud. His wife, Lea Fastow, pleaded guilty to filing a false joint tax return. Mr. Fastow was the mastermind behind the cre- ation of off-the-books partnerships to which Enron’s substantial debt was trans- ferred. The result was that Enron’s financial reports made the company seem healthy because, under accounting rules that existed at that time, the debt in the entities, which included Mr. and Mrs. Fastow as principals and officers, did not have to be reported on Enron’s financial statements. The Fastows and other offi- cers, including 26 executives who were indicted, have all explained that they were simply trying to meet projected earnings statements so that they could preserve shareholder value and share price on the market. As he testified against his former boss, former Enron CEO Jeffrey Skilling, Mr. Fastow said, “I thought I was being a hero for Enron. At the time, I thought I was helping myself and helping Enron to make its numbers.”

Forensic accounting has been labeled “the most secure job in America” because these individuals are trained to detect fraudulent conduct within companies, whether perpetrated by a management team driven to achieve

I hope no one is taping this. An Amgen mAnAger At A SAleS meeting A fellow employee/whistle-blower was taping it; Amgen paid a $762 million fine for the illegal marketing practices covered in the meeting and later used by the company’s sales force.

Mordechay Sasy owns M & H Used Auto Parts & Cars, Inc. (defendants), a vehicle dismantling business, located in Queens County, New York. Between January 1999 and January 2000, the New York City Police Department conducted an undercover investigation of vehicle dismantling businesses. An undercover detec- tive posed as a scrap metal processor and purchased 166 “junked” vehicles from M & H. The detective discovered that there was oil and other chemicals on

the soil and a sump pump with oil slick was pumping liquids into the street sewers. Mordechay and M  & H were criminally charged for dumping waste into the waterways. Mordechay testified that he did not know that what went into the sewer ended up in any waterways and that he did not intend to violate the environmental laws. Does Mordechay have a defense to the environmental crime of dumping waste into waterways?

Consider . . . 8.1

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250 part 2 Business: Its Regulatory Environment

goals or by individual employees. In 2015, the FBI initiated 84 cases of finan- cial institution fraud, made 69 recommendations for prosecution of individ- uals in those institutions, had 73 indictments of executives and employees, and had 160 individuals sentenced for financial fraud. The average prison time served for financial fraud is 44 months, up from the 2013 average of 32 months.

8-1b Marketing Missteps: Sales Zeal and Crimes

A number of pharmaceutical firms have paid billions in fines for marketing techniques that crossed legal lines. The Food and Drug Administration (FDA) does not permit pharmaceutical firms to market prescription drugs for purposes other than their federally approved use. For example, AstraZeneca paid $520 million to settle federal charges related to its marketing of its antipsychotic drug Seroquel to doctors for prescriptions for children and the elderly when the drug was not approved for use with children or the elderly. In addition, AstraZeneca inter- nal e-mails indicated its awareness that the drug resulted in weight gains and possible development of diabetes, information that was not disclosed to those who were taking Seroquel. Eli Lilly, Bristol-Myers Squibb, Johnson & Johnson, and Pfizer together paid over $6 billion in fines for similar marketing missteps. Salespeople, particularly in the pharmaceutical industry, must be supervised carefully because criminal lines are crossed quite easily in the zeal for more sales.

8-1c Friendly Fire: employee theft

In addition to pressure to meet company goals, some individual employees feel personal financial pressure and resort to embezzlement as a means of remedying their own bleak financial positions. Employee theft is estimated at $50 billion annu- ally. The Association of Certified Fraud Examiners estimates that 37.5% of employ- ees have stolen at least twice from their employers. Walmart loses $3 billion each year to employee theft. In February 2013, Penny Winters, a 63-year-old mainte- nance worker at Walmart, was arrested for felony theft because she was caught on camera eating Oreos and other snacks as she worked her third shift at a Walmart store. She had eaten so much snack food that her charges rose to the felony level of theft. Sarbanes–Oxley imposes requirements (see Chapter 18 for additional infor- mation) for internal control certifications so that companies have adequate systems for detecting embezzlement.

Small businesses have higher employee theft costs because they cannot afford the sophisticated monitoring measures that larger corporations adopt. Most employee theft is systematic. For example, Aramark, a company that specializes in vending machine sales, reported that employees had skimmed millions in revenue by underreporting sales, ever so slightly over a period of time, in its cash/coin business. Employee theft has the hallmark of small amounts taken over a period of time with well-planned and -executed schemes. For example, employees of an air- craft plant filled their pockets with nuts and bolts each day at the end of the shift. Over time, the employees had accumulated enough hardware to fill kegs, which were then sold. Garment workers for apparel manufacturers have gone home with jeans in their purses.

