You are on page 1of 64

"BORDERLAND of TORT and CONTRACT" + ELD

I. A. What Is The Borderland? Cases where parties are brought together by a contractual relationship and one party alleges a tort. i. Conduct amounting to a breach of contract becomes tortious only when it also violates a duty independent of the contract arising from principles of tort law. ii. Different objectives. 1. The purpose of contract law is to enforce bargained for agreements. 2. The purpose of tort law is to control people in accordance with social policy, by deterring socially obnoxious behavior, and to compensate innocent people from misfortunes that are unexpected and overwhelming. iii. Different remedies. Contracts: May agree to limit duties and the remedies for a breach via K. Usually more difficult to obtain consequential damages for breach of contract than for tort, because of the requirement that consequential damages (e.g., lost profits) must have been within the contemplation of the breaching party (or reasonably foreseeable) at the time of the agreement. Torts: Damages are awarded to fully compensate for all injury suffered. Allows for punitive damages; K law does not. How to distinguish Sommer v. Federal Signal Corp., 79 N.Y.2d 540 (1992). Whether the defendant had committed the tort of negligence, or, instead, had merely breached a contract. The elements of the tort of negligence are: (1) the existence of a duty of care owed to the plaintiff; (2) breach of the duty by the defendant; and (3) damages proximately caused by the breach of duty Court looked at (1) the nature of the duty; and (2) the nature of the injury, the manner in which the injury occurred and the resulting harm. HELD: D had a tort duty that was independent of the contractual duty. First, for policy reasons, the alarm service should act with due care. It is a franchised and regulated service that affects public safety, and fires can have catastrophic consequences. Second, the nature of the harm supported a tort claim. A fire rapidly spread out of control. Sommer was not a mere suit for the replacement cost of a product or for enforcement of a bargain; it was not just a case of disappointed commercial expectations. The harm that was suffered was an abrupt, cataclysmic occurrence. [Courts will enforce the breach of a contractual promise through contract law, except when the actions that constitute the breach also violate a social policy that merits the imposition of tort remedies. Contracts are negligently performed all the time, but this does not mean that they all generate legally cognizable tort claims for negligence. We discussed the case of Erlich v. Menzes, 21 Cal. 4th 543 (1999), which was not assigned for reading. That case involved the negligent 1

B. 1.

breach of a contract to construct a house. The California Supreme Court held that because the contractor's negligence directly caused only economic injury and property damage, and breached no legal duty of care that was independent of the contract, the plaintiffs had no tort claim for negligence against the contractor.] 2. IKEA v. Northeast Graphics, 56 F. Supp. 2d 340 (S.D.N.Y. 1999). P alleges both a fraud claim and a negligence claim. Elements of fraud: o (a) a misrepresentation (false representation, concealment, or nondisclosure) of material fact; o (b) knowledge of falsity (scienter); o (c) intent to defraud, i.e., to induce reliance; o (d) justifiable reliance by the plaintiff; and o (e) damages caused by the fraud. Here, the fraud was committed after the parties had executed their contract; that is, this was a case of fraud committed in the course of contract performance. HELD: P IKEA failed to state a fraud claim because: o (1) the fraud arose from the same legal duty as to perform the contract; o (2) there was no misrepresentation that was collateral to the contract; and o (3) the plaintiff was just seeking benefit of the bargain damages. Intentionally misleading statements about ones intention to perform under an existing contract and concealment of ones breach of an existing contract do not give rise to an action for fraud. ALSO HELD: claim for negligence just restated a contract claim; did not set forth independent tort duty. II. The Economic Loss Doctrine 1. Judge-made rule. It functions principally as a products liability doctrine (but, as we shall see, it has also been applied more broadly in some jurisdictions to cases involving services). a. As a products liability doctrine, the ELD denies the purchaser of a defective product a tort action against the seller for purely economic losses sustained as a result of the products failure. b. Maintains traditional limits on manufacturers' liability provided by the law of warranty, except in cases of physical injury to persons or property. c. Economic loss refers to damages that are solely monetary, as opposed to damages involving physical harm to person or property. 2. Other property exception to the ELD: 3. There are three basic (and different) tests for determining when the other property exception will or will not be applied. a. Integrated system test. i. This test seeks to narrow the number of cases where a court will find that a defective product caused damage to other property. ii. Under this test, damage caused by a defective component of an integrated system to either the system as a whole or other system components is not damage to other property that precludes the application of the ELD. iii. The Wassau Tile case, discussed in Grams v. Milk Products, illustrates the integrated system test. iv. One rationale for this test is that because all but the very simplest of machines have component parts, a holding that a component of a machine was other property 2

would require a finding of other property damage in virtually every case where a product damages itself. Such a holding would eliminate the distinction between warranty and tort liability. b. Product separately bargained-for (Bright-line test). i. This is a bright-line test. ii. Property that is acquired separately from the defective good or service is other property, whether or not it is, or is intended to be, integrated or incorporated into the same physical object. iii. The Indiana Supreme Court (in a case that was not assigned for reading) adopted this test and wrote: Whether damaged property is other property turns on whether it was acquired by the plaintiff as a component of the defective product or was acquired separately. Gunkel v. Renovations, Inc., 822 N.E.2d 150 (Ind. 2005). c. Disappointed commercial expectations test (similar to foreseeability test). i. Include consideration of the purpose or thrust of the parties bargain and whether the harm that occurred to other property should have been the subject of contractual negotiations. ii. Denies tort recovery where a commercial product causes damage to other property but the damage to that other property was within the scope of bargaining, or as one court put it, the occurrence of such damage could have been the subject of negotiations between the parties. iii. This test is illustrated by Grams v. Milk Products. 1. HELD: Even though the defective Half Time milk product caused damage to the plaintiffs calves, calves were not other property because the damage to the calves flowed naturally and predictably from the fact that the Half Time milk product did not work as the plaintiffs had hoped. d. We saw how these three tests can lead to different results. i. Ex. defective synthetic cork causes the contents of a wine bottle to spoil. If the wine bottle is considered an integrated product, the damage to the wine caused by the defective cork would not be damage to other property. 1. If the product purchased by the plaintiff test is applied, the damaged wine would be other property because wine was separate from product purchased by plaintiff (i.e., the cork). 2. If the disappointed expectations test is applied, then it is very likely that the wine would not be considered other property because damage to wine was an injury that was or should have been considered when cork was purchased 4. Aas v. Superior Court, 24 Cal.4th 627 (2000), a. Presented the problem of defects in a product that present a serious risk of personal injury, but the harm has not yet materialized. b. The plaintiffs in Aas alleged serious defects in housing that violated building codes, but had not yet resulted in any harm to person or other property. Thus, as yet, they had suffered only economic loss. c. HELD: ELD barred a tort claim against the builder: d. Whether the economic loss rule applies depends on whether property [or personal] damage has occurred rather than on the possible gravity of damages that have not yet occurred. e. Dissent: asked why a homeowner should have to wait for a personal tragedy to occur in order to recover damage to repair known serious defects caused by negligent construction. 5. Aas v. Robinson Helicopter a. Both cases: Were decided by the California Supreme Court. Involved parties to a K where P sued D in tort. Ds conduct created the risk of causing physical harm Builder in Aas created the risk that a building occupant would be harmed 3

Supplier of the sprag clutches in Robinson Helicopter created the risk that the helicopter rotor would fail and the helicopter would crash. No physical harm had yet occurred. b. Difference: Aas was a negligence action ELD bars Robinson Helicopter was a fraud action no ELD bar 1. Fraud is an intentional tort. 2. P allowed to recover economic losses based on a claim for fraud in the performance, reasoning that "ELD is designed to limit liability in commercial activities that negligently or inadvertently go awry; not to reward malefactors who affirmatively misrepresent and put people at risk." 3. When does the ELD bar a claim for fraud? a. Some courts hold that the ELD does not bar a claim for fraud in the inducement. b. The fraud in the inducement exception to the ELD can be applied broadly or narrowly: Broadly: the ELD never bars a claim for fraud in the inducement. Florida appears to follow this broad application of the ELD. 1. Moransais v. Heathman, 744 So.2d 973, 981-82 (1999) (we have declined to extend the economic loss rule to actions based on fraudulent inducement . . . . [A] claim for fraudulent inducement constitute[s] a tort independent from the underlying contract.). Narrowly: ELD permits a claim for fraud in the inducement only if the misrepresentation (which can be an omission) does not relate to the subject matter of the contract. 1. Require that the misrepresentation be extraneous to, rather than interwoven with, the contract; otherwise, the ELD will bar the fraud in the inducement claim (if the lie pertains to quality of product, too tightly wound w/ K representations). 2. Huron Tool (finding that the misrepresentation was not extraneous to the contract). c. Robinson Helicopter was a case about fraud in the performance of a contract, as opposed to fraud in the inducement. Compare with IKEA: 1. Both cases involved fraud in the performance, rather than fraud in the inducement. a. Robinson Helicopter allowed tort recovery I. Rule: if in the performance of a K a party is making false statements w intent that P rely and those statements relate to something that involves human safety and exposes P to L, ELD does not bar fraud case in CA (rare exception) b. IKEA did not. 2. If the fraud in Robinson Helicopter had involved false statements certifying that the leather seats were a particular grade of leather as opposed to false statements certifying that an item of safety equipment (the sprag clutch) was a certain grade of hardness how should the case have been decided? Me: wouldnt fit exception 4. Does the ELD apply to contracts for services? SPLIT: a. NO: Wisconsin Supreme Court b. YES: ex. Berschauer/Phillips Const. Co. v. Seattle School Dist No. 1., 124 Wash.2d 816 (1994). P was a general contractor that successfully bid on a project to build a school for a school district. Prior to soliciting the plaintiff's bid, the school district had contracted with an architect, an engineering firm, and a field inspection laboratory to provide design, engineering and inspection services to the school district. The plaintiff's bid was based on plans and information that had been provided to the district by the architect, engineering firm, and field inspection 4

laboratory. The plaintiff was in privity with the school district; but the plaintiff was not in privity with the architect, engineering firm, or field inspection laboratory. It turned out that the plaintiff had to spend far more than it had expected to build the school. This made the plaintiff unhappy, so it sued the architect, engineering firm, and field inspection laboratory for negligence and negligent misrepresentation (tort claims), contending that their inaccurate plans and lack of care misled the plaintiff into submitting an artificially low bid to construct the school. The plaintiff suffered purely economic loss. HELD: P could sue the school district for breach of contract, but the ELD barred the plaintiff's claims tort claims against the architect, engineering firm, and field inspection laboratory. 1. If P could seek tort damages against these third parties, itd circumvent K limitations on liability that these third parties had negotiated: 2. "[We] maintain the fundamental boundaries of tort and contract law by limiting the recovery of economic loss due to construction delays to the remedies provided by contract. We so hold to ensure that the allocation of risk and the determination of potential future liability is based on what the parties bargained for in the contractIf tort and contract remedies were allowed to overlap, certainty and predictability in allocating risk would decrease and impede future business activity. The construction industry in particular would suffer, for it is in this industry that we see most clearly the importance of the precise allocation of risk as secured by contract. The fees charged by architects, engineers, contractors, developers, vendors, and so on are founded on their expected liability exposure as bargained and provided for in the contract." 5. Cases of professional malpractice in Ks for services a. Even where courts generally apply the ELD to Ks for services, they often carve out an exception when the services are those of a professional and the suit is for the well-recognized tort of professional malpractice. b. Moransais v. Heathman (1999), Florida Supreme Court held that the ELD was never intended to displace traditional torts for professional negligence (malpractice) such as against lawyers, accountants and engineers. The Florida Supreme Court therefore held that P could bring a malpractice claim against engineers who negligently inspected a house and failed to detect defects that rendered the house uninhabitable. 6. K for goods or for services? a. Judges can struggle to determine if K is for goods or services. b. e.g. Hannah enters into a contract with Sarah, an architect. The contract calls for Sarah to design and create the architectural drawings for a building in exchange for a $1,000 architect fee. Sarah provides the drawings to Hannah. Daniel, a general contractor, constructs the building strictly according to Sarah's drawings. Significant defects and code violations are discovered after the building is complete. Hannah sues Sarah for negligence. Hannah is in a jurisdiction where the ELD applies to contracts for products, but not for services; so if Hannah's contract with Sarah is for services, the ELD does not apply. Hannah (who wants tort recovery) argues that the contract is for architectural services. Sarah (who wants to bar tort recovery) argues that the contract is for a product namely the drawings. c. Courts usually use the "predominant purpose" test. These courts look to the totality of the circumstances, including "the primary objective the contracting parties entered into the contract to achieve, the requirements of the contract, the nature of the business of the party doing work under the contract, and the value of the materials used." See Stuart v. Weisflog's Showroom Gallery, Inc. (2008) (majority holding that the contract was for the "service of creating architectural designs and communicating those designs"; concurrence holding that the contract was for "drawings," i.e., a product.

FRAUD
ELEMENTS: a. Misrepresentation of material fact e.g. false statement, acts of concealment, or a nondisclosure where there is a duty of disclosure b. Knowledge of falsity (scienter); c. Intent to defraud, i.e., to induce reliance; d. Justifiable reliance; e. Causation; f. Damage caused by the fraud _____________________ I. Fraudulent misrepresentation: i. PROMISSORY FRAUD 1. Channel Master case. a. Fraud consisted of an affirmatively false statement by D. i. Sometimes an affirmatively false statement refers to a fact about goods e.g. saying a counterfeit watch is genuine. b. An affirmative promise to do something can be a fraudulent misrepresentation when it is made without any intention to perform the promise. i. Misrepresents the speakers state of mind. ii. A promise to do something necessarily implies the present intention to perform. Therefore, where a promise is made without any such intention, it is treated as fraudulent. 2. Most jurisdictions recognize the tort of promissory fraud, including California. a. Lazar v. Superior Court, 12 Cal.4th 31 (1996) (defendant employer fraudulently induced plaintiff to leave his secure job in New York and move to California by falsely promising plaintiff that he would continue to be employed by defendant employer so long as he performed his job and achieved results, and defendant employer had no intention of keeping his promise). 3. Something more than nonperformance is required to prove the defendant's intent not to perform his promise. Tenzer v. Superscope, Inc., 39 Cal.3d 18-30-31 (1985). a. P must have other evidence to support the charge that the promise was fraudulently made, e.g. circumstantial evidence: i. Ds inability to perform at the time of the K (such as if the defendant was insolvent); ii. Ds hasty repudiation of the promise; iii. Evidence that D has a history of failing to honor similar promises; iv. Ds failure even to attempt performance; or 6

ii.

v. Ds continued assurances after it is clear that the D would not perform. FRAUD by OMISSION 1. RULE: Silence, absent a duty to disclose, is not fraud. 2. When is there a duty to disclose? a. Restatement (Second) Torts 551, reprinted in J. Abrahamsons dissent in Kaloti: i. D owes P a fiduciary duty of disclosure; ii. D has made a statement that is misleading and ambiguous without further disclosure (half-truths); iii. D subsequently acquires info that he knows will make untrue or misleading a previous representation that when made was true or believed to be so; iv. D made false representation with no expectation that it would be acted upon, but subsequently learns that the other is about to act in reliance on the representation in a transaction w/him; and v. D knows that the plaintiff is ignorant about facts basic to the transaction and is about to enter into the transaction because of this ignorance, and where, because of the relationship between the parties, the customs of the trade or other objective circumstances, the plaintiff would reasonably expect a disclosure of those facts. 1. Kaloti special version of this factor: the fact [must be] peculiarly and exclusively within the knowledge of one party, and the mistaken party could not reasonably be expected to discover it. 2. In many cases where plaintiffs allege fraud by omission, their claims fail this test the omitted matter is one that the plaintiff could reasonably be expected to discover on his or her own. 3. Nelson v. Wiggs (Florida 1997) a. Buyers of a house contended that the seller committed fraud by failing to disclose the seasonal flooding to which the property was subject. b. HELD: seller had no duty to disclose because the regulations intended to protect homes in the county from seasonal flooding were a matter of public record. c. Dissent: the majority is leaving Ps with no way to get out of their situation; they will have to wait till the dry season to try to resell to some other ignorant buyers; vicious cycle 4. Greenery Rehabilitation Gp v. Antaramian (Mass App 1994) a. The buyer of a building sued the seller, alleging fraudulent nondisclosure. The buyer contended that the seller knew that the buildings major tenant, Northern Construction,

was financially incapable of meeting its obligations under the lease. The buyer contended that the seller had a duty to disclose this fact to the buyer. b. HELD: Seller had no duty to disclose this fact to the buyer: here was a negotiation and agreement between sophisticated businessmen active in real estate transactions; they were represented by counsel; the buyers made no credit check or inquiry of their own into the financial condition of Northern Construction, nor did they request the seller to produce such information; they did not request a guarantee of the Northern Construction lease but now seek to exact what in effect would be a guarantee.2 5. Where the purchaser knows facts about the sellers property that the seller does not know, and the purchaser does not disclose his special knowledge. a. We are here considering an arms length purchase, not a transaction where the purchaser owes fiduciary duties to the seller i. e.g. hypo where S hires D, land and mineral expert, to conduct independent appraisal of her land, reposing trust & confidence in him. D finds a gold mine & offers to purchase the land w/o telling her about the mine he is then violating a FD to disclose the gold mine to S; satisfying the first element of fraud (false statement (omission) of material fact). b. As a general rule, the purchaser owes no duty of disclosure to the seller. i. An old case states: A vendee [purchaser], who knows that there is a gold mine on the land, is not compelled to disclose that fact to the vendor [seller]. ii. But if he is interrogated as to his knowledgedenial will make transaction fraudulent. Smith v. Beatty (NC 1843). 1. But not in Michigan -- Zaschak v. Traverse Corp. (1983) No duty on the part of a vendee to disclose facts relevant to the value of the real estate in question even when specifically asked. c. Why no duty of disclosure on the part of the purchaser? i. Society wants to encourage people to find out the true value of things, and it does this by allowing them to profit from their knowledge. ii. People would have little incentive to hunt for bargains if they had to disclose to the seller the true value of the seller's property. iii. The seller owns the property and could conduct his or her own investigation. iv. If the buyer's duty were extended as broadly as the seller's duty, the rule would result in the

iii.

