Business Law - Commercial - Chapter 28, 29, 30, 31, 32, 33, 34

creditor or obligee

pg. 624 The party entitled to receive payment or performance

Ambiguous provisions

pg. 627 Ambiguous provisions of surety agreements are construed in favor of the unpaid surety and against the creditor. Ambiguous provisions of surety agreements involving compensated sureties are resolved against the surety This distinction results from the fact that ambiguous language is generally construed against the party writing it. In the case of unpaid sureties, the language is usually framed by the creditor and signed by the surety. In the case of compensated sureties, the surety usually prepares the contract.

Performance bonds and fidelity bonds

pg. 627 are also examples of suretyship.

A performance bond

pg. 627 delity bonds are also examples of suretyship. A performance bond provides protection against losses that may result from the failure of a contracting party to perform the contract as agreed. The surety (bonding company) promises the party entitled to performance to pay losses caused by nonper-formance by the principal in an amount not to exceed the face of the bond.

compensated sureties

pg. 627 perceived as being able to take care of themselves.

"Adjustment of Debts of a Family Farmer," is treated in a manner somewhat similar to

pg. 648 those that file under Chapter 13.

Article III, § 1, of the Constitution mandates that

pg. 650 "[t]he judicial Power of the United States, shall be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish."

Sham sale

pg. 614 A sales transaction arranged by the seller to benefit a buyer who pays an unreasonably low price for the item sold

Procedural Steps Introduction

pg. 659 Chapter 3 of the 1978 Bankruptcy Reform Act is concerned with procedural aspects and administration of all types of bankruptcy cases, regardless of the chapter under which the case is filed. The provisions of Chapter 3 give guidance in how to and who can file a case, in how the automatic stay prohibits any action against the debtor, and in how creditors are informed of the debtor's status.

principal

pg. 677 The person for whom the agent acts, and who controls the agent,

agent

pg. 677 The person who acts for another

Reservation of Rights

pg. 633 & 634 Even a nonconsenting surety is not released when a principal is released if the creditor reserves rights against the surety. In essence, the creditor's reservation of rights is interpreted to be a promise by the creditor that the principal will not be sued. The creditor can still hold the surety liable, and the surety can seek reimbursement from the principal upon the surety's performance. Due to its vital importance and its impact on the surety's liability, notice of the reservation of rights against a surety should be given in writing to both the surety and the principal.

these defenses extinguish the principal's liability altogether.

pg. 636 (1) lack of capacity, (2) discharge in bankruptcy, and/or (3) expiration of the statute of limitations.

waiver

pg. 641 voluntary relinquishment of the right to a lien before a notice of lien is filed A waiver occurs before a notice of lien is filed

Voidable Preferences

pg. 664 One of the goals of bankruptcy proceedings is to provide an equitable distribution of a debtor's property among creditors. To achieve this goal, the trustee in bankruptcy is allowed to recover transfers that constitute a preference of one creditor over another. As one judge said, "A creditor who dips his hand in a pot which he knows will not go round must return what he receives, so that all may share." To constitute a recoverable preference, the transfer must (1) have been made by an insolvent debtor; (2) have been made to a creditor for, or on account of, an antecedent debt owed by the debtor before the transfer; (3) have been made within ninety days of the filing of the bankruptcy petition; and (4) enable the creditor to receive a greater percentage of the claim than he/she would receive under a distribution from the bankruptcy estate in a liquidation proceeding. Insofar as the time period is concerned, there is an exception when the transfer is to an insider. In this case, the trustee may avoid the transfer if it occurred within one year of the date of filing the petition, provided the insider had reasonable cause to believe the debtor was insolvent at the time of the transfer. A debtor is presumed to be insolvent during the ninety-day period prior to the filing of the petition. Any person contending that the debtor was solvent has the burden of coming forward with evidence to prove solvency. Once credible evidence is introduced, the party with the benefit of the presumption of insolvency has the burden of persuasion on the issue. Recoverable preferences include not only payments of money but also the transfer of property as payment of, or as security for, a prior indebtedness. Since the law is limited to debts, payments by the debtor of tax liabilities are exempt from the preference provision and are not recoverable. A mortgage or pledge may be set aside as readily as direct payments. A pledge or mortgage can be avoided if received within the immediate ninety-day period prior to the filing of the petition in bankruptcy, provided it was obtained as security for a previous debt. The effective date of a transfer or a mortgage of real property may be questioned if the date the legal documents are signed is different from the date these documents are recorded. A logical solution to this potential problem seems to be to rely on the date the document is recorded in the public records. Payment of a fully secured claim does not constitute a preference and may not, therefore, be recovered. Transfers of property for a contemporaneous consideration may not be set aside because there is a corresponding asset for the new liability. A mortgage given to secure a contem-poraneous loan is valid even when the mortgagee took the security with knowledge of the debtor's insolvency. An insolvent debtor has a right to attempt to extricate him/herself, as far as possible, from financial difficulty. If the new security is personal property, it must be perfected within ten days after the security interest attaches. The law also creates an exception for transfers in the ordinary course of business or in the ordinary financial affairs of persons not in business. The payment of such debts is not recoverable by the trustee. This exception covers ordinary debt payments such as utility bills. The law on preferences is directed at unusual transfers and payments, not those occurring promptly in the ordinary course of the debtor's affairs.

Priorities

pg. 668 The bankruptcy law establishes certain priorities in the payment of claims. After secured credi-tors have had the opportunity to benefit from a security interest in collateral, the general order of priority for unsecured debts is as follows (from first priority to last): 1. Domestic-support obligations 2. Administrative expenses associated with administering the bankruptcy estate 3. Involuntary gap creditors 4. Wages, salaries, and commissions, subject to certain limits 5. Contributions to employee benefit plans 6. Suppliers of grain to a grain storage facility or of fish to a fish produce storage or processing facility 7. Consumer deposits, subject to certain limits 8. Governmental units for certain taxes 9. Certain claims for death or personal injury 10. Claims of general creditors Alimony and child support are the most prominent examples of domestic-support obliga-tions. Administrative expenses include all costs of administering the debtor's estate, including taxes incurred by the estate. Typical costs include attorney's fees, appraiser's fees, and wages paid to persons employed to help preserve the estate. The term involuntary gap creditor describes a person who extends credit to the estate after the filing of an involuntary petition under Chapter 11 and before a trustee is appointed or before the order for relief is entered. Such claims include taxes incurred as the result of the conduct of business in this period. The fourth class of priority is limited to amounts earned by an indi-vidual within 180 days of the filing of the petition or the cessation of the debtor's business, whichever occurred first. The priority is limited to $10,000 for each individual and includes vacation, severance, and sick leave pay, as well as regular earnings. The employee's share of employ-ment taxes is included in this fourth category, provided the wages and the employee's share of taxes have been paid in full. The category does not include fees paid to independent contractors. The fifth priority recognizes that fringe benefits are an important part of many employment contracts. The priority is limited to claims for contributions to employee benefit plans arising from services rendered within 180 days before commencement of the case or cessation of the debtor's business, whichever occurs first. The priority is limited to $10,000 multiplied by the number of employees less the amount paid under priority 4. The net effect is to limit the total priority for wages and employee benefits to $10,000 per employee. The sixth priority is designed to protect the farmer who raises grain and the fisherman, if the owner of a production or storage facility holds their grain or fish. If the farmers or fishermen have not been paid for the grain or fish transferred, they have a priority claim to the extent of $4,000 per creditor. The seventh priority is an additional method of consumer protection that protects consum-ers who have deposited money in connection with the purchase, lease, or rental of property or the purchase of services for personal, family, or household use that were not delivered or provided. The priority is limited to $1,800 per consumer. The eighth priority is for certain taxes. Priority is given to income taxes for a taxable year that ended on or before the date of filing the petition. The last due date of the return must have occurred not more than three years before the filing. Employment taxes and transfer taxes such as gift, estate, sale, and excise taxes are also given seventh-class priority. Again, the transaction or event that gave rise to the tax must precede the petition date, and the return must have been due within three years. The bankruptcy laws have several very technical aspects relating to taxation, and they must be reviewed carefully for tax returns filed by the trustee and claims for taxes. The ninth priority is for claims of death or serious injury resulting from an automobile accident caused by the unlawful use of alcohol or drugs. In liquidation cases, the property available is first distributed among the priority claimants in the order just discussed. Then, the property is distributed to general unsecured creditors who file their claims on time. Next, payment is made to unsecured creditors who tardily file their claims. Thereafter, distribution is made to holders of penalty, forfeiture, or punitive damage claims. As a matter of policy, punitive penalties, including tax penalties, are subordinated to the first three classes of claims. Regular creditors should be paid before windfalls to persons and entities collecting penalties. Finally, postpetition interest on prepetition claims is paid if any property is available to do so. After the interest is paid, any surplus goes to the debtor. Claims within a particular class are paid pro rata if the trustee is unable to pay them in full.

Indemnify

pg. 686 Literally, "to save harmless"—thus, one person agrees to protect another against loss

to reimburse someone means to

pg. 686 repay him/her for funds already spent

Acting as Agent

pg. 699 Second, an agent's act may be ratified only when the agent holds him/herself out as acting for the one who is alleged to have approved the unauthorized agreement. In other words, the agent must have professed to act as an agent. A person who professes to act for him/herself and who makes a contract in his/her own name does nothing that can be ratified, even though that person intends at the time to let another have the benefit of the agreement.

Tort Liability of Employers Respondeat Superior

pg. 703 & 704 An employer is liable to third persons for the torts committed by employees within the scope of their employment and in prosecution of the employer's business. This concept, frequently known as respondeat superior ("let the master respond"), imposes vicarious liability on employers as a matter of public policy. Although negligence of the employee is the usual basis of liability, the doctrine of respondeat superior is also applicable to intentional torts (e.g., trespass, assault, libel, and fraud) that are committed by an employee acting within the scope of his/her employment. It is applicable even though the employer did not direct the willful act or assent to it. This vicarious liability imposed on employers, which makes them pay for wrongs they have not actually committed, is not based on logic and reason but on business and social policy. The theory is that the employer is in a better position to pay for the wrong than is the employee. This concept is sometimes referred to as the deep pocket theory. The business policy theory is that injuries to persons and property are hazards of doing business, the cost of which the business should bear rather than have the loss borne by the innocent victim of the tort or society as a whole. There is universal agreement that an employer is vicariously liable for the actual damages caused by an employee acting within the scope of employment. However, there is disagreement about when the employer is liable for punitive damages that may be awarded to punish the employee's wrong. One theory that has been widely adopted by courts in some states is called vicarious liability rule. This rule states that the employer is always liable for punitive damages awarded against the employee if the wrong committed occurred within the scope of the employee's employment. The logic behind this rule involves the belief that making the employer liable for punitive damages will help deter reckless or intentional torts. The more modern view of punitive damages that has been adopted by a growing number of states has been called the complicity rule. The advantage of this rule is that it allows for a determination of whether an employer actually is blameworthy before making that employer liable for punitive damages. In essence, under this second principle, to collect punitive damages from the employer, an injured third party must be able to prove that (1) the employer authorized the employee to commit the tort, (2) the employer was reckless in employing or retaining the employee, (3) the employee was employed in a managerial position, or (4) the employer ratified the employee's tortious conduct. The application of the doctrine of respondeat superior usually involves the issue of whether the employee was acting within the scope of his/her employment at the time of the commission of the tort. The law imposes liability on the employer only if the tort occurs while the employee is carrying on the employer's business or if the employer authorizes or ratifies the employee's actions. The employer's liability does not arise when the employee steps aside from his/her employment to commit the tort or when the employee does a wrongful act to accomplish a personal purpose. It is not possible to state a simple test to determine whether the tort is committed within the scope of the employment. Factors to be considered include the nature of the employment, the right of control "not only as to the result to be accomplished but also as to the means to be used," the ownership of the instrumentality (such as an automobile), whether the instrumentality was furnished by the employer, whether the use was authorized, and the time of the occurrence. Most courts inquire into the employee's intent and the extent of deviation from expected conduct involved in the tort. As a general rule, the employer cannot avoid liability by showing that the employee was instructed not to do the particular act that is the focus of the complaint. When an employee disobeys the instructions of an employer, the fact of disobedience alone does not insulate the employer from liability. In addition, the employer is not released by evidence that the employee was not doing the work the employer had instructed him/her to do when the employee misunderstood the instruction. As long as the employee is attempting to further the employer's business, the employer is liable because the employee is acting within the scope of his/her employment. One of the most difficult situations to resolve is an employee going to or coming from work. Generally, traveling from home to work and vice versa is not considered to be within the employee's employment. However, the issue of whether an employee is acting within the scope of employment usually is one of fact. Therefore, a jury typically must resolve this issue. Seldom will a judge be able to make a ruling involving the doctrine of respondeat superior as a matter of law. The peculiar facts of each case are crucial in determining whether an employer is liable for the employee's acts.

History

pg. 728 The ever-changing functions of unions and the impact of labor laws in the United States for more than a hundred years provide strong evidence of the dynamic nature of law. With the growth of corporations during the Industrial Revolution (around 1820-1870), the worker's role also began to change. Instead of working in a small shop, many employees found themselves in a factory setting, with hundreds or even thousands of fellow workers. If those workers were at odds with a management decision, they might come together and function as a unit to influence their employer to take a more favorable position toward them. In time, particularly after the Civil War, formal unions became more common. For example, the Knights of Labor union was formed in 1869, and the American Federation of Labor (AFL) was created in 1886. However, the political environment was often not supportive of union activity. During the nineteenth century, Congress, state legislatures, and courts (federal and state) provided little protection for union activities and often sided with management in limiting the role of unions in society. The early part of the twentieth century, however, brought change to the political winds regarding the viability of the union movement. Congress passed the Railway Labor Act in 1926, which provided protection for union activity within the railway industry. The Norris-LaGuardia Act, enacted in 1932, curtailed the role of the federal courts to enjoin strikes and picketing. These two acts of Congress laid the stage for the most important federal labor law statute: the National Labor Relations Act (NLRA), enacted in 1935. The NLRA (also known as the Wagner Act) provides employees with three important privileges: the right to organize, the right to collectively bargain, and the right to strike. Congress also saw the need to create a federal administrative agency for the purpose of implementing the NLRA; thus, one provision of the NLRA establishes the National Labor Relations Board (discussed below). In addition, the NLRA prohibits employers from entering into unfair labor practices. Examples of types of activities that fall within this concept include refusing to bargain with employee representatives, retaliating against employees who file charges under the NLRA, discriminating against a union member because of their association with the union, interfering with the administration of a union, and discouraging employees from forming or joining a union. The NLRA was a significant boost to unions and union membership for several decades. In fact, during the mid-1950s, more than 30 percent of the private-sector workforce carried a union card. However, even before those years when the percentage of union membership was at its peak, forces were at work to change the direction of public policy once again. Some of these were legislative in nature. For example, Congress amended the NLRA in 1947 to curtail certain union activities. This amendment, called the Labor Management Relations Act (better known as the Taft-Hartley Act) made it illegal for a union to refuse to bargain with an employer, to engage in certain types of picketing, to discourage employees from joining a union, to encourage an employer to discriminate against an employee who is not a union member, to coordinate a secondary boycott (an action against a third party who deals with the employer but has no direct contact with the union), and to promote "featherbedding" (requiring an employer to hire more employees than necessary). The Taft-Hartley Act also created the Federal Mediation and Conciliation Service to aid unions and employers in settling disputes under a contract. Finally, this law articulated just how "union" a workforce could be under federal law. The legislation clearly prohibits a closed shop, where a business requires union membership before an individual is hired. Those arrangements in which management requires a person who is hired to join a union after a particular duration of employment, termed a union shop, are legal. Moreover, the Taft-Hartley Act allows states to pass right-to-work laws. Today, almost half of all states have adopted this position, which makes it illegal for an employer to mandate union membership as a condition of employment. Today, union membership is well below 10 percent of the private-sector workforce. Although some of the reasons for the decline of union strength are related to unfavorable legislation, a myriad of other factors have also contributed, such as -the well-publicized corruption of unions during the 1950s (prompting Congress to pass the Landrum-Griffin Act in 1959 in an attempt to govern internal union activities), -the shift away from a manufacturing to a service economy, -population growth in the traditionally nonunion regions in the western and southern parts of the United States, and -the significant growth of a global economy.

What is the difference between a surety and a guarantor?

pg. 624 Historically, the distinction has involved the difference between a third party being either primarily liable or secondarily liable. It also involves the distinction of assuring a creditor that the principal will perform a noncredit contractual promise and that the principal will repay money borrowed.

Account debtor

pg. 598 The person who is obligated on an account, chattel paper, contract right, or general intangible

absolute guaranty

pg. 626 a creditor can go directly to the guarantor to collect.

The Surety's Consent

pg. 633 most situations involving a surety's consent to remain personally liable probably will involve a friendship or kinship between the surety and the principal. a surety may wish to help a friend or relative by improving that principal's financial record furthermore, the principal, in return for acting as a surety, may secure a surety. We could assume that a business, as principal, granted its president, as the surety, a security interest in all its accounts and general intangibles. A creditor may be willing to take the surety's security interest in full satisfaction of the performance owed. The creditor might agree to release the principal from further personal liability if the surety consents to the creditor's having the right to pursue its claim against the accounts and general intangibles. The basis for this conclusion is the creditor's right of subrogation,

surety or guarantor

pg. 624 Any party who promises the creditor to be liable for a principal's payment of performance a creditor could demand performance from the surety rather than the principal. From this concept came the general rule that no notice of the principal's default had to be given for the creditor to hold the surety liable. A guarantor's promise to be liable for a principal's obligation is created separate from and inde-pendent of the principal's agreement to perform. In other words, a guarantor's promise is only related to, but not an essential part of, the principal's obligation. A guarantor will become liable to the creditor only when the principal has defaulted.

Unsecured Creditors

pg. 595 Most debtors voluntarily repay their obligations, and most creditors depend only on the debtor's personal promise to pay. Such creditors are said to be unsecured. An unsecured creditor does not have any source other than the debtor from which to collect the debt. A credit sales transaction wherein the seller is unsecured is often called a sale on open account or open credit. The steps an unsecured creditor must take if the debtor fails to repay voluntarily illustrate the danger facing unsecured creditors. The unsecured creditor must first sue the debtor and obtain a judgment. Then, as a judgment creditor, it may pursue the enforcement procedures available to a judgment creditor. These postjudgment procedures include obtaining a writ of execution—that is, having a legal, enforceable, official levy on the debtor's property and having the property sold at a public auction. The process of litigation and enforcement of the judgment are costly in terms of both time and money. More important, the debtor may not have any property that can be sold to pay the judgment, in which case the creditor will be unable to collect the debt. Many unsecured debts become simply uncollectible

Secured Debt

pg. 595 & 596 As stated in the introductory paragraphs to this chapter, an Article 9 secured creditor has an interest in one or more items of the debtor's personal property. When these secured creditors perfect their security interests, they are in a much more favorable position than unsecured creditors. For example, the secured creditor, upon the debtor's default, can seize the collateral and have the collateral applied to payment of the debt. Secured creditors enjoy an advantage when a debtor becomes insolvent or files for bankruptcy. The secured creditor has personal property from which repayment may be obtained. By having a security interest in the debtor's personal property, a secured creditor is, in effect, given priority over unsecured creditors. However, a perfectly secured party is not assured that the debt will be repaid. As discussed later in the chapter, secured creditors may lose their claim to the property under a number of circumstances. Furthermore, the value of the debtor's personal property may be insufficient to satisfy the entire debt. It is the secured creditor's responsibility always to keep informed of the debtor's business practices and personal obligations.

Scope of Article 9 In General

pg. 596 Although Article 9 deals primarily with secured transactions, it also covers outright sales of certain types of property, such as accounts receivable. Thus, a sale of the accounts receivable of a business must comply with the Code requirements as if the accounts were security for a loan. Except for sales such as those of accounts receivable, the main test to be applied in determining whether a given transaction falls within the purview of Article 9 is whether it was intended to have effect as security. Article 9 covers every transaction with such intent. A lease with option to buy may be considered a security transaction, rather than a lease, if the necessary intent is present. Certain credit transactions are expressly excluded from Article 9 coverage. In general, these exclusions involve transactions that are not of a commercial nature. Examples of common exclusions include a landlord's lien, an assignment of wages, and a transfer of an insurance policy. Another important exclusion is the lien created by state law in favor of those who service or repair personal property, such as automobiles. This lien, known as an artisan's lien, is discussed in more detail in Chapter 29

Classifications of Collateral

pg. 596 The broad application of Article 9 can best be seen by examining the various types of collateral covered by it. There is not an item of personal property that cannot be used as collateral in a secured transaction. The only limitation to what is acceptable as collateral is the creditor's willingness to accept an interest in a particular item of personal property. Collateral may be classified according to its physical makeup into three types: (1) tangible, physical property or goods; (2) documentary property that has physical existence, such as a negotiable instrument, but that is simply representative of a contractual obligation; and (3) purely intangible property, such as an account receivable.

Farm products

pg. 597 Crops or livestock used or produced in farming operations The farm products category includes crops and livestock, supplies used or produced in farming operations, and the products of crops or livestock in their unmanufactured state (ginned cotton, wool, milk, and eggs), provided that the items are in the possession of a debtor who is engaged in farming operations [9-102(a)(34)]. Farm products are not equipment or inventory. Note that goods cease to be farm products and must therefore be reclassified when (1) they are no longer in the farmer's possession, or (2) they have been subjected to a manufacturing process. Thus, when the farmer delivers his/her farm products to a marketing agency for sale or to a frozen-food processor as raw materials, the products in the hands of the other party are inventory. Likewise, if the farmer maintained a canning operation, the canned product would be inventory, even though it remained in the farmer's possession.

Consumer goods

pg. 597 Goods that are used or bought for use primarily for personal, family, or household purposes Goods fall into the consumer goods classification if they are used or bought primarily for personal, family, or household purposes

Equipment

pg. 597 Goods that are used or bought for use primarily in business or by a debtor that is a nonprofit organization or a governmental subdivision or agency Goods that are used or bought for use primarily in a business, in farming, in a profession, or by a nonprofit organization or governmental agency fall within the equipment category [9-102(a)(33)]. The category is something of a catchall, embracing goods that otherwise defy classification. Since equipment often is attached to realty and becomes a fixture, the discussion of fixtures later is especially significant for the equipment classification.

Tangible Goods

pg. 597 In secured transactions under Article 9, four categories of tangible goods are established: 1. Consumer goods 2. Equipment 3. Farm products 4. Inventory In determining the classification of any particular item of goods, it is necessary to take into account not only the physical attributes of the collateral but also the status of the debtor who is buying the property or using it as security for a loan, as well as the use the debtor will make of the goods. Keep in mind that the classification will determine the place of filing to perfect the security interest against third parties. It may also affect the rights of the debtor on default.

Chattel paper

pg. 598 A writing that evidences both a monetary obligation and a security interest in, or a lease of, specific goods Chattel paper refers to a writing or writings that evidence both (1) an obligation to pay money and (2) a security interest in, or a lease of, specific goods [9-102(a)(11)]. The chattel paper itself is a security agreement. A security agreement in the form of a conditional sales contract, for example, is often executed in connection with a negotiable note or a series of notes. The group of writings (the contract plus the note), taken together as a composite, constitutes chattel paper. A typical situation involving chattel paper as collateral is one in which a secured party who has obtained it in a transaction with a customer may wish to borrow against it in his/her own financing. For example, a dealer sells an electric generator to a customer in a conditional sales contract, and the customer signs a negotiable installment note. At this point, the contract is the security agreement, the dealer is the secured party, the customer is the debtor, and the generator is the collateral (equipment). The dealer, needing funds for working capital, transfers the contract and the note to a financing agency as security for a loan. In the transaction between dealer and finance company, the contract and note are the collateral (chattel paper), the finance company is the secured party, the dealer is the debtor, and the customer is now designated as the account debtor.

Documentary Collateral

pg. 598 In secured transactions, three types of paper are considered to represent such valuable property interests that they are included as potential collateral. These items of paper property include chattel paper, documents of title, and instruments. These items comprise various categories of paper frequently used in commerce. These papers may be negotiable or nonnegotiable. Each item of potential collateral is evidenced by a writing, and each represents rights and duties of the parties who signed the writing.

Inventory

pg. 598 Inventory consists of goods that are held by a person for sale or lease or to be furnished under a contract of service. They may be raw materials, work in progress, completed goods, or material used or consumed in a business [9-102(a)(48)]. The basic test to be applied in determining whether goods are inventory is whether they are held for immediate or ultimate sale or lease. The reason for the inclusion of materials used or consumed in a business (e.g., supplies of fuel, boxes, and other containers for packaging the goods) is that they will soon be used in making an end product for sale. The proper classification of goods is determined on the basis of their nature and intended use by a debtor. For example, a television set in a dealer's warehouse is inventory to the dealer. When the set is sold and delivered to a consumer customer, it becomes a consumer good. If an identical set were sold on the same terms to the owner of a tavern, to be used for entertaining customers, the set would be equipment in the hands of the tavern owner. The secured party, generally, cannot rely on the classification furnished by the debtor. The secured party must analyze all facts to ensure proper classification of the collateral and proper perfection of the security interest.

Bill of lading

pg. 599 A document evidencing the receipt of goods for shipment, issued by a person engaged in the business of transporting or forwarding goods

Attachment

pg. 599 A four-step process of creating an enforceable security interest

Accounts

pg. 599 A right to payment that is not evidenced by a writing An account is any right to payment arising out of a contract for the sale of goods or services if that right is not evidenced by a writing [9-102(a)(2)]. An account receivable, which arose from a sale on open credit, is a typical example of an account. These rights of payments may be valuable business assets in which a creditor is willing to take a security interest as collateral for the business's debt.

Instrument

pg. 599 A writing that evidences an obligation to pay money, a negotiable instrument, or an investment security As distinguished from chattel paper, an instrument means (1) negotiable instrument, (2) an investment security such as stocks and bonds, or (3) any other writing that evidences a right to the payment of money and is not itself a security agreement or lease [9-102(a)(47)]. To qualify as an instrument, the other writing must also be one that is, in the ordinary course of business, transferred by endorsement or assignment. Thus, the classification includes, in addition to negotiable instruments, those that are recognized as having some negotiable attri-butes. Instruments are frequently used as collateral, and they present certain problems in this connection because of their negotiable character. These problems are discussed further in the part of this chapter concerning perfection. Due to the readily transferable nature of negotiable instruments, priority issues also are complicated when this type of collateral is used in a secured transaction. These complications are explained in the next chapter.

General intangible

pg. 599 Any personal property (including things in action) other than goods, chattel paper, documents, instruments, and accounts The general intangibles category is a catchall that includes miscellaneous intangible personal property that may be used as commercial security but does not fall within any of the preceding classifications of collateral. Examples of general intangibles include goodwill, literary rights, patents, and copyrights [9-102(a)(42)].

Intangible Collateral

pg. 599 In the law of secured transactions, there is a third basic classification of collateral, called intangibles, with two categories: (1) accounts and (2) general intangibles. These categories are distinguished from documentary collateral by virtue of the fact that they are not represented by a writing. In other words, these categories of potential collateral are truly lacking any physical characteristics.

Document of title

pg. 599 Includes bill of lading, dock warrant, dock receipt, warehouse receipt, and order for the delivery of good Included under the heading of documents of title are bills of lading, warehouse receipts, and any other document that in the regular course of business or financing is treated as sufficient evidence that the person in possession of it is entitled to receive, hold, and dispose of the document and the goods it covers [

Warehouse receipt

pg. 599 Issued by a person engaged in the business of storing goods for hire

Creation of a Security Interest Introduction

pg. 599 & 600 The ultimate goal of the secured party is to have an enforceable, attached, and perfected security interest. The remainder of this chapter is devoted to these three concepts: enforceability, attach-ment, and perfection. Completing the steps as outlined in section 9-203 causes a security interest to spring into existence. This moment of creation is called attachment. At the time of attachment, the security interest is also enforceable against the debtor and third parties [9-203(a), 9-201]. However, third parties may defeat the security interest if it is not perfected. Perfection is discussed later in this chapter. The following steps are required of creditors to create a security interest: 1. Make a security agreement with the debtor. 2. Make sure the debtor has "rights in the collateral." 3. Give value. 4. Make the security interest enforceable, either by putting the security agreement in writing, which the debtor signs, or by taking possession of the collateral pursuant to the agreement. The four steps can occur in any order. For example, security agreement may be executed and the secured party may give value (such as a loan) before the debtor acquires rights in the collateral. Assume that Sewall, a small manufacturing company, is seeking a loan of $5,000 from a bank. Sewall intends to buy a Model 711 Reaper sewing machine, which will be the collateral. Assume that progressive steps occur as follows: 1. A security agreement is signed by Sewall but not by the bank. Sewall has yet to deal with Reaper. Only the debtor is required to sign this document. 2. Sewall contracts with Reaper to buy the Model 711 machine. According to Article 2, a buyer does not have any rights in the goods until the goods are identified to the contract. 3. Reaper removes a Model 711 machine from its inventory and marks it for delivery to Sewall. Now the goods are identified to the contract. Therefore, the debtor, Sewall, has rights in the collateral. 4. The bank, for the first time, makes a binding commitment to lend Sewall the $5,000. The requirement that the secured party give value is met. Agreeing to lend money, as well as actually making a loan, is the giving of value. Not until Step 4 is completed does an Article 9 security interest exist. Only after these four steps are completed has a security interest attached to the collateral (sewing machine). After Step 4, we find a written security agreement signed by the debtor, the debtor has rights in the collateral, and the secured party has given value. Thus, an attached and enforceable security interest comes into existence. The following three sections describe a few more rules about the elements of creating a valid security interest.

Debtor's Rights in Collateral

pg. 600 Another requirement for attachment (or creation of a valid security interest) is that the debtor must have rights in the collateral. It is clear that the debtor-buyer gets rights in the collateral against the seller upon delivery of the goods. A number of recent cases have held that the buyer can also acquire rights prior to shipment, the earliest time being when the seller identifies the goods to the contract. The rights acquired by the buyer are subject to the seller's right of reclamation if the buyer fails to pay or if the buyer's check bounces. If a security interest created by the buyer attaches to the goods prior to the seller exercising a right to reclaim, the secured party generally prevails over the unpaid seller holding the bounced check. There are many situations in which a debtor grants a creditor an interest in collateral that the debtor is not acquiring under a contract. Typically, in these situations, a debtor has rights in the collateral if the debtor has possession of the property. However, when does a commercial fisher have rights in the fish as inventory? When does a farmer have rights in the crops to be grown or in the unborn offspring of livestock? The best answers to these questions seem to be that the fisher has rights in the fish when they are caught and the farmer has rights in the crops when they are planted and in the offspring of livestock when they are conceived. While the debtor's possession of the collateral is an important factor in considering the debtor's rights in the collateral, such possession cannot be viewed as conclusive.