Exhibit 8.1 provides a partial list of the companies and business executives that have had encounters with laws, regulators, and courts.

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Chapter 8 Business Crime 251

Exhibit 8.1 a Roster of Wrongdoing

COMpaNY/peRSON ISSUe StatUS Boeing (2003) Charges of illicit use of competitor’s

proprietary documents; charges of recruiting government official

Loss of 7 government contracts worth $250 million; $615 million fine; guilty plea by official who was wooed; 9-month sentence

Countrywide Mortgage (2009) Insider trading; securities fraud Former CEO Angelo Mozilo charged with insider trading, CFO and COO charged with failure to disclose firm’s relaxed lending standards; settled case for fines

Andrew Fastow, former CFO of Enron (2004)

Multi-million-dollar earnings from serving as principal in SPEs (Special purpose entities) of Enron created to keep debts off the company books

Entered guilty plea to securities and wire fraud; sentenced to 6 years; helped plaintiffs in shareholder suits

Lea Fastow (2004) Filing false income tax return Guilty plea; sentenced to 5 months in prison and 5 months of house arrest

Jeffrey Skilling, former CEO of Enron (2004)

Questions about his role in the Enron fraud; resigned just prior to company’s collapse

Found guilty of securities fraud and sentenced to 24.4 years; U.S. Supreme Court partially reversed his conviction on honest services fraud; sentence reduced to 14 years

Galleon Group (2011) Insider trading charges related to hedge fund’s operations

23 executives, including CEO, convicted or entered guilty pleas; Galleon’s $3.7 billion fund liquidated; CEO (Raj Rajaratnam) sentenced to 11 years; a Goldman Sachs director (Rajat Gupta) also convicted of insider trading and sentenced to 2 years in prison for feeding information to Rajaratnam

HealthSouth (2003) $2.7 billion accounting fraud; overstatement of revenues

16 former executives indicted; 5 guilty pleas

Richard Scrushy, CEO of HealthSouth (2003)

85 federal felony counts, including violations of Sarbanes–Oxley financial certification provisions

Acquitted of financial fraud charges; found guilty of bribery and sentenced to 7 years

Martha Stewart, CEO of Martha Stewart Omnimedia and close friend of Sam Waksal (2003)

Sold 5,000 shares of ImClone one day before public announcement of negative FDA action on Ebritux

Convicted of making false statements and conspiracy; served 5 months in prison, 5 months of home confinement, and 2 years of probation; fine of $30,0000

KMPG (2006) Tax shelter fraud Settled with federal regulators by payment of $456 million penalty

Sotheby’s (2003) Price-fixing Chairman given 1 year and 1 day in prison and a $7.5 million fine; CEO placed under house arrest for 1 year

WorldCom (2003) Accounting issues centered on swaps— selling to other telecommunications companies and hiding expenses, thereby overstating revenue

WorldCom emerged from bankruptcy as MCI; four officers and managers entered guilty pleas; CEO Bernard Ebbers convicted and sentenced to 25 years


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COMpaNY/peRSON ISSUe StatUS Bernie Madoff (2009) $50 billion Ponzi scheme Entered guilty plea to all charges; sentenced

to 150 years (was 71 years old at time of sentencing); direct reports convicted

BP (2013) Violation of Clean Air Act; willful failure to correct OSHA violations; manslaughter and obstruction

$50 million fine to EPA; $58 million fine to OSHA (largest in U.S. history) for pre– Deepwater Horizon explosion; $4 billion for crimes related to Deepwater Horizon explosion; $20 billion civil penalty

Stanford Securities (2012) $9 billion Ponzi scheme CEO convicted of mail, wire, and securities fraud and sentenced to 110 years; Laura Pendergest-Holt, the former chief investment officer, entered a guilty plea and was sentenced to 3 years; CFO entered a guilty plea

Massey Coal (2016) Mine collapse resulting in the deaths of 29 miners

3 company officials entered guilty pleas, and one was convicted of charges related to tipping off employees on mine inspections and destroying records to avoid government review; former CEO convicted of violating mine safety rules

Peanut Corporation of America (2016)

Indictments for producing and selling product without cleaning up salmonella issue at plant and falsifying tests that showed the salmonella was gone when it was not