ridiculous conclusion that a buyer must disclose to the seller factors that have or will indicate that the seller is selling the property below its true value. Absent affirmative representation, such a rule would eliminate the freedom to negotiate in the marketplace. d. Nussbaum v. Weeks (Cal App 1989) i. HELD: A buyer in a real estate transaction has a duty to disclose material facts to a seller only under limited circumstances, such as if a fiduciary relationship exists, a misleading disclosure has been made, or the buyer knows that the seller would reasonably expect a disclosure to be made. 1. Unlikely for seller to ever expect buyer to disclose in an arms-length deal FRAUDULENT CONCEALMENT. 1. D engages in affirmative conduct to hide or suppress a fact with the intent to defraud the plaintiff. Suppose Hannah's BMW develops a crack in the engine block. At Hannah's request, her mechanic fills the crack with a temporary epoxy sealant that conceals the existence of the crack. Hannah then sells the BMW to a used car dealer without disclosing the crack; and because of the temporary epoxy sealant, the crack is a latent defect that the car dealer is unable to discover. Hannah has committed fraud through concealment. 2. Restatement (Second) of Torts 550: One party to a transaction who by concealment or other action intentionally prevents the other from acquiring material information is subject to the same liability to the other, for pecuniary loss as though he had stated the nonexistence of the matter that the other was thus prevented from discovering. a. Comment to 550: the rule commonly applies when D actively conceals a defect or other disadvantage in something that he is offering for sale to another. b. The rule also applies when D successfully prevents the plaintiff from making an investigation that he would otherwise have made, and which, if made, would have disclosed the facts; or when D frustrates an investigation. i. Sending one in search of information in a direction where it cannot be obtained is a typical illustration of frustration. ii. A false denial of knowledge or info by one party to a transaction, who is in possession of the facts, may subject him to liability as fully as if he had expressly misstated the facts, if its effect upon P is to lead him to believe that the facts do not exist or cannot be discovered. Id. 3. As is as is clause will bar fraud claims based on patent defects, but not for latent defects that could not reasonably have been discovered by the buyer. a. caveat emptor continues to apply and the vendor

may be insulated from liability for nondisclosure of facts basic to the transaction if the facts at issue are patent, or if the purchaser has been given an appropriate opportunity to discover latent defects. Universal Inv. Co. v. Sahara Motor Inn, Inc., (Ariz App. 1980) (applying caveat emptor to the sale of real property when the defect would have been discovered upon a reasonable inspection and the evidence did not indicate that the purchaser was prevented from inspecting). b. If the vendor fails to disclose a known latent defect or fails to give appropriate opportunity to discover latent defects, caveat emptor does not apply and the vendor must disclose the defect or, at a minimum, be subject to tort liability for nondisclosure. S Development Co. v. Pima Capital Management Co. (Ariz App. 2001). 4. False statements of OPINION: Presidio Enterprises v. Warner Bros. (5th Cir. 1986): statement of opinion is generally not actionable when made by an adverse party to a business transaction. This generally includes predictions of future events. a. Special knowledge exception: an opinion will be treated as a fact when the parties do not have equal information regarding the subject matter of the transaction and the purchaser therefore has the right to expect the truth and to rely on the opinions. Presidio. i. Narrow typically applies to specialized expertssuch as jewelers, lawyer, physicians, scientists, and dealers in antiqueswhere their opinions are based on concrete, specific information and objective facts. Id. (citing Restatement (Second) of Torts 542, comment f.) ii. Purchaser of an ordinary commodity is not justified in relying upon the vendors opinion of its quality or worth. e.g. purchasing a horse from a dealer -- not justified in relying upon the dealers opinioneven though one party is somewhat more conversant with the value and quality of the things about which they are bargaining. Id & 542 comment d. 5. Puffery: loose general statements made by sellers in commending their wares. An expression of opinion by [a] seller not made as a representation of fact Black's. It has been described as an exaggeration or overstatement expressed in broad, vague and commendatory language. Castrol Inc. v. Pennzoil Co., 987 F.2d 939, 945 (3d Cir. 1993). RST 109 states that puffery is offered and understood as an expression of the seller's opinion only, which is to be discounted as such by the buyer, and on which no reasonable [person] would rely. It is common knowledge and may always be assumed that any seller will express a favorable opinion concerning what he has to sell; and when he praises it in general terms, without specific content or reference to facts, buyers understand that they cannot literally rely upon such representations. RST 542 comment e. a. Presidio, Ds vague and extravagant statements (e.g., The Swarm would be a blockbuster) were puffery. They

10

6.

could not reasonably have been understood by Presidio a sophisticated film exhibitor to be anything other than expressions of optimism and salesmanship. b. Except in very special cases (where the maker of the representation knows of some peculiar characteristic of the recipient, such as stupidity, illiteracy, or gullibility), fraud occurs only when a person of ordinary prudence and comprehension would rely on the misrepresentations. c. The distinction between (i) praising ones wares in loose and general terms, and (ii) making statements with specific content or reference to facts, is important: Pancakes of Hawaii, Inc. v. Pomare Properties Corp (HI 1997) lessor of a shopping center represented to a potential tenant that available space is going fast, in order to induce that tenant to lease space in a new shopping center. The statement was false; the lessor was struggling to lease the property. Held: statement plainly related to an existing fact. The statement available space is going is neither an opinion nor a loose general statement commending any wares of the shopping center. d. Minority approach: Even when a statement would otherwise constitute classic puffery (e.g. an investment is a winning opportunity), some courts might find the statement to be actionable as a false statement of fact if the statement was an extreme departure from the true facts. RST: a. 538(a): a representation is one of opinion if it expresses only (a) the belief of the maker, without certainty, as to the existence of a fact; or (b) his judgment as to quality, value, authenticity, or other matters of judgment. b. 539: (1) A statement of opinion as to facts not disclosed and not otherwise known to the recipient may, if it is reasonable to do so, be interpreted by him as an implied statement (a) that the facts known to the maker are not incompatible with his opinion; or (b) that he knows facts sufficient to justify him in forming it. (2) In determining whether a statement of opinion may reasonably be so interpreted, the recipients belief as to whether the maker has an adverse interest is important. c. Comment on Subsection 1 of Section 539: Frequently a statement which, though in form an opinion upon facts not disclosed or otherwise known to their recipient, is reasonably understood as implying that there are facts that justify the opinion or at least that there are no facts that are incompatible with it. d. Comment b to 542: determining whether a statement of opinion by a party with an adverse interest in a transaction should reasonably be interpreted as an implied representation of fact, the fact that the speaker purports to have special knowledge of the matter that the recipient

11

does not have is of special significance. e. Comment on Subsection 2 of 539: An intending purchaser may not be justified in relying upon vendors statement of value, etc, but a purchaser is justified in assuming that even his vendors opinion has some basis of fact, and thus in believing that vendor knows of nothing which makes his opinion fantastic. f. Section 542: The recipient of a fraudulent misrepresentation solely of the makers opinion is not justified in relying upon it in a transaction with the maker, UNLESS the fact to which the opinion relates is material, and the maker: a. purports to have special knowledge of the matter that recipient does not have, or b. stands in a fiduciary or other similar relation of trust and confidence to the recipient, or c. has successfully endeavored to secure the confidence of the recipient, or d. has some other special reason to expect that recipient will rely on his opinion. II. Scienter a. D had: (i) knowledge of falsity, OR (ii) was at least reckless. i. Recklessness: Engalla v. Permanente Medical Group, Inc. (Cal 1997) False representations made recklessly and without regard for their truth in order to induce action by another are the equivalent of misrepresentations knowingly and intentionally uttered. ii. Must be an extreme departure from the standards of ordinary care, that presents a danger of misleading buyers or sellers that is either known to D or so obvious that D must have been aware of it. III. Intent to defraud intent to induce the plaintiffs reliance. b. Geernaert v. Mitchell, 31 Cal. App. 4th 601 (1995). Discusses RST 531, which discusses the element of intent to defraud in cases of intentional fraud (as opposed to negligent misrepresentation). One who makes a fraudulent misrepresentation is subject to liability to the persons or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation, for pecuniary loss suffered by them through their justifiable reliance in the type of transaction in which he intends or has reason to expect their conduct to be influenced. i. Reason to expect: stricter standard than mere foreseeability. 1. Comment to 531: One has reason to expect a result if he has information from which a reasonable man would conclude that the result will follow or would govern his conduct upon the assumption that it will do so. In order for the maker of a fraudulent misrepresentation to have reason to expect that it will reach third persons and influence their conduct it is not enough that he recognizes, or as a reasonable man should recognize, the risk that it may be communicated to them and they may act upon it. Virtually any misrepresentation is capable of being transmitted or repeated to third persons, and if sufficiently convincing may create

12

an obvious risk that they may act in reliance upon it. The maker of the misrepresentation must have information that would lead a reasonable man to conclude that there is an especial likelihood that it will reach those persons and will influence their conduct. IV. Justifiable reliance. c. Two components: i. P must actually rely on the misrepresentation. 1. Comment to RST 548 explains: In order to justify recovery, the recipient of a misrepresentation must rely upon the truth of the misrepresentation itself, and his reliance upon its truth must be a substantial factor in inducing him to act or refrain from action a. Substantial factor: not necessary that Ps reliance upon the truth of the fraudulent misrepresentation be sole or even predominant factor in influencing his conduct. It is enough that the representation has played a substantial part in influencing his decision. RST 546, comment b. 2. In California, a presumption, or at least an inference, of reliance arises wherever there is a showing that a misrepresentation was material. A misrepresentation is judged to be material if a reasonable man would attach importance to its existence or nonexistence in determining his choice of action in the transaction in question and as such materiality is generally a question of fact unless the fact misrepresented is obviously unimportant. Engalla v. Permanente Medical Gp. (Cal 1997). ii. Ps reliance must be justifiable 1. This is determined based on qualities of particular P and circumstances of the particular case 2. P is generally allowed to rely on the truth of Ds representation of fact, and generally has no affirmative duty to investigate whether that factual representation is true. a. RST 540: this applies not only when an investigation would involve an expenditure of effort and money out of proportion to the magnitude of the transaction, but also when it could be made without any considerable trouble or expense. 3. However, P cannot close her eyes to an obvious falsity one that could be discovered through a cursory examination or investigation, RST 541 a. Crigger v. Fahnestock and Co. (2d Cir 2006) Ps were investors in an obviously fishy investment program (Ponzi scheme). They were placed on guard that the investment opportunity was not legit, and under those circumstances, they needed to investigate futher. Denied recovery because they intentionally or recklessly ignored the red flags. i. Illustrates how Ps sophistication and business acumen are important in judging whether the plaintiffs reliance was justifiable --the greater the

13

sophistication of the investor, the more inquiry that is required ii. Crigger involved investors of reasonable means and prudence who had prior experience with complex investment opportunities. iii. When confronted with ample evidence that the Rayvon investment opportunity was a Ponzi scheme, these plaintiffs were required to make further inquiries. 4. Where P is relying an a fraudulent misrepresentation by a speaker who has an adverse interest in the transaction, the Restatement draws a distinction: a. Fact: The recipient of a fraudulent misrepresentation of fact may be justified in relying upon it although he believes the maker to have an adverse interest in the transaction. RST 541A. b. Opinion: where the fraudulent misrepresentation is merely the opinion of an adverse party, then the recipient is not justified in relying upon the opinion unless the recipient can satisfy the requirements of Section 542: i. Fact to which the opinion relates is material, and the maker: purports to have special knowledge of the matter that recipient doesnt have, or stands in a fiduciary or other similar relation of trust and confidence to the recipient, or has successfully endeavored to secure the confidence of the recipient, or has some other special reason to expect that the recipient will rely on his opinion." 5. Under the Restatement, justifiable reliance is not the same thing as reasonable reliance. i. Reasonable reliance -- entails an objective standard, and requires that the plaintiff conform her conduct to that of a reasonable person.. ii. Justifiable reliance -- Although some courts (e.g. 2d Cir in Crigger) require reasonable reliance, the Rst (majority) requires only that the plaintiffs reliance be justifiable. Comment to 545A: There will be cases in which a plaintiff may be justified in relying upon the representation, even though his conduct in doing so does not conform to the community standard of knowledge, intelligence, judgment or care. iii. Reliance might be unreasonable and yet justifiable: e.g. D knows of Ps extreme naivet, credulity and gullibility, and

14

deliberately exploits those qualities in order to deceive the plaintiff. In reliance on the defendants statements about the value of a notoriously terrible property, the plaintiff buys it for far more than its actual value. The plaintiff then sues for fraud. RST 545A: plaintiff is not barred by her contributory negligence in relying upon defendants misrepresentation. (Note that this rule applies only in cases of fraudulent misrepresentation, which is an intentional tort; Ps contributory negligence does bar recovery when Ds misrepresentation is merely a negligent one. RST 552A. V. Causation. d. Movitz v. First National Bank of Chicago (7th Cir. 1998). i. Two components must be demonstrated for the plaintiff to recover: 1. Causation in fact: whether the misrepresentation made by the defendant has caused the plaintiffs loss at all. This is sometimes called transaction causation. For a misrepresentation to be a cause in fact of the plaintiffs loss (or, put another way, for transaction causation to exist), the plaintiff must have relied on the truth of the misrepresentation. a. Under RST, the plaintiff does not have to show that her reliance on the truth of the misrepresentation was the sole or decisive factor in influencing her conduct; she need only show that the misrepresentation played a substantial part, and so has been a substantial factor, in influencing her decision. 2. Legal causation of loss: sometimes called loss causation. Under RST, a fraudulent misrepresentation is a legal cause of a pecuniary loss resulting from action or inaction in reliance upon it if, but only if, the loss might reasonably be expected to result from the reliance. Section 548A. a. HYPO: Suppose D (CEO of company) misrepresents business conditions of the company to the purchaser of the stock by falsely issuing a press release that says that company has recently discovered new reserves for the raw materials it uses for its product. P relies on the misrepresentation in deciding to buy the stock for $10. The company then issues new press release that explains company did not discover new reserves. The stock price falls to $8. P can recover for the $2 loss that she sustains when the true business condition of the company becomes known and the price of the stock falls from $10 to $8 as a result. There is loss causation in this scenario bc when P sells the stock, the lower price of $8 that she gets reflects the truth about the company, which was earlier concealed by misrepresentation. b. BUT D is not liable if the value of the stock falls after the sale to the purchaser, not because of the misrepresented business condition of the company, but because of some other event that has no connection with or relation to the misrepresented fact. e.g. if President of company is run over by a bus & stock falls, the misrepresentation is a cause in fact of the loss, because it induced the plaintiff to purchase the stock for $10, that misrepresentation is not a legal cause of the $2 loss (i.e., there is no loss causation) that resulted when the President was hit by the bus. ii. Movitz Although banks negligent misrepresentation re: the building & its investment prospects caused P to buy the building, P failed to show that the misrepresentation was the legal cause of the entire decline in value of the building, which the Court believed was substantially attributable to independent, intervening market forces (i.e., the overall general decline of the Houston real estate market). 1. The element of loss causation should be considered