The Security Agreement

pg. 600 The basic instrument in a secured transaction is the security agreement [9-105(a)(73)]. It must be written or authenticated unless the security arrangement is a possessory one and the secured party is in possession of the collateral. Allowing the creditor to possess the collateral is not always feasible. Indeed, most circumstances require that the debtor have possession of the collateral. In these situations, the security agreement must be in writing, and the debtor must sign it. Regardless of whether the security agreement is in oral or written form, this agreement must describe the collateral in a manner sufficient for it to be reasonably identified [9-108]. When it is a written form, the security agreement usually will contain many other provi-sions in addition to the names of the parties, a grant of a security interest, and an identification of the collateral. The forms, in general, include -a statement of the amount of the obligation and the terms of repayment; -the debtor's duties in respect to the collateral, such as insuring it; and -the rights of the secured party on default. In general, the parties can include such terms and provisions as they may deem appropriate to their particular transactions.

Perfection

pg. 601 A process that may occur by filing a financing statement, by possession, by attachment, or by noting the security interest on a certificate of title (It is essential to inform the public that a creditor has an interest in the debtor's personal property.)

Perfection of a Security Interest Introduction

pg. 601 Between the debtor and the secured party, the security agreement protects the secured party's security interest; however, the secured party also wants protection against third parties, who may later make claims against the secured collateral. Perfection of the security interest will give this desired protection to the secured party. Perfection is designed to give notice to third parties that financing is occurring on the basis of collateral described. In general, an unperfected secured party's claim is subordinate to the claims of others who acquire an interest in the collateral without knowledge of the unperfected security interest. Article 9 provides numerous ways in which a security interest can be perfected, three of which are (1) filing a financing statement, (2) taking possession of the collateral, or (3) simply creating a security interest (automatic perfection). Several factors must be taken into account in determining which of the three methods is appropriate in any given transaction: (1) the kind of collateral in which security interest was created, (2) the use the debtor intends to make of the collateral, and (3) the status of the debtor in relation to the secured party.

Creditor's Value

pg. 601 For purposes of attachment, value means that a secured party has furnished to the debtor any consideration sufficient to support a simple contract. When a creditor loans money, value is clearly given. Even when the creditor agrees to loan money in the future, perhaps by establish-ing a line of credit for the debtor, value is given. The executory nature of the creditor's promise to loan money in the future does not destroy the existence of value being given. Furthermore, value also is present when a creditor takes a security interest to secure a preexisting claim against the debtor

With respect to the proceeds of a forced sale, the artisan generally has a superior claim when compared with a preexisting Article 9 secured party.

pg. 624 The lienholder has priority because the law presumes that the work of improvement done on the personal property has increased that property's value, at least in an amount equal to the lienholder's claim. Therefore, having inferior status has not damaged the secured creditor. Any surplus proceeds left after all claims against the property are satisfied are paid to the property owner.

Perfection by Filing What Must Be Filed?

pg. 602 & 603 The document that creditors file to perfect a security interest is known as a financing statement. This document includes the names and addresses of the creditor and debtor. It also contains a statement that identifies the collateral. If the collateral includes crops, timber, minerals, or fixtures, the financing statement needs to include a description of the real estate involved. The financing statement must indicate that the debtor and creditor have entered into a security agreement. Finally, the debtor must sign the financing statement. Simple forms, often referred to as a UCC-1 form, are available for use as a financing statement. These forms have spaces for additional provisions as agreed on by the parties. However, the basic information, as stated in this paragraph, is all that is necessary to have a valid financing statement. The purpose of filing a financing statement is to give notice that the secured party has a security interest in the described collateral. Potential creditors are charged with the task of going to a public office to see if the proposed collateral is already encumbered. A person search-ing the records finds only minimal information and may seek more from the parties listed in the financing statement. The addresses of the creditor and debtor are available, so interested third parties know the sources of the additional information. At times, the issue of whether a financing statement can substitute for a security agreement, or vice versa, arises. Generally, a financing statement is not a substitute for a security agreement. A security agreement may be filed as a financing statement if it contains the required informa-tion and is signed by the debtor. However, a financing statement usually will not qualify as a security agreement. Most businesspeople use a separate financing statement because filing a security agreement would make public some information that the parties might prefer to keep confidential.

Financing statement

pg. 602 & 603 The legal documentation that must be properly filed by the creditor to be perfected by filing includes the names and addresses of the parties, an identification of the collateral, and the debtor's signature

Where Should It Be Filed?

pg. 603 & 604 The Code allows the states to require that the financing statement be filed in a central filing system, a local filing system, or a combination of the two [9-301]. A central filing system means that all filing is in the state capital except for fixtures, which are filed locally. Local filing means that filing is at the county level. Most states have enacted dual filing systems. The usual system requires local filing for fixtures and for farm-related collateral and consumer goods and central filing for other business-related collateral, such as inventory and equipment. If the appropriate office for filing is unclear, the secured party should file the financing statement in every office that might be considered proper. The three proposed alternatives for a filing system create problems when the secured transaction involves parties and collateral in several states. The proper location for filing is determined by the debtor's residence or principal place of business

When Should It Be Filed?

pg. 604 A secured party can file a financing statement before the security interest attaches to the collateral. In fact, since the filing serves as notice to third parties, it is wise for the secured party to file at the earliest possible moment. Nevertheless, the filing of a financing statement does not perfect a security interest until such interest is in existence by attachment. The financing statement may provide a maturity or expiration date, but more often it is silent on this point. In the absence of such data, the filing is effective for a period of five years, subject to being renewed by the filing of a continuation statement signed by the secured party [9-515(a)]. To be effective, a continuation statement must be filed within six months of the financing statement's termination. If it is properly renewed, the original financing statement continues to be valid for another five years [9-515(b)]. The presence in the records of a financing statement constitutes a burden on the debtor since it reveals to all persons with whom the debtor may be dealing that his/her property is or may be subject to the claims of others. The Code, therefore, provides for the filing of a termination statement to clear the record when the secured party is no longer entitled to a security interest. Failure of the secured party to send a termination statement within one month of the final payment or twenty days after written demand by the debtor, whichever is earlier, subjects the secured party to a $500 penalty and makes him/her liable for any loss suffered by the debtor [

Pledge

pg. 604 Personal property, as security for a debt or other obligation, deposited or placed with a person

Certificates of Title

pg. 604 Under certain circumstances, the filing of a financing statement does not perfect the creditor's security interest. The Code makes special provisions for goods such as motor vehicles that have a certificate of title. The Code's filing requirements do not apply, and the usual method of indi-cating a security interest is to have it noted on the certificate of title. If the security interest is properly perfected on the certificate of title, the security interest is valid, even though a substi-tute certificate of title fails to disclose the interest of the secured party. In most states, taking title in the name of the secured party is not a valid means of perfection.

Perfection by Possession

pg. 604 & 605 The simplest way to give notice of a security interest is for the secured party to take possession of the collateral [9-313]. This transfer of the collateral's possession from the debtor to the secured party is called a pledge. Since a secured party's possession of the collateral gives notice of his/her security interest, no public filing is required. As noted previously, the possessory security interest is easy to accomplish because a written security agreement is not required. However, the use of possession as perfection is quite limited because most debtors either need or want possession of the collateral. Possession is the required method of perfection of a security interest in instruments. Filing a financing statement is deemed inappropriate since instruments are created to be freely trans-ferable in commercial transactions. Because a third party accepting an instrument as security or as payment would not think to check for the existence of a financing statement, the Code limits the method of perfection in instruments to possession. Possession is an optional method of perfection if the collateral consists of goods, negotiable documents of title, or chattel paper. Since intangible collateral lacks a physical existence, it cannot be possessed. Therefore, the filing of a financing statement is essential for perfection if the collateral is an account or a general intangible. Although it usually is considered an alternative to filing, possession of the collateral is the only method whereby complete protection in documents and chattel paper can be obtained. The reason possession of documents is necessary for absolute perfection is that the rights of good-faith holders to whom a document has been negotiated by the debtor will prevail over the secured party, even though there has been a filing. Possession of chattel paper is necessary to prevent buyers who purchase chattel paper in the ordinary course of their business from obtain-ing a superior claim in the paper. These situations involving issues of priority to the collateral are discussed in more detail later in the chapter.

Purchase-money security interest (PMSI)

pg. 605 A security interest that is taken or retained by the seller of the collateral to secure all or part of its price or taken by a person who, by making a loan, gives value to enable the debtor to acquire rights in, or the use of, collateral

Perfection by Attachment

pg. 605 Another method of perfection simply involves the attachment of the security interest to the collateral. In other words, in some situations, the creation of the security interest, which is attachment, is also perfection. In these situations, the secured party is automatically perfected by attachment. Two examples of when and why the Code permits perfection by attachment are discussed next. A third situation involving this type of perfection is presented in Section 28.5d.

Trustee

pg. 647 The person named to handle the debtor's assets and obligations during the bankruptcy proceeding the person responsible for managing the debtor's assets and for satisfying the creditor's claim to the extent possible.

Temporary Perfection by Attachment

pg. 605 For a variety of commercial reasons, it may be necessary or desirable for the secured party with a security interest perfected by possession not to have this possession for a short time. For example, a debtor granting a new security interest in instruments or negotiable documents may not have these papers to hand to the creditor at the time the loan-related papers, such as the note and security agreement, are signed. The Code provides the secured party twenty-one days at the outset of this transaction to get possession of the instruments or negotiable documents used as collateral. During this initial twenty-one days, the secured party is automatically perfected by attachment [9-315(d)]. If the secured party fails to obtain possession of this collat-eral within the twenty-one days, that creditor is no longer perfected. Even after obtaining possession of the collateral, a second party may find it necessary to release possession of the collateral to the debtor. Since the release is of short duration, it would be cumbersome to require a filing. The Code therefore provides that a security interest remains perfected for a period of twenty-one days without filing when a secured party having a perfected security interest releases the collateral to the debtor. This grace period applies only to instru-ments, negotiable documents, and goods in the hands of a bailee not covered by a negotiable document of title. If an instrument is temporarily released to the debtor, the purpose must be to enable the debtor to make a presentation of it, collect it, renew it, obtain registration of a transfer, or make an ultimate sale or exchange. The risks associated with such a release involve the debtor's improper or unauthorized negotiation of the instrument or the debtor's sale of the instrument to a bona fide purchaser. If the debtor has possession of the instruments, these risks always are present. The purposes for which goods or documents may be released to the debtor are limited. The release to the debtor of these items of collateral must be for the purpose of ultimate sale or exchange or of loading, unloading, storing, shipping, transshipping, manufacturing, processing, or otherwise dealing with them in a manner preliminary to their sale or exchange.

Purchase-Money Security Interests in Consumer Goods

pg. 605 Probably the most common example of perfection by attachment occurs when a creditor receives a purchase-money security interest (PMSI) in consumer goods as collateral. To understand why perfection by attachment is necessary in these situations, you must first appre-ciate what a purchase-money security interest is. There are two types of PMSIs [9-309]. The first, called the seller's PMSI, occurs when a seller of goods finances the purchase price and retains a security interest in the goods sold as collateral. The second example involves the lender's PMSI and arises when a lender advances money to enable a debtor to acquire the collateral and the money is, in fact, used to buy the collateral [9-107(1)(b)]. Perfection by attachment is possible when a PMSI is created in any item of consumer goods. Creditors are allowed to be automatically perfected when they have taken a PMSI in consumer goods because it would be burdensome to have to file a financing statement after every consumer credit sales transaction. Furthermore, this perfection by attachment prevents the official record keepers from being overworked with a multitude of filings.

Future Advances

pg. 606 In a security agreement, a creditor may include that the collateral protects him/her with respect to future advances in addition to the original loan [9-204(c)]. Such a provision is usually referred to as a dragnet clause, which is also used to pick up existing debts. A future advance occurs when the secured party makes another loan to the debtor. This additional loan is a future advance covered by a properly worded security agreement, even if the secured party was not obligated to make the second loan. A problem that arises with future advances occurs in this context: Secured Party 1 (SP1) lends money, files a financing statement, and has perfected his security interest. Secured Party 2 (SP2) later lends money, files, and perfects his interest in the same collateral. SPl gener-ally would have priority because he was the first to file. What happens, however, when SP1 lends additional money after SP2 has filed and perfected? SP1 still has priority. If the future advance is made while a security interest is perfected, the secured party with priority to the original collateral has the same priority with respect to the future advance. Likewise, if a perfected secured party makes a commitment to lend money later, that party has the same priority regarding the future advance as he/she has with respect to the original collat-eral. These rules are justified by the necessity of protecting the filing system. In other words, a secured party that is perfected by filing remains perfected when future advances are made without having to check for filings made later than his/her financing statement.

Floating Liens In General

pg. 606 Often, a creditor may create a security interest in collateral that is likely to be sold by the debtor. This event is common when the collateral is inventory. To remain secured, the creditor will want to create a floating lien, which is when the security agreement describes the collateral as includ-ing property acquired in the future by the debtor. The security agreement may also provide that future advances made to the debtor will be covered. The secured party can also have a security interest in the proceeds of the sale of collateral in the debtor's ordinary course of business. The secured party's floating lien is protected against the claims of third parties by virtue of the public notice that such a financing arrangement has been made. The amount of the debt and the actual collateral can be constantly changing if the security agreement is worded to include after-acquired property, future advances of money, and the proceeds of any sale. This sort of arrangement allows the secured party to tie up most of the assets of a debtor, a possibility considered acceptable in business financing but restricted toward consumers, as the next section indicates.

After-Acquired Property

pg. 606 The security agreement may provide that property acquired by the debtor at any later time shall also secure some or all of the debtor's obligation under the security agreement. Many security agreements contain an after-acquired property clause such as the following: The security interest of the secured party under this security agreement extends to all collateral of the type that is the subject of this agreement and is acquired by the debtor at any time during the continuation of this agreement. Under this clause, as soon as the debtor acquires rights in new property, a security interest in the new property vests in favor of the secured party [9-204(a)]. This clause obviously binds a debtor severely. The Code limits the effect of after-acquired property clauses in relation to consumer goods since the clauses seem best suited to commercial transactions and might work undue hardship on a consumer. Unless a consumer obtains goods within ten days after the secured party gives value, a security interest usually cannot attach under an after-acquired property clause in consumer goods contracts [9-204(b)].

Artisian's Lien

pg. 623 A possessory lien given to a person who has made improvements and added value to another person's personal property as security for payment for services performed. A security interest in personal property in favor of one who has performed services on the personal property. The claim against an item of personal property that arises when one has expended labor on, or added to, the property with the result that the person is entitled to possession of the property as security until paid for the value of his/ her labor or material Can retain possession of the property as security for compensation the artisan's lien is generally considered to be personal to the party who performs the services; the lien is not assignable. pg. 624 Under common law, the lienholder had to retain the property until a judgment was obtained; then he/she levied execution on the property. Modern statutes permit the lienholder to have the property sold to satisfy the claim. These statutes usually require notice to the owner prior to the sale.

Proceeds

pg. 606 Whatever is received when collateral is sold, exchanged, collected, or otherwise disposed of The passing of the security interest from goods to the proceeds of the sale is an important part of the floating lien concept. Although the debtor may sell or otherwise dispose of the collateral, the secured party may have an interest in the identifiable proceeds [9-315(c)]. These proceeds may take the form of cash or noncash proceeds. Examples of noncash proceeds include accounts receivable, instruments, chattel paper, documents of title, or any form of goods. Insurance payments also clearly are proceeds. Two different factual situations concerning proceeds may arise. A debtor may have the authority to dispose of the collateral, as in a sale of inventory, or the debtor may dispose of the collateral without authority. In either situation, the secured party has an interest in the proceeds. In the former, the debtor loses security interest in the collateral that is sold in the ordinary course of business but retains an interest in the proceeds. If the debtor sells the collat-eral without authority, the secured party retains a security interest in the original collateral, and the secured party gains an interest in the proceeds. An interest in the proceeds from the sale of collateral may remain perfected, even if the original financing statement does not specifically mention proceeds. This continuous perfection occurs if the original financing statement's description of collateral includes the type of collateral that covers the proceeds. For example, suppose that the original financing statement describes the collateral as inventory and accounts. If an item of inventory is sold on account, the proceeds are an account receivable. The secured party is perfected with respect to this account by the original financing state-ment. However, suppose the item of inventory is sold, and the buyer signs a promissory note. This note, as an instrument, is not covered by the original financing statement. Indeed, to be perfected, the secured party must take possession of this note. In this situation, the Code provides that the secured party is automatically perfected for twenty days with regard to the proceeds not covered by the original financing statement. To remain perfected, the secured party must perfect the interest in these proceeds by some acceptable method during this twenty-day period. Special provisions relate to the secured party's interest in proceeds if the debtor becomes involved in bankruptcy or other insolvency proceedings. In general, the secured party is entitled to reclaim from the trustee in bankruptcy proceeds that can be identified as relating to the original collateral. If the proceeds are no longer identifiable because they have been commingled or deposited in an account, the secured party nonetheless has a perfected security interest in an amount up to the proceeds received by the debtor within ten days prior to the commencement of the bankruptcy proceedings.

Priority Issues in General

pg. 608 Collateral is frequently the subject of conflicting claims. Two or more persons may claim a security interest in the same collateral, or a person may claim that he/she has a better right to the collateral than does the secured party. Interests that may compete with the secured party's claim of priority fall into the following two basic categories: those who purchase the collateral from the debtor and those who are creditors of the debtor. These creditors may be further subdivided into those who have a conflicting security interest in the same collateral and those who have some other lien on the collateral. Among the many ways in which conflicting claims to collateral may arise, the following are some of the more important situations: • A debtor sells the collateral to a good-faith purchaser who may or may not know of the security interest. • A debtor gives more than one security interest in the same collateral. • Collateral becomes attached to real property and thus is a fixture. • Collateral becomes attached as security interest. • Collateral has been processed (such as raw material, in which there is a security interest, being converted into a finished product). • The government or some other creditor claims a lien on the property. • Collateral has been repaired or improved by the services or materials of another. • A trustee in bankruptcy claims the collateral in connection with a bankruptcy case involving the debtor. In all of these situations, as well as in many others, it is necessary to sort out the conflict-ing interests and determine the priority among them. Keep in mind that the priority of a secured party's claim often is determined by whether the secured party has perfected his/her security interest. If it is not properly perfected, there is no priority. The general rule of Article 9 regarding priority is that, after proper perfection, the secured party has priority over (1) those who purchase the collateral from the debtor; (2) those who are also creditors of the debtor; and (3) those who represent creditors in insolvency proceedings instituted by, or against, the debtor. The bulk of the following material involves exceptions to this general rule. In addition to these exceptions, a secured party that has priority to collateral may agree, explicitly or implic-itly, to subordinate its claim in preference to the rights of a third party. We assume in these discussions that this has not occurred.

Buyers in the Ordinary Course of Business

pg. 609 A person who, in good faith and without knowledge that the sale is in violation of the ownership rights or security interest of a third party in the goods, buys in ordinary course from a person in the business of selling goods of that kind A buyer in the ordinary course of business takes possession free of a security interest created by his seller, even though the security interest is perfected and even though the buyer knows of its existence [9-320(a)]. A buyer in the ordinary course of business is a buyer who buys goods from a seller who is in the business of selling goods of that kind [1-201(9)]. When you buy goods at the grocery store, department store, or gas station, you are a buyer in the ordinary course of business. In general, a transaction in the ordinary course of business involves the sale of a seller's inventory. The reason for giving priority to a buyer in the ordinary course of business is obvious. When you buy goods from a professional seller, you expect to get clear title to the goods and would never think that they might be subject to a security interest. This rule, then, simply codifies the customary expectations of buyers in our society. It has been applied to buyers of new cars from a dealership and to a dealer-buyer who buys from another dealer. Generally, this rule would not apply if you bought a used car from a car repair garage since the garage is not in the business of selling cars on a daily basis. In other words, the garage does not sell cars in the ordinary course of its business. The buyer-in-ordinary-course-of-business rule does not apply to a person buying farm products from a person engaged in farming operations. Typically, farmers or ranchers get loans and grant security interest in their crops or cattle. This rule allows the secured party to follow its security interest into the hands of a cattle buyer or a grain elevator or food processor. To under-stand the reason for this exception, you should recognize that most farmers borrow money to plant and raise their crops. These loans are repaid when the crops are sold. If the law did not grant priority to creditors of farmers, these farmers would not be able to function. Creditors of farmers and those who do business with farmers must keep this exception to the buyer-in-ordinary-course-of-business rule clearly in mind.

Buyers of Consumer Goods

pg. 609 The rule of continuing priority for the secured party does not apply when a consumer-buyer purchases consumer goods from a consumer-debtor. The consumer-debtor, by definition, cannot sell his/her property in the ordinary course of business, because, as a consumer, the seller is not engaged in a business activity. Previously, we discussed that a secured party with a PMSI in consumer goods is automatically perfected when the security interest is created; in other words, a PMSI in consumer goods is perfected by attachment. Nevertheless, a secured party who relies on this automatic perfection may lose priority. As the next paragraph explains, a secured party with a PMSI in consumer goods has to file a financing statement to be assured of priority over a consumer-buyer of the collateral Section 9-302(b) allows a consumer-buyer of consumer goods from a consumer-debtor to take free of the PMSI unless, prior to the purchase, the secured party has filed a financing state-ment covering such goods. Suppose that Smith buys a sofa from Furniture Company and gives it a PMSI in the sofa for the unpaid purchase price. Furniture Company does not file a financing statement. A few months later, Smith sells the sofa to her next-door neighbor, Jones, who uses the sofa in his home. Although Furniture Company has an automatically perfected security interest in the sofa, the sale is free of that PMSI if Jones paid value, did not know of the PMSI, and uses the sofa for consumer purposes. If Furniture Company had filed a financing statement, Jones's purchase would be subject to the PMSI. In the alternative, if Jones had purchased this sofa from Smith for a resale in his used-furniture store, Jones's purchase would be subject to the Furniture Company's security interest even if the Furniture Company had not filed a financing statement. This result is because Jones would not be a consumer-buyer in this latter example.

Secured Party Versus Buyers of Collateral General Rule

pg. 609 We now turn our attention to the secured party's priority when the collateral is sold or trans-ferred to a third party. In general, the secured party's security interest continues in any collateral sold or transferred unless the security agreement authorizes such a sale or transfer free of the security interest. This general rule makes sense; the secured party and the debtor are free to make any legal agreement they wish, and a secured party may voluntarily give up the security interest. A more likely issue arises when the debtor sells the collateral without the secured party's approval. If the debtor makes an unauthorized sale or transfer, the security interest usually continues in the collateral in the hands of the buyer. There are two principal situations in which the buyers take priority over the secured party, even though the sale was unauthorized. These situations are considered in the next two sections.

Suretyship

pg. 623 An express contract in which a third party to a debtor-creditor relationship (the surety) promises to be primarily responsible for the debtor's obligation. provides security for a creditor without involving an interest in property. In suretyship, the security for the creditor is provided by a third person's promise to be responsible for the debtor's obligation. The relationship created between the debtor, creditor, and third party when that third party promises the creditor that the debtor will perform the promises made or, in the alternative, the third party will perform them

Artisan's liens and suretyships

pg. 623 Both relate to personal property

Order of relief

pg. 647 The ruling by a bankruptcy judge that a particular case is properly before the bankruptcy court The bankruptcy judge enters an order of relief when he/she finds that the debtor is entitled to the protection of the bankruptcy law.

Secured Party Versus Secured Party General Rule

pg. 611 This section basically provides a first-in-time rule—in other words, the first creditor to file or to perfect, if filing is not required, will have priority. This rule emphasizes the special status of filing a financing statement. Remember, filing can occur at any time, even prior to attachment. The Code adopts a pure race type statute—that is, the first to file or perfect wins, and knowledge is unimportant. The benefit of a race statute is that it provides for certainty and predictability: Whichever party wins the race has priority. This first-in-time rule also makes it advantageous to be perfected by attachment. Suppose a retail merchant sold a refrigerator to Smith to be used in Smith's home. Assume the merchant sold this refrigerator to Smith on credit, and the merchant had Smith sign a security agree-ment. This merchant is automatically perfected by attachment since he has a PMSI in consumer goods. If Smith then granted a security interest in this refrigerator to a bank in return for a loan, the bank must file a financing statement to be perfected. If Smith defaults on his payments to both the merchant and the bank, which party has priority to the refrigerator? The merchant has priority, since he was perfected before the bank filed. Section 9-322(a)(1) states that the creditor who files or perfects first has priority.

PMSI in Inventory Collateral

pg. 612 To be really protected, a secured party with a security interest in inventory usually will insist on having the security agreement contain an after-acquired inventory clause. If filing perfects that security interest, the general rule is that this secured party will have priority over a later secured party, since he/she was first in time. However, what happens if the debtor wants to finance a new line of inventory? This general rule effectively stops the debtor unless the secured party is willing to make a future advance. For the purpose of allowing the debtor more control over his/ her inventory, Section 9-324(b) creates an exception to this general rule. For example, a bank lends a store money secured by the store's entire inventory now owned or hereafter acquired. The bank properly files a financing statement. A year later, a loan company advances money to allow the store to acquire a new line of appliances. Before the new appliances arrive, the loan company properly files a financing statement covering the appli-ances. The loan company then notifies the bank that the loan company intends to finance the new appliances for the store on a PMSI. The loan company now has priority over the bank but only in relation to the new appliances. The requirements of Section 9-324(b) are rather simple. First, the PMSI-secured party must perfect its PMSI and give the other secured party written notice that it has (or expects to have) a PMSI in certain described inventory. Perfection and notice must occur prior to the debtor receiving the inventory. The purpose of the notice is to protect the first secured party so he/she will not make new loans based on the after-acquired inventory or otherwise rely on the new inventory as collateral. It is not important whether the perfection of the PMSI or the notification to the preexisting secured party occurs first. What is important is that these steps must occur before the debtor takes possession of the new inventory. Proof of the time that each step was accomplished is essential if the PMSI creditor is to have priority.

PMSI in Noninventory Collateral

pg. 612 For collateral other than inventory, a PMSI is superior to conflicting security interests in the same collateral, provided that the PMSI is perfected when the debtor receives the collateral or within twenty days thereafter [9-324(a)]. Thus, prior notice to other secured parties is not required in cases of equipment if the security interest is perfected within twenty days after the debtor receives the equipment. The prior notice requirement is limited to a PMSI in new inventory. Why is prior notice required for inventory but not other classifications of collateral? The answer is that secured parties are likely to rely on the debtor's inventory more than on other types of collateral as a primary source of repayment. In other words, the sale of inventory is much more likely to produce regular income from which debts can be paid. Therefore, the secured parties need to be informed more readily about the fact that they cannot rely on new inventory. The lack of prior notice about new equipment being purchased on credit, for example, does not create a problem for the preexisting secured parties, since their reliance on that equipment should be minimal. A secured party with a PMSI in noninventory collateral is given a special status for twenty days after the debtor receives the property. The protection during this period is limited. It gives priority over the rights of only (1) transferees in bulk (buyers of all or a substantial portion of a business) from the debtor and (2) lien creditors to the extent that such rights arise between the time the PMSI attaches and the time of filing. The purchase-money secured party is not protected against a sale by the debtor to another party or by a secured transaction in which the collateral is given as security for a loan during the period prior to filing. Of course, to remain continuously perfected, the secured party must file a financing statement or otherwise perfect during this twenty-day period.

Rights and Duties on Debtor's Default Introduction

pg. 613 A debtor's default is the event that illustrates the real benefits of being an Article 9 secured party. Article 9 defines the rights and duties of both secured parties and debtors in default situations. The provisions of Part 6 of Article 9 permit the secured party to take possession of the collateral and dispose of it to satisfy the claim. This secured party may obtain the collateral by self-help (if this procedure does not breach the peace) or by court action [9-609(b)]. Once the collateral is in hand, the secured party has two alternatives [9-620]. -The first is to conduct a foreclosure sale, with the proceeds to be applied to the unpaid debt. -The second option is strict foreclosure, which occurs when the secured creditor retains the collateral in satisfaction of the debt. At any time before either alternative regarding disposition of the collateral becomes final, the debtor has the right to redeem his/her interest in the collateral by paying off the debt. The first event that a secured party must establish is a default by the debtor. The security agreement will set forth the debtor's obligations, which, if breached, will constitute a default. A default may occur even though payments on the debt are current. For example, a note may require that the debtor insure the collateral. Failure to maintain proper insurance coverage may justify the creditor's repossessing the collateral and selling it according to the procedures described in the sections that follow.

Secured Party Versus Lien Creditors

pg. 613 In addition to other secured parties and buyers of the collateral, a secured party's security interest can conflict with parties holding liens arising from operation of law. Four types of liens created by law may come into conflict with an Article 9 security interest: (1) federal tax lien; (2) laborer's, artisan's, or material person's lien; (3) judgment creditor's lien; and (4) the bank-ruptcy trustee's lien. In general, the rule determining priority between a secured party and a lien holder is the first-in-time rule. In other words, the party that is first to indicate its interest on the public record has priority. For example, failure to pay federal taxes allows the Internal Revenue Service to file a notice of a tax lien on any property of the delinquent taxpayer. The property described in a federal tax lien may also be subject to an Article 9 security interest. The secured party has a priority claim to this property if the notice of the tax lien is filed after the security interest is perfected. If the notice of the tax lien is filed before the security interest is perfected, the Internal Revenue Service has priority.

As exceptions to the general rule that the lienholder must maintain possession to have perfection of the artisan's lien, two points are emphasized:

pg. 623 First, a lienholder may temporarily surrender possession with an agreement that the lien will continue. However, if rights of a third party arise while the lienholder is not in possession of the property, the lien is inferior to the third party's rights. In addition, surrender of possession of part of the goods will not affect the lien on the remaining goods. Second, the release of possession will not terminate the lien if a notice of lien is recorded in accordance with a state's lien and recording statutes prior to surrender of possession of the goods. Notice of an artisan's lien in the public records serves as an adequate substitute for possession. Some states have adopted the concept of a filing in the public records as an essential step in perfecting an artisan's lien

Rights and Duties of Secured Party in Possession

pg. 613 The secured party has certain rights against the debtor who has defaulted. First, any reason-able expenses incurred in connection with the collateral are chargeable to the debtor and are secured by the collateral [9-607]. Second, the risk of accidental loss or damage to the collateral is on the debtor to the extent that the loss is not covered by insurance. Finally, the secured party is entitled to hold as additional security any increase in or profits received from the collateral, unless the increase or profit is money. Once the secured party has obtained possession of the collateral, that party must decide what to do with the collateral. The secured party may sell the collateral and apply the sale proceeds to satisfy the debt, or the secured party may decide to keep the collateral in satisfac-tion of the debt. Because of the potential harshness of strict foreclosure, there are situations when a debtor or other interested party can force the secured party to sell the collateral. The Code imposes certain duties on a secured party in possession of the collateral. The most important is to exercise reasonable care in the custody and preservation of the collateral. If the collateral is chattel paper or instruments, reasonable care includes taking steps to preserve rights against prior parties unless otherwise agreed. Example: A debtor pledged its stock in ABC Corporation to a creditor to secure a loan. While the creditor was in possession, ABC issued rights to current stockholders to buy additional shares, which rights would expire if not exercised by a stated date. Knowing of this right, the creditor failed to notify the debtor about it before the expiration date. The creditor thus failed to exercise due care and would be liable to the debtor for any loss caused by the failure to notify

Foreclosure Sale

pg. 614 After default, a secured party may sell, lease, or otherwise dispose of the collateral [9-610(a)]. The usual disposition is by public or private foreclosure sale. The primary goal is to get the best possible price on the resale, since that benefits both the debtor and the secured party. For example, the higher the foreclosure sale price, the greater the likelihood of a surplus for the debtor. In addition, the likelihood of a deficiency is diminished. The foreclosure sale can be public or private, and it can be by one or more contracts [9-610(b)]. A public sale, or a sale by auction open to the general public often occurs on the courthouse steps. A private sale is a sale through commercial channels to a buyer arranged by the secured party. Such a buyer could be a dealer who regularly buys and sells goods like the collateral. Although the Code provides flexible rules for the foreclosure sale, it does not leave the debtor unprotected and at the secured party's mercy. Indeed, the Code imposes definite restric-tions on the secured party, who must adhere to these restrictions or risk losing the remedies provided by the Code. Of these restrictions, three are the most important: (1) reasonable notifica-tion of the foreclosure sale given to the debtor by the secured party, (2) reasonable timing of the foreclosure sale, and (3) commercial reasonableness of every aspect of the foreclosure sale. Although the Code allows the secured party to buy the collateral at any public sale, the right to buy at a private sale is restricted. Only if the collateral is of a type normally sold in a recognized market or is subject to universal price quotations can the secured party buy at a private sale. This prohibition against the creditor's buying at a private sale acknowledges that creditors can overreach the debtor's rights by conducting a sham sale. A sham sale occurs if the creditor purchases the collateral at an unreasonably low price that allows the creditor to make the debtor liable for a substantial deficiency. Obviously, this type of resale is commercially unreasonable. A resale is recognized as commercially reasonable if the secured party (1) sells the collateral in the customary manner in a recognized market, (2) sells at a price current in such market at the time of resale, or (3) sells in conformity with reasonable commercial practices among dealers in the type of property sold.

