Nuisance Law

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					                         Economic Analysis of Law
                         Professor Geoffrey Miller
                            University of Basel
                                May, 2010



              Supplemental Readings


                      Coase Theorem
                          PIERSON V. POST
                             3 Cai. R. 175
                             N.Y.Sup. 1805


       THIS was an action of trespass on the case commenced in a
justice's court, by the present defendant against the now plaintiff.
       The declaration stated that Post, being in possession of certain
dogs and hounds under his command, did, “upon a certain wild and
uninhabited, unpossessed and waste land, called the beach, find and
start one of those noxious beasts called a fox,” and whilst there
hunting, chasing and pursuing the same with his dogs and hounds,
and when in view thereof, Pierson, well knowing the fox was so hunted
and pursued, did, in the sight of Post, to prevent his catching the
same, kill and carry it off. A verdict having been rendered for the
plaintiff below, the defendant there sued out a certiorari, and now
assigned for error, that the declaration and the matters therein
contained were not sufficient in law to maintain an action.
                                 * * *
       Sanford, for the now plaintiff. It is firmly settled that animals,
feræ naturæ, belong not to any one. If, then, Post had not acquired
any property in the fox, when it was killed by Pierson, he had no right
in it which could be the subject of injury. As, however, a property may
be gained in such an animal, it will be necessary to advert to the facts
set forth, to see whether they are such as could give a legal interest in
the creature, that was the cause of the suit below. Finding, hunting,
and pursuit, are all that the plaint enumerates. To create a title to
ananimal feræ naturæ, occupancy is indispensable. It is the only mode
recognised by our system. 2 Black. Com. 403. The reason of the thing
shows it to be so. For whatever is not appropriated by positive
institutions, can be exclusively possessed by natural law alone.
Occupancy is the sole method this code acknowledges. Authorities are
not wanting to this effect. Just. lib. 2. tit. 1. s. 12. “ Feræ igitur
bestiæ, simul atque ab aliquo captæ fuerint jure gentium statim illius
esse incipiunt.” There must be a taking; and even that is not in all
cases sufficient, for in the same section he observes, “ Quicquid autem
corum ceperis, eo usque tuum esse intelligitur, donec tua custodia
coercetur; cum vero tuam evaserit custodiam, et in libertatem
naturalem sese receperit, tuam esse desinit, et rursus occumpantis
fit.” It is added also that this natural liberty may be regained even if in
sight of the pursuer, “ ita sit, ut difficilis sit ejus persecutio.” In section
13. it is laid down, that even wounding will not give a right of property
in an animal that is unreclaimed. For, notwithstanding the wound, “
multa accidere soleant ut eam non capias;” and “ non aliter tuam esse,
quam si eam ceperis.” Fleta, b. 3. p. 175. and Bracton, b. 2. c. 1. p.
86. are in unison with the Roman lawgiver. It is manifest, then, from
the record, that there was no title in Post, and the action, therefore,
not maintainable.

        Colden, contra. I admit with Fleta, that pursuit alone does not
give a right of property in animals feræ naturæ, and I admit also that
occupancy is to give a title to them. But then, what kind of occupancy?
and here I shall contend it is not such as is derived from manucaption
alone. In Puffendorf's Law of Nature and of Nations, b. 4. c. 4. s. 5. n.
6. by Barbeyrac, notice is taken of this principle of taking possession.
It is there combatted, nay, disproved; and in b. 4. c. 6. s. 2. n. 2. Ibid.
s. 7. n. 2. demonstrated that manucaption is only one of many means
to declare the intention of exclusively appropriating that, which was
before in a state of nature. Any continued act which does this, is
equivalent to occupancy. Pursuit, therefore, by a person who starts a
wild animal, gives an exclusive right whilst it is followed. It is all the
possession the nature of the subject admits; it declares the intention
of acquiring dominion, and is as much to be respected as manucaption
itself. The contrary idea, requiring actual taking, proceeds, as Mr.
Barbeyrac observes, in Puffendorf, b. 4. c. 6. s. 10. on a “false notion
of possession.”

      Sanford, in reply. The only authority relied on is that of an
annotator. On the question now before the court, we have taken our
principles from the civil code, and nothing has been urged to impeach
those quoted from the authors referred to.

* * *


                                       2
TOMPKINS, J. delivered the opinion of the court.
      This cause comes before us on a return to a certiorari directed to
one of the justices of Queens county.
       The question submitted by the counsel in this cause for our
determination is, whether Lodowick Post, by the pursuit with his
hounds in the manner alleged in his declaration, acquired such a right
to, or property in, the fox, as will sustain an action against Pierson for
killing and taking him away?
      The cause was argued with much ability by the counsel on both
sides, and presents for our decision a novel and nice question. It is
admitted that a fox is an animal feræ naturæ, and that property in
such animals is acquired by occupancy only. These admissions narrow
the discussion to the simple question of what acts amount to
occupancy, applied to acquiring right to wild animals?
      If we have recourse to the ancient writers upon general
principles of law, the judgment below is obviously erroneous.
Justinian's Institutes, lib. 2. tit. 1. s. 13. and Fleta, lib. 3. c. 2. p. 175.
adopt the principle, that pursuit alone vests no property or right in the
huntsman; and that even pursuit, accompanied with wounding, is
equally ineffectual for that purpose, unless the animal be actually
taken. The same principle is recognised by Bracton, lib. 2. c. 1. p. 8.
Puffendorf, lib. 4. c. 6. s. 2. and 10. defines occupancy of beasts feræ
naturæ, to be the actual corporal possession of them, and
Bynkershoek is cited as coinciding in this definition. It is indeed with
hesitation that Puffendorf affirms that a wild beast mortally wounded,
or greatly maimed, cannot be fairly intercepted by another, whilst the
pursuit of the person inflicting the wound continues. The foregoing
authorities are decisive to show that mere pursuit gave Post no legal
right to the fox, but that he became the property of Pierson, who
intercepted and killed him.
       It therefore only remains to inquire whether there are any
contrary principles, or authorities, to be found in other books, which
ought to induce a different decision. Most of the cases which have
occurred in England, relating to property in wild animals, have either
been discussed and decided upon the principles of their positive
statute regulations, or have arisen between the huntsman and the
owner of the land upon which beasts feræ naturæ have been
apprehended; the former claiming them by title of occupancy, and the
latter ratione soli. Little satisfactory aid can, therefore, be derived from
the English reporters.



                                       3
       Barbeyrac, in his notes on Puffendorf, does not accede to the
definition of occupancy by the latter, but, on the contrary, affirms, that
actual bodily seizure is not, in all cases, necessary to constitute
possession of wild animals. He does not, however, describe the acts
which, according to his ideas, will amount to an appropriation of such
animals to private use, so as to exclude the claims of all other persons,
by title of occupancy, to the same animals; and he is far from averring
that pursuit alone is sufficient for that purpose. To a certain extent,
and as far as Barbeyrac appears to me to go, his objections to
Puffendorf's definition of occupancy are reasonable and correct. That is
to say, that actual bodily seizure is not indispensable to acquire right
to, or possession of, wild beasts; but that, on the contrary, the mortal
wounding of such beasts, by one not abandoning his pursuit, may,
with the utmost propriety, be deemed possession of him; since,
thereby, the pursuer manifests an unequivocal intention of
appropriating the animal to his individual use, has deprived him of his
natural liberty, and brought him within his certain control. So also,
encompassing and securing such animals with nets and toils, or
otherwise intercepting them in such a manner as to deprive them of
their natural liberty, and render escape impossible, may justly be
deemed to give possession of them to those persons who, by their
industry and labour, have used such means of apprehending them.
Barbeyrac seems to have adopted, and had in view in his notes, the
more accurate opinion of Grotius, with respect to occupancy. That
celebrated author, lib. 2. c. 8. s. 3. p. 309. speaking of occupancy,
proceeds thus: “ Requiritur autem corporalis quædam possessio ad
dominium adipiscendum; atque ideo, vulnerasse non sufficit.” But in
the following section he explains and qualifies this definition of
occupancy: “ Sed possessio illa potest non solis manibus, sed
instrumentis, ut decipulis, retibus, laqueis dum duo adsint: primum ut
ipsa instrumenta sint in nostra potestate, deinde ut fera, ita inclusa sit,
ut exire inde nequeat.” This qualification embraces the full extent of
Barbeyrac's objection to Puffendorf's definition, and allows as great a
latitude to acquiring property by occupancy, as can reasonably be
inferred from the words or ideas expressed by Barbeyrac in his notes.
The case now under consideration is one of mere pursuit, and presents
no circumstances or acts which can bring it within the definition of
occupancy by Puffendorf, or Grotius, or the ideas of Barbeyrac upon
that subject.
      The case cited from 11 Mod. 74--130. I think clearly
distinguishable from the present; inasmuch as there the action was for
maliciously hindering and disturbing the plaintiff in the exercise and
enjoyment of a private franchise; and in the report of the same case, 3
Salk. 9. Holt, Ch. J. states, that the ducks were in the plaintiff's decoy


                                     4
pond, and so in his possession, from which it is obvious the court laid
much stress in their opinion upon the plaintiff's possession of the
ducks, ratione soli.
      We are the more readily inclined to confine possession or
occupancy of beasts feræ naturæ, within the limits prescribed by the
learned authors above cited, for the sake of certainty, and preserving
peace and order in society. If the first seeing, starting, or pursuing
such animals, without having so wounded, circumvented or ensnared
them, so as to deprive them of their natural liberty, and subject them
to the control of their pursuer, should afford the basis of actions
against others for intercepting and killing them, it would prove a fertile
source of quarrels and litigation.
       However uncourteous or unkind the conduct of Pierson towards
Post, in this instance, may have been, yet his act was productive of no
injury or damage for which a legal remedy can be applied. We are of
opinion the judgment below was erroneous, and ought to be reversed.

LIVINGSTON, J. My opinion differs from that of the court.
      Of six exceptions, taken to the proceedings below, all are
abandoned except the third, which reduces the controversy to a single
question.
       Whether a person who, with his own hounds, starts and hunts a
fox on waste and uninhabited ground, and is on the point of seizing his
prey, acquires such an interest in the animal, as to have a right of
action against another, who in view of the huntsman and his dogs in
full pursuit, and with knowledge of the chase, shall kill and carry him
away?
       This is a knotty point, and should have been submitted to the
arbitration of sportsmen, without poring over Justinian, Fleta, Bracton,
Puffendorf, Locke, Barbeyrac, or Blackstone, all of whom have been
cited; they would have had no difficulty in coming to a prompt and
correct conclusion. In a court thus constituted, the skin and carcass of
poor reynard would have been properly disposed of, and a precedent
set, interfering with no usage or custom which the experience of ages
has sanctioned, and which must be so well known to every votary of
Diana. But the parties have referred the question to our judgment, and
we must dispose of it as well as we can, from the partial lights we
possess, leaving to a higher tribunal, the correction of any mistake
which we may be so unfortunate as to make. By the pleadings it is
admitted that a fox is a “wild and noxious beast.” Both parties have
regarded him, as the law of nations does a pirate, “ hostem humani
generis,” and although “ de mortuis nil nisi bonum,” be a maxim of our


                                    5
profession, the memory of the deceased has not been spared. His
depredations on farmers and on barn yards, have not been forgotten;
and to put him to death wherever found, is allowed to be meritorious,
and of public benefit. Hence it follows, that our decision should have in
view the greatest possible encouragement to the destruction of an
animal, so cunning and ruthless in his career. But who would keep a
pack of hounds; or what gentleman, at the sound of the horn, and at
peep of day, would mount his steed, and for hours together, “ sub jove
frigido,” or a vertical sun, pursue the windings of this wily quadruped,
if, just as night came on, and his stratagems and strength were nearly
exhausted, a saucy intruder, who had not shared in the honours or
labours of the chase, were permitted to come in at the death, and bear
away in triumph the object of pursuit? Whatever Justinian may have
thought of the matter, it must be recollected that his code was
compiled many hundred years ago, and it would be very hard indeed,
at the distance of so many centuries, not to have a right to establish a
rule for ourselves. In his day, we read of no order of men who made it
a business, in the language of the declaration in this cause, “with
hounds and dogs to find, start, pursue, hunt, and chase,” these
animals, and that, too, without any other motive than the preservation
of Roman poultry; if this diversion had been then in fashion, the
lawyers who composed his institutes, would have taken care not to
pass it by, without suitable encouragement. If any thing, therefore, in
the digests or pandects shall appear to militate against the defendant
in error, who, on this occasion, was the foxhunter, we have only to say
tempora mutantur; and if men themselves change with the times, why
should not laws also undergo an alteration?
       It may be expected, however, by the learned counsel, that more
particular notice be taken of their authorities. I have examined them
all, and feel great difficulty in determining, whether to acquire
dominion over a thing, before in common, it be sufficient that we
barely see it, or know where it is, or wish for it, or make a declaration
of our will respecting it; or whether, in the case of wild beasts, setting
a trap, or lying in wait, or starting, or pursuing, be enough; or if an
actual wounding, or killing, or bodily tact and occupation be necessary.
Writers on general law, who have favoured us with their speculations
on these points, differ on them all; but, great as is the diversity of
sentiment among them, some conclusion must be adopted on the
question immediately before us. After mature deliberation, I embrace
that of Barbeyrac, as the most rational, and least liable to objection. If
at liberty, we might imitate the courtesy of a certain emperor, who, to
avoid giving offence to the advocates of any of these different
doctrines, adopted a middle course, and by ingenious distinctions,
rendered it difficult to say (as often happens after a fierce and angry


                                    6
contest) to whom the palm of victory belonged. He ordained, that if a
beast be followed with large dogs and hounds, he shall belong to the
hunter, not to the chance occupant; and in like manner, if he be killed
or wounded with a lance or sword; but if chased with beagles only,
then he passed to the captor, not to the first pursuer. If slain with a
dart, a sling, or a bow, he fell to the hunter, if still in chase, and not to
him who might afterwards find and seize him.
       Now, as we are without any municipal regulations of our own,
and the pursuit here, for aught that appears on the case, being with
dogs and hounds of imperial stature, we are at liberty to adopt one of
the provisions just cited, which comports also with the learned
conclusion of Barbeyrac, that property in animals feræ naturæ may be
acquired without bodily touch or manucaption, provided the pursuer be
within reach, or have a reasonable prospect (which certainly existed
here) of taking, what he has thus discovered an intention of converting
to his own use.
       When we reflect also that the interest of our husbandmen, the
most useful of men in any community, will be advanced by the
destruction of a beast so pernicious and incorrigible, we cannot greatly
err, in saying, that a pursuit like the present, through waste and
unoccupied lands, and which must inevitably and speedily have
terminated in corporal possession, or bodily seisin, confers such a right
to the object of it, as to make any one a wrongdoer, who shall
interfere and shoulder the spoil. The justice's judgment ought,
therefore, in my opinion, to be affirmed.
      Judgment of reversal.




                                      7
                       Nuisance Law
                             BOOMER
                               v.
                  ATLANTIC CEMENT COMPANY, Inc.,

              257 N.E.2d 870, 309 N.Y.S.2d 312 (1970)

BERGAN, Judge.

Defendant operates a large cement plant near Albany. These are
actions for injunction and damages by neighboring land owners
alleging injury to property from dirt, smoke and vibration emanating
from the plant. A nuisance has been found after trial, temporary
damages have been allowed; but an injunction has been denied.

The public concern with air pollution arising from many sources in
industry and in transportation is currently accorded ever wider
recognition accompanied by a growing sense of responsibility in State
and Federal Governments to control it. Cement plants are obvious
sources of air pollution in the neighborhoods where they operate.
But there is now before the court private litigation in which individual
property owners have sought specific relief from a single plant
operation. The threshold question raised by the division of view on this
appeal is whether the court should resolve the litigation between the
parties now before it as equitably as seems possible; or whether,
seeking promotion of the general public welfare, it should channel
private litigation into broad public objectives.

A court performs its essential function when it decides the rights of
parties before it. Its decision of private controversies may sometimes
greatly affect public issues. Large questions of law are often resolved
by the manner in which private litigation is decided. But this is
normally an incident to the court's main function to settle controversy.
It is a rare exercise of judicial power to use a decision in private
litigation as a purposeful mechanism to achieve direct public objectives
greatly beyond the rights and interests before the court.



                                   8
Effective control of air pollution is a problem presently far from
solution even with the full public and financial powers of government.
In large measure adequate technical procedures are yet to be
developed and some that appear possible may be economically
impracticable.

It seems apparent that the amelioration of air pollution will depend on
technical research in great depth; on a carefully balanced
consideration of the economic impact of close regulation; and of the
actual effect on public health. It is likely to require massive public
expenditure and to demand more than any local community can
accomplish and to depend on regional and interstate controls.

A court should not try to do this on its own as a by-product of private
litigation and it seems manifest that the judicial establishment is
neither equipped in the limited nature of any judgment it can
pronounce nor prepared to lay down and implement an effective policy
for the elimination of air pollution. This is an area beyond the
circumference of one private lawsuit. It is a direct responsibility for
government and should not thus be undertaken as an incident to
solving a dispute between property owners and a single cement plant--
one of many--in the Hudson River valley.

The cement making operations of defendant have been found by the
court of Special Term to have damaged the nearby properties of
plaintiffs in these two actions. That court, as it has been noted,
accordingly found defendant maintained a nuisance and this has been
affirmed at the Appellate Division. The total damage to plaintiffs'
properties is, however, relatively small in comparison with the value of
defendant's operation and with the consequences of the injunction
which plaintiffs seek.

The ground for the denial of injunction, notwithstanding the finding
both that there is a nuisance and that plaintiffs have been damaged
substantially, is the large disparity in economic consequences of the
nuisance and of the injunction. This theory cannot, however, be
sustained without overruling a doctrine which has been consistently
reaffirmed in several leading cases in this court and which has never
been disavowed here, namely that where a nuisance has been found
and where there has been any substantial damage shown by the party
complaining an injunction will be granted.




                                   9
The rule in New York has been that such a nuisance will be enjoined
although marked disparity be shown in economic consequence
between the effect of the injunction and the effect of the nuisance. . .
. . Although the court at Special Term and the Appellate Division held
that injunction should be denied, it was found that plaintiffs had been
damaged in various specific amounts up to the time of the trial and
damages to the respective plaintiffs were awarded for those amounts.
The effect of this was, injunction having been denied, plaintiffs could
maintain successive actions at law for damages thereafter as further
damage was incurred.

The court at Special Term also found the amount of permanent
damage attributable to each plaintiff, for the guidance of the parties in
the event both sides stipulated to the payment and acceptance of such
permanent damage as a settlement of all the controversies among the
parties. The total of permanent damages to all plaintiffs thus found
was $185,000. This basis of adjustment has not resulted in any
stipulation by the parties.

This result at Special Term and at the Appellate Division is a departure
from a rule that has become settled; but to follow the rule literally in
these cases would be to close down the plant at once. This court is
fully agreed to avoid that immediately drastic remedy; the difference
in view is how best to avoid it.1

One alternative is to grant the injunction but postpone its effect to a
specified future date to give opportunity for technical advances to
permit defendant to eliminate the nuisance; another is to grant the
injunction conditioned on the payment of permanent damages to
plaintiffs which would compensate them for the total economic loss to
their property present and future caused by defendant's operations.
For reasons which will be developed the court chooses the latter
alternative.

If the injunction were to be granted unless within a short period--e.g.,
18 months--the nuisance be abated by improved methods, there
would be no assurance that any significant technical improvement
would occur.

The parties could settle this private litigation at any time if defendant
paid enough money and the imminent threat of closing the plant would

1
       Respondent's investment in the plant is in excess of $45,000,000. There are
over 300 people employed there.


                                        10
build up the pressure on defendant. If there were no improved
techniques found, there would inevitably be applications to the court at
Special Term for extensions of time to perform on showing of good
faith efforts to find such techniques.

Moreover, techniques to eliminate dust and other annoying by-
products of cement making are unlikely to be developed by any
research the defendant can undertake within any short period, but will
depend on the total resources of the cement industry nationwide and
throughout the world. The problem is universal wherever cement is
made.

For obvious reasons the rate of the research is beyond control of
defendant. If at the end of 18 months the whole industry has not
found a technical solution a court would be hard put to close down this
one cement plant if due regard be given to equitable principles.
On the other hand, to grant the injunction unless defendant pays
plaintiffs such permanent damages as may be fixed by the court
seems to do justice between the contending parties. All of the
attributions of economic loss to the properties on which plaintiffs'
complaints are based will have been redressed.

The nuisance complained of by these plaintiffs may have other public
or private consequences, but these particular parties are the only ones
who have sought remedies and the judgment proposed will fully
redress them. The limitation of relief granted is a limitation only within
the four corners of these actions and does not foreclose public health
or other public agencies from seeking proper relief in a proper court.
It seems reasonable to think that the risk of being required to pay
permanent damages to injured property owners by cement plant
owners would itself be a reasonable effective spur to research for
improved techniques to minimize nuisance.
The power of the court to condition on equitable grounds the
continuance of an injunction on the payment of permanent damages
seems undoubted.

Thus it seems fair to both sides to grant permanent damages to
plaintiffs which will terminate this private litigation. The theory of
damage is the 'servitude on land' of plaintiffs imposed by defendant's
nuisance. The judgment, by allowance of permanent damages
imposing a servitude on land, which is the basis of the actions, would
preclude future recovery by plaintiffs or their grantees This should be
placed beyond debate by a provision of the judgment that the
payment by defendant and the acceptance by plaintiffs of permanent


                                    11
damages found by the court shall be in compensation for a servitude
on the land.

Although the Trial Term has found permanent damages as a possible
basis of settlement of the litigation, on remission the court should be
entirely free to ex-examine this subject. It may again find the
permanent damage already found; or make new findings.
The orders should be reversed, without costs, and the cases remitted
to Supreme Court, Albany County to grant an injunction which shall be
vacated upon payment by defendant of such amounts of permanent
damage to the respective plaintiffs as shall for this purpose be
determined by the court.


JASEN, Judge (dissenting).

I agree with the majority that a reversal is required here, but I do not
subscribe to the newly enunciated doctrine of assessment of
permanent damages, in lieu of an injunction, where substantial
property rights have been impaired by the creation of a nuisance.
It has long been the rule in this State, as the majority acknowledges,
that a nuisance which results in substantial continuing damage to
neighbors must be enjoined. To now change the rule to permit the
cement company to continue polluting the air indefinitely upon the
payment of permanent damages is, in my opinion, compounding the
magnitude of a very serious problem in our State and Nation today. . .
.

The harmful nature and widespread occurrence of air pollution have
been extensively documented. Congressional hearings have revealed
that air pollution causes substantial property damage, as well as being
a contributing factor to a rising incidence of lung cancer, emphysema,
bronchitis and asthma.

The specific problem faced here is known as particulate contamination
because of the fine dust particles emanating from defendant's cement
plant. The particular type of nuisance is not new, having appeared in
many cases for at least the past 60 years. It is interesting to note that
cement production has recently been identified as a significant source
of particulate contamination in the Hudson Valley. This type of
pollution, wherein very small particles escape and stay in the
atmosphere, has been denominated as the type of air pollution which
produces the greatest hazard to human health. We have thus a



                                   12
nuisance which not only is damaging to the plaintiffs, but also is
decidedly harmful to the general public.

I see grave dangers in overruling our long-established rule of granting
an injunction where a nuisance results in substantial continuing
damage. In permitting the injunction to become inoperative upon the
payment of permanent damages, the majority is, in effect, licensing a
continuing wrong. It is the same as saying to the cement company,
you may continue to do harm to your neighbors so long as you pay a
fee for it. Furthermore, once such permanent damages are assessed
and paid, the incentive to alleviate the wrong would be eliminated,
thereby continuing air pollution of an area without abatement.

It is true that some courts have sanctioned the remedy here proposed
by the majority in a number of cases, but none of the authorities relied
upon by the majority are analogous to the situation before us. In those
cases, the courts, in denying an injunction and awarding money
damages, grounded their decision on a showing that the use to which
the property was intended to be put was primarily for the public
benefit. Here, on the other hand, it is clearly established that the
cement company is creating a continuing air pollution nuisance
primarily for its own private interest with no public benefit.

This kind of inverse condemnation may not be invoked by a private
person or corporation for private gain or advantage. Inverse
condemnation should only be permitted when the public is primarily
served in the taking or impairment of property. The promotion of the
interests of the polluting cement company has, in my opinion, no
public use or benefit.

...

In sum, then, . . . the permanent impairment of private property for
private purposes is not authorized in the absence of clearly
demonstrated public benefit and use.
I would enjoin the defendant cement company from continuing the
discharge of dust particles upon its neighbors' properties unless, within
18 months, the cement company abated this nuisance.

It is not my intention to cause the removal of the cement plant from
the Albany area, but to recognize the urgency of the problem
stemming from this stationary source of air pollution, and to allow the
company a specified period of time to develop a means to alleviate this
nuisance.


                                   13
I am aware that the trial court found that the most modern dust
control devices available have been installed in defendant's plant, but,
I submit, this does not mean that Better and more effective dust
control devices could not be developed within the time allowed to
abate the pollution.

Moreover, I believe it is incumbent upon the defendant to develop
such devices, since the cement company, at the time the plant
commenced production (1962), was well aware of the plaintiffs'
presence in the area, as well as the probable consequences of its
contemplated operation. Yet, it still chose to build and operate the
plant at this site.

In a day when there is a growing concern for clean air, highly
developed industry should not expect acquiescence by the courts, but
should, instead, plan its operations to eliminate contamination of our
air and damage to its neighbors.

Accordingly, the orders of the Appellate Division, insofar as they
denied the injunction, should be reversed, and the actions remitted to
Supreme Court, Albany County to grant an injunction to take effect 18
months hence, unless the nuisance is abated by improved techniques
prior to said date.

FULD, C.J., and BURKE and SCILEPPI, JJ., concur with BERGAN, J.

JASEN, J., dissents in part and votes to reverse in a separate opinion.

BREITEL and GIBSON, JJ., taking no part.




                                   14
                       SPUR INDUSTRIES, INC.,
                                 v.
                    DEL E. WEBB DEVELOPMENT CO.

                108 Ariz. 178, 494 P.2d 700 (Ariz. 1972)


CAMERON, Vice Chief Justice.

From a judgment permanently enjoining the defendant, Spur
Industries, Inc., from operating a cattle feedlot near the plaintiff Del E.
Webb Development Company's Sun City, Spur appeals. Webb cross-
appeals. Although numerous issues are raised, we feel that it is
necessary to answer only two questions. They are:

1. Where the operation of a business, such as a cattle feedlot is lawful
in the first instance, but becomes a nuisance by reason of a nearby
residential area, may the feedlot operation be enjoined in an action
brought by the developer of the residential area?

2. Assuming that the nuisance may be enjoined, may the developer of
a completely new town or urban area in a previously agricultural area
be required to indemnify the operator of the feedlot who must move or
cease operation because of the presence of the residential area
created by the developer?

The facts necessary for a determination of this matter on appeal are as
follows. The area in question is located in Maricopa County, Arizona,
some 14 to 15 miles west of the urban area of Phoenix, on the
Phoenix-Wickenburg Highway, also known as Grand Avenue. About
two miles south of Grand Avenue is Olive Avenue which runs east and
west. 111th Avenue runs north and south as does the Agua Fria River
immediately to the west.