15

whenever a purchaser who alleges fraud has subsequently resold the allegedly misrepresented item (whether it is a share of stock or a building or anything else) at a lower price. That lower price may reflect not the earlier misrepresentation, but changed economic or market circumstances, or other facts, conditions and events that taken separately or together account for some or all of that lower price. 2. HYPO: DanielCo's stock trades at $90 a share. DanielCo issues a misleading press release and the stock rises to $100 a share. H and S buy. DanielCo's stock falls to $80 a share. H sells. DanielCo's stock falls to $60 a share. DanielCo. issues a press release that corrects the misleading press release referred to in #2 above. The stock drops to $50 a share. S sells. H has no damages. Although she sold her stock for $20/share less than she paid, the $20/share decline was the result of factors other than the fraud (the fraud remained concealed until step #5, after H sold). Thus, although H can show transaction causation (the misleading press release caused her to buy), H cannot show loss causation. S has damages of $10/share. When the previously misstated truth was revealed, the stock price declined in value by $10/share. S can show both transaction causation and loss causation. VI. Damages. 1. Burke v. Harman, 574 N.W.2d 156 (1998). Under RST, typical measure of damages in a case of fraudulent misrepresentation or negligent misrepresentation is Ps out of pocket loss. a. P may recover: i. Difference between the value of what P received in transaction and its purchase price or other value given for it; and ii. Any other pecuniary loss suffered otherwise as a consequence of Ps reliance upon the misrepresentation. b. In cases of fraudulent misrepresentation only: RST permits the plaintiff to recover benefit of the bargain damages if the damages are proved with reasonable certainty. c. However, in cases of negligent misrepresentation, RST DOES NOT permit P recover benefit of the bargain damages. d. Out of pocket loss rule, illustrated in Burke: P gave D a blanket that was worth $190,000 at the time of the transaction (although the plaintiff was unaware of the blankets true worth). In return, the plaintiff received $1,000. The plaintiffs out of pocket loss was $189,000. i. When the defrauded P had made a good bargain, P will usually seek to recover benefit of the bargain damages. (1) RST HYPO: D fraudulently tells P that land for sale has valuable timber. In fact, there is no valuable timber on the land. Justifiably relying on the fraudulent misrepresentation, P pays $5,000 for the land. Even though there is no valuable timber on the land, the land is still worth $5,000. Under this scenario, P has suffered no out of pocket loss. But suppose the plaintiff can show that if the representation had been true, then the land with the timber would have been worth $9,000. Plaintiff could recover benefit of the bargain damages of $4,000.

16

NEGLIGENT MISREPRESENTATION
A. RST 552 (Information Negligently Supplied For The Guidance Of Others): (1) One who, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information. (2) [T]he liability stated in Subsection (1) is limited to loss suffered (a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction. (3) Philosophy of RST. One who relies upon information in connection with a commercial transaction may reasonably expect to hold the maker to a duty of care only in circumstances in which the maker was manifestly aware of the use to which the information was to be put and intended to supply it for that purpose. By limiting the liability for negligence of a supplier of information to be used in commercial transactions to cases in which he manifests an intent to supply the information for the sort of use in which the plaintiff's loss occurs, the law promotes the important social policy of encouraging the flow of commercial information upon which the operation of the economy rests." B. HYPO 1: no liability D was clear that info provided was only for named entity H is negotiating with Bank X for a loan of $50,000. H employs A, an accountant, to conduct an audit. H tells A the purpose of the audit is to provide the audit report to Bank X. S agrees, with the express understanding that the report is for transmission to Bank X only. H transmits the audit report to Bank Y, who, in reliance on the report, loans H $50,000. Ss audit report was negligent, and Bank Y suffers financial loss. S is not liable to Bank Y for negligent misrepresentation. The identity of the entity for whose guidance the information is given (Bank X) is regarded by the person supplying it (Sarah) as important and material; and Sarah has made it clear that her liability is to be restricted to the named entity and to it only. C. HYPO 2: liability bc D thought her report might be relied upon by a different bank, but she didnt care which bank it was Same as Hypo #1, except that here H tells S the purpose of the audit is to provide the audit report to a bank, and H merely says that she has Bank X in mind. S does not say that she is supplying the audit report for the guidance of Bank X only. S is liable to Bank Y. The entity for whose guidance the information is given (Bank X) is not regarded as important and material bc S and H did not have the express understanding that H had to go to a particular bank (Bank X), S can be liable to Bank Y. D. HYPO 3: liability bc D knew her report would be relied upon by a bank Same as Hypo #1, except H does not even say that she has Bank X in mind H just says she intends to provide the audit report to a bank for a $50,000 loan. S is liable to Bank Y.

17

E. HYPO 4: no liability bc D thought her report would be relied upon for a different type of transaction Same as Hypo #1, but H uses Ss audit report to take out a bank loan of $50,000,000, instead of only $50,000. S is not liable, bc the significant difference in loan amount makes the $50,000,000 loan a different kind of transaction than S had contemplated. F. Bily (CA Sct) -- applied Restatement 552 in a case involving the claim that investors had been injured by a negligently prepared auditor's report. Ps in Bily were persons who allegedly purchased securities in Osborne securities. Held: auditor does not owe a general duty of care regarding the conduct of an audit to persons other than the client which means that nonclients cannot sue the auditor for the tort of negligence. However, an auditor may be liable to nonclients for (i) fraudulent representations and (ii) negligent misrepresentations. (1) Fraudulent misrepresentations auditor may be held liable to reasonably foreseeable third persons for intentional fraud in the preparation and dissemination of an audit report. (a) Compare RST 531: One who makes a fraudulent misrepresentation is subject to liability to the persons or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation . . . . reason to expect is narrower than foreseeable. (2) Negligent misrepresentations -- tort of negligent misrepresentation is not the same thing as the tort of negligence. Bily: "Negligent misrepresentation isa species of the tort of deceit. Where D makes false statements, honestly believing that they are true, but without reasonable ground for such belief, he may be liable for negligent misrepresentation." G. A professional's statement of opinion can qualify as a fact. (1) Bily: " When a statement, although in the form of an opinion, is 'not a casual expression of belief' but 'a deliberate affirmation of the matters stated,' it may be regarded as a positive assertion of fact.") (2) SEC v. Weiss (D.C. Cir. 2006). Attorney gave an unqualified opinion that certain bonds to be sold to investors were tax-exempt. Court rejected D attorney's argument that an unqualified tax opinion "contain[s] no statements of fact on which to predicate liability for misrepresentation or deceit." Held: "a statement of opinion includes an implied representation that the speaker rendered the opinion in good faith and with a reasonable basis. Good faith alone is not enough. An opinion must have a reasonable basis . . . ." Id. (a) Why can an attorney who gives a bond opinion be liable to nonclients who rely on the bond opinion in investing in the bonds? The answer is that the whole purpose of giving a bond opinion is to make the bonds marketable to investors; the attorney knows that investors will rely on the opinion in deciding whether to invest in the bonds. See Petrillo v. Bachenberg (NJ 1995) ("The purpose of a legal opinion letter is to induce reliance by others."); Norman v. Brown, Todd & Heyburn (D. Mass. 1989) ("As a general matter, tax opinion letters are drafted so that someone can rely upon them.") (b) How is the attorney who gives a bond opinion different from the auditor in Bily?

18

The Court held in Bily that an auditor who makes negligent misrepresentations may be liable to those persons who act in reliance upon those misrepresentations in a transaction which the auditor intended to influence. All the auditor did in Bily was prepare annual audit reports. There was no evidence that the auditor supplied the audit reports to Osborne with the understanding that the reports would be given to people to influence their decision to purchase Osborne securities. The point of Bily is that it is not enough for the speaker (here, the auditor) to merely know of the ever-present possibility that the statement may be repeated to anyone who might rely on the statement in connection with a transaction that the speaker did not intend to influence. Bily dissent: "By permitting recovery only by those persons, or limited groups of persons, that the accountant actually knows will receive and rely upon the audit report, the Restatement rule penalizes knowledge and rewards ignorance. To avoid liability, the accountant need only agree with the client to remain blissfully unaware of the report's proposed distribution and the uses to which it will be put. However, as we discussed, there are often circumstances where the nature of the engagement puts the speaker on notice that his or her statement will be relied upon by a particular class of people in a particular type of transaction that that the speaker intends to influence. Consider again the example of bond counsel giving the opinion that a particular bond offering will be taxexempt; bond counsel obviously knows that people who choose to invest in the bond offering will be influenced by the bond opinion, and bond counsel therefore may be liable to those investors for negligent misrepresentation. H. Minority rule: no tort of negligent misrepresentation in cases involving parties who are dealing with each other at arms length in a business transaction. (1) Parties who deal with each other at arms length are entitled to expect honesty from their adversary (and thus they may sue for fraudulent misrepresentations) but are not entitled to expect due care from their adversary (and thus they may not sue for negligent misrepresentation). (2) Onita (Sct Oregon), Safeco Ins. (Minn App 1995) (in commercial relationships involving sophisticated parties, negotiating at arm's length, where neither party is supplying information for the guidance of the other, contracting parties owe each other no duty beyond honesty, and an aggrieved party is limited to suit in contract or in fraud.) I. Majority rule: recognizes tort of negligent misrepresentation in arms length business transactions. (1) See Williams Ford, Inc. v. Hartford Courant Co. (Conn 1995) We recognize that some jurisdictions do not recognize the tort of negligent misrepresentation where the situation involves business adversaries in the commercial sense. We find these cases unpersuasive and contrary to

19

the language and intent of 552 of the Restatement (Second) of Torts. (2) Similarly, the Nebraska Court of Appeals recognized the tort of negligent misrepresentation in Burke v. Harman, which involved an arms length transaction regarding the sale of a blanket.

20

Negligent Misrepresentation v Fraud


Fraud False Statement Positive assertion of material fact (which can include a false promise); omissions; concealment Neg. Misrep. Positive assertion of material fact only (which does not include false promise); no liability for negligent omission

Scienter (defendants

or negligent concealment Knowledge of falsity or at least Negligence recklessness

state of mind) Intent to Intends or has reason to Induce expect Reliance that plaintiff will rely in a particular transaction or other transactions of the same Applicable to arms-length deals Is contributory negligence a bar to the claim? Can plaintiff recover benefit of the bargain damages? general type Yes

Intends or knows that plaintiff will rely in a particular transaction or substantially similar transaction Majority rule is yes; minority rule is no

No fraud is an intentional Yes plaintiffs contributory tort (but plaintiff may not show negligence is a bar justifiable reliance if plaintiff recklessly turned a blind eye to the falsity of the statement) Majority rule is yes Majority rule is no

Among other things, we discussed the fact that courts have (i) refused to recognize the tort of negligent false promise (Tarmann); (ii) have refused to recognize negligent omissions (because an omission does not satisfy the requirement that there be a positive assertion of fact for the tort of negligent misrepresentation (Wilson)); and (iii) have refused to recognize negligent concealment.

21

THE USE OF CONTRACT LAW TO RESTRICT OR ELIMINATE FRAUD LIABILITY


1. As is clauses. The general rule is that an as is clause will bar a claim for fraud based on patent (observable) facts, but not a claim for fraud based on latent (not readily observable) facts. 2. No reliance on oral representations clauses. a. DE + NY: no reliance on oral representations clause will bar fraud claim based on alleged oral representations as matter of law. i. BUT: Abry Partners, the Delaware Chancery Court held: stipulation in a contract that limited the buyers remedy for fraud to $20M (in a case where the alleged fraud-related damages were at least $100M) would be contrary to public policy and unenforceable if the buyer could show that the seller committed fraud. The contractual limitation on remedy would be enforceable (rescission or money damages) if the buyer could not make this high showing of the sellers actual intent to deceive. b. CA: no reliance on oral representations clause will not bar fraud claim based on alleged oral representations as matter of law. i. But D can argue that the clause constitutes evidence that the plaintiff did not justifiably rely on the oral representation. ii. McLain: CA courts have concluded that a variety of contract terms neither bar fraud claims nor establish as a matter of law that reliance upon the defendants misrepresentations was unjustifiable; however, a no reliance clause may nonetheless be a factor to be considered in the determination of justifiable reliance based on the record as a whole iii. A stipulation intended to bar a partys fraud claim does not bind the party. (1) McLain. A party to a contract who has been guilty of fraud in its inducement cannot absolve himself or herself from the effects of his or her fraud by any stipulation in the K . . . . (2) CA Civil Code 1668: All Ks which have for their object, directly or indirectly, to exempt anyone from the responsibility for his own fraud or willful injury to the person or property of another, or violation of law, whether willful or negligent, are against the policy of the law. 3. Settling fraud claims: it is, of course, possible to settle fraud claims, notwithstanding provisions such as California Civil Code 1668 a. Bellefonte (2d Cir App 1985): if someone knowingly settles a fraud claim, his or her agreement to release that claim is binding, as long as that contract itself isnt induced by fraud -- you cant come back later and try to 22

weasel out of it by saying that the fraud turned out to be worse than you thought it was. It is possible to settle fraud claims you just cant throw a general release into a contract and protect yourself from later litigation if you act fraudulently. You would need to show an independent fraud, distinct from the fraud claim being settled, in order to get out of a settlement agreement of a fraud claim. 4. Parole Evidence Rule (in CA): a. Pendergrass: established that the parol evidence rule will exclude evidence of a promise that is directly at variance with the promise of an integrated, written agreement it can be tangential to those terms, but it cannot be the actual terms b. Cobbs. v. Cobbs (Cal 1942 -- as part of a divorce agreement, Husband signed a contract committing him to pay Wife $300 per month for her natural life. Husband alleged he was induced to sign this contract by Wifes oral promise that she would never remarry and, if she did, she would cancel and nullify the contract. Held: Husband cannot prove an oral promise directly contrary to the written agreement cannot say that you relied upon an oral promise that the terms of the K should not be complied with. c. Limitations on Pendergrass: i. Will not exclude parol evidence of a promise where the only contractual language that the promise seeks to vary is a no representations clause or an integration (merger) clause. (1) Ron Greenspan Volkswagen, Inc. v. Ford Motor Land Dev. Corp (Cal 1995) entered into a contract with Ds. The agreement contained a sole agreement merger clause and a no representations clause. After the deal soured, P alleged intentional misrepresentations and nondisclosures. The trial court held that, in view of the merger clause and no representations clause, there was no justifiable reliance as a matter of law. The Court of Appeal reversed, holding that a merger clause or a contract provision stating that all representations are contained therein does not bar an action for fraud. ii. Does not bar evidence that the defendant made a misrepresentation of fact concerning the contents of the physical document at the time of signing. (1) Pacific State Bank v. Greene (Cal 2003) Ps claim is different from Pendergrass, in that P is

23

saying that the bank made a misrepresentation of fact they lied to her about what it was that she was signing. Pendergrass doesnt apply to false representations of fact about the document being signed; only to extrinsic promises that are contrary to the terms of the agreement. P didnt know what she was signing its not that she thought a term was different than it actually was. 1. NOTE: This claim works because she is not a sophisticated party; would be much harder for a sophisticated company to make this claim, because the party alleging fraud must show a reasonable reliance on the misrepresentation that excuses the failure to familiarize himself or herself with the contents of the document this is a difficult burden & subjective inquiry.

24

BREACH OF FIDUCIARY DUTY


1. Who is a fiduciary? A fiduciary is one who seeks, and in whom another (the beneficiary) reposes, trust and confidence to act in the beneficiarys interests. RST 874 A fiduciary relation exists between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation. 2. What are the duties of a fiduciary? The hallmark of a fiduciary duty is the duty to act in the interest of the beneficiary. Scrupulous good faith and candor are required. Fiduciaries must make fair and complete disclosure of all material facts to the beneficiary. Fiduciaries must always act in complete fairness and may not exert any influence or pressure, take selfish advantage, or deal with the beneficiary in such a way that it benefits themselves or prejudices the beneficiary. Business shrewdness, hard bargaining, and taking advantage of the forgetfulness or negligence of the beneficiary are impermissible. 3. Formal relationships that give rise to fiduciary duties as a matter of law. Some examples: trustees, guardians, partners, lawyers, CPAs, registered investment advisors, and agents are fiduciaries as a matter of law. 4. Borderline cases. Borderline cases arise when the parties are not in a formal relationship that give rise to fiduciary duties as a matter of law (such as attorney-client), but, nonetheless, one party argues that, in light of the overall circumstances, she was owed a fiduciary duty by another party to a business transaction. Courts struggle with such cases. 5. Informal Fiduciary Duty: Meyer v. Cathey (Tex. 2005) Cathey and Meyer collaborated on eight real estate projects over four-year relationship. Meyer was always in charge of all aspects of the projects and made the final decisions. Meyer controlled the financing and the books, and Cathey relied on and trusted Meyer to treat him fairly and keep accurate financial records. Cathey considered Meyer a friend. Three years into their relationship, the parties embarked on two new real estate projects. Cathey contended that Meyer owed him FD, which was breached when Meyer secretly paid himself large consulting fees that drained the profits from the Dallas and Waco projects. Held: Meyer did not owe Cathey a fiduciary duty. a. Some formal relationships, such as attorney-client or trustee-beneficiary, create fiduciary duties as a matter of law, or there can be an informal fiduciary duty that arises from a moral, social, domestic or purely personal relationship of trust and confidence.7 b. Bc courts want to give full force to Ks, they will not lightly recognize an informal fiduciary duty. Not every relationship involving a high degree of trust and confidence rises a fiduciary relationship.