Strict foreclosure

pg. 614 The agreement by the creditor and debtor to allow the creditor to retain possession of the debtor's property in satisfaction of the creditor's claim

Rights of Parties After Foreclosure

pg. 614 The buyer of the collateral at a foreclosure sale receives it free of the security interest under which the sale was held. This buyer also is free of any inferior security interest. Thus, the good-faith purchaser at a disposition sale receives substantial assurance that he/she will be protected in purchase. After the sale has been made, the proceeds of the sale will be distributed and applied as follows. -First, the expenses the secured party incurred in taking repossession and conducting the foreclosure sale will be paid. -After these expenses are paid, the sale's proceeds are used to satisfy the debt owed to the secured party. -Third, any indebtedness owed to persons who have inferior security interest in the collateral will be paid. -Fourth, and finally, any surplus remaining after all these debts are satisfied will be returned to the debtor. If the foreclosure sale is commer-cially reasonable in all respects but does not produce enough to satisfy all these charges, the debtor is liable for any deficiency.

Foreclosure

pg. 614 The forced sale of a defaulting debtor's property at the insistency of the creditor

Strict Foreclosure

pg. 614 The secured party who intends to keep the collateral in satisfaction of the debt rather than conduct a foreclosure sale must send written notice to the debtor indicating this intent [9-620(a)]. As with the notice of resale, this notice is not required if the debtor has signed, after default, a statement modifying or renouncing the right to this notice. If the collateral is consumer goods, only the debtor needs to be given notice of the proposed strict foreclosure. Notice to other interested parties is not necessary when consumer goods are involved, since most of the secured parties claiming a conflicting interest will have PMSI and will be relying on perfection by attachment. Thus, the secured party proposing a strict foreclosure will not even know of conflicting interests. When collateral other than consumer goods is involved, written notice proposing strict foreclosure must be sent to all persons who have filed a financing statement covering the collat-eral or who are known to have a security interest in it. Within the time period (discussed in the next subsection), the debtor or any interested party may object in writing to the proposed strict foreclosure. If no objections are received, the secured party can retain the collateral in satisfaction of the debt. Strict foreclosure is disallowed in two situations. First, special provisions relate to consumer transactions. Disposition of consumer goods may be compulsory; if so, a sale must be made within ninety days after possession is taken by the secured party. This resale of the collateral is mandatory when either (1) there exists a PMSI in consumer goods and 60 percent of the purchase price has been paid or (2) there exists an interest in consumer goods to secure a nonpurchase money loan and 60 percent of the loan has been repaid [9-620(e), 9-260(f)]. As stated previously, these rules exist because there is a presumption that the resale will result in surplus proceeds. The resale within ninety days ensures that the consumer-debtor will not be deprived of this surplus. Of course, it is possible that even though a large percentage of the purchase price or loan amount has been paid, the resale of the collateral clearly will not produce a surplus. Thus, the consumer-debtor is allowed to waive the right of mandatory resale. This waiver must be in writing and must be signed by the debtor after default. The second situation when strict foreclosure may be prevented involves an objection to the secured party keeping the collateral. As noted earlier, the debtor and all other interested parties must be sent written notice that a strict foreclosure is proposed. Any of these parties may object to this proposal. This objection must be made in writing, and it must be received by the secured party proposing the strict foreclosure within twenty days of when the original notice was sent. If these requirements for objecting to a strict foreclosure are met, the collateral must be sold [9-620(a)].

Debtor's General Remedies

pg. 615 Except for the ninety-day period for consumer goods, the secured party is not required to make disposition of the repossessed goods within any time limit. The debtor has the right to redeem or reinstate his/her interest in the collateral until either that property has been sold or contracted to be sold or the obligation has been satisfied by the retention of the property [9-623]. The debtor must, as a condition of redemption, tender the full amount of the obligation secured by the collateral plus expenses incurred by the secured party in connection with the collateral and (if so provided in the security agreement) attorney fees and legal expenses

Redemption

pg. 615 When a debtor redeems (buys back) his/her mortgaged property in paying the debt

Because the artisan's lien is perfected by possession

pg. 623 voluntary surrender of the property usually terminates the lien. If the artisan parts with possession, reacquisition of the goods involved will not re-create the lien.

Guarantor

pg. 624 The principal is primarily liable, and the guarantor is secondarily liable. Historically, this concept has required the creditor to give the guarantor notice of the debtor's default before action could be commenced against the guarantor. Furthermore, a creditor, if necessary, must bring two legal actions: first against the principal and second (and separately) against the guarantor. To summarize, a guarantor promises that the principal will do what the principal promised to do.

A principal or principal debtor or obligor is the party who:

pg. 624 borrows money or assumes direct responsibility to perform a contractual obligation.

The word party includes not only

pg. 624 individuals but also all types of business organizations.

a surety is considered ____________ for the principal's performance.

pg. 624 primarily liable

Guaranty Agreements

pg. 625 There are two types of guaranty agreements: general and special. A general guarantor is a party whose promise is not limited to a single transaction or to a single creditor. For example, a principal may have an open line of credit and may borrow from the creditor many times within the overall credit limitation. A guarantor who promises to be liable upon the principal's default, regardless of the number of transactions within the credit line, is called a general guarantor. The general guarantor has significant potential liability. A special guarantor is a party who limits the promise made to a single transaction or to a single creditor or both. A special guarantor's obligation would not protect a creditor to the full extent of an open line of credit if the initial loan transaction were for a lesser amount. classified as absolute or conditional.

Restatement of Security

pg. 626 a legal treatise on the subject of suretyship. Those scholars who prepared the Restatement of Security considered surety to be interchangeable with guarantor.

the statute of frauds applies only to

pg. 626 guaranty contracts involving secondary promises and not to contracts involving a primary promise.

conditional guaranty

pg. 626 the creditor must have made reasonable, but unsuccessful, attempts to collect from the principal before the guarantor can be held liable.

Creation of Suretyship Contracts Two basic situations exist when a surety's promise would benefit the creditor:

pg. 627 (1) when the creditor is concerned about the principal's ability to repay a loan and (2) when the creditor is concerned about the principal's completion of a contractual promise other than repayment.

Suretyship Versus Indemnity

pg. 627 Both contracts ultimately provide protection so that what has been promised will be performed. A surety makes a promise to a person (creditor) who is to receive the performance of an act or payment of a debt by another (principal). In a contract of indemnity, the assurance of performance is made to the party (principal) who is promising to do an act or to pay a debt. Whereas suretyship provides security to creditors, indemnity provides security to principal debtors. In other words, indemnity is a promise to the debtor, or obligor, to hold that debtor harmless from any loss incurred as a result of nonpayment of a debt or nonperformance of a promise. Most insurance contracts are examples of indemnification agreements between the insurer and the insured.

uncompensated sureties

pg. 627 a surety's promise to the creditor to pay the principal's loan is made gratuitously. The consideration (or money) given to the principal is sufficient consideration to make the surety's promise enforceable.

Bonding companies usually are

pg. 627 compensated sureties

Fidelity bonds

pg. 627 give protection against the dishonest acts of a person. In other words, such a bonding company promises to repay the employer any loss, not to exceed a stated amount, caused by the covered employees' embezzlement. Bonding companies are sureties in the sense that the term surety includes security either for the payment of money or for the faithful performance of some other duty.

Creditor-Surety Relationship Fiduciary Aspects

pg. 630 requires good faith and fair dealing. a creditor possessing information affecting the risk must communicate such information to the surety before the contract is made. This duty applies only to information that is significant to the risk, it does not cover all matters that might affect the risk. If some facts make the risk a materially greater one than the surety intends to assume, and if the creditor knows this, the creditor has a duty to disclose those facts to the surety. The duty to disclose exists only if the creditor has reason to believe that the surety does not know the facts and the creditor has a reasonable opportunity to communicate them to the surety. when in doubt about its appropriateness, the creditor should disclose what it knows about the principal when the surety inquires. At the time of the contract, however, a creditor who is aware of the principal's misrepresentation is obligated to inform the surety of the misrepresentation. This duty to inform probably occurs most frequently when a creditor learns that a principal has misrepresented its financial condition to a prospective surety. Particularly when the surety does not have access to the principal's records and books.

Surety as Drawer or Endorser of Commercial Paper Any drawer of a draft (check) and any endorser of a note, draft, or certificate of deposit becomes liable on the instrument signed if

pg. 631 (1) presentment for payment or acceptance was made within a reasonable time, (2) dishonor occurred, and (3) notice of dishonor was given within the time allowed. Since this notice of dishonor must be given, parties who become a surety through their status as an accommodating drawer or endorser or both are entitled to be notified of the principal's (primary party's) default (dishonor).

Surety-Creditor Agreement

pg. 631 A surety may insist on including a clause in the contract with the creditor requiring that the notice of the principal's default be given within a specified time. Whenever such a clause is included, courts will enforce it. If such a clause is binding on the parties, the creditor's failure to notify the surety of the principal's default discharges the surety from liability. However, the notice requirement must be reasonably, and not strictly, interpreted.

Claim

pg. 647 creditor's right to payment in a bankruptcy case a right to payment from the debtor Claims are held and asserted by creditors.

Today's bankruptcy law is based on

pg. 647 on the Bankruptcy Reform Act of 1978 (1978 Bankruptcy Act).

Principal's Default: Notice

pg. 631 By the nature of the agreement, a surety has no obligation to the creditor unless the principal fails to perform. Although no performance is owed prior to that time, a surety is liable to the creditor as soon as the principal defaults. This simple-sounding rule means that the creditor usually does not have to exhaust his/her remedies against the principal before seeking to recover from the surety. Additionally, a creditor may take action against the surety without having to give notice to the surety that the principal has defaulted. The action will provide the notice. The rule that notice need not be given the surety is subject to the following three exceptions: • The contract may require notice to the surety. • A surety who is a drawer or endorser of commercial paper is entitled to notice unless waived in the paper. • A surety who only guarantees collection is entitled to notice.

Subrogation

pg. 631 The substitution of one person in another's place, whether as a creditor or as the possessor of any lawful right, so the substituted person may succeed to the rights, remedies, or proceeds of the claim

Surety as Collection Guarantor

pg. 631 a collection guarantor, under the terms of the Uniform Commercial Code, assures the creditor that collection can be obtained from the guarantor if all efforts to collect from the principal prove unsuccessful. Due to the nature of this assurance, equity requires that the guarantor's potential liability not be unresolved indefinitely while the creditor pursues its claim against the principal. To the extent that a collection guarantor suffers from a lack of notice, that guarantor is discharged. The collection guarantor is not damaged by a lack of notice if that guarantor is aware of what actions the creditor is taking to collect from the principal.

Surety's Performance and Subrogation Rights

pg. 631 & 632 The surety can satisfy its obligation to the creditor by performing as promised or by showing that it has a valid excuse for not performing. The surety who fully performs the obligation of the principal is subrogated to the creditor's rights against the principal. The surety who pays the principal's debt becomes entitled to any security interest the principal has granted to the creditor regarding the debt paid. Furthermore, whenever the creditor obtains a judgment against the principal, the surety receives the benefit of this judgment when the surety satisfies the principal's debts. The right of subrogation protects the creditor as well as the surety. In other words, a creditor has the right to step into the shoes of the surety and to enforce the surety's rights against the principal. Because of the right of subrogation, a creditor in possession of collateral given to him/her by the principal is not at liberty to return it without the consent of the surety. Any surrender of security releases the surety to the extent of its value, with the loss of subrogation damaging the surety to that extent. Failure of the creditor to make use of the security, however, does not release the surety since the latter is free to pay the indebtedness and to obtain the security for his/her own protection. If the creditor loses the benefit of collateral by inactivity—say, by failure to record a mortgage or notify an endorser—the surety is released to the extent that he/ she is injured.

There are three important exceptions to the general rule that defenses available to the principal may be used by the surety to avoid liability to the surety:

pg. 632 (1) the principal's lack of capacity, (2) the principal's discharge in bankruptcy, and (3) the principal's performance excused due to the statute of limitations having run.

Principal's Defenses

pg. 632 a surety may use any defense the principal can use to reduce liability to the creditor. This idea of making the principal's defenses available to the surety is not conditioned on the principal's utilizing the defense first. The surety is protected by the defense regardless of whether the principal is relieved of liability. One important defense is that of lack of a primary obligation. In other words, the surety is not bound if the principal is not bound. This situation may occur when the principal fails to sign a contract when expected to do so. Other common examples of defenses that may be available to the principal and surety include mutual mistake fraud duress undue influence illegality impossibility lack or failure of consideration. Under certain circumstances, the surety may use setoffs and counterclaims of both the principal and the surety as a defense. The surety can set off any claim it has against the creditor and use the setoff to reduce or eliminate the liability. The surety is entitled to use as a defense any setoff that could be used by the principal debtor in a suit by the creditor. -If the principal is insolvent -if the principal and surety are sued jointly -if the surety has taken an assignment of the claim of the principal

Creditor-Principal Relationship

pg. 632 there may be other situations in which the principal has not defaulted because he/she has a valid excuse for nonperformance. These situations may involve a defense the principal can assert against the creditor, a release of the principal by the creditor, or a modification of the creditor-principal relationship. Any of these possible situations may have an impact on the surety's liability.

Lack of Capacity and Discharge in Bankruptcy

pg. 633 Lack of capacity and discharge in bankruptcy are not available to the surety as defenses because the surety promised, in the first instance, to protect the creditor against the principal's inability to perform. Most creditors, particularly those in loan transactions, anticipate the principal's lack of capacity or discharge in bankruptcy. A creditor is likely to protect against the consequences of these possible events by insisting that a surety becomes involved.

Statute of Limitation

pg. 633 The principal's defense that the statute of limitations prevents collection by the creditor may not be used by the surety. The principal and the surety have separate time periods for which they remain liable to the creditor, and that period may be longer for the surety. Obviously, the creditor who waits for three years after the principal's default cannot recover from the principal. Nevertheless, in this situation, the surety remains liable.

Releases

pg. 633 a creditor who voluntarily releases the principal from liability also releases the surety. exceptions to this general rule. The following three are discussed here: (1) a surety that consents to a principal's release is not released, (2) a creditor that reserves rights against a surety does not release that surety, and (3) a release obtained by that principal's fraud does not release the surety if the creditor rescinds the release prior to the surety's reliance on the release.

Types of Agents

pg. 678 -Broker -Factor -General Agent -Special Agent -Independent contractor

Principal's Fraud

pg. 634 Once that creditor learns of this fraudulent scheme by the principal, the creditor may rescind its release agreement. if the surety had no knowledge of the fraud, that surety is released only to the extent that it has relied on the release and on the changed legal position as a result of the release. If the surety had knowledge of the principal's wrongful acts, the surety is not justified in relying on the release. In this latter situation, the creditor still may hold the surety liable for the principal's uncompleted performance.

Extensions of Time for Payment

pg. 634 To affect the surety's liability, the extension agreement must be a binding, enforceable contract. As such, it must be for a definite time and supported by consideration. In other words, the principal must induce the creditor to extend the time originally involved by promising something in addition to what the principal is already obligated to do. Merely promising to pay the original debt at a future date will not supply the consideration because performance of a preexisting obligation is not consideration. The creditor's gratuitous indulgence or passive permission to the principal to take more time than the contract provides has no impact on the surety's liability. Such conduct by the creditor does not injure the surety in any way. Upon the principal's default, the surety is free to perform at any time and pursue all available remedies. If there is a formalized agreement between creditor and principal whereby the time for performance is extended to a definite time, a nonconsenting, uncompensated surety is discharged from liability. During the extension, the principal's financial condition could worsen, which could increase the surety's ultimate risk of loss. general rule of releasing the surety upon the creditor granting a formal extension of time does not apply if the surety consents to the extension. Furthermore, a surety is not discharged by a formal extension of time if the creditor expressly reserves rights against the surety. This reservation of rights must be a part of the extension agreement. a formalized extension of the time for performance discharges a compensated surety only to the extent that surety is injured by the extension. Of course, this rule assumes that the surety does not consent to the extension agreement A compensated surety is perceived as being capable of protecting itself by anticipating possible extension agreements and charging a premium in accordance with expectations.

Other Modifications

pg. 634 & 635 any other modification of the creditor-principal agreement generally discharges the surety. The logic behind this general rule is that a surety should not be liable for the performance of some agreement made after the surety's commitment to the creditor. In general, evidence of a renewed obligation is not considered to be a modification that relieves the surety of liability. However, if the renewal note increases the principal's obligation, the surety is relieved of further liability unless the surety consents to the renewal agreement. If a change in the work represents a material, substantial departure from the risk inherent in the original contract, the surety's obligation ends. First, a surety that consents to the modification is not discharged. Second, an uncompensated but nonconsenting surety is not discharged to the extent that the modification benefits the surety. Third, a compensated surety is not discharged if the modification does not materially increase the surety's risk

Surety's Consent

pg. 635 As in other areas of suretyship, the parties can override the application of the general rule on modification by this agreement. A surety who consents to remain liable is not discharged by a modification to the creditor-principal agreement. This exception is applicable regardless of when the surety consents. Whether consent to modifications occurs before, at the time of, or after the modification, the consenting surety remains liable to the creditor. If the surety's consent is not a part of the original agreement signed by the surety, the creditor has the responsibility to notify the surety of the modification and to obtain the surety's consent. Failure to obtain this consent upon full notice of the modification automatically discharges the surety.

Uncompensated Sureties

pg. 635 In fact, the uncompensated surety is so protected in some states that any modification to the principal's obligation results in an absolute discharge of this surety, assuming no consent. there are deci-sions that hold that an uncompensated (and nonconsenting) surety should not be discharged if the creditor-principal modification benefits the surety. This benefit must be so obvious that there is no way to doubt its beneficial nature. Typically, such a modification occurs only when the creditor agrees to reduce the amount due or the rate of interest.

Compensated Sureties

pg. 635 with respect to the impact of creditor-principal modifications, a compensated surety is discharged altogether only if that surety's risk has materially increased. If the increased risk to the surety cannot be readily determined, it is immaterial. To the extent that a compensated surety's risk is increased only slightly by the modification, that surety is discharged only to the extent of the increased risk; if the compensated surety's risk is not affected by the modification, the surety remains liable as promised. Why is an extension of time for payment treated differently from other modifications? This distinction in treatment is basically due to the creditor's ability to reserve rights against the surety upon an extension of the time of performance. In this discussion of modification, there has been no mention of reservation of rights. A creditor cannot reserve rights against a surety when a general modification of the principal's agreement is made.

Liability of Co-sureties

pg. 636 Co-sureties are jointly and severally liable to the creditor. joint and several means the creditor may sue the co-sureties jointly for the performance promised or may sue each surety separately for the entire performance due. A subsurety promises to be liable only in the event that the surety refuses to perform and thereby defaults. A subsurety is a surety's surety. Unless the sureties involved in a transaction agree otherwise, they are considered co-sureties. A subsuretyship normally must be created by the agreement of the parties, whereas a co-suretyship may be created by implication. When a creditor releases one surety but not the other sureties, the general rule is that the remaining sureties are released to the extent that they cannot seek contribution against the released surety. Once again, this rule is not applicable if the remaining sureties consent or if the creditor reserves rights against the remaining sureties. a creditor can hold one surety liable for the principal's entire obligation surety is liable for only a pro rata share (among the co-sureties) of the performance rendered. The right of contribution works to allocate the liability 50-50 between two co-sureties, 331/3-331/3-331/3 among three co-sureties, and so forth. Before one co-surety can collect from another, proof of payment of the obligation is required. In general, any recovery does not include attorney's fees, although interest calculated at the statutory rate may be recovered.

Surety's Right to Reimbursement

pg. 636 Generally, after the surety has performed, the surety is entitled to be reimbursed by the prin-cipal. As you have come to expect, this general rule on the surety's right to be reimbursed is subject to at least two exceptions: -First, a principal may inform a surety of a valid defense that a principal can assert to deny the creditor's claim -a surety has performed for a creditor after a principal has been released. a surety remains liable to perform the principal's obligations if the creditor reserves rights against the surety. If the surety must perform for the creditor, it is only fair that the principal reimburse the surety.

Principal-Surety Relationship Surety's Duty to Account

pg. 636 Not only does the principal owe a duty to perform to the creditor, but the principal also owes that same duty to the surety. This duty arises by express agreement or by implication. Whenever a surety is present, the principal owes the duty to protect that surety from liability, regardless of whether the surety has a contract with that principal or with the creditor. The only exception to this general rule is when the principal is relieved of liability due to a defense assertable against the creditor's claim. The surety owes a duty to account to the principal for any profits obtained after the surety performs. This surety's duty to account emphasizes that the surety is liable for the principal's performance of an obligation. In essence, the surety should be liable for no more than, and should not benefit from, the commitment made.

Mechanic's lien

pg. 637 A lien for the value of material and labor expended in the construction of buildings and other improvements laws provide for the filing of liens on real estate that has been improved. An improvement is any addition to the land. The purpose of a mechanic's lien is to protect contractors, suppliers, and laborers in the event of nonpayment of their accounts. State laws that grant a lien against real estate to the unpaid party accomplish this purpose.

the term improvement

pg. 637 does not always mean that the land's value has been increased, most improvements usually do increase the real estate's value.

contractors

pg. 638 Persons that contract with the owner, whether they furnish labor or material or agree to construct the building

Potential Lienholders

pg. 638 The persons usually entitled to a lien include those who do any or all of the following: (1) deliver material, fixtures, apparatus, machinery, or forms to be used in repairing, altering, or constructing a building on the premises; (2) fill, sod, or do landscape work in connection with the premises; (3) act as architect, engineer, or superintendent during the construction of a building; or (4) furnish labor for repairing, altering, or constructing a building virtually any contract between the owner and another that has for its purpose the improvement of real estate gives rise to a lien on the premises in favor of those responsible for the improvement

Different kinds of liens

pg. 639 Many states simply capture the entire array of relationship where a security interest in real property is created in favor of those that have supplied labor or materials to improve the property under the rubric "mechanic's lien." In some states, it is referred to as a "construction lien." More specifically, if the reference is to the supply of labor, the lien might be referred to as a "laborer's lien." If referring to the work of an architect, the reference is to a "design professional's lien." If the lien occurs within the common situation where supplies or materials are provided to improve real estate, the lien might be referenced as a "materialman's lien" or "supplier's lien."

subcontractors

pg. 639 anyone to whom a distinct part of the contract has been sublet has a right to a lien

suppliers and laborers

pg. 639 parties who furnish materials to a contractor or subcontractor and those who do the physical work also may have the right to mechanic's liens.

Perfection and Enforcement

pg. 639 & 640 In some states, a contractor has a lien as soon as the contract to repair or to improve the real estate is entered into. In others, the lien attaches as soon as the work is commenced. A supplier of materials usually has a lien as soon as the materials are furnished. A laborer has a lien when the work is performed. The statutes relating to mechanic's liens provide for the method of perfecting these mechanic's liens and for the time period during which they may be perfected. The time period begins when the work is substantially completed. The usual procedure is that the party seeking to perfect a mechanic's lien files or records a notice of lien in the office of the county in which deeds to real estate are recorded. Some statutes provide for filing in the owner's county of residence. A copy of the notice is sent to the owner of record and to the party contracting for the repair or improvement. This notice must be filed within the prescribed statutory period. The law then requires a suit to foreclose the lien and specifies that it be commenced within an additionally prescribed period, such as one year. Anything less than strict observance of the filing requirements eliminates the mechanic's lien but not the debt. Most mechanic's lien laws provide a relatively long period, such as one year, during which a contractor may file a mechanic's lien A much shorter time period is set for subcontractors, suppliers, and laborers to file a mechanic's lien, the time period in which the statutory procedures must be followed is relatively short, such as sixty to ninety days Under these statutory provisions, a mechanic's lien that could be enforced against the property interest of the original contracting owner cannot be enforced against the property interest of the new owner or mortgagee after the expiration of the prescribed statutory period. Thus, during the relatively short statutory period, a mechanic's lien is good against innocent third parties, even though it has not been properly perfected. Consequently, a purchaser of real estate should always ascertain if any repairs or improvements have been made to the premises within the time period for filing mechanic's liens. If a contractor, subcontractor, supplier of material, or laborer fails to file notice of the lien within the appropriate prescribed period or fails to commence suit within the additional period, the lien is lost

Priorities Among Mechanic's Lienholders

pg. 640 If there are several mechanic's liens filed as the result of the same improvement project, the liens are entitled to priority on the basis of when the lienholder began work on the project. If several liens are considered equal in priority and there are insufficient funds to satisfy all these claims, the lienholders must share the proceeds on a pro-rata basis. Each lienholder is entitled to that portion of the proceeds that his/her work represented of the entire improvement Between Mechanic's Lienholder and Mortgagee When determining the priority of a mechanic's lien and a mortgage on the same property, the date of attachment is crucial. Nearly all states provide that a mortgage attaches when it is properly recorded. If the state where the land is located is one of the few providing that a mechanic's lien attaches when a notice of lien is filed, then priority is given to the creditor who is first to file. The majority of states' laws on mechanic's liens say that these liens attach when work first begins or when supplies are first delivered. In these states a mortgage may be filed before a notice of lien is filed, and yet the lien has priority. Still other states give priority to mechanic's liens over a previously recorded mortgage because the lienholder has increased the value of the real property. This added value should be evident in the greater proceeds obtained at the foreclosure sale. Some states by statute give priority to a construction mortgage over mechanic's liens. This preference is given because all the parties intend that the contractors and suppliers will be paid out of the proceeds of the construction loan.

Broker

pg. 678 A person employed for a commission to make contracts with third persons on behalf of a principal A broker is an agent with special, limited authority to procure a customer so that the owner can affect a sale or exchange of property. For example, a real estate broker has authority to find a buyer for another's real estate, but the real estate remains under the control of the owner.

Protection Against Liens

pg. 640 & 641 the owner, prior to payment, obtain from the contractor a sworn statement setting forth all the creditors and the amounts due, or to become due, to each of them. An owner has a right to rely on the truthfulness of the contractor's sworn statement. If the contractor misstates the facts and obtains a sum greater than that to which he/she is entitled, the loss falls on the subcontractors who dealt with the contractor rather than on the owner. Under such circumstances, the subcontractors may look only to the contractor for payment. Payments made by the owner, without first obtaining a sworn statement, may not be used to defeat the claims of subcontractors, suppliers, and laborers. Before making any payment, the owner has the duty to require the sworn statement and to withhold the amount necessary to pay the claims indicated. The owner may also protect him/herself by obtaining waivers of the contractor's lien and of the liens of subcontractors, suppliers, and laborers. The owner may also protect him/herself by obtaining waivers of the contractor's lien and of the liens of subcontractors, suppliers, and laborers. A waiver is the voluntary relinquishment of the right to a lien before a notice of lien is filed. In a few states, a waiver of the lien by the contractor is also a waiver of the lien of the subcontractors, as they derive their rights through those of the contractor. However, in most states, lien waivers are effective only against those who agree not to claim a mechanic's lien and who execute a waiver.

Garnishment

pg. 641 A proceeding by which a plaintiff seeks to reach the assets of the defendant that are in the hands of a third party, the garnishee In the process of garnishment, the person owing the money to a judgment debtor—the employer, bank of deposit, or third party—will be directed to pay the money into court rather than to the judgment debtor; such money will be applied against the judgment debt.

Enforcement of Judgments and Decrees

pg. 641 In the trial court, a decision is final at the expiration of time for appeal. In a reviewing court, it is expiration of the time to request a rehearing or to request a further review of the case.

Writ of Execution Execution

pg. 641 The process by which the court, through the sheriff, enforces the payment of the judgment and seizes the unsuccessful party's property and sells it to pay the judgment creditor If the judgment debtor's personal property seized and sold by the sheriff does not produce sufficient funds to pay the judgment, the writ of execution is returned to the court with a statement of the extent to which the judgment is unsatisfied. A judgment creditor with an unsatisfied writ of execution has not only a lien on real property owned by the judgment debtor at the time the judgment becomes final but also a judicial lien on any real property acquired by the judgment debtor during the life of the judgment

In connection with writs of execution and garnishment proceedings, it is extremely signifi-cant that the laws of the various states have statutory provisions that exempt certain property from writs of execution and garnishment.

pg. 641 The state laws limit the amount of wages that can be garnished and usually provide for both real property and personal property exemptions.

release of the lien

pg. 641 postfiling process Even after a notice of lien is filed, lienholders may extinguish their right to enforce the lien. a release is used after there is a public filing

Attachment

pg. 642 A legal proceeding accompanying an action in court by which a plaintiff may acquire a lien on a defendant's property as a security for the payment of any judgment that the plaintiff may recover Attachment is a method of acquiring in rem jurisdiction of a nonresident defendant who is not subject to the service of process. The court may attach property of the nonresident defendant; in so doing, the court acquires jurisdiction over the defendant to the extent of the value of the property attached. Attachment, as a means of obtaining in rem jurisdiction, is used in cases involving the status of a person, such as divorce, or the status of property, such as in eminent domain (acquisition of private property for public use) proceedings. A plaintiff who fears that the defendant will dispose of his/her property before the court is able to enter a final decision uses attachment as a method of ensuring collection of a judgment. The plaintiff has the property of the defendant seized, pending the outcome of the lawsuit.