Four company officers, including owner and CEO, convicted of fraud and conspiracy; food broker also indicted for his role in test falsification; CEO sentenced to 28 years, food broker to 20 years

GM (2015) Guilty plea to criminal mishandling of defective ignition switch

$900 million fine

SAC Capital (2014) Insider trading charges; use of advance information from pharmaceutical trials

Settled charges for $600 billion fine; 11 former and current employees convicted of or entered guilty pleas to insider trading

8-2 What Is Business Crime? The Crimes against a Corporation

Interbusiness crime occurs among competitors and results in one business gain- ing a competitive advantage over others. The list of companies and misdeeds in Exhibit 8.1 provides examples of the wide variety of business crimes committed, from kickbacks to antitrust violations to securities fraud to OSHA and EPA viola- tions to obstruction.

Once again, competitive pressure led to these types of crimes. Employees within one company postponed necessary safety fixes so as to correct OSHA viola- tions in order to contain costs and remain competitive. However, as the remainder of the chapter shows, any competitive advantage gained through criminal activity is only temporary.

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Chapter 8 Business Crime 253

8-3 Who Is Liable for Business Crime? One of the major differences between nonbusiness and business crimes is that more people can be convicted of business crimes. For nonbusiness crimes, only those involved in the planning or execution of the crime or assistance after it is committed can be convicted. In other words, those who were in any way involved in the criminal act or aftermath are criminally responsible. For business crimes, on the other hand, those in management positions at firms whose employees actu- ally commit criminal acts can be held liable if they authorized the conduct, knew about the conduct but did nothing, or failed to act reasonably in their supervisory positions. Liability for crimes also extends to employees who participate with the company and its management in illegal acts. For example, employees who help their employers establish fraudulent tax shelters for customers can be held liable along with the company and its officers. The key to establishing criminal liability is showing personal knowledge of wrongdoing.

U.S. v Park (Case 8.1), a landmark case, discusses the liability standards for those who are in charge but may not themselves commit a criminal act.

United States v Park 421 U.S. 658 (1975)

Is Chasing Rats from the Warehouse in My Job Description?

Case 8.1


Acme Markets, Inc., was a national food retail chain headquartered in Philadelphia, Pennsylvania. At the time of the government action, John R. Park (respon- dent) was president of Acme, which employed 36,000 people and operated 16 warehouses.

In 1970, the Food and Drug Administration (FDA) forwarded a letter to Mr. Park describing, in detail, problems with rodent infestation in Acme’s Philadel- phia warehouse facility. In December 1971, the FDA found the same types of conditions in Acme’s Balti- more warehouse facility. In January 1972, the FDA’s chief of compliance for its Baltimore office wrote to Mr. Park about the inspection. The letter included the following language:

We note with much concern that the old and new ware- house areas used for food storage were actively and extensively inhabited by live rodents. Of even more con- cern was the observation that such reprehensible con- ditions obviously existed for a prolonged period of time without any detection, or were completely ignored.

We trust this letter will serve to direct your atten- tion to the seriousness of the problem and formally

advise you of the urgent need to initiate whatever mea- sures are necessary to prevent recurrence and ensure compliance with the law.

After Mr. Park received the letter, he met with the vice president for legal affairs for Acme and was assured that he was “investigating the situation imme- diately and would be taking corrective action.”

When the FDA inspected the Baltimore warehouse in March 1972, there was some improvement in the facility, but there was still rodent infestation. Acme and Mr. Park were both charged with violations of the Federal Food, Drug, and Cosmetic Act. Acme plead- ed guilty. Mr. Park was convicted and fined $500; he appealed based on error in the judge’s instruction, given as follows:

The individual is or could be liable under the statute even if he did not consciously do wrong. However, the fact that the Defendant is president and chief executive officer of the Acme Markets does not require a finding of guilt. Though he need not have personally participated in the situation, he must have had a responsible rela- tionship to the issue. The issue is, in this case, whether the Defendant, John R. Park, by virtue of his position in

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254 part 2 Business: Its Regulatory Environment

the company, had a position of authority and responsi- bility in the situation out of which these charges arose.

The court of appeals reversed Mr. Park’s convic- tion, and the government appealed.


BURGER, Chief Justice Central to the Court’s conclusion [in United States v Dotterweich, 320 U.S. 277 (1943)], that individuals other than proprietors are subject to the criminal provisions of the Act was the reality that “the only way in which a corporation can act is through the individuals who act on its behalf.”