25

c. To impose an informal FD in a business transaction, the special relationship of trust and confidence must exist prior to, and apart from, the agreement made the basis of the suit. i. No preexisting relationship of trust and confidence between Meyer and Cathy. The projects they worked on prior to the Dallas and Waco projects were arms-length transactions entered into for the parties mutual benefit, and thus do not establish a basis for a fiduciary relationship 1. The agreements governing the earlier projects expressly disavowed the creation of any fiduciary duties or other special relationships. 2. The fact that Cathey trusted Meyer does not mean theres a fiduciary relationship, bc parties in fact dealt with each other at arms-length. 3. The fact that Cathey and Meyer were friends and frequent dining partners for four years does not create a fiduciary relationship. 6. Independent preexisting advisory relationship: EBC I v. Goldman, Sachs (N.Y. 2005) eToys decided to IPO & retained GS to advise it as to a fair price & act as underwriter. eToys was induced to and did repose confidence in GSs knowledge and expertise in pricing securities. eToys alleged that GS had secretly entered into compensation agreements with GSs customers that obligated the customers to kick back to GS a portion of the profits they made from the sale of eToys stock. eToys alleged that, in light of these compensation agreements, GS had an undisclosed economic incentive to underprice the eToys shares. eToys alleges that GS owed eToys a FD to disclose the existence of these compensation agreements. Held: Prior to finalizing the terms of the underwriting agreement, eToys and GS created an independent, preexisting advisory relationship that justified eToys in trusting GS to price the eToys shares fairly and to engage in honest dealings with eToys best interest in mind. The duty to act as eToys advisor was independent of the buyer-seller relationship. Essentially, eToys hired FS to give it advice for the benefit of the company, and GS thereby had a FD to disclose any conflict of interest concerning pricing of the IPO. a. Buyer-seller relationship: Generally FDs do not exist between commercial parties operating at arms length. In a typical buyer-seller relationship, the buyer purchases the sellers goods at a wholesale price and tries to resell the goods at a retail price. No rational seller would place trust in a buyers pricing given the parties opposing interests. i. But here they agreed to a fixed profit from the IPO. (Goldman Sachs would receive approximately 7% of the offering proceeds). Thus, eToys rationally believed that its interests in pricing the stock were aligned with Goldman Sachs interests: The higher the price, the higher GSs 7% profit. b. DISSENT: These are sophisticated & counseled parties

26

engaged in a major, arms-length purchase-sale transaction, thus the written K relationship is very important. Here, the parties written K did not expressly provide for FD. Majority decision injects uncertainty into a complex, highly-regulated industry that is of enormous importance to investors. 7. Knowingly undertaking a fiduciary duty: City of Hope v. Genentech (Cal. 2008) Dr. Boyer spoke with two City of Hope scientists about their scientific discovery of great therapeutic and commercial value. Dr. Boyer and a VC incorporated Genentech to commercially exploit biotechnology & proposed to fund City of Hope to use the scientific process and to secure patents necessary for commercialization. K stated that Genentech would pay royalty on the manufacture, use, or sale of covered products, but, Nothing herein shall be deemed to create an agency, joint venture or partnership relation between the parties hereto. It is agreed that the relationship between the parties is such that City of Hope in its performance of this Agreement is an independent contractor. Genentech obtained valuable patents based on the scientific discovery, but failed to pay City of Hope royalties and concealed and withheld information from City of Hope. City of Hope sued for breach of K and breach of FD. Held: Jury found for City of Hope & awarded $300,000,000 compensatory damages & $200,000,000 punitive damages. CA Supreme Court upheld breach of K claim and damages, but held that no fiduciary duty existed and thus vacated the award of punitive damages. 1. For a fiduciary relationship to exist, one must either: a. knowingly undertake to act on behalf & for the benefit of the other or b. enter into a relationship that imposes that undertaking as a matter of law. 2. (a) Genentech did not enter into its relationship with City of Hope with the view of acting primary for the benefit of City of Hope. a. First examine the parties written agreement. Here, K creates a mutually beneficial relationship between the parties. Genentech did not agree to act on behalf of & for the benefit of City of Hope, & did not agree to subordinate its interests to those of City of Hope. b. Next examine Genentechs conduct. The record does not show that Genentech, through its conduct, knowingly undertook the obligations of a fiduciary. c. Therefore, Genentech could owe fiduciary duties only if the relationship is one that creates a fiduciary relationship as a matter of law. 3. (b) Was there a fiduciary relationship as a matter of law? City of Hope: said relationship was fiduciary as a matter of law bc they entrusted a secret idea or device to G under an arrangement whereby they agreed to develop, patent & commercially exploit the idea in return for royalties (citing Stevens v. Marco,)

27

a. The relationship with Genentech had four characteristics typical of a fiduciary relationship: i. one party entrusts its affairs, interests or property to another; ii. there is a grant of broad discretion to another, generally because of a disparity in expertise or knowledge; iii. the two parties have an asymmetrical access to information, meaning one party has little ability to monitor the other and must rely on the truth of the other partys representations; and iv. one party is vulnerable & dependent upon the other. b. Held: even when all of the aforementioned four factors are present, it does not follow that a fiduciary duty necessarily exists as a matter of law. Thus, the language in Stevens is overbroad, even if, on the facts of that case, the holding was correct. 4. K was negotiated between two sophisticated parties of substantial bargaining power. Both parties were represented by counsel. Genentech was to be the sole owner of the patents. The contract said that the parties relationship was not one involving agency, joint venture, or partnership, which are categories in which fiduciary duties are imposed by operation of law; rather, City of Hope was to be an independent contractor. 5. City of Hope was vulnerable in that it had to rely on Genentechs superior ability in obtaining patents and marketing the products. But this is not enough to warrant the imposition of a FD on Genentech. The element of vulnerability does not generally come into play unless one partys vulnerability is so substantial as to raise equitable concerns underlying the protection afforded by the law governing fiduciaries. 6. The fact that City of Hope reposed trust and confident in Genentech is not enough, bc every contract requires one party to repose an element of trust and confidence in the other. Similarly, a mere disparity of bargaining power will not alone create a fiduciary duty. 7. The secrecy of the info imparted to Genentech may be considered by the trier of fact in deciding whether a FD exists, but it does not compel the conclusion that a FD exists. 8. If the parties relationship is one that gives rise to fiduciary duties as a matter of law, can those duties be eliminated by contract? Neubauer v. Goldfarb (Cal 2003). Andy and Steven Goldfarb owned 60% of a corporation called HCC. Walter Neubauer owned 40%. The Goldfarbs purchased Neubauers minority interest for $70 per share. Less than three months later, the Goldfarbs sold the stock to a third party for $350 per share. Neubauer alleged that the Goldfarbs cheated him by purchasing his stock for $70 while failing to disclose they had information indicating that the stock could be sold to an interested buyer for five times that price. The Goldfarbs, as directors and majority shareholders of HCC, owed Neubauer a fiduciary duty (which included honesty, fairness and complete disclosure). However, the K whereby the Goldfarbs purchased Neubauers interest stated:

28

Seller acknowledges that neither HCC nor its officers, directors or controlling shareholders have any fiduciary duty to seller or HCC in connection with the execution of this agreement or a sale including, but not limited to, the fairness of the overall consideration or the allocation thereof. 9. Each party to this contract was represented by sophisticated legal counsel. 10. CA Civil Code 1668: a. All contracts which have for their object, directly or indirectly, to exempt anyone from the responsibility for his own fraud or willful injury to the person or property of another, or violation of law, whether willful or negligent, are against the policy of the law. 11. Held: in view of Section 1668, the Goldfarbs FD could not be eliminated by K: waiver of corporate directors' and majority shareholders' fiduciary duties to minority shareholders in private close corporations is against public policy and a contract provision in a buy-sell agreement purporting to effect such a waiver is void.

29

ATTORNEY LIABILITY
Legal malpractice (professional negligence). Elements of legal malpractice are: 1. The duty of the attorney to use such skill, prudence and diligence as members of his or her profession commonly possess and exercise; 2. A breach of that duty; 3. Actual and proximate causal connection between the breach and the resulting injury; and 4. Loss or damage resulting from the attorneys negligence. Wiley v. County of San Diego (Cal 1998). 1. DUTY Duty of care to a non-client a. Goodman v. Kennedy (CA Sct 1976). Held: Attorney (who allegedly gave his client bad advice about whether stock could be sold without adverse consequences) owed no duty of care to the people who bought the stock from Attorneys client. Attorney did not give advice to his client for the purpose of benefiting the people who bought the stock from the client. Rather, the end and aim of the legal representation was to assist the client, and not to confer a benefit on the buyers of the stock. [Buyers] only relationship to the proposed transaction was that of parties with whom [Attorneys Client] might negotiate a bargain at arms length. b. McIntosh County Bank v. Dorsey (Minn. 2008) a number of Banks bought participation interests in a loan. M&S sold the participation interests to the Banks. Attorney represented M&S and advised M&S that the loan was enforceable. It turned out that the loan was unenforceable. This made the Banks unhappy. M&S was insolvent, so Banks sued Attorney. Banks theory was that Attorney owed Banks a duty of care when Attorney advised M&S about the enforceability of the loan, because Attorney knew that M&S was going to sell participation interests in the loan to third parties (namely the Banks). So Banks sued Attorney for malpractice. Held: for Attorney. In order for a third party to proceed in a legal malpractice action, that party must be a direct and intended beneficiary of the attorney's services. i. Direct beneficiary of a transaction -- if the transaction has as a central purpose an effect on the third party and the effect is intended as a purpose of the transaction. ii. The attorney must be aware of the client's intent to benefit the third party. iii. Reasoning: Banks have not produced evidence that a central purpose of the attorney-client relationship between M & S and Attorney was to affect the Banks or that the purpose of the transaction was to benefit the Banks. The purpose of the transaction was to close the St. Regis loans. The respondents had no direct communication with Attorney. The names of the Bank Participants were not included in any of the instruments Attorney drafted. No Bank Participant met with Attorney prior to or at closing. There was no communication between the Bank

30

Participants and Attorney before or at closing. The respondents' situation is more analogous to that of the plaintiffs in the CA case of Goodman v. Kennedy, whose only relationship to the proposed transaction was that of parties with whom defendant's clients might negotiate a bargain at arm's length. c. Note Goodman and McIntosh only deal with the issue of whether the attorney owes the third party a duty of care, which is a requirement to sue for malpractice. As Goodman itself makes clear, a different issue is presented if the attorney is sued not for malpractice (which requires a duty of care running to the plaintiff) but, instead, for the torts of negligent misrepresentation or fraud. d. Will drafting: paradigmatic case where an attorney has been found to owe a duty of care to the non-client has been the case of will drafting. An attorney who negligently drafts a will, with the result being that the clearly intended beneficiary fails to obtain the bequest that the decedent (client) wanted to give, may be liable to the intended beneficiary for legal malpractice. Here, the end and aim of the representation is to directly benefit the non-client by preparing a valid will that will result in a bequest to the non-client, and the clients intention is thwarted by the negligence of the attorney. i. Also, in the defective will case, when mistake comes to light client is dead, so if intended beneficiary cannot sue lawyer for thwarting clients intention, who can? 2. Causation. But-for causation 1. Viner v. Sweet (Cal 2003). P must prove the element of causation according to the but for test, meaning that the harm or loss would not have occurred without the attorneys breach of duty. This but for test is required in cases of litigation malpractice and in cases of transactional malpractice. 2. Marshak v. Ballesteros (Cal 1999) Attorney represented Husband in a divorce. After settlement, Husband sues Attorney, claiming that Attorney advised Husband to settle the divorce case for less than the case was worth. To show causation, the Husband had to prove that, but for Attorneys alleged negligent advice, Husband would have gotten a better result than he got under stipulated settlement. Held: Husband failed to show causation, and only alleged that the case was worth more than he settled it for. He offered no real evidence for this, but even if he were able to prove this, he would not prevail. For he must also prove that his ex-wife would have settled for less than she did, or that, following trial, a judge would have entered judgment more favorable than that to which he stipulated. Plaintiff has not even intimated how he would establish one or the other of these results with the certainty required to permit an award of damages. 3. Immunocept v. Fulbright & Jaworski (Fed. Cir. 2007) Attorney prosecuted a patent application for Client. One of the claims of the patent was drafted using the phrase consisting of. This is a narrower phrase than comprising. The Patent and Trademark Office

31

issued the patent as drafted by the Attorney. After the patent issued, Buyer considered purchasing Client. When Buyers lawyers discovered that Clients patent used the narrow phrase, Buyer pulled out of the deal. Client then sued Attorney for negligently drafting the patent claim. To prove causation, Client would have to prove that, if the claim had used the broader phrase comprising, then (i) the PTO would have issued the patent; and (ii) Buyer would have gone forward with the transaction. 4. Air Measurement Technologies, Inc. v. Akin Gump (Fed. Cir. 2007) Attorney prosecuted a patent application for Client and allegedly made various errors. Nevertheless, the patent issued. Client sued various third-party infringers for patent infringement. The third-party infringers asserted various defenses to the infringement suit, allegedly based on the errors that Attorney made (including failing to file the patent application on a timely basis and failing to disclose two prior patents and other facts during the prosecution of the patent applications.) Client settled the third-party infringement suits for less than Client believed the cases would have been worth if the Attorney errors had not been committed. Client sued Attorney for malpractice. Held: Because [Clients] malpractice claim stems in part from unsuccessful prior litigation, [Client] must establish that [it] would have prevailed in the prior litigation but for [Attorneys] negligence that compromised the litigation. This would require Client to prove that, but for the Attorneys negligence, Client would have obtained a valid patent and would have proven patent infringement against the third parties. Substantial Factor causation The causation test that is generally applied in malpractice cases is the but for test. But substantial factor test is applied when there are concurrent independent causes of the harm: a. multiple forces b. operating at the same time c. and independently, d. each of which would have been sufficient by itself to bring about the harm. In effect, the substantial factor test provides an exception to the but for test that permits a plaintiff to prove causation where there are concurrent independent causes of the harm. 1. RST examples of concurrent independent causes: a. Two fires are negligently set by separate acts of the A and B Railway Companies in forest country during a dry season. The two fires coalesce before setting fire to C's timber land and house. The normal spread of either fire would have been sufficient to burn the house and timber. C barely escapes from his house, suffering burns while so doing. It may be found that the negligence of either the A or the B Company or of both is a substantial factor in bringing about C's harm. b. The same facts as in Illustration 3, except that the one fire is set by the negligence of the A Company and the

32

other is set by a stroke of lightning or its origin is unknown. It may be found that the negligence of the A Company is a substantial factor in bringing about C's harm. Negligent Mispreresentation An attorney may also be liable for the tort of negligent misrepresentation. As we saw in Bily, the tort of negligent misrepresentation is not the same thing as the tort of negligence. Rather, the tort of negligent misrepresentation is a species of the tort of fraud. 2. Goodman and Roberts v. Ball Hunt if the attorney, through a lack of due care, makes false affirmative representations to non-clients, he can be sued for the tort of negligent misrepresentation. a. In Roberts, the attorney gave the client a written opinion with the intention that the opinion be transmitted to and relied upon by the third party in dealing with the client. The opinion asserted that the entity in question was a general partnership; the opinion did not disclose that a number of the so-called general partners denied that the entity was a general partnership. The third party claimed to have been injured when, in reliance on the attorneys opinion, the third party made an investment and later became embroiled in expensive litigation to establish that the entity was a general partnership. The third partys theory of injury was that the attorney had a duty to disclose facts known to the attorney that were materially inconsistent with the attorneys opinion that the entity was a general partnership. In that situation, the attorney could be liable for making negligent misrepresentations to the third party. b. Transactional Attorney in Law Firm prepares a legal opinion letter stating in good faith that there is no pending litigation against the clients business. Transactional Attorney knows that the client will give this opinion letter to third-parties to induce them to invest in the clients business. In fact, contrary to Transactional Attorneys opinion letter, a lawsuit was recently filed against the clients business. This lawsuit is being handled by Litigation Attorney who works in the same Law Firm as Transactional Attorney. Litigation Attorney has for years handled all litigations for the client, and Transactional Attorney was aware of this when he prepared the opinion letter. However, Transactional Attorney made no inquiries of Litigation Attorney before preparing the opinion letter; if Transactional Attorney had made those inquiries, then he would have known about the new lawsuit against the client. Transactional Attorney may be liable to third parties who relied