Citation Proceeding

pg. 642 In recent years, many states have adopted a citation proceeding, which greatly assists the creditor in collecting a judgment. The citation procedure begins with the service of a citation on the judgment debtor to appear in court at a stated time for examination under oath about his/her financial affairs. It also prohibits the judgment debtor from making any transfer of property until after the examination in court. At the hearing, the judgment creditor or representing attorney questions the judgment debtor about his/her income, property, and affairs. Any nonexempt property that is discovered during the questioning may be ordered sold by the judge, with the proceeds applied to the judgment. The court may also order that the judgment debtor make weekly or monthly payments. In states that have adopted the citation proceeding, the difficulties in collecting a judgment have been substantially reduced.

Is It Worth It?

pg. 642 the creditor recognizes the futility of attempting to use additional legal process to collect and the matter simply lies dormant until it dies a natural death by the expiration of the time allowed to collect the claim or judgment. Everyone should be aware that some people are judgment-proof and that, in such cases, the law has no means of collecting a judgment. Debtors are not sent to prison simply because of their inability to pay debts or judgments.

The law of bankruptcy provides possible solutions to problems that arise when

pg. 646 a person, partnership, limited liability company, corporation, farmer, or municipality is unable, or finds it difficult, to satisfy obligations to creditors.

Article I, Section 8 of the U.S. Constitution empowers Congress with the responsibility to

pg. 646 create a bankruptcy system at the federal level

Discharge

pg. 647 An order by a bankruptcy court that a debt is no longer valid—in essence, the debtor's forgiven obligation an order by the bankruptcy judge that a debtor is relieved of paying specific debts.

Debtor

pg. 647 The party that files a bankruptcy petition or against whom such a petition is filed the individual, business organization, municipality, or farmer that a bankruptcy proceeding involves.

The basic concept underlying bankruptcy is

pg. 647 to allow a debtor who is in a difficult financial situation to have a fresh financial start. In other words, the bankruptcy laws permit a deserving debtor the opportunity to come out from under overwhelming financial burdens and to begin life anew. For the majority of personal bankruptcies, seeking protection under bankruptcy law comes after a catastrophic event has occurred that is beyond the control of the individuals filing for bankruptcy (e.g., death of the principal wage earner, devastating illness of a family member, or natural disaster). the bankruptcy laws have always attempted to balance the debtor's rights with the creditors' rights. To protect the creditors, the debtor must turn over his/her assets to court supervision in the form of a trust. Loss of every asset would deprive the debtor of the opportunity for a fresh financial start. Therefore, the debtor may exempt certain items from the bankruptcy estate and retain them as the basis for a new beginning. More than ever before, bankruptcy has become an acceptable solution to the financial distress individuals or businesses could not otherwise overcome.

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA)

pg. 647 which was enacted primarily in response to the fact that personal bankruptcy filings were increasing each year at an alarming rate. The provisions of the BAPCPA generally make it more difficult for individuals to declare bankruptcy (and thus have their debts to business eliminated). Congress observed that bankruptcies were declared in many instances where consumers should be able to pay off their debts. Also, the BAPCPA mandates that an individual may not be deemed a debtor under any provision of federal bankruptcy law unless the debtor received appropriate credit counseling within 180 days of filing for bankruptcy. pg. 651 The law grants a bankruptcy judge the power to dismiss a petition of bankruptcy for "substantial abuse" where the debtor's income fails to meet the "means test." Substantial abuse will be presumed where the debtor's family income is greater than that of the median income of a family in the debtor's state.

Types of Proceedings In General

pg. 648 There are three types of bankruptcy proceedings relevant to business, each identified by a chapter of the statute: -Chapter 7, Liquidation; -Chapter 11, Reorganization; -Chapter 13, Adjustment of Debts of an Individual with Regular Income. The federal bankruptcy laws have two distinct approaches to the problems of debtors. -One approach is to liquidate debts. The liquidation approach recognizes that misfortune and poor judgment often create a situation in which debtors will never be able to pay their debts by their own efforts, or at least it will be very difficult to do so. -The second approach is to postpone the time of payment of debts or to reduce some of them to levels that make repayment possible. This approach is found in the reorganization sections for businesses and in the adjustment of debts provisions for municipalities, farmers, and individuals with regular incomes. The reorganization and adjustment provisions are aimed at rehabilitation of debtors. These procedures, if used, prevent harassment of debtors and spare them undue hardship, while enabling most creditors to eventually obtain some repayment.

The U.S. Bankruptcy Court

pg. 648 plays a large role in adjudicating bankruptcy claims. While this court functions in many ways as a standard federal court created under Article III of the U.S. Constitution, it is important to realize that it is a court of limited jurisdiction and is not granted all powers provided to a judicial tribunal created under Article III. may hear and enter final judgments in "core proceedings" in a bankruptcy case In non-core proceedings, the bankruptcy courts instead submit proposed findings of fact and conclusions of law to the district court, for that court's review and issuance offinal judgment.

Certain businesses are denied the right to liquidation proceedings.

pg. 651 -Railroads -insurance companies -banks -savings and loan associations -homestead associations -credit unions may not be debtors under Chapter 7 of the Bankruptcy Act. These organizations are subject to the jurisdiction of administrative agencies that handle all aspects of such organizations, including problems related to insolvency. Under this arrangement, there are alternative legal provisions for their liquidation

Stockbrokers and commodity brokers are subject only to

pg. 651 Chapter 7

Liquidation Proceedings Under Chapter 7 Liquidation

pg. 651 The process of winding up the affairs of a corporation or firm for the purpose of paying its debts and disposing of its assets used to eliminate most of a debtor's debts. In exchange for having the debts declared uncollectible, the debtor must allow many, if not most, of his/her assets to be used to satisfy creditors' claims. Cases under Chapter 7 of the statute may involve individuals, partnerships, limited liability companies, or corporations, but only individuals may receive a discharge from the court. A discharge voids any judgment against the debtor to the extent that it creates a personal liability. A discharge covers all scheduled debts that arose before the date of the order for relief. It is irrelevant whether a claim was filed or allowed. A discharge also operates as an injunction against all attempts to collect the debt—judicial proceedings, telephone calls, letters, personal contacts, or other efforts. Under all types of proceedings, once they are commenced, creditors are prohibited from attempting to collect their debts.

The debts of partnerships, limited liability companies, and corporations that go through liquidation proceedings are not

pg. 651 discharged. These businesses are still technically liable for their debts; however, the lack of discharge is immaterial unless the partnership, limited liability company, or corporation acquires assets later. This lack of discharge stops people from using "shell" businesses for other purposes after bankruptcy.

Reorganization Proceedings Under Chapter 11

pg. 651 & 652 Reorganization proceedings are used when debtors wish to restructure their finances and attempt to pay creditors over an extended period, as required by a court-approved plan. Such cases almost always involve a business as the debtor. Chapter 11 of the 1978 Bankruptcy Act contains detailed provisions on all aspects of the plan of reorganization and its execution. In addition, the BAPCPA creates a special group of "small business debtors" (those with less than $2 million in debt), which are allowed to function under special rules that expedite the process. As soon as practicable after the order for relief, a committee of creditors, holding unsecured claims, is formed. The committee ordinarily consists of persons with the largest claims and may employ attorneys, accountants, or other agents to assist it. Working with the trustee and the debtor concerning administration of the case, it represents the interests of the creditors. It may investigate the debtor's financial condition and will assist in formulating the reorganization plan The court in reorganization cases will usually appoint a trustee before approving the plan of reorganization. If the court does not appoint a trustee, it will appoint an examiner who conducts an investigation into the debtor's affairs, including any mismanagement or irregularities. After the trustee or the examiner conducts the investigation of the debtor's acts, conduct, assets, liabilities, financial conditions, and other relevant aspects, a written report of this investigation is filed with the court. The trustee may file a plan of reorganization, if the debtor does not choose to, or may recommend that the case be converted to liquidation proceedings. The trustee will also file tax returns for the debtor, file reports with the court, and may even operate the debtor's business unless the court orders otherwise. The debtor may file a plan of reorganization with the voluntary petition or may attempt to extricate the business from its financial difficulties and help it to survive. The plan will classify claims; all claims within a class will be treated the same. All unsecured claims for less than a specified amount may be classified together. The plan will designate those classes of claims that are unimpaired under the plan and will specify the treatment to be given claims that are impaired. The plan must provide a means for its execution. It may provide that the debtor will retain all or part of the property of the estate. It may also propose that property be sold or transferred to creditors or other entities. Mergers and consolidations may be proposed. In short, the plan will deal with all aspects of the organization of the debtor, its property, and its debts. Some debts will be paid in full, some will be partially paid over an extended period of time, and some may not be paid at all. The only limitation is that all claimants must receive as much as they would receive in liquidation proceedings. Holders of claims or interests in the debtor's property are allowed to vote and to accept or reject the proposed plan of reorganization. A class of claims has accepted a plan if at least two-thirds in amount and more than half in number of claims vote "yes." Acceptance by a class of interests, such as equity holders, requires a two-thirds "yes" vote. A hearing is held on the confirmation of a plan to determine if it is fair and equitable. The statute specifies several conditions, such as good faith, which must be met before the plan is approved. Also before approval, it must be established that each holder of a claim or interest has either accepted the plan or will receive as much under the reorganization plan as would be received in liquidation proceedings. For secured creditors, this means they will receive the value of their security either by payment or by delivery of the property. Confirmation of the plan makes it binding on the debtor, equity security holders, and creditors. Confirmation vests the property of the estate in the debtor and releases the debtor from any payment not specified in the reorganization plan. As a general rule, any debtor subject to liquidation under the statute (Chapter 7) is also subject to reorganization (Chapter 11).

Partially Disclosed

pg. 678 A third situation falls between the disclosed and undisclosed principal's circumstances. A third party may know an agent represents a principal, but that third party may not know the principal's identity. When a third party learns of the principal's existence but not his/her identity, a partially disclosed principal is present. For the most part, legal issues treat undisclosed and partially disclosed principals in a similar manner.

Adjustment of Individuals' Debts Under Chapter 13

pg. 653 Chapter 13 proceedings are used to adjust the debts of individuals with regular income whose debts are small enough and whose income is significant enough that substantial repayment is feasible. Such persons often seek to avoid the stigma of bankruptcy. Moreover, under the BAPCPA, many Chapter 7 liquidation provisions will be turned into Chapter 13 repayment plans. Unsecured debts of individuals using Chapter 13 proceedings cannot exceed $394,725, and the secured debts cannot exceed $1,184,200. People using Chapter 13 are usually employees earning a salary, but people engaged in business also qualify. Self-employed people who incur trade debts are considered to be engaged in business. The debtor files a plan that provides for the use of all or a portion of future earnings or income for the payment of debts. The income is under the trustee's supervision and control. Except as provided in the plan, the debtor keeps possession of his/her property. If the debtor is engaged in business, the debtor continues to operate the business. The plan must provide for the full payment of all claims entitled to priority, unless the creditors with priority agree to a different treatment. If a plan divides unsecured claims into classes, all claims within a class must be given the same treatment. Unsecured claims not entitled to priority may be repaid in full or reduced to a level not lower than the amount that would be paid upon liquidation. Since this amount is usually zero, any payment to unsecured creditors will satisfy the law. The secured creditors may be protected by allowing them to retain their lien, by payment of the secured claim in full, or by the surrender of the property to the secured claimant. Under provisions of the BAPCPA, the debtor's median income determines whether the length of the plan is three or five years. A typical plan allocates one-fourth of a person's take-home pay to repay debts. The plan may modify the rights of holders of secured and unsecured claims, except that the rights of holders of real estate mortgages may not be modified. Claims arising after the filing of the petition may be included in the plan. This is a realistic approach because all the debts of the debtor must be taken into account if the plan is to accomplish its objectives. If the court is satisfied that the debtor will be able to make all payments to comply with the plan when the court conducts a hearing on the confirmation of it, the plan will be approved. Of course, the plan must be proposed in -good faith -be in compliance with the law -be in the best interest of the creditors. As soon as the debtor completes all payments under the plan, the court grants the debtor a discharge of all debts, unless the debtor waives the discharge or the debts are not legally dischargeable. After a hearing, courts may also grant a discharge, even though all payments have not been made, if the debtor's failure to complete the payments is due to circumstances for which the debtor should not justly be held accountable. In such cases, the payments under the plan must be not less than those that would have been paid on liquidation, and modification must not be practicable

Types of Bankruptcy

pg. 654 - Chapter 7 - Chapter 11 - Chapter 13

Property of the Estate

pg. 654 The bankruptcy estate consists of all legal or equitable interests of the debtor in property, wherever located. The property may be tangible or intangible and includes causes of action. To begin, all property is included in the estate, though the debtor may exempt portions entitled to exemption. The estate includes property that the trustee recovers by using his/her power to avoid prior transactions. It also includes property inherited by the debtor or received as a beneficiary of life insurance within 180 days of the petition. Proceeds, products, offerings, rents, and profits generated by or coming from property in the estate are also part of the estate. In general, property acquired by the debtor after commencement of the case—including earnings from employment—belongs to the debtors. Property held in trust for the benefit of the debtor under a spendthrift trust does not become a part of the estate. In essence, the trustee in bankruptcy acquires the same interest with the same restrictions as the debtor had at the time the bankruptcy petition was filed. However, the trustee can require creditors to turn over possession of assets held by the creditors when the petition was filed. In return, the trustee must provide adequate protection for these creditors' claims. These concepts also apply to the IRS and other government agencies.

Exemptions Federal Exemptions

pg. 654 & 655 1. Real property used as a residence, up to $23,675 in equity 2. The debtor's interest, not to exceed $3,775, in one motor vehicle 3. The debtor's interest, not to exceed $600 in any particular item or $12,625 in aggregate value, in household furnishings, wearing apparel, appliances, books, animals, crops, or musical instruments that are held primarily for the personal family or household use of the debtor and his/her dependents 4. The debtor's interest in jewelry, not to exceed $1,600 5. The debtor's interest in other property, not to exceed $1,250, plus up to $11,850 of any unused real property exemption 6. The debtor's interest, not to exceed $2,375, in any implements, professional books, or tools of the trade of the debtor or the trade of his/her dependents 7. Unmatured life insurance contracts 8. The cash value of life insurance, not to exceed $12,625 9. Professionally prescribed health aids 10. The debtor's right to receive benefits such as social security, unemployment compen-sation, public assistance, disability benefits, alimony, and child support and separate maintenance reasonably necessary, as well as current payments of pension, profit sharing, annuity, or similar plans 11. The debtor's right to receive payment traceable to the wrongful death of an individual on whom the debtor was dependent or to life insurance on the life of such a person or to payments for personal injury, not to exceed $20,200 12. For some retirement funds and pensions, no limit; for others, up to $1,283,025, along with education savings accounts, which are exempt from taxation under the Internal Revenue Code

Status of Exempt Property

pg. 655 As a general rule, exempt property is not subject to any debts that arise before commencement of the case. Exceptions to the general rule apply to: -tax claims -alimony -child support -separate maintenance judicial liens and nonpossessory, nonpurchase money, security interests in household goods, wearing apparel, professional books, tools, and professionally prescribed health aids may be avoided. A debtor may redeem such tangible personal property from a lien securing a dischargeable consumer debt by paying the lienholder the amount of the secured claim. Exempt property is free of such liens after the proceedings Waivers of exemptions are unenforceable to prevent creditors from attempting to deny debtors the necessary property to gain a fresh start

State Exemptions

pg. 655 some state exemptions exceed those provided by the federal bankruptcy laws. Other state exemptions are too small to give a debtor a real chance at a fresh financial start. To encourage some states to raise their exemptions, the 1978 Bankruptcy Act provides that the federal exemptions will be available to debtors unless the state specifically passes a law denying its residents the federal exemptions. Debtors may claim the larger exemptions offered by their state if it is to their advantage to do so. More than half the states have adopted laws denying debtors the use of the federal exemptions; however, these states have substantially increased their own exemptions. One of the most popular exemptions provided by state law is the homestead exemption. In prior years, some states allowed debtors to shield an unlimited amount of equity in their homes through the use of the homestead exemption. However, the BAPCPA now restricts the maximum equity exempted to no more than $155,675 and provides other restrictions to those who wish to use a state homestead exemption

Debts That Are Not Discharged

pg. 655 & 656 A debt is a liability on a claim. A claim may be based on the right to payment that could be enforced in a proceeding at law, or it may be based on the right to an equitable remedy for breach of performance if the breach gives a right to payment. Claims based on equitable remedies may be dischargeable, the same as those based on legal remedies. A discharge in bankruptcy does not discharge an individual debtor from the following debts: 1. Certain taxes and customs duties accruing within two years of bankruptcy 2. Debts for obtaining money, property, services, or credit by false pretenses, false representations, or actual fraud 3. Consumer debts over $650 for luxury goods and services incurred within ninety days of the order of relief 4. Cash advances over $925 that are extensions of consumer credit under an open-ended credit plan within seventy days of the order of relief 5. Unscheduled debts 6. Debts for fraud or defalcation while acting in a fiduciary capacity and debts created by embezzlement or larceny 7. Alimony, child support, and separate maintenance 8. Liability for willful and malicious torts 9. Tax penalties if the tax is not dischargeable 10. Student loans less than five years old, unless payment creates an undue hardship 11. Debts incurred as a result of an accident caused by driving while intoxicated 12. Debts owed before a previous bankruptcy 13. Fines and penalties payable to and for the benefit of governmental units that are not compensation for actual pecuniary losses

To justify discharging the debtor's student loans, the Brunner test requires a three-part showing:

pg. 658 (1) that the debtor cannot maintain, based on current income and expenses, a "minimal" standard of living for [himself] and [his] dependents if forced to repay the loans; (2) that addi-tional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor has made good faith efforts to repay the loans.

Grounds for Denying Discharge the 1978 Bankruptcy Act specifies the following grounds for denying an individual debtor a discharge:

pg. 658 1. Fraudulent transfers 2. Inadequate records 3. Commission of a bankruptcy crime 4. Failure to explain a loss of assets or deficiency of assets 5. Refusing to testify in the proceedings or to obey a court order 6. Any of the above within one year in connection with another bankruptcy case of an insider 7. Another discharge within eight years (Under the 1978 Bankruptcy Act, the time between discharges was six years, but the BAPCPA extended this duration.) 8. Approval by the court of a waiver of discharge 9. Failure to complete the required consumer credit education course, as mandated under the BAPCPA The first three grounds for denying discharge are predicated on wrongful conduct by the debtor in connection with the case. Fraudulent transfers involve such acts as removing, destroy-ing, or concealing property with the intent to hinder, delay, or defraud creditors or the trustee. The conduct must occur within one year preceding the case, or it may occur after the case is commenced. A debtor is also denied a discharge if he/she has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any books and records relating to his/her financial condition. A debtor is required to keep records from which his/her financial condition may be ascertained, unless the failure is justified. Bankruptcy crimes are generally related to the proceedings. They include a false oath, the use or presentation of a false claim, or bribery in connection with the proceedings and with the withholding of records. The six-year rule, which allows a discharge only if another discharge has not been ordered within six years, extends to Chapter 11 and Chapter 13 proceedings, as well as to those under Chapter 7. Confirmation of a plan under Chapter 11 or 13 does not have the effect of denying a discharge within six years if all the unsecured claims were paid in full or if 70 percent of them were paid and the debtor has used his/her best efforts to pay the debts. Either a creditor or the trustee may object to the discharge. The court may order the trustee to examine the facts to see if grounds for the denial of the discharge exist. Courts are also granted the authority to revoke a discharge within one year if it was obtained by fraud on the court

Voluntary Commencement

pg. 659 A debtor may voluntarily instigate a bankruptcy case under any appropriate chapter by filing a petition with the bankruptcy court. In recognition of the fact that husbands and wives often owe the same debts, a joint case may be filed. A joint case is a voluntary one concerning a husband and wife, and it requires only one petition. Both spouses must sign the petition, since one spouse cannot take the other into bankruptcy without the other's consent. Insolvency is not a condition precedent to any form of voluntary bankruptcy action. As of June 2017, all petitioners must pay a filing fee, in installments if they prefer, of $335 for Chapter 7, $1,717 for Chapter 11, and $310 for Chapter 13. Only one filing fee is required in a joint case. A petition filed by a partnership as a firm is not a petition on behalf of the partners as individuals. If they intend to obtain individual discharges, separate petitions are required. The petition contains lists of: -secured and unsecured creditors -all property owned by the debtor -property claimed by the debtor to be exempt -a statement of affairs of the debtor. This statement includes current income and expenses so the judge can dismiss a case if he/she believes that a substantial abuse of the bankruptcy code has occurred. This statement is an important consideration when a debtor's liabilities do not exceed assets and the filing is based on some fact other than the debtor not being able to pay debts as they come due. The statement of affairs of a debtor engaged in business is much more detailed than the one filed by a debtor not in business. In general, the filing of a voluntary petition constitutes an order of relief indicating that the debtor is entitled to the bankruptcy court's protection. Further, the filing of the petition (either voluntary or involuntary) triggers an automatic stay, which has the effect of suspending almost all actions by creditors against the debtor or the debtor's assets.

Conversion of Cases

pg. 659 Because a case may be filed voluntarily or involuntarily under the various chapters, the issue arises as to whether the debtor or the creditors can convert a filing to another type of proceeding. If the original filing is under Chapter 7, the debtor can request a conversion to a Chapter 11 or 13 proceeding. Creditors can have a Chapter 7 case converted to Chapter 11 but not to Chapter 13. If the case was filed voluntarily as a Chapter 11 reorganization proceeding, the debtor may request that the case be converted to a Chapter 7 or 13 proceeding. However, if the Chapter 11 proceeding had begun involuntarily, the creditors must consent to a conversion to Chapter 7. Creditors may seek to convert a Chapter 11 proceeding to Chapter 7 as long as the debtor is neither a farmer nor a nonprofit corporation. Creditors cannot convert a case from Chapter 11 to Chapter 13 without the debtor's consent. In general, a debtor may convert a Chapter 13 proceeding to Chapter 7 or 11—whichever is more appropriate. Creditors also may ask the court to convert a case filed under Chapter 13 to Chapter 7 or 11, unless the debtor is a farmer. If the debtor is a farmer, any conversion must be agreed to by that farmer before that conversion will occur.

General agent

pg. 678 An agent authorized to do all the acts connected with carrying on a particular trade, business, or profession one who has authority to transact all the business of the principal—of a particular kind or in a particular case. The powers of a general agent are coextensive with the business entrusted to the agent's care, authorizing him/her to act for the principal in all matters coming within the usual and ordinary scope and character of such business. A general agent has much broader authority than a special agent. Some cases define a general agent as one authorized to conduct a series of transactions involving a continuity of service, whereas a general agent conducts a single transaction or a series of transactions without continuity of service

Involuntary Commencement

pg. 659 & 660 One or more creditors filing a petition commence involuntary cases. If there are twelve or more creditors, the petition must be signed by at least three creditors whose unsecured claims are not contingent and aggregate at least $15,775. If there are fewer than twelve creditors, only one need sign the petition; however, the $15,775 amount must still be met. Employees, insiders, and transferees of voidable transfers are not counted in determining the number of creditors. Insiders are persons such as relatives, partners of the debtor, and directors and officers of the corporation involved. Creditors may commence involuntary proceedings to harass the debtor. To protect the debtor, the court may require the petitioning creditors to file a bond to indemnify the debtor. This bond will cover the amounts for which the petitioning creditors may have liability to the debtor. The liability may include court costs, attorney's fees, and damages caused by taking the debtor's property. Until the court enters an order for relief in an involuntary case, the debtor may continue to operate his/her business and to use, acquire, and dispose of property. However, the court may order an interim trustee to be appointed to take possession of the property and to operate the business. If the case is a liquidation proceeding, the appointment of the interim trustee is manda-tory unless the debtor posts a bond guaranteeing the value of the property in his/her estate Since some debtors against whom involuntary proceedings are commenced are, in fact, not bankrupt, the debtor has a right to file an answer to the petition of the creditors and to deny the petition's allegations. If the debtor does not file an answer, the court orders relief against the debtor. If an answer is filed, the court conducts a trial on the issues raised by the petition and the answer. A court will order relief in an involuntary proceeding against the debtor only if it finds that the debtor is generally not paying debts as they become due. Insolvency in the balance sheet sense (liabilities exceeding assets) is not required. Relief may also be ordered if, within 120 days before the filing of the petition, a custodian, receiver, or agent has taken possession of the debtor's property for the purpose of enforcing a lien against the debtor. Creditors also are prohibited from forcing any debtor into a Chapter 13 proceeding. The reason for this rule is that a Chapter 13 debtor is required to pay off his/her debts pursuant to an approved plan. To force an individual debtor to work to pay debts is equivalent to involuntary servitude, which violates the Thirteenth Amendment of the U.S. Constitution. Moreover, federal bankruptcy law provides penalties against creditors who file frivolous petitions and allow a debtor to receive damages, including punitive damages, against such creditors.

Automatic Stay

pg. 660 Bankruptcy cases operate to stay other judicial or administrative proceedings against the debtor. These stays of proceedings may operate to the detriment of a creditor or third party. For example, a stay would prevent a utility company from shutting off service to the debtor. Despite this potential harm to creditors, the stay automatically becomes applicable immedi-ately upon the bankruptcy petition being filed. The stay provision often works to the disadvantage of secured creditors, especially in reorganization cases under Chapter 11. If the value of the property securing the debt does not cover the full debt, the creditor will lose because he/she cannot sell the property during the period of the stay. Creditors whose collateral is worth less than the loan amount are not entitled to compensation for the period of the stay in the bankruptcy court. When the trustee continues to operate the debtor's business, it is frequently necessary to use, sell, or lease property of the debtor. To prevent irreparable harm to creditors and other third parties as a result of stays, a trustee may be required to provide adequate protection to third parties. In some cases, adequate protection requires that the trustee make periodic cash payments to creditors. In others, the trustee may be required to provide a lien to the creditor. When the sale, lease, or rental of the debtor's property may decrease the value of an entity's interest in property held by the trustee, a creditor may be entitled to a lien on the proceeds of any sale, lease, or rental. The court is empowered to determine if the trustee has furnished adequate protection; when the issue is raised, the burden of proof is on the trustee. The automatic stay is designed to protect both debtor and creditor. The stay provides the debtor with time and freedom from financial pressures to attempt repayment or to develop a plan of reorganization. The stay protects creditors since it forces them to comply with the orderly administration of the debtor's estate. In other words, the stay prevents some creditors from grabbing all the debtor's assets while other creditors receive nothing. It also allows for orderly trials of claims such as those for personal injury or wrongful death; such claims are tried in the federal district courts and not in the bankruptcy courts. Despite these advantages of staying all proceedings against the debtor who files a bank-ruptcy petition, there are exceptions to the application of the automatic stay. These exceptions apply to proceedings that are not directly related to the debtor's financial situation. Proceedings that are not automatically stayed when a bankruptcy petition is made include (1) criminal actions against the debtor; (2) the collection of alimony, maintenance, or support from property that is not part of the estate; and (3) the commencement or continuation of an action by a governmental unit to enforce that governmental unit's police power. Although these actions are not stayed automatically by the filing of a bankruptcy petition, the trustee may seek to enjoin these actions if they harm the debtor's estate.

Stay

pg. 660 The order of relief that prevents all creditors from taking any action to collect debts owed by the protected debtor

Meeting of Creditors

pg. 662 In a voluntary case, the debtor has filed the required schedules with the petition. In an involuntary case, if the court orders relief, the debtor will be required to complete the same schedules as the debtor in a voluntary proceeding. From this point, the proceedings are identical. All parties are given notice of the order for relief. If the debtor owns real property, notice is usually filed in the public records of the county where the land is situated. The notice to creditors will include the date by which all claims are to be filed and the date of a meeting of the creditors with the debtor. This meeting of creditors must be within a reasonable time after the order for relief. The debtor appears at the meeting with the creditors, and the creditors are allowed to question the debtor under oath. The court may also order a meeting of any equity security holders of the debtor. At the meeting of creditors, the creditors may examine the debtor to ascertain if property has been omitted from the list of assets, if property has been conveyed in defraud of creditors, or if other matters may affect the debtor's right to have his/her obligations discharged. In liquidation cases, the first meeting of creditors includes the important step of electing a permanent trustee. This trustee will replace the interim trustee appointed by the court at the time the order for relief was entered. The unsecured creditors who are not insiders elect this perma-nent trustee. To have a valid election, creditors representing at least 20 percent of the amount of unsecured claims held against the debtor must vote. The election is then determined by a majority of the unsecured creditors voting.

Trustee and Case Administration Trustee and the Estate

pg. 662 The trustee may be an individual or a corporation that has the capacity to perform the duties of a trustee. In a case under Chapter 7 or 13, an individual trustee must reside or have an office, and the corporate trustee must have an office, in the judicial district in which the case is pending or in an adjacent district. Prior to becoming a trustee in a particular case, the trustee must file with the court a bond in favor of the United States. This bond may be used as a source of collection if the trustee should fail to faithfully perform his/her duties. The trustee is the representative of the estate and has the capacity to sue and to be sued. Trustees are authorized to employ professional persons such as attorneys, accountants, appraisers, and auctioneers and to deposit or invest the money of the estate during the proceedings. In making deposits or investments, the trustee must seek the maximum reasonable net return, taking into account the safety of the deposit or investment. The statute has detailed provisions on the trustee's responsibilities under the tax laws. As a general rule, the trustee has responsibility for filing tax returns for the estate. After the order for relief, income received by the estate is taxable to it and not to an individual debtor. The estate of a partnership or a corporation debtor is not a separate entity for tax purposes. While the tech-nical requirements of the tax laws are beyond the scope of this text, it should be remembered that the bankruptcy laws contain detailed rules complementary to the Internal Revenue Code in bankruptcy cases; the trustee must follow both

General Duties and Powers

pg. 663 The statutory duties of the trustees in liquidation proceedings are to (1) collect and reduce to money the property of the estate; (2) account for all property received; (3) investigate the debtor's financial affairs; (4) examine proofs of claims and object to the allowance of any claim that is improper; (5) oppose the discharge of the debtor, if advisable; (6) furnish information required by a party in interest; (7) file appropriate reports with the court and the taxing authori-ties, if a business is operated; and (8) make a final report and account and file it with the court. A trustee that is authorized to operate the debtor's business is authorized to obtain unse-cured credit and to incur debts in the ordinary course of business. These debts are paid as administrative expenses. A trustee in bankruptcy has several rights and powers with respect to the debtor's property. First, the trustee has a judicial lien on the property, just as if the trustee were a creditor. Second, the trustee has the rights and powers of a judgment creditor who obtained a judgment against the debtor on the date of the adjudication of bankruptcy and who had an execution issued that was returned unsatisfied. Third, the trustee has the rights of a bona fide purchaser of the debtor's real property as of the date of the petition. Finally, the trustee has the rights of an actual unsecured creditor to avoid any transfer of the debtor's property and to avoid any obliga-tion incurred by the debtor that is voidable under any federal or state law. As a result of these rights, the trustee is able to set aside transfers of property and to eliminate the interests of other parties where creditors or the debtor could do so. The trustee also has the power to avoid certain liens of others on the debtor's property. Liens that first become effective on the bankruptcy or insolvency of the debtor are voidable. As a general rule, liens that are not perfected or enforceable against a bona fide purchaser of the property are also voidable. Assume that a seller or creditor has an unperfected lien on goods in the hands of the debtor on the date the petition is filed. The lien is perfected later. That lien is voidable if it could not be asserted against a good-faith purchaser of the goods. Liens for rent and for distress for rent are also voidable. The law imposes certain limitations on all these rights and powers of the trustee. A purchase-money security interest under Article 9 of the Code may be perfected after the petition is filed if it is perfected within ten days of delivery of the property. Such a security interest cannot be avoided by the trustee if properly perfected. The trustee's rights and powers are subject to those of a seller of goods in the ordinary course of business that has the right to reclaim goods if the debtor was insolvent when the debtor received them. The seller must demand the goods back within ten days, and the right to reclaim is subject to any superior rights of secured creditors. Courts may deny reclamation and protect the seller by giving his/her claim priority as an administrative expense.