At the same time, however, the Court was aware of the concern . . . that literal enforcement “might operate too harshly by sweeping within its condem- nation any person however remotely entangled in the proscribed shipment.” A limiting principle, in the form of “settled doctrines of criminal law” defining those who “are responsible for the commission of a misdemeanor,” was available. In this context, the Court concluded, those doctrines dictated that the offense was committed “by all who have . . . a respon- sible share in the furtherance of the transaction which the statute outlaws.”

The Act does not, as we observed in Dotter- weich, make criminal liability turn on “awareness of some wrongdoing” or “conscious fraud.” The duty imposed by Congress on responsible corporate agents is, we emphasize, one that requires the highest standard of foresight and vigilance, but the Act, in its criminal aspect, does not require that which is objec- tively impossible. The theory upon which responsible corporate agents are held criminally accountable for “causing” violations of the Act permits a claim that a defendant was “powerless” to prevent or correct the violation to “be raised defensively at a trial on the merits.” U.S. v Wiesenfield Warehouse Co., 376 U.S. 86 (1964). If such a claim is made, the defendant has the burden of coming forward with evidence, but this does not alter the Government’s ultimate burden of proving beyond a reasonable doubt the defendant’s guilt, including his power, in light of the

duty imposed by the Act, to prevent or correct the prohibited condition.

Turning to the jury charge in this case, it is of course arguable that isolated parts can be read as intimating that a finding of guilt could be predicated solely on respondent’s corporate position?. . . . Viewed as a whole, the charge did not permit the jury to find guilt solely on the basis of respondent’s position in the corporation; rather, it fairly advised the jury that to find guilt it must find respondent “had a responsible relation to the situation,” and “by virtue of his position . . . had authority and responsibility” to deal with the situation. The situation referred to could only be “food . . . held in unsanitary conditions in a warehouse with the result that it consisted, in part, of filth or . . . may have been contaminated with filth.”

Park testified in his defense that he had employed a system in which he relied upon his subordinates, and that he was ultimately responsible for this system. He testified further that he had found these subordinates to be “dependable” and had “great confidence” in them.

[The rebuttal] evidence was not offered to show that respondent had a propensity to commit criminal acts, that the crime charged had been committed; its purpose was to demonstrate that respondent was on notice that he could not rely on his system of delega- tion to subordinates to prevent or correct unsanitary conditions at Acme’s warehouses, and that he must have been aware of the deficiencies of this system before the Baltimore violations were discovered. The evidence was therefore relevant since it served to rebut Park’s defense that he had justifiably relied upon sub- ordinates to handle sanitation matters.



1. What problems did the FDA find in the Acme warehouses, and over what period?

2. Was Mr. Park warned about the problem? What action did he take?

3. What standard of liability did the instruction given by the judge impose?

8-4 Federal Laws Targeting Officers and Directors for Criminal Accountability

8-4a White-Collar Crime’s Origins and History

With each wave of accounting and fraud scandals, new legislation at the federal level has increased penalties for those who are the masterminds of white-collar

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Chapter 8 Business Crime 255

crimes. In 1988, following the Michael Milken junk-bond era and the Ivan Boesky insider trading scandal, Congress passed additional laws against and sanctions covering insider trading in the Insider Trading and Securities Fraud Enforce- ment Act of 1988 (ITSFEA) (see Chapter 18 for more information). Criminal and civil penalties increased at least 10-fold under the law. In 1990, Congress enacted what has been called the “white-collar kingpin” law. A response to the 1980s and 1990s savings and loan scandals and the 2000 dot-com and 2008 financial mar- ket collapses, the law imposes minimum mandatory sentences (10 years in most instances) for corporate officers who mastermind financial crimes such as bank and securities fraud.

8-4b Sarbanes–Oxley (SOX)

Following the collapses of Enron, WorldCom, Adelphia, and others in the period from 2001 to 2002, Congress passed Sarbanes–Oxley, also known as the White-Collar Criminal Penalty Enhancement Act of 2002. Under SOX, as it is known among businesspeople, penalties for mail and wire fraud, which had a former maximum of five years, have been increased to 20 years in prison. (Refer to Exhibit 8.1 to see the number of wire and fraud charges that have been brought against executives.)