33

on the opinion to their detriment for negligent misrepresentation. Fraud Fraudulent misrepresentations 3. Shafer v. Berger (Cal 2003) attorney made affirmatively false representations of fact to a non-client concerning the insurance coverage available to attorneys client. In reliance on the false representation, the non-client settled for less than the non-client would have settled for if the truth had been known. Attorney was liable for fraud. The Court explained that Lawyers are subject to the general law and A lawyer communicating on behalf of a client with a nonclient may not knowingly make a false statement of material fact to the nonclient. The non-clients reliance on the attorneys fraudulent misrepresentation of fact was justifiable, because the non-client had no reason to disbelieve the attorneys false affirmative statements of material existing fact. a. Note that Shafer involved an affirmative misstatement about a matter of material existing fact, namely whether or not the carrier had agreed to provide coverage for willful acts. Certain statements, such as some statements relating to price or value, are considered nonactionable hyperbole or a reflection of the state of mind of the speaker and not misstatements of fact. Whether a misstatement should be so characterized depends on whether it is reasonably apparent that the person to whom the statement is addressed would regard the statement as one of fact or as merely an expression of the speakers mind. In general, a lawyer who is known to represent a person in a negotiation will be understood by nonclients to be making nonimpartial statements in the same manner as would the lawyers client. Fraud for omissions Where an attorney commits fraud by remaining silent as to a matter that should have been disclosed. 4. General rule: lawyers do not have a duty to blow the whistle on their clients. Thus, if the lawyer makes no false or misleading misrepresentations, but merely remains silent despite his or her knowledge that the client is committing fraud, then the lawyer will not be liable for fraud on an omission theory. a. Rationale. Attorneys have privileges not to disclose and imposing liability for mere silence would undermine the attorney-client privilege. 1. Schatz v. Rosenberg (4th Cir. 1991) declined to hold an attorney liable for fraud despite the fact that the attorney represented the client in a transaction where the attorney knew the client was defrauding a third party.

34

Facts: MER Enterprises purchased an eighty percent interest in two companies owned by Ps. As payment for the eighty percent interest, Ps received $1.5 million in promissory notes issued by MER. In accepting the notes, the Ps relied on a financial statement and an update letter delivered at closing indicating that the net worth of Mark Rosenberg, the creator of MER, exceeded $7 million. The financial documents failed to disclose that Rosenberg's largest company had filed for bankruptcy and that Rosenberg himself had filed for bankruptcy. Rosenberg and his entities were represented by a law firm named as a defendant in the suit. Ps alleged the law firm committed fraud by remaining silent when it knew that Rosenberg was financially insolvent. The Court rejected this argument, explaining: [P]laintiffs . . . argue that, as a matter of public policy, lawyers should not be permitted to perpetrate or assist in a fraud without being held responsible for their wrongdoingand have a duty to disclose misrepresentations to innocent third parties on the basis of public policyPublic policy counsels against imposing such a duty. Any other result may prevent a client from reposing complete trust in his lawyer for fear that he might reveal a fact which would trigger the lawyer's duty to the third party. Similarly, attorneys would have an incentive not to press clients for information. The net result would not be less securities fraud. Instead, attorneys would more often be unwitting accomplices to the fraud as a result of being kept in the dark by their clients or by their own reluctance to obtain information. The better rule-that attorneys have no duty to blow the whistle on their clientsallows clients to repose complete trust in their lawyers. Under those circumstances, the client is more likely to disclose damaging or problematic information, and the lawyer will more likely be able to counsel his client against misconduct. 2. In re Cascade Intern. Securities Litigation (S.D.Fla. 1993): The Court will not go so far as to require law firms to fully investigate their clients at any hint that they may be conducting fraudulent activities, and then to punish the law firms if they do not do so. Otherwise, the law firms would be charged with a duty to the public

35

at large to tattle on their clients. 5. However, once a lawyer has chosen to speak, he or she may not omit facts material to his or her statements. a. Schatz distinguished the facts before it from cases where the lawyer prepared solicitation documents that contained false and misleading statements. A lawyer who makes false or misleading statements orally or in writing, or who utters or writes half-truths, has the same duty that everyone else has to disclose such additional facts as are necessary to make the lawyers statements not false or misleading. Thus, many cases impose liability on lawyers for drafting or editing documents that that lawyer knows contain false or misleading statements. b. Schatz distinguished between: 1. a case where an attorney drafts an offering document that contains a false or misleading statement and 1. Maybe liability bc attorney is making a representation in connection w/soliciting the deal 2. a case where an attorney prepares the closing documents or merely papers the deal after the terms are worked out between the client and the third party. 1. No liability attorney is simply transcribing deal made by client c. Schatz also held that if the lawyer drafts closing documents that contain misrepresentations by the client, the attorney is not responsible for those misrepresentations: 1. We hold that a lawyer or law firm cannot be liable for the representations of a client, even if the lawyer incorporates the client's misrepresentations into legal documents or agreements necessary for closing the transaction. In this case, [Attorney] merely papered the deal, that is, put into writing the terms on which the Schatzes and Rosenberg agreed and prepared the documents necessary for closing the transactions. Thus, [Attorney] performed the role of a scrivener. Under these circumstances, a law firm cannot be held liable for misrepresentations made by a client in a financial disclosure statement. d. Schatz has been criticized on ethical grounds. 1. The National Law Journal criticized Schatz for concluding that lawyers have a special immunity from the responsibility not to assist a client in making a representation the lawyer

36

knows is fraudulent. Schatz gives lawyers a license to steal. Fiduciary Duty and Fraud If the attorney owes a fiduciary duty of disclosure to the plaintiff, then the attorney may be liable for failing to disclose material facts. 1. Skarbrevik v. Cohen (1991) attorney prepared documents that assisted his client in defrauding a minority shareholder. The minority shareholder sued the attorney for civil conspiracy, alleging that the attorney conspired with the three majority shareholders to violate their fiduciary duty of disclosure to the client. The attorney, however, was not a shareholder of the corporation, nor a corporate officer or director, and he therefore did not share the fiduciary duty owned by the majority shareholders to the minority shareholder. Therefore, the attorney had no duty to disclose. This meant that the attorney could not be held liable for civil conspiracy, because to be liable for civil conspiracy the defendant must be personally bound by the duty that was breached, and here the attorney was not bound by that duty. Personal Financial Interest in Underlying Transaction Finally, if the attorney has a personal financial interest in the underlying transaction, then the attorney may be held to have a duty of disclosure to the counterparty to the transaction.

37

The right to enter markets and compete fairly


When, if ever, can business competition involving purely lawful methods be a tort? Two views: a. One who engages in competition solely for the purpose of causing harm to another is subject to liability, regardless of whether the methods used are otherwise lawful in themselves. This was the view in the first Restatement of Torts. i. Tuttle v. Buck: To divert to ones self the customers of a business rival by the offer of goods at lower prices is in general a legitimate mode of serving ones own interest, & justifiable as fair competition. But when a man starts an opposition place of business, not for the sake of profit to himself, but regardless of loss to himself, and for the sole purpose of driving his competitor out of business, & with the intention of himself retiring upon the accomplishment of his malevolent purpose, he is guilty of a wanton wrong & an actionable tort. 1. Note how narrow this holding is. Cases that have followed Tuttle have articulated the concern as being with merely simulated competition as opposed to genuine competition. ii. In New York and a few other jurisdictions: there is a tort known as the prima facie tort. This is sometimes called the tort of disinterested malevolence. Purely lawful means may subject an actor to liability for prima facie tort if the actor acts with no purpose other than to maliciously injure the plaintiff. 1. The genesis which will make a lawful act unlawful must be a malicious one unmixed with any other and exclusively directed to injury and damage of another. Beardsley v. Kilmer (N.Y. 1923) 2. The prima facie tort is so narrow as to be of little practical effect because recovery has been limited to those instances where the sole motivation for the damaging acts has been a malicious intention to injury the plaintiff. Where there are other motives, e.g., profit, self-interest, business advantage, there is no recovery under tort prima facie. Squire Records v. Vanguard Recording Soc. (N.Y. 1966) a. In Squire, D made false and disparaging statements about Ps legal right to sell Joan Baez recordings; this was not a prima facie tort because defendant was motivated for its own profit and self-interest and not solely out of disinterested malevolence (but D could be liable under a separate tort, namely trade libel). As a practical matter, how many actions could successfully be challenged as lacking any self-interested motivation whatsoever? b. An act lawful in itself does not become unlawful because of a malicious or unlawful motive. This is the view espoused in the Restatement (Third) of Unfair Competition 1, which states, an actor who causes harm to another merely by engaging in a business or trade is not subject to liability regardless of motive. Liability is thus determined by an analysis of the business methods employed by

38

the actor and not by the actors motivation. i. Deceptive advertising, trademark infringement, misappropriation of trade secrets & the right of publicity, & other acts of actionable unfair competition are the sorts of wrongful methods that can support liability under the Restatement, but it is insufficient merely to show a malicious motive uncoupled with wrongful methods. ii. Katz v. Kapper (CA 1935), An act lawful in itself does not become unlawful because of a malicious or wrongful motive. 1. Ds wanted to run a rival fish wholesaler out of business and, to that end, they (i) threatened the rival wholesalers customers that they would be run out of business if they continued to buy from the rival wholesaler; (ii) offered the customers substantial price reductions; and (iii) opened a store and widely advertised and sold fish at lower prices than either the rival wholesaler or its customers could buy fish, and at a loss to the defendants. T 2. Held: This is essentially business competition. Ds threatened plaintiffs customers with the ruination of their business if they continued to trade with P, but a threat is not unlawful if it is to do a lawful thing. a. Note: if the threats had been to do an unlawful act, such as to injure the customers, or if other unlawful methods had been used (such as false advertising, or fraud, or trade libel), this would have been actionable. 2. CA statutory unfair competition law in the context of claims between business competitors. a. Cel-Tech v. L.A. Cellular (Cal 1999) case of below cost sales. (Note: Katz also involved below cost sales; Tuttle can be understood as involving below cost sales). Held: such below cost sales might be unfair under the statutory unfair competition law, Section 17200 of the California Business and Professions Code. a. New definition of unfairness to be used in suits between business competitors. More guidance to business community than previous tests (such previous tests appealed to notions of public policy or morality and ethics, or asked the court to balance the utility of the defendants conduct against the gravity of the harm). i. Test: When P who claims to have suffered injury from a direct competitors unfair act or practice invokes section 17200, the word unfair in that section means conduct that threatens an incipient violation of an antitrust law, or violates the policy or spirit of one of those laws because its effects are comparable to or the same as a violation of the law, or otherwise significantly threatens or harms competition. a. Below-cost pricing in this case might be unfair under its new test because L.A. Cellular was in a legallyprotected duopoly with one other company in the business of providing cellular service, and was able to use that position to

39

subsidize the cost of cell phones sales to the detriment of competition in the market for selling phones, because others in that market did not enjoy a position in the cellular service duopoly. 3. Predatory pricing Where a firm invests in below-cost pricing to drive its competitors out of the market, with the expectation that it will then be able to raise its prices to supracompetitive levels and earn monopoly profits to recoup its investment in below-cost sales. Predatory pricing makes economic sense if the predator has a substantial expectation of recouping its costs by raising its prices to supracompetitive levels once competitors are eliminated. For supracompetitive pricing and recoupment to occur, however, the predator must acquire not only market share but market power by creating conditions that would prevent new competitors from re-entering the market once the predator raises prices to supracompetitive levels. Without such barriers to entry, predatory pricing does not work. Were there barriers to entry that would raise the concern of predatory pricing in Tuttle v. Buck and Katz v. Kapper?

40

INTERFERENCE WITH EXISTING CONTRACT


1. Classic case: where A and B have a contract, and C induces or otherwise causes B to breach the contract. 2. Origin: Lumley v. Gye (Q.B.1853) P owned a theater at which operas were presented. P had a K with a soprano to perform at the theater between April 15 and July 15, with stipulation that during exclusivity period she could not sing elsewhere. D owned a rival theater & knew about the contract. D enticed (i.e., induced) soprano to breach her K with P and sing at Ds theater. The Queens Bench in Lumley held that Ds act of interfering with the K was an actionable wrong. a. Note: D did not use independently tortious means against the soprano; D interfered with the K without using violence, fraud, defamation or otherwise independently tortious conduct directed against the soprano. His conduct of enticing her to breach her contract with P was not tortious as to her. RST notes that the cases significance is its extension of the rule of liability to nontortious methods of inducement. 3. RST 766: One who intentionally and improperly interferes with the performance of a K (except a K to marry) between another and a third person by inducing or otherwise causing the third person not to perform the K, is subject to liability to the other for the pecuniary loss resulting to the other from the failure of the third person to perform the contract. ELEMENTS: 1. Knowledge of the contract. D must have knowledge of the contract with which he is interfering. 2. Intent to interfere -- satisfied in either of the following situations: a. D acts for the primary purpose of interfering with the performance of the contract; b. D desires to interfere, even though he acts for some other purpose in addition; c. D knows interference is certain or substantially certain to occur as result of his action. Broadest and easiest to demonstrate. Note: ill will or malice on the part of D toward P is not a condition of liability. Imperial Ice v. Rossier Co. (Cal 1941): The presence or absence of ill-will, sometimes referred to as malice, is immaterial, except as it indicates whether an interest is actually being protected. Interest = here an interest which has greater social value than insuring the stability of the K. 3. Interference (inducing or otherwise causing the breach. RST: No technical requirement as to the kind of conduct that may result in interference with the third party's performance of the K. a. Inducement. RST: interference is often by inducement. Inducement may be any conduct conveying to the third person the actor's desire to influence him not to deal with the other. i. Kelley v. Laforce (1st Cir 2002) -- element of inducement was missing. P entered into a contract to buy a pub from LaForce. The contract prohibited LaForce from excluding P from the pub. LaForce decided to reclaim the pub and exclude P from it, in violation of his contract. LaForce requested the police to assist him in taking back the pub and forcing P out. P sued the police for intentional interference with the P-LaForce contract. Held: Ps claim failed because he could not show inducement: Ds [the

41

police] did not induce LaForce to breach the contract, but LaForce induced the defendants to breach his own contract. A party to a K cannot be held liable for intentional interference with that K. 1. Can a party to a K be sued for conspiring with a third party to interfere with his own K? HYPO: A and B have a contract. B and C agree that B will breach the A-B contract and B will make a new contract with C. Instead of suing B for breach of contract, A sues B for conspiring with C to interfere with the A-B contract. Is that a viable theory? Applied Equipment Corp. v. Litton Saudi Arabia Ltd. (CA Sct 1994) said no. The Court gave two reasons why: a. Contrary rule would illogically expand the doctrine of civil conspiracy by imposing tort liability for an alleged wrong interference with a contract that the purported tortfeasor is legally incapable of committing. To be liable for civil conspiracy, D must be legally capable of committing the tort (i.e., D must itself owe a duty not to do the thing to the P). Because a party to a K does not have a tort duty not to interfere with his own K (the duty not to interfere falls only on strangers to the K), he cannot be liable for civil conspiracy to interfere with his own K. b. Contrary rule would obliterate vital and established distinctions between contract and tort theories by effectively allowing tort remedies for an ordinary breach of contract. b. Otherwise causing -- situations in which A leaves B no choice. Thus, [i]nterference with the third party's performance may be by prevention of the performance, as by physical force, by depriving him of the means of performance or by misdirecting the performance, as by giving him the wrong orders or information. c. Refusal to deal -- does not constitute actionable interference. i. RST 766, comment b: Deliberately and at his pleasure, one may ordinarily refuse to deal with another, and the conduct is not regarded as improper, subjecting the actor to liability. 1. But it can sometimes be difficult to draw the line between a nonactionable refusal to deal and actionable interference when A refuses to deal with B, is it simply an exercise of freedom of dealing, or is it part of a scheme to induce B not to perform on his contract with C? a. Note: A's aversion to C is as legitimate a reason for his refusal to deal with B as his aversion to B. If he is merely exercising that freedom, he is not liable to C for the harm caused by B's choice not to lose A's business for the sake of getting C's. On the other hand, if A uses his own refusal to deal or the threat of it as a means of affirmative inducement to make B break his contract with C, he may be acting improperly and subject to liability. d. Offering better terms: in the ordinary course of business, or simply making a K with another with the knowledge that the other will be breaching his K -- not inducement. i. RST: A is free to conduct his business in the usual manner, to advertise his goods, to extol their qualities, to fix their prices and to sell them, regardless of the fact that B has agreed to buy similar goods from C. 1. BUT, example of actionable inducement: A writes to B: I know you are under K to buy these goods from C. Therefore I offer you a special price way below my cost. If you accept this offer, you can break your K with C, pay him something in settlement and still make money. I am confident that you will find it