Farming started in this area about 1911. In 1929, with the completion
of the Carl Pleasant Dam, gravity flow water became available to the
property located to the west of the Agua Fria River, though land to the
east remained dependent upon well water for irrigation. By 1950, the
only urban areas in the vicinity were the agriculturally related
communities of Peoria, El Mirage, and Surprise located along Grand
Avenue. Along 111th Avenue, approximately one mile south of Grand
Avenue and 1 1/2 miles north of Olive Avenue, the community of


                                    15
Youngtown was commenced in 1954. Youngtown is a retirement
community appealing primarily to senior citizens.

In 1956, Spur's predecessors in interest, H. Marion Welborn and the
Northside Hay Mill and Trading Company, developed feed-lots, about
1/2 mile south of Olive Avenue, in an area between the confluence of
the usually dry Agua Fria and New Rivers. The area is well suited for
cattle feeding and in 1959, there were 25 cattle feeding pens or dairy
operations within a 7 mile radius of the location developed by Spur's
predecessors. In April and May of 1959, the Northside Hay Mill was
feeding between 6,000 and 7,000 head of cattle and Welborn
approximately 1,500 head on a combined area of 35 acres.

In May of 1959, Del Webb began to plan the development of an urban
area to be known as Sun City. For this purpose, the Marinette and the
Santa Fe Ranches, some 20,000 acres of farmland, were purchased for
$15,000,000 or $750.00 per acre. This price was considerably less
than the price of land located near the urban area of Phoenix, and
along with the success of Youngtown was a factor influencing the
decision to purchase the property in question.

By September 1959, Del Webb had started construction of a golf
course south of Grand Avenue and Spur's predecessors had started to
level ground for more feedlot area. In 1960, Spur purchased the
property in question and began a rebuilding and expansion program
extending both to the north and south of the original facilities. By
1962, Spur's expansion program was completed and had expanded
from approximately 35 acres to 114 acres.

Accompanied by an extensive advertising campaign, homes were first
offered by Del Webb in January 1960 and the first unit to be
completed was south of Grand Avenue and approximately 2 1/2 miles
north of Spur. By 2 May 1960, there were 450 to 500 houses
completed or under construction. At this time, Del Webb did not
consider odors from the Spur feed pens a problem and Del Webb
continued to develop in a southerly direction, until sales resistance
became so great that the parcels were difficult if not impossible to sell.
...

By December 1967, Del Webb's property had extended south to Olive
Avenue and Spur was within 500 feet of Olive Avenue to the north. Del
Webb filed its original complaint alleging that in excess of 1,300 lots in
the southwest portion were unfit for development for sale as
residential lots because of the operation of the Spur feedlot. Del


                                    16
Webb's suit complained that the Spur feeding operation was a public
nuisance because of the flies and the odor which were drifting or being
blown by the prevailing south to north wind over the southern portion
of Sun City. At the time of the suit, Spur was feeding between 20,000
and 30,000 head of cattle, and the facts amply support the finding of
the trial court that the feed pens had become a nuisance to the people
who resided in the southern part of Del Webb's development. The
testimony indicated that cattle in a commercial feedlot will produce 35
to 40 pounds of wet manure per day, per head, or over a million
pounds of wet manure per day for 30,000 head of cattle, and that
despite the admittedly good feedlot management and good
housekeeping practices by Spur, the resulting odor and flies produced
an annoying if not unhealthy situation as far as the senior citizens of
southern Sun City were concerned. There is no doubt that some of the
citizens of Sun City were unable to enjoy the outdoor living which Del
Webb had advertised and that Del Webb was faced with sales
resistance from prospective purchasers as well as strong and
persistent complaints from the people who had purchased homes in
that area. . . .

It is noted, however, that neither the citizens of Sun City nor
Youngtown are represented in this lawsuit and the suit is solely
between Del E. Webb Development Company and Spur Industries, Inc.

                      MAY SPUR BE ENJOINED?

The difference between a private nuisance and a public nuisance is
generally one of degree. A private nuisance is one affecting a single
individual or a definite small number of persons in the enjoyment of
private rights not common to the public, while a public nuisance is one
affecting the rights enjoyed by citizens as a part of the public. To
constitute a public nuisance, the nuisance must affect a considerable
number of people or an entire community or neighborhood.

Where the injury is slight, the remedy for minor inconveniences lies in
an action for damages rather than in one for an injunction. Moreover,
some courts have held, in the 'balancing of conveniences' cases, that
damages may be the sole remedy [see Boomer]. Thus, it would
appear from the admittedly incomplete record as developed in the trial
court, that, at most, residents of Youngtown would be entitled to
damages rather than injunctive relief.

We have no difficulty, however, in agreeing with the conclusion of the
trial court that Spur's operation was an enjoinable public nuisance as


                                  17
far as the people in the southern portion of Del Webb's Sun City were
concerned.

The following conditions are specifically declared public nuisances
dangerous to the public health:

'1. Any condition or place in populous areas which constitutes a
breeding place for flies, rodents, mosquitoes and other insects which
are capable of carrying and transmitting disease-causing organisms to
any person or persons.'

By this statute, before an otherwise lawful (and necessary) business
may be declared a public nuisance, there must be a 'populous' area in
which people are injured: '* * * (I)t hardly admits a doubt that, in
determining the question as to whether a lawful occupation is so
conducted as to constitute a nuisance as a matter of fact, the locality
and surroundings are of the first importance. A business which is not
per se a public nuisance may become such by being carried on at a
place where the health, comfort, or convenience of a populous
neighborhood is affected. * * * What might amount to a serious
nuisance in one locality by reason of the density of the population, or
character of the neighborhood affected, may in another place and
under different surroundings be deemed proper and unobjectionable.

It is clear that as to the citizens of Sun City, the operation of Spur's
feedlot was both a public and a private nuisance. They could have
successfully maintained an action to abate the nuisance. Del Webb,
having shown a special injury in the loss of sales, had a standing to
bring suit to enjoin the nuisance. The judgment of the trial court
permanently enjoining the operation of the feedlot is affirmed.

                  MUST DEL WEBB INDEMNIFY SPUR?

. . . Courts of equity may, and frequently do, go much further both to
give and withhold relief in furtherance of the public interest than they
are accustomed to go when only private interests are involved.
Accordingly, the granting or withholding of relief may properly be
dependent upon considerations of public interest. * * *.' In addition to
protecting the public interest, however, courts of equity are concerned
with protecting the operator of a lawfully, albeit noxious, business
from the result of a knowing and willful encroachment by others near
his business.

In the so-called 'coming to the nuisance' cases, the courts have held


                                    18
that the residential landowner may not have relief if he knowingly
came into a neighborhood reserved for industrial or agricultural
endeavors and has been damaged thereby: 'Plaintiffs chose to live in
an area uncontrolled by zoning laws or restrictive covenants and
remote from urban development. In such an area plaintiffs cannot
complain that legitimate agricultural pursuits are being carried on in
the vicinity, nor can plaintiffs, having chosen to build in an agricultural
area, complain that the agricultural pursuits carried on in the area
depreciate the value of their homes. The area being Primarily
agricultural, and opinion reflecting the value of such property must
take this factor into account. The standards affecting the value of
residence property in an urban setting, subject to zoning controls and
controlled planning techniques, cannot be the standards by which
agricultural properties are judged.

'People employed in a city who build their homes in suburban areas of
the county beyond the limits of a city and zoning regulations do so for
a reason. Some do so to avoid the high taxation rate imposed by
cities, or to avoid special assessments for street, sewer and water
projects. They usually build on improved or hard surface highways,
which have been built either at state or county expense and thereby
avoid special assessments for these improvements. It may be that
they desire to get away from the congestion of traffic, smoke, noise,
foul air and the many other annoyances of city life. But with all these
advantages in going beyond the area which is zoned and restricted to
protect them in their homes, they must be prepared to take the
disadvantages.'

Were Webb the only party injured, we would feel justified in holding
that the doctrine of 'coming to the nuisance' would have been a bar to
the relief asked by Webb, and, on the other hand, had Spur located
the feedlot near the outskirts of a city and had the city grown toward
the feedlot, Spur would have to suffer the cost of abating the nuisance
as to those people locating within the growth pattern of the expanding
city: 'The case affords, perhaps, an example where a business
established at a place remote from population is gradually surrounded
and becomes part of a populous center, so that a business which
formerly was not an interference with the rights of others has become
so by the encroachment of the population * * *.'

We agree, however, with the Massachusetts court that:

'The law of nuisance affords no rigid rule to be applied in all instances.
It is elastic. It undertakes to require only that which is fair and


                                    19
reasonable under all the circumstances. In a commonwealth like this,
which depends for its material prosperity so largely on the continued
growth and enlargement of manufacturing of diverse varieties,
'extreme rights' cannot be enforced. * * *.'

There was no indication in the instant case at the time Spur and its
predecessors located in western Maricopa County that a new city
would spring up, full-blown, alongside the feeding operation and that
the developer of that city would ask the court to order Spur to move
because of the new city. Spur is required to move not because of any
wrongdoing on the part of Spur, but because of a proper and
legitimate regard of the courts for the rights and interests of the
public.

Del Webb, on the other hand, is entitled to the relief prayed for (a
permanent injunction), not because Webb is blameless, but because of
the damage to the people who have been encouraged to purchase
homes in Sun City. It does not equitable or legally follow, however,
that Webb, being entitled to the injunction, is then free of any liability
to Spur if Webb has in fact been the cause of the damage Spur has
sustained. It does not seem harsh to require a developer, who has
taken advantage of the lesser land values in a rural area as well as the
availability of large tracts of land on which to build and develop a new
town or city in the area, to indemnify those who are forced to leave as
a result.

Having brought people to the nuisance to the foreseeable detriment of
Spur, Webb must indemnify Spur for a reasonable amount of the cost
of moving or shutting down. It should be noted that this relief to Spur
is limited to a case wherein a developer has, with foreseeability,
brought into a previously agricultural or industrial area the population
which makes necessary the granting of an injunction against a lawful
business and for which the business has no adequate relief.

It is therefore the decision of this court that the matter be remanded
to the trial court for a hearing upon the damages sustained by the
defendant Spur as a reasonable and direct result of the granting of the
permanent injunction. Since the result of the appeal may appear novel
and both sides have obtained a measure of relief, it is ordered that
each side will bear its own costs.

Affirmed in part, reversed in part, and remanded for further
proceedings consistent with this opinion.



                                    20
                                 PLOOF
                                   v.
                               PUTNAM.
                           81 Vt. 471 (1908)


MUNSON, J.

It is alleged as the ground on recovery that on the 13th day of
November 1904, the defendant was the owner of a certain island in
Lake Champlain, and of a certain dock attached thereto, which island
and dock were then in charge of the defendant's servant; that the
plaintiff was then possessed of and sailing upon said lake a certain
loaded sloop, on which were the plaintiff and his wife and two minor
children; that there then arose a sudden and violent tempest, whereby
the sloop and the property and persons therein were placed in great
danger of destruction; that, to save these from destruction or injury,
the plaintiff was compelled to, and did, moor the sloop to defendant's
dock; that the defendant, by his servant, unmoored the sloop,
whereupon it was driven upon the shore by the tempest, without the
plaintiff's fault; and that the sloop and its contents were thereby
destroyed, and the plaintiff and his wife and children cast into the lake
and upon the shore, receiving injuries. This claim is set forth in two
counts--one in trespass, charging that the defendant by his servant
with force and arms willfully and designedly unmoored the sloop; the
other in case, alleging that it was the duty of the defendant by his
servant to permit the plaintiff to moor his sloop to the dock, and to
permit it to remain so moored during the continuance of the tempest,
but that the defendant by his servant, in disregard of this duty,
negligently, carelessly, and wrongfully unmoored the sloop. Both
counts are demurred to generally.

There are many cases in the books which hold that necessity, and an
inability to control movements inaugurated in the proper exercise of a
strict right, will justify entries upon land and interferences with
personal property that would otherwise have been trespasses. A
reference to a few of these will be sufficient to illustrate the doctrine.
In Miller v. Fandrye, Poph. 161, trespass was brought for chasing
sheep, and the defendant pleaded that the sheep were trespassing
upon his land, and that he with a little dog chased them out, and that,
as soon as the sheep were off his land, he called in the dog. It was


                                    21
argued that, although the defendant might lawfully drive the sheep
from his own ground with a dog, he had no right to pursue them into
the next ground; but the court considered that the defendant might
drive the sheep from his land with a dog, and that the nature of a dog
is such that he cannot be withdrawn in an instant, and that, as the
defendant had done his best to recall the dog, trespass would not lie. .
..

It is clear that an entry upon the land of another may be justified by
necessity, and that the declaration before us discloses a necessity for
mooring the sloop. But the defendant questions the sufficiency of the
counts because they do not negative the existence of natural objects
to which the plaintiff could have moored with equal safety. The
allegations are, in substance, that the stress of a sudden and violent
tempest compelled the plaintiff to moor to defendant's dock to save his
sloop and the people in it. The averment of necessity is complete, for it
covers not only the necessity of mooring to the dock; and the details
of the situation which created this necessity, whatever the legal
requirements regarding them, are matters of proof, and need not be
alleged. It is certain that the rule suggested cannot be held applicable
irrespective of circumstance, and the question must be left for
adjudication upon proceedings had with reference to the evidence or
the charge.

The defendant insists that the counts are defective, in that they fail to
show that the servant in casting off the rope was acting within the
scope of his employment. It is said that the allegation that the island
and dock were in charge of the servant does not imply authority to do
an unlawful act, and that the allegations as a whole fairly indicate that
the servant unmoored the sloop for a wrongful purpose of his own,
and not by virtue of any general authority or special instruction
received from the defendant. But we think the counts are sufficient in
this respect. The allegation is that the defendant did this by his
servant. The words "willfully, and designedly" in one count, and
"negligently, carelessly, and wrongfully" in the other, are not applied
to the servant, but to the defendant acting through the servant. The
necessary implication is that the servant was acting within the scope of
his employment.

Judgment affirmed and cause remanded.




                                   22
                           Contract Law

                               BLOOR
                                 v.
                  FALSTAFF BREWING CORPORATION
                            (SDNY 1978).


FINDINGS AND CONCLUSIONS

BRIEANT, District Judge.

This action was filed July 21, 1976 to recover monetary damages for
breach of contract. Plaintiff James Bloor is the Reorganization Trustee
of Balco Properties Corporation, formerly named P. Ballantine & Sons
("Ballantine"). Defendant is the Falstaff Brewing Corporation
("Falstaff"), which on March 31, 1972 bought from Investors Funding
Corporation ("IFC") the Ballantine brewing labels, trademarks,
accounts receivable, distribution systems and other property,
excepting only the Ballantine brewery.

The purchase agreement called for an immediate payment to
Ballantine of $4,000,000.00 and royalty payments thereafter of $.50
to be paid on each barrel (31 gallons) of the Ballantine brands sold
between April 1, 1972 and March 31, 1978. The contract contained a
liquidated damages clause, calling for payments of $1,100,000.00 a
year which were to be made in the event Falstaff "substantially
discontinue(d) the distribution of beer under the brand name
'Ballantine'." The contract also required that Falstaff "use its best
efforts to promote and maintain a high volume of sales" of the
Ballantine brands.

This action arises out of defendant's alleged breach of these covenants
by its substantial discontinuance of the Ballantine brands or its failure
to use best efforts in their promotion, and also by its failure to pay any
royalties whatsoever on sales of those brands after December 1975
and by its alleged underpayment of royalties before that date.
The contract is integrated and provides that it "shall be governed by
and construed and enforced in accordance with the laws of the State of
New York."




                                    23
Defendant Falstaff has in turn counterclaimed against the plaintiff,
alleging (1) a shortage in the cooperage (beer barrels, now universally
made of aluminum) purchased from Ballantine: (2) the illegality and
consequent uncollectibility of one of the accounts receivable purchased
from Ballantine; (3) the invalidity of Ballantine's claimed ownership of
the brand name "Munich"; (4) the moldiness and infestation of eleven
carloads of bulk corn grits purchased from Ballantine as a part of the
acquired inventory; and (5) Ballantine's fraudulent inducement and
misrepresentation in the making of the original contract.

Beer

Some preliminary discussion of brewing, the brewing industry in
America and some of its current vicissitudes, is essential to a proper
understanding of this case.

Generically speaking, "beer" is the name given any alcoholic beverage
made by the fermentation of extracts of various starchy materials,
usually grains. The process was known, and was apparently
independently developed, in ancient Babylon, Egypt and China, as well
as in South Africa, where the Kaffirs made a species of beer from
millet. In the Near East, barley was apparently the original grain used
for beer. It was buried in pots to allow it to germinate ("malting") and
then mixed with water and allowed to ferment through the action of
air-borne yeasts. In essence the same process is still used today. All
ancient beers contained various herbs to relieve the flatness and
sweetness of simple beer. The use of hops for this purpose dates from
the 10th century B.C., and is now almost universal. In English-
speaking countries the presence or absence of hops originally
distinguished beer from ale, but both products now contain hops, and
the term "ale" now merely denotes a product with a heartier and more
robust flavor.

The Domesday Book (1086) records the existence of some forty-three
Cerevisarii (brewers) then found in England, but the distribution of a
brewer's products nationally or internationally is largely a twentieth
century, and in the United States specifically a post-World War II,
phenomenon. On the trial of this matter, experts testified that it was
the exposure of American servicemen and women to the beers
produced by the larger breweries under contract to the armed services
that began the trend away from the many small, local or regional
brewers, each of whom made their own beer with distinctive flavor,
towards the few national brewers who produce beers essentially
indistinguishable in taste and body.


                                   24
The biggest single factor contributing to the decline of local and
regional brewers has been the enormous market growth, with its
consequent efficiency and economy of scale, recently experienced by
the "nationals": Miller's, Schlitz, Anheuser-Busch, Coors and Pabst,
with Pabst now holding only a precarious position relative to the other
four. Although beer consumption in the United States has been rising
at approximately 4% per year, the "nationals" have increased their
sales by an average of 12% per year, with the difference coming
largely out of the sales of the smaller, local and regional brewers.
From 1956 to 1966 the nationals expanded their production capacity
by some 5.5 million barrels; from 1966 to 1976 they expanded their
capacity by more than 75 million barrels and each year produced beer
at almost the full capacity constructed the previous year. The cost-
effectiveness of full production is obvious, especially in light of the
fact, testified to by Mr. Paul Kalmanovitz, Chairman of the Board of
Falstaff, that the cost of the ingredients in any two brands of domestic
beer is exactly the same, with the exception of coloring materials
which might add 2 cents to the cost of a case of beer. It is estimated
that by 1980 the nationals will have 80% of the beer market in the
United States, a 24% increase over the share held in 1976.

There was expert testimony at trial concerning "general discussion" in
the beer industry of the "predatory pricing practices" of the national
brewers, although no formal court action has yet been filed against
them. It was suggested that several of the nationals may have sold
their product in areas, or generally, at a loss for extended periods in
order to broaden their market and drive out competition. There is
knowledgeable suspicion that some national brewers may have
operated their entire malt beverage operations at a loss for these
same purposes, while being supported by income from other
operations. It is uncontested that the increases in the retail price of
beer during the last ten years have lagged considerably behind rises in
the cost of its ingredients and the labor to manufacture it.
Advertising has also been a major factor in the growth of the nationals
and the decline of local or regional breweries. It was undisputed at
trial that, except for "ales" generally and excluding a very few
distinctive smaller brews such as Rolling Rock Beer (produced by
Latrobe Brewing Co. in Pennsylvania) and Anchor Steam Beer, made in
San Francisco since the Gold Rush, all beers appear to be relatively
indistinguishable in taste for the average customer. "Image"
apparently sells beer, the image of the beer in the marketplace, and
the image projected by advertising, of the typical consumer of that
brand.


                                   25
In 1961 it became lawful for the major sports teams to combine to sell
network television rights to their games. In an event, such as Monday
Night Football, a minute of advertising can cost approximately
$100,000.00, with a typical advertising "package" for the whole event
costing about $1,400,000.00. For the national brewers such
advertising is efficient and inexpensive: they sell beer in the same
geographic area covered by the television networks, and the cost of
reaching an individual home only amounts to seven-tenths of a cent.
The same cost factors make national network advertising unreasonably
expensive for the local or regional brewer.

Coupled with these economic factors have been profound changes in
the American public's tastes and beer-drinking habits. At the beginning
of World War II, two-thirds of the beer consumed in America was
drunk in licensed premises or purchased in draft from such premises:
the beer bucket was still a familiar household utensil. Now only one-
third of all beer is consumed in saloons and bars, and two-thirds is
consumed at home. In addition, the taste preference of the American
consumer has tended more and more towards clearer, lighter beers
and away from "porters," "stouts," and distinctive heavy-flavored
beverages. The phenomenal success of Coors Beer is partially
attributable to Coors' lightness. In the 1960's several of the nationals,
specifically Schlitz and Budweiser, reformulated their product to bring
it more in line with current American tastes. Most recently, the
brewing industry has been affected by a wave of "light" beers,
beginning with Miller's Lite Beer. Falstaff has marketed its version,
Falstaff 96 Beer, containing only 96 calories. In 1977 "light" beers
accounted for about 7% of total industry production.

The result of all these changes, and the smaller brewers' inability or
failure to keep pace with them, has been the bankruptcy or elimination
from the marketplace of many smaller brewers and the decline of the
market share held by the local and regional survivors. After Prohibition
there were some 866 brewers in the United States. Today there are
only 40. Expert testimony at trial suggested that by 1980 there would
be only 5 of any importance. Western New York provides in microcosm
a view of the whole industry. In the 1890's there were 32 local
breweries in Buffalo alone; today only the Fred Koch Brewery ("The
Tiny Little Brewery Where Real Beer Is Made") remains in the whole
area, and it is the nation's second smallest brewer, holding only five-
tenths of 1 percent of the American beer market. The smallest
producer is San Francisco's unique Anchor Steam Beer. Mr.



                                   26
Kalmanovitz testified that at the time of trial one of his breweries was
the only independent brewer left in the State of California.

The result of all these changes in the industry has been to compel the
smaller brewers to combine in order to produce beer at near capacity
levels in one brewery, rather than at a fraction of capacity in several
inefficient breweries. Also, as Robert T. Colson, Executive Vice-
President of Falstaff testified, "the brewing industry in the late '60's
and early '70's was a hotbed of price promotions,'' as brewers
scrambled for a piece of the declining market share held by regionals,
and cut prices to do so.

Ballantine and Falstaff

For the first half-century of its existence, P. Ballantine & Sons was a
family owned operation, producing generally for the northeast market.
In the early 1970's, the "tristate" area of New York, New Jersey,
Connecticut and Pennsylvania accounted for approximately half of its
sales. Its principal products were Ballantine Beer, Ballantine Ale,
Ballantine India Pale Ale and Munich Beer. Ballantine Beer is primarily
a "price" beer, the term used in the brewing industry to distinguish
low-priced beers from middle-range or high-priced "premium" beers.
The distinction is based on price and "image" rather than on any
inherent difference in quality. Ballantine's sales declined from 1961 on,
and the company lost money from 1965 on.

On June 1, 1969, Investors Funding Corporation, a New York based
real estate conglomerate having no prior experience in the brewing
industry, acquired substantially all of the capital stock of Ballantine for
$16,290,000.00. In the first two years of its ownership, IFC increased
advertising expenditures significantly, leveling off its advertising
budget in 1971 at approximately $1 million a year. Although its period
of ownership coincided with the entry of the nationals into the
northeast market, the largest beer consumption area in the country,
IFC managed to increase its sales of Ballantine products during each
month it held the company. Despite this apparent "success," Ballantine
never turned a profit for IFC, and during the first three months of
1972, immediately before Falstaff's acquisition of the company, was
losing approximately $1 Million a month. During the whole period
1969-1972, the Ballantine Brewery in Newark, New Jersey was
producing at only about 50% of its five-million barrel capacity.




                                    27
IFC used two methods to distribute the Ballantine products. The first
was the normal method in the industry, sales at wholesale to
independent distributors. Ballantine also, however, sold beer directly
to smaller accounts ("Mom and Pop stores," bars, and the like), using
its own warehouses and trucks. In the New York area this "retail"
operation in 1972 was servicing some 25,000 accounts directly from
the Ballantine brewery in Newark, New Jersey.

In the early 1960's, Falstaff Brewing Company was the nation's fourth
largest brewer, although its distribution was primarily in the West and
Midwest. In 1964 it embarked upon a ten year program to enter the
ranks of the "national" brewers. As part of this expansion, Falstaff in
1965 acquired the Narragansett Brewing Company, at the time the
largest producer of beer in New England.

By contract dated March 3, 1972, Falstaff acquired Ballantine's assets.
The closing took place on March 31, 1972. At that time Falstaff was
the fifth ranking brewer in the United States but had failed to acquire a
substantial foothold in New York, New Jersey and Pennsylvania, the
highest beer consuming region in the country. Its purchase of
Ballantine was apparently prompted by the desire to acquire a ready-
made distribution system in the New York area, and by its need to
utilize the excess capacity of its own breweries. Falstaff did not buy
the Ballantine brewery in Newark, New Jersey. At some undetermined
date during its ownership of Ballantine, Falstaff began using its own
beer, without formula alteration, to fill Ballantine Beer containers. At
the present time, the only difference between Ballantine and Falstaff
Beer is the label. Falstaff was also motivated in its purchase by the
fact that Ballantine Beer was (and is) a "price" beer in the Northeast
and would in the normal course of events not compete with Falstaff's
own so-called "premium" beer.

Shortly after acquiring the Ballantine assets, Falstaff moved the
"retail" distribution operation from Newark, New Jersey (the location of
the Ballantine brewery) to North Bergen, New Jersey, where it
continued until 1975 to service generally the same accounts. Between
1972 and 1975, Falstaff also continued the former policy of substantial
advertising of Ballantine products, spending more than $1 million a
year for that purpose. Falstaff continued in every way the former
pricing policies used by IFC, including substantial "post-offs" from
listed prices. During this period, Falstaff claims to have lost $22 million
in its Ballantine brands operations.




                                    28
A very significant change in the modus operandi of Falstaff-Ballantine
took place in 1975. In March of that year, Mr. Paul Kalmanovitz, an
entrepreneur with 40 years experience in the brewing industry who
had owned a small position in Falstaff stock prior to that time,
advanced $3 million to Falstaff to enable it to meet its payroll and
other pressing debts then due. On March 10, 1975, in return for some
$10 million cash advanced, and additional loan guaranties, Mr.
Kalmanovitz was issued new convertible preferred shares in amounts
equal to about 35% of the company's outstanding shares. A voting
trust arrangement was made to give him control of the Board of
Directors. The shareholders of Falstaff approved the agreement on
April 28, 1975. At present, Mr. Kalmanovitz is Chairman of the Board
of Falstaff.

Mr. Kalmanovitz is a highly individualistic entrepreneur in the highest
tradition of the old school. He has built and owned several television
studios, including the first ABC studio in California, and owns several
advertising agencies. His experience in the brewing industry began in
1935, when he began to purchase the 27 nightclubs and restaurants
he eventually came to own in California. His acquisition of breweries
began in 1950, and at different times he has bought 17 of them,
including Regal Pale Brewing Company, Maier Brewing Company,
Walter Brewing Company, Grace Brewing Company, Goebel Brewing
Company and General Brewing Company (the California producer of
Lucky Lager Beer). In January 1978, he acquired the Pearl Brewing
Company of San Antonio, Texas.

Although he is now 72 years old, Mr. Kalmanovitz testified convincingly
to his drive to keep active and specifically to his desire to attempt to
set aside what he called "the Coors' timetable" (Tr. p. 699). This is a
reference to the estimate of Mr. William K. Coors, President of Coors
Brewing Company, that by 1980 there would be only five brewers left
in the United States. Mr. Kalmanovitz's philosophy in attempting this
task is simple:

"So I have a firm opinion that profit is not a dirty word. Profit is a
better product at lower cost to the consumer, and (is) employment . . .
."

The message conveyed to his distributors is equally simple:
" 'Just buy our product and sell it and make a profit.' That's my
philosophy. It has been successful because I am still here as an
independent brewery."