The Drug Enforcement Administration (DEA) issued a suspension order that revoked the controlled medication licenses of two phar- macies because the pharmacies were filling prescriptions for oxycodone (the painkiller) in excess of their monthly allowances for controlled substances. The DEA cited its findings that two pharmacies in a city of only 53,570 residents were alone dispensing over 8 million dosage units over an approximately three-year period. In addition, the DEA is- sued its findings that the pharmacies’ corpo- rate entities failed to conduct on-site inspec- tions and also failed to notice that 42% to 58% of all the sales of the substances were cash sales, a red flag in the sale and distri- bution of controlled substances. Also, the number of prescriptions filled continued to escalate—increasing ninefold in one year to more than 2 million dosages dispensed.

When investigators were present on- site at one of the pharmacies, every third car going through the drive-thru pickup was receiving a prescription for oxycodone. Those using the drive-thru also used “street slang” for requesting certain brands of oxy- codone. Pharmacists at the drugstores, in interviews with the DEA agents, indicat- ed that the customers paying cash for the

oxycodone were “shady” and that they sus- pected that some of the prescriptions were not valid. [Holiday CVS, L.L.C. v Holder, 839 F. Supp. 2d 145 (D.D.C. 2012)]

The shipment of oxycodone to the phar- macies was five times the amount that would have been within normal bounds for the pop- ulation in the area. Many patients living at the same address had the same prescriptions for oxycodone from the same doctor.

The two pharmacies filed suit in federal district court to have the suspension order lifted, but the appellate court upheld the actions of the DEA. [Holiday CVS, L.L.C. v Holder, 493 Fed. Appx. 108 (C.A.D.C. 2012)] Both companies, CVS and Cardinal Health, have indicated in court filings that they have changed their practices and provided train- ing to pharmacy personnel so that they can spot these types of illegal prescriptions and report suspicious activity.

However, the DEA seeks to hold the corporations responsible because of the lack of on-site presence and the failure to follow the numbers for sales and distribu- tion at the pharmacies. Can the corporation be held liable when it was not actual- ly participating in the distribution of the oxycodone?

Consider . . . 8.2

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Penalties for violation of the trust, reporting, and fiduciary duties under pen- sion laws increased from one year to 10 years, with fines increasing from $5,000 to $100,000. SOX also provides for the specific crime of false financial statement certification, a crime directed at CEOs and CFOs, who are now required to certify the financial statements issued by their companies. Top officers who certify finan- cial statements that they know contain false information now face being charged with a specific federal crime because of SOX reforms. Richard Scrushy, the former CEO of HealthSouth, became the first CEO charged with a violation of these new provisions. Mr. Scrushy was acquitted of all financial fraud charges but was later convicted of bribery in connection with payments he made to the ad campaign funds of the governor of Alabama. Mr. Scrushy is currently serving a seven-year sentence.

8-4c Honest Services Fraud

Following the Boesky and Milken scandals, part of the 1988 federal reforms included a 28-word addition to the federal mail and wire fraud statutes that provided, “For the purposes of this chapter, the term, scheme or artifice to defraud includes a scheme or artifice to deprive another of the intangible right of honest services.” (18 U.S.C. § 1346) The provision lay fallow for some time until the Enron era of company failures attributable to accounting fraud by officers. Prosecutors began adding so-called honest services fraud charges to mail and wire fraud as a way to obtain harsher sentences for the white-collar criminals. Conviction on this charge requires proof that the activities of the officers deprived the shareholders of the corporation of the honest services to which they were entitled as beneficiaries of the officers’ fiduciary duties. Conrad Black, Richard Scrushy, and Jeffrey Skilling all received longer sentences because they were convicted of honest services fraud. However, the U.S. Supreme Court held in Skilling v U.S., 561 U.S. 358 (2010), that this portion of the mail and wire fraud statute was void for vagueness in the way prosecutors were using it for convictions and pleas (see substantive due process in Chapter 5). The court held that company officers would not know when and how they had violated the law because this portion of the statute was being applied when anything went wrong in the company. In other words, it was difficult to know what conduct deprived shareholders of officers’ “honest services.” The court held that the statute could be applied to the conduct of officers only in those sit- uations in which officers accepted bribes or kickbacks so that they breached their fiduciary duties to shareholders and deprived them of the honest services officers are required to provide. There must be an underlying conflict created by a bribe or a kickback for the statute to apply. This significant decision curbed the govern- ment’s flexibility in prosecuting white-collar crime and resulted in a reduction in sentences for Messrs. Black and Skilling and other white-collar criminals serving their sentences at the time of the decision.