42

more satisfactory to deal with me than with C. As a result of this letter, B breaks his K with C. A has induced the breach. ii. Imperial Ice Co. v. Rossier (Cal 1941) Justice Traynor: A person is free to carry on his business, including reduction of prices, advertising, and solicitation in the usual lawful manner although some third party may be induced thereby to breach his K with a competitor in favor of dealing with the advertiser. Had Ds merely sold ice to Coker without actively inducing him to violate his K, his distribution of the ice in the forbidden territory in violation of his K would not then have rendered defendants liable. They may carry on their business of selling ice as usual without incurring liability for breaches of K by their customers. It is necessary to prove that they intentionally and actively induced the breach. 4. The interference must be improper [for RST jurisdictions, NOT Imperial Ice] a. RST 767: Under all of the circumstances, did D act with an improper purpose or use improper means? Consideration is given to the following factors: 1. the nature of the actor's conduct, 2. the actor's motive,

3. the interests of the other with which the actor's conduct interferes, 4. the interests sought to be advanced by the actor,

5. the social interests in protecting the freedom of action of the actor and the contractual interests of the other, 6. the proximity or remoteness of the actor's conduct to the interference and 7. the relations between the parties. b. Fikes v. Furst (NM 2003) -- P and D were academic rivals. P had a K with Madison Books to publish Ps book, which was highly critical of Dr. Furst. D learned about the K and wrote to Madison, threatening to sue for libel if the book was published. Madison canceled the K to publish Dr. Fikes book. P sued D for intentional interference with the P-Madison contract. Held: P had to show that D was not substantially motivated by a desire to protect his own interest. P failed to show this. The record showed that D was motivated by more than a desire to harm P when he sent the letter. He wanted to protect his own reputation. c. Imperial Ice + some other jurisdictions: do not require P to prove that the interference was improper; instead, permit D to assert a privilege or justification to interfere as an affirmative defense. i. Imperial Ice -- Justice Traynor spoke of justification for the inducement, which places the burden of proof on the D: Such justification exists when a person induces a breach of contract to protect an interest which has greater social value than insuring the stability of contract, and he gave as an example the interest of labor in improving working conditions. Justice Traynor also explained that if two parties have separate contracts with a third, each may resort to any

43

legitimate means at his disposal to secure performance of his contract even though the necessary result will be to cause a breach of the other contract. ii. Korea Supply v. Lockheed Martin (Cal 2003) -- CA Supreme Court held that intentionally interfering with an existing contract is a wrong in and of itself. Thus, it appears that in California D has the burden of justifying the interference. Again, the focus is essentially on whether the defendant acted with an improper purpose or used improper means under the circumstances. 5. Causation. The interference must cause the other to not perform his contract with P. 6. Damages. P must have suffered damages as a result of the nonperformance of the contract. 7. Types of Contracts. a. Void or illegal or against public policy -- no liability for interfering with the agreement. b. Merely voidable -- there may be liability. If the contract is terminable at will, most courts analyze interference with such a contract under the tort of interference with prospective economic advantage Where third party causes a partys performance of a K with another to become more burdensome or expensive: 1. Tort according to RST 766A: One who intentionally and improperly interferes with the performance of a K (except a contract to marry) between another and a third person, by preventing the other from performing the contract or causing his performance to be more expensive or burdensome, is subject to liability to the other for the pecuniary loss resulting to him. 2. Windsor Securities, Inc. v. Hartford Life Ins. Co. (3d Cir. 1993) Windsor was a company that managed investments for clients. Windsors strategy was to engage in market timing transactions for the clients, which resulted in multiple transactions. Windsors clients had accounts with Hartford, and Windsor engaged in market timing in those Hartford accounts. Hartford decided that market timing activity had an adverse effect on the performance of Hartfords funds. So Hartford imposed restrictions on market timing transactions. Windsor sued Hartford for tortious interference with existing contract, arguing, under RST 766A, that Windsors restrictions on market timing made Windsors performance of services for its clients more expensive and/or more burdensome. a. Third Circuit noted that Wyoming had declined to adopt 766A, and questioned whether Pennsylvania would do the same. Expressed the view that liability under 766A might be unnecessarily duplicative of other liability for the same conduct that constitutes the interference, bc where D prevents Ps performance, P will presumably not be a willing participant and [g]enerally, such cases will involve force, fraud, or other independently actionable conduct; adverse affects on contract rights will become an element of damages subject only to the usual limitations on causation, mitigation, and reasonable certainty. b. Third Circuit ultimately did not decide whether Pennsylvania would reject 766A, because it held: D Hartford had not used unlawful means and it acted with a legitimate business purpose -- interference was not improper. First, D did not use improper means: even if Ds conduct amounted to a breach of K, that conduct was not unlawful, illegal, or independently wrongful. Second, D did not act with an improper purpose: motivated by a desire to protect its own financial interests and those of non-market timer K owners, toward whom D clearly had a proper motive. c. Courts tend to focus on the question of whether the means the

44

defendant used, or the motive with which the defendant acted, were improper under the circumstances. 3. Stop-N-Go v. Uno-Ven Co. (7th Cir. 1999), -- Stop-N-Go was a gas station chain that had a K with Francois where Francois would be Stop-N-Gos exclusive supplier of gas. Uno-Ven approached Stop-N-Go and urged Stop-N-Go to replace Francoise with Uno-Ven. Uno-Ven offered to aggressively advertise Uno-Vens gas (the 76 brand) and to pay Stop-N-Go $1 million in advance incentives. Stop-N-Go was persuaded and breached its K with Francois in favor of Stop-N-Go. Francois sued Stop-N-Go for breach of K. Uno-Ven lost the right to market the 76 brand and terminated its K with Stop-N-Go. a. Stop-N-Go sued Uno-Ven for tortious interference with existing contract. StopN-Gos theory proceeded under 766A of the Restatement; Stop-N-Gos argument was that it had been induced by Uno-Ven to breach its own contract with Francois. b. Held: this was a defective theory of liability. Stop-N-Go willingly decided to breach the Francois K because it believed that it stood to make enough under the Uno-Ven K to cover any liability to Francois attempted efficient breach. To allow Stop-N-Go to sue Uno-Ven would make Uno-Ven the insurer of Stop-N-Gos efficient breach. Under 766A, D cannot be liable for inducement; rather, D must have prevented Ps performance. We are aware of no authority for the proposition that, absent fraud, force or intimidation, otherwise lawful conduct (offering incentives and promising future support) can be the basis for an interference claim by the breaching party. . . .

45

INTERFERENCE WITH PROSPECTIVE ECONOMIC ADVANTAGE


The Restatement approach a. Restatement 766B: One who intentionally and improperly interferes with another's prospective contractual relation (except a contract to marry) is subject to liability to the other for the pecuniary harm resulting from loss of the benefits of the relation, whether the interference consists of i. inducing or otherwise causing a third person not to enter into or continue the prospective relation; or ii. preventing the other from acquiring or continuing the prospective relation. b. The elements: i. Prospective contractual relation. P must show that he and a third party were in an economic relationship that probably would have resulted in economic benefit to P. It must be reasonably probable that the prospective economic advantage would have been realized but for Ds interference. a. Youst Longo (Cal 1987) -- P could not satisfy this element as a matter of law in a case based on the claim that the Ds interference caused P to finish lower in a horse race than P allegedly would have finished but for the Ds interference. The tort protects probable expectancies but not speculative outcomes. b. Blank v. Kirwan (Cal 1985). P was an unsuccessful applicant for a license from the city to operate a poker club. Plaintiff sued the city and several others for conspiring to prevent him from getting a poker license. Held: P had not shown a probability of future economic benefit. Among other reasons, plaintiff had no real expectation of economic advantage because the city councils discretion to grant or deny applications for a poker club license was broad and negated any expectancy as a matter of law. c. RST: relationship can be any prospective contractual relations, except those leading to contracts to marry, if the potential contract would be of pecuniary value to the plaintiff. a. Included: interferences with the prospect of obtaining employment or employees, the opportunity of selling or buying land or chattels or services, and any other relations leading to potentially profitable contracts. i. Interference with the exercise by a third party of an option to renew or extend a contract with the plaintiff is also included. ii. Also included is interference with a continuing business or other customary relationship not amounting to a formal contract. In many respects, a contract terminable at will is closely analogous to the relationship covered by this Section. The expression, prospective contractual relation, is not used in this Section in a strict, technical sense. It is not necessary that the prospective relation be expected to be reduced

46

to a formal, binding contract. It may include prospective quasi-contractual or other restitutionary rights or even the voluntary conferring of commercial benefits in recognition of a moral obligation. ii. Knowledge. D must know about the relation. iii. Interference. The act of interference can be (a) inducing or causing third person not to enter the relationship, or (b) preventing P from acquiring or continuing the prospective relation). iv. Intent to interfere with the relation. The intent requirement is satisfied if D desires to bring the interference about or if he knows that the interference is certain or substantially certain to occur as a result of his action. v. The interference must be improper. RST factors here are the same as for interference with existing conduct, as stated in 767. a. Whether the defendant acted with an improper purpose or with improper means. RST adds: The fact that the interference is not with a subsisting contract but only with a prospective relation not yet reduced to contract form is important in determining whether the actor was acting properly in pursuing his own purposes. If the means of interference is itself tortious, as in the case of defamation, injurious falsehood, fraud, violence or threats, there is no greater justification to interfere with prospective relations than with existing contracts; but when the means adopted is not innately wrongful and it is only the resulting interference that is in question as a basis of liability, the interference is more likely to be found to be not improper. b. RST employs a multi-factor balancing test on the question of wrongfulness. In an effort to give some further guidance, the RST has a number of sections that represent special applications of the factors to be used in determining whether interference is improper or not, as stated in 767. One such section ( 768) deals with competition as proper or improper interference. It states: One who intentionally causes a third person not to enter into a prospective contractual relation with another who is his competitor or not to continue an existing contract terminable at will does not interfere improperly with the other's relation if: a. the relation concerns a matter involved in the competition between the actor and the other and b. the actor does not employ wrongful means and c. his action does not create or continue an unlawful restraint of trade and d. his purpose is at least in part to advance his interest in competing with the other. The fact that one is a competitor of another for the business of a third person does not prevent his causing a breach of an existing K with the other from being an improper interference if the contract is not terminable at will. c. Another, similar special application of 767 is 769, which deals with the situation when the defendant has a financial interest in the affairs of the

47

person induced. It states: One who, having a financial interest in the business of a third person intentionally causes that person not to enter into a prospective contractual relation with another, does not interfere improperly with the other's relation if he: a. does not employ wrongful means and b. acts to protect his interest from being prejudiced by the relation. d. Section 771 deals with the situation when D engages in inducement to affect anothers business policy: It states: One who intentionally causes a third person not to enter into a prospective contractual relation with another in order to influence the other's policy in the conduct of his business does not interfere improperly with the other's relation if: 1. the actor has an economic interest in the matter with reference to which he wishes to influence the policy of the other and 2. the desired policy does not unlawfully restrain trade or otherwise violate an established public policy and 3. the means employed are not wrongful. d. Section 772 deals with the issue of advice as being proper or improper interference: It states: One who intentionally causes a third person not to perform a contract or not to enter into a prospective contractual relation with another does not interfere improperly with the other's contractual relation, by giving the third person a. truthful information, or b. honest advice within the scope of a request for the advice. e. Section 773 deals with the issue of asserting a bona fide claim. It states: One who, by asserting in good faith a legally protected interest of his own or threatening in good faith to protect the interest by appropriate means, intentionally causes a third person not to perform an existing contract or enter into a prospective contractual relation with another does not interfere improperly with the other's relation if the actor believes that his interest may otherwise be impaired or destroyed by the performance of the contract or transaction. vi. Causation. The interference must be a substantial factor in causing the relation to be disrupted. vii. Damages. The plaintiff must have suffered damages as a result of the disruption of the relation. The California Approach independently wrongful conduct required a. CA (and a number of other jurisdictions) require that the plaintiff plead and prove that the defendants interfering conduct was independently wrongful. Della Penna must be wrongful beyond the fact of the interference itself. b. When is an act independently wrongful? Korea Supply -- an act is independently wrongful if it is unlawful, that is, if it is proscribed by some constitutional, statutory, regulatory, common law, or other determinable legal standard. An act must be wrongful by some legal measure, rather than merely a product of an improper, but lawful purpose or motive. Thus, the defendants

48

conduct must be independently actionable. i. In Korea Supply, P was the low bidder on a contract to supply materials to the Republic of Korea, who allegedly lost the contract because D provided bribes and sexual favors to the decision-makers in Korea. The conduct that constituted the interference was independently actionable because it violated the Foreign Corrupt Practices Act. ii. Other determinable legal standard. Korea Supply did not explain what might constitute an other determinable legal standard. In class we discussed whether a trade associations rules might suffice. A CA appellate court has held that in certain circumstances, a violation of well-defined, established rules or standards of a trade, association or profession may constitute the type of wrongful conduct that will support a cause of action for intentional interference with prospective economic advantage. The Court added, however, that because Korea Supply required independently actionable conduct, it followed that the rules or standards [must] provide for, or give rise to, a sanction or means of enforcement for a violation of the particular rule or standard that allegedly makes the defendant's conduct wrongful. [I]nternal remedies available within the association, such as a right of arbitration between the aggrieved members, should suffice to establish independently actionable conduct. Stevenson Real Estate Services, Inc. v. CB Richard Ellis Real Estate Services, Inc. (Cal 2006) b. Reeves v. Hanlon (Cal 2004) -- the issue of the nexus between the actionable conduct and the interfering conduct. Illustrates majority approach of treating interference with an at-will contract (a contract terminable at will) under the rubric of interference with prospective economic advantage. i. Some lawyers who left their firm engaged in a malicious campaign designed to hurt the firms business. These actions included deleting and destroying client files, misappropriating confidential information, and improperly soliciting clients and cultivating employee discontent. The prospective economic relation at issue was the relation between the P firm and its atwill employees, many of whom left to go work for defendants in the wake of this malicious campaign. ii. Held: trial court did not abuse its discretion in finding that the independently actionable conduct engaged in by defendants was designed in part to interfere with and disrupt plaintiffs relationships with their key atwill employees. c. Della Penna concurrence: identifies several policy reasons for requiring P to prove that D engaged in independently wrongful conduct, rather than focusing, as some courts do, on whether the defendant acted with ill-will or a malicious motive. Worried that the untoward results of the focus on the interfering partys motive may present themselves in individual cases in the form of arbitrary and capricious outcomes. The Aleyska Approach -- places the burden of proving privilege or justification on the defendant. a. Focus on a variety of factors, centering ultimately on Ds motive and the means used, to determine whether the interfering conduct was privileged or justified. b. Aleyska case: Ds (Aleyska) alleged act of interference was committed when the Aleyska exercised a unilateral right to modify its contract with RCA. This, in turn,