                                   29
Since Mr. Kalmanovitz's assumption of control of Falstaff the
advertising budget for Ballantine products has decreased from about
$1 million a year to a point near non-existence (about $115,000.00
since the beginning of 1976). Substantial cuts have also been made in
sales and management personnel. In late 1975 four of the six "retail"
distribution centers, including the North Bergen depot, were
substantially closed or phased out. The North Bergen depot was
replaced by two independent distributors who together service
substantially fewer accounts. In mid-1976 Mr. Kalmanovitz also
discontinued the price cutting policies of former management, ordering
that no beer was to be "given away" in the future.

Concomitant with these changes, and, plaintiff argues, causally related
to them, there has been a precipitous decline in the sales of Ballantine
products, and a slightly less precipitous diminution in the sale of
Falstaff products. In December 1975, Falstaff unilaterally discontinued
royalty payments on sales of Ballantine products.

After selling its brewery assets in March 1972, Balco Properties
Corporation attempted to convert the Newark Industrial and Office
Plaza, the site of the brewery, into an industrial park. Financially, the
attempt was unsuccessful, and in October 1974 both Balco and its
parent corporation, IFC, filed petitions for voluntary reorganization
under Chapter X of the bankruptcy laws.

Plaintiff's Claims Pleaded

Plaintiff is suing to recover money damages for Falstaff's breach of
contract in three separate instances: (1) Falstaff's "substantial
discontinuance" of distribution of Ballantine products, or its failure to
use best efforts to keep sales of them high; (2) Falstaff's
underpayment of royalties prior to December 1975; and (3) Falstaff's
discontinuance of royalty payments on Ballantine products sold after
December 1975. We consider these claims separately.

After the trial of this action, plaintiff abandoned all claims for
substantial discontinuance and lack of best efforts for the period before
May 1975 (the date Mr. Kalmanovitz assumed operating control of
Falstaff).

The relevant portions of the contract on which plaintiff relies are as
follows:




                                    30
"8. Certain Other Covenants of Buyer. (a) After the Closing Date the
(Buyer) will use its best efforts to promote and maintain a high volume
of sales under the Proprietary Rights."

"2(a)(v) (The Buyer will pay a royalty of $.50 per barrel for a period of
6 years), provided, however that if during the Royalty Period the Buyer
substantially discontinues the distribution of beer under the brand
name 'Ballantine' (except as the result of a restraining order in effect
for 30 days issued by a court of competent jurisdiction at the request
of a governmental authority), it will pay to the Seller a cash sum equal
to the years and fraction thereof remaining in the Royalty Period times
$1,100,000, payable in equal monthly installments on the first day of
each month commencing with the first month following the month in
which such discontinuation occurs . . . ."

I find that plaintiff has failed to prove "substantial discontinuance"
under the contract. In interpreting a contract, "'(t)hat interpretation is
favored which will make every part of a contract effective.'" In this
instance, any interpretation of the contract which would apply the
substantial discontinuance clause to the facts proved on the trial would
render nugatory the "best efforts" clause of the same contract. Falstaff
now and at all times has distributed beer under the Ballantine name to
all who would purchase it at a price above Falstaff's costs. Whether the
totality of its merchandising efforts complies with the obligation to use
"best efforts" presents a more difficult question.

Plaintiff apparently attempts to distinguish the two clauses on the
ground that the "substantial discontinuance" clause looks to the
distribution of beer rather than to its sale, and argues that the closing
of the North Bergen "retail" distribution center and other similar
actions constitutes such discontinuance. This, however, is a distinction
without a significant difference, and stands opposed to the fact that
Falstaff, during its control of Ballantine, increased the number of
distributors carrying Ballantine labels from 106 to 644, and has to
some extent introduced Ballantine in its own national markets. The
amount of sales must be considered in determining substantiality. If
this is done, Ballantine's claim fails, even under its proposed
construction of the substantial discontinuance clause. Total Ballantine
sales in 1975 amounted to 974,774 barrels; in 1976 they declined to
582,964 barrels; and in 1977 to 518,899 barrels. A very significant
part of this decline is attributable, as we shall discuss below, to the
general decline of the market share of the smaller brewers, and to
other causes unconnected with Falstaff's closing of the North Bergen
facility. The remaining decline is regarded as "insubstantial" under the


                                    31
contract. It is clear from the royalty rate established in the contract
itself that the liquidated damages clause was included to cover
situations approaching the total cessation of Ballantine production,
rather than situations involving gradual but significant declines in
sales.

Ballantine has, however, proved its claim that Falstaff failed to use its
best efforts to promote sales of Ballantine products after May 1975.
The parties differ with respect to the meaning and effect of "best
efforts". Defendant has urged on the Court the argument that the
interpretation of such a clause requires the application of a subjective
standard: Falstaff contracted to use "its" best efforts, and any
determination of those efforts must include considerations of Falstaff's
own allegedly precarious financial position. Plaintiff, on the contrary,
cites substantial precedent holding that financial difficulty and
economic hardship do not excuse performance of a contract, and
argues for the application of an objective standard, that of the
"average, prudent comparable" brewer.

The point of the argument appears to be defendant's contention that it
promoted Ballantine to the full extent that its own straitened financial
abilities permitted, and could do no more.

"Best efforts" is a term "which necessarily takes its meaning from the
circumstances." . . . It is obvious that any determination of the best
efforts achievable by Falstaff must take into account Falstaff's abilities
and the opportunities which it created or faced; Falstaff did not
contract to promote Ballantine at the level or to the degree that
Anheuser-Busch or Schlitz might have done. It did, however, contract
to merchandise Ballantine products in good faith and to the extent of
its own total capabilities, and this it failed to do.

The evidence in the case also shows that Falstaff's financial position
during most of the period in litigation was far from that depicted by
defendant, and that Falstaff failed to use even its own temporarily
circumscribed abilities and resources to promote the sale of Ballantine
products.

The record shows that when Mr. Kalmanovitz assumed operating
control of Falstaff, the company was faced with serious cash-flow
difficulties and could not meet its immediate (March 1975) payroll. The
record also shows, however, that the company had considerable
borrowing capacity. Indeed, it did borrow successfully from Mr.
Kalmanovitz. Also, by 1976 Falstaff's financial picture was much


                                    32
improved: the net income of Falstaff in 1976 was $8.7 million; its
working capital in that year was $20.2 million, up from $8.6 million in
1975, and its cash and certificates of deposits in 1976 stood at $12.1
million, up from.$2.1 million in 1975. This upward trend has
continued, and even improved in 1977. More significantly, in late 1975
Falstaff ignored an opportunity to promote distribution of Ballantine
products in the New York City area that would have cost it nothing to
exploit and that was well within its "capabilities." After August 1975,
Falstaff closed four of its six "retail" distribution centers, including the
North Bergen, New Jersey center, which accounted for a very
significant percentage of all Ballantine sales. Its reason for taking this
drastic action was the losses these operations were allegedly
experiencing; the North Bergen facility alone was apparently losing
about $2.2 million annually in distributing Falstaff and Ballantine
products.

No studies were made on the effect such closings would have on
Ballantine sales, and the only alternative explored was to continue the
North Bergen depot on an enormously reduced basis. Albert C.
Hoffmeister, a Falstaff Vice-President, testified that the result of the
closing and consequent failure to service the "Mom and Pop stores"
was "disastrous." . . .

As a consequence of this precipitous departure from the New York City
market area, Ballantine registered no sales there for the month of
September 1975. In October and November 1975, Falstaff, on the
initiative of several independent distributors, selected Thomas Fatato,
Inc. to distribute Ballantine products in New York, and L. A. Piccirrillo,
Inc. to distribute them in New Jersey. The performance of these two
has been less than impressive, and, indeed, at the time of their
appointment, strong concern about their ability to cover the
metropolitan area adequately was expressed by Mr. Griesedieck,
President of Falstaff . . .

Defendant argues that it had the right, and even the duty to use in
good faith its best business judgment in all matters arising under the
contract, and also had the right to look to its own interest. This
argument has some validity, but Falstaff has gone beyond that point.
As the New York Court of Appeals said in a similar situation:

"Although a publisher has a general right to act on its own interests in
a way that may incidentally lessen an author's royalties, there may be
a point where that activity is so manifestly harmful to the author, and
must have been seen by the publisher so to be harmful, as to justify


                                     33
the court in saying there was a breach of the covenant to promote the
author's works."

Mr. Kalmanovitz as a traditional businessman expressed at trial his
contempt for "studies" and "projections." Consequently, in making the
decisions to close the North Bergen facility and to appoint Mr. Fatato
distributor in the New York City area, no effort was made to ascertain
in advance the effect on Ballantine sales. Mr. Kalmanovitz did not even
consult Falstaff's regional manager, Albert Hoffmeister. Coupled with
this is Falstaff's expressed willingness to see the whole New York-New
Jersey area lost for Ballantine, and its expectation of that result.
Falstaff was willing to appoint a distributor for the area, Mr. Fatato,
about whose abilities the President of Falstaff had serious reservations,
and to continue him in a virtual monopoly of Falstaff products in the
area despite Mr. Molyneux's proposals. These actions exceed any
reasonable variance allowable in the exercise of sound business
judgment. No effect was made by Falstaff to examine or find
alternatives to the drastic step of closing the North Bergen facility,
although it accounted for a very large percentage of Ballantine sales.
Some of this apparent callousness towards Ballantine sales is
undoubtedly caused by the fact that even though the liquid in a can of
Ballantine Beer and in a can of Falstaff Beer is identical, and
accordingly costs exactly the same amount to produce, sale of Falstaff
Beer produces a greater profit for Falstaff. In part this is the result of
the fact that Falstaff is a "premium" beer and nets Falstaff about $4.20
more a barrel than does Ballantine, even before the $.50 Ballantine
royalty is subtracted from the latter. Also, Mr. Kalmanovitz testified,
the process of changing a production line over from Falstaff to
Ballantine Beer "cost(s) a lot of money." (Plaintiff's Ex. 123, p. 16.) . .
.

Falstaff has also failed in several other notable respects to promote
Ballantine products with its best efforts. After Mr. Kalmanovitz's
assumption of control of Falstaff, the company severely cut back
personnel in distribution, sales, marketing, administrative and
warehousing areas. It virtually eliminated its promotion and
advertising of Ballantine Beer and closed its advertising department,
all this despite the repeated assertions by experts for both sides (for
example, Mr. Weinstein for plaintiff and Mr. Dependahl, former Vice-
President of Falstaff, for defendant) that personal contact,
merchandising and advertising were essential to the marketing of any
beer. While some cutbacks may have been temporarily justified in late
1975, the situation was quite different in 1976 and 1977 when Falstaff
continued its stated policy of simply making the beer available, and


                                    34
when solicited by distributors, funding one-half of "co-op" promotional
costs. After Mr. Kalmanovitz assumed control of Falstaff, the company
even discontinued the establishing of goals for its remaining salesmen,
an essential step in any marketing effort, and one which would have
cost the company nothing to implement. This is not "best efforts."

Defendant has stressed the argument that Falstaff's policies after 1975
were evenhanded, that is, that Falstaff's cutbacks and marketing
strategy affected Falstaff and Ballantine performance equally. Even if
this were the case, which it is not, Falstaff's relationship to Ballantine
is essentially different from its relationship to its own products. In the
latter case, it may promote, continue or discontinue its products as it
wills, subject to its duty to shareholders; in the former case it is bound
by a contractual duty to the promisee. . . .

Additionally, Falstaff has not treated both products equally. Robert
Thibaut, a Falstaff Vice-President, testified that Falstaff but not
Ballantine had been advertised extensively in Texas and Missouri. In
the same areas Falstaff, although a "premium" beer, was sold for
extended periods below the price of Ballantine. These actions and
failures to act were not consistent with those of the average, prudent,
comparable brewer in the same circumstances seeking to promote a
beer to the extent of his best efforts. The "business judgment"
argument is of no help to Falstaff in this regard.
...

Accordingly, I find that from September 1975 until the present,
Falstaff has breached the covenant in its agreement with plaintiff's
predecessor, in that it failed without justification to use its best efforts
to promote the sale of Ballantine products and has neglected to act in
the manner required of the average, prudent, comparable brewer in
marketing his product.




                                     35
                     Hadley v. Baxendale
                156 Eng. Rep. 145 (Ex. 1854).
The plaintiffs operated a steam mill in Gloucester. The crank shaft of
the steam engine broke. Plaintiffs ordered a new crank shaft from W.
Joyce & Co., located in Greenwich, county of Kent. To make a new
shaft the Joyce company needed to have the old broken one as a
model. The defendants were common carriers operating under the
name Pickford & Co. Plaintiffs delivered the broken shaft to the
defendants, who promised second day delivery. Defendants knew that
the mill could not function until the crank shaft was repaired.
However, due to neglect they failed to deliver the broken shaft until
seven days had passed. Plaintiffs sued for lost profits during the extra
time the mill was shut.

Alderson, J. delivered the judgment of the court.

We think that there ought to be a new trial in this case, but in so doing
we deem it to be expedient and necessary to state explicitly the rule
which the Judge, at the next trail ought, in our opinion, to direct the
jury to be governed by when they estimate the damages.

It is, indeed, of the last importance that we should do this, for if the
jury are left without any definite rule to guide them, it will, in such
cases as these, manifestly lead to great injustices . . .

Now we think the proper rule in such a case as the present is this:
Where to parties have made a contract which one of them has broken,
the damages which the other party ought to receive in respect of such
breach of contract should be such as may fairly and reasonably be
considered, either arising naturally, i.e., according to the usual course
of things, from such breach of contract itself, or such as may
reasonably be supposed to have been in the contemplation of both
parties, at the time they made the contact, as the probable result of
the breach of it.

Now if the special circumstances under which the contract was actually
made were communicated by the plaintiffs to the defendants, and thus
known to both parties, the damages resulting form the breach of such
a contract, which they would reasonably contemplate, would be the
amount of injury which would ordinarily follow from a breach of


                                    36
contract under these special circumstances so known and
communicated. But on the other hand, if these special circumstances
were wholly unknown to the party breaking the contract, he at the
most, could only be supposed to have had in his contemplation the
amount of injury which would arise generally, and in the great
multitude of cases not affected by any special circumstances, from
such a breach of contract.

For, had the special circumstances been known, the parties might have
especially provided for the breach of contract by special terms as to
the damages in that case, and of this advantage it would be very
unjust to deprive them.

Now the above principles are those by which we think the jury ought
to be guided in estimating the damages arising out of any breach of
contract. It is said, that other cases such as breaches of contract in
the non-payment of money, or in the not making a good title to land,
are to be treated as exceptions from this, and as governed by a
conventional rule. But as, in such cases, both parties must be
supposed to be cognizant of that well-known rule, these cases may,
we think, be more properly classed under the rule above enunciated as
to cases under known special circumstances, because there both
parties may reasonably be presumed to contemplate the estimation of
the amount of damages according o the conventional rule.

Now, in the present case, if we are to apply the principles above laid
down, we find that the only circumstances here communicated by the
plaintiffs to the defendants at the time the contact was made, were,
that the article to be carried was the broken shat of a mill, and that
the plaintiffs were millers of that mill. But how do these circumstances
shew reasonably that the profits of the mill must be stopped by an
unreasonable delay in the delivery of the broken shaft by the carrier to
the third person?

Suppose the plaintiffs had another shaft in their possession put up or
putting up at the same time, and that they only wished to send back
the broken shaft to the engineer who made it; it is clear that this
would be quite consistent with the above circumstances, and yet the
unreasonable delay in the delivery would have no effect upon the
intermediate profits of the mill. Or, again suppose that, at the time of
the delivery to the carrier, the machinery of the mill had been in other
respects defective, then, also, the same results would follow. Here it
is true that the shaft was actually sent back to serve as a model for a
new one, and that the want of a new one was the only cause of the


                                   37
stoppage of the mill, and that the loss of profits really arose from not
sending down the new shaft in proper time, and that this arose from
the delay in delivering the broken one to serve as a model. But it is
obvious that, in the great multitude of cases of millers sending off
broken shafts to third persons by a carrier under ordinary
circumstances, such consequences would not, in all probability, have
occurred, and that these special circumstances were here never
communicated by the plaintiffs to the defendants.

It follows therefore, that the loss of profits here cannot reasonably be
considered such a consequence of the breach of contract as could have
been fairly and reasonably contemplated by the parties when they
made this contract. For such loss would neither have flowed naturally
from the breach of this contract in the great multitude of such cases
occurring under ordinary circumstances, not were the special
circumstances, where perhaps, would have made it a reasonable and
natural consequences of such breach of contract, communicated to or
know by the defendants.

The judge ought, therefore, to have told the jury, that upon the facts
then before them, they ought not to take the loss of profits into
consideration at all in estimating the damages. There must therefore
be a new trial in this case.




                                    38
                          Accident Law

                            UNITED STATES
                                  v.
                          CARROLL TOWING CO.

L. HAND, Circuit Judge.

These appeals concern the sinking of the barge, 'Anna C,' on January
4, 1944, off Pier 51, North River. The Conners Marine Co., Inc., was
the owner of the barge, which the Pennsylvania Railroad Company had
chartered; the Grace Line, Inc., was the charterer of the tug, 'Carroll,'
of which the Carroll Towing Co., Inc., was the owner. . . .

The facts, as the judge found them, were as follows. On June 20,
1943, the Conners Company chartered the barge, 'Anna C.' to the
Pennsylvania Railroad Company at a stated hire per diem, by a charter
of the kind usual in the Harbor, which included the services of a
bargee, apparently limited to the hours 8 A.M. to 4 P.M. On January 2,
1944, the barge, which had lifted the cargo of flour, was made fast off
the end of Pier 58 on the Manhattan side of the North River, whence
she was later shifted to Pier 52. At some time not disclosed, five other
barges were moored outside her, extending into the river; her lines to
the pier were not then strengthened. At the end of the next pier north
(called the Public Pier), lay four barges; and a line had been made fast
from the outermost of these to the fourth barge of the tier hanging to
Pier 52. The purpose of this line is not entirely apparent, and in any
event it obstructed entrance into the slip between the two piers of
barges. The Grace Line, which had chartered the tug, 'Carroll,' sent
her down to the locus in quo to 'drill' out one of the barges which lay
at the end of the Public Pier; and in order to do so it was necessary to
throw off the line between the two tiers. On board the 'Carroll' at the
time were not only her master, but a 'harbormaster' employed by the
Grace Line. Before throwing off the line between the two tiers, the
'Carroll' nosed up against the outer barge of the tier lying off Pier 52,
ran a line from her own stem to the middle bit of that barge, and kept
working her engines 'slow ahead' against the ebb tide which was
making at that time. The captain of the 'Carroll' put a deckhand and
the 'harbormaster' on the barges, told them to throw off the line which
barred the entrance to the slip; but, before doing so, to make sure
that the tier on Pier 52 was safely moored, as there was a strong


                                   39
northerly wind blowing down the river. The 'harbormaster' and the
deckhand went aboard the barges and readjusted all the fasts to their
satisfaction, including those from the 'Anna C.' to the pier.
After doing so, they threw off the line between the two tiers and again
boarded the 'Carroll,' which backed away from the outside barge,
preparatory to 'drilling' out the barge she was after in the tier off the
Public Pier. She had only got about seventy-five feet away when the
tier off Pier 52 broke adrift because the fasts from the 'Anna C,' either
rendered, or carried away. The tide and wind carried down the six
barges, still holding together, until the 'Anna C' fetched up against a
tanker, lying on the north side of the pier below- Pier 51- whose
propeller broke a hole in her at or near her bottom. Shortly thereafter:
i.e., at about 2:15 P.M., she careened, dumped her cargo of flour and
sank. The tug, 'Grace,' owned by the Grace Line, and the 'Carroll,'
came to the help of the flotilla after it broke loose; and, as both had
syphon pumps on board, they could have kept the 'Anna C' afloat, had
they learned of her condition; but the bargee had left her on the
evening before, and nobody was on board to observe that she was
leaking. . . .

[The Court addressed the issue of whether the Connors Company, as
owner of the barge Anna C, was negligent in its management of the
vessel].

We cannot . . . excuse the Conners Company for the bargee's failure to
care for the barge . . . First as to the facts. As we have said, the
deckhand and the 'harbormaster' jointly undertook to pass upon the
'Anna C's' fasts to the pier; and even though we assume that the
bargee was responsible for his fasts after the other barges were added
outside, there is not the slightest ground for saying that the deckhand
and the 'harbormaster' would have paid any attention to any protest
which he might have made, had he been there. We do not therefore
attribute it as in any degree a fault of the 'Anna C' that the flotilla
broke adrift. Hence she may recover in full against the Carroll
Company and the Grace Line for any injury she suffered from the
contact with the tanker's propeller, which we shall speak of as the
'collision damages.' On the other hand, if the bargee had been on
board, and had done his duty to his employer, he would have gone
below at once, examined the injury, and called for help from the
'Carroll' and the Grace Line tug. Moreover, it is clear that these tugs
could have kept the barge afloat, until they had safely beached her,
and saved her cargo. This would have avoided what we shall call the
'sinking damages.' Thus, if it was a failure in the Conner Company's
proper care of its own barge, for the bargee to be absent, the


                                   40
company can recover only one third of the 'sinking' damages from the
Carroll Company and one third from the Grace Line. For this reason
the question arises whether a barge owner is slack in the care of his
barge if the bargee is absent.

As to the consequences of a bargee's absence from his barge there
have been a number of decisions; and we cannot agree that it it never
ground for liability even to other vessels who may be injured.

It appears from the foregoing review that there is no general rule to
determine when the absence of a bargee or other attendant will make
the owner of the barge liable for injuries to other vessels if she breaks
away from her moorings. However, in any cases where he would be so
liable for injuries to others obviously he must reduce his damages
proportionately, if the injury is to his own barge. It becomes apparent
why there can be no such general rule, when we consider the grounds
for such a liability. Since there are occasions when every vessel will
break from her moorings, and since, if she does, she becomes a
menace to those about her; the owner's duty, as in other similar
situations, to provide against resulting injuries is a function of three
variables: (1) The probability that she will break away; (2) the gravity
of the resulting injury, if she does; (3) the burden of adequate
precautions.

Possibly it serves to bring this notion into relief to state it in algebraic
terms: if the probability be called P; the injury, L; and the burden, B;
liability depends upon whether B is less than L multiplied by P: i.e.,
whether B less than PL. Applied to the situation at bar, the likelihood
that a barge will break from her fasts and the damage she will do, vary
with the place and time; for example, if a storm threatens, the danger
is greater; so it is, if she is in a crowded harbor where moored barges
are constantly being shifted about. On the other hand, the barge must
not be the bargee's prison, even though he lives aboard; he must go
ashore at times. We need not say whether, even in such crowded
waters as New York Harbor a bargee must be aboard at night at all; it
may be that the custom is otherwise, as Ward, J., supposed in 'The
Kathryn B. Guinan,' supra; [and that, if so, the situation is one where
custom should control. We leave that question open; but we hold that
it is not in all cases a sufficient answer to a bargee's absence without
excuse, during working hours, that he has properly made fast his
barge to a pier, when he leaves her. In the case at bar the bargee left
at five o'clock in the afternoon of January 3rd, and the flotilla broke
away at about two o'clock in the afternoon of the following day,
twenty-one hours afterwards. The bargee had been away all the time,


                                    41
and we hold that his fabricated story was affirmative evidence that he
had no excuse for his absence. At the locus in quo- especially during
the short January days and in the full tide of war activity- barges were
being constantly 'drilled' in and out. Certainly it was not beyond
reasonable expectation that, with the inevitable haste and bustle, the
work might not be done with adequate care. In such circumstances we
hold- and it is all that we do hold- that it was a fair requirement that
the Conners Company should have a bargee aboard (unless he had
some excuse for his absence), during the working hours of daylight.




                                   42
               IRA S. BUSHEY & SONS, INC.,
                            v.
                      UNITED STATES
                      398 F.2d 167 (2d Cir. 1968)


FRIENDLY, Circuit Judge:

While the United States Coast Guard vessel Tamaroa was being
overhauled in a floating drydock located in Brooklyn's Gowanus Canal,
a seaman returning from shore leave late at night, in the condition for
which seamen are famed, turned some wheels on the drydock wall. He
thus opened valves that controlled the flooding of the tanks on one
side of the drydock. Soon the ship listed, slid off the blocks and fell
against the wall. Parts of the drydock sank, and the ship partially did--
fortunately without loss of life or personal injury. The drydock owner
sought and was granted compensation by the District Court for the
Eastern District of New York in an amount to be determined, 276
F.Supp. 518; the United States appeals. . . .

The Tamaroa had gone into drydock on February 28, 1963; her keel
rested on blocks permitting her drive shaft to be removed and repairs
to be made to her hull. The contract between the Government and
Bushey provided in part:

“(o) The work shall, whenever practical, be performed in such manner
as not to interfere with the berthing and messing of personnel
attached to the vessel undergoing repair, and provision shall be made
so that personnel assigned shall have access to the vessel at all times,
it being understood that such personnel will not interfere with the work
or the contractor's workmen.”

Access from shore to ship was provided by a route past the security
guard at the gate, through the yard, up a ladder to the top of one
drydock wall and along the wall to a gangway leading to the fantail
deck, where men returning from leave reported at a quartermaster's
shack.

Seaman Lane, whose prior record was unblemished, returned from
shore leave a little after midnight on March 14. He had been drinking


                                   43
heavily; the quartermaster made mental note that he was 'loose.' For
reasons not apparent to us or very likely to Lane, he took it into his
head, while progressing along the gangway wall, to turn each of three
large wheels some twenty times; unhappily, as previously stated,
these wheels controlled the water intake valves. After boarding ship at
12:11 A.M., Lane mumbled to an off-duty seaman that he had 'turned
some valves' and also muttered something about 'valves' to another
who was standing the engineering watch. Neither did anything;
apparently Lane's condition was not such as to encourage proximity.
At 12:20 A.M. a crew member discovered water coming into the
drydock. By 12:30 A.M. the ship began to list, the alarm was sounded
and the crew were ordered ashore. Ten minutes later the vessel and
dock were listing over 20 degrees; in another ten minutes the ship slid
off the blocks and fell against the drydock wall. [Lane disappeared
after completing the sentence imposed by a courtmartial and being
discharged from the Coast Guard.]

The Government attacks imposition of liability on the ground that
Lane's acts were not within the scope of his employment. It relies
heavily on § 228(1) of the Restatement of Agency 2d which says that
'conduct of a servant is within the scope of employment if, but only if:
“* * * (c) it is actuated, at least in part by a purpose to serve the
master.' Courts have gone to considerable lengths to find such a
purpose, as witness a well-known opinion in which Judge Learned
Hand concluded that a drunken boatswain who routed the plaintiff out
of his bunk with a blow, saying 'Get up, you big son of a bitch, and
turn to,' and then continued to fight, might have thought he was
acting in the interest of the ship.