Executory Contracts and Unexpired Leases

pg. 663 & 664 Debtors are frequently parties to contracts that have not been performed. There are also often lessees of real property, and the leases usually cover long periods of time. As a general rule, the trustee is authorized, subject to court approval, to assume or to reject an executory contract or unexpired lease. If the contract or lease is rejected, the other party has a claim subject to some statutory limitations. A rejection by the trustee creates a prepetition claim for the rejected contract or lease debt subject to these limitations. If the contract or lease is assumed, the trustee will perform the contract or assign it to someone else; the estate will presumably receive the benefits. If the trustee assumes a contract or lease, he/she must cure any default by the debtor and provide adequate assurance of future performance. In shopping center leases, adequate assurance includes protection against declines in percentage rents and preservation of the tenant mix, among other things. A trustee may not assume an executory contract that requires the other party to make a loan, deliver equipment, or issue a security to the debtor. A party to a contract based on the debtor's financial strength is not required to extend new credit to a debtor in bankruptcy. Contracts and leases often have clauses prohibiting assignment. The law also prohibits the assignment of certain contract rights, such as those that are personal in nature. The trustee in bankruptcy is allowed to assume contracts, notwithstanding a clause prohibiting the assump-tion or assignment of the contract or lease. The trustee is not allowed to assume a contract if applicable nonbankruptcy law excuses the other party from performance to someone other than the debtor, unless the other party consents to the assumption. The statute invalidates contract clauses that automatically terminate contracts or leases upon filing of a petition in bankruptcy or upon the assignment of the lease or contract. The law also invalidates contract clauses that give a party other than the debtor the right to terminate the contract upon assumption by the trustee or assignment by the debtor. Such clauses hamper rehabilitation efforts and are against public policy. They are not needed because the court can require the trustee to provide adequate protection and can ensure that the other party receives the benefit of its bargain. If the trustee assigns a contract to a third party and the third party later breaches the contract, the trustee has no liability. This is a change in the common law in which an assignor is not relieved of liability by an assignment. An assignment by a trustee in bankruptcy is, in effect, a novation if the assignment is valid.

Preference

pg. 664 Occurs when an insolvent debtor pays some creditors a greater percentage of the debts than other creditors in the same class and when the payments are made within ninety days prior to filing a bankruptcy petition; illegal and voidable payments to one creditor over another

Fraudulent Transfers

pg. 664 & 665 A transfer of property by a debtor may be fraudulent under federal or state law; the trustee may proceed under either to set aside a fraudulent conveyance. Under federal law, a fraudulent conveyance is a transfer within two years of filing the petition with the intent to hinder, delay, or defraud creditors. Under state law, the period may be longer and is usually within the range of two to five years. Fraudulent intent may be inferred from the fact that the consideration is unfair, inadequate, or nonexistent. Solvency or insolvency at the time of the transfer is significant but is not controlling. Fraudulent intent exists when the transfer makes it impossible for the creditors to be paid in full or for the creditors to use legal remedies that would otherwise be available. The intent to hinder, delay, or defraud creditors may also be implied. Such is the case when the debtor is insolvent and makes a transfer for less than a full and adequate value. Fraudulent intent is present if the debtor was insolvent on the date of the transfer or if the debtor becomes insolvent as a result of the transfer. If the debtor is engaged in business or is about to become so, the fraudulent intent will be implied when the transfer leaves the businessperson with an unreasonably small amount of capital. The businessperson may be solvent; nevertheless, he/she has made a fraudulent transfer if the net result of the transfer leaves him/her with an unreasonably small amount of capital, provided the transfer was without fair consideration. Whether the remaining capital is unrea-sonably small is a question of fact. The trustee may also avoid a transfer made in contemplation of incurring obligations beyond the debtor's ability to repay as they mature. Assume that a woman is about to enter business and that she plans to incur debts in the business. Because of her concern that she may be unable to meet these potential obligations, she transfers all her property to her husband, without consideration. Such a transfer may be set aside as fraudulent. The requisite intent is supplied by the factual situation at the time of the transfer and by the state of mind of the transferor. The debtor's actual financial condition in such a case is not controlling, but it does shed some light on the debtor's intent factor and state of mind. The trustee of a partnership debtor may avoid transfers of partnership property to partners if the debtor was, or thereby became, insolvent. This rule was made to prevent a partnership's preferring partners who are also creditors to other partners. Such transfers may be avoided if they occurred within one year of the date of filing the petition. If a transferee is liable to the trustee only because the transfer was to defraud creditors, the law limits the transferee's liability. To the extent that the transferee does give value in good faith, the transferee has a lien on the property. For the purpose of defining value in the fraudulent transfer situation, the term includes property or the satisfaction or securing of a present or existing debt. It does not include an unperformed promise to support the debtor or a relative of a debtor

Clawback within a bankruptcy proceeding occurs in one of two instances.

pg. 665 First, preference can be improperly provided to one creditor over another, regardless of whether the transfer was voluntary or involuntary. within the context of fraudulent transfers

clawback suits

pg. 665 power to examine transactions that have occurred over the relevant time and to demand the return of assets transferred.

Factor

pg. 678 An agent for the sale of merchandise who may hold goods in his/her own name or in the name of a principal and who is authorized to sell, and to receive payment for, the goods A factor is a person who has possession and control of another's personal property, such as goods, and is authorized to sell that property. A factor has a property interest and may sell the property in his/her own name, whereas a broker may not. Although the term factor is seldom used today, a retail merchant who has a manufacturer's goods on consignment is a factor.

Special agent

pg. 678 An agent with a limited amount of authority who usually has instructions to accomplish one specific task authorized to act for the principal only in a particular transaction or in a particular way. Most agents usually are considered to be general agents of the employer as long as they stay within the scope of their employment. However, an athlete's agent assisting in contract negotiations likely would be a special agent and generally would not be authorized to make investments or purchase property.

Fraudulent transfer, Voidable Preference, or Acceptable Transaction? Facts Robin Enterprises (Robin) is struggling financially. On March 1, Robin has assets of only $1,000 in its checking account and a company truck worth $5,000. On that date, it owes Eagle Bank $7,000 for overdraft funds taken in other months, $5,000 to a landscape company that just finished a job making Robin's rented office exteriors look more professional, and $4,000 in back rent to Robin's landlord. A. Robin decides to pay the entire rent due of $4,000 on March 1. Robin files for bankruptcy on April 1. B. Robin decides to pay the entire rent due of $4,000 on March 1. Robin files for bankruptcy on September 1. C. Robin decides to pay the entire rent due of $4,000 on March 1. Robin files bankruptcy on December 1. One of the three owners of Robin is also the landlord. D. Robin decides to sell the truck to one of its owners for $300 on March 1 and files bankruptcy on December 1.

pg. 666 A bankruptcy court referee or judge would first decide whether it should order a preferential payment to be recovered. In Scenario A, the presumption is that because the payment was made within ninety days of the filing of bankruptcy, the payment is preferential and would be recovered. In Scenario B, the presumption of preferential treatment is not appropriate because the filing was beyond the ninety-day period. However, the trustee of the bankrupt estate or a creditor will be able to show that on March 1 the debtor was bankrupt and, with that showing, be able to have the amount paid in rent recovered. Scenario C illustrates the fact that the time of the preference is extended for one year where the creditor is also an insider. Because the landlord was also a co-owner, the presumption of preference occurs; the amount paid is recovered. Scenario D presents a common situation of fraud; note the filing was well within the two-year period.

Creditors and Claims

pg. 666 & 667 Creditors are required to file proof of their claims if they are to share in the debtor's estate. Filed claims are allowed unless a party in interest objects. If an objection is filed, the court conducts a hearing to determine the validity of the claim. A claim may be disallowed if it is (1) unenforceable because of usury, unconscionability, or failure of consideration; (2) for unmatured interest; (3) an insider's or attorney's claim and exceeds the reasonable value of the services rendered; (4) for unmatured alimony or child support; (5) for rent; or (6) for breach of an employment contract. These latter two claims may be disallowed to the extent that they exceed the statutory limitations for such claims. Illegality can be raised because any defense available to the debtor is available to the trustee. Postpetition interest is not collectible because interest stops accruing at the date of filing the petition. Bankruptcy operates as an acceleration of the principal due. From the date of filing, the amount of the claim is the total principal plus interest to that date. Unreasonable attorney's fees and claims of insiders are disallowed because they encourage concealing assets or returning them to the debtor. Since alimony claims are not dischargeable in bankruptcy, there is no reason to allow a claim for postpetition alimony and child support Claims are sometimes contingent or otherwise unliquidated and uncertain. Personal injury and wrongful death claims against a debtor that cannot be settled are tried in federal district courts and not in bankruptcy courts. The law authorizes the bankruptcy court to estimate and fix the amount of such claims, if necessary, to avoid undue delay in closing the estate or approving of a plan of reorganization. The same is true of equitable remedies such as specific performance. Courts will convert such remedies to dollar amounts and proceed to close the estate or approve the plan. If a secured claim is undersecured—that is, if the debt exceeds the value of the collateral—the claim is divided into two parts. The claim is secured to the extent of the collateral's value. It is an unsecured claim for the balance.

Right of Setoff

pg. 667 Any creditor who also owes the debtor money may have a right ofsetoff. In essence, this creditor is allowed to cancel out these obligations. For example, suppose that a bank lends a debtor $2,000 and that this debtor has $1,500 on deposit at the bank. If the debtor fails to make payment on the $2,000 loan, the bank can use the deposit to reduce the amount of the debtor's loan. If a debtor files a bankruptcy petition and the creditor exercises the right of setoff, the issue of a preference arises. In our example, the bank becomes a preferred creditor to the extent of the $1,500 setoff; however, the bank, generally, is legally entitled to this preference if the amount of the deposit has not increased during the ninety days preceding the filing of the petition in bankruptcy. However, this preference would be nullified if the deposit was made or increased just before the bankruptcy petition was filed for the purpose of preferring the bank to other creditors. In that case, the deposit becomes a part of the debtor's estate, and the setoff is disallowed. Since the filing of the petition in bankruptcy operates as a stay of all proceedings, the right of setoff operates at the time of final distribution of the estate. Since the law allows the trustee, with court approval, to use the debtor's funds, parties who wish to exercise the right of setoff should seek adequate protection. A creditor will usually exercise the right to setoff against a deposit that has been made within ninety days of the filing of a petition in bankruptcy. Quite frequently, there are several such deposits, and there may also have been several payments on the debt during the ninety-day period. As a result of these variables, the application of setoff principles is sometimes difficult. The law seeks to prohibit a creditor from improving his/her position during the ninety-day period. It does so by allowing the trustee to recover that portion of the setoff that would be considered a preference. This amount recoverable by the trustee is the insufficiency between the amount owed and the amount on deposit on the first day of the ninety-day period preceding the filing of a bankruptcy petition that a deficiency occurred—to the extent that this insufficiency is greater than the insufficiency existing on the day the petition is filed. If the deposit on the first day of the preceding ninety-day period exceeds the creditor's claim, look for the first insufficiency during the ninety-day period and calculate the setoff based on the first insufficiency. Assume that a bankruptcy petition was filed on September 2. Throughout the ninety days prior to this filing, the debtor owes $2,000 to the creditor. On June 4, the debtor has $1,500 on deposit with the creditor. On July 15, the amount on deposit is reduced to $700. On September 1, the debtor's balance is increased to $1,800. At the time of the filing, the creditor seeks to use the entire $1,800 on deposit to set off its claim against the debtor. The trustee would be able to recover $300 of this attempted setoff since there was a greater insufficiency of that amount on the first day of the ninety-day period prior to the petition's being filed. In other words, the creditor's setoff would be limited to $1,500.

agency

pg. 676 The term agency is used to describe the fiduciary relationship that exists when one person acts on behalf and under the control of another person.

The following examples illustrate the problems and issues involved in the law of agency:

pg. 677 -P v. A: The principal sues the agent for a loss caused by A's breach of a fiduciary duty, such as to obey instructions. -P v. T: The principal sues a third party for breach of a contract that A negotiated with T while A was acting on P's behalf. -A v. T: The agent sues a third party for a loss suffered by A, such as the loss of a commission due to T's interference with contractual obligations. -T v. P: A third party sues the principal for breach of a contract that A negotiated with T. -T v. A: A third party sues the principal for damages caused by a tort committed by A

Agency issues are usually discussed within a framework of three parties:

pg. 677 -the principal (P); -the agent (A); -the third party (T), with whom A contracts or against whom A commits a tort while in P's service.

Disclosed

pg. 677 An agent who reveals that he/she is working for another and who reveals the principal's identity is an agent of a disclosed principal. The existence of a disclosed principal will be found in most agency relationships—in particular, employment situations.

Undisclosed

pg. 677 At the other extreme, a principal is undisclosed whenever a third party reasonably believes that the agent acts only on his/her own behalf. In essence, when an undisclosed principal is involved, the third party does not realize that any agency relationship exists. A well-known or wealthy principal may not want a third party to know he/she is interested in buying that third party's land, business, or merchandise. Therefore, the principal hires an agent to deal with the third party. The principal would instruct this agent to keep the principal's existence a secret from the third party.

Types of Principals

pg. 677 From the third party's perspective, an agent may act for one of three types of principles: -disclosed -undisclosed -partially disclosed.

the law of agency includes several aspects of the law of torts, in which case the principal was usually called

pg. 677 a master and the agent was called a servant.

Independent contractor

pg. 678 & 679 A person who exercises his/ her independent judgment on the means used to accomplish the result When a person contracts for the services of another in a way that gives the employing party full and complete control over the details and manner in which the work will be conducted, a principal-agent relationship is established. when the employing party simply contracts for a certain end result, and the employed party has full control over the manner and methods to be pursued in bringing about the result, the latter party is deemed an independent contractor. A proprietor is generally not responsible to third parties for the independent contractor's actions, either in contract or in tort.

Attorney in fact

pg. 679 A person acting for another under a grant of special power created by an instrument in writing agent named in a power of attorney

Fiduciary

pg. 679 A position of trust and confidence in relation to a person or his/her property

real estate listing agreements.

pg. 679 Although these documents are used to authorize a real estate agent to find a ready, willing, and able buyer, most states do not require these agreements to be in writing. Technically, the agent cannot create a binding sales contract between the buyer and seller. In other words, the real estate agent is not authorized to sign a contract on the seller's behalf. Rather, that agent's responsibility is to bring the buyer and seller together so the two parties may sign a contract. Despite oral listing agreements being enforceable, agents generally insist on a written one to ease the burden of proof required to establish when a commission is owed. Furthermore, a number of states do require that listing agreements be evidenced by a writing.

Power of attorney

pg. 679 An instrument authorizing another to act as one's agent or attorney in fact When a formal instrument is used for conferring authority on an agent,

Formal Requirements

pg. 679 As a general rule, agency relationships are based on the consent of the parties involved. No particular formalities are required to create a principal-agent relationship. A principal may appoint an agent either in writing or orally. Furthermore, the agency may be either expressed or implied. Despite the general lack of formal requirements, some states require that the appointment of an agent be evidenced by a writing when the agent is to negotiate a contract required to be written by the statute of frauds. Recall from Chapter 18 that these written contracts include those involving title to real estate, guaranty contracts, performance that cannot be completed within one year of the date of making, and sales of goods for $500 or more. When a formal instrument is used for conferring authority on an agent, it is known as a power of attorney. Generally, the principal signs this written document in the presence of a notary public. The agent named in a power of attorney is called an attorney in fact—a term that distinguishes this formally appointed agent from an attorney at law, who is a licensed lawyer. A power of attorney may be general, which gives the agent authority to act in all respects for the principal. For example, an elderly person signs a general power of attorney appointing an agent to handle all the necessary matters that may arise. Under other circumstances, a power of attorney, known as a special power of attorney, may be narrowly written. For example, a seller of land may need to be out of town on the date set to close the sales transaction. This seller can sign a special power of attorney appointing an agent to act on the seller's behalf by signing the deed and other necessary papers required to complete the closing. Furthermore, a seller or buyer of real estate typically must appoint an agent via a special power of attorney for that agent to have authority to sign a binding contract.

Capacity of Parties

pg. 679 It is generally stated that anyone who may act for him/herself may act through an agent. For example, a minor may enter into a contract, and as long as the minor does not disaffirm it, the agreement is binding. the majority of states have held that a contract of an agent on behalf of a minor principal is voidable. Therefore, such an agreement is subject to rescission or ratification by the minor, the same as if the minor personally had entered into the contract. To this general rule concerning an infant's capacity as a principal, some states recognize an exception. There is some authority to the effect that any appointment of an agent by an infant is void and not merely voidable. Under this view, any agreement entered into by an infant's agent would be ineffective, and an attempted disaffirmance by the principal would be unnecessary. A minor may act as an agent for an adult. Any agreements the minor makes for a principal while acting within the authority of an agent are binding on the principal. Although the minor who acts as an agent has a right to terminate a contract of agency at will, the minor's acts within the scope of the authority conferred become those of the principal, so long as the minor continues employment.

proprietor

pg. 679 person contracting with an independent contractor and receiving the benefit of his/her service

Duties of Agents

pg. 679 & 681 In addition to the duties expressly designated, certain others are implied by the fiduciary nature of the relationship and by the legal effects on the principal of actions or omissions by the agent. The usual implied duties associated with being a fiduciary include the obligation to (1) be loyal to the principal, (2) protect confidential information, (3) obey all reasonable instructions, (4) inform the principal of material facts that affect the relationship, (5) take care to avoid negligence, and (6) account for all money or property received for the principal's benefit.

Duty of Loyalty

pg. 681 At the foundation of any fiduciary relationship is the duty of loyalty that each party owes to the other. Since an agent is in a position of trust and confidence, the agent owes an obligation of undivided loyalty to the principal. While employed, an agent should not undertake a business venture that competes or interferes in any manner with the principal's business, nor should the agent make any contract for him/herself that should have been made for the principal. A breach of this fundamental duty can result in the principal's enjoining the agent's new business or recovering money damages or both. This duty of loyalty also prevents an agent from entering into an agreement on the principal's behalf if the agent is the other contracting party. To create a binding agreement with the principal, the agent first must obtain the principal's approval. Since a contract between the agent and the principal is not a deal "at arm's length," the circumstances demand the utmost good faith from the agent. Indeed, an agent must fully disclose all facts that might materially influence the principal's decision-making process. Likewise, an agent usually cannot represent two principals in the same transactions if the principals have differing interests. To act as a dual agent often leads the agent to an unavoidable breach of the duty of loyalty to one, if not both, of the principals. To prevent the breach of this basic duty in this situation, the agent should inform both principals of all the facts in the transaction, including that the agent is working for both principals. If these principals agree to continue negotiations, the agent in effect becomes a "go-between" or messenger. The agent is acting on behalf of both principals while avoiding active negotiations. Due to the nature of their business, real estate agents, particularly, must be aware of the hazards of dual agencies. The principal may always rescind transactions violating the duty of loyalty, even though the agent acted for the best interests of the principal and the contract was as favorable as could be obtained elsewhere. The general rule is applied without favor so that every possible motive or incentive for unfaithfulness may be removed. In addition to the remedy of rescission, a principal is entitled to treat any profit realized by the agent in violation of this duty as belonging to the principal. Such profits may include rebates, bonuses, commissions, or divisions of profits received by an agent for dealing with a particular third party. Here again, the contracts may have been favorable to the employer; however, the result is the same because the agent should not be tempted to abuse the confidence placed in him/her. The principal may also collect from the agent a sum equal to any damages sustained as the result of the breach of the duty of loyalty

Duty to Protect Confidential Information

pg. 682 & 683 The duty of loyalty demands that the agent shall not use information of a confidential character acquired while in the principal's service to advance the agent's interests in opposition to those of the principal. In other words, an agent has a duty to protect the principal's confidential information. This confidential information is usually called a trade secret. Trade secrets include plans, processes, tools, mechanisms, compounds, and informational data used in business operations. They are known only to the owner of the business and to a limited number of other persons in whom it may be necessary to confide. An employer seeking to prevent the disclosure or use of trade secrets or information must demonstrate that he/she pursued an active course of conduct designed to inform employees that such secrets and information were to remain confidential. An issue to be determined in all cases involving trade secrets is whether the information sought to be protected is, in fact and in law, confidential. The result in each case depends on the conduct of the parties and the nature of the information. An employee who learns of secret processes or formulas or comes into possession of lists of customers may not use this information to the detriment of his/her employer. Former employees may not use such information in a competing business, regardless of whether the trade secrets were copied or memorized. The fact that a product is on the market does not amount to a divulgence or abandonment of the secrets connected with the product. The employer may obtain an injunction to prevent their use because use is a form of unfair competition. The rule relating to trade secrets is applied with equal severity whether the agent acts before or after severing the connection with the principal. Knowledge that is important but not a trade secret may be used, even if its use may injure the agent's former employer. Information that, by experience, has become a part of a former employee's general knowledge should not and cannot be enjoined from further and different uses. For this reason, there usually is nothing to hinder a person who has made the acquaintance of his/her employer's customers from later contacting those whom he/she can remember. These acquaintances are part of the employee's acquired knowledge. The employer may protect him/ herself by a clause in the employment agreement to the effect that the employee will not compete with the employer or work for a competitor for a limited time after employment is terminated.

Duty to Inform

pg. 683 In Chapter 32, we will see that knowledge acquired by an agent within the scope of his/her authority binds the principal. More succinctly, the law states that an agent's knowledge is imputed as notice to the principal. Therefore, the law requires that the agent inform the principal of all facts that affect the subject matter of the agency that are obtained within the scope of the employment. The rule requiring full disclosure of all material facts that might affect the principal is equally applicable to both gratuitous and compensated agents. This rule extends beyond the duty to inform the principal of conflicting interests of third parties or possible violations of the duty of loyalty in a particular transaction. It imposes on the agent a duty to give the principal all information that materially affects the principal's interest. Knowledge of facts that may have greatly advanced the value of property placed with an agent for sale must be communicated before property is sold at a price previously established by the principal. Knowledge of financial problems of a buyer on credit must also be communicated to the principal. This duty generally applies even if the agent is not currently working on behalf of the principal. Suppose an agent is out to dinner with her family. The agent overhears two people talking at the next table. A portion of the conversation reveals information that would be relevant to a business venture involving the principal. The agent is under a duty to disclose the information to the principal.

Duty to Obey Instructions

pg. 683 It is the duty of an agent to obey all instructions issued by his/her principal as long as they refer to duties contemplated by the contract of employment. The employer cannot indiscriminately impose burdens not required by the agreement, and any material change in an employee's duties may constitute a breach of the employment contract. An instruction may not be regarded lightly merely because it departs from the usual procedure and seems fanciful and impractical to the agent. It is not the agent's business to question the procedure outlined by his/her superior. Any loss that results while the agent is pursuing any other course makes the agent absolutely liable to the principal for such resulting loss. Furthermore, an instruction of the principal does not become improper merely because the motive is bad, unless it is illegal or immoral. The principal may be well aware of the agent's distaste for certain tasks; however, if those tasks are called for under the employment agreement, it becomes the agent's duty to perform them. Failure to perform often results in proper grounds for discharge. Closely allied to the duty to follow instructions is the duty to remain within the scope of the authority conferred. Because it often becomes possible for an agent to exceed his/her authority and still bind the principal, the agent has a duty not to exceed the authority granted. In case the agent does so, the employee or agent becomes responsible for any resulting loss. Occasionally, circumstances arise that nullify instructions previously given. Because of the new conditions, the old instructions would, if followed, practically destroy the purpose of the agency. Whenever such an emergency arises, it becomes the agent's duty, provided that the principal is not available, to exercise his/her best judgment in meeting the situation

Duty Not to Be Negligent

pg. 683 & 684 As will be discussed more fully in Chapter 32, the doctrine of respondeat superior imposes liability on a principal or master for the torts of an agent or servant acting within the scope of his/her employment. The agent or servant is primarily liable, and the principal or master is vicariously or secondarily liable. It is an implied condition of employment contracts, if not otherwise expressed, that the employee has a duty to act in good faith and to exercise reasonable care and diligence in performing tasks; failure to do so is a breach of the employment contract. Therefore, if the employer has liability to third persons because of the employee's acts or negligent omissions, the employer may recover his/her loss from the employee. This right may be transferred by the doctrine of subrogation to the employer's liability insurance carrier. For example, assume that a bakery company is held liable for damages to an injured child who was struck by a company delivery truck as the result of the employee-driver's negligence. After the company's insurance company pays the total coverage to the injured party, any unpaid damages can be collected from the company. The company, in turn, can sue the employee for breach of the duty not to be negligent. In some states, the insurance company could also collect from the employee. However, there are some reasons to keep liability from being passed ultimately to the careless employee. T

The agency relationship becomes involved with tort liability whenever

pg. 695 an agent's actions produce injury or damage to a third party or that party's property. The terms master (employer) and servant (employee) are technically more accurate than the terms principal and agent in describing the parties when tort liability is discussed Courts, nevertheless, frequently describe the parties as principal and agent.

Before an agent can create a binding contract between the principal and third party

pg. 695 that agent must have authority from the principal or the principal must have ratified the agent's unauthorized actions. As we will see, authority may actually be granted to the agent by the principal, or it may be apparent to the third party from the principal's actions or inactions.

Duty to Account

pg. 684 Money or property entrusted to the agent must be accounted for to the principal. Therefore, the agent is required to keep proper records showing receipts and expenditures so that a complete accounting may be rendered. Any money collected by an agent for a principal should not be mingled with the agent's funds. If they are deposited in a bank, they should be kept in a separate account; otherwise, any loss resulting must be borne by the agent. In addition, the duty to account can arise out of the agent's breach of any other fiduciary duty. An agent who receives money from third parties for the benefit of the principal owes no duty to account to the third parties. The only duty to account is owed to the principal. However, money paid to an agent who has no authority to collect it and does not turn it over to the principal may be recovered from the agent in an action by the third party. A different problem is presented when money is paid in error to an agent, as in the overpayment of an account. If the agent has passed the money on to the principal before the mistake is discovered, it is clear that only the principal is liable. Nevertheless, money that is still in the possession of the agent when he/she is notified of the error should be returned to the third party. The agent is not relieved of this burden by subsequently making payment to the principal. Any payment made in error to an agent and caused by the agent's mistake or misconduct may always be recovered from him/her, even if the agent has surrendered it to the principal. In addition, any overpayment may be recovered from the agent of an undisclosed principal because the party dealing with the agent was unaware of the existence of the principal.

Duties of Principals

pg. 685 The principal-agent relationship is a fiduciary one. Like agents, principals also have fiduciary duties. The trust and confidence of a fiduciary relationship is a two-way obligation. Thus, the law requires that the principal be loyal and honest in dealing with the agents. In addition, the agent is entitled to be compensated for his/her services in accordance with the terms of the contract of employment. If no definite compensation has been agreed on, there arises a duty to pay the reasonable value of such services—that is, the customary rate in the community. Furthermore, the principal owes duties to reimburse agents for their reasonable expenses and to hold the agents harmless for liability that may be incurred while the agent is within the scope of employ-ment. Finally, there is a duty not to discriminate in personnel decisions.

Duty to Compensate: In General

pg. 685 & pg. 686 Many employment contracts include provisions for paying a percentage of profits to a key employee. If the employment contract does not include a detailed enumeration of the items to be considered in determining net income, it will be computed in accordance with generally accepted accounting principles, taking into consideration past custom and practice in the operation of the employer's business. It is assumed that the methods of determining net income will be consistent and that no substantial changes will be made in the methods of accounting without the mutual agreement of the parties. The employer cannot unilaterally change the accounting methods, nor can the employee require a change to affect an increase in his/her earnings. The right of a real estate broker or agent to a commission is frequently the subject of litiga-tion. In the absence of an express agreement, the real estate broker earns a commission (1) if he/ she finds a purchaser who is ready, willing, and able to meet the terms outlined by the seller in the listing agreement or (2) if the owner contracts with the purchaser (whether the price is less than the listed price), even though it later develops that the purchaser is unable to meet the terms of the contract. The contract is conclusive evidence that the broker found a ready, willing, and able purchaser. If a prospective purchaser conditions the obligation to purchase on an approval of credit or approval of a loan, that purchaser is not ready, willing, and able to buy until such approval. If such approval is not forthcoming, the broker is not entitled to a commission Multiple listing is a method of listing property with several brokers simultaneously. These brokers belong to an organization, the members of which share listings and divide the commissions. A typical commission would be split 60 percent to the selling broker, 30 percent to the listing broker, and 10 percent to the organization for operating expenses. These multiple-listing groups give homeowners the advantage of increased exposure to potential buyers. In return for this advantage, most multiple-listing agreements are of the exclusive right-to-sell type

Duty to Reimburse

pg. 686 An agent has a general right to reimbursement for money properly expended on behalf of his/her principal. It must appear that the money was reasonably spent and that its expenditure was not necessitated by the agent's misconduct or negligence. Travel-related expenses, such as airfare, mileage, lodging, and food purchases necessitated by travel, are typical examples of the items for which a principal must reimburse an agent, unless those parties agree otherwise. An agent also is entitled to be reimbursed for the costs of completing an agreement when the performance was intended to benefit the principal. This is an especially true statement when the agent has performed on behalf of an undisclosed principal. That principal must protect his/her agent by making funds available to perform the contract as agreed. Suppose that a fast food company is seeking prime locations for its franchises. Not wanting to pay an additional premium just because it is the buyer, the company may hire a local real estate agent to purchase a site in its own name. The company must reimburse this agent for any money that the agent may have used to complete performance of any contract signed.

Duty to Compensate: Sales Representatives

pg. 686 Sales representatives who sell merchandise on a commission basis are confronted by problems similar to those of the broker, unless their employment contract is specific in its details. Let us assume that Low Cal Pies Inc. appoints Albert, on a commission basis, as its exclusive sales representative in a certain territory. A grocery chain in the area involved sends a large order for pies directly to the home office of Low Cal Pies. Is Albert entitled to a commission on the sale? It is generally held that such a salesperson is entitled to a commission only on sales solicited and induced by him/her, unless the contract of employment gives the salesperson greater rights. The sales representative usually earns a commission as soon as an order from a responsible buyer is obtained, unless the contract of employment makes payment contingent on delivery of the goods or collection of the sale's price. If payment is dependent on the purchaser's performance, the employer cannot deny the sales representative's commission by terminating the agency prior to collection of the account. When the buyer ultimately pays for the goods, the seller is obligated to pay the commission. An agent who receives a weekly or monthly advance against future commissions is not obligated to return the advance if commissions equal thereto are not earned. The courts consider the advance, in the absence of a specific agreement, as a minimum salary. For example, assume a salesperson works for six months on commission and is fired. If this person was granted a monthly draw of $1,500 and has earned only $6,000 in commissions, the general rule is that the $3,000 excess of draws over commissions does not have to be repaid.