49

caused RCA to exercise its unilateral right to terminate its contract with Aurora. Aurora sued Aleyska for interference. The Alaska Supreme Court held that the critical issue was whether Aleyska could show justification for exercising its unilateral right to modify its contract with RCA. This was held not part of Auroras prima facie case, which only requires a showing that a breach was intentionally procured. Held: to negate liability, the justification must be as broad as the act and must cover not only the motive and purpose, but also the means used. i. Aleyska approach differs from CA approach in two fundamental ways: 1. Aleyska does not require the plaintiff to plead and prove independent wrongfulness as part of his prima facie case. 2. Aleyska holds that if D acted out of ill will toward P, rather than to protect a legitimate business interest, then the defendant might be liable for interference. Thus, Aleyska permits the imposition of liability simply if D is motivated by a desire to injure P, even if the means used are entirely lawful. As noted above, in California, it is insufficient for P to show that D acted with a malicious motive; Pmust show that Ds interfering conduct was independently actionable. ii. Deauville -- Fifth Circuit held that if D acted with malice toward P, D might still be able to excuse this if the interference were privileged or resulting from legitimate business considerations. Held: there was a privilege of reasonable competition in the solicitation of contracts but that this privilege is limited to what is considered within the realm of fair play. Bc the memoranda adduced here would permit a jury reasonably to find that Federated [defendant] acted only to harm Deauville [plaintiff], the issue of privilege was for the jury to decide. iii. Lowell v. Mothers Cake and Cookie Co. (Cal 1978), Plaintiff owned a trucking business. 40% of plaintiffs business was hauling defendants baked goods. Plaintiff was in negotiations to sell the business to a third party. Defendant informed the third party that it would not continue to use the trucking company if plaintiffs business was sold. Defendants purpose was to discourage potential buyers from buying plaintiffs business, so the sale price of the business would be depressed and defendant could buy the business cheaply, which is what happened. Held: even if the means used by the defendant are entirely lawful, intentional interference with prospective economic advantage constitutes actionable wrong if it results in damages to the plaintiff, and the defendant's conduct is not excused by a legally recognized privilege or justification. This presented an issue of fact for a jury to decide. 1. Why is it wrongful for defendant to want to purchase plaintiffs business for the lowest price possible? Why should the defendant be forced to pay the same price as a third party, when the price offered by that third party is premised on the defendant continuing to do business post-sale on terms that the defendant is unwilling to accept? If the defendant could properly terminate its business with the trucking firm after a sale, why is it tortious when the defendant truthfully informs the prospective purchaser of this intention? 2. Lowell is no longer good law in the State of California. This is for at least two reasons: a. First, Lowell put the burden of proving privilege or justification on the defendant. Della Penna changed the law, and now requires

50

that the plaintiff must prove that the defendants conduct was independently wrongful. b. Second, Lowell held that the issue of privilege or justification turned on a murky balancing of numerous factors the question on the issue of privilege is whether the actor's conduct was fair and reasonable under the circumstances. Korea Supply clarified that the question whether the defendants conduct was wrongful is not a murky balancing test, but, instead, requires plaintiff to show that the defendants document was independently actionable under some discernable legal standard. Professor Dobbs, in his treatise The Law of Torts, is sharply critical of Alyeska and Deauville and other cases that base liability upon the defendants bad motive, even when the means used by the defendant are not independently illegal and are within defendants rights. These decisions can chill appropriate competition. Even if courts have a roving commission to root out bad thoughts and inspect the inner purposes of economic actors, liability for motive alone is an especially bad idea when it comes to competitive behavior that is otherwise permissible [because] the public benefits of competition do not correlate with the defendants motivation.

51

MISAPPROPRIATION OF TRADE SECRETS


1. Trade secret law protects several important public policies and values: a. The maintenance of standards of commercial ethics. Kewanee Oil Co. v. Bicron Corp., (USSCT 1974). In addition to the increased costs for protection from burglary, wire-tapping, bribery, and the other means used to misappropriate trade secrets, there is the inevitable cost to the basic decency of society when one firm steals from another. A most fundamental human right, that of privacy, is threatened when industrial espionage is condoned or is made profitable. b. The encouragement of invention. Id. Trade secret protection encourages firms to engage in research and development. Firms would be more cautious about investing in R&D if a competitor could freely obtain the desired knowledge without himself paying the price in labor, money, or machines expended by the discoverer. Id. c. To promote the dissemination of useful information and to discourage hoarding of useful information. Id. Trade secret protection allows the holder of a trade secret to share the secret with employees and licensees, which encourages organized scientific and technological research, and the most efficient use of existing manufacturing and marketing structures within the industry. 2. Definition of a trade secret. Section 39 of the Restatement (Third) of Unfair Competition: A trade secret is any information that can be used in the operation of a business or other enterprise and that is sufficiently valuable and secret to afford an actual or potential economic advantage over others. This definition eliminates former requirement that the information be capable of continuous use in the operation of a business, which was found in the original Restatement of Torts (1939). 3. The elements of a trade secret are: a. Information that b. Deprives its independent economic value from c. Not being generally known or readily ascertainable, and; d. Whose holders have used reasonable efforts to maintain secrecy. EXAMINATION OF EACH ELEMENT: 1. Information. e. Two categories of trade secrets: (a) technology and (b) business information. i. Not all technology trade secrets are patentable, but some are. Once a trade secret has been patented, it is no longer a trade secret because it is public info. ii. Trade secrets can be anything from products, to processes (e.g., a process for manufacturing, treating or preserving materials), computer programs, customer and supplier lists, financial information, and business methods. f. Must be concrete and reasonably defined, rather than an abstract concept. i. Schlage Lock P must describe the trade secret with sufficient particularity to separate it from matters of general knowledge in the trade or of special knowledge of those persons who are skilled in the trade, and to permit D to ascertain at least the boundaries within which the secret lies. ii. It is not enough to point to broad areas of technology and

52

assert that something there must have been secret . . . . The plaintiff must show concrete secrets. Composite Marine Propellers, Inc. v. Van Der Woude (7th Cir. 1992) Reluctance to be specific is understandable; the more precise the claim, the more a party does to tip off a business rivalStill, P must do more than just identify a kind of technology and then invite the court to hunt through the details in search of items meeting the statutory definition [of a trade secret]. IDX Systems Corp. v. Epic Systems Corp., 285 F.3d 581 (7th Cir. 2002). g. Trade secret protection does not extend to an employees general skill and knowledge acquired in the course of employment. Any other result would severely impede employee mobility and undermine the competitive basis of our free economy. The hiring of a close competitor's executives is a usual and permissible practice in any industry. AMP Inc. v. Fleischhacker (7th Cir. 1987) i. As we discussed, distinguishing general skill and knowledge from a trade secret is often very difficult, and there are no bright lines. Courts will not prevent a former employee from using independent recollections of generalized business and technical information to which he had access while employed at his former employer. But an employee is not permitted to take with him a specific secret owned by his employer, even if the employee has memorized that secret. 1. HYPO: Standard Paint develops a new and desirable formula for latex paint. No other competitor can duplicate it. Standard employs Hannah to mix the new paint formula according to instructions provided to her by the Standard paint scientists. Hannah has no college education and has never worked in paint development. Hannah leaves and is hired by Matrix, a competitor of Standard's. Matrix has tried without success for years to duplicate the Standard paint formula. A week after joining Matrix, Hannah produces a latex paint identical to Standard's. When asked to duplicate this feat on a large scale for commercial production, Hannah is unable to; a Matrix scientist is needed to take the batch that Hannah has prepared and duplicate it for large scale production. The Matrix scientist concludes that Hannah has no real understanding of how the paint formula works. Here, the inference is easy to draw that Hannah has simply transported Standard's trade secret to Matrix, because memory, not skill, was the source of Hannah's revelation in creating the paint for Matrix. h. A court is more likely to find a trade secret where the former employee held a technical position & was responsible for distinct and specialized areas of technology and research that are not known outside the company. (e.g. Hannahs paint). i. If the employee had a great deal of experience in the industry before joining the company, a court may be more skeptical about a claim of trade secret. (Whereas, in the paint example, Hannah had no such experience and did not understand the paint process). ii. Information that is easily distinguished from matters of skill is more likely to be deemed a trade secret than something that is closely related to an employees skills. iii. And if competitors have failed to duplicate the relevant product or process, a court is more likely to find a trade secret. (e.g. where other competitors had tried and failed to come up with plaintiffs paint process). i. We discussed the fact that so-called negative information can be a trade secret. i. Under the Uniform Trade Secrets Act, the definition of a trade secret

53

includes information that has commercial value from a negative viewpoint, for example the results of lengthy and expensive research which proves that a certain process will not work could be of great value to a competitor. Comment 1. ii. Fifth Circuit: Knowing what not to do often leads automatically to knowing what to do. Metallurgical Indus. Inc. v. Fourtek, Inc. (5th Cir. 1985). j. Even if all of the info is publicly available, a unique compilation of that information, which adds value to the information, also may qualify as a trade secret. Capital Asset Research Corp. v. Finnegan (11th Cir. 1998). As another case puts it, the combination of those elements may be a trade secret if it produces a product superior to that of competitors. 2. Independent economic value. The information must give the holder a competitive advantage because others do not know it. k. Info kept secret that would be useful to a competitor and require cost, time and effort to duplicate is of economic value. Thus, a customer list may be a trade secret if the list gives its owner an advantage over competitors who did not have this information. Likewise, a secret device or process that permits the owner to manufacture a product that customers regard as better than products made by others has independent economic value. l. The trade secret need not have actually have been used by the plaintiff in his business for the trade secret to be of value HYPO where Hannah came up with a design for a "clickety-clack" wooden train track, which design had value even though Hannah had never herself commercially exploited that design. 3. Not being generally known or readily ascertainable by proper means. m. Does not require that information be generally known to the public for trade secret rights to be lost. A method of casting metal, for example, may be unknown to the general public but readily known within the foundry industry. Comment 1 UTSA. No trade secret protection for information generally known or understood within an industry even if not to the public at large. n. A limited, controlled disclosure does not destroy secrecy. USSCT: This necessary element of secrecy is not lost, however, if the holder of the trade secret reveals the trade secret to another in confidence, and under an implied obligation not to use or disclose it. These others may include those of the holder's employees to whom it is necessary to confide it, in order to apply it to the uses for which it is intended. Often the recipient of confidential knowledge of the subject of a trade secret is a licensee of its holder. Kewanee, supra. i. Policy: To hold otherwise would greatly limit the holder's ability to profit from his secret. e.g. Hannah disclosed her clickety-clack-track concept to the machine shop pursuant to a written confidentiality agreement. Under the circumstances, Hannah's limited disclosure did not destroy secrecy. o. What if the holders trade secret is posted to the Internet and widely disseminated? i. Religious Technology Center v. Lerma (E.D.Va. 1995) Former Scientologist, published on the Internet a document that contained 69 pages of what the Religious Technology Center (holder of Scientologys intellectual property rights) described as trade secrets. By the time the RTC discovered them, the postings had been copied around the globe and were widely available. Held: once a trade secret is widely published on the Internet, "it is effectively part of the public domain, impossible to retrieve. Although the person who originally posted

54

a trade secret on the Internet may be liable for trade secret misappropriation, the party who merely downloads Internet information cannot be liable for misappropriation because there is no misconduct involved in interacting with the Internet. ii. Publication on the Internet does not necessarily destroy the secret if the publication is sufficiently obscure or transient or otherwise limited so that it does not become generally known to the relevant people. DVD Copy Control Ass'n Inc. v. Bunner (Cal 2004). It is a fact-intensive inquiry where the concern is whether the information has retained its value to the creator in spite of the publication. 4. Reasonable efforts to maintain secrecy. 1. P should have taken adequate steps to protect the trade secret. Moreover, such measures constitute evidence probative of the existence of secrets. Security measures, cost money; a manufacturer therefore presumably would not incur these costs if it believed its competitors already knew about the info involved. Metallurgical. 2. The plaintiff must act reasonably, which is not the same thing as heroically. As the train track hypothetical illustrates, this is a question of degree. Although Hannah in that hypothetical might have done more to protect its secret (recall that she gave a copy of the track to Sarah with only an oral promise of confidentiality), one could conclude that her steps were sufficient under all of the circumstances. The answer depends on a balancing of costs and benefits that will vary from case to case. The size and sophistication of the parties are relevant. 3. Schlage, the company required its employees to sign confidentiality agreements, which the Court held was a reasonable step to ensure secrecy. 4. Metallurgical, the plaintiff employed security measures taken to conceal the secret devices from all but authorized personnel. The secret devices were in areas hidden from public view, while signs warned all about restricted access. Company policy, moreover, required everyone authorized to see the furnace to sign a non-disclosure agreement. This was sufficient. 5. Motor City Bagels, LLC v. American Bagel Co. (D.Md. 1999), the plaintiff claimed a trade secret in a business plan. The plaintiffs disclosed the business plan to 15 potential investors. The plaintiffs drafted an extensive confidentiality agreement that they had most potential investors sign when they received a copy of the business plan. But they only produced five executed copies of the confidentiality agreement when they distributed the business plan to over fifteen individuals. When questioned as to whether he recalled ever receiving any confidentiality agreements from other individuals who were given the business plan, Mr. Anthony responded, I mean I don't remember. I think I probably got-had more of them but maybe not. This might be it. Mr. Anthony's equivocating response to this question reveals that the plaintiffs did not act diligently to protect the secrecy of their business plan. The Supreme Court has observed that the disclosure of a trade secret to others who are under no obligation to protect the confidentiality of the information extinguishes the property right in the disclosure. Plaintiffs lost their trade secret claim. Claim for misappropriation of trade secrets can be established by showing that the defendant did either (or both) of the following two things: (i)

55

improperly acquired the trade secret, or (ii) improperly disclosed or used a trade secret. Specifically, the plaintiff must show that the defendant: 1. Acquired a trade secret of another, and knew or had reason to know that the trade secret was acquired by improper means; or 2. Disclosed or used a trade secret of another without express or implied consent and who: i. Used improper means to acquire knowledge of the trade secret; or ii. At the time of disclosure or use, knew or had reason to know that his or her knowledge of the trade secret was: 1. Derived from or through a person who had utilized improper means to acquire it; 2. Acquired under circumstances giving rise to a duty to maintain its secrecy or limit its use; or 3. Derived from or through a person who owed a duty to the person seeking relief to maintain its secrecy or limit its use; or 4. Before a material change of his or her position, knew or had reason to know that it was a trade secret and that knowledge of it had been acquired by accident or mistake. 5. 1. Improper means. The UTSA 1 definition: includes theft, bribery, misrepresentation, breach or inducement of a breach of a duty to maintain secrecy, or espionage through electronic or other means. iii. Improper means could include otherwise lawful conduct which is improper under the circumstances; e.g., an airplane overflight used as aerial reconnaissance to determine the competitor's plant layout during construction of the plant. iv. By contrast, proper means include: discovery by independent invention; discovery by "reverse engineering", that is, by starting with the known product and working backward to find the method by which it was developed (the acquisition of the known product must also be by a fair and honest means, such as purchase of the item on the open market); observation of the item in public use or on public display; or obtaining the trade secret from published literature. v. A trade secret may be misappropriated through memorization. An employee who commits his employers trade secret to memory is as responsible as one who physically took trade secret information. 1. Milgrim on Trade Secrets states: The majority rule is ... that appropriation by memory will be restrained under the same circumstances as will appropriation by written list.). Thus, in the paint hypothetical, Hannah was able to reconstruct her former employers secret paint process from memory. vi. Competitive intelligence. Gathering information about the competition is a traditional and accepted business activity, when performed within the generally accepted standards of commercial morality and reasonable conduct. 1. One Court wrote: For our industrial competition to remain healthy there must be breathing room for observing a competing industrialist. A competitor can and must shop his competition for pricing and

56

examine his products for quality, components, and methods of manufacture. 2. However, there are limits. The First Restatement of Torts had this to say: Improper means of discovery. The discovery of another's trade secret by improper means subjects the actor to liability independently of the harm to the interest in the secret. Thus, if one uses physical force to take a secret formula from another's pocket, or breaks into another's office to steal the formula, his conduct is wrongful and subjects him to liability apart from the rule stated in this Section. Such conduct is also an improper means of procuring the secret under this rule. But means may be improper under this rule even though they do not cause any other harm than that to the interest in the trade secret. Examples of such means are fraudulent misrepresentations to induce disclosure, tapping of telephone wires, eavesdropping or other espionage. In general they are means which fall below the generally accepted standards of commercial morality and reasonable conduct. vii. Raiding employees. The paint hypothetical illustrates this problem. In that hypo, although the company defendant contended that it did not know that its new employee, Hannah, had brought her former employers trade secrets to them, the facts of the hypothetical made such an inference impossible to deny. At the very least, the Hannah's new employer should have asked Hannah where her paint process came from. Hannah's employer will be charged with the knowledge it would have had if it had asked that question. viii. Courts are permitted to grant injunctions to prevent actual or threatened misappropriation. See Schlage. Where the plaintiff cannot prove that a former employee has engaged in actual or threatened misappropriation, the plaintiff may seek an injunction based on the doctrine of inevitable disclosure. This doctrine is controversial, however. As we saw in Schlage, California has rejected the inevitable disclosure doctrine for reasons of fundamental public policy, because the doctrine imposes a covenant not to compete after the employment relationship has been made. ix. Reverse engineering. Reverse engineering is starting with the known product and working backward to divine the process. Reverse engineering is permissible, provided (as noted above) that the product or process that is being reverse engineered was lawfully obtained. A defendant has no right to reverse engineer a product that it received in confidence or improperly.