It would be going too far to find such a purpose here; while Lane's
return to the Tamaroa was to serve his employer, no one has
suggested how he could have thought turning the wheels to be, even
if-- which is by no means clear-- he was unaware of the consequences.
In light of the highly artificial way in which the motive test has been
applied, the district judge believed himself obliged to test the
doctrine's continuing vitality by referring to the larger purposes poses
respondeat superior is supposed to serve. He concluded that the old
formulation failed this test. We do not find his analysis so compelling,
however, as to constitute a sufficient basis in itself for discarding the
old doctrine. It is not at all clear, as the court below suggested, that
expansion of liability in the manner here suggested will lead to a more
efficient allocation of resources. As the most astute exponent of this
theory has emphasized, a more efficient allocation can only be
expected if there is some reason to believe that imposing a particular


                                   44
cost on the enterprise will lead it to consider whether steps should be
taken to prevent a recurrence of the accident. And the suggestion that
imposition of liability here will lead to more intensive screening of
employees rests on highly questionable premises. The unsatisfactory
quality of the allocation of resource rationale is especially striking on
the facts of this case. It could well be that application of the traditional
rule might induce drydock owners, prodded by their insurance
companies, to install locks on their valves to avoid similar incidents in
the future, while placing the burden on shipowners in much less likely
to lead to accident prevention. [The record reveals that most modern
drydocks have automatic locks to guard against unauthorized use of
valves.] It is true, of course, that in many cases the plaintiff will not be
in a position to insure, and so expansion of liability will, at the very
least, serve respondeat superior's loss spreading function. But the fact
that the defendant is better able to afford damages is not alone
sufficient to justify legal responsibility, and this overarching principle
must be taken into account in deciding whether to expand the reach of
respondeat superior.

[Although it is theoretically possible that shipowners would demand
that drydock owners take appropriate action, see Coase, The Problem
of Social Cost, 3 J.L. & Economics 1 (1960), this would seem unlikely
to occur in real life.]

A policy analysis thus is not sufficient to justify this proposed
expansion of vicarious liability. This is not surprising since respondeat
superior, even within its traditional limits, rests not so much on policy
grounds consistent with the governing principles of tort law as in a
deeply rooted sentiment that a business enterprise cannot justly
disclaim responsibility for accidents which may fairly be said to be
characteristic of its activities. It is in this light that the inadequacy of
the motive test becomes apparent. Whatever may have been the case
in the past, a doctrine that would create such drastically different
consequences for the actions of the drunken boatswain in Nelson and
those of the/drunken seaman here reflects a wholly unrealistic attitude
toward the risks characteristically attendant upon the operation of a
ship. We concur in the statement of Mr. Justice Rutledge in a case
involving violence injuring a fellow-worker, in this instance in the
context of workmen's compensation:

'Men do not discard their personal qualities when they go to work. Into
the job they carry their intelligence, skill, habits of care and rectitude.
Just as inevitably they take along also their tendencies to carelessness
and camaraderie, as well as emotional make-up. In bringing men


                                     45
together, work brings these qualities together, causes frictions
between them, creates occasions for lapses into carelessness, and for
fun-making and emotional flare-up. * * * These expressions of human
nature are incidents inseparable from working together. The involve
risks of injury and these risks are inherent in the working
environment.'

Put another way, Lane's conduct was not so 'unforeseeable' as to
make it unfair to charge the Government with responsibility. We agree
with a leading treatise that 'what is reasonably foreseeable in this
context (of respondeat superior) * * * is quite a different thing from
the foreseeably unreasonable risk of harm that spells negligence * * *.
The foresight that should impel the prudent man to take precautions is
not the same measure as that by which he should perceive the harm
likely to flow from his long-run activity in spite of all reasonable
precautions on his own part. The proper test here bears far more
resemblance to that which limits liability for workmen's compensation
than to the test for negligence. The employer should be held to expect
risks, to the public also, which arise 'out of and in the course of' his
employment of labor.' Here it was foreseeable that crew members
crossing the drydock might do damage, negligently or even
intentionally, such as pushing a Bushey employee or kicking property
into the water. Moreover, the proclivity of seamen to find solace for
solitude by copious resort to the bottle while ashore has been noted in
opinions too numerous to warrant citation. Once all this is granted, it
is immaterial that Lane's precise action was not to be foreseen.

One can readily think of cases that fall on the other side of the line. If
Lane had set fire to the bar where he had been imbibing or had caused
an accident on the street while returning to the drydock, the
Government would not be liable; the activities of the 'enterprise' do
not reach into areas where the servant does not create risks different
from those attendant on the activities of the community in general. We
agree with the district judge that if the seaman 'upon returning to the
drydock, recognized the Bushey security guard as his wife's lover and
shot him,' vicarious liability would not follow; the incident would have
related to the seaman's domestic life, not to his seafaring activity, and
it would have been the most unlikely happenstance that the
confrontation with the paramour occurred on a drydock rather than at
the traditional spot. Here Lane had come within the closed-off area
where his ship lay, to occupy a berth to which the Government insisted
he have access, and while his act is not readily explicable, at least it
was not shown to be due entirely to facets of his personal life. The risk
that seamen going and coming from the Tamaroa might cause damage


                                    46
to the drydock is enough to make it fair that the enterprise bear the
loss. It is not a fatal objection that the rule we lay down lacks sharp
contours; in the end, as Judge Andrews said in a related context, 'it is
all a question (of expediency,) * * * of fair judgment, always keeping
in mind the fact that we endeavor to make a rule in each case that will
be practical and in keeping with the general understanding of
mankind.'

Affirmed.




                                   47
         Law Enforcement Using Fines

                            PEREZ
                              v.
                   Z FRANK OLDSMOBILE, INC.
                      223 F.3d 617 (7th Cir. 2000)

EASTERBROOK, Circuit Judge.

This $8,000 dispute about a used car has led to an $800,000 judgment
against Z Frank Oldsmobile. Punitive damages exceeding $500,000
and attorneys' fees near $240,000 make up the bulk of the award.
These damages are at least an order of magnitude too high, and final
decision about attorneys' fees must abide the outcome on remand.

Jack Bowler bought a new car from Z Frank in 1993, trading in his
1990 Oldsmobile Cutlass Supreme. The odometer showed about
28,000 miles. Z Frank resold the car to Miguel Perez, who had asked
to buy a single-owner, low mileage auto. Perez drove the Oldsmobile
some 50,000 miles through 1997. When he offered it in trade to a
different dealer, however, he learned that the odometer was incorrect.
By tracing the chain of title back with the aid of state authorities, Perez
learned that he had been the car's eighth owner and that Moe Pour
(the fourth owner, doing business as Portage Auto Sales) had rolled
the odometer back roughly 70,000 miles.

Perez sued Z Frank and Pour under the Motor Vehicle Information and
Cost Savings Act of 1972. Section 32703 prohibits odometer
tampering. Z Frank did not violate § 32703, but § 32705(a) required it
either to disclose the Oldsmobile's true mileage or confess inability to
determine that mileage, and Z Frank did neither. Perez believes that Z
Frank should have figured out from General Motors' warranty records,
which maintenance workers accessed by computer, that a rollback had
occurred. This supported a claim under § 32710(a):
A person that violates this chapter or a regulation prescribed or order
issued under this chapter, with intent to defraud, is liable for 3 times
the actual damages or $1,500, whichever is greater.

Illinois has an essentially identical provision, adding that "[a]ny
recovery ... under this Section shall be offset by any recovery made



                                    48
pursuant to the federal Motor Vehicle Information and Cost [sic] Act of
1972."

Both federal and state statutes provide that violators must reimburse
prevailing plaintiffs' legal expenses. Perez also sought to recover
damages under state tort law.

Perez paid Z Frank $11,000 for the car. A jury's special verdict
establishes that the difference between fair market value of the car,
given its actual mileage, and the actual purchase price was $7,900.
The jury also assessed damages of $3,000 for repairs required by the
car's extra mileage, $10,000 for loss of use while the car was being
repaired, $3,600 for finance charges on the loan Perez took out to buy
the car, and $30,000 for "aggravation, humiliation, or inconvenience",
for total compensatory damages of $54,500. In post-judgment
motions the district judge chopped the compensatory award down to
$11,500, stating that the evidence did not establish that the difference
in mileage caused the losses of which Perez complains.

Perez appeals, contending that the jury's figure was justified, but we
think that any error runs in Perez's favor. The $7,900 difference
between the $11,000 market value of a car with 28,000 miles (as
Perez supposed) and the $3,100 value of a car with about 100,000
miles (the actual figure) reflects elements such as anticipated repair
costs and diminished use. That's why a high-mileage car sells for less
than a low-mileage car. To allow cumulative awards for the difference
in market value, and repairs, and loss of use, and "inconvenience," is
quadruple counting. Even if Z Frank sold Perez a hunk of scrap with no
engine and square wheels, the loss could not logically exceed the
purchase price less salvage value, for Perez could sell it to a junk yard
and buy a functioning car. As for the finance charge: a buyer's loss
does not depend on how much of the purchase price was borrowed or
how long it took to repay the loan. To evaluate economic loss
correctly, the court should add prejudgment interest on the
overpayment (here $7,900) from the time of sale, using the rate at
which the judgment debtor pays for capital. The buyer loses the use of
this money and should be compensated for its time value whether he
buys the car with cash or on credit. But Perez does not seek
prejudgment interest, and Z Frank does not contend that $11,500 is
too high, so we leave the compensatory damages as the district judge
set them.

In separate answers, the jury concluded that Z Frank misstated the
mileage "with the intent to defraud plaintiff" and that a punitive award


                                   49
is warranted. The jury assessed $550,000 in punitive damages against
Z Frank. The "intent to defraud" finding required trebling of the award
for the odometer rollback. The judge deducted the entire treble-
damages award of $34,500 from the punitive award, cutting it to
$515,500. Thus the total judgment against Z Frank after all post-trial
motions was $550,000: $11,500 in compensatory damages, $23,000
(double this) to achieve trebling under the odometer statutes, and
$515,500 in punitive damages.

Because Z Frank does not contest the jury's conclusion that it
misstated the mileage "with the intent to defraud", we need not
pursue the question whether any person (or the corporate entity)
acted with that mental state. Frauds often escape detection, and the
need to augment deterrence of concealable offenses is a principal
justification of punitive damages.

Although a damages multiplier of some kind is in order, what is the
right multiple? Optimal deterrence is achieved when damages equal
the harm done by the wrong, divided by the probability of detecting
the injury and prosecuting the claim. This is an application of Gary S.
Becker, Crime and Punishment: An Economic Approach, 76 J. Pol.
Econ. 169 (1968), a theory of sanctions that played a role in his
receipt of a Nobel Prize in 1992. For example, if a wrong causes
$5,000 injury and is redressed one time in five, the optimal damages
are $25,000. That redresses the injury to victims as a whole, and the
injurer then can decide what precautions are appropriate. (A firm such
as Z Frank must work out, for example, how much to spend
investigating the history of the used cars it receives and coordinating
the operations of its sales and maintenance staffs.)

The punitive award even as reduced by the judge is 45 times
compensatory damages (and 65 times the difference in market price,
the best measure of both the customer's loss and the dealer's gain).
Are odometer rollbacks detected that infrequently? When it is so hard
to be certain, it is appropriate to rely on rules of thumb. Both the state
and federal odometer statutes supply such a rule: treble damages.
Both say that the wrongdoer "is liable for 3 times the actual damages
or $1,500, whichever is greater." They do not say something like "3
times the actual damages, or $1,500, or any other multiplier the jury
prefers, whichever is greatest."

When a federal statute provides for treble damages (or some other
multiplier), judges regularly conclude that punitive damages may not
be added. Congress has specified the multiplier, which judges and


                                    50
juries alike must respect. Indeed, no case of which we are aware holds
that, when Congress specifies a damages multiplier, the jury may
select a different and higher multiplier by awarding punitive damages
under federal law.

When denying Z Frank's motion to reduce the punitive award, the
district judge wrote that "odometer roll backs are a nationwide
problem [that] needs to be deterred. Both the state of Illinois and the
United States have seen fit to enact statutes to deal with this problem.
An award of punitive damages such as the one awarded by the jury in
this case will not fall on deaf ears. Automobile agencies who would not
be scared off by a small award of compensatory damages, even if the
award is trebled, will undoubtedly be scared off by this award of over
one-half million dollars." Indeed they will be "scared off" by awards 40
or more times the loss (and, in this case, 65 times the profit from the
wrong). They may be scared right out of the used-car business.
Excessive awards tend to discourage participation in the underlying
economic activity, for some level of error by employees is a risk of
doing business.

Auto dealers also would be terrified by the prospect of a judge
ordering the Army to drive an M1-A1 main battle tank through their
showrooms, flattening their inventory. High penalties deter more, but
this is not to say that higher always is better. One problem with an
excessive penalty is that it attracts too many enforcers, who pursue
private riches. This concern has led to proposals to decouple damages
from recovery, so that the defendant pays more than the plaintiff
receives, with the difference going to the public fisc. Section 32710
does not take that approach, however, nor does it say that more is
always better. Congress decided that the right penalty is trebling, with
a minimum of $1,500 to ensure some sting even when the harm is
slight. The district judge, like the jury, obviously believed this
inadequate. But disagreement with an Act of Congress is not a good
reason to amerce a defendant.

Adequacy of deterrence cannot be evaluated by limiting attention to
private awards. Section 32709 authorizes both civil suits and criminal
prosecutions by the United States, plus civil suits by states. Section
32709(a) is particularly telling. It permits the United States to enforce
the odometer-tampering rules by civil suits for damages and
prescribes "a civil penalty of not more than $2,000 for each violation.
A separate violation occurs for each motor vehicle or device involved in
the violation. The maximum penalty under this subsection for a related
series of violations is $100,000." Rolling back the odometer (or lying


                                   51
about the mileage) on one car can support no more than a $2,000
penalty; for 25 cars the penalty is $50,000 at most; and the maximum
penalty for more than 50 cars is $100,000. What sense could it make
to have a statutory cap of $100,000 on the civil penalty for 50 or more
violations yet allow a jury to impose a $550,000 penalty for a single
violation? Punitive damages are a form of civil penalty, going to a
victim rather than the public but serving the same function. Section
32709 demonstrates that for violations of this statute the sky is not
the limit. A victim is entitled to treble damages, and the maximum civil
penalty on top of trebling is $2,000 per car, plus criminal penalties
under § 32709(b) for really severe infractions.

Even criminal sentencing, once the subject of unbridled discretion by
district judges, is now controlled by principles of proportionality. If the
United States had prosecuted Z Frank Oldsmobile, Inc., for what it did
to Perez, the maximum penalty would have been a fine of $11,500.
See U.S.S.G. § 2N3.1(a) (setting an offense level of 6 for a single
odometer violation), § 8C2.4(d) (fine of $5,000 for a level 6 offense by
an organization, though an increase to the victim's actual loss is
authorized by § 8C2.4(a)(3)). Federal judges may, and should, insist
that the award be sensible and justified by a sound theory of
deterrence. Random and freakish punitive awards have no place in
federal court, and intellectual discipline should be maintained. If the
award is well justified, then it is also constitutionally sound . . . .

REVERSED AND REMANDED




                                    52
                              CIRAOLO
                                 v.
                         CITY OF NEW YORK

                      216 F.3d 236 (2d. Cir. 2000)


CALABRESI, Circuit Judge:

After a jury trial in the United States District Court for the Southern
District of New York, plaintiff-appellee Debra Ciraolo was awarded
$19,645 in compensatory damages and $5,000,000 in punitive
damages against defendant-appellant the City of New York (the
"City"), in her suit for, inter alia, an unlawful strip search of her
person. The City now appeals the award of punitive damages, and, for
the following reasons, we reverse.

I

In January 1997, following a complaint by her neighbor, with whom
she was apparently having a legal dispute, Debra Ciraolo was arrested
for aggravated harassment in the second degree, a misdemeanor.
Ciraolo was taken to the police station and then to Central Booking,
where she was subjected to a strip and body cavity search by two
female Corrections Department employees. Ciraolo was ordered to
strip naked and made to bend down and cough while she was visually
inspected. After spending the night in jail, she was released on her
own recognizance; the charges against her were subsequently
dismissed. Ciraolo was traumatized by the entire experience, and
particularly by the humiliation of the strip search. Diagnosed with
post-traumatic stress disorder, she entered therapy and began taking
antidepressants.

The search of Ciraolo was not an isolated incident. Rather, it was in
accordance with an established City policy of strip-searching all
arrestees, including misdemeanants, whether or not there was
reasonable suspicion that the arrestee possessed contraband. In July
1996, the City's Correction Department had adopted "guidelines [for]
the acceptance of all Police Cases for the Manhattan Court Division,"
providing that "[a]ll police prisoners received shall be strip search[ed]
by the officer assigned to the search post." In October 1996, the
Executive Officer of the Manhattan Detention Complex implemented



                                    53
the guidelines by sending a memo to all personnel ordering that,
"[e]ffective immediately, all female police prisoners arriving at this
facility ... be strip searched." Accordingly, when Ciraolo was arrested
in early 1997, she was strip-searched as a matter of course, despite
the conceded lack of any reasonable suspicion for the intrusive and
demeaning search.

Ciraolo brought suit against the City, the police department, and the
individual police officers involved in her arrest and search, claiming
that she had been falsely arrested, that the police had employed
excessive force during the arrest, and that her strip search violated the
Fourth Amendment. She also alleged battery, in violation of state law.
The district court found that the City's policy of strip-searching all
arrestees regardless of the existence of reasonable suspicion violated
the Fourth Amendment, in contravention of the clearly established law
of this Circuit that "the Fourth Amendment precludes prison officials
from performing strip/body cavity searches of arrestees charged with
misdemeanors or other minor offenses unless the officials have a
reasonable suspicion that the arrestee is concealing weapons or other
contraband."

Because the parties had stipulated to the existence of the City's policy
of strip-searching all arrestees, and because there was no evidence
that Ciraolo was believed to be concealing contraband, the court
instructed the jury that the City was liable for any injuries the jury
found to have been proximately caused by the strip search.
After soliciting letter briefs from the parties on the issue of punitive
damages, the district court concluded that, in this case, punitive
damages were available against the City because the strip search was
pursuant to an official City policy that was contrary to the settled law
of the Circuit. Accordingly, over the City's objection, the court charged
the jury that punitive damages could be awarded against the City if
they found that the City had acted maliciously or wantonly. In doing
so, the court told the jury to consider whether compensatory damages
would be adequate to punish the City and to deter future unlawful
conduct.

The jury found in favor of the defendants on Ciraolo's claims of
unlawful arrest, excessive force, and battery. It concluded, however,
that the City had acted in wanton disregard of Ciraolo's rights when
she was strip-searched, and awarded her $5,000,000 in punitive
damages, as well as $19,645 in compensatory damages.

II


                                   54
On appeal, the City does not contest the district court's holding that
the strip-search policy was clearly unconstitutional. Nor does it
challenge the award of compensatory damages to Ciraolo. Rather, it
contests only the award of punitive damages, arguing that the award
was foreclosed by the Supreme Court's decision in City of Newport v.
Fact Concerts, Inc., 453 U.S. 247, 101 S.Ct. 2748, 69 L.Ed.2d 616
(1981), which held that, ordinarily, municipalities are immune from
punitive damages. In her turn, Ciraolo argues that Newport, in a
footnote, permitted municipalities to be charged punitive damages in
cases where "the taxpayers are directly responsible for perpetrating an
outrageous abuse of constitutional rights," and that her case falls
within this exception. We are, of course, bound by Newport. And we
believe that the only fair reading of that decision, and of the footnote
on which Ciraolo relies, mandates a conclusion that punitive damages
are not available to her.

In Newport, a musical concert promoter, Fact Concerts, Inc., brought
suit against the City of Newport, Rhode Island, for a violation of its
First Amendment rights. Fact Concerts had entered into a contract
with Newport to present a jazz festival. Shortly before the festival,
Fact Concerts hired the group Blood, Sweat and Tears to replace an
act that had dropped out. Under the impression that Blood, Sweat and
Tears was a "rock" group and that it might attract "a rowdy and
undesirable audience," id., Newport tried to prevent the group from
performing; eventually, the City Council voted to cancel the contract, a
decision reported in the local media. Although Fact Concerts obtained
an injunction from a state court allowing the festival to proceed, ticket
sales were off substantially due to the adverse publicity. At trial, Fact
Concerts won $200,000 in punitive damages against Newport, as well
as other damages against the individual officials.

The Supreme Court reversed the award of punitive damages. In doing
so, the Court applied "a two-part approach". It considered, first, the
extent of municipal immunity at common law and the legislative
history r, and, second, the policies behind punitive damages and their
compatibility with the [statute’s] purpose. . . .

The Court then turned to the question whether the two major policy
arguments for punitive damages--deterrence and retribution--would be
advanced by assessing punitive damages against cities. It concluded
that punitive damages against cities were not justified by a policy of
deterrence because (1) it was unclear that municipal officials would be
deterred by the prospect of damages borne by the taxpayers; (2)
voters would, nonetheless, be likely to vote wrongdoing officials out of


                                   55
office absent punitive damages, both because they had done wrong
and because of the possibility of compensatory damages; (3) punitive
damages assessed directly against the offending officials would be a
more effective means of deterrence; and (4) punitive damages could
"create a serious risk to the financial integrity" of cities.

Nor, the Court opined, was the goal of retribution furthered by punitive
damages, since such damages would punish only the innocent
taxpayers. "[P]unitive damages imposed on a municipality are in effect
a windfall to a fully compensated plaintiff, and are likely accompanied
by an increase in taxes or a reduction of public services for the citizens
footing the bill. Neither reason nor justice suggests that such
retribution should be visited upon the shoulders of blameless or
unknowing taxpayers." IAccordingly, the Court held that "a
municipality is immune from punitive damages.”

The Court did, however, indicate that in some rare cases, the goal of
retribution might be furthered by punitive damages against a
municipality. In a footnote, the majority mused, "It is perhaps possible
to imagine an extreme situation where the taxpayers are directly
responsible for perpetrating an outrageous abuse of constitutional
rights. Nothing of that kind is presented by this case. Moreover, such
an occurrence is sufficiently unlikely that we need not anticipate it
here."

Ciraolo relies on [this] footnote for her claim that punitive damages
are warranted in her case. She reads the footnote as creating an
"outrageous abuse" exception to the general municipal immunity
established by Newport, and contends that the City's strip-search
policy is sufficiently outrageous to fall within that exception. We
believe that Ciraolo misapprehends the footnote.

Footnote 29 must be read as part of the Court's discussion of the
retributive function of punitive damages. As such, it elaborates on the
Court's conclusion that it is unjust to punish the taxpayers for tortious
conduct by municipal officials, because the taxpayers are not normally
directly responsible for that conduct. The footnote suggests that, in the
rare case where the taxpayers are directly responsible for an
outrageous violation of a plaintiff's constitutional rights, it may well be
just for the taxpayers to bear the burden of punitive damages. To the
extent that footnote 29 creates an exception to Newport 's general rule
against punitive damages, therefore, it is not an exception for
particularly outrageous abuses, as Ciraolo would have it, but rather an



                                    56
exception for outrageous abuses for which the taxpayers are directly
responsible.

The footnote does not tell us when, in the Court's judgment, taxpayers
could be held to be directly responsible for a municipal policy.
Although it could be argued that, to the extent that they are also
voters who play a part in choosing municipal officials, taxpayers are
always responsible for municipal policies, such responsibility is clearly
too indirect to give rise to liability for punitive damages under the logic
of Newport. Footnote 29 seems, instead, to contemplate a much more
immediate connection between the taxpayers' behavior and the
unconstitutional municipal policy, perhaps--for example--as close a
link as a referendum in which the taxpayers directly adopted the
invalid policy.

We are, moreover, aware of no case in which a court of appeals has
upheld an award of punitive damages against a municipality premised
on footnote 29. . . .

We are inclined . . . to the view that any exception envisioned in
footnote 29 must be an exception for cases in which the taxpayers are
directly responsible--in their role as voters--for the adoption of an
unconstitutional municipal policy, rather than an exception for
especially outrageous abuses of constitutional rights. If, for example, a
town adopted, by a unanimous vote, a referendum establishing an
unconstitutional rule, we can see no reason in the policies discussed in
Newport why punitive damages ought not to be awarded. But such a
case is not before us today. (And so nothing we here say about the
applicability of footnote 29 to a referendum can be binding on any
future court presented with the question.) Rather, we are here faced
with the much more common situation in which an unconstitutional
policy has been adopted by municipal officials without any clear
endorsement of the policy by the electorate. In such circumstances,
while we emphatically deplore the City's conduct in adopting a policy
that this Circuit had earlier clearly held unconstitutional, the taxpayers
themselves cannot be held to be responsible for the policy under the
reasoning of Newport.

The district court, while not relying explicitly on footnote 29, concluded
that Newport did not preclude the award of punitive damages to
Ciraolo because the Newport cause of action stemmed from one
improper action by Newport officials, while in Ciraolo's case the City
had adopted a policy contrary to the clearly established law of this
Circuit. We sympathize with the district court's desire to allow the jury


                                    57
to award punitive damages in this case. Like it, we are seriously
troubled by the City's adoption of a policy we had previously held to be
unconstitutional. Nevertheless, we conclude that the district court
misread Newport, and that the distinction drawn by the court has little
force in this context.

Municipal liability occurs, if at all, at the level of policy-making, and
cannot be premised on a theory of respondeat superior. As a result,
the fact that Ciraolo's strip search occurred because of an established
City policy in no way distinguishes her case from other cases in which
municipal liability is established, and cannot suffice to place this case
within the seemingly narrow exception carved out by footnote 29.
Accordingly, and despite what might be the salutary effects of punitive
damages in a case such as this, we are constrained by the Supreme
Court's holding in Newport to reverse the award of punitive damages.

The award of punitive damages against the City is REVERSED and the
case is REMANDED to the district court for entry of judgment in
accordance with this opinion.

CALABRESI, Circuit Judge, concurring:

Although the result the court reaches today is compelled by Supreme
Court precedent, I respectfully suggest that the policies behind
punitive damages and the purpose of § 1983 would be better furthered
by a different outcome. I write separately to explain why I believe this
to be so.

I

The purpose of [the statute] is "not only to provide compensation to
the victims of past abuses, but to serve as a deterrent against future
constitutional deprivations, as well." Indeed, the Court in Newport
recognized that punitive damages serve the dual purpose of
deterrence and retribution. Nevertheless, and as discussed above, the
Court concluded that "the deterrence rationale does not justify making
punitive damages available against municipalities," because (1) it was
unclear that municipal officials would be deterred by the prospect of
damages borne by the taxpayers; (2) voters would still be likely to
vote wrongdoing officials out of office absent punitive damages, both
because they had done wrong and because of the possibility of
compensatory damages; (3) punitive damages assessed directly
against the offending officials would be a more effective means of



                                   58
deterrence; and (4) punitive damages could "create a serious risk to
the financial integrity" of cities.

The Court's analysis, however, neglected at least one aspect of the
deterrence function of punitive damages--an aspect underscored by
this case. Punitive damages can ensure that a wrongdoer bears all the
costs of its actions, and is thus appropriately deterred from causing
harm, in those categories of cases in which compensatory damages
alone result in systematic underassessment of costs, and hence in
systematic underdeterrence.

It is easy to show why this is so. A rational actor will undertake an
activity when the benefits of doing so exceed the costs. [A municipality
is unlikely always to act rationally. Nevertheless, it is fair to assume
that its behavior will be influenced by the extent to which it is made to
bear the costs associated with its behavior.] In doing so, it will make
some sort of formal or informal, spoken or unspoken, cost-benefit
analysis, based on the information it possesses, to determine if a
particular activity is worth its price. Such an analysis cannot be even
roughly accurate unless approximately all the costs of the activity are
borne by the actor. When the perceived benefits of an activity accrue
to the actor, but some significant part of the costs is borne by others,
the cost-benefit analysis will necessarily be distorted. In such a case,
the actor will have an incentive to undertake activities whose social
costs exceed their social benefits. In other words, the actor will not be
adequately deterred from undesirable activities. And society will suffer.


These basic principles of the economic theory of deterrence are widely
accepted, and have been applied to both tort and criminal law. See
generally, e.g., Gary S. Becker, Crime and Punishment: An Economic
Approach, 76 J. Pol. Econ. 169 (1968); see also Guido Calabresi, The
Costs of Accidents (1970); A. Mitchell Polinsky & Steven Shavell,
Punitive Damages: An Economic Analysis, 111 Harv. L.Rev. 870
(1998).