Duty to Indemnify

pg. 686 & 687 Whereas to reimburse someone means to repay him/her for funds already spent, to indemnify means to hold a person harmless or free from liability. A servant is entitled to indemnity for certain tort losses. They are limited to factual situations in which the servant is not at fault and his/her liability results from following the master's instructions. An agent or a servant is justified in presuming that a principal has a lawful right to give instructions and that performance resulting from the instructions will not injure third parties. When this is not the case and the agent incurs a liability to some third party because of trespass or conversion, the principal must indemnify the agent against loss. There will ordinarily be no indemnification for losses incurred in negligence actions because the servant's own conduct is involved. Any indemnification is usually of the master by the servant in tort situations. If the agent or servant is sued for actions within the course of employment in which he/she is not at fault, the agent or servant is entitled to be reimbursed for attorney's fees and court costs incurred if the principal or master does not furnish them in the first instance.

Death

pg. 688 The death of an individual acting as a principal or agent immediately terminates the agency, even if the other party is unaware of the death. Once the time of death is established, there should not be any controversy about an agency ceasing to exist.

Termination by Operation of Law

pg. 688 The occurrence of certain events is viewed as automatically terminating the agency. As a legal principle, any one of four happenings may end the principal-agent relationship: -the death of either party -the insanity of either party -the bankruptcy of either party under specific conditions -the destruction or illegality of the agency's subject matt

Insanity

pg. 689 Like death, insanity of either the principal or agent terminates their relationship. However, unlike death, insanity of a party does not always provide a distinctive time of termination. For example, if the principal has not been publicly adjudged insane, courts often hold that an agent's contract with a third party is binding on the principal unless that third party was aware of the principal's mental illness. This ruling occurs especially when the contract is beneficial to the insane principal's estate

Bankruptcy

pg. 689 The timing of the termination of an agency due to bankruptcy is not always clear. Bankruptcy has the effect of termination only when it affects the agency's subject matter. Assume that a business organization files for reorganization under the bankruptcy laws. Since the court's order of relief will allow this organization to continue its business activity, its agency relationships will not be terminated. However, if the debtor's petition sought Chapter 7 liquidation, the organization's bankruptcy would terminate all its agencies, because the organization will cease to exist as a viable principal. When a bankruptcy case will act to terminate an agency, its impact happens at the time the court grants an order of relief. At that time, a trustee typically is appointed to hold the debtor's assets. This substitution of the trustee for the debtor terminates that debtor's agency relationships. (See Chapter 30 for a thorough discussion of bankruptcy.

Destruction or Illegality of Subject Matter

pg. 690 Events other than bankruptcy may destroy the agency's subject matter. For example, if the purpose of the agency relationship becomes illegal or impossible to perform, termination occurs auto-matically. Whereas it may be unlikely for the purpose of most business relationships to become illegal, the purpose may become impossible to perform whenever the agency's subject matter is destroyed. Suppose that an owner of real estate hires a real estate agent to find a ready, willing, and able buyer for his four-bedroom, two-bathroom house. If that house were destroyed by fire or wind or other causes, the agent's appointment would be terminated since the house could not now be sold in its former condition.

Unilateral Action

pg. 690 In addition to allowing the principal and the agent to mutually agree to end their relationship, the law generally allows either one of these parties to act independently in terminating an agency unilaterally. As a general rule, either party to an agency agreement has full power to terminate the agreement whenever desired, even though he/she possesses no right to do so. For example, if the Paulson Company agreed to employ Alicia for one year, an agency for a definite stated period has been created—that is, these parties have agreed to be principal and agent, respectively, for a one-year period. Despite this agreement, the courts are hesitant to force either an employer or employee to remain in an unhappy situation. Therefore, these parties generally do have the power to terminate this employment contract. A premature breach of the agreement is considered to be a wrongful termination, and the breaching party becomes liable for damages suffered by the other party. Of course, if an agent is discharged for cause, such as for failing to follow instructions, he/she may not recover damages from the employer.

Termination by Parties' Actions Mutual Agreement

pg. 690 Termination of an agency may occur due to the terms of the principal-agent agreement. For example, an agency may be created to continue for a definite period. If so, it ceases, by virtue of the terms of the agreement, at the expiration of the stipulated period. If the parties consent to the continuation of the relationship beyond the period, the courts imply the formation of a new contract of employment. The new agreement contains the same terms as the old one and continues for a like period. No implied contract can run longer than one year because of the statute of frauds. Another example is an agency created to accomplish a certain purpose, which ends automatically with the accomplishment of the purpose. Furthermore, when it is possible for one of several agents to perform the task, such as selling certain real estate, it is held that performance by the first party terminates the authority of the other agents without notice of termination being required. An agency may always be terminated by the mutual agreement of the principal and agent. Even if their original agreement does not provide for a time of duration, the parties may agree to cancel their relationship. Since the agency is, in essence, based on a consensual agreement, the principal and agent can agree to end their association.

The law of agency is essentially concerned with issues of

pg. 694 contractual liability and tort liability.

Basic Aspects of Contract Liability Actual Authority

pg. 695 A principal may confer actual authority on the agent or may unintentionally, by want of ordinary care, allow the agent to believe that he/she possesses it. Actual authority includes express actual authority and implied actual authority. The term express actual authority describes authority explicitly given to the agent through the principal's written or oral instructions. Implied actual authority is used to describe authority that is necessarily incidental to the express authority or that arises because of business custom and usage or prior practices of the parties. Implied actual authority is sometimes referred to as incidental authority; it is required or reasonably necessary to carry out the purpose for which the agency was created. Implied authority may be established by deductions or inferences from other facts and circumstances in the case, including prior habits or dealings of a similar nature between the parties. Implied authority based on custom and usage varies from one locality to another and among different kinds of businesses. For example, Perfection Fashions Inc. appoints Andrea as its agent to sell its casual wear to retail stores. As part of this relationship, Andrea has express authority to enter into written contracts with the purchasers and to sign Perfection Fashions' name to such agreements. Whether Andrea has implied or incidental authority to consign the merchandise, thereby allowing the purchaser to return items not sold, may depend on local custom and past dealings. Likewise, whether Andrea may sell on credit instead of cash may be determined by similar standards. If it is customary for other agents of fashion companies in this locality to sell on consignment or on credit, Andrea and the purchasers with whom she deals may assume she possesses such authority. Custom, in effect, creates a presumption of authority. Of course, if the agent or third party has actual knowledge that contradicts customs or past dealings, such knowledge limits the existence of implied or incidental authority. Implied authority cannot be derived from the agent's words or conduct. A third person dealing with a known agent may not act negligently in regard to the extent of the agent's authority or blindly trust that agent's statements. The third party must use reasonable diligence and prudence in ascertaining whether the agent is acting within the scope of his/her authority. Similarly, if persons who deal with a purported agent desire to hold the principal liable on the contract, they must ascertain not only the fact of the agency but also the nature and extent of the agent's authority. Should either the existence of the agency or the nature and extent of the authority be disputed, the burden of proof regarding these matters is on the third party. All agents, even presidents of corporations, have limitations on their authority. Authority is not readily implied. Possession of goods by one not engaged in the business of selling such goods does not create the implication of authority to sell. Authority to sell does not necessarily include the authority to extend credit—although custom may create such authority. The officers of a corporation must have actual authority to enter into transactions that are not in the ordinary course of the corporation's business. For this reason, persons purchasing real estate from a corporation usually require a resolution of the board of directors specifically authorizing the sale.

Express actual authority

pg. 695 A type of actual authority granted by a principal to an agent by written or spoken words

Implied actual authority

pg. 695 A type of actual authority that is granted by a principal to an agent and incidental to express authority or that arises from the position held by the age

A principal, however, is liable for torts of only

pg. 695 those agents who are subject to the kind of control that establishes the master-servant relationship. For the purpose of tort liability, an employee is a person who is employed, with or without pay, to perform personal services for another and who, with respect to the physical movements in the performance of such service, is subject to the master's right or power of control. A person who renders services for another but retains control over the manner of rendering such services is not an employee; rather, he/she is an independent contractor. Generally, the party employing an independent contractor is not liable for the latter's torts.

tort

pg. 695a noncontractual, noncriminal breach of a duty. Typically, the liability that arises from a tort involves a personal injury or property damage. An automobile accident is but one, albeit a classic, example of a situation that creates tort liability.

Apparent or ostensible authority

pg. 698 The authority that a principal leads a third party to believe exists when there is no actual authority granted by the principal to the agent

Estoppel

pg. 698 To prevent a party from denying the legal consequences of that party's conduct

Apparent or Ostensible Authority

pg. 698 & 699 To be distinguished from implied authority is apparent or ostensible authority (the two terms are synonymous), which describes the authority a principal, intentionally or by want of ordinary care, causes or allows a third person to believe the agent possesses. Liability of the principal for the ostensible agent's acts rests on the doctrine of estoppel. The estoppel is created by some conduct of the principal that leads the third party to believe that a person is the principal's agent or that an actual agent possesses the requisite authority. The third party must know about this conduct and must be injured or damaged by his/her reliance on it. The injury or damage may be a change of position, and the facts relied on must be such that a reasonably prudent person would believe that the agency's authority existed. Thus, three usual essential elements of an estoppel -conduct -reliance -injury are required to create apparent authority. The theory of apparent or ostensible authority is that if a principal's words or actions lead others to believe that he/she has conferred authority on an agent, the principal cannot deny his/her words or actions to third persons that have relied on them in good faith. The acts may include words, oral or written, or may be limited to conduct that, when reasonably interpreted by a third person, causes that person to believe that the principal consents to have the act done on his/her behalf by the purported agent. Apparent authority requires more than the mere appearance of authority. The facts must be such that a person exercising ordinary prudence, acting in good faith, and knowing business practices would be misled. Apparent authority may be the basis for liability when the purported agent is, in fact, not an agent. It also may be the legal basis for finding that an actual agent possesses authority beyond that actually conferred. In other words, apparent authority may exist in one who is not an agent or it may expand the authority of an actual agent. However, an agent's apparent authority to act for a principal must be based on the principal's words or conduct and cannot be based on anything the agent has said or done. An agent cannot unilaterally create his/her own apparent authority. An agency by estoppel or additional authority by estoppel may arise from the agent's dealings being constantly ratified by the principal, or it may result from a person's acting the part of an agent without any dissent from the purported principal. Perhaps the most common situation in which apparent authority is found to exist occurs when the actual authority is terminated but notice of this fact is not given to those entitled to receive it. Cancellation of actual authority does not automatically terminate the apparent authority created by prior transactions. The ramification of apparent authority's surviving the termination of an agency relationship requires the principal to give notice of termination to third parties.

Ratification

pg. 699 The confirmation of an act or act of another (e.g., a principal may ratify the previous unauthorized act of his/ her agent) As previously noted, a purported principal may become bound by ratifying an unauthorized contract. Having knowledge of all material matters, the principal may express or imply adoption or confirmation of a contract entered on his/her behalf by someone who had no authority to do so. Ratification is implied by the principal's conduct, which is inconsistent with the intent to repudiate the agent's action, and is similar to ratification by an adult of a contract entered while a minor. Ratification relates back to, and is the equivalent of, authority at the commencement of the act or time of the contract. It is the affirmance of a contract already made. It cures the defect of lack of authority and creates the relation of principal and agent.

Capacity Required

pg. 699 Various conditions must exist before ratification will be effective in bringing about a contractual relation between the principal and the third party. First, because ratification relates back to the time of the contract, ratification can be effective only when both the principal and the agent were capable of contracting at the time the contract was executed and are still capable at the time of ratification. Therefore, a corporation may not ratify contracts made by its promoters on the corporation's behalf before the corporation was formed. For the corporation to be bound by such agreements, a novation (that is, a new contract substituted for an old one) or an assumption of liability by the corporation must occur.

Conduct Constituting Ratification

pg. 700 Ratification may be either express or implied. Any conduct that definitely indicates an intention on the principal's part to adopt the transaction will constitute ratification. It may take the form of words of approval to the agent, a promise to perform, or actual performance, such as delivery of the product called for in the agreement. Accepting the benefits of the contract or basing a suit on the validity of an agreement clearly amounts to ratification. If the principal makes no objection for an unreasonable time, knowing what the agent has done, ratification results by operation of law. Generally, the question of what an unreasonable time is defined as is left for the jury to decide. The issue of whether ratification has occurred is also a question to be decided by the jury. Among the facts to be considered by the jury are the relationships of the parties, conduct prior, circumstances pertaining to the transaction, and the action or inaction of the alleged principal upon learning of the contract. Inaction or silence by the principal creates difficulty in determining whether ratification has occurred. Failure to speak may mislead the third party, and courts frequently find that a duty to speak exists where silence will mislead. Silence and inaction by the party to be charged as a principal, or failure to dissent and speak up when ordinary human conduct and fair play would normally call for some negative assertion within a reasonable time, tends to justify the inference that the principal acquiesced in the course of events and accepted the contract as his/her own. Acceptance and retention of the fruits of the contract with full knowledge of the material facts of the transaction are probably the most certain evidence of implied ratification. As soon as a principal learns of an unauthorized act by his/her agent, the principal should promptly repudiate it to avoid liability on the theory of ratification. An unauthorized act may not be ratified in part and rejected in part. The principal cannot accept the benefits of the contract and refuse to assume its obligations. Because of this rule, a principal, by accepting the benefits of an authorized agreement, ratifies the means used in procuring the agreement—unless, within a reasonable time after learning the actual facts, the principal takes steps to return, as far as possible, the benefits received. Therefore, if an unauthorized agent commits fraud in procuring a contract, acceptance of the benefits ratifies not only the contract but the fraudulent acts as well; the principal is then liable for the fraud.

Full Knowledge

pg. 700 Third, as a general rule, ratification does not bind the principal unless he/she acts with full knowledge of all the material facts attending negotiation and execution of the contract. Of course, when there is express ratification and the principal acts without any apparent desire to know or learn the facts, the principal may not later defend him/herself on the ground that he/ she was unaware of all the material facts. However, when ratification is to be implied from the principal's conduct, he/she must act with knowledge of all the important details.

Contract Liability of Principals

pg. 700 With respect to contractual matters, a principal may become liable to its agents and third parties. The answers to when and why such liability is created depend, in part, on the type of principal involved. As mentioned in Chapter 31, there are three possible choices concerning the types of principals: from the third party's perspective, a principal may be disclosed, partially disclosed, or undisclosed. When studying the rest of this chapter, it is important to keep in mind the distinctions between these categories. For the most part, the law treats the disclosed principals differently from the other types of principals. In general, the law views the liability of partially disclosed and undisclosed principals as being the same. Therefore, in the following sections, any mention of an undisclosed principal's liability includes the liability of a partially disclosed principal, unless the text states otherwise

Disclosed Principal's Liability to Agents

pg. 700 & 701 From a contractual perspective, a disclosed principal implicitly agrees to protect its agents from any liability, as long as these agents act within the scope of authority granted. In other words, when a disclosed principal is involved, agency principles are applied in such a way that the third party must look to the principal for contractual performance if the agent acted within the authority given. If the third party seeks to hold the agent personally liable, that agent may insist that the disclosed principal hold him/her harmless for liability purposes. A similar result of the principal holding the agent harmless for contractual performance occurs if a disclosed principal ratifies an unauthorized agent's actions. However, if an agent for a disclosed principal exceeds the authority granted, the principal is not liable to the agent and is not required to protect the agent from liability. In general, the agent who exceeds authority becomes personally liable to the third party and cannot rely on the principal as a substitute for liability or indemnification. The one exception to this general rule is when the disclosed principal ratifies the unauthorized actions of an agent. When ratification does occur, the liability of the parties is the same as if the agent's acts were authorized prior to their happening.

Disclosed Principal's Liability to Third Parties

pg. 701 Because of the concept of the principal holding the agent harmless, a disclosed principal generally becomes liable to third parties who negotiate and enter into contracts with authorized agents. With respect to transactions involving disclosed principals, the agent's authority may be either actual or apparent. Furthermore, disclosed principals become liable to third parties if the unauthorized actions of an agent are ratified. With respect to such ratification, the laws of agency state that the act of ratification must occur before the third party withdraws from the contract. The reason for protecting the third party in this way is the constant legal concern with mutuality of obligations. One party should not be bound to a contract if the other party is not also bound. Therefore, the law recognizes that the third party may withdraw from an unauthorized contract entered into by an agent at any time before the principal ratifies it. If the third party were not allowed to withdraw, the unique situation in which one party is bound and the other is not would exist. Remember, however, that ratification does not require notice to the third party. As soon as the principal indulges in conduct constituting ratification, the third party loses the right to withdraw.

Undisclosed Principal's Liability to Agents

pg. 701 The fact that a principal's identity or even existence is hidden from third parties does not change the principal-agent relationship. Therefore, undisclosed principals may become liable for breach of a fiduciary duty owed to agents. Furthermore, undisclosed principals are liable to agents who negotiate and enter into contracts within their actual authority. Since a third party may hold an agent of an undisclosed principal personally liable, the authorized agent may recover the amount of its liability from the undisclosed principal. The rule of law set forth in the previous sentence limits the undisclosed principal's liability only to contracts entered pursuant to the agent's actual authority. When a principal is undisclosed, neither apparent authority nor ratification can occur since these happenings arise as a result of the principal-third party relationship. Of course, when the principal's identity or existence is unknown to the third party, there cannot be a principal-third party relationship. In other words, an undisclosed principal has no liability to an agent who exceeds the actual authority granted by the principal.

Tort Liability Concepts Introduction

pg. 702 The fundamental principles of tort liability in the law of agency, which are discussed in this chapter, can be summarized as follows: 1. Agents, employees, and independent contractors are personally liable for their own torts. 2. An employer is liable under a doctrine known as respondeat superior for the torts of an employee if the employee is acting within the scope of his/her employment. 3. A principal, proprietor, employer, or contractee (each of these terms is sometimes used) is not, as a general rule, liable for the torts of an independent contractor.

Undisclosed Principal's Liability to Third Parties

pg. 702 The liability of undisclosed principals to third parties is limited by two important principles. First, undisclosed principals are liable to third parties only when the agent acted within the scope of actual authority. Remember, apparent authority and ratification cannot occur when the principal is undisclosed. However, an undisclosed principal who retains the benefits of a contract is liable to the third party in quasi-contract for the value of such benefits. To allow a principal to keep the benefits would be an unacceptable form of unjust enrichment at the third party's expense. Second, the contract entered into by an actual authorized agent must be the type that can be assigned to the undisclosed principal. For example, an employment contract requiring the personal services of the agent would not bind the undisclosed principal and the third party. Suppose a group of young engineers form an architectural design firm. Wishing to be hired to design a new fifty-story building that will serve as a corporation's headquarters, these engineers decide to submit a bid. However, fearful that their lack of reputation will harm their chances of being employed, they hire Paul Jackson, a renowned designer-architect, to present the bid. Jackson is instructed not to reveal the new firm's identity—in other words, the bid is to be submitted in Jackson's name alone. If the corporation were to award the design job to Jackson, it is very unlikely that the new design firm and the corporation would become contractually bound. This result would occur because of the corporation's belief that it was hiring Jackson's unique personal talents—that is, the contract between the agent (Jackson) and the third party (the corporation) is not assignable to the undisclosed principal (the young engineering firm) without the third party's consent. The vast majority of contracts negotiated by agents for undisclosed principals will not involve those agents' personal services. Thus, most of these contracts will be freely assignable.

Joint and several liability

pg. 702 When two or more persons have an obligation that binds them individually as well as jointly (This obligation can be enforced either by joint action against all persons or by separate actions against one person or against any combination of these persons.)

Tort Liability of Agents, Employees, and Independent Contractors

pg. 702 & 703 Every person who commits a tort is personally liable to the individual whose body or property is injured or damaged by the wrongful act. An agent or officer of a corporation who commits or participates in the commission of a tort, whether or not he/she acts on behalf of his/her corporation, is liable to the third persons injured. One is not relieved of tort liability by establishing that the tortious act was committed under the direction of someone else or in the course of employment of another. The fact that the employer or principal may be held liable does not, in any way, relieve the employee or agent from liability. The liability of the agent or employee is joint and several with the liability of the principal or employer. Of course, the converse is not true. An agent, employee, or independent contractor is not liable for the torts of the principal, master, or employer. Assume that an employer is liable as the result of a tort committed by an agent or employee. Is the employer, upon paying the judgment, entitled to recover from the agent or employee? The answer is technically yes because an employee is liable for his/her own misconduct either to others or to his/her employer. Suits by employers against employees for indemnity are not common for several reasons. -First, the employee's financial condition frequently does not warrant suit. -Second, the employer knows of the risk of negligence by employees and covers this risk with insurance. If indemnity were a common occurrence, the ultimate loss would almost always fall on employees or workers. If this situation were to develop, it would have an adverse effect on employee morale and would make labor-management relations much more difficult. Therefore, few employers seek to enforce the right to collect losses from employees. Just as an employer may have a right to collect from the employee, the employee may, under certain situations, maintain a successful action for reimbursement and indemnity against the employer. Such a case would occur when the employee commits a tort by following the employer's instructions if that employee did not know his/her conduct was tortious. Example: Matthews, a retail appliance dealer, instructs Stewart to repossess a television from Trevor, who had purchased it on an installment contract. Matthews informs Stewart that Trevor is in arrears in his payments. Actually, Matthews had made a bookkeeping error, and Trevor is current in his payments. Despite Trevor's protests, Stewart repossesses the television pursuant to Matthews's instructions. Stewart has committed the torts of trespass and wrongful conversion. Matthews must indemnify Stewart and satisfy Trevor's claim if Trevor elects to collect tort damages from Stewart.

Respondeat superior

pg. 703 The doctrine that places legal liability on an employer for an employee's torts committed within the scope of employment

Exceptions: Frolics and Detours

pg. 705 Although it often is difficult to know with certainty whether an employee is within the scope of employment, the law has recognized that the employer is not liable when the employee is on a frolic or when the employee has detoured in a substantial manner from the employer's instructions. A frolic exists whenever an employee pursues personal interests while neglecting the employer's business. For example, a route salesperson who leaves or detours from his route to accomplish a personal errand is on a frolic. If an accident occurs while this person is on the frolic, his employer would not be liable for the third party's injuries. A very hard question to answer is this: When does a frolic or detour end so the employee is again within the scope of employment? Not every deviation from the strict course of duty is a departure that will relieve an employer of liability for the acts of the employee. The fact that an employee, while performing a duty for the employer, incidentally does something for him/herself or a third person does not automatically relieve the employer from liability for negligence that causes injury to another. To sever the employee from the scope of employment, the act complained of must be such a divergence from the employee's regular duties that its very character severs the relationship of employer and employee. Another difficult situation is presented when the employee combines his/her own business with that of the employer. As a general rule, this dual purpose does not relieve the employer of liability. Furthermore, the doctrine of respondeat superior has been extended to create the employer's liability for the negligence of strangers while assisting an employee in carrying out the employer's business if the authority to obtain assistance is given or required, as in an emergency.

Expanding Vicarious Liability

pg. 705 In recent years, the law has been expanding the concept of vicarious liability, even to acts of persons who are not employees. A person engaged in some endeavor gratuitously may still be an employee within the scope of the employer-employee doctrine. The two key elements for determining whether a gratuitous undertaking is a part of the employer-employee relationship are (1) whether the actor has submitted to the directions and to the control of the one for whom the service is done, and (2) whether the primary purpose of the underlying act was to serve another. If so, the employer is liable for the torts of the unpaid "employee." Most of the expansion of the application of respondeat superior and vicarious liability has been by statute. Liability for automobile accidents has been a major area of expansion. Some states have adopted what is known as the family car doctrine. Under it, if the car is generally made available for family use, any member of the family is presumed to be an agent of the parent/owner when using the family car for his/her convenience or pleasure. The presumption may be rebutted, however. Other states have gone further and provided that anyone driving a car with the permission of the owner is the owner's agent, and the owner has vicarious liability to persons injured by the driver.

Intentional Torts

pg. 707 Intentional or willful torts are not as likely to occur within the scope of the employee's employment as are those predicated on a negligence theory. If the employee's willful misconduct has nothing to do with the employer's business and is based entirely on hatred or a feeling of ill will toward the third party, the employer is not liable. Nor is the employer liable if the employee's act has no reasonable connection with his/her employment. However, the injured third party generally does not have to prove that the employer actually instructed the employee to commit the intentional tort. Once again, the key issue for determining the employer's liability is whether the employee was within the scope of employment.

Tort Liability of Independent Contractors Control over Independent Contractors

pg. 708 An independent contractor has power to control the details of the work he/she performs for an employer. Because the performance is within his/her control, an independent contractor is not an employee, and his/her only responsibility is to accomplish the result for which he/she is contracted. For example, Rush contracts to build a boat according to certain specifications for Water-King at a cost of $40,000. It is clear that Rush is an independent contractor, and the completed boat is the result. Had Water-King engaged Rush by the day to assist in building the boat under Water-King's supervision and direction, the employer-employee relationship would have resulted. Recall that an agent with authority to represent a principal will contractually be, at the same time, either an employee or an independent contractor for the purpose of tort liability. The hallmark of an employer-employee relationship is that the employer not only controls the result of the work but also has the right to direct the manner in which the work will be accomplished. The distinguishing feature of a proprietor-independent contractor relationship is that the person engaged to do the work has exclusive control of the manner of performing it, being responsible only to produce the desired result. Whether the relationship is employer/ employee or proprietor/independent contractor is usually a question of fact for the jury—or for a fact finder if the issue arises in an administrative proceeding. Without changing the relationship from that of proprietor and independent contractor or the duties arising from that relationship, an employer of an independent contractor may retain a broad general power of supervision of the work to ensure satisfactory performance of the contract. This employer may inspect, stop the work, make suggestions or recommendations about details of the work, or prescribe alterations or deviations.

Tort Suits: Procedures

pg. 708 As previously noted, the law of torts in most states, unlike the law of contracts, allows joinder of the employer and employee as defendants in one cause of action or permits them to be sued separately. Although the plaintiff is limited to one recovery, the employer and employee are jointly and severally liable. The party may collect from either or both in any proportion until the judgment is paid in full. If the employee is sued first and a judgment is obtained that is not satisfied, the suit is not a bar to a subsequent suit against the employer; however, the amount of the judgment against the employee fixes the maximum limit of potential liability against the employer. If the employee is found to be free of liability, either in a separate suit or as a codefendant with the employer, then the suit against the employer on the basis of respondeat superior will fail. The employer's liability is predicated on the fault of the employee; if the employee is found to be free of fault, the employer has no liability as a matter of law.

General Rule: No Liability

pg. 709 The distinction between employees and independent contractors is important because, as a general rule, the doctrine of respondeat superior and the concept of vicarious liability in tort are not applicable to independent contractors. There is usually no tort liability because the theories that justify liability of the employer for the employee's tort are not present when the person engaged to do the work is not an employee. The application of the doctrine of respondeat superior and the tests for determining if the wrongdoer is an independent contractor are quite difficult to apply to professional and technically skilled personnel. It can be argued that a physician's profession requires such high skill and learning that others, especially laypeople, cannot, as a matter of law, be in control of the physician's activities. That argument, if accepted, would eliminate the liability of hospitals for acts of medical doctors. Notwithstanding the logic of this argument, courts usually hold that respondeat superior may be applied to professional persons and that such persons may be employees. Of course, some professional and technical persons are independent contractors. Hospitals and others who render professional service through skilled employees have the same legal responsibilities as everyone else. If the person who commits a tort is an employee acting on the employer's behalf, the employer is liable, even though no one actually "controls" the employee in the performance of his/her skill. These concepts are applicable to doctors, chemists, airline pilots, lawyers, and other highly trained specialists. Since it is generally understood that one is not liable for the torts of an independent contractor, contracts frequently provide that the relationship is that of proprietor and independent contractor, not of employer and employee. Such a provision is not binding on third parties, and the contract cannot be used to protect the contracting parties from the actual relationship as shown by the facts.

Exceptions: Where Liability Is Created

pg. 709 The rule of insulation from liability in the independent contractor situation is subject to several well-recognized exceptions, the most common of which is related to work that is inherently dangerous to the public, such as blasting dynamite. The basis of this exception is that it would be contrary to public policy to allow one engaged in such an activity to avoid liability by selecting an independent contractor rather than an employee to do the work. Another exception to insulation from vicarious liability applies to illegal work. An employer cannot insulate him/herself from liability by hiring an independent contractor to perform a task that is illegal. Still another common exception involves employees' duties considered to be duties that cannot be delegated. In discussing the law of contracts, we noted that personal rights and personal duties could not be transferred without the other party's consent. Many statutes impose strict duties on parties such as common carriers and innkeepers. If an attempt is made to delegate these duties to an independent contractor, it is clear that the employer on whom the duty is imposed has liability for the torts of the independent contractor. In a contract to perform a service or supply a product, liability for negligence cannot be avoided by engaging an independent contractor to perform the duty. Finally, an employer is liable for the torts of an independent contractor if the tort is ratified. If an independent contractor wrongfully repossesses an automobile and the one hiring him/her refuses to return it on demand, the tort has been ratified, and both parties have liability. Tort liability is also imposed on the employer who is at fault, such as when the employer negligently selects the employee. This is true whether the party performing the work is an employee or an independent contractor.

Laws affecting the employment arrangement can be organized into four general categories.

pg. 714 & 715 -First, the concept of employment at will and various exceptions to that doctrine are presented within this chapter. Also known as the law of wrongful discharge, this is an important topic for both employer and employee, for each wants to understand constraints the law asserts on employers who wish to terminate someone's employment. Where an employer violates one of the exceptions to at-will employment, the employer may be subject to legal liability for wrongful discharge. -Next, this chapter explores various laws that shape the employment relationship. Statutes that impact an employee's pay and benefits greatly influence the conditions of employment within all types of employer-employee relations. This category also includes the important areas of worker safety and privacy. -The third division of this chapter explores basic aspects of labor law, which is that area of jurisprudence devoted to controlling the union-management relationship. -The fourth category of laws affecting the workplace deals with discrimination, harassment, and related matters.

Wrongful Discharge The Theory of Employment at Will

pg. 715 The employer-employee relationship is based, for most purposes, on a contract. Yet this contract is somewhat unique; for more than one hundred years, society has indicated that the employment-at-will theory is the foundation upon which the employment relationship is built. Drawing from the principle of reciprocity, this doctrine provides that the employee can quit at any time for any reason and that the employer can terminate the employee at any time for any reason. The common-law doctrine of at-will employment is central to the employment relationship in the United States. However, this is not necessarily the law in other countries where, by either tradition or statute, there is a presumption of continued employment that can be overcome only if there is a reason for terminating the contract of employment. In other words, many countries adopt the doctrine that an individual can be terminated only for good cause. The severe impact of the employment-at-will doctrine on employees has been softened in recent years. For example, in almost all states today, employment at will is simply a presumption, and this presumption can be overcome if the parties expressly provide in the contract that employment is only for a set duration. For example, Celine signs a contract to perform services as a singer in a specific concert hall for a period of two years. The contract provision indicating a specific duration of employment removes this arrangement from the presumption of at-will employment. There is a second method of overcoming the employment-at-will presumption. In a situation where the employer and employee expressly agree in a contract that continuing employment is dependent on the existence or nonexistence of certain conditions, the employer no longer has the unfettered discretion to terminate. In the marketing industry, for instance, it is common for a company to establish sales goals for their salespeople and provide in the contract of employment for each salesperson a provision that states that failure to meet the sales goals could result in dismissal.