57

COMMERCIAL DISPARAGEMENT
a. Distinguished from defamation. a. Defamation law protects the plaintiffs personal reputation. b. Disparagement law protects the quality and reputation of the plaintiffs products, goods or services. c. Note, however, that in some cases a communication regarding the plaintiffs products, goods or services might also imply that the plaintiff is guilty of fraud, deceit, dishonesty or reprehensible conduct. In such a case, the plaintiff could sue for either commercial disparagement or defamation, or both. b. Historical antecedents. The modern tort of commercial disparagement encompasses two older commercial torts: a. Slander of title -- a false and disparaging statement regarding ones title to property. b. Trade libel -- a false and disparaging statement regarding the qualities or characteristics of ones products, goods or services. The modern tort of commercial disparagement broadly covers cases of disparagement of the title to, or quality of, real or personal property, and to other publications of false statements that do harm to the interests of another having pecuniary value and so result in pecuniary loss. c. Elements of the tort. Under RST 623A: One who publishes a false statement harmful to the interests of another is subject to liability for pecuniary loss resulting to the other if a. He intends for publication of the statement to result in harm to interests of the other having a pecuniary value, or either recognizes or should recognize that it is likely to do so, and b. He knows the statement is false or acts in reckless disregard of its truth or falsity. Elements Explained: a. Publication. a. Publication is an intentional or negligent communication to someone other than the plaintiff. The communication may be oral or written. It may also take the form of non-verbal conduct that is intended to, or reasonably understood as, an assertion of a disparaging statement. For example, if Hannah encloses part of her neighbors adjoining premises in such a way as to indicate that it is part of Hannahs property, this could be a publication of a disparaging statement. b. False statement harmful to the interests of another. a. The plaintiff has the burden of proving that the statement declares or implies a provably false assertion. As we saw in the Franklin case and the Unelko case, courts use a totality of the circumstances test, focusing on the language of the statement and the context of the statement. Courts also consider the knowledge and understanding of the audience to whom the publication was directed. Franklin. In addition to being false, the statement must be also be harmful, which means the statement must be capable of influencing a third party not to deal with plaintiff. Thus, for example, in Enriquez, the defendant told third parties that the plaintiff had gone out of business. In Unelko, the defendant published the statement that the plaintiffs product did not work. Such

58

statements are clearly capable of influencing third parties not to deal with the plaintiff. b. A statement of opinion is actionable only if it implies the existence of undisclosed false and demeaning facts. However, if a statement of opinion is based on fully disclosed or assumed facts, then the opinion is not actionable unless the underlying facts are themselves false and demeaning. (Ridicule is a statement that exposes another to contempt and scorn. Ridicule is treated like a statement of opinion.) i. Unelko v. Rooney (9th Circuit) -- Andy Rooney said It didnt work in regards to plaintiffs product. Rooney argued this statement was nonactionable opinion. Held: the statement it didnt work was reasonably understood as implying a provable assertion of fact about the performance of the product. ii. By contrast, the emails that the defendant sent in Franklin were non-actionable statements of opinion because they represented the plaintiffs legal opinion based on fully-disclosed facts. iii. Similarly, in the Texas Beef case, Howard Lymans statement that mad cow disease could be worse than AIDS was a statement of opinion based on fully disclosed facts, and therefore was not actionable. A simple expression of opinion based on disclosed or assumed nondefamatory facts is not itself sufficient for an action for commercial disparagement, no matter how unjustified and unreasonable the opinion or how derogatory it is. iv. Role of judge and jury. The judge decides whether the expression of opinion is capable of bearing a defamatory meaning because it may reasonably be understood to imply the assertion of undisclosed facts. The jury decides whether that meaning was attributed to it by the recipient of the communication. See Franklin. 1. Statements that are clearly made in jest, colorful epithets , fiery rhetoric, and obviously hyperbolic, imaginative, or figurative statements are protected because the content and tenor of the statements negate the impression that the author seriously is maintaining an assertion of actual fact. See Franklin and Unelko. 2. Similarly, in the Texas Beef case, the Court noted that exaggeration does not equal defamation, in concluding that Mr. Lymans statement comparing mad cow disease to AIDS was hyperbolic and not actionable. Unelko teaches, however, that just because a statement is made in a humorous and satirical presentation, it does not automatically follow that that the speaker was not making a factual assertion. Context is critical. v. A competitors puffing, or general assertion that his product is superior, is not actionable. Thus, Hannah may make an unduly favorable comparison of the quality of her own land, chattels, or other things, with the quality of another competitors so long as the comparison does not contain false

59

assertions of specific unfavorable facts regarding the rival competitors things. Even if Hannah does not honestly and in good faith believe that her goods are better than her competitors, Hannah can say that they are. 1. Similar to puffery are statements that are highly vague and subjective; such statements are not actionable because they do not declare or imply a provably false assertion of fact. c. Intent to cause harm. a. The plaintiff has to prove that the defendant either (a) intended for the statement to cause pecuniary harm to the plaintiff or (b) knew or should have known that the statement is substantially certain to do cause pecuniary harm. b. If the defendant had no reason to anticipate that the publication of the statement would in any way affect the conduct of any third person, then there is no liability, even if the defendant knew the statement is false. i. Ex: Hannah, in the presence of friends, casually says that a piece of property is owned by Sarah. Hannah knows that the property is really owned by Margaret. As a result, one of the friends who had intended to buy the property from Margaret does not do so. Unless Hannah knew that a prospective purchaser was present or that the statement was likely to reach him, she has no liability. d. Knowledge of falsity. a. The plaintiff has to prove that the defendant either (a) knew the statement was false or (b) acted in reckless disregard of its truth or falsity. (Negligence is not sufficient; nor is this a strict-liability tort). b. What if the plaintiff cannot prove that the defendant had knowledge or acted with reckless disregard, but the plaintiff can prove that the defendant had a motive of ill will toward the plaintiff? The Restatement takes no position on that question. e. Actual monetary loss. a. The false and disparaging statement is a cause of the plaintiffs monetary loss so long as it is a substantial factor. That is, it need only be one of the considerations that has substantial weight to the person who heard the statement. b. Enriquez v. West Jersey -- Held: the false and disparaging statement must play a material part in inducing others not to deal with plaintiff. i. If the plaintiff cannot prove actual monetary loss, then the tort claim fails. Thus, the defense argued that plaintiff failed to prove that any patient chose to go elsewhere as a result of what defendants said about her. ii. The Court allowed plaintiffs case to proceed to discovery, but it is clear that if, following discovery, he cannot prove any actual monetary loss resulting from the published statement, then his cause of action will fail.

60

FALSE ADVERTISING
a. Policy against false advertising. a. The numerous private economic decisions of our market economy should be in the aggregate . . . intelligent and well informed. Proctor & Gamble Co. v. Haugen (10th Cir. 2000). b. It is socially beneficial for vendors to make truthful statements that will help consumers locate products that will do them good. Federal Trade Commission v. QT Inc. (7th Cir. 2008). c. One important reason for requiring truth is so that competition in the market will lead to appropriate prices. Id. In addition to harming consumers, false advertising is a form of unfair competition that injures competitors who play by the rules and truthfully market their products. b. The Lanham Act. 15 U.S.C. 1125(a) permits business competitors to sue one another for false advertising. Section 43(a) of the Lanham Act is directed against a false or misleading description or representation of fact, in commercial advertising or promotion, that misrepresents the nature, characteristics, qualities, or geographic origin of goods, services, or commercial activities. The relevant text of the statute is: a. Any person who, on or in connection with any goods or services, uses in commerce any false or misleading description of fact, or false or misleading representation of fact, which (2) in commercial advertising or promotion, misrepresents the nature, characteristics, qualities, or geographic origin of his or her or another person's goods, services, or commercial activities, shall be liable in a civil action by any person who believes that he or she is or is likely to be damaged by such act. b. The statute condemns false representations about the qualities or characteristics of the plaintiffs products or services. It also condemns false representations about the plaintiffs commercial activities which do not solely involve the provision of services or the production of goods. c. Proctor & Gamble -- defendant violated Section 43(a) by falsely representing in commercial advertising or promotion that the plaintiff used the profits from the sale of its goods to make charitable donations to the Church of Satan. c. Standing to sue under the Lanham Act. a. The Seventh, Ninth and Tenth Circuits have held that the plaintiff must be in actual or direct competition with the defendant and assert a competitive injury to establish prudential standing under 43(a). b. The First, Second and Eleventh Circuits follow a more flexible test that asks whether the plaintiff has a reasonable interest to be protected against the type of harm that the Lanham Act is intended to prevent. c. It does not appear, however, than any Circuit holds that consumers as such have standing to sue under the Lanham Act. d. Thus, at a bare minimum, standing to bring a Lanham Act claim requires the potential for commercial or competitive injury to the plaintiff. d. The five elements that must be proved under Section 43(a) of the Lanham Act. As we saw in CKE Restaurant v. Jack in the Box (C.D. Cal. 2007), a plaintiff suing for false advertising under Section 43(a) must prove the following five elements: a. The defendant made a false or misleading statement of fact in its commercial advertising or promotions;

61

b. The statement actually deceived or has the tendency to deceive a substantial segment of their audience; c. Such deception is material because it is likely to influence buying decisions; d. The defendant caused its falsely advertised goods or its commercial advertising or promotion to enter interstate commerce; e. The plaintiff has been, or is likely to be, injured as the result of those activities, either by direct diversion of sales from itself to defendant, or by damaging the goodwill its products enjoy with the buying public. * To obtain money damages, as opposed to simply injunctive relief, P must demonstrate actual consumer reliance on the false advertising & a resulting economic impact on Ps own business. e. Characterizing the statement. The first step is to determine what sort of statement is being challenged. Courts place statements into three basic categories: a. literally false statements; b. literally true but misleading statements; and c. non-actionable statements, including true & non-misleading statements & puffery. f. Types of statements explained: a. Literally false statements. When a merchandising statement or representation is literally false, the court may grant relief without reference to the advertisements impact on the buying public. Coca-Cola Co. v. Tropicana (2d Cir. 1982) There are two recognized categories of literally false statements. i. Establishment claims. Explicitly or implicitly state that tests prove the claim being made. To attack an establishment claim, the plaintiff can either (1) show that the tests or surveys relied upon are unreliable or do not in fact support the advertising claim; or (2) show that the claim is actually false: 1. BASF Corp. v. Old World Trading Co. (7th Cir. 1994) If the challenged advertisement makes implicit or explicit references to tests, the plaintiff may satisfy its burden by showing that those tests do not prove the proposition; otherwise, the plaintiff must offer affirmative proof that the advertisement is false. a. Usually, the plaintiff will prefer to proceed under the former, because proving the falsity of a fact asserted in an advertising claim may well be more difficult than merely proving that a test asserted to validate the claim is not sufficiently reliable to do so. C.B. Fleet Co. v. SmithKline Beecham Consumer Healthcare (4th Cir. 1997). 2. Castrol, Inc. v. Quaker State Corp (2d Cir. 1992), Castrol sued Quaker State for running an ad stating that tests prove Quaker State oil protects better at start-up. The court found the claim literally false because the tests only showed that Quaker State has a faster oiling time (the speed with which oil flows to engine parts.) Having a faster oiling time as actually irrelevant to Quaker State's claim of better engine protection at start-up, because residual oil left from a prior running of an engine provides more than adequate lubrication at the next start-up. Thus, the tests did not prove that Quaker State oil protects better at start-up. ii. Non-establishment claims. If the advertisement does not explicitly or implicitly state that tests prove the claim being made, then the plaintiff must show that the claim is actually false. The plaintiff cannot merely show

62

that the claim is unsupported by reliable tests or surveys. b. Misleading statements. Some statements are literally true, but imply another message that is false. i. See CKE, supra (the Lanham Act encompasses more than blatant falsehoods. It embraces innuendo, indirect intimations, and ambiguous suggestions evidenced by the consuming publics misapprehension of the hard facts underlying an advertisement). ii. In such a case, the plaintiff must affirmatively prove that a significant portion of consumers received the implied false message from the challenged advertisement and was deceived. Id. (Where a statement is not literally false and is only misleading in context . . . proof that the advertising actually conveyed the implied message and thereby deceived a significant portion of the recipients becomes critical.) This is usually done through a consumer survey. Id. iii. Example of a literally true but misleading statement. In a case not assigned for reading, the defendant advertised that the moisturizing strip on its shaving razor Ultra Glide was six times smoother than its competitors strips, while showing a man rubbing his hand down his face. The narrator stated: It's smoother than glass, smoother than ivory, twice as smooth as teflon and six times smoother than Gillette's white strip. Introducing the remarkable new blue Ultra Glide strip on the Wilkinson Sword Ultra glide blade. The statement was literally true: Ultra Glides moisturizing strip was six times smoother than the plaintiffs moisturizing strip. However, the statement was misleading because it implied that the consumer would receive a smoother shave from the defendants razor, which was false. The court explained that the necessary implication of the advertisement is that the shave from the Ultra Glide shaving system is six times smoother than the shave from the Wilkinson shaving system. iv. Some cases hold that a court may presume that consumers were in fact deceived if there is proof that the defendant intentionally set out to deceive consumers. See CKE. c. Nonactionable statements. Obviously, statements that are literally true and not misleading are not actionable. Similarly, statements that constitute mere puffery are not actionable. i. Puffery exists in two forms: (1) exaggerated statements of bluster or boast upon which no reasonable consumer would rely; and (2) vague or highly subjective claims of product superiority, including bald assertions of superiority. Puffery and statements of fact are mutually exclusive. If a statement is a specific, measurable claim or can be reasonably interpreted as being a factual claim, i.e., one capable of verification, the statement is one of fact. Conversely, if the statement is not specific and measurable, and cannot be reasonably interpreted as providing a benchmark by which the veracity of the statement can be ascertained, the statement constitutes puffery. 1. Defining puffery broadly provides advertisers and manufacturers considerable leeway to craft their statements, allowing the free market to hold advertisers and manufacturers accountable for their statements, ensuring vigorous competition, and protecting legitimate commercial speech. American Italian Pasta Co. v. New World Pasta Co., 371 F.3d 387 (8th Cir. 2004). 2. Example of puffery. In American Italian Pasta, a small, regional pasta manufacturer advertised its product as Americas Favorite Pasta. The Court held that Americas Favorite Pasta was non-actionable puffery. The Court first determined what the words meant. The key term in the phrase

63

America's Favorite Pasta is favorite. Used in this context, favorite is defined as markedly popular especially over an extended period of time. Webster's Third New International Dictionary 830 (unabridged 1961). Webster's definition of favorite begs the question of how popular is defined. In this context, popular is defined as well liked or admired by a particular group or circle. Id. at 1766. By combining the term favorite with America's, American claims Mueller's pasta has been well liked or admired over time by America, a non-definitive person. The Court then determined if the words used by the defendant made a specific, measurable claim or could be reasonably interpreted as a verifiable factual claim. The Courts answer was no: America's Favorite Pasta is not a specific, measurable claim and cannot be reasonably interpreted as an objective fact. Well liked and admired are entirely subjective and vague. Neither the words well liked nor admired provide an empirical benchmark by which the claim can be measured. Well liked and admired do not convey a quantifiable threshold in sheer number, percentage, or place in a series. A product may be well liked or admired, but the product may not dominate in sales or market share. [ . . . ] America's Favorite Pasta also does not imply Mueller's is a national brand. First, America's is vague, and America's, as well as America and American used in a similar context, is a broad, general reference. Second, a brand, chain, or product could be America's favorite without being national. g. Commercial advertising or promotion. In Proctor & Gamble, the Court identified a 4-part test to determine if a representation constituted commercial advertising or promotion. The representation must be (1) commercial speech; (2) by a defendant who is in commercial competition with plaintiff; (3) for the purpose of influencing consumers to buy defendants goods or services; and (4) disseminated sufficiently to the relevant purchasing public to constitute advertising or promotion within that industry. In Proctor & Gamble, the defendant argued that its representation was not commercial speech. The Court disagreed, holding that the representation had a commercial purpose (notwithstanding a theological component to the representation) because it unambiguously urges recipients to eschew purchasing P&G products in favor of Amway products.

64