One goal of the tort system, therefore, is to ensure that actors bear
the costs of their activities. See, e.g., Calabresi, supra note 4. And
that is also a goal of the civil rights laws, which, as the Supreme Court
has noted, was designed to deter constitutional torts by making the
tortfeasors liable in damages to their victims.

In some circumstances, compensatory damages alone will be enough
to promote an adequate cost-benefit analysis. In other cases,


                                   59
however, compensatory damages will not come close to equaling all
the costs properly attributable to the activity. Costs may not be
sufficiently reflected in compensatory damages for several reasons,
most of which go to the fact that not all injured parties are in fact
compensated by the responsible injurer. For example, a victim may
not realize that she has been harmed by a particular actor's conduct,
or may not be able to identify the person or entity who has injured
her.

Where the injurer makes active efforts to conceal the harm, this
problem is of course exacerbated. Moreover, even if a victim is aware
of her injury and is able to identify its cause, she may not bring suit. A
person will be unlikely to sue if the costs of doing so--including the
time, effort, and stress associated with bringing a lawsuit-- outweigh
the compensation she can expect to receive. A victim is especially
unlikely to sue, therefore, in cases where the probable compensatory
damages are relatively low. As a result, a harm that affects many
people, but each only to a limited degree, will generally be given
inadequate weight if only compensatory damages are assessed.
In addition, some victims will not sue even if the damages they could
expect to receive would exceed the costs of suing. Victims will differ
greatly in their knowledge of and access to the legal process, and
those who are relatively poor and unsophisticated, as a practical
matter, are frequently unable to bring suit to redress their injuries
even if those injuries are grave. A harm that disproportionately affects
such victims, therefore, is also particularly likely not to be accurately
reflected in compensatory damages.

For these and other like reasons, compensatory damages are, in wide
categories of cases, an inaccurate measure of the true harm caused by
an activity, and, as a result, making an injurer bear only such
damages does not provide adequate deterrence against socially
harmful acts. In such circumstances, additional damages, assessed in
the cases that are brought, may be an appropriate way of making the
injurer bear all the costs associated with its activities.

This idea is far from new. Many years ago, in an influential article that
was in part responsible for his receipt of the Nobel Memorial Prize in
economics, Professor Becker pointed out that charging a thief the cost
of what he had stolen would not adequately deter theft unless the thief
was caught every time. Since thieves will not always be caught, they
must be penalized by more than the cost of the items stolen on the
occasions on which they are caught. This "multiplier" is essential to
render theft unprofitable and properly to deter it. See Becker, supra


                                    60
note 4. More recently, scholars have recognized that punitive damages
can serve the same function in tort law. See, e.g., Thomas C. Galligan,
Jr., Augmented Awards: The Efficient Evolution of Punitive Damages,
51 La. L.Rev. 3 (1990); Polinsky & Shavell, supra note 4.

Professors Polinsky and Shavell, for example, have argued that
punitive damages should be assessed whenever a tortfeasor has a
significant likelihood of escaping liability, and have even suggested a
formula (simpler to state than to apply) for calculating such damages:
total damages should equal the amount of loss in a particular case,
multiplied by the inverse of the probability that the injurer will be
found liable. Thus, if the injurer causes harm of $10,000, but will be
found liable only one-fifth of the time, total damages--according to
Polinsky and Shavell--should equal $50,000 ($10,000 in compensatory
damages and $40,000 in punitive damages). Use of such a multiplier,
they argue, will cause damages to equal the total harm caused, forcing
the injurer to take into account all the costs of its activity and thus
decreasing the likelihood that socially harmful activities will persist.


[It is possible that, in some circumstances, use of a multiplier formula
might overdeter socially useful conduct. Litigation costs borne by the
defendant themselves have a deterrent effect that may not be taken
into account by a simple multiplier formula. And, although in a legal
system that works efficiently, litigation costs would generally be a part
of the social cost attributable to the harm caused by the defendant,
unnecessary costs of administering such a system may properly be
viewed as beyond the actual harm caused. Where a defendant is
forced to bear such excess administrative costs, the multiplier formula
might overdeter. Despite such failings, however, it seems likely that,
in many instances, use of a multiplier will produce more accurate cost
allocation than currently occurs.]

Such a conception of punitive damages, again, is not new, and it has
been recognized by courts as well as scholars. Indeed, the Supreme
Court, considering punitive damages in a quite different context from
that in Newport, acknowledged that in determining such punitive
damages, it is proper to consider the extent to which the tortfeasor
might otherwise escape liability. . . .

Although widely accepted by economists and acknowledged by some
courts, the multiplier function of punitive damages has nonetheless
been applied haphazardly at best. One reason this is so is that the twin
goals of deterrence and retribution are often conflated, rather than


                                   61
recognized as analytically distinct objectives. The term "punitive
damages" itself contributes greatly to the confusion. For punitive
damages, the term traditionally used for damages beyond what is
needed to compensate the individual plaintiff, improperly emphasizes
the retributive function of such extracompensatory damages at the
expense of their multiplier-deterrent function. It also fails totally to
explain the not unusual use of such damages in situations in which the
injurer, though liable, was not intentionally or wantonly wrongful. A
more appropriate name for extracompensatory damages assessed in
order to avoid underdeterrence might be "socially compensatory
damages." For, while traditional compensatory damages are assessed
to make the individual victim whole, socially compensatory damages
are, in a sense, designed to make society whole by seeking to ensure
that all of the costs of harmful acts are placed on the liable actor.

Indeed, it would not be inappropriate to disaggregate the retributive
and deterrent functions of extracompensatory damages altogether and
allow separate awards to further the two separate goals. In such a
system, socially compensatory damages might be permitted in cases
in which all the costs of a defendant's actions were not before the
court, whether or not the defendant's conduct was particularly
blameworthy.2 But a separate award of punitive damages would be
allowed only in cases where the defendant's conduct was sufficiently
reprehensible to deserve punishment apart from whatever assessment
was required to compensate the individual victim or society as a
whole.3

2
         In order to award such socially compensatory damages, the jury would have
to calculate the probability that the defendant would otherwise evade full liability for
its act. Such a calculation would rarely be precise. A rough estimate, however, would
not be more unlikely than many other estimates that courts currently ask juries to
make. Thus, juries are routinely required to estimate the monetary value of a
plaintiff's pain and suffering, or of the loss sustained by a family as a result of a
wrongful death, a sum that "defies any precise mathematical computation." The
dangers that might attach to letting fact-finders assess socially compensatory
damages could be mitigated by permitting closer judicial control over these damages
and by placing the burden on the party seeking such damages to introduce evidence
as to the likelihood of escaping liability--for example, proof that the defendant has
tried to conceal its act, or evidence of the number of times a particular wrongful act
has occurred and the number of lawsuits brought against the defendant. The case
before us shows that, at least in some circumstances, it will be readily possible to
ascertain how often a particular violation has taken place. Here, records were kept
that allowed the City to estimate that about 65,000 arrestees were subjected to the
strip-search policy.
3
      One could argue that allowing both socially compensatory and punitive
awards runs the risk of overdeterrence. But, once the goals of social compensation


                                           62
Of course, to the extent that punitive awards were permitted in order
to further this quasi-criminal function, it would be appropriate to
reconsider the procedural protections that should attach before such
an award can be made. Indeed, one disadvantage of the current
system, which conflates punitive and social deterrence goals, is that
what are actually punitive damages rather than socially compensatory
damages can be awarded without adequate procedural safeguards and
imposed on defendants who are not intentionally wrongful.

The majority in Newport raised the objection that "punitive damages
... are in effect a windfall to a fully compensated plaintiff." It is likely
that a feeling that such "windfalls" are not warranted--and are
distributed arbitrarily among plaintiffs--lies, and properly so, behind
much of the current distaste for punitive damages. Of course, socially
compensatory damages will have an equivalent deterrent effect on the
injurer no matter whom they are paid to. As one commentator put it,
"[a]n efficient windfall is still efficient." Nevertheless, the existence of
such potential windfalls may well induce undesirable behavior on the
part of victims and of their lawyers. And there is no good reason why
socially compensatory damages should be paid to the individual
plaintiff, at least beyond a relatively small part sufficient to induce the
victim to undertake the expense of pleading and proving them.
In fact, in order to achieve the goal of social compensation, as well as
the goal of optimal deterrence, it would be preferable if such damages
were paid into a fund that could then be applied to remedy some of
the unredressed social harm stemming from the defendant's conduct.
And some states have explicitly recognized this socially compensatory
function by mandating that at least a portion of punitive damages
awards should go not to the plaintiff, but to the state treasury or to a
specified fund. A similar mechanism could be employed in the case of
socially compensatory damages assessed against municipalities.4

and punishment are disaggregated, allowing a separate award of punitive damages
could represent a societal judgment that, for certain conduct, a cost-benefit analysis
is inappropriate. That might be the case, for example, if the "benefit" resulting from
the defendant's conduct is socially illicit--perhaps because it consists of pleasure in
the victim's pain. This function of punitive damages renders them analogous to
criminal penalties that seek not to achieve a socially optimal level of activity, but to
discourage or even eliminate a particular activity altogether. See Becker, supra note
4, at 191.
4
        In the case of constitutional torts by municipalities, socially compensatory
damages could appropriately be paid into a federally administered fund. In other
suits against municipalities, however, it would not make much sense to require that
the extracompensatory damages be placed into the general state treasury. For the
deterrence function would then be diluted, since some of the monies would likely


                                           63
II

As Judge Posner suggested in Kemezy, socially compensatory
damages are anything but foreign to the goals of § 1983. And the
rationale for socially compensatory damages in the case of an
individual defendant holds equally true where the defendant is a
municipality. Indeed, the case before us shows especially vividly the
possible utility of such socially compensatory damages. Here, the City
of New York adopted a strip-search policy that it knew or clearly
should have known was unconstitutional. Counsel for the City
estimated at trial that about 65,000 people arrested for misdemeanors
had been subjected to strip searches under the policy. Under ordinary
circumstances, very few of those 65,000 victims would have been
likely to sue, both because the compensatory damages they would
have received would have been relatively low and because they were
no doubt, in the main, relatively poor and unsophisticated.

As one scholar has noted:

“[T]he conditions of constitutional tort litigation for harm caused by
law enforcement officials are ones in which the deterrent effect is likely
to be on the low side. The potential plaintiffs, after all, are individuals
who are in contact with the criminal justice system, generally as
suspects or defendants. Many are unlikely to bring suit for harm
suffered, whether because of ignorance of their rights, poverty, fear of
police reprisals, or the burdens of incarceration. Moreover, in many
cases the harm suffered by individuals from the constitutional violation
itself may be small, widely dispersed, and intangible, providing little


return to the city. Rather, in order to preserve the desired deterrent effect, the
damages would more properly be paid to a specific fund whose purpose, at least in
theory, would be to attenuate the harm borne by those victims who did not receive
compensatory damages. Thus, in cases of environmental damage, the fund might
serve environmental purposes, and in auto injury cases, road safety. Such a fund
might also be used to compensate victims whose damages had already been
assessed to the defendant as a result of the multiplier and who, nevertheless,
successfully sued later.

In establishing and controlling the use of such "limited purpose" funds, one should
keep in mind the possible undesirability of having a significant part of general
government revenues derive not from taxation, but from tort judgments. This
problem is not, however, limited to or even primarily connected with awards of
extracompensatory damages. t therefore must be addressed, if at all, at a more
general level.


                                         64
incentive for potential plaintiffs to sue, especially given the lack of
sympathy that this group of plaintiffs can expect from the trier of fact.”

In such circumstances--which are epitomized in the case before us--
socially compensatory damages may well be necessary if, consistent
with the goals of the statute, constitutional violations are to be
deterred adequately.

Socially compensatory damages are, of course, not the only possible
means of deterrence in such situations. Two other approaches come
readily to mind. Neither, however, is likely to suffice to achieve the
purposes of the statute.

First, one might think that an injunction, and the possibility of
contempt sanctions for flouting it, would deter municipalities from
engaging in repeated constitutional violations. Standing doctrine,
however, generally precludes a plaintiff from obtaining injunctive relief
unless she can demonstrate that she is likely to be subjected to the
same conduct in the future, a showing that can be very difficult to
make.

Second, it is possible that where many people suffer a relatively small
harm, they could bring a class action and obtain damages that would
approximate the total harm caused by the constitutional violation.
And, in fact, a class action has been brought against the City by the
victims of the strip-search policy. But class actions have their own
limitations. For one thing, there are many situations in which the
likelihood of escaping liability stems not from the high number of
victims of an unconstitutional wrong, but from the municipal
defendant's attempts to conceal that wrong. It may be, therefore, that
a municipal defendant has a significant chance of escaping liability and
yet the number of potential plaintiffs is not great enough to satisfy the
[class action rule]. Moreover, use of the class mechanism can result in
compromising plaintiffs' autonomy and ignoring conflicts among class
members. Finally, like individual plaintiffs, class-action plaintiffs face
costs that might dissuade them from bringing suit, including the added
cost of managing the class, and these may well offset the economies
of scale achieved through a class action. All in all, there is little reason
to think that class actions can, or should, be the sole or even the
principal vehicle for dealing with underdeterrence.

Once it is recognized that remedying underdeterrence is an
appropriate function of extracompensatory damages against a
municipality, and that it is a goal that can be separated from


                                     65
punishment, Newport 's objections to punitive damages . . . lose
much of their force.

First, the kind of socially compensatory damages I have been
discussing would not punish "blameless or unknowing taxpayers," for
they would not be punishment at all. Second, if deterrence is viewed
not as an incidental byproduct of punishment, but as deriving instead
from the placement of the relevant costs of a city policy on the city in
order to encourage a more rational decisionmaking process, Newport
's arguments that extracompensatory damages would not be likely to
deter cities also fall. Thus, the Newport Court contended that it was
unclear that municipal officials would be deterred by the prospect of
damages borne by the taxpayers. But an analogous argument was
long ago refuted with respect to corporations and to not-for-profit
institutions. It is no more valid for governmental ones. Assuming that
a city is at least minimally rational in its decisionmaking, it will be
better able to assess the relative social costs and benefits of a
particular municipal policy if it knows that it will bear all, rather than
only some, of the costs of that policy. Both a city's power to tax and
its officials' ability to stay in office are limited by political
considerations, and when taxpayers must pay more and get less in
return they--like charitable donors or buyers of goods--will make their
displeasure known.

Second, the Court argued that voters would be likely to vote
wrongdoing officials out of office even absent punitive damages, both
because the officials had done wrong and because of the possibility of
compensatory damages. But, again, damages that are equal to the
harm caused by a particular municipal policy would presumably
encourage voters to call their elected representatives to account more
often than would damages that by definition represent only a small
fraction of that harm.

Third, the Court contended that punitive damages assessed directly
against the offending officials would be a more effective means of
deterrence. But, in the case of a municipal policy for which no one
official is primarily responsible, damages premised on individual guilt
are unlikely to be efficacious.

Fourth, and finally, the Newport majority evinced concern that punitive
damages could "create a serious risk to the financial integrity" of
cities, in part because "the unlimited taxing power of a municipality
may have a prejudicial impact on the jury, in effect encouraging it to
impose a sizable award." I am not insensitive to the possibility that a


                                    66
very large award of damages could affect a city's finances. And it is for
that very reason--contrary to the Newport Court's first argument--that
socially compensatory damages would be likely to prove an effective
deterrent. Nevertheless, I emphasize that, in assessing the kind of
damages that I have been discussing (in contrast to traditional
punitive damages), it would not be proper for a trier of fact to take the
city's taxing power into account. The basis for socially compensatory
damages is the multiplier effect, that is, the probability that the city
would otherwise escape liability for damages it actually caused, and
not the depth of its pockets. And this basis should be strictly enforced
by the court in reviewing damage awards.

Because the Court in Newport focused on the difficulty with furthering
the retributive goals of punitive damages in the case of a municipality,
and envisioned deterrence as an ancillary consequence of retribution,
it did not examine the possibility that socially compensatory, as
opposed to traditional punitive, damages might comport both with
Congress's original intent and with the policies behind § 1983. As a
lower court bound by Newport, it is not for us to decide this question.
Nevertheless, I respectfully suggest that the purpose of § 1983, to
protect federal constitutional rights against infringement by state
actors, is not served when--as in the case before us--the prospect of
damages awarded pursuant to the statute manifestly fails to deter a
municipality from adopting a policy that it clearly knows or should
know violates the Fourth Amendment.




                                   67
                    VAUGHAN AND SONS, INC.
                              v.
                            STATE

              737 S.W.2d 805 (Tex. Ct. Crim. App. 1987)

The prosecution charged as follows:

On or about November 13, 1978, Paul Tawater was the agent of the
Defendant and while acting in behalf of the Defendant and within the
scope of his office and employment, the said Paul Tawater failed to
equip the Defendant's vehicle for its operation by Johnny Hendricks
when a duty to so eqip the vehicle in accordance with the law existed
and that such failure constituted criminal negligence which caused the
vehicle in which the Complainants were traveling to collide with the
Defendant's vehicle thereby causing the deaths of Complainants and
further,

That on or about November 13, 1978, Paul Tawater, while acting as an
agent in behalf of the Defendant and within the scope of his office and
employment, failed to remove the Defendant's vehicle from the paved
and main-traveled part of a highway when a duty to act in accordance
with the law existed and it was possible to so remove the vehicle and
that such failure constituted criminal negligence which caused the
vehicle in which the Complainants were traveling to collide with the
Defendant's vehicle thereby causing the deaths of Complainants.

ONION, Presiding Judge.

Appellant, Vaughan and Sons, Inc., a Texas corporation, was convicted
by a jury of criminally negligent homicide. The information alleged that
appellant, acting through two of its agents, caused the death of two
individuals in a motor vehicle collision. Punishment was assessed by
the trial court at a fine of $5,000.00.

On appeal the appellant contended, inter alia, that the "penal code
provisions for prosecution of corporations and other artificial legal
entities do not extend to any type of criminal homicide, therefore the
trial court erred in failing to grant appellant's motion to set aside the
information."



                                    68
The Court of Appeals agreed and reversed the conviction. The Court of
Appeals wrote in part: ". . . . We should make haste slowly when it is
in the direction of holding either an individual or a corporation
criminally liable for a crime, especially one so serious as homicide,
when it is committed by someone other than the person charged."

Thus, the Court of Appeals ruled that even though the statutes so
state, the Legislature could not have intended to include corporations
within the class of culpable parties because corporations are unable to
formulate "intent" in their "artificial and soulless" form. . . .

At common law a corporation could not commit a crime. This position
was predicated on the rationale that a corporation had no mind and
hence could not entertain the appropriate criminal intent required for
all common law crimes. Also, the absence of physical body precluded
imprisonment, the primary punishment available at common law.
Illegal acts of a corporate agent were not imputed to the corporate
entity because they were considered ultra vires and therefore without
the authority of the corporation."

The rule that a corporation could not be tried for any criminal offense
was once widely accepted, not just in Texas, but throughout the
nation. Today, however, the general rule is that a corporation may be
held liable for criminal acts performed by its agents acting on its
behalf.

Prior to the 1974 Penal Code and the conforming amendments thereto
corporate criminal responsibility was recognized only to a very limited
extent in Texas. . . . It is not difficult to see why it could be said that
prior to the 1974 Penal Code "a corporation or a partnership could not
be indicted or tried under the criminal laws of Texas." . . .

With that background we turn to the 1974 Penal Code. . . .
The Legislature, recognizing that for years Texas was the only
jurisdiction in which corporations bore no general criminal
responsibility, and aware of the previous roadblocks in case law to the
prosecution of corporations for criminal offenses, enacted statutes to
remedy the situation. As earlier noted, the Legislature defined
"person" in both the Penal Code, and the Code of Criminal Procedure
so as to expressly embrace corporations. . . . and the Legislature was
not content to rest upon the definitions of "person" to impose
corporate criminal responsibility. . . .




                                    69
The intention of the Legislature could hardly be made clearer given the
history, the reform intended and the literal meaning of the statutes
involved. Taken collectively, the foregoing statutes furnish the basis
for overcoming the obstacles which in the past have prevented the
criminal prosecution of corporations.

It is the State's contention that a corporation is a "person" under
general definitional statute of the Penal Code, and since the crime of
criminally negligent homicide can be committed by a "person" it
follows that the crime can be committed by a corporation. We agree.

The Court of Appeals stated that those jurisdictions which have
addressed the issue of corporate criminal liability "... are divided as to
criminal responsibility for personal crimes such as homicide or rape,
though the majority still agrees that a corporation cannot commit a
crime requiring specific intent." No authority is cited. . . .

The wisdom of legislation is for the Legislature and not for the courts
in construing statutes. See generally 53 Tex.Jur.2d, Statutes, § 124,
p. 176; Vance v. Hatten, 600 S.W.2d 828, 830 (Tex.Cr.App.1980).

The Court of Appeals judgment is reversed and the cause remanded to
that court for consideration of appellant's points of error.


CLINTON, Judge, concurring.

[omitted]


TEAGUE, Judge, dissenting.

Please, dear reader, believe me: Contrary to what you might surmise
from this Court's majority opinion, the law that addresses corporate
criminal liability, as reflected by the many law review articles and court
decisions on the subject, is one big mess. I must, however, sadly
report: The majority opinion actually does absolutely nothing to clear
the air in this area of the law. In fact, I find that the majority opinion
will actually add to the confusion that presently exists in this area of
our law.

Without any limitation whatsoever, this Court granted the State's
petition for discretionary review in order to review the decision of the
Texarkana Court of Appeals in Vaughan and Sons, Inc. v. State, 649


                                    70
S.W.2d 677 (Tex.App.-6th 1983), which declared that a private
corporation in Texas could not be prosecuted for the offense of
criminally negligent homicide that had been previously committed by
one or more of its employees or agents. Contrary to the court of
appeals' decision, the majority opinion of this Court holds generally
that a private corporation doing business in Texas can be held strictly
and automatically criminally liable for the personal negligent acts of its
employees or agents, provided that at a later date the trier of fact
finds that the employees' or agents' personal negligent acts were
actually criminal. Given this Court's unlimited grant, what the court of
appeals stated and held, and what the State argues in its petition for
discretionary review, I respectfully dissent to the majority opinion's
failure to "put some meat on the bones of that old corporation dog"
that it has now discovered exists. I also dissent for other reasons that
I will give.

Although I dissent, I nevertheless acknowledge that the law that
addresses the civil and criminal liability of a private corporation in
Texas and elsewhere has come a long way since the year 1250 when
Pope Innocent IV decreed that because a corporation, although
apparently then a "person", did not have a soul that could be damned,
it could not be excommunicated from the Church.

. . . After the members of the Legislature have thoroughly digested the
majority opinion, I predict that we will soon see more strict and
automatic criminal liability statutes enacted. For example, the next
session of the Legislature should be able to enact a strict and
automatic criminal liability statute making any natural parent or legal
guardian or custodian of a young child strictly and automatically
criminally liable for the personal negligent wrongs of the child,
provided that a trier of fact finds that the child's negligent acts are
criminal.

It is actually not the reasoning that the majority opinion uses to reach
its conclusion, that a private corporation doing business in Texas falls
within the statutory term "person", that concerns me. What actually
concerns me lies in the fact that the majority opinion fails to give the
bench and bar of this State any guidance as to how the concept of
strict and automatic criminal liability, which it approves, either
expressly or implicitly, is to be applied to future criminal cases
involving corporate criminal defendants.

The facts of this cause reflect that what has happened to many of us
also happened to the appellant corporation's truck driver in this cause,


                                    71
namely, his assigned motor vehicle quit running; at the most
unexpected and undesirable time and place--a little after noon in what
is now a feeder lane that often terminates on what will ultimately be,
we hope, the 290 North Freeway in Houston, which I can personally
attest is not, because of the amount of traffic that travels this stretch
of the road both day and night, where, if one's motor vehicle has to
quit running, one would like to see his motor vehicle quit running.
Several hours later, approximately six, after unsuccessful rescue
efforts by other company employees and agents to locate appellant
and his truck had occurred, which delay occurred because the driver of
the truck gave them the wrong location, he missed his then location by
several miles, another vehicle drove into the back of the truck, causing
the untimely and unfortunate deaths of its driver and a passenger. The
driver of the truck, who was then in the truck's cab, was only slightly
injured. The driver was charged but not prosecuted for committing the
misdemeanor offense of criminally negligent homicide, apparently
because he testified for the State. Another employee, who was several
miles distant from the location where the accident occurred, was also
accused of committing the same offense but was not prosecuted
because he was given immunity from prosecution and testified for the
State. Based upon the truck driver's and the employee at the
company's headquarters negligent acts, the corporation was also
charged, prosecuted, and convicted for committing the offense of
criminally negligent homicide. A $5,000 fine was assessed as
punishment, which I assume has been or will be passed on to
consumers of the appellant corporation.

The trial judge, however, did not also see fit to assess a "scarlet letter"
type of punishment, such as requiring the corporation to place on the
sides of all its trucks such signs stating "Killer corporation" or
"BEWARE--CAUTION: THIS CORPORATION HAS BEEN FOUND GUILTY
OF KILLING ANOTHER HUMAN BEING". After today, I assume that
some of our innovative trial judges will, after a corporation has been
found strictly and automatically criminally liable for committing a
similar offense as was committed here, criminally negligent homicide,
assess a "scarlet letter" type of punishment in addition to any fine.
See, § 12.51(d), which appears to expressly authorize a trial judge to
assess this type punishment in addition to any fine assessed. Such
should, of course, be the equivalent of assessing the death penalty for
such a corporation. . . .

Today, this Court should exercise its constitutional authority and hold
that the Legislature in this instance violated the due process and due
course of law clauses of the respective constitutions when it enacted §


                                    72
7.22(a)(1). At a minimum, this Court should resist the temptation,
outside of "public welfare offenses", to put the judicial gloss of
approval to the overuse of strict and automatic criminal liability in
situations as we have at Bar. In the type of act we are dealing with
here, a personal negligent act, that is later determined to be criminal,
this Court is actually subscribing, to the concept that "without fault
there is a criminal wrong." This is wrong, wrong, wrong, oh so terribly
wrong.

I find that the majority opinion, in creating the beast of "criminal no
fault", when it comes to private corporate criminal liability, may have
actually created a far larger and more uncontrollable beast than it did
when it created "Almanza the Terrible".

. . . For the above and foregoing reasons, I respectfully dissent to the
majority opinion.




                                   73
     Law Enforcement with Imprisonment
                          UNITED STATES
                                v.
                             ELLIOTT

                     467 F.3d 688 (7th Cir. 2006)


EASTERBROOK, Circuit Judge.

While he was a partner at Schiff, Hardin & Waite in Chicago, Alfred
Elliott used clients' confidential information for his own benefit in
securities transactions. Eventually he was convicted on 70 counts of
securities fraud, mail fraud, tax evasion, and operating a racketeering
enterprise. His sentence was five years' imprisonment plus fines and
forfeitures of about $700,000. On October 11, 1989, when he was
scheduled to report to prison (a minimum-security camp in Oxford,
Wisconsin), he phoned his lawyer to say that he was on his way from
Chicago. He was on his way, all right--but he was in Las Vegas en
route to San Diego, not Oxford. He did not appear at the prison, and
his lawyer lost contact with him. His appeal was dismissed under the
fugitive disentitlement doctrine.

Fifteen years later, the FBI tracked him to Arizona, where he was living
under the name L. David Cohn, which he had appropriated from a
cousin and used to obtain a driver's license and other credentials.
When the agents came to arrest him, he calmly claimed to be David
Cohn, denied knowing any Alfred Elliott, and denied recognizing his
own photograph. The agents were not fooled by that ploy or another:
Elliott's claim that he was on his way to an urgent medical
appointment for a life-threatening condition. A phone call revealed that
the appointment was for a routine checkup.