Employment at will

pg. 716 A legal doctrine that allows an employee to quit at any time for any reason (or no reason) and that allows an employer to terminate employment for any reason or no reason

Public policy exception

pg. 716 An exception to at-will employment that occurs where an employee is terminated for refusing to perform an action that violates a public policy or for performing an act that advances a public policy

Statutory and Judicial Exceptions to Employment at Will

pg. 716 The doctrine of employment at will, in its purest form, allows the employer to terminate an employee for any reason, even a reason that is reprehensible, and allows an employee to leave their employment at any time for any or no reason. During the past fifty years in particular, Congress and state legislators have created exceptions to at-will employment. In these situations, an exception to the employment-at-will presumption is deemed necessary in order to further a particular interest. Roughly, these statutory exceptions can be categorized into two groups. One set of laws might best be termed those statutes that prevent discrimination based on a protected trait or attribute. Under Title VII of the 1964 Civil Rights Act, for instance, an employer cannot terminate a person because of their gender. This statute, among others that erode employer prerogatives to terminate at will, is examined in Chapter 34. The second set of laws that protects an employee from being terminated for a "bad" reason encompasses situations where an employee is terminated for exercising a legal right. State workers' compensation statutes generally prohibit an employer from firing an employee when that employee files a workers' compensation claim. In addition, federal and state whistle-blowing statutes often provide protection from termination for an employee who reports to a government agency alleged wrongdoing by an employer. The process of creating exceptions through the legislative process has, for many, been too slow. Therefore, given that employment at will is a common-law doctrine, many aggrieved employees or former employees during the past thirty years have sought to have the courts create exceptions to the strident impact of employment at will on the employer-employee relationship. These efforts have been surprisingly successful—with more than forty states recognizing two judicially created exceptions to the doctrine of employment at will (see Table 33-1). Each of these exceptions has significantly changed the legal landscape pertaining to the law of wrongful discharge.

The Public Policy Exception

pg. 716, 717, & 718 State courts have developed an exception to at-will employment where a termination violates a public policy. For an employer who violates the public policy exception, most states provide that an individual who is terminated may pursue damages based on tort law. Therefore, in addition to recovering lost wages and benefits, a successful plaintiff may be entitled to damages for pain and suffering and punitive damages because the nature of the termination is generally egregious. As a result, it is very important that employers do not terminate an employee if that action violates an important public policy of the state. The public policy exception occurs where an employee is terminated for refusing to perform an action that violates a public policy or for performing an act that advances a public policy. Because the nature of this exception is grounded in tort law, courts are very reserved in applying this doctrine. Therefore, just because a termination is perceived as violating an employee's "rights," that does not mean that the public policy exception to employment at will applies. As a general rule, the courts look at two factors. -First, application of the public policy exception requires that the termination violate a public policy—that is, an employee must be asked to commit an illegal act, refuse to do so, and be terminated as a result. Another example is when the employee is told not to perform a legal act, which he/she indicates he/she will perform, and he/she is terminated as a result. In both situations, there must be a benefit to the public associated with the employee's action in countering the employer's wishes. If the employee's position does not advance an interest of society in general, the "policy" is not a public one. For example, a bank employee believes that her newly hired boss is under investigation for embezzlement that is alleged to have occurred at the boss's previous place of employment. The employee discloses this belief to the bank president but is told to remain quiet. Instead, the employee continues to press her concern with the president. Ultimately, the employee is terminated. In a tort action for violating the public policy exception to at-will employment, the plaintiff's cause of action will fail because the disclosure was aimed at benefiting only her bank, not society. However, if the employee saw evidence that the boss was embezzling from her current bank and told federal regulators or the police, courts would generally conclude that the interest was a public one. Thus, in this latter scenario, a lawsuit against the bank for wrongful discharge may well succeed. Second, the public policy exception applies only to protect important public policies. Usually, requiring that the public policy be "tethered" to a constitutional provision, statute, or administrative regulation makes this determination. Examples include asking an employee to commit perjury, refusing to allow an employee to serve on a jury, or declining to take an illegal polygraph test. One of the most famous cases dealing with the public policy exception comes from the Arizona Supreme Court. In the case of Wagenseller v. Scottsdale Memorial Hospital, a nurse went on a camping trip with colleagues from the hospital; the trip included rafting down the Colorado River. While other employees staged a parody of the song Moon River during nightly campfire gatherings that included participants "mooning" their camping compatriots, the plaintiff in the case refused to bare her bottom. As a result, she was shunned on the trip and ostracized when she returned to duty at the hospital. Ultimately, she was terminated. The Arizona high court found that a public policy exception might well exist under these conditions because the plaintiff was asked to violate an indecent exposure criminal statute that the court believed existed in order to advance an important public policy.

Good cause exception

pg. 718 An exception to at-will employment that occurs when the employer acts in such a manner that an implied contract to terminate only for good cause is formed

The Good Cause Exception

pg. 718 & 719 As indicated above, the employer and employee can agree through their words that an employment relationship is not one based on employment at will. Courts have, however, fashioned an exception to at-will employment where the parties, through their words and actions after an employment contract has been entered into, change the nature of the relationship from one that is at will to one that provides that an employee can be dismissed only for good cause. The implied good cause exception requires that the employer treat the employee in such a manner that the presumption of employment at will is provided generally or that the express language in an employment contract stating an at-will relationship is overcome. If the nature of the relationship has shifted to "good cause," then the employer must provide evidence that there was a good reason for terminating the employment relationship. Courts will look at a variety of factors to decide whether the employer has created an environment where the employee can be terminated only for good cause. The company's human resource policy is often a starting place for analysis. The policy manual may begin with a statement that all employees are at will but then provide a detailed progressive discipline policy that indicates the various substantive and procedural steps the company should go through before a worker can be terminated. A progressive discipline policy statement is evidence of a good cause relationship. Another major factor is the duration of employment. If someone has worked for a firm continuously for thirty years, then this lengthy period of service is strong evidence of the creation of an implied contract to terminate only for good cause. If someone has worked only three months, then the presumption of at will is much more difficult to overcome. Finally, courts will examine indications that the worker is being treated as if he/she were a "good cause" employee. Promotions, raises, statements from supervisors indicating continued employment, and awards for performance, among many other factors, can be construed as evidence by a court that the employer has altered the employment relationship from at will to good cause Note that the good cause exception is based on contract-law theory (implied contract); thus, only contract damages provide a viable monetary remedy for a former employee terminated in violation of this exception to at-will employment. Therefore, damages for pain and suffering, or punitive damages, are not available. A number of courts are beginning to recognize a strategy that businesses might employ to keep at-will employment in the face of factors that might otherwise indicate an implied contract to terminate only for good cause. In a growing number of jurisdictions, businesses are having their employees sign, on a yearly basis, a statement that provides they are an at-will employee; courts are agreeing with employers that these statements, signed on a periodic basis, trump any other actions or statements of the employer that might indicate a good cause relationship.

Ancillary Torts

pg. 719 At-will employment and its recognized exceptions are concerned with why an employee might be or was terminated. Employers also have to be concerned about how they dismiss a worker. This section addresses two of the most popular ancillary torts associated with dismissals. An employer who terminates a single employee for having an affair with a married employee may be well within their rights if the employment relationship is based on at-will principles. However, naming the single employee and stating in a companywide e-mail the reason the employee was fired would violate the dismissed employee's right of privacy in many states. As a result, the employer might be liable for the tort of invasion of privacy. Tort liability also arises where an employer terminates an individual and intentionally causes emotional distress. Calling a worker up in front of other workers during lunch, firing the employee, berating the employee, and then ceremoniously taking away a company clipboard, name badge, and electronic access card might well create liability for the company even if an at-will employment relationship does not require the employer to provide reasons for the dismissal. Where the tort of intentional infliction of emotional distress occurs in a termination scenario similar to that presented, an employer could be liable for punitive damages, along with damages for economic and noneconomic (pain and suffering) harm. Employers (management and supervisors) are advised to consider both why they are terminating and how they go about terminating an employee.

Conditions of Employment Determining Employment Status Importance of Status

pg. 719 & 720 As a preliminary matter, when discussing many aspects of employment conditions, it is important to determine whether a particular person is an employee or an independent contractor. This determination was covered in Chapter 32 in the discussion of the law of agency, particularly regarding the application of the common-law doctrine of respondeat superior referencing tort liability for the principal. The employee/independent contractor determination is equally important within the statutory arena. Today, employers face numerous laws affecting the employer-employee relationship. However, if an individual who is performing services for another is an independent contractor, then employment laws may not apply. For a variety of reasons, businesses use the services of independent contractors for both short-and long-term projects, rather than hire new employees. Most often, independent contractors are hired because employment costs are lower than if employees are hired. However, this strategy has potential risks that can have severe consequences. Let us first look at the advantages. There are several advantages associated with using independent contractors. -First, the employer does not have to contribute the usual mandatory employer contributions for Social Security, federal unemployment tax, and state unemployment tax. -Second, the employer does not have to provide an independent contractor with voluntary benefits, including vacation leave, medical insurance, sick time, or retirement plan participation. In addition, the employer using independent contractors avoids various employment laws regarding minimum wage and overtime. -Furthermore, since most discrimination and harassment laws only apply to employees, there is a reduced risk of discrimination claims. An independent contractor also cannot hold a hiring party vicariously liable for injuries resulting from the contractor's own actions; therefore, the business does not need to pay for workers' compensation insurance. Moreover, exposure for wrongful discharge and unemployment claims are reduced because those avenues for relief are only available for employees. -Finally, administrative costs are reduced because independent contractors are paid on a gross basis and do not need to be included in a payroll system. Now let's look at the disadvantages. -The risk of misclassifying a true employee as an independent contractor means that federal and state taxing entities may be able to recover back employment-related taxes. Significant, too, are penalties associated with misclassification, even if such misclassification is not deemed to be aimed at "intentionally" avoiding the law. -Lawsuit exposure will increase because those individuals thought to be independent contractors may be defined as employees for purposes of harassment, discrimination, retaliation, or a myriad of other legal theories associated with protecting employees. -One particularly popular area for litigants today involves the potential for class-action suits based on misclassification of individuals as independent contractors under overtime and minimum wage laws. For employers who misclassify workers as independent contractors, there are legal precedents requiring such employers to bring those misclassified employees on a par with properly classified employees regarding pay and benefits.

Determining Status

pg. 720 Whether an individual is an employee or an independent contractor is often difficult to determine, and each state may have its own separate test. Unfortunately, the test for determining whether someone is an independent contractor under federal tax law for purposes of withholding is probably not identical to a state's test relating to unemployment insurance coverage. Therefore, the same person can be an employee for one purpose and an independent contractor for another. For example, a real estate agent is commonly deemed an independent contractor for state income tax purposes but an employee for purposes of workers' compensation. Tests for determining status, as one might imagine given all the different purposes possible, are numerous. Three prominent tests are highlighted here. -First, the common-law test, based on agency principles, states that an employee relationship exists if the employer has the right to control not only the means by which the worker performs his/her services but also the ends. If one has only the ability to determine the ends (e.g., a homeowner says to a builder, "Build a house on my lot"), then an independent contracting relationship is indicated. -Second, an "economic realities" test can be employed. In this case, a variety of factors are weighed. Common factors include (1) the degree of control, (2) the skill required, (3) the party who furnishes equipment, (4) the length of engagement, (5) the question of how payment is determined (by task or by another method), and (6) the intention of the parties. -Finally, the U.S. Internal Revenue Service uses twenty specific factors to make the determination. Fortunately, these factors can be organized into three categories: (1) behavioral control (e.g., if a business provides training, then that is an indicator of an employment relationship); (2) financial control (e.g., if a business pays on an hourly basis, then that is an indicator of an employment relationship); and (3) the actual relationship of the parties (e.g., if an agreement indicates that the parties desire an independent contractor relationship, then that is an indicator of such). Note, of course, that just because the parties sign a contract indicating they wish to form an independent contractor relationship does not control the determination of whether a state or federal entity will find an independent contractor relationship

Labor Law Overview of Labor Law

pg. 728 Labor law affects the working relationship of thousands upon thousands of employees within the United States. As you read this section, consider the role of government regarding union-management relations. Instead of mandating certain rights, the government has created an environment through a comprehensive set of laws wherein the worker, the union, and a management team can create a set of "internal laws" unique to that business for the purpose of controlling the employment relationship and formulating a mechanism for resolving disputes (usually known as the grievance process). While the role of government is quite limited within a collective bargaining environment, labor laws provide the necessary framework that allows unions and management to function.

Fair Labor Standards Act

pg. 721 A federal law that regulates child labor, minimum wage, and overtime Fair Labor Standards Act In 1938, Congress passed a sweeping piece of legislation geared at nationalizing key aspects of the law regarding pay in the workplace. The Fair Labor Standards Act (FLSA) applies to almost all employers with two or more employees as long as the company is engaged in inter-state commerce. In essence, the FLSA applies in two areas. -First, it regulates child labor; the FLSA forbids children under age fourteen from working and regulates the work activities of children from ages fourteen to eighteen. -Second, the act provides for a minimum wage (set by Congress) and a standard workweek (forty hours). Under the FLSA, an employee who wants to work more than forty hours in a week may do so, but that person is entitled to one-and-one-half times the normal rate of pay for those hours worked in excess. Workers in certain occupations, including agricultural workers and child actors, are exempt from the wage and hour requirements. Perhaps even more important, selected categories of workers are deemed exempt employees who are not subject to these provisions of the FLSA (and, therefore, may not properly claim overtime). Executive, administrative, professional, and certain types of outside sales and computer workers are not subject to the overtime provisions of the FLSA

Pay and Benefits

pg. 721 Recognizing the possibility that employers may take advantage of their superior bargaining position, Congress has been quite active in regulating the area of employee pay and benefits. Two of the areas addressed in this section—the Fair Labor Standards Act (FLSA) and the federal law creating unemployment compensation guidelines for states to follow—were the product of Congress acting during the 1930s to protect aspects of pay. The Equal Pay Act, which forbids sex discrimination regarding pay, is an amendment to the FLSA that occurred in 1963. The statutory framework for granting and controlling benefits came along in the 1970s, 1980s, and 1990s.

Exempt employees

pg. 721 Selected categories of employees who are not subject to the overtime provisions of the Fair Labor Standards Act

detailing

pg. 722 whereby employees known as "detailers" or "pharmaceuti-cal sales representatives" provide information to physicians about the company's products in hopes of persuading them to write prescriptions for the products in appropriate cases.

Equal Pay Act

pg. 724 The Equal Pay Act (EPA) is a 1963 amendment to the FLSA; however, its coverage is greater than the FLSA, for it covers both exempt and nonexempt employees. The very nature of the act is quite different from older provisions of the FLSA since the EPA is aimed at combatting discrimination in the workforce. Before adopting the expansive provisions of the Civil Rights Act in 1964, Congress began a decades-long process of legislating antidiscrimination by passing the EPA. Aimed only at the area of pay and focused solely on sex discrimination, this act created a foothold for the antidiscrimination statutes described in Chapter 34. To be a successful plaintiff in the typical EPA case, a female worker must show that she is paid less than a male worker who performs "substantially equal" work for the same employer. The statute identifies a four-part test to determine "substantially equal" work: (1) whether the two employees exert equal effort (e.g., physical energy); (2) whether the two employees must possess equal skill to perform their jobs (e.g., training); (3) whether the two employees have equal responsibility (e.g., supervise the same number of subordinates); and (4) whether the two employees perform their respective jobs under substantially similar (but not equal) working conditions (e.g., exposure to chemicals). Assuming that a plaintiff shows that the two jobs are equal, the employer may assert one of four defenses under the EPA; seniority, merit, quality or quantity of output, and "any factor other than sex." A successful plaintiff under the EPA may recover the amount of back pay lost because of sex discrimination. This amount is usually the difference in the pay and benefits received by the female employee and the pay and benefits received by a male employee who performs "equal work" under the EPA guidelines. As with major federal antidiscrimination provisions, the Equal Employment Opportunity Commission (EEOC) is charged with enforcing this provision of the EPA. Other aspects of the FLSA are enforced by the Department of Labor instead of the EEOC, which is an independent federal agency. Note that Chapter 34 discusses sex discrimination under the Civil Rights Act of 1964, which addresses sex discrimination in all areas of the workplace, including pay. Because the statutory model for the EPA presented above (e.g., what a plaintiff needs to show) differs from the model employed under the Civil Rights Act, a plaintiff may bring an action under both acts.

Unemployment Insurance

pg. 725 Every state provides an unemployment compensation insurance program that is covered by a tax paid by employers. To draw from the program, an employee must have worked for a specified period. In addition, compensation is not provided if the employee quits without good cause or is fired for egregious behavior. Further, workers must be capable of work and must actively look for a job appropriate to their previous work history, skill set, education, and a host of additional factors. Benefits are a percentage of past earnings and are subject to a set duration.

Worker Safety

pg. 725 In general, laws dealing with worker safety are divided between the federal and state governments. The federal government provides a statutory and regulatory framework requiring employers to create a reasonably safe workplace. Individual states may also have laws that create additional mandates for employers. The main focus of this section is on federal law. When an employee is injured on the job, regardless of whether the injury was a result of the employer's failure to provide a nondangerous environment or caused by the employee's or a co-worker's actions, all states provide workers' compensation benefits. Each of these areas is examined below.

Family and Medical Leave Act

pg. 725 Provides leave, subject to a variety of constraints, for an employee who needs to leave work in order to take care of family or medical responsibilities While a small number of states are providing a system that allows employees to be paid if they need to leave work for medical reasons or to care for a family member, the federal Family and Medical Leave Act (FMLA) only guarantees that the employee can retain their job. The FMLA, enacted by Congress in 1993, applies to employers with fifty or more employees. Under the law, an employee may receive leave if they have worked for the employer for at least twelve months. If an employee qualifies, the FMLA entitles the employee to no more than twelve weeks of leave during a twelve-month period for family reasons (e.g., birth and care for a newborn, care for a foster child, or adoption of a child) or for medical reasons (e.g., the employee's own serious health condition or the serious health condition of a spouse, child, or parent). Determining a "serious health condition" has been the subject of considerable litigation, but generally the term refers to a situation that requires continued treatment by a health provider and includes three days of incapacitation.

Coverage

pg. 728 The NLRA excludes certain groups of employers and individuals from coverage. For example, because other statutes govern the union relationship in the public sector, the NLRA does not apply to most divisions of the U.S. government, state government, or local government. What workers are excluded? Central to the idea of collective bargaining is the requirement that the worker be an employee. Therefore, the NLRA does not govern independent contractors. Likewise, an individual who is working for a member of his/her family is generally exempt. Perhaps the most important category of workers not subject to provisions of the NLRA is comprised of those employees who are supervisors.

Pensions and Health Insurance Employee Retirement Income Security Act

pg. 725 Provides protection for pensions and, to a lesser degree, employer-sponsored health benefit plans The Employee Retirement Income Security Act (ERISA), passed by Congress in 1974, regulates employer pension plans. This federal law, which establishes set standards for an employer who wishes to establish a pension plan, mandates that an employer disclose a great amount of information regarding the funding and related aspects of a pension program. The ERISA provisions also apply to employer-created medical, disability, and other types of welfare benefit plans. In contrast to the considerable regulation that ERISA provides those employers creating a pension plan, the law allows employers tremendous discretion in fashioning benefit plans with little government oversight and in changing those plans in almost any manner the employer wishes. It is important to recognize that federal law does not require that an employer provide either a pension or health insurance (among other benefits). Further, for those workers whose jobs have been eliminated and are no longer eligible for the group health insurance plan offered by their former employer, the Consolidated Omnibus Budget Reconciliation Act of 1985 (better known as COBRA) allows the former employee to continue with the employer's group plan. This can be a considerable advantage to the former employee as group rates are generally far less than what the employee might find on the health insurance open market. Under COBRA, the right to continued eligibility extends for eighteen months; however, the former employee must pay the entire premium; the employer need not pay any part of the premium.

Affordable Care Act

pg. 725 The Affordable Care Act (Public Law 111-148) began to be introduced into law beginning in 2014; the plan is to phase in the remainder of the law by 2020. Requirements for medium-sized and large employers to offer insurance coverage or face penalties are an extremely complicated part of the law. The U.S. Supreme Court has ruled that the employer mandates are constitutional. Note that there is no mandate for smaller companies. Also, regardless of size, there is no penalty if workers of a firm are so poor as to be eligible for Medicaid.

Workers' Compensation

pg. 726 A set of laws that provide financial benefits to employees who are injured while at work or to the dependents of employees whose deaths arise as a result of an illness or injury connected with work Every state has a set of laws that provide financial benefits to employees who are injured while at work or to the dependents of employees whose deaths arise as a result of an illness or injury connected with work. This law, which creates a type of insurance system, is termed workers' compensation. It is critical to note that if an injury or death is subject to workers' compensation, this compensation becomes the exclusive remedy. That means, for example, that an employee cannot sue an employer for injuries resulting from the employer's negligence that released harmful radiation into the employee's workspace. In essence, workers' compensation is no-fault insurance. There are two principal exceptions to the exclusive-remedy doctrine: (1) Workers' compensation does not cover intentional actions that result in harm, regardless of whether the employee purposefully injures him/herself (e.g., an employee drops an anvil on his/her foot in order to go home early) or the employer intentionally hurts the employee (e.g., a supervisor assaults a subordinate). (2) An employee is free to sue the manufacturer of a defective product used in the workplace that causes injury. Certain types of workers are not within workers' compensation coverage. Independent contractors, along with agricultural workers and domestic workers, generally may not seek the benefits associated with workers' compensation. For those covered, workers' compensation will provide compensation for the injury or death only if the harm arose out of employment. Courts commonly require some connection in time and space with the workplace. However, the law's overriding purpose is to provide benefits; therefore, courts will liberally construe the language of a statute in order to cover a wide variety of work-related situations. For example, a number of jurisdictions will apply workers' compensation law where an employee, playing on the company softball team, injures his ankle while sliding into home base, especially if it is expected that employees will participate in sports teams sponsored by an employer. Benefits typically associated with workers' compensation include lost pay and benefits, medical costs, and other expenses associated with rehabilitation

Occupational Safety and Health Act

pg. 726 Provides minimal standards for employee safety and health In 1970, Congress passed the Occupational Safety and Health Act (OSH Act) to provide a minimum level of safety and health standards for employees across the country. The OSH Act creates two obligations of an employer that is subject to provisions of the law. First, the act establishes the general duty of employers to keep their workplaces reasonably safe. Under the general duty clause of the OSH Act, an employer must provide a place of employment free from recognized hazards that cause or are likely to cause death or serious physical injury. Second, under the specific duty clause, the legislation requires employers to comply with specific occupational safety and health regulations that are promulgated by the Occupational Safety and Health Administration (OSHA). These regulations are usually industry specific. For example, the construction industry is subject to OSHA regulations that require the scaffolding used for employees to work on roofs, ceilings, and walls be constructed in a specific manner to prevent the structure's collapse while workers are on it. OSHA is the principal administrative agency in charge of creating regulations and enforcing federal occupational safety and health law (a separate entity, the Occupational Safety and Health Review Commission, performs the adjudicatory function). OSHA becomes aware of potential violations of the OSH Act and of OSHA regulations primarily through one of three means: (1) Employees may report violations directly to OSHA or through their employer, who then reports to OSHA. (2) OSHA may conduct inspections of work sites and discover violations. (3) If an injury on the job occurs, OSHA may conduct an investigation to determine whether violations of federal laws contributed to the injury. In most instances, violating the OSH Act or regulations created by OSHA results in the employer being cited and fined. It is possible, however, that criminal sanctions (including time in prison) can occur if a violation is willful.

Substance and Medical Testing

pg. 727 A majority of large organizations and a sizeable percentage of smaller businesses require their employees to submit to alcohol and drug testing to ensure safety and reduce costs. While there is no comprehensive federal statute dealing with substance testing in the private-sector work-place, states have been active in attempts to balance the interests of employers and employees. Generally, state statutes allow employers to conduct alcohol and drug testing, but they restrict when the test occurs and how it is conducted. The area is exceedingly complex since many of the tests are not terribly accurate; and a test may detect off-site use with a presence so small in the testing sample that the alcohol or drug would not impact performance at work. It is not surprising that the privacy expectations of employees continue to increase. Medical testing, including the testing for acquired immune deficiency syndrome (AIDS), is generally monitored under provisions of the Americans with Disabilities Act (ADA), which is examined more fully in Chapter 34. Broadly speaking, the ADA prohibits employers from testing an applicant for a job or an employee for any medical condition. What about genetic testing? The ADA may or may not prohibit employers from conducting genetic testing, unless the employee has been exposed to radiation or a dangerous chemical and the testing is for the purpose of determining the level of exposure. Many states have moved to prohibit employers from conducting genetic tests on applicants or employees. Congress followed the lead of those states when it passed the Genetic Information Nondiscrimination Act (GINA) in 2008. GINA is aimed at prohibiting the improper use of genetic information in health insurance and employment. Specifically, this act declares illegal any type of employment-related discrimination based on genetic information and forbids an employer from requesting, requiring, or purchasing genetic information associated with an applicant, employee, or family member of an employee.

Privacy

pg. 727 Perhaps there is no area of employment and labor law that is creating more need for creative solutions to workplace issues than those situations involving privacy. What is the proper balance between an employee's expectation of privacy and an employer's right to inquire into the actions and status of an employee? The issues associated with privacy are made all the more complicated with sophisticated technological developments.

National Labor Relations Act

pg. 728 The principal federal statute that governs union-management relations

Is an employer in violation of the NLRA when, having purchased a business, it refuses to recognize and bargain with the union that represented a majority of employees with the previous employer?

pg. 730 A successor employer has an obligation to bargain with a union if its predecessor employed a majority of its employees.

Collective Bargaining Creating the Relationship

pg. 730 As alluded to above, the NLRA provides the mechanism through which employees decide whether they wish to be represented by a union. Under Section 9 of the NLRA, establishing a collective bargaining relationship occurs in two stages. -First, before a representation election is held, the union must show that workers within a community of interest, or unit, are sufficiently interested in being represented. Having the union solicit employee signatures determines interest. Under NLRA and NLRB regulations, employers may limit the solicitation to nonwork times (e.g., lunch breaks) and nonwork locations (an employee cafeteria is a common place). If the union is able to secure the signatures on authorization cards of at least 30 percent of the company's employees within a particular unit, then the second stage occurs. Although the employer may choose to recognize the union as the bargaining agent once the signature solicitation process has registered the required percentage of employee interest, management will usually refuse to recognize the union. At this time, the union petitions the NLRB for a representation election. The NLRB usually will grant the petition as long as there is no collective bargaining agreement in place with another union if there has not been an election held within the previous year. During the campaign period (generally fewer than fifty days), both union and management may attempt to secure votes; however, the process must be conducted under laboratory conditions—that is, a fair election can be held only if the conditions are so ideal, so free from undue influence by either union or management, that the uninhibited desires of those voting are expressed. If the NLRB rules that laboratory conditions were not attained because of undue pressure by either the union or the employer, then the results of the election may be set aside.

The National Labor Relations Board

pg. 730 The National Labor Relations Board (NLRB), comprised of five members appointed by the U.S. president, possesses powers normally associated with an administrative agency. The NLRB functions in a rulemaking capacity, generating in the form of regulations interpretations of the NLRA. Courts reviewing an NLRB action generally respect these regulations. Most often, the public reads about the NLRB as it exercises its enforcement duties. This agency is charged with the responsibility of overseeing union elections. The law prescribes the method, culminating in an election, by which employees can determine whether they wish to be represented by a union. The NLRB makes sure that the union and management campaign in a proper fashion. If the union wins the election, then the NLRB will certify the union as the exclusive representative of the workers. In addition, the NLRB will investigate allegations of unfair labor practices by either union or management, whether the activity is alleged to have occurred during the election process or after a union is certified. The NLRB's adjudicatory function is entrusted primarily to administrative law judges. Under the NLRA's statutory scheme, the NLRB's Office of General Counsel brings an action against individuals or entities that have engaged in illegal labor activities. These actions are heard before an administrative law judge. The NLRB decides appeals of a decision by an administrative law judge.

Job Actions, Strikes, and Lockouts

pg. 732 If the union and management bargain in good faith but fail to reach a contract, or if management fails to fulfill an obligation under an existing contract, the workers may participate in either a job action or a strike against their employer. A union-sponsored activity by workers designed to put pressure on the employer without resorting to a strike is termed a job action. Examples include wearing T-shirts that have the union name, having selected individuals calling in sick, and refusing as a group to work voluntary overtime. The complete stoppage of work, or strike, is used in one of two situations: (1) Where the strike is for economic purposes (e.g., higher wages or increased benefits), the NLRA allows the strike but also provides that the employer may hire replacement workers and is under no obligation to rehire those who participated in the strike. (2) In rare situations, the strike is to protest an unfair labor practice perpetrated by the employer. In this case, federal law allows the protesters to reclaim their jobs in most situations. If the employer believes the union needs to be pressured, it may lock out the workers. Many times a lockout, just like a strike, is an acceptable strategy under the NLRA. For example, if the negotiation process is taking too long from the employer's perspective, it is legal for management to initiate a lockout as a means of encouraging greater activity on the part of the union. A lockout, however, is not permissible and will be termed an unfair labor practice when, for example, the employer refuses to let employees come to work as a means of discouraging employees from joining a union

Negotiating the Collective Bargaining Agreement

pg. 732 If the union wins the election, then under Section 7 of the NLRA, the union becomes the exclusive bargaining representative for the employees in a particular unit. Therefore, an individual represented by a union cannot contract with the employer directly, for example, to achieve a higher hourly wage. The collective bargaining process into which a union and management enter creates a contract that determines the terms and conditions of employment. During this process, the employer and the union are under a duty to bargain in good faith. Negotiating in good faith involves, for example, the generation of information that is shared by both the union and management. Data such as the projected cost of providing medical insurance during the proposed contract period are typical of the type of information that management and a union should possess before negotiating on the topic of this important employee benefit. Also, for good faith to be present, both the union and management must make a concerted effort to make offers and to compromise. One example of an unfair labor practice pertaining to negotiation might include a situation where one side says, "This is our only offer; take it or leave it." Another is where one party refuses to meet with the other.

Age Discrimination in Employment Act

pg. 748 Prohibits an employer from discriminating against applicants and employees who are at least forty years of age

Basic Provisions

pg. 748 The ADA is similar to Title VII in that it provides for both administrative action under the EEOC and a private right of action. Compensatory and punitive damages are available, subject to the limitations (or caps) applicable under Title VII. In addition, as with Title VII, this federal law applies to employers with fifteen or more employees and those employers who are engaged in interstate commerce.