8-4d Financial Services Crimes and Reforms

Following the 2008 collapses and near-collapses of so many investment firms, banks, insurers, and mortgage lenders, Congress passed the Financial Services Reform Act, also known as the Dodd–Frank Wall Street Reform and Consumer Protection Act. The act creates a Bureau of Consumer Financial Services (CFSB) (see Chapter 11 for more information) that can impose civil penalties and also refer cases to the Department of Justice for criminal prosecution for violations of

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Chapter 8 Business Crime 257

disclosure requirements or misrepresentations related to financial transactions. The act covers brokers, insurers, mortgage lenders, investment firms, banks, and any company that provides consumer financial services, including additional dis- closure requirements as well as prohibitions on predatory lending.

8-4e Other Business Crimes and White-Collar liability

There are other federal statutes that impose liability on CEOs and other executives when harm results. For example, Midnight Rider director Randall Miller was sen- tenced to two years in prison based on alleged violations of OSHA rules during the filming of that movie. One crew member lost her life when she was struck by a train while setting up a shoot on a narrow trestle of a railway in Georgia. Criminal liability for those in charge at a company or at a movie shoot can be held criminally liable for the failure to follow OSHA rules, obtain clearance for the location shoot, or not taking proper precautions in setting up a scene. In the Miller case, the alle- gations were that the focus was on the artistic aspects of getting a good shot and not on issues such as safety measures and permissions for use of the trestle. CEOs of mining companies and food processors have been convicted of crimes related to safety issues as well as compliance with various federal standards for production.

8-5 The Penalties for Business Crime Statutes specify penalties for crimes. Some statutes have both business and indi- vidual penalties. Exhibit 8.2 provides a summary of the penalties under the major federal statutes.

8-5a New penalties and New processes

Some regulators and legislators argue that the difficulty with most criminal law penalties is that they were instituted with “natural” persons in mind, as opposed to “artificial” corporate persons. Fines may be significant to individuals, but a $10,000 fine to a corporation with billions in assets and millions in income is sim- ply a cost of doing business.

A recommendation advanced for the reformation of criminal penalties is that the penalties must cost the corporation as much as a bad business decision would cost. For example, if a company develops a bad product line, net earnings could decline 10% to 20%. Penalties expressed in terms of net earnings, as opposed to set dollar amounts, are more likely to have a deterrent effect on business criminal behavior.

8-5b Corporate Integrity agreements (CIas)

Using a corporate integrity agreement (CIA), judges are able to, in effect, place cor- porations on probation. Under CIAs, companies are assigned monitors who are on-site and follow up to be sure the company is not committing any further viola- tions. Most CIAs include requirements that the company create or improve its eth- ics and compliance program, something that can include additional staffing and mandatory training for all employees. A CIA is a form of a deferred prosecution agreement (DPA). If the corporation has no further violations during the time of the CIA, which is generally three to five years, then the CIA is lifted and prosecu- tors do not go forward with a criminal case against the company.

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Exhibit 8.2 penalties for Business Crime under Federal law

aCt peNaltIeS

Internal Revenue Code

26 U.S.C. § 7201

$100,000 ($500,000 for corporations) and/or 5 years

For evasion (plus costs of prosecution as well as penalties and assessments: 5–50%)

Sherman Act (antitrust)

15 U.S.C. § 1

$350,000 and/or 3 years; $10,000,000 for corporations




15 U.S.C. § 1341

(document destruction, concealment, alteration, mutilation during pending civil or criminal investigation)

20 years plus fines

(25 years for perjury)


(certification of financial statements)

$1,000,000 and/or 10 years

If willful: $5,000,000 and 20 years; officers who earn bonuses based on falsified financial statements must forfeit them

1933 Securities Act

15 U.S.C. § 77× (as amended by Sarbanes–Oxley)

$100,000 and/or 10 years

Securities and Exchange Act of 1934 $5,000,000 and/or 20 years

15 U.S.C. § 78ff $25,000,000 for corporations

Civil penalties in addition of up to three times profit made or $1,000,000, whichever is greater

Clean Air Act

42 U.S.C. § 7413

$1,000,000 and/or 5 years

Clean Water Act

33 U.S.C. § 1319

For negligent violations: $25,000 per day and/or 1 year

For knowing violations: $50,000 per day and/or 3 years

For second violations: $100,000 per day and/or 6 years

For false statements in reports, plans, or records: $10,000 per day and/or 2 years