In custody at last on his 1989 conviction, Elliott was indicted on the
new charge of failing to report as directed to serve that sentence. His
principal defense was that the indictment returned in 2004 came ten
years too late, for the statute of limitations is five years from the
crime's commission. The district judge rejected that defense, a jury
found Elliott guilty, and the court sentenced him to 21 months'
imprisonment, which will begin in 2009 after his 60-month sentence
ends.


                                   74
....

Guideline 2J1.6 does not take into account the duration of the flight
from justice. How long the fugitive remains on the lam is vital to
assessing the deterrent effect of a sentence . . . . If Elliott had been
caught by the end of October 1989, then tacking 21 months on to his
60-month sentence might well have provided appropriate deterrence
and desert. But he remained at liberty for almost 15 years, which
substantially eroded the deterrent force of his 60-month sentence.
Instead of serving five years, with certainty, starting in 1989, Elliott
converted his sentence to five years starting in 2004--with a
substantial chance that it would never start at all. Time served in
future years must be discounted to present value. As a deterrent, a
50% chance of serving five years starting 15 years from now must
have less than 25% the punch of five years, with certainty, starting
right now. This represents only a modest discount (about 5% per
annum); many people discount the future even more steeply.

Having evaded 75% of the deterrent value of his five-year sentence,
what did Elliott receive in return? Why, an extra 21 months starting in
20 years (the 15 years of freedom during the escape, plus the 5 years
of his principal sentence). And of course he would serve time for failing
to report in 1989 only if caught later, and only if he survived long
enough. Thus the expected value of the additional sentence--21
months starting in 20 years, but only if caught--must be discounted
even more steeply than the 75% we calculated for the principal
sentence. Make it an 80% discount: a 50% probability of serving an
extra 21 months, starting 20 years from now, has the same disutility
as a threat of 4 months with certainty starting now. The net effect is
that, by taking flight, Elliott cut the cost of his 60-month sentence to
the (1989) equivalent of 15 months, at the price of a (1989)
equivalent of 4 extra months. Who wouldn't trade a 60-month
sentence for a 19-month sentence (15 + 4 months in 1989-equivalent
terms)? No wonder Elliott absconded.

Doubtless fugitive status carries a price of its own: uncertainty hangs
over the fugitive's head, and activities that draw attention to oneself
must be avoided. But Elliott would have been excluded from many
activities (such as the practice of law) by his conviction, independent
of his fugitive status. Time as a fugitive must be superior (in the
felon's eyes) to serving the sentence, or the felon would turn himself
in. So the gain from postponing (or avoiding) time in prison is not
offset by the fact that the fugitive cannot lead a full life. Thus the law's


                                     75
deterrent and retributive effect can be maintained, in the event of
prolonged fugitive status, only by substantial incremental penalties.
Even imposing the statutory maximum of 10 years for Elliott's failure-
to-report offense would not bring the law's deterrent power in 2004 up
to what it would have been had Elliott reported as required in 1989.
(We deem the maximum to be 10 years under § 3146(b)(1)(A)(i)
rather than 5 years under § 3146(b)(1)(A)(ii), because the cap
depends on the statutory maximum for the underlying crime rather
than the actual sentence imposed for that offense. Elliott's statutory
maximum for his fraud, tax, and RICO convictions exceeded 300
years.)

. . . Elliott's conviction is affirmed. His sentence is vacated, and the
case is remanded for further proceedings consistent with this opinion.




                                   76
                       Products Liablity

                            MACPHERSON
                                 V.
                        BUICK MOTOR COMPANY

                  217 N.Y. 382, 111 N.E. 1050 (1916)


Cardozo, J.

The defendant is a manufacturer of automobiles. It sold an automobile
to a retail dealer. The retail dealer resold to the plaintiff. While the
plaintiff was in the car, it suddenly collapsed. He was thrown out and
injured. One of the wheels was made of defective wood, and its spokes
crumbled into fragments. The wheel was not made by the defendant;
it was bought from another manufacturer. There is evidence, however,
that its defects could have been discovered by reasonable inspection,
and that inspection was omitted. There is no claim that the defendant
knew of the defect and willfully concealed it. . . . The charge is one,
not of fraud, but of negligence. The question to be determined is
whether the defendant owed a duty of care and vigilance to any one
but the immediate purchaser.

The foundations of this branch of the law, at least in this state, were
laid in Thomas v. Winchester. A poison was falsely labeled. The sale
was made to a druggist, who in turn sold to a customer. The customer
recovered damages from the seller who affixed the label. 'The
defendant's negligence,' it was said, 'put human life in imminent
danger.' A poison falsely labeled is likely to injure any one who gets it.
Because the danger is to be foreseen, there is a duty to avoid the
injury. Cases were cited by way of illustration in which manufacturers
were not subject to any duty irrespective of contract. The distinction
was said to be that their conduct, though, negligent, was not likely to
result in injury to any one except the purchaser. We are not required
to say whether the chance of injury was always as remote as the
distinction assumes. Some of the illustrations might be rejected to-
day. The principle of the distinction is for present purposes the
important thing.




                                    77
Thomas v. Winchester became quickly a landmark of the law. In the
application of its principle there may at times have been uncertainty or
even error. There has never in this state been doubt or disavowal of
the principle itself. . . . These early cases suggest a narrow
construction of the rule. Later cases, however, evince a more liberal
spirit. . . . We are not required at this time either to approve or to
disapprove the application of the rule that was made in these cases. It
is enough that they help to characterize the trend of judicial thought.

...

We hold, then, that the principle of Thomas v. Winchester is not
limited to poisons, explosives, and things of like nature, to things
which in their normal operation are implements of destruction. If the
nature of a thing is such that it is reasonably certain to place and limb
in peril when negligently made, it is then a thing of danger. Its nature
gives warning of the consequences to be expected. If to the element of
danger there is added knowledge that the thing will be used by
persons other than the purchaser, and used without new tests then,
irrespective of contract, the manufacturer of this thing of danger is
under a duty to make it carefully. That is as far as we are required to
go for the decision of this case. There must be knowledge of a danger,
not merely possible, but probable. It is possible to use almost anything
in a way that will make it dangerous if defective. That is not enough to
charge the manufacturer with a duty independent of his contract.
Whether a given thing is dangerous may be sometimes a question for
the court and sometimes a question for the jury. There must also be
knowledge that in the usual course of events the danger will be shared
by others than the buyer.

Such knowledge may often be inferred from the nature of the
transaction. But it is possible that even knowledge of the danger and
of the use will not always be enough. The proximity or remoteness of
the relation is a factor to be considered. We are dealing now with the
liability of the manufacturer of the finished product, who puts it on the
market to be used without inspection by his customers. If he is
negligent, where danger is to be foreseen, a liability will follow. We are
not required at this time to say that it is legitimate to go back of the
manufacturer of the finished product and hold the manufacturers of
the component parts. To make their negligence a cause of imminent
danger, an independent cause must often intervene; the manufacturer
of the finished product must also fail in his duty of inspection. It may
be that in those circumstances the negligence of the earlier members
of the series as too remote to constitute, as to the ultimate user, an


                                    78
actionable wrong. We leave that question open to you. We shall have
to deal with it when it arises.

The difficulty which it suggests is not present in this case. There is
here no break in the chain of cause and effect. In such circumstances,
the presence of a known danger, attendant upon a known use, makes
vigilance a duty. We have put aside the notion that the duty to
safeguard life and limb, when the consequences of negligence may be
foreseen, grows out of contract and nothing else. We have put the
source of the obligation where it ought not be. We have put its source
in the law.

From this survey of the decisions, there thus emerges a definition of
the duty of a manufacturer which enables us to measure this
defendant's liability. Beyond all question, the nature of an automobile
gives warning of probable danger if its construction is defective. This
automobile was designed to go fifty miles an hour. Unless its wheels
were sound and strong, injury was almost certain. It was as much a
thing of danger as a defective engine for a railroad. The defendant
knew the danger. It knew also that the care would be used by persons
other than the buyer. This was apparent from its size; there were
seats for three persons. It was apparent also from the fact that the
buyer was a dealer in cars, who bought to resell. The maker of this car
supplied it for the use of purchasers from the dealer just as plainly as
the contractor in Devlin v. Smith supplied the scaffold for use by the
servants of the owner. The dealer was indeed the one person of whom
it might be said with some approach to certainly that by him the car
would not be used. Yet the defendant would have us say that he was
the one person whom it was under a legal duty to protect. The law
does not lead us to so inconsequent a conclusion. Precedents drawn
from the days of travel by stage coach do not fit the conditions of
travel today. The principle that the danger must be imminent does not
change, but the things subject to the principle do change. They are
whatever the needs of life in a developing civilization require them to
be.

In reaching this conclusion, we do not ignore the decisions to the
contrary in other jurisdictions. Some of them, at first sight inconsistent
with our conclusion, may be reconciled upon the ground that the
negligence was too remote, and that another cause had intervened.
But even when they cannot be reconciled, the difference is rather in
the application of the principle than in the principle itself. . . .




                                    79
There is nothing anomalous in a rule which imposes upon A, who has
contracted with B, a duty to C and D and others according as he knows
or does not know that the subject matter of the contract is intended
for their use. We may find an analogy in the law which measures the
liability of landlords. If A leases to B a tumble-down house he is not
liable, in the absence of fraud, to B's guests who enter it and are
injured. This is because B is then under the duty to repair it, the lessor
has the right to suppose that he will fulfill that duty, and if he omits to
do so, his guests must look to him. But if A leases a building to be
used by the lessee at once as a place of public entertainment, the rule
is different. There is injury to persons other than the lessee is to be
foreseen, and foresight of the consequences involves the creation of a
duty.

In this view of the defendant's liability there is nothing in- consistent
with the theory of liability on which the case was tried. It is true that
the court told the jury that 'an automobile is not an inherently
dangerous vehicle.' The meaning, however, is made plain by the
context. The meaning is that danger is not to be expected when the
vehicle is well constructed. The court left it to the jury to say whether
the defendant ought to have foreseen that the car, if negligently
constructed, would become 'imminently dangerous.' Subtle distinctions
are drawn by the defendant between things inherently dangerous and
things imminently dangerous, but the case does not turn upon these
verbal niceties. If danger was to be expected as reasonably certain,
there was a duty of vigilance, and this whether you call the danger
inherent or imminent. In varying forms that the court would not have
been justified in ruling as a matter of law that the car was a dangerous
thing. If there was any error, it was none of which the defendant can
complain.

We think the defendant was not absolved from a duty of inspection
because it bought the wheels from a reputable manufacturer. It was
not merely a dealer in automobiles. It was a manufacturer of
automobiles. It was responsible for the finished product. It was not at
liberty to put the finished product on the market without subjecting
the componet parts to ordinary and simple tests. Under the charge of
the trial judge nothing more was required of it. The obligation to
inspect must vary with the nature of the thing to be inspected. The
more probable the danger, the greater the need of caution.

The judgment should be affirmed.




                                    80
Willard Bartlett, Ch.J., Dissenting.

The plaintiff was injured in consequence of the collapse of a wheel of
an automobile manufactured by the defendant corporation which sold
it to a firm of automobile dealers in Schenectady, who in turn sold the
car to the plaintiff. The wheel was purchased by the Buick Motor
Company, ready made, from the Imperial Wheel Company of Flint,
Michigan, a reputable manufacturer of automobile wheels which had
furnished the defendant with eighty thousand wheels, none of which
had proved to be made of defective wood prior to the accident in the
present case. The defendant relied upon the wheel manufacturer to
make all necessary tests as to the strength of the material therein and
made no such tests itself. The present suit is an action for negligence
brought by the subvendee of the motor car against the manufacturer
as the original vendor. The evidence warranted a finding by the jury
that the wheel which collapsed was defective when it left the hands of
the defendant. The automobile was being prudently operated at the
time of the accident and was moving at a speed of only eight miles an
hour.

There was no allegation or proof of any actual knowledge of the defect
on the part of the defendant or any suggestion that any element of
fraud or deceit or misrepresentation entered into the sale.
The theory upon which the case was submitted to the jury by the
learned judge who presided at the trial was that, although an
automobile is not an inherently dangerous vehicle, it may become such
if equipped with a weak wheel; and that if the motor car in question,
when it was put upon the market was in itself inherently dangerous by
reason of its being equipped with a weak wheel, the defendant was
chargeable with a knowledge of the defect so far as it might be
discovered by a reasonable inspection and the application of
reasonable tests. This liability, it was further held, was not limited to
the original vendee, but extended to a subvendee like the plaintiff,
who was not a party to the original contract of sale.

I think that these rulings, which have been approved by the Appellate
Division, extend the liability of the vendor of a manufactured article
further than any case which has yet received the sanction of this court.
It has heretofore been held in this state that the liability of the vendor
of a manufactured article for negligence arising out of the existence of
defects therein does not extend to strangers injured in consequence of
such defects but is confined to the immediate vendee. The exceptions
to this general rule which have thus far been recognized in New York
are cases in which the article sold was of such a character that danger


                                       81
to life or limb was involved in the ordinary use thereof; in other words,
where the article sold was inherently dan- gerous. As has already been
pointed out, the learned trial judge instructed the jury that an
automobile is not an inherently dangerous vehicle.

....

I do not see how we can uphold the judgment in the present case
without overruling what has been so often said by this court and other
courts of like authority in reference to the absence of any liability for
negligence on the part of the original vendor of an ordinary carriage to
any one except his immediate vendee. . . .

[If] rules applicable to stage coaches are archaic when applied to
automobiles [then] the change should be effected by the legislature
and not by the courts. A perusal of the opinion in that case and in the
Huset case will disclose how uniformly the courts throughout this
country have adhered to the rule and how consistently they have
refused to broaden the scope of the exceptions. I think we should
adhere to it in the case at bar and, therefore, I vote for a reversal of
this judgment.

Hiscock, Chase and Cuddeback, JJ., concur with Cardozo, J., and
Hogan, J., concurs in result; Willard Bartlett, Ch. J., reads dissenting
opinion; Pound, J., not voting.

Judgment affirmed.




                                    82
                               SINDELL
                                  v.
                         ABBOTT LABORATORIES

MOSK, Justice.

This case involves a complex problem both timely and significant: may
a plaintiff, injured as the result of a drug administered to her mother
during pregnancy, who knows the type of drug involved but cannot
identify the manufacturer of the precise product, hold liable for her
injuries a maker of a drug produced from an identical formula?

Plaintiff Judith Sindell brought an action against eleven drug
companies and Does 1 through 100, on behalf of herself and other
women similarly situated. The complaint alleges as follows:
Between 1941 and 1971, defendants were engaged in the business of
manufacturing, promoting, and marketing diethylstilbesterol (DES), a
drug which is a synthetic compound of the female hormone estrogen.
The drug was administered to plaintiff's mother and the mothers of the
class she represents,5 for the purpose of preventing miscarriage. In
1947, the Food and Drug Administration authorized the marketing of
DES as a miscarriage preventative, but only on an experimental basis,
with a requirement that the drug contain a warning label to that effect.

DES may cause cancerous vaginal and cervical growths in the
daughters exposed to it before birth, because their mothers took the
drug during pregnancy. The form of cancer from which these
daughters suffer is known as adenocarcinoma, and it manifests itself
after a minimum latent period of 10 or 12 years. It is a fast-spreading
and deadly disease, and radical surgery is required to prevent it from
spreading. DES also causes adenosis, precancerous vaginal and
cervical growths which may spread to other areas of the body. The
treatment for adenosis is cauterization, surgery, or cryosurgery.
Women who suffer from this condition must be monitored by biopsy or
colposcopic examination twice a year, a painful and expensive
procedure. Thousands of women whose mothers received DES during
pregnancy are unaware of the effects of the drug.




5
        The plaintiff class alleged consists of "girls and women who are residents of
California and who have been exposed to DES before birth and who may or may not
know that fact or the dangers" to which they were exposed. Defendants are also
sued as representatives of a class of drug manufacturers which sold DES after 1941.


                                         83
In 1971, the Food and Drug Administration ordered defendants to
cease marketing and promoting DES for the purpose of preventing
miscarriages, and to warn physicians and the public that the drug
should not be used by pregnant women because of the danger to their
unborn children.

During the period defendants marketed DES, they knew or should
have known that it was a carcinogenic substance, that there was a
grave danger after varying periods of latency it would cause cancerous
and precancerous growths in the daughters of the mothers who took
it, and that it was ineffective to prevent miscarriage. Nevertheless,
defendants continued to advertise and market the drug as a
miscarriage preventative. They failed to test DES for efficacy and
safety; the tests performed by others, upon which they relied,
indicated that it was not safe or effective. In violation of the
authorization of the Food and Drug Administration, defendants
marketed DES on an unlimited basis rather than as an experimental
drug, and they failed to warn of its potential danger.

Because of defendants' advertised assurances that DES was safe and
effective to prevent miscarriage, plaintiff was exposed to the drug
prior to her birth. She became aware of the danger from such
exposure within one year of the time she filed her complaint. As a
result of the DES ingested by her mother, plaintiff developed a
malignant bladder tumor which was removed by surgery. She suffers
from adenosis and must constantly be monitored by biopsy or
colposcopy to insure early warning of further malignancy.
The first cause of action alleges that defendants were jointly and
individually negligent in that they manufactured, marketed and
promoted DES as a safe and efficacious drug to prevent miscarriage,
without adequate testing or warning, and without monitoring or
reporting its effects.

A separate cause of action alleges that defendants are jointly liable
regardless of which particular brand of DES was ingested by plaintiff's
mother because defendants collaborated in marketing, promoting and
testing the drug, relied upon each other's tests, and adhered to an
industry-wide safety standard. DES was produced from a common and
mutually agreed upon formula as a fungible drug interchangeable with
other brands of the same product; defendants knew or should have
known that it was customary for doctors to prescribe the drug by its
generic rather than its brand name and that pharmacists filled
prescriptions from whatever brand of the drug happened to be in
stock.


                                  84
Other causes of action are based upon theories of strict liability,
violation of express and implied warranties, false and fraudulent
representations, misbranding of drugs in violation of federal law,
conspiracy and "lack of consent."

Each cause of action alleges that defendants are jointly liable because
they acted in concert, on the basis of express and implied agreements,
and in reliance upon and ratification and exploitation of each other's
testing and marketing methods.

Plaintiff seeks compensatory damages of $1 million and punitive
damages of $10 million for herself. For the members of her class, she
prays for equitable relief in the form of an order that defendants warn
physicians and others of the danger of DES and the necessity of
performing certain tests to determine the presence of disease caused
by the drug, and that they establish free clinics in California to perform
such tests.

Defendants demurred to the complaint. While the complaint did not
expressly allege that plaintiff could not identify the manufacturer of
the precise drug ingested by her mother, she stated in her points and
authorities in opposition to the demurrers filed by some of the
defendants that she was unable to make the identification, and the
trial court sustained the demurrers of these defendants without leave
to amend on the ground that plaintiff did not and stated she could not
identify which defendant had manufactured the drug responsible for
her injuries. Thereupon, the court dismissed the action. This appeal
involves only five of ten defendants named in the complaint.

....

This case is but one of a number filed throughout the country seeking
to hold drug manufacturers liable for injuries allegedly resulting from
DES prescribed to the plaintiffs' mothers since 1947. According to a
note in the Fordham Law Review, estimates of the number of women
who took the drug during pregnancy range from 1 1/2 million to 3
million. Hundreds, perhaps thousands, of the daughters of these
women suffer from adenocarcinoma, and the incidence of vaginal
adenosis among them is 30 to 90 percent. Most of the cases are still
pending. With two exceptions, those that have been decided resulted
in judgments in favor of the drug company defendants because of the
failure of the plaintiffs to identify the manufacturer of the DES
prescribed to their mothers. The same result was reached in a recent


                                    85
California case. The present action is another attempt to overcome this
obstacle to recovery.

We begin with the proposition that, as a general rule, the imposition of
liability depends upon a showing by the plaintiff that his or her injuries
were caused by the act of the defendant or by an instrumentality
under the defendant's control. The rule applies whether the injury
resulted from an accidental event or from the use of a defective
product.

There are, however, exceptions to this rule. Plaintiff's complaint
suggests several bases upon which defendants may be held liable for
her injuries even though she cannot demonstrate the name of the
manufacturer which produced the DES actually taken by her mother.
The first of these theories, classically illustrated by Summers v. Tice
(1948) 33 Cal.2d 80, 199 P.2d 1, places the burden of proof of
causation upon tortious defendants in certain circumstances. The
second basis of liability emerging from the complaint is that
defendants acted in concert to cause injury to plaintiff. There is a third
and novel approach to the problem, sometimes called the theory of
"enterprise liability," but which we prefer to designate by the more
accurate term of "industry-wide" liability, which might obviate the
necessity for identifying the manufacturer of the injury-causing drug.
We shall conclude that these doctrines, as previously interpreted, may
not be applied to hold defendants liable under the allegations of this
complaint. However, we shall propose and adopt a fourth basis for
permitting the action to be tried, grounded upon an extension of the
Summers doctrine.

I

Plaintiff places primary reliance upon cases which hold that if a party
cannot identify which of two or more defendants caused an injury, the
burden of proof may shift to the defendants to show that they were
not responsible for the harm. This principle is sometimes referred to as
the "alternative liability" theory.

The celebrated case of Summers v. Tice best exemplifies the rule. In
Summers, the plaintiff was injured when two hunters negligently shot
in his direction. It could not be determined which of them had fired the
shot which actually caused the injury to the plaintiff's eye, but both
defendants were nevertheless held jointly and severally liable for the
whole of the damages. We reasoned that both were wrongdoers, both
were negligent toward the plaintiff, and that it would be unfair to


                                    86
require plaintiff to isolate the defendant responsible, because if the
one pointed out were to escape liability, the other might also, and the
plaintiff-victim would be shorn of any remedy. In these circumstances,
we held, the burden of proof shifted to the defendants, "each to
absolve himself if he can." (We stated that under these or similar
circumstances a defendant is ordinarily in a "far better position" to
offer evidence to determine whether he or another defendant caused
the injury.

In Summers, we relied upon Ybarra v. Spangard. There, the plaintiff
was injured while he was unconscious during the course of surgery. He
sought damages against several doctors and a nurse who attended
him while he was unconscious. We held that it would be unreasonable
to require him to identify the particular defendant who had performed
the alleged negligent act because he was unconscious at the time of
the injury and the defendants exercised control over the
instrumentalities which caused the harm. Therefore, under the
doctrine of res ipsa loquitur, an inference of negligence arose that
defendants were required to meet by explaining their conduct.

Defendants assert that these principles are inapplicable here. First,
they insist that a predicate to shifting the burden of proof under
Summers-Ybarra is that the defendants must have greater access to
information regarding the cause of the injuries than the plaintiff,
whereas in the present case the reverse appears.

Plaintiff does not claim that defendants are in a better position than
she to identify the manufacturer of the drug taken by her mother or,
indeed, that they have the ability to do so at all, but argues, rather,
that Summers does not impose such a requirement as a condition to
the shifting of the burden of proof. In this respect we believe plaintiff
is correct.

In Summers, the circumstances of the accident themselves precluded
an explanation of its cause. To be sure, Summers states that
defendants are "(o)rdinarily . . . in a far better position to offer
evidence to determine which one caused the injury" than a plaintiff,
but the decision does not determine that this "ordinary" situation was
present. Neither the facts nor the language of the opinion indicate that
the two defendants, simultaneously shooting in the same direction,
were in a better position than the plaintiff to ascertain whose shot
caused the injury. As the opinion acknowledges, it was impossible for
the trial court to determine whether the shot which entered the



                                    87
plaintiff's eye came from the gun of one defendant or the other.
Nevertheless, burden of proof was shifted to the defendants.
Here, as in Summers, the circumstances of the injury appear to render
identification of the manufacturer of the drug ingested by plaintiff's
mother impossible by either plaintiff or defendants, and it cannot
reasonably be said that one is in a better position than the other to
make the identification. Because many years elapsed between the time
the drug was taken and the manifestation of plaintiff's injuries she,
and many other daughters of mothers who took DES, are unable to
make such identification. Certainly there can be no implication that
plaintiff is at fault in failing to do so the event occurred while plaintiff
was in utero, a generation ago.

On the other hand, it cannot be said with assurance that defendants
have the means to make the identification. In this connection, they
point out that drug manufacturers ordinarily have no direct contact
with the patients who take a drug prescribed by their doctors.
Defendants sell to wholesalers, who in turn supply the product to
physicians and pharmacies. Manufacturers do not maintain records of
the persons who take the drugs they produce, and the selection of the
medication is made by the physician rather than the manufacturer.
Nor do we conclude that the absence of evidence on this subject is due
to the fault of defendants. While it is alleged that they produced a
defective product with delayed effects and without adequate warnings,
the difficulty or impossibility of identification results primarily from the
passage of time rather than from their allegedly negligent acts of
failing to provide adequate warnings.

It is important to observe, however, that while defendants do not have
means superior to plaintiff to identify the maker of the precise drug
taken by her mother, they may in some instances be able to prove
that they did not manufacture the injury-causing substance. In the
present case, for example, one of the original defendants was
dismissed from the action upon proof that it did not manufacture DES
until after plaintiff was born.

Thus we conclude that the fact defendants do not have greater access
to information which might establish the identity of the manufacturer
of the DES which injured plaintiff does not per se prevent application
of the Summers rule.

Nevertheless, plaintiff may not prevail in her claim that the Summers
rationale should be employed to fix the whole liability for her injuries
upon defendants, at least as those principles have previously been


                                     88
applied. There is an important difference between the situation
involved in Summers and the present case. There, all the parties who
were or could have been responsible for the harm to the plaintiff were
joined as defendants. Here, by contrast, there are approximately 200
drug companies which made DES, any of which might have
manufactured the injury-producing drug.

Defendants maintain that, while in Summers there was a 50 percent
chance that one of the two defendants was responsible for the
plaintiff's injuries, here since any one of 200 companies which
manufactured DES might have made the product which harmed
plaintiff, there is no rational basis upon which to infer that any
defendant in this action caused plaintiff's injuries, nor even a
reasonable possibility that they were responsible.

These arguments are persuasive if we measure the chance that any
one of the defendants supplied the injury-causing drug by the number
of possible tortfeasors. In such a context, the possibility that any of
the five defendants supplied the DES to plaintiff's mother is so remote
that it would be unfair to require each defendant to exonerate itself.
There may be a substantial likelihood that none of the five defendants
joined in the action made the DES which caused the injury, and that
the offending producer not named would escape liability altogether.
While we propose, infra, an adaptation of the rule in Summers which
will substantially overcome these difficulties, defendants appear to be
correct that the rule, as previously applied, cannot relieve plaintiff of
the burden of proving the identity of the manufacturer which made the
drug causing her injuries.

II

The second principle upon which plaintiff relies is the so-called "concert
of action" theory. . . . [There] was no concert of action among
defendants within the meaning of that doctrine.

III

A third theory upon which plaintiff relies is the concept of industry-
wide liability, or according to the terminology of the parties,
"enterprise liability." This theory was suggested in Hall v. E. I. Du Pont
de Nemours & Co., Inc. In that case, plaintiffs were 13 children injured
by the explosion of blasting caps in 12 separate incidents which
occurred in 10 different states between 1955 and 1959. The
defendants were six blasting cap manufacturers, comprising virtually


                                    89
the entire blasting cap industry in the United States, and their trade
association. There were, however, a number of Canadian blasting cap
manufacturers which could have supplied the caps. The gravamen of
the complaint was that the practice of the industry of omitting a
warning on individual blasting caps and of failing to take other safety
measures created an unreasonable risk of harm, resulting in the
plaintiffs' injuries. The complaint did not identify a particular
manufacturer of a cap which caused a particular injury.