Disability Discrimination

pg. 748 The Americans with Disabilities Act (ADA), enacted in 1990, is a comprehensive piece of civil rights legislation relating, in part, to discrimination in the workplace. This act draws heavily on aspects of Title VII yet also incorporates new approaches to dealing with discrimination.

Definition of a Disability

pg. 748 & 750 Congress crafted an exceedingly broad definition of the term disability. Under the ADA, a person with a disability (1) has a physical or mental impairment that substantially limits one or more of the individual's life activities, (2) has a record of such an impairment, or (3) has been or is regarded as having such an impairment. The first category, at least on a cursory level, is straightforward. The second category covers an individual who had an impairment in the past but no longer is so situated. A person who had a bad heart valve that was surgically replaced would fall into this category. As for the third type of disability covered by the ADA, if employees believe rumors that co-employee Monroe is HIV-positive, then he is regarded as being disabled, even though he is not HIV-positive. The statute provides a list of exclusions from the definition of disability, including homosexuality, compulsive gambling, behavior flowing from the illegal use of drugs, and use of alcohol in the workplace that violates company policy. Note that the definition includes both physical and mental impairments. Also, the protection afforded by the ADA extends only to those impairments that substantially limit one or more of an individual's life activities. Since the 1990s, the U.S. Supreme Court has favored a narrow reading of this aspect of the ADA. For example, in one case, severely nearsighted twin sisters were denied jobs as airline pilots, even though their eyesight was 20/20 with corrective lenses. The Court ruled that corrective measures must be taken into account in determining whether a particular impairment is a disability. In another case, the Court found that carpel tunnel syndrome was not a disability because although the plaintiff could not perform certain manual tasks associated with her specific job, she was still able perform other manual tasks. In an attempt to expand the scope of ADA protections along the lines of what Congress intended in the original act, Congress adopted the ADA Amendments Act of 2008. The major change that comes from the amendments is an expansion of employees who will qualify for coverage under the ADA because of the broader interpretation of what is considered a covered disability. The ADA Amendments Act still uses the ADA's basic definition of disability as an impairment that substantially limits one or more major life activities, a record of such an impairment, or being regarded as having such an impairment. However, it changes the way these terms are interpreted so that employees are not inadvertently omitted from coverage under the ADA because they do not meet the previously narrow court interpretations of what is considered a covered disability. The definition of major life activities is expanded by including two example lists: one for major life activities (caring for oneself, performing manual tasks, seeing, hearing, eating, sleeping, walking, standing, lifting, bending, speaking, breathing, learning, reading, concentrating, thinking, communicating, and working) and another for major bodily functions (functions of the immune system; normal cell growth; and digestive, bowel, bladder, neurological, brain, respiratory, circulatory, endocrine, and reproductive functions). The amendment also states that employers may not consider mitigating measures other than "ordinary eyeglasses or contact lenses" in assessing whether an individual has a disability. This means that even if an employee's condition is correctable, either through therapy or medication, it may still be considered a covered disability. In general, this new legislation requires that the term disability be interpreted broadly.

Laws Prohibiting Employment Discrimination

pg. 739 & 740 Two significant events in U.S. history have focused the nation's attention on discrimination: -the abolition of slavery resulting from the Civil War and -the civil rights movement of the 1960s. Because discrimination against individuals pursuing economic interests is a central aspect of any public policy agenda aimed at eradicating unsavory types of discrimination, Congress responded to both events with laws that have been used to prohibit discrimination in the workplace. A portion of the Civil Rights Act of 1866 continues to be a viable legal cause of action for employees who wish to claim discrimination because of race. More prominent today, Title VII of the Civil Rights Act of 1964 prohibits discrimination based on race, color, religion, national origin, and gender. Of course, a statutory scheme that restricts an employer's ability to discriminate on the basis of these categories necessarily erodes the doctrine of at-will employment discussed in Chapter 33. Congress also has expanded protection to job applicants and employees in situations where discrimination is based on factors other than those addressed in Title VII, including age (the Age Discrimination in Employment Act of 1967), disability (the Americans with Disabilities Act of 1990), and genetic information (the Genetic Information Nondiscrimination Act of 2008). Some states have gone further. California, for example, prohibits discrimination based on economic factors, family relationships, and sexual preference. Florida provides protection based on marital status. The major federal acts addressing discrimination matters are presented in Table 34-1. Moreover, the judiciary has been exceedingly active in the arena of prohibiting employment discrimination and providing defenses to employers sued for discrimination. The U.S. Supreme Court, in particular, has provided employers and employees with considerable guidance in interpreting antidiscrimination laws relating to the workplace. Every year, numerous lower federal courts and many state courts rule on matters of employment discrimination. Perhaps even more surprising is the general reticence of Congress to legislate in the areas pertaining to discrimination. For example, Congress has never passed a major piece of legislation specifically forbidding harassment in the private-sector workplace. The federal law that dictates the rights and duties associated with harassment in the workplace, while having its genesis in Title VII, is entirely the product of the Supreme Court and the lower federal courts. This type of case-by-case development of harassment law explains why the area is quite complicated. Also, Congress and most states have yet to address the subject of workplace bullying, a behavior that is expressly prohibited, for example, in certain European countries

Procedures

pg. 740 Congress created the Equal Employment Opportunity Commission (EEOC) to administer the provisions of Title VII. Specifically, the EEOC is authorized to conduct investigations of discrimination in the workplace and to sue to enforce the provisions of Title VII (and the Equal Pay Act [EPA]), which is addressed in Chapter 33). If, as is often the case, an individual wishes to pursue a claim against a covered employer for violating Title VII, the prospective plaintiff must still use an EEOC procedure before being able to sue. (Under the EPA, a litigant may proceed to court without having to submit a complaint to the EEOC.) While the procedure is not overly cumbersome, it does slow the process for some in pursuing a legal cause of action. Any individual who believes he/she has been discriminated against on the basis of Title VII must first file a charge with the EEOC or the appropriate state agency. The EEOC or the state agency will then usually investigate the claim; if there is sufficient proof of discrimination revealed after the investigation, an attempt will be made to reach a voluntary settlement. Because of the volume of claims, the EEOC does not investigate many allegations. In those instances where no investigation occurs or where a voluntary settlement is not achieved, the EEOC or state agency may issue a right-to-sue letter, which allows the individual to privately sue the employer.

Title VII Scope of Title VII Coverage

pg. 740 Title VII applies to employers engaged in interstate commerce with fifteen or more employees. Employers subject to the provisions of this statute include sole proprietorships, partnerships, and corporations on the private-sector side and state and local governments on the public-sector side. Title VII and most state equal opportunity laws similar to Title VII also apply only to individuals who are "employees." Therefore, the provisions of Title VII do not protect a true independent contractor. The antidiscrimination provisions of Title VII do, however, apply to employees of U.S. firms who are working in another country as long as compliance with Title VII would not force the organization into violating the host country's law.

Disparate treatment

pg. 741 A type of discrimination that requires a plaintiff to show the presence of intentional discrimination

Intentional Discrimination

pg. 741 Courts will find a Title VII violation where an employer intentionally discriminates against an applicant or employee. This type of discrimination is also known as disparate treatment. Usually, intent is difficult to prove unless it is of the obvious type illustrated previously. Therefore, the courts have fashioned a scheme that provides guidance in determining whether an adverse action by an employer was based on an individual difference in a person's race, color, religion, national origin, or gender. In disparate treatment cases, a plaintiff first shows a prima facie case consisting of four elements: (1) a membership in a protected class, (2) the adequate qualifications, (3) a rejection, and (4) the benefit applied for remains open (or went to another individual). Meeting these four elements of the prima facie case is relatively easy. Assume a woman with many years of experience in sales within the software industry applies for a position with a software-manufacturing firm but is denied the job. The applicant has probably met the requirements of the prima facie case for intentional discrimination. The plaintiff does not immediately win the case with the showing of a prima facie case. Instead, the burden now shifts to the defendant (employer) to show that the challenged employment action (e.g., refusal to hire) was taken because of a legitimate, nondiscriminatory reason. If the defendant cannot offer proof of a legitimate reason, then the plaintiff prevails. Usually, an employer is able to show a satisfactory, legal reason for denying a plaintiff an employment-related benefit. For example, an employer might provide evidence that the female applicant for the sales position at the software firm lacked the minimum qualifications posted for the job or that another person (even if male) possessed superior qualifications. With sufficient evidence of a legitimate reason, the burden then shifts back to the plaintiff to show that the employer's offered reason is mere pretext—that is, the supposedly legitimate reason is not the true reason, and discriminatory intent motivated the employer to deny the benefit. The female applicant for the position at the software firm would win a case based on disparate treatment if she could show that the president of the company, in an e-mail, directed the human resources department not to hire any more women for sales positions. In the process of showing disparate treatment, there may be proof that the employer's decision was tainted by impermissible discriminatory intent and proof that the employer would have made the same decision in the absence of the illegal intent. In these mixed-motive cases, the employer will usually prevail if he/she can show that the legitimate reason—standing by itself—would justify the decision. Practically, this can be a difficult burden to bear because evidence of illegal intent is already present. Case 34.1 illustrates an important mixed-motive case.

Proving Discrimination Under Title VII

pg. 741 The central thrust of Title VII is directed at prohibiting an employer from discriminating against an applicant for a job or a current employee (e.g., in the case of promotion, assignment, or termination) because of membership in a protected classification. Any legal action brought by the government or by an impacted individual, therefore, must require that plaintiffs prove the adverse employment action was the product of discrimination. In the situation where a corporation posts a sign in front of its headquarters, includes a disclosure on its application form, and creates a banner on the corporation's Internet home page all indicating that the firm will not hire a person from a certain protected class, it is easy for a plaintiff to provide evidence of the discriminatory rationale for a decision not to hire. Unfortunately, few of these simplistic cases exist. Instead, the courts have crafted two methods of showing discrimination under Title VII: disparate treatment and disparate impact.

Remedies

pg. 741 Title VII provides several types of remedies. Courts are given the discretion of awarding a successful plaintiff equitable relief. For example, courts might impose an injunction (e.g., prohibiting an employer from discriminating against ethnic minorities in hiring) or issue an order (e.g., requiring female candidates to be awarded additional points on an entrance examination). More prominent in successful Title VII actions is the award of monetary damages. For all types of Title VII actions, the law provides compensation to a current employee for lost salary and benefits for up to two years prior to the filing of the charge, "front pay" equal to what the former employee would have earned if not discharged, and attorney's fees. For the plaintiff who is successful with an intentional (disparate treatment) cause of action, federal law provides the potential for full compensatory damages (including damages for emotional pain and suffering) and punitive damages (to punish the defendant for acting in an egregious manner), in addition to the aforementioned remedies. While state law may provide that these damages are unlimited, Title VII limits (or caps) the amount of compensatory and punitive damages plaintiffs may recover against an employer who intentionally discriminates. The limitation is based on the size of the employer. For organizations with one hundred or fewer employees, the cap is $50,000. The range then proceeds in a graduated fashion up to employers with more than five hundred employees, who are subject to a $300,000 limit.

Disparate impact

pg. 743 A type of discrimination that occurs where an employer uses an employment practice that, while neutral on its face, has an adverse impact on members of a protected group

Unintentional Discrimination

pg. 743 & 744 Early in the development of antidiscrimination law under Title VII, the U.S. Supreme Court endorsed the position that Title VII can be violated by employer conduct that is intentional and by conduct that is unintentional. This latter type of discrimination is called disparate impact (or adverse impact). Whereas disparate treatment is most common when an individual sues under Title VII, disparate impact is the type of analysis used when the alleged discrimination is oriented more broadly to a group. The idea behind disparate impact is that an employer uses an employment practice that has a disproportionately adverse effect on one of the groups protected under Title VII. A high school graduation requirement for hiring, a passing grade on an aptitude test for promotion, completing a Web-based training program for a raise—all are examples of common employment practices that may have an unintended impact on members of a protected class. Note: These practices are neutral on their face; the concern is that they discriminate illegally, as applied. The prima facie case for disparate impact requires that the complaining party show statistically the discriminatory effect of a specific employment practice. The EEOC has created the four-fifths rule, (or the 80 percent rule) as a mechanism that assists in determining whether an employment practice is unlawful. Under this rule, if the selection rate for members in a protected class is less than four-fifths the selection rate for those in the majority, there is evidence of disparate impact. Suppose that fifty minority applicants take an entrance examination, and five pass; the passage rate is 10 percent. Two hundred members of a majority class take the same examination, with one hundred passing. The resulting 50 percent passage rate is then compared to the 10 percent rate. Because the 10 percent rate is less than four-fifths (80 percent) of the 50 percent passage rate, a plaintiff could use this disparity to show a prima facie case of disparate impact. From another perspective, the nature of disparate impact requires comparing the impact of an employment practice (or policy) on various groups. Usually, the statistical comparison is between the racial, religious, or gender-based composition of the group that currently holds a position and the racial, religious, or gender-based composition of qualified individuals in the labor pool. If the position requires only the most basic of skills, then all members of the labor pool (usually based on a geographic area) might well be considered. If, however, a particular degree, certification, license, or skill is required, then the relevant labor pool will include that attribute or ability. When a plaintiff can establish a prima facie case, the employer will lose a disparate impact case unless it presents evidence that the employment practice under scrutiny is job-related and consistent with business necessity. Courts increasingly scrutinize employers that attempt to indicate a particular employment practice is necessary. If a business sets minimum height or weight requirements that could have a negative impact on female applicants or those from selected racial groups, the employer must show that physical size is necessary to perform duties associated with the job. In those instances where the employer is able to show an employment practice is necessary, the burden shifts to the plaintiff. At this point in the case, a plaintiff will win if the party comes forward with proof that the challenged employment practice is merely pretext for discrimination or that there is another employment practice equivalent in the information it provides the employer that could be substituted for the offending practice. In the instance of height and weight requirements, a plaintiff could offer a lifting test that would not have the discriminatory impact.

Constructive discharge

pg. 744 Where the employer creates a work environment that is so uncomfortable that a reasonable employee would quit Actual discharge occurs when an employee is fired. If the cause of the firing is based on a classification protected by Title VII, then the former employee may have a good cause of action. If an employee quits, then there is no action on the part of the employer that could be termed a discharge. However, a growing number of jurisdictions are embracing the notion that constructive discharge can serve as an adverse employment action that deserves protection under Title VII. In those situations where an employer creates a workplace that is so intolerable that a reasonable person in the shoes of an employee would feel compelled to quit, then the employee can seek protection under Title VII.

Retaliation

pg. 744 & 745 An employer penalizes an employee when the employee reports an illegal employment practice. Although not a popular cause of action for many years, plaintiffs are increasingly using the provision of Title VII that prohibits an employer from taking adverse actions that discriminate against an applicant or employee where an employee has opposed a practice illegal under Title VII. A complaint to a company official or the EEOC is often the basis for a supervisor or a co-employee acting in retaliation against an employee. Although early cases limited the notion of a complaint to a formal, written statement, today it is clear that an oral complaint is also protected under the retaliation provision of Title VII. The U.S. Supreme Court has ruled that any retaliation need not even be work related, as long as the employer's action would dissuade a reasonable employee from complaining about discrimination. As a result of plaintiffs receiving favorable rulings in recent years from prominent courts, the retaliation cause of action is increasingly common. Moreover, employers have to be quite cognizant of retaliation claims as they administer human resource policies within their organizations. Suppose an employee is about to receive a poor evaluation. He knows that the evaluation may lead to his dismissal, so he goes to the human resource management office and claims that he is working in a hostile work environment under sexual harassment laws. This puts the organization in a potential bind: Issue the negative review and risk a retaliation action (with the employee alleging that the negative review is retaliation for the claim of sexual harassment) or not issue the negative review and risk a further degradation in the quality of work generated from this employee.

Categories of Discrimination

pg. 745 & 746 Title VII specifies five categories of illegal discrimination: race, color, national origin, sex, and religion. The EEOC offers its interpretation of each of these terms through various administrative agency functions (e.g., "Guidance"), but generally those interpretations are merely options that courts may consider in applying Title VII. Therefore, determining the meaning of the five terms used in Title VII to create categories of illegal discrimination rests with the courts. Individual states can also offer additional categories of discrimination. California, for example, forbids discrimination based on a number of additional classifications, including ancestry, marital status, sexual orientation, and gender identity and gender expression. Finally, local jurisdictions can create laws that make it illegal for an employer to discriminate on even more categories. For example, Washington, D.C., makes it illegal to discriminate based on personal appearance, and San Francisco forbids employers from using an applicant's or employee's weight or height.

Equal Pay Act

pg. 746 The statute that prohibits an employer from paying employees of one gender less than employees of another gender for doing substantially equal work

Employer Liability for Harassment

pg. 754 The employer is not liable for all harassment that occurs in the workplace. Under the doctrine of respondeat superior, discussed in Chapter 32, employers are vicariously liable only for those torts conducted by employees who are acting within the scope of employment. In those instances when a supervisor harasses, it is appropriate that aspects of agency law apply. If there is harassment by a coworker or a nonemployee, agency principles are not applicable; still, the employer may be liable, based on negligence. The remaining portion of this section discusses in greater detail important legal principles associated with employer liability for harassment conducted by a supervisor and for harassment conducted by someone other than a supervisor.

Sex

pg. 746 Title VII forbids an employer from discriminating against an individual on the basis of sex. While women claim the protections of Title VII in the vast majority of cases, men are also protected. An advertisement in a newspaper asking for women only to apply for a waitress position at a restaurant would provide strong evidence that the employer was violating Title VII. Because the provision of Title VII prohibiting sex discrimination has been interpreted to pertain only to sex-based discrimination, this federal law does not cover adverse employment actions based on sexual orientation or transsexuality. Two acts of Congress are closely associated with the Title VII provision that prohibits sex discrimination. The Pregnancy Discrimination Act amends Title VII to make illegal discrimination based on pregnancy, childbirth, or related conditions. A principal component of this provision requires that pregnancy and related conditions must be treated like other medical conditions that similarly affect an employee's status. Also, as explored in Chapter 33, just one year before it passed Title VII, Congress enacted the Equal Pay Act (EPA) of 1963. The focus of this provision is narrow: It forbids sex discrimination regarding pay only. An employer has violated the EPA if a woman receives lower pay than a man for performing substantially equal work. A plaintiff in an EPA action must show that the woman's job and the higher-paid man's job involve the following: (1) equal effort, (2) equal skill, (3) equal responsibility, and (4) similar working conditions. If all of this is proven, the employer prevails only if he/she is able to show that the disparity in pay relates to (1) seniority, (2) merit, (3) quality or quantity of work product, or (4) a factor other than sex.

Race, Color, and National Origin

pg. 746 Title VII's provisions barring discrimination based on race and color are designed to protect against employers' taking adverse employment actions against black people, other racial minorities, Eskimos, and American Indians. Title VII also prohibits discrimination against white people. It is acceptable under Title VII, however, for a private employer to voluntarily create a minority racial preference plan if (1) it is geared to open traditionally segregated job categories to minorities, (2) it does not unnecessarily trammel the employment rights of white people, and (3) it is only temporary. The following scenario illustrates discrimination based on color: Dark-skinned black people dominate the management ranks at a particular factory. The dark-skinned supervisors discriminate against light-skinned black subordinates. This behavior would violate Title VII's color provision. With an increasingly global workforce, instances of discrimination based on national origin are common. The prohibition certainly applies to situations where an employer discriminates against a worker who was born in another country. The Title VII ban also extends, however, to prevent discrimination based on an individual's ancestor's country of origin and an individual's physical, cultural, or linguistic characteristics that are identified by people of a certain national origin. For example, English-only rules in the workplace would violate the national origin provision of Title VII unless the employer can show a business necessity for the rule (e.g., job safety). The Immigration Reform and Control Act of 1986 also prohibits discrimination on the basis of national origin or citizenship.

Religion

pg. 746 & 747 Title VII prohibits an employer from discriminating based on an individual's religious beliefs, practices, and observances. The notion of belief is broadly interpreted, covering Catholics to the same degree as atheists. In fact, at least according to the EEOC, religious belief includes almost all moral or ethical beliefs that are sincerely held in a manner similar to those beliefs associated with followers of traditional religions. As Case 34.2 shows, however, there are limits to the concept of religious belief for Title VII purposes. Protections associated with religion extend beyond belief to religious practices and observances. Requiring an employee to work on the Sabbath, for example, may violate Title VII. There is an important difference associated with the religion provision in contrast with other protected classification schemes under Title VII. Congress also requires employers to reasonably accommodate the religious practices of its employees unless that accommodation would create an undue hardship on the employer. Therefore, if other employees could and would work on the Sabbath, then a shift change is probably a reasonable accommodation that would not create an undue hardship. The failure to provide such an accommodation would result in strong evidence of discrimination on the basis of religion. The courts have interpreted the accommodation provision quite narrowly, so employers today have considerable discretion to discriminate if an accommodation will create anything more than a minimal disruption to the workplace. The "religious" nature of a belief depends on whether the belief (1) is based on a theory of "man's nature or his place in the Universe," (2) is not merely a personal preference but has an institutional quality about it, and (3) is sincere.

Defenses to Discrimination Seniority and Merit

pg. 747 While considered more an exception than an affirmative defense, Title VII provides that as long as seniority and merit-based systems used in an organization are not the product of intentional discrimination, Title VII is not violated.

Bona Fide Occupational Qualification

pg. 747 & 748 While not applicable to discrimination based on race or color, Title VII does provide that an employer may discriminate on the basis of national origin, religion, or gender if such action is necessary to the operation of the business. For example, a theater company hiring an actor to play a female role may assert this defense successfully in limiting those auditioning for the part to women. The defense only applies in cases of disparate treatment. Perhaps it is not surprising that the bona fide occupational qualification (BFOQ) defense is narrowly construed.

Bona fide occupational qualification

pg. 748 An attribute or trait of an employee associated with national origin, religion or gender that is necessary to the employer's particular business

Age and Disability Discrimination Age Discrimination

pg. 748 In 1967, Congress passed the Age Discrimination in Employment Act (ADEA) to prevent discrimination against applicants and employees who are at least forty years of age. The ADEA covers employers with twenty or more employees who are engaged in interstate commerce. In terms of operation, the processes associated with ADEA are similar to those employed under Title VII. For example, before an individual asserting a violation of the ADEA can sue, a claim must be filed with the EEOC or the appropriate state agency. Also, both disparate treatment and disparate impact theories apply to ADEA actions. The ADEA does recognize, for the purposes of the statute of limitations, that actions that violate the ADEA may be willful or non-willful. Note, also, that it is not a violation of the ADEA for an employer to favor older employees over younger employees, even if those younger employees are in the forty-and-older age group. The ADEA has a BFOQ defense and a "reasonable factor other than age" defense.

Reasonable Accommodation and Undue Hardship

pg. 749 & 750 Borrowing language from the religion provisions of Title VII, the ADA requires employers to make reasonable accommodations to a job applicant's or an employee's disability, as long as making the accommodation does not create an undue hardship for the employer. While the statutory language is quite similar, it is clear that Congress intended greater accommodations under the ADA than those found under Title VII dealing with religious accommodation. The courts have followed the wishes of Congress and created a fairly significant obligation on employers to accommodate. The ADA protects two types of individuals: (1) those who can perform essential functions associated with their position despite their disability, and (2) those who can perform duties if the employer provides a reasonable accommodation. Because each disability and the situation surrounding the person claiming a disability are unique, employers should give considerable weight to the employee's accommodation preferences. There is a constraint on the employer's duty to accommodate. Contrary to the minimum level of accommodation necessary under the religion provision of Title VII, the ADA mandates that an undue hardship will occur only if the financial or other type of burden is substantial. The nature and cost of the accommodation, the employer's overall financial resources, and the number of employees are factors that are considered in determining whether an undue hardship exists. Therefore, a court could find an undue hardship exists in a call center operation with thirty employees but not make a similar finding in a manufacturing firm with five hundred employees. Exhibit 34-4 provides the processes associated with an ADA claim.

Harassment Theoretical Aspects of Harassment

pg. 750 While Title VII was initially directed at situations where an individual was deprived of a benefit associated with employment, this concept of discrimination was insufficient to adequately protect job applicants and employees in view of members of the judiciary. Courts in the 1970s and 1980s expanded the reach of Title VII to cover situations where an employee was harassed. While it is possible that harassment can be associated with any of the groups protected by Title VII, by far the most common version is harassment based on sex. Sexual harassment includes unwelcome sexual advances; requests for sexual favors; and other verbal, physical, and visual (including the use of a computer) conduct of a sexual nature.

Harassment Type

pg. 750 & 751 The courts have determined that sexual harassment, broadly speaking, can take one of two forms. The first is called quid pro quo sexual harassment. In this form, a benefit relating to employment is offered to an employee in exchange for sexual favors. Quid pro quo sexual harassment will arise when an employee refuses to submit to the request for sexual favors and that individual suffers a tangible job detriment. Thus, if a male supervisor fails to promote a female subordinate because she refuses to date him, quid pro quo sexual harassment has occurred. Note that there is no requirement that the supervisor state explicitly that the penalty for refusing the advance is failure to advance. Because quid pro quo sexual harassment involves the potential granting of an economic benefit relating to employment, only supervisory employees commit this type of sexual harassment. The other type of sexual harassment is far more frequent. Hostile environment sexual harassment occurs when, according to the U.S. Supreme Court, "the workplace is permeated with discriminatory intimidation, ridicule, and insult that is sufficiently severe or pervasive to alter the conditions of the victim's employment and create an abusive working environment." No tangible economic impact on the workplace is necessary to establish a violation of Title VII if a claim is brought under hostile environment theory. Specific aspects of hostile environment sexual harassment are addressed in the next section.

Sexual Favoritism

pg. 751 Does an employee have a valid cause of action under the quid pro quo theory of harassment law where another employee has submitted to sexual harassment or voluntarily entered into a romantic or sexual relationship and receives tangible employment benefits as a result? Manuel is supervising both Anita and Bonita, but he is also dating Bonita. Manuel is allowed to promote either of these two; Bonita is selected, even though Anita is more deserving. In another consideration, what if the situation were one in which there is no tangible job benefit, but the working environment is tainted. Manuel is spending time in Bonita's office, bringing her coffee, and taking her to lunch—all in front of Anita and others. Does Anita have a valid hostile environment claim? At this point, the courts are split as to whether sexual favoritism violates Title VII.

Hostile Environment Sexual Harassment

pg. 751 For a plaintiff to be successful in a sexual harassment suit based on the hostile environment theory, two requirements must be shown. -First, the sexual conduct must be unwelcome. The requirement that the alleged victim of the harassment consider the actions as unwelcome is, practically, somewhat difficult to assess. If a female employee participates in making jokes of a sexual nature, can she claim a hostile environment if males offer similar types of attempts at humor? Moreover, how do individuals in the workplace, whether they are superiors, coworkers, subordinates, or customers, know that an individual finds behavior to be unwelcome? Does an individual who finds offense necessarily have to express objection? These are some of the tough questions that must be addressed in determining whether conduct is unwelcome. -According to the second requirement, that plaintiff must show that the offending behavior is so severe or pervasive that it creates an intimidating, hostile, or offensive working environment. Certainly, one particularly serious incident—for example, an attempted rape—would be sufficient to create a hostile environment; however, isolated statements of teasing or offhand remarks are simply not sufficient to change the conditions of employment. Therefore, as the courts have held, there is sufficient leeway in the law such that employers should not fear having to enforce a general civility code. The U.S. Supreme Court has further indicated that common sense should prevail in making these determinations, which means that cultural and economic matters can be considered. Therefore, stevedores working the docks in Houston are going to be given a bit more leeway in their actions than corporate executives in New York City. In a similar vein, a football coach patting the bottom of a player as they enter the stadium will not create a hostile environment, but a male executive touching the bottom of a female clerk certainly might. Still, there are large gray areas in making this determination. In one case, a court failed to find the creation of a hostile working environment when a male coworker touched a female co-employee's breast while she was working. The fact that the incident occurred only once, others did not see the touching, and there was no physical injury compelled the court to rule against the plaintiff. It is clear that other courts would reach a different decision. Consider Case 34.3

Same-Gender Harassment

pg. 751 Recall that Title VII prohibits sex discrimination only where the actions are based on gender differences; thus, the statute does not cover incidents of homosexual or transgender discrimination. However, the U.S. Supreme Court has extended the reach of harassment law to cover instances in which the individual harassing and the victim are of the same gender. As with male-female harassment, there is no need for a plaintiff to show that the creation of a hostile environment was motivated by sexual desire when the harassment is male-male or female-female.

Harassment by Coworker and Non-employee

pg. 755 Harassment by Coworker and Non-employee Because sexual harassment by a coworker or non-employee does not entail the harasser using the power of the employer to harass, the doctrine of respondeat superior is inapplicable. The employer, however, may be negligent regarding sexual harassment if (1) the employer knew or should have known of the sexual harassment, and (2) the employer failed to take immediate action to stop the offending behavior. In essence, the employer is liable for harassment by nonsupervisors only if the employer is negligent in controlling working conditions. For those organizations that possess a sexual harassment policy, implementing the means for employees to report alleged instances of harassment and for corrective action to be taken after a reasonable investigation, liability for sexual harassment is limited. The underlying policy is quite simple: Although the employer should be responsible for creating a workplace free of harassment, an employer should have notice and an opportunity to correct before being liable. The same rule and policy apply when the harasser is not a coworker but is, instead, a client or customer. A male bank customer who repeatedly harasses female tellers by attempting to kiss them or hold their hands creates notice for the employer given the public nature of the behavior. If the bank fails to take steps to prevent the harassment, then the employer is liable.

Harassment by a Supervisor

pg. 755 Sexual harassment conducted by a supervisor with immediate or higher authority over the employee creates liability for the organization based on principles of vicarious liability. The current state of law regarding employer liability is roughly based on agency principles. Two principal factors shape the doctrine: (1) the victim suffered a tangible job loss and (2) the degree to which the employer has created an anti-harassment atmosphere. Two U.S. Supreme Court decisions issued in 1998 form the legal landscape in this area. Both Burlington Industries, Inc. v. Ellerth (524 U.S. 742) and Faragher v. City of Boca Raton (524 U.S. 775) are referenced so often in harassment litigation and human resource management training that the legal concept is commonly known as the Ellerth/Faragher defense. Under Ellerth/Faragher, in those situations where tangible job action is taken against the victim, the employer is strictly liable because the supervisor is drawing on the power of the employer to harass. All quid pro quo harassment cases and those hostile environment cases involving a tangible job action (such as termination or demotion) require, under federal judicial decisions, that the employer is liable without any additional showing. However, for hostile environment cases not involving a tangible job loss, the U.S. Supreme Court has crafted an affirmative defense for employers. To establish the defense, the employer must show the following: (1) the employer exercised reasonable care to prevent (e.g., establishing an adequate sexual harassment policy; conducting reasonable investigations) and promptly correct any sexually harassing behavior (e.g., dealing appropriately with instances of harassment); and (2) the employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer (e.g., waited a long time to report the harassment) to otherwise avoid harm.