Occupational Health Safety Act

29 U.S.C. § 666

Willful violation causing death: $70,000 and/or 1 year; minimum of $5,000 per willful violation

Giving advance notice of inspection: $1,000 and/or 6 months

False statements or representations: $10,000 and/or 6 months

Consumer Product Safety Act

15 U.S.C. § 2070

$50,000 and/or 1 year

Tampering: up to $500,000 and/or 10 years

Monitors One portion of a corporate integrity agreement is generally the assignment of monitors to corporations to follow up on corporate activity. Monitors have offices within the corporation and are permitted to attend meetings, make observations, and provide feedback. The monitors are also there to report back to prosecutors

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Chapter 8 Business Crime 259

any missteps. For example, ConEd was assigned a Natural Resources Defense Council lawyer as a monitor for its asbestos activity. Although their cases were not criminal in nature, both Coca-Cola and Mitsubishi agreed to a panel of monitors as part of their settlements in civil discrimination cases. America Online, Bank of New York, Blue Cross Blue Shield, Boeing, KPMG, and Monsanto are all examples of companies that have had monitors on-site as part of their criminal CIAs.

8-5c Criminal Indictments of Corporations on Common law Crimes

Another recommendation for reforming criminal penalties requires corporations to stand criminally responsible under traditional criminal statutes for corporate wrongs. For example, when Ford Motor Company manufactured the Pinto auto- mobile with a design flaw involving the gas tank location, many civil suits were brought for deaths and injuries caused by the exploding gas tank. However, Ford was also indicted for a criminal charge of homicide. In 1999, the state of Florida charged ValuJet, Inc., with murder and manslaughter for carelessly handling deadly materials for shipment after an investigation showed that company pro- cedural omissions resulted in an airplane crash and the deaths of 110 passengers and the crew. A traditional common law crime was applied to corporations for the wrongful deaths of their customers. The owner of Imperial Foods Company in North Carolina pled guilty to workplace hazards that resulted in the burn deaths of 25 employees at his chicken-processing plant and received a 19-year prison sen- tence. Even though the crimes with which he was charged were violations of busi- ness laws, the sentence was traditional in the sense that an individual within a company was held personally and criminally responsible for the crimes.

8-5d Shame punishment

“Shame punishment” has been on the increase in corporate criminal cases. Shame punishment involves public disclosure of an offense. For example, a Delaware fed- eral judge ordered Bachetti Brothers Market to take out an ad for three weeks con- fessing to its crime of violating federal law by selling meat consisting “in whole or in part of filthy, putrid and contaminated substances.” Another federal judge, Ricardo Urbina, sentenced a former Bristol-Myers Squibb executive to write a book about his criminal misdeeds in reaching an agreement with a competitor to keep its generic drug off the market. The executive had to write, publish, and distrib- ute the book to other pharmaceutical executives at his own expense. The executive was also sentenced to two years of probation and a $5,000 fine. The book was com- pleted, as required, by the end of his probation.

Community Service Courts have begun using community service sentences with corporate execu- tives in the same way they have been using this form of punishment for celebri- ties for a number of years. For example, in United States v Allegheny Bottling Co., 695 F. Supp. 856 (E.D. Va. 1988), cert. denied, 493 U.S. 817 (1989), the court imposed a fine of $1,000,000 on the corporation but also required officers of the corpora- tion to provide community service during the period of the corporate sentence so that nonprofits and community organizations could benefit from the management expertise of executives, expertise that is given free of charge as part of the corpo- ration’s penalty. The corporation had to provide one officer for community/non- profit service for 40 hours per week for three years.

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Officer and executive Banishment: the designated Felon One of the rapidly increasing areas of focus when criminal activity is uncovered in a company is that of sanctions, discipline, and punishment for executives and officers of the company. The Park case set the standards for criminal liability of officers, but plea agreements and DPAs often demand that someone within the company be held accountable for the failure to catch, stop, or adequately super- vise those who were directly involved. One of the issues evolving is whether the corporate compliance officer (CCO) can be considered a supervisor for purposes of accountability. For example, the SEC holds CCOs responsible as if they are a supervisor and they become aware of illegal conduct in a corporation and fail to take action to stop that conduct. The SEC has fined compliance officers personally for the failure to report violations of the law. And, as discussed in Chapter 18, those who sign off on financial statements that turn out to be false are personally and criminally liable for that false information.