The court reasoned as follows: there was evidence that defendants,
acting independently, had adhered to an industry-wide standard with
regard to the safety features of blasting caps, that they had in effect
delegated some functions of safety investigation and design, such as
labelling, to their trade association, and that there was industry-wide
cooperation in the manufacture and design of blasting caps. In these
circumstances, the evidence supported a conclusion that all the
defendants jointly controlled the risk. Thus, if plaintiffs could establish
by a preponderance of the evidence that the caps were manufactured
by one of the defendants, the burden of proof as to causation would
shift to all the defendants. The court noted that this theory of liability
applied to industries composed of a small number of units, and that
what would be fair and reasonable with regard to an industry of five or
ten producers might be manifestly unreasonable if applied to a
decentralized industry composed of countless small producers.

Plaintiff attempts to state a cause of action under the rationale of Hall.
She alleges joint enterprise and collaboration among defendants in the
production, marketing, promotion and testing of DES, and "concerted
promulgation and adherence to industry-wide testing, safety, warning
and efficacy standards" for the drug. We have concluded above that
allegations that defendants relied upon one another's testing and
promotion methods do not state a cause of action for concerted
conduct to commit a tortious act. Under the theory of industry-wide
liability, however, each manufacturer could be liable for all injuries
caused by DES by virtue of adherence to an industry-wide standard of
safety. . . .

We decline to apply this theory in the present case. At least 200
manufacturers produced DES; Hall, which involved 6 manufacturers
representing the entire blasting cap industry in the United States,
cautioned against application of the doctrine espoused therein to a
large number of producers. Moreover, in Hall, the conclusion that the
defendants jointly controlled the risk was based upon allegations that
they had delegated some functions relating to safety to a trade


                                    90
association. There are no such allegations here, and we have
concluded above that plaintiff has failed to allege liability on a concert
of action theory.

Equally important, the drug industry is closely regulated by the Food
and Drug Administration, which actively controls the testing and
manufacture of drugs and the method by which they are marketed,
including the contents of warning labels. To a considerable degree,
therefore, the standards followed by drug manufacturers are
suggested or compelled by the government. Adherence to those
standards cannot, of course, absolve a manufacturer of liability to
which it would otherwise be subject. But since the government plays
such a pervasive role in formulating the criteria for the testing and
marketing of drugs, it would be unfair to impose upon a manufacturer
liability for injuries resulting from the use of a drug which it did not
supply simply because it followed the standards of the industry.

IV

If we were confined to the theories of Summers and Hall, we would be
constrained to hold that the judgment must be sustained. Should we
require that plaintiff identify the manufacturer which supplied the DES
used by her mother or that all DES manufacturers be joined in the
action, she would effectively be precluded from any recovery. As
defendants candidly admit, there is little likelihood that all the
manufacturers who made DES at the time in question are still in
business or that they are subject to the jurisdiction of the California
courts. There are, however, forceful arguments in favor of holding that
plaintiff has a cause of action.

In our contemporary complex industrialized society, advances in
science and technology create fungible goods which may harm
consumers and which cannot be traced to any specific producer. The
response of the courts can be either to adhere rigidly to prior doctrine,
denying recovery to those injured by such products, or to fashion
remedies to meet these changing needs. . .. [W]e acknowledge that
some adaptation of the rules of causation and liability may be
appropriate in these recurring circumstances. The Restatement
comments that modification of the Summers rule may be necessary in
a situation like that before us.

The most persuasive reason for finding plaintiff states a cause of
action is that advanced in Summers : as between an innocent plaintiff
and negligent defendants, the latter should bear the cost of the injury.


                                    91
Here, as in Summers, plaintiff is not at fault in failing to provide
evidence of causation, and although the absence of such evidence is
not attributable to the defendants either, their conduct in marketing a
drug the effects of which are delayed for many years played a
significant role in creating the unavailability of proof.

From a broader policy standpoint, defendants are better able to bear
the cost of injury resulting from the manufacture of a defective
product. As was said by Justice Traynor in Escola, "(t)he cost of an
injury and the loss of time or health may be an overwhelming
misfortune to the person injured, and a needless one, for the risk of
injury can be insured by the manufacturer and distributed among the
public as a cost of doing business." The manufacturer is in the best
position to discover and guard against defects in its products and to
warn of harmful effects; thus, holding it liable for defects and failure to
warn of harmful effects will provide an incentive to product safety.
These considerations are particularly significant where medication is
involved, for the consumer is virtually helpless to protect himself from
serious, sometimes permanent, sometimes fatal, injuries caused by
deleterious drugs.

Where, as here, all defendants produced a drug from an identical
formula and the manufacturer of the DES which caused plaintiff's
injuries cannot be identified through no fault of plaintiff, a modification
of the rule of Summers is warranted. As we have seen, an undiluted
Summers rationale is inappropriate to shift the burden of proof of
causation to defendants because if we measure the chance that any
particular manufacturer supplied the injury-causing product by the
number of producers of DES, there is a possibility that none of the five
defendants in this case produced the offending substance and that the
responsible manufacturer, not named in the action, will escape
liability.

But we approach the issue of causation from a different perspective:
we hold it to be reasonable in the present context to measure the
likelihood that any of the defendants supplied the product which
allegedly injured plaintiff by the percentage which the DES sold by
each of them for the purpose of preventing miscarriage bears to the
entire production of the drug sold by all for that purpose. Plaintiff
asserts in her briefs that Eli Lilly and Company and 5 or 6 other
companies produced 90 percent of the DES marketed. If at trial this is
established to be the fact, then there is a corresponding likelihood that
this comparative handful of producers manufactured the DES which



                                    92
caused plaintiff's injuries, and only a 10 percent likelihood that the
offending producer would escape liability.

If plaintiff joins in the action the manufacturers of a substantial share
of the DES which her mother might have taken, the injustice of
shifting the burden of proof to defendants to demonstrate that they
could not have made the substance which injured plaintiff is
significantly diminished. [W]e hold only that a substantial percentage
is required.

The presence in the action of a substantial share of the appropriate
market also provides a ready means to apportion damages among the
defendants. Each defendant will be held liable for the proportion of the
judgment represented by its share of that market unless it
demonstrates that it could not have made the product which caused
plaintiff's injuries. In the present case, as we have see, one DES
manufacturer was dismissed from the action upon filing a declaration
that it had not manufactured DES until after plaintiff was born. Once
plaintiff has met her burden of joining the required defendants, they in
turn may cross-complaint against other DES manufacturers, not joined
in the action, which they can allege might have supplied the injury-
causing product.

Under this approach, each manufacturer's liability would approximate
its responsibility for the injuries caused by its own products. Some
minor discrepancy in the correlation between market share and liability
is inevitable; therefore, a defendant may be held liable for a somewhat
different percentage of the damage than its share of the appropriate
market would justify. It is probably impossible, with the passage of
time, to determine market share with mathematical exactitude. But
just as a jury cannot be expected to determine the precise relationship
between fault and liability in applying the doctrine of comparative fault
or partial indemnity, the difficulty of apportioning damages among the
defendant producers in exact relation to their market share does not
seriously militate against the rule we adopt. As we said in Summers
with regard to the liability of independent tortfeasors, where a correct
division of liability cannot be made "the trier of fact may make it the
best it can."

We are not unmindful of the practical problems involved in defining the
market and determining market share, but these are largely matters of
proof which properly cannot be determined at the pleading stage of
these proceedings. Defendants urge that it would be both unfair and
contrary to public policy to hold them liable for plaintiff's injuries in the


                                     93
absence of proof that one of them supplied the drug responsible for
the damage. Most of their arguments, however, are based upon the
assumption that one manufacturer would be held responsible for the
products of another or for those of all other manufacturers if plaintiff
ultimately prevails. But under the rule we adopt, each manufacturer's
liability for an injury would be approximately equivalent to the
damages caused by the DES it manufactured.

The judgments are reversed.


BIRD, C. J., and NEWMAN and WHITE, JJ., concur.


RICHARDSON, Justice, dissenting.

I respectfully dissent. In these consolidated cases the majority adopts
a wholly new theory which contains these ingredients: The plaintiffs
were not alive at the time of the commission of the tortious acts. They
sue a generation later. They are permitted to receive substantial
damages from multiple defendants without any proof that any
defendant caused or even probably caused plaintiffs' injuries.
Although the majority purports to change only the required burden of
proof by shifting it from plaintiffs to defendants, the effect of its
holding is to guarantee that plaintiffs will prevail on the causation issue
because defendants are no more capable of disproving factual
causation than plaintiffs are of proving it. "Market share" liability thus
represents a new high water mark in tort law. The ramifications seem
almost limitless, a fact which prompted one recent commentator, in
criticizing a substantially identical theory, to conclude that "Elimination
of the burden of proof as to identification (of the manufacturer whose
drug injured plaintiff) would impose a liability which would exceed
absolute liability." In my view, the majority's departure from
traditional tort doctrine is unwise.

The applicable principles of causation are very well established. A
leading torts scholar, Dean Prosser, has authoritatively put it this way:
"An essential element of the plaintiff's cause of action for negligence,
or for that matter for any other tort, is that there be some reasonable
connection between the act or omission of the defendant and the
damage which the plaintiff has suffered." With particular reference to
the matter before us, and in the context of products liability, the
requirement of a causation element has been recognized as equally
fundamental. "It is clear that any holding that a producer,


                                    94
manufacturer, seller, or a person in a similar position, is liable for
injury caused by a particular product, must necessarily be predicated
upon proof that the product in question was one for whose condition
the defendant was in some way responsible. Thus, for example, if
recovery is sought from a manufacturer, it must be shown that he
actually was the manufacturer of the product which caused the injury .
. . " Indeed, an inability to prove this causal link between defendant's
conduct and plaintiff's injury has proven fatal in prior cases brought
against manufacturers of DES by persons who were situated in
positions identical to those of plaintiffs herein.

The majority now expressly abandons the foregoing traditional
requirement of some causal connection between defendants' act and
plaintiffs' injury in the creation of its new modified industry-wide tort.
Conceptually, the doctrine of absolute liability which heretofore in
negligence law has substituted only for the requirement of a breach of
defendant's duty of care, under the majority's hand now subsumes the
additional necessity of a causal relationship.

According to the majority, in the present case plaintiffs have openly
conceded that they are unable to identify the particular entity which
manufactured the drug consumed by their mothers. In fact, plaintiffs
have joined only five of the approximately two hundred drug
companies which manufactured DES. Thus, the case constitutes far
more than a mere factual variant upon the theme composed in
Summers v. Tice, wherein plaintiff joined as codefendants the only two
persons who could have injured him. As the majority must
acknowledge, our Summers rule applies only to cases in which " . . . it
is proved that harm has been caused to the plaintiff by . . . one of (the
named defendants), but there is uncertainty as to which one has
caused it, . . . " In the present case, in stark contrast, it remains
wholly speculative and conjectural whether any of the five named
defendants actually caused plaintiffs' injuries.

The fact that plaintiffs cannot tie defendants to the injury-producing
drug does not trouble the majority for it declares that the Summers
requirement of proof of actual causation by a named defendant is
satisfied by a joinder of those defendants who have together
manufactured "a substantial percentage " of the DES which has been
marketed. Notably lacking from the majority's expression of its new
rule, unfortunately, is any definition or guidance as to what should
constitute a "substantial" share of the relevant market. The issue is
entirely open-ended and the answer, presumably, is anyone's guess.



                                    95
Much more significant, however, is the consequence of this
unprecedented extension of liability. Recovery is permitted from a
handful of defendants each of whom individually may account for a
comparatively small share of the relevant market, so long as the
aggregate business of those who have been sued is deemed
"substantial." In other words, a particular defendant may be held
proportionately liable even though mathematically it is much more
likely than not that it played no role whatever in causing plaintiffs'
injuries. Plaintiffs have strikingly capsulated their reasoning by
insisting " . . . that while one manufacturer's product may not have
injured a particular plaintiff, we can assume that it injured a different
plaintiff and all we are talking about is a mere matching of plaintiffs
and defendants." In adopting the foregoing rationale the majority
rejects over 100 years of tort law which required that before tort
liability was imposed a "matching" of defendant's conduct and
plaintiff's injury was absolutely essential. Furthermore, in bestowing on
plaintiffs this new largess the majority sprinkles the rain of liability
upon all the joined defendants alike those who may be tortfeasors and
those who may have had nothing at all to do with plaintiffs' injury and
an added bonus is conferred. Plaintiffs are free to pick and choose
their targets.

The "market share" thesis may be paraphrased. Plaintiffs have been
hurt by someone who made DES. Because of the lapse of time no one
can prove who made it. Perhaps it was not the named defendants who
made it, but they did make some. Although DES was apparently safe
at the time it was used, it was subsequently proven unsafe as to some
daughters of some users. Plaintiffs have suffered injury and
defendants are wealthy. There should be a remedy. Strict products
liability is unavailable because the element of causation is lacking.
Strike that requirement and label what remains "alternative" liability,
"industry-wide" liability, or "market share" liability, proving thereby
that if you hit the square peg hard and often enough the round holes
will really become square, although you may splinter the board in the
process.

The foregoing result is directly contrary to long established tort
principles. Once again, in the words of Dean Prosser, the applicable
rule is: "(Plaintiff) must introduce evidence which affords a reasonable
basis for the conclusion that it is more likely than not that the conduct
of the defendant was a substantial factor in bringing about the result.
A mere possibility of such causation is not enough ; and when the
matter remains one of pure speculation or conjecture, or the
probabilities are at best evenly balanced, it becomes the duty of the


                                   96
court to direct a verdict for the defendant." Under the majority's new
reasoning, however, a defendant is fair game if it happens to be
engaged in a similar business and causation is possible, even though
remote.

In passing, I note the majority's dubious use of market share data. It
is perfectly proper to use such information to assist in proving,
circumstantially, that a particular defendant probably caused plaintiffs'
injuries. Circumstantial evidence may be used as a basis for proving
the requisite probable causation. The majority, however, authorizes
the use of such evidence for an entirely different purpose, namely, to
impose and allocate liability among multiple defendants only one of
whom may have produced the drug which injured plaintiffs. Because
this use of market share evidence does not implicate any particular
defendant, I believe such data are entirely irrelevant and inadmissible,
and that the majority errs in such use. In the absence of some
statutory authority there is no legal basis for such use.

Although seeming to acknowledge that imposition of liability upon
defendants who probably did not cause plaintiffs' injuries is unfair, the
majority justifies this inequity on the ground that "each manufacturer's
liability for an injury would be approximately equivalent to the
damages caused by the DES it manufactured." In other words,
because each defendant's liability is proportionate to its market share,
supposedly "each manufacturer's liability would approximate its
responsibility for the injuries caused by his own products." The
majority dodges the "practical problems" thereby presented, choosing
to describe them as "matters of proof." However, the difficulties, in my
view, are not so easily ducked, for they relate not to evidentiary
matters but to the fundamental question of liability itself.

Additionally, it is readily apparent that "market share" liability will fall
unevenly and disproportionately upon those manufacturers who are
amenable to suit in California. On the assumption that no other state
will adopt so radical a departure from traditional tort principles, it may
be concluded that under the majority's reasoning those defendants
who are brought to trial in this state will bear effective joint
responsibility for 100 percent of plaintiffs' injuries despite the fact that
their "substantial" aggregate market share may be considerably less.
This undeniable fact forces the majority to concede that, "a defendant
may be held liable for a somewhat different percentage of the damage
than its share of the appropriate market would justify." With due
deference, I suggest that the complete unfairness of such a result in a



                                     97
case involving only five of two hundred manufacturers is readily
manifest.

Furthermore, several other important policy considerations persuade
me that the majority holding is both inequitable and improper. The
injustice inherent in the majority's new theory of liability is
compounded by the fact that plaintiffs who use it are treated far more
favorably than are the plaintiffs in routine tort actions. In most tort
cases plaintiff knows the identity of the person who has caused his
injuries. In such a case, plaintiff, of course, has no option to seek
recovery from an entire industry or a "substantial" segment thereof,
but in the usual instance can recover, if at all, only from the particular
defendant causing injury. Such a defendant may or may not be either
solvent or amenable to process. Plaintiff in the ordinary tort case must
take a chance that defendant can be reached and can respond
financially. On what principle should those plaintiffs who wholly fail to
prove any causation, an essential element of the traditional tort cause
of action, be rewarded by being offered both a wider selection of
potential defendants and a greater opportunity for recovery?

The majority attempts to justify its new liability on the ground that
defendants herein are "better able to bear the cost of injury resulting
from the manufacture of a defective product." This "deep pocket"
theory of liability, fastening liability on defendants presumably because
they are rich, has understandable popular appeal and might be
tolerable in a case disclosing substantially stronger evidence of
causation than herein appears. But as a general proposition, a
defendant's wealth is an unreliable indicator of fault, and should play
no part, at least consciously, in the legal analysis of the problem. In
the absence of proof that a particular defendant caused or at least
probably caused plaintiff's injuries, a defendant's ability to bear the
cost thereof is no more pertinent to the underlying issue of liability
than its "substantial" share of the relevant market. A system priding
itself on "equal justice under law" does not flower when the liability as
well as the damage aspect of a tort action is determined by a
defendant's wealth. The inevitable consequence of such a result is to
create and perpetuate two rules of law one applicable to wealthy
defendants, and another standard pertaining to defendants who are
poor or who have modest means. Moreover, considerable doubts have
been expressed regarding the ability of the drug industry, and
especially its smaller members, to bear the substantial economic costs
(from both damage awards and high insurance premiums) inherent in
imposing an industry-wide liability.



                                    98
. . . . “It is also true in particular of many new or experimental drugs
as to which, because of lack of time and opportunity for sufficient
medical experience, there can be no assurance of safety, or perhaps
even of purity of ingredients, but such experience as there is justifies
the marketing and use of the drug notwithstanding a medically
recognizable risk. The seller of such products, again, with the
qualification that they are properly prepared and marketed, and proper
warning is given, where the situation calls for it, is not to be held to
strict liability for unfortunate consequences attending their use, merely
because he has undertaken to supply the public with an apparently
useful and desirable product, attended with a known but apparently
reasonable risk.” This section implicitly recognizes the social policy
behind the development of new pharmaceutical preparations. As one
commentator states, '(t)he social and economic benefits from
mobilizing the industry's resources in the war against disease and in
reducing the costs of medical care are potentially enormous. The
development of new drugs in the last three decades has already
resulted in great social benefits. The potential gains from further
advances remain large. To risk such gains is unwise. Our major
objective should be to encourage a continued high level of industry
investment in pharmaceutical R & D (research and development).'

In the present case the majority imposes liability more than 20 years
after ingestion of drugs which at the time they were used, after careful
testing, had the full approval of the United States Food and Drug
Administration. It seems to me that liability in the manner created by
the majority must inevitably inhibit, if not the research or
development, at least the dissemination of new pharmaceutical drugs.
Such a result, as explained by the Restatement, is wholly inconsistent
with traditional tort theory.

I also suggest that imposition of so sweeping a liability may well prove
to be extremely shortsighted from the standpoint of broad social
policy. Who is to say whether, and at what time and in what form, the
drug industry upon which the majority now fastens this blanket
liability, may develop a miracle drug critical to the diagnosis,
treatment, or, indeed, cure of the very disease in question? It is
counterproductive to inflict civil damages upon all manufacturers for
the side effects and medical complications which surface in the
children of the users a generation after ingestion of the drugs,
particularly when, at the time of their use, the drugs met every fair
test and medical standard then available and applicable. Such a result
requires of the pharmaceutical industry a foresight, prescience and
anticipation far beyond the most exacting standards of the relevant


                                   99
scientific disciplines. In effect, the majority requires the
pharmaceutical research laboratory to install a piece of new equipment
the psychic's crystal ball.

I am not unmindful of the serious medical consequences of plaintiffs'
injuries, and the equally serious implications to the class which she
purports to represent. In balancing the various policy considerations,
however, I also observe that the incidence of vaginal cancer among
"DES daughters" has been variously estimated at one-tenth of 1
percent to four-tenths of 1 percent. These facts raise some penetrating
questions. Ninety-nine plus percent of "DES daughters" have never
developed cancer. Must a drug manufacturer to escape this blanket
liability wait for a generation of testing before it may disseminate
drugs? If a drug has beneficial purposes for the majority of users but
harmful side effects are later revealed for a small fraction of
consumers, will the manufacturer be absolutely liable? If adverse
medical consequences, wholly unknown to the most careful and
meticulous of present scientists, surface in two or three generations,
will similar liability be imposed? In my opinion, common sense and
reality combine to warn that a "market share" theory goes too far.
Legally, it expects too much.

I believe that the scales of justice tip against imposition of this new
liability because of the foregoing elements of unfairness to some
defendants who may have had nothing whatever to do with causing
any injury, the unwarranted preference created for this particular class
of plaintiffs, the violence done to traditional tort principles by the
drastic expansion of liability proposed, the injury threatened to the
public interest in continued unrestricted basic medical research as
stressed by the Restatement, and the other reasons heretofore
expressed.

The majority's decision effectively makes the entire drug industry (or
at least its California members) an insurer of all injuries attributable to
defective drugs of uncertain or unprovable origin, including those
injuries manifesting themselves a generation later, and regardless of
whether particular defendants had any part whatever in causing the
claimed injury. Respectfully, I think this is unreasonable overreaction
for the purpose of achieving what is perceived to be a socially
satisfying result.

Finally, I am disturbed by the broad and ominous ramifications of the
majority's holding. The law review comment, which is the wellspring of
the majority's new theory, conceding the widespread consequences of


                                    100
industry-wide liability, openly acknowledges that "The DES cases are
only the tip of an iceberg." Although the pharmaceutical drug industry
may be the first target of this new sanction, the majority's reasoning
has equally threatening application to many other areas of business
and commercial activities.

Given the grave and sweeping economic, social, and medical effects of
"market share" liability, the policy decision to introduce and define it
should rest not with us, but with the Legislature which is currently
considering not only major statutory reform of California product
liability law in general, but the DES problem in particular, which would
establish and appropriate funds for the education, identification, and
screening of persons exposed to DES, and would prohibit health care
and hospital service plans from excluding or limiting coverage to
persons exposed to DES.) An alternative proposal for administrative
compensation, described as "a limited version of no-fault products
liability" has been suggested by one commentator. Compensation
under such a plan would be awarded by an administrativetribunal
from funds collected "via a tax paid by all manufacturers." In any
event, the problem invites a legislative rather than an attempted
judicial solution.

I would affirm the judgments of dismissal.

                    CLARK and MANUEL, JJ., concur




                                  101
                      CONNOR
                         v.
      GREAT WESTERN SAVINGS & LOAN ASSOCIATION

                  69 Cal.2d 850, 447 P.2d 609 (1968)

TRAYNOR, Chief Justice.

Plaintiffs in each action purchased single family homes in a residential
tract development known as Weathersfield, located on tracts 1158,
1159, and 1160 in Ventura County. Thereafter their homes suffered
serious damage from cracking caused by ill-designed foundations that
could not withstand the expansion and contraction of adobe soil.
Plaintiffs accordingly sought rescission or damages from the various
parties involved in the tract development.

Holders of promissory notes secured by second deeds of trust on the
homes filed cross-complaints, alleging that their security had been
impaired by the damage to the homes. They sought to impose liens on
any recovery plaintiffs might obtain from other defendants.
There was abundant evidence that defendant Conejo Valley
Development Company, which built and sold the homes, negligently
constructed them without regard to soil conditions prevalent at the
site. Specifically, it laid slab foundations on adobe soil without taking
proper precautions recommended to it by soil engineers. When the
adobe soil expanded during rainstorms two years later, the
foundations cracked and their movement generated further damage.
In addition to seeking damages from Conejo, plaintiffs sought to hold
Great Western liable, either on the ground that its participation in the
tract development brought it into a joint venture or a joint enterprise
with Conejo, which served to make it vicariously liable, or on the
ground that it breached an independent duty of care to plaintiffs.

A brief review of the negotiations leading to Great Western's role in
the development of the Weathersfield tract is essential to a clear
perspective of the issues. Since the appeals are from a judgment of
nonsuit, such a review must give to plaintiffs' evidence all the value to
which it is legally entitled, must recognize every legitimate inference
that may be drawn from that evidence, and must disregard conflicting
evidence. If there is evidence that would support a recovery against
Great Western on either of the grounds set forth by plaintiffs, the
judgment of nonsuit must be reversed.




                                   102
The Weathersfield project originated in December 1958, when Harris
Goldberg, president of South Gate Development Company, undertook
negotiations to purchase for South Gate 547 acres of the McRea ranch,
a parcel of approximately 1,600 acres of undeveloped real property in
the Conejo Valley, which was then undergoing the beginnings of large-
scale development. Goldberg and Keith Brown together owned and
controlled South Gate Development Company. They planned to
develop the property with the goal of creating a community of
approximately 2,000 homes.

Neither Goldberg nor Brown had any significant experience in large-
scale construction of tract housing. Goldberg had left the men's
apparel business in 1955 to begin a career in real estate. He
subsequently established a number of companies that engaged
principally in subdividing raw acreage. In 1958 he undertook the
construction of a 31-home development called Waverly Manor; when
15 or 20 homes had been partially completed under the supervision of
a South Gate employee, he engaged Brown to supervise completion of
the job. This task was Brown's first experience with tract construction,
although he had been licensed as a general contractor in 1950 and had
built approximately 50 single-family dwellings on an individual custom
basis before 1958.

In January 1959 South Gate signed an agreement to purchase 100
acres of the McRea ranch for $340,000 within 120 days, and a
conditional sales agreement to purchase 447 adjoining acres for
$2,500 per acre over a 10-year period. Neither South Gate nor
Goldberg had the financial resources to perform these agreements,
and in March Goldberg approached Great Western for the necessary
funds to purchase the 100-acre parcel on which Weathersfield was to
be constructed.

Great Western processed between 8,000 and 9,000 loans each year,
amounting to more than $100,000,000, but had not previously made
loans in Ventura County. It expressed an interest to Goldberg in
developing a volume of new construction loan business and in
providing long-term financing in the form of first trust deeds to the
buyers of the homes to be built. By the end of April, the general
outlines of an agreement with Goldberg had been developed, and they
were recorded in the minutes of Great Western's Loan Committee.
During the ensuing four months the parties and their lawyers worked
out the details of a transaction whereby Great Western would supply
the funds necessary to enable Goldberg to purchase the 100-acre
parcel and construct homes thereon. In return, Great Western was


                                  103
given the right to make construction loans on the homes to be built
and the right of first refusal to make long-term loans to the buyers of
the homes. Before agreeing to provide money for the purchase of the
land, Great Western also demanded and received a 'gentleman's
agreement' that it would have the right of first refusal to make
construction loans on the homes to be built on the adjoining 477-acre
parcel.

Great Western employed a geologist to determine whether an
adequate quantity and quality of water would be available in the area.
As a result of the geologist's report and its own investigations, Great
Western further demanded and received a guarantee from South Gate,
Goldberg, and Mr. and Mrs. Brown that if Great Western held title to
the 100-acre parcel in September 1960, adequate water service lines
from a new or existing public utility would be available at the property
line for consumer use.

In July, Great Western provided the necessary funds for the purchase
of the Weathersfield tract. Goldberg had deposited $190,000 of the
$340,000 purchase price with the escrow agent on behalf of South
Gate. He apparently obtained the money by draining assets from his
corporations, leaving a combined net worth in those enterprises of
$36,000 as of July 31.

Goldberg, by amended escrow instructions, substituted Conejo
Development Company in place of South Gate as purchaser of the land
from the McReas, and all funds deposited theretofore by South Gate
were credited to Conejo. Conejo had been incorporated several months
earlier, though with only $5,000 capital to handle the tract
development.