This punishment practice of fining executives for violations of the law is known as finding a “designated felon.” Executives can also be held criminally liable for withholding information, altering information, or participating in the destruction of documents. A Wells Fargo compliance officer was charged with altering an investi- gation report to make it appear as if there had been a more thorough investigation into insider trading at the bank. The judge dismissed the case because he did not want to send the wrong signal of punishing those who are doing the investigations in companies and trying to navigate that line of being employed by a company that they are expected to blow the whistle on when there are violations of the law.

In the health care field, federal agencies use the “responsible corporate officer” (RCO) doctrine to hold those who head up companies criminally responsible when their hospitals submit false Medicare claims or their drug firms misbrand prescrip- tion drugs. In addition to holding these RCOs criminally responsible, the agen- cies prosecuting the cases often seek to have the RCOs barred from the health care industry for periods that range from one year to life, with the typical time being 12 to 20 years. In some cases, a banishment from the field for eight years or more means that their careers as health care officers are ended.

Other forms of punishment for executives and officers may not be fines or prison. For example, the SEC can bar those who are convicted of securities-related crimes from the securities industry for a period of years or even for life (as in the case of Michael Milken). Henry Blodgett, an equity research analyst at Merrill Lynch, was banned for life from the securities industry when his e-mails showed that his true feelings about certain stocks were very different from the positive views his public reports for Merrill Lynch indicated.

deferred prosecution agreements Deferred Prosecution Agreements (DPAs) are negotiated settlements of criminal charges against a corporate defendant. Under a DPA, the defendant company usu- ally agrees to pay a fine and then go through a period of, generally, one to five years, of monitoring and/or no commission of any additional offenses. In exchange, the company avoids prosecution if the terms of the DPA are met. For example, in U.S. v Fokker Services B.V., 79 F. Supp. 3d 160 (D.D.C. 2015), Fokker was charged with violating U.S. prohibitions on trade with Iran and other countries and an alleged conspiracy to hide the trades from the federal government. Under a consent agree- ment, Fokker was to pay a $10.5 million fine and, for a period of 18 months, to avoid any further violations of the law, implement a new compliance program, and

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Chapter 8 Business Crime 261

cooperate with several U.S. agencies in their investigations of violations of export laws. These DPAs must be approved by a court, just as plea bargains for individu- als require approval by a court. In the Fokker case, the federal district court had to approve the DPA. However, the federal district court judge held that he could not approve the DPA in the form presented because of the following:

Here, Fokker Services is charged with a five-year conspiracy to violate and evade United States export laws for the benefit, largely, of Iran and its military during the post–9/1 1 world when we were engaged in a two-front War against terror in the Middle East. These voluminous violations during that period were knowing and willful, and were orchestrated at the highest levels of the company. The company brought in $21 million in revenue from these illegal transactions of parts that were being excluded from sale to these particular countries for national security and anti-terrorism reasons. Indeed, the majority of Fokker Services’ illegal conduct involved sales of aviation and avionic parts to Iran.

The court denied approval, but the parties appealed, and the appellate court held that the district judge did not have the discretion to deny approval. Fokker had admitted the violations and cooperated with the federal government in its ongoing investigation. For those reasons, the appellate court remanded for approval because the DPA was based on mitigating factors.

Ethical Issues

In 1994, Congress passed a law that per- mitted nonviolent convicts to cut up to 12 months from their sentences if they complete a drug rehab/counseling program. When the program was first created, 3,755 inmates entered the program. In 2008, 18,000 federal prisoners were in the pro- gram, and there was a waiting list of 7,000 inmates.

The program has had some big names. For example, Dr. Sam Waksal, the former CEO of ImClone, served nine fewer months than his original seven-year sentence because he participated in a prison rehab program for inmates who have a problem with substance abuse. When Dr. Waksal was interviewed for the presentencing report, he told the probation officer that he was a “social drinker” and had perhaps five glasses of wine per week. One month after the interview with the probation officer, Waksal’s lawyers informed a federal judge that Waksal had a “dependence on alcohol” and requested approval for Waksal’s entry into a prison rehab program.

The former mayor of Atlanta, Bill Campbell, was admitted into a federal rehab program

and got a nine-month reduction on his 30-month sentence for tax evasion. He was admitted to rehab despite the fact that his lawyers argued at his sentencing hearing that he had no substance abuse problem and that he hated the taste of alcohol and therefore urged the judge to conclude that Campbell’s imprisonment was not necessary.