Great Western deposited the remaining $150,000 of the purchase
price in a second escrow opened between Conejo as seller and Great
Western as buyer, took title to the land from Conejo, and granted
South Gate a one-year option to repurchase the land in three parcels
for a total of $180,000. South Gate, Goldberg, and Mr. and Mrs. Brown
agreed to repurchase the property from Great Western on demand for
$200,000 if the option were not exercised and adequate water facilities
were not available by September 1960.

The arrangement for the purchase of the land by Great Western was
an early example of what has come to be known as 'land
warehousing.' Under such an arrangement, a financial institution holds
land for a developer until he is ready to use it. Unlike a normal bailee


                                  104
of personal property, however, the institution retains title to the
property as well as the right to possession. . . .

Great Western agreed to make the necessary construction loans to
Conejo only after assuring itself that the homes could be successfully
built and sold. During the negotiations on the terms of the
contemplated construction loans to Conejo and the long-term loans to
be offered to the buyers of homes in the proposed development, Great
Western investigated Goldberg's financial condition and learned that it
was weak. Moreover, Great Western received, without comment or
inquiry, an August 1959 financial statement from Conejo that set forth
capital of $325,000, of which $320,000 was accounted for as
estimated profits from the sales of homes when the sales transactions,
then in escrow, were completed. Such an entry was far outside the
bounds of generally accepted accounting principles. The estimated
profits, representing 64/65 of the total purported capital, were not
only hypothetical, but were hypothesized on the basis of houses that
had not yet been constructed.

Great Western delved no deeper into the proposed foundations of the
houses than into the conjectural bases of Conejo's capital. It did
require Conejo to submit plans and specifications for the various
models of homes to be built, cost breakdowns, a list of proposed
subcontractors and the type of work each was to perform, and a
schedule of proposed prices. Conejo, which at no time employed an
architect, purchased plans and specifications from a Mr. L. C. Majors
that he had prepared for other developments, and submitted them to
Great Western.

Great Western departed from its normal procedure of reviewing and
approving plans and specifications before making a commitment to
provide construction funds. It did not examine the foundation plans
and did not make any recommendations as to the design or
construction of the houses. It was preoccupied with selling prices and
sales. It suggested increases in Goldberg's proposed selling prices,
which he accepted. It also refused any formal commitment of funds to
Conejo until a specified number of houses were pre-sold, namely, sold
before they were constructed.

Prospective buyers reserved lots after inspecting three landscaped and
furnished model homes standing on 1.6 acres of the otherwise barren
tract. The model homesites as well as a 60-foot wise access road had
been granted by the McReas directly to Conejo 'without consideration



                                   105
and as an accommodation' two weeks before the close of the land-
purchase escrows.

When Conejo sold the lots, its sales agents informed the buyers that
Great Western was willing to make long-terms secured by first trust
deeds to approved persons, and obtained credit information for later
submission to Great Western. This procedure was dictated by the right
of first refusal that Conejo agreed to give Great Western to obtain the
construction loans. If an approved buyer wished to obtain a long-term
loan elsewhere, Great Western had 10 days to meet the terms of the
proposed financing; if it met the terms and the loan was not placed
with Great Western, Goldberg, Brown, and South Gate were required
to pay Great Western the fees and interest obtained by the other
lender in connection with the loan. Most of the buyers of homes in the
Weathersfield tract applied to Great Western for loans. They obtained
approximately 80 percent of the purchase price in the form of 24-year
loans from Great Western at 6.6 percent interest secured by first trust
deeds. Great Western charged Conejo a 1 percent fee for loans made
to qualified buyers, and a 1 1/2 percent fee for loans made to Conejo
on behalf of buyers who, in Great Western's opinion, were poor risks.
By September, the specified number of houses had been reserved by
buyers, and Great Western accordingly made approximately
$3,000,000 in construction loans to Conejo. Conejo agreed to pay
Great Western a 5 percent construction loan fee and 6.6 percent
interest on the construction loans as disbursed for six months and
thereafter on the entire amount. Great Western had originally
demanded 6.6 percent interest on the entire amount without regard to
the disbursement of the funds, and its 5 percent loans fee was higher
than normal because it assessed the loan as one involving a
substantial risk. When the construction loans were recorded, Conejo
became entitled to advances on the loans and to 'land draws,' lump
sums calculated as a percentage of the value of the land. Conejo
received advances on the construction loans and land draws in the
sum of $148,200. It turned this sum together with $31,800 over to
South Gate, which in turn paid the total of $180,000 back to Great
Western in the exercise of its option to repurchase the 100-acre tract
from Great Western. South Gate simultaneously transferred the land
to Conejo.

Conejo accepted notes secured by second trust deeds from the buyers
of homes for the balance of the purchase price that was not provided
by Great Western. Goldberg planned to discount the notes at 50
percent of their face value and to use the proceeds to pay the interest
and fees to Great Western and provide a profit to Conejo. The


                                  106
evidence indicates, however, that in his enthusiasm to develop the
first 100 acres of his projected community, Goldberg pared estimated
profits to the dangerously thin margin of $500 per house, and that he
exceeded his depth in expertise and finances, with a resulting
deterioration in his financial position as construction progressed.
Conejo ultimately pledged the notes as security for a $300,000 loan,
43 percent of their face value, forfeiting profits in the urgent need for
liquid capital. This loan was obtained from cross-complainants Meyer
Pritkin et al. seven business acquaintances of Goldberg who at his
suggestion organized a joint venture in December 1959 to purchase
382 acres of land in the Conejo Valley.

A subcontractor employed by Conejo began grading the property
before Great Western made a final commitment to provide
construction loan funds, and while Great Western still nominally owned
the land. During the course of construction, Great Western's inspectors
visited the property weekly to verify that the pre-packaged plans were
being followed and that money was disbursed only for work completed.
Under the loan agreement, if construction work did not conform to
plans and specifications, Great Western had the right to withhold
disbursement of funds until the work was satisfactorily performed;
failure to correct a nonconformity within 15 days constituted a default.
Representatives of Great Western remained in constant communication
with the developers of the Weathersfield tract until all the houses were
completed and sold in mid-1960.

The evidence establishes without conflict that there was no express
agreement either written or oral creating a joint venture or joint
enterprise relationship between Great Western and Conejo or
Goldberg. Without exception the testimony of the principal witnesses
discloses specific disclaimers of all intention that any such relationship
should exist, and the written documents provided only for typical
option and purchase agreements and loan and security transactions.
Plaintiffs contend, however, that the evidence of the conduct of the
parties demonstrates that neither the documents nor the testimony as
to the parties' intentions accurately reflect their legal relationship.
They assert that such evidence of conduct supports an inference that a
joint venture or joint enterprise relationship existed.

A joint venture exists when there is 'an agreement between the parties
under which they have a community of interest, that is, a joint
interest, in a common business undertaking, and understanding as to
the sharing of profits and losses, and a right of joint control.' lthough
the evidence establishes that Great Western and Conejo combined


                                   107
their property, skill, and knowledge to carry out the tract
development, that each shared in the control of the development, that
each anticipated receiving substantial profits therefrom, and that they
cooperated with each other in the development, there is no evidence
of a community or joint interest in the undertaking. Great Western
participated as a buyer and seller of land and lender of funds, and
Conejo participated as a builder and seller of homes. Although the
profits of each were dependent on the overall success of the
development, neither was to share in the profits or the losses that the
other might realize or suffer. Although each received substantial
payments as seller, lender, or borrower, neither had an interest in the
payments received by the other. Under these circumstances, no joint
venture existed.

Even though Great Western in not vicariously liable as a joint venturer
for the negligence of Conejo, there remains the question of its liability
for its own negligence. Great Western voluntarily undertook business
relationships with South Gate and Conejo to develop the Weathersfield
tract and to develop a market for the tract houses in which prospective
buyers would be directed to Great Western for their financing. In
undertaking these relationships, Great Western became much more
than a lender content to lend money at interest on the security of real
property. It became an active participant in a home construction
enterprise. It had the right to exercise extensive control of the
enterprise. Its financing, which made the enterprise possible, took on
ramifications beyond the domain of the usual money lender. It
received not only interest on its construction loans, but also
substantial fees for making them, a 20 percent capital gain for
'warehousing' the land, and protection from loss of profits in the event
individual home buyers sought permanent financing elsewhere.
Since the value of the security for the construction loans and
thereafter the security for the permanent financing loans depended on
the construction of sound homes, Great Western was clearly under a
duty of care to its shareholders to exercise its powers of control over
the enterprise to prevent the construction of defective homes. Judged
by the standards governing nonsuits, it negligently failed to discharge
that duty. It knew or should have known that the developers were
inexperienced, undercapitalized, and operating on a dangerously thin
capitalization. It therefore knew or should have known that damage
from attempts to cut corners in construction was a risk reasonably to
be foreseen. It knew or should have known of the expansive soil
problems, and yet it failed to require soil tests, to examine foundation
plans, to recommend changes in the prepackaged plans and
specifications, or to recommend changes in the foundations during


                                   108
construction. It made no attempt to discover gross structural defects
that it could have discovered by reasonable inspection and that it
would have required Conejo to remedy. It relied for protection solely
upon building inspectors with whom it had had no experience to
enforce a building code with the provisions of which it was ignorant.
The crucial question remains whether Great Western also owed a duty
to the home buyers in the Weathersfield tract and was therefore also
negligent toward them.

The fact that Great Western was not in privity of contract with any of
the plaintiffs except as a lender does not absolve it of liability for its
own negligence in creating an unreasonable risk of harm to them.
'Privity of contract is not necessary to establish the existence of a duty
to exercise ordinary care not to injure another, but such duty may
arise out of a voluntarily assumed relationship if public policy dictates
the existence of such a duty.' The basic tests for determining the
existence of such a duty are as follows: 'The determination whether in
a specific case the defendant will be held liable to a third person not in
privity is a matter of policy and involves the balancing of various
factors, among which the (1) the extent to which the transaction was
intended to affect the plaintiff, (2) the foreseeability of harm to him,
(3) the degree of certainty that the plaintiff suffered injury, (4) the
closeness of the connection between the defendant's conduct and the
injury suffered, (5) the moral blame attached to the defendant's
conduct, and (6) the policy of preventing future harm.'

In the light of the foregoing tests Great Western was clearly under a
duty to the buyers of the homes to exercise reasonable care to protect
them from damages caused by major structural defects.

(1) Great Western's transactions were intended to affect the plaintiffs
significantly.

The success of Great Western's transactions with South Gate and
Conejo depended entirely upon the ability of the parties to induce
plaintiffs to buy homes in the Weathersfield tract and to finance the
purchases with funds supplied by Great Western. Great Western's
agreement to supply funds to Conejo to build homes in return for a 5
percent construction loan fee and 6.6 percent interest, was on
condition that a sufficient number of persons first made commitments
to buy homes. Great Western agreed to warehouse land for Conejo on
the understanding that the land would be used for a residential
subdivision. Great Western also stipulated that advances from its
construction loans would be used by Conejo to exercise repurchase


                                   109
options, thereby affording Great Western the opportunity for a
$30,000 capital gain. Finally, Great Western took steps to have Conejo
channel buyers of homes to its doors for loans, extracting a 1 percent
loan fee from Conejo in the process.

(2) Great Western could reasonably have foreseen the risk of harm to
plaintiffs.

Great Western knew or should have known that neither Goldberg nor
Brown had ever developed a tract of similar magnitude. Great Western
knew or should have known that Conejo was operating on a
dangerously thin capitalization, creating a readily foreseeable risk that
it would be driven to cutting corners in construction. That risk was
enlarged still further by the additional pressures on Conejo ensuing
from its onerous burdens as a borrower from Great Western.

(3) It is certain that plaintiffs suffered injury.

Counsel stipulated that each of the plaintiff homeowners, if called,
would testify that their respective homes sustained damage in varying
degrees 'of the character of which we have been concerned in this
action.' Sufficient evidence was presented to show by way of example
the existence of damage to the homes and therefore injury to
plaintiffs. Under the terms of the pretrial order, the extent of each
plaintiff's injury is to be litigated in further proceedings after the
question of Great Western's liability is determined.

(4) The injury suffered by plaintiffs was closely connected with Great
Western's conduct.

Great Western not only financed the development of the Weathersfield
tract but controlled the course it would take. Had it exercised
reasonable care in the exercise of its control, it would have discovered
that the pre-packaged plans purchased by Conejo required correction
and would have withheld financing until the plans were corrected.

(5) Substantial moral blame attaches to Great Western's conduct.

The value of the security for Great Western's construction loans as well
as the projected security for its long-term loans to plaintiffs depended
on the soundness of construction, Great Western failed of its obligation
to its own shareholders when it failed to exercise reasonable care to
preclude major structural defects in the homes whose construction it
financed and controlled. It also failed of its obligation to the buyers,


                                     110
the more so because it was well aware that the usual buyer of a home,
is ill-equipped with experience or financial means to discern such
structural defects. Moreover a home is not only a major investment for
the usual buyer but also the only shelter he has. Hence it becomes
doubly important to protect him against structural defects that could
prove beyond his capacity to remedy.

(6) The admonitory policy of the law of torts calls for the imposition of
liability on Great Western for its conduct in this case.

Rules that tend to discourage misconduct are particularly appropriate
when applied to an established industry.
By all the foregoing tests, Great Western had a duty to exercise
reasonable care to prevent the construction and sale of seriously
defective homes to plaintiffs. The countervailing considerations
invoked by Great Western and amici curiae are that the imposition of
the duty in question upon a lender will increase housing costs, drive
marginal builders out of business, and decrease total housing at a time
of great need. These are conjectural claims. In any event, there is no
enduring social utility in fostering the construction of seriously
defective homes. If reliable construction is the norm, the recognition of
a duty on the part of tract financiers to home buyers should not
materially increase the cost of housing or drive small builders out of
business. If existing sanctions are inadequate, imposition of a duty at
the point of effective financial control of tract building will insure
responsible building practices. Moreover, in either event the losses of
family savings invested in seriously defective homes would be
devastating economic blows if no redress were available.

Defendants contend, however, that the question of their liability is one
of policy, and hence should be resolved only by the Legislature after a
marshalling of relevant economic and social data. There is no
assurance, however, that the Legislature will undertake such a task,
even though tract financing grows apace. In the absence of actual or
prospective legislative policy, the court is free to resolve the case
before it, and indeed must resolve it in terms of common law.

Great Western contends that lending institutions have relied on an
assumption of non-liability and hence that a rule imposing liability
should operate prospectively only. In the past, judicial decisions have
been limited to prospective operation when they overruled earlier
decisions upon which parties had reasonably relied and when
considerations of fairness and public policy precluded retroactive
effect. Conceivably such a limitation might also be justified when there


                                   111
appeared to be a general consensus that there would be no extension
of liability. Such is not the case here. At least since MacPherson v.
Buick Motor Co. (1916), there has been a steady expansion of liability
for harm caused by the failure of defendants to exercise reasonable
care to protect others from reasonably foreseeable risks. Those in the
business of financing tract builders could therefore reasonably foresee
the possibility that they might be under a duty to exercise their power
over tract developments to protect home buyers from seriously
defective construction. Moreover, since the value of their own security
depends on the construction of sound homes, they have always been
under a duty to their shareholders to exercise reasonable care to
prevent the construction of defective homes. Given that traditional
duty of care, a lending institution should have been farsighted enough
to make such provisions for potential liability as would enable it to
withstand the effects of a decision of normal retrospective effect.

Great Western contends finally that the negligence of Conejo in
constructing the homes and the negligence of the county building
inspectors in approving the construction were superseding causes that
insulate it from liability. Conejo's negligence could not be a
superseding cause, for the risk that it might occur was the primary
hazard that gave rise to Great Western's duty. "If the realizable
likelihood that a third person may act in a particular manner is the
hazard or one of the hazards which makes the actor negligent, such an
act whether innocent, negligent, intentionally tortious or criminal does
not prevent the actor from being liable for harm caused thereby." he
negligence of the building inspectors, confined as it was to inspection,
could not serve to diminish, let alone spirit away, the negligence of the
lender. Great Western's duty to plaintiffs was to exercise reasonable
care to protect them from seriously defective construction whether
caused by defective plans, defective inspection, or both, and its
argument that there was a superseding cause of the harm 'is answered
by the settled rule that two separate acts of negligence may be the
concurring proximate causes of an injury.

The question remains whether granting a nonsuit in favor of Great
Western against cross-complainants was also erroneous. As pledgees
of promissory notes secured by second deeds of trust, cross-
complainants seek to hold Great Western liable for the impairment to
their security caused by the damage to the homes and to impose liens
on any recovery plaintiffs may obtain from Great Western or other
defendants. By stipulation and pretrial order the parties agreed that
the issue of Great Western's liability should be determined first and
that thereafter the rights and liabilities of the other parties among


                                   112
themselves should be determined. The question whether cross-
complainants are entitled to liens on any recoveries plaintiffs may
obtain from Great Western has therefore not yet been litigated.
Accordingly, it was error to grant a nonsuit against cross-complainants
as well as against plaintiffs, for in further proceedings cross-
complainants may be able to establish some basis for sharing in
plaintiffs' recoveries.

For the purposes of such proceedings, however, we also hold that
Great Western owed no independent duty of care to cross-
complainants. The balance of the factors set forth in the Biakanja case
is significantly different when an investor in or pledgee of notes
secured by second deeds of trust is substituted for a member of the
homebuying public as the party claiming a duty of care on the part of
the tract financier. Although some factors may indicate no difference
between plaintiffs and cross-complainants insofar as Great Western's
duties are concerned, others point toward a duty to plaintiffs but not
toward a duty to cross-complainants.

The foreseeability of harm to cross-complainants as a result of
defective construction was substantially less than in the case of
plaintiffs. As security cross-complainants had notes from the home
owners as well as second deeds of trust. Furthermore, they assured
themselves of a substantial margin of safety against the risk that the
notes would not be paid or that the homes would be worth less than
the purchase price when they lent only 43 percent of the face value of
the notes. Plaintiffs, on the other hand, were powerless to protect their
equities in their homes from reduction or extinction by diminution of
the value of the property as a result of defective construction.
Likewise, Great Western's negligence was more closely connected with
plaintiffs' injuries than cross-complainants' injuries. Plaintiffs were
injured by the diminution of value of their homes as a result of
defective construction. Cross-complainants will be injured only if
plaintiffs default on their notes and the diminution in value of the
homes leaves insufficient security to protect the second trust deeds.

Finally, substantially less moral blame attached to Great Western's
conduct with respect to cross-complainants than attached to its
conduct with respect to plaintiffs. The roles played by cross-
complainants and plaintiffs in the transaction were crucially different.
Like Great Western itself, cross-complainants were investors in a
business enterprise and dealt with Conejo as creditors, not as
purchasers of the homes it built. As substantial creditors of Conejo,
cross-complainants were voluntary co-participants with Great Western


                                   113
and Conejo in the enterprise of building and selling homes to the
general public. Cross-complainants did not have Great Western's
power to prevent defective construction through control of construction
loan payments; but, unlike plaintiffs, who had no practical alternative
to accepting Conejo's qualifications and responsibility on faith, cross-
complainants as substantial investors were in a position to protect
themselves. Under these circumstances, we do not believe that either
Great Western or cross-complainants were under a duty to exercise
reasonable care to protect the other from negligence on the part of
Conejo. Accordingly, Great Western's duty to exercise reasonable care
to prevent Conejo from constructing defective homes was limited to
the members of the public who bought those homes.

PETERS, TOBRINER and SULLIVAN, JJ., concur.

MOSK, Justice (dissenting).

The evidence is overwhelming, and the majority concede, that as
between the lender of funds and the tract developer there was no
agency, no joint venture, no joint enterprise. It is clear there was
merely a lender-borrower relationship. Nevertheless, the majority here
hold the lender of funds vicariously liable to third parties for the
negligence of the borrower. This result is (a) unsupported by statute or
precedent; (b) inconsistent with accepted principles of tort law; (c)
likely to be productive or untoward social consequences.
At the threshold, it would be helpful to review some elementary
economic factors and relationships that appear to be involved in this
proceeding.

The function of the entrepreneur in a free market is to discern what
goods or services are in apparent demand and to gather and arrange
the factors of production in order to supply to the consumer, at a
profit, the goods and services desired. In so doing, the enterpreneur
undertakes a number of risks. The demand may be less than he
calculated; the costs of production may be greater. He is not only in
danger of losing his own capital investment but he incurs obligations to
the suppliers of land, materials, labor and capital, and he stands liable
under now-accepted principles of law for harm and loss caused by
defects in his products to those persons injured thereby.

The entrepreneur undertakes these calculated risks in the hope of an
ultimate substantial monetary reward resulting from the return over
and above his costs, which include not only land, materials and labor
but the charges incurred in obtaining capital. Indeed, 'profit' has been


                                   114
commonly understood to be the return above expenses to innovators
or entrepreneurs as the reward for their innovation and enterprise. The
upper limit of the entrepreneur's profit is determined by his success in
the market, and this results from his skill in assessing the demand for
his product and his minimizing losses through skillful production.

Conejo Valley Development Company and associated parties were
entrepreneurs. The role of the supplier of capital is entirely different.
The lender, as a supplier of capital, is to receive by contract a fixed
return or price for his investment. He owns no right to participate in
the profits of the enterprise no matter how great they may be. On the
other hand, he is insulated from the risk of loss of capital and interest
in return for making his money available, other than the risk of
nonpayment of the contract obligations. Indeed, it is elementary that
the owner of money lends it to an entrepreneur and receives only a
fixed return, rather than obtaining the gain from using the money
himself as an entrepreneur, on the condition that he be relieved of
risk. The basic, underlying risk in mortgage lending is that the lender
might not get back what is owed to him in principal and interest.
It seems abundantly clear, both legally and logically, that if the lender
has no opportunity to share in the profits or gains beyond the fixed
return for his supplying of capital, i.e., if he has no chance of reaping
the entrepreneur's reward and exercises no control over the
entrepreneur's business, elementary fairness requires that he should
not be subjected to the entrepreneur's risks.

Great Western Savings and Loan Association was a lender, a supplier
of capital.

By imposing the entrepreneur's risks upon the supplier of capital, even
though the latter has bargained away the opportunity of participating
in the entrepreneurial gain on his capital by lending it at a fixed fee,
the majority have effected a drastic restructuring of traditional
economic relationships. The results may reverberate throughout the
economy of our state, and may seriously affect the money and
investment market, the construction industry, and regulatory schemes
of financial institutions, all without the faintest hint in either statutory
or case authority that such a draconian result is compelled.
In fact, all available authority points to a contrary result. 'The obvious
drawback of the negligence solution (to this problem) is the lack of
legal precedent for imposing such a duty upon the lending institution.'
. . . The remedy is, as it should be, against the negligent builder.
It has never been doubted that the imposition of a duty implies
significant control over the agency of harm. The issue of right of


                                    115
control goes to the very heart of the ascription of tortious
responsibility, particularly where the alleged negligent conduct is
asserted to be a failure to control the conduct of an independent third
party.

In the absence of a special relationship a party has no duty to control
the conduct of a third person, so as to prevent him from causing harm
to another. No authority holds that lender-borrower is the type of
relationship contemplating the duty of control over the conduct of
another so as to prevent injury to third parties.

The Financial Code, which contains California statutory rules governing
the operations of institutional lenders, creates no duty of care by those
institutions to any parties other than their shareholders and
depositors, and, of course, to governmental regulatory agencies.
Indeed, the majority point out that 'Great Western was clearly under a
duty of care to its shareholders to exercise its powers of control over
the enterprise to prevent the construction of defective homes. Judged
by the standards governing nonsuits, it negligently failed to discharge
That duty.' (Italics added.) That duty, the only duty delineated in the
majority opinion, was care to its shareholders. Assuming arguendo
that negligence to shareholders is reflected in the evidence, no cause
of action by these plaintiffs is stated for the obvious reason that they
were not Great Western shareholders, and thus no duty was owed to
them. . . .

Actual control or an implied agreement to control construction is a
factual question, decided against the plaintiffs here by the trier of fact.
Before the written loan contract between the lender and the developer
was signed and before the plans were approved, the lender could have
exercised 'control' over the building project only by insisting on
changes in the foundation plans as a condition of making the loan. In
this respect, the lender here is in no different position than any other
lender and exercised no greater 'control' over the building project than
any other lender who can, if he wishes, withhold funds if he believes
the funds will be used in a harmful manner.

Whether the lender should be under a duty to conduct an independent
investigation to discover defects in the plans is an entirely different
matter. The majority conclude that this duty should be imposed on the
lender here because it had control of the construction enterprise. Upon
analysis, however, it is clear that this control was mythical; it
consisted merely of the power to refuse to lend money for the project.



                                    116
In this respect all lenders may be held to 'control' the projects they
finance. Therein lies the vice of the majority opinion.

As to the 'control' exercised by Great Western after construction
began, the only right it had under the contract was to withhold funds if
the work did not conform to the plans. The inspections conducted by it
were performed for this purpose and to comply with the statutory
requirements concerning disbursement of funds. Thus, if the
foundation plans appeared defective, the lender had no right under the
contract to insist upon their revision.

Great Western's position, as indicated above, was no different from
that of any other lender: it had no contractual or statutory right to
conduct the operations of the builder-borrower. Even if it were to be
established that Great Western was negligent in its duty to its own
shareholders by extending loans to a builder of dubious competence,
this did not set in motion the subsequent relationship of the builder to
the third parties, and the builder's superseding negligence insulates
Great Western from liability for whatever negligence resulted from
merely lending money. 'If the accident would have happened anyway,
whether defendant was negligent or not, then his negligence was not a
cause in fact, and of course cannot be the legal or responsible cause.'
In short, neither the identity of the lender nor the terms of the loan
had any effect whatever upon the builder's ultimate negligence. The
lending of money cannot be said to have created a possibility of harm
to third parties. The producing institution, here the builder, created the
risk, controlled the agency of harm, and thus was the actor under a
duty to minimize the risk. The defects in home construction were not
caused by the lending of money; they were an incident of the process
of physical construction.

The majority assert the lender knew or should have known the
developers were inexperienced and undercapitalized and that there
were soil problems. Assuming this to be so, the lender may have been
remiss in its duty to its shareholders, but that conduct is unrelated to
the builder's negligence in creating structural defects which resulted in
injury to plaintiffs. The defects would have occurred if the loans were
made by defendant, if they were not made by defendant, if they were
made by another lending institution, or if the builders used their own
resources exclusively. No relationship, however tenuous, can be
established between the loans and the negligence of the builder.

The plaintiffs also rely upon the appraisals and inspections by
defendant. These, however, were performed in compliance with law


                                   117
and were intended to be a means of verifying the existence of the
construction for which loans had been made, and of determining the
progress of construction in order to regulate the disbursement rate.
The appraisals and inspections were intended only for the benefit of
defendant and state regulatory authorities. They were never in fact
communicated to outsiders, neither the general public nor the
prospective homeowners. They were not used to encourage or induce
anyone to purchase homes, but were adapted solely as tools of
internal management. Plaintiffs strain logic in attempting to convert
these internal operations of the defendant into representations to
them, negligent or otherwise.

A duty of care is imposed only upon parties creating a risk of
foreseeable harm. To find that an institutional lender, merely by
providing capital, creates a risk of foreseeable harm in place of or in
addition to the borrower who constructs or sets the harmful agency in
motion, is a novel concept of tort law. By parity of reason, a finance
company would, by lending money for the purchase of an automobile,
be liable for injuries to third parties caused by the owner's negligent
operation of the vehicle.

The majority attempt to adapt the 'balancing of various factors' in
Biakanja v. Irving (1958), 49 Cal.2d 647, 650, 320 P.2d 16, 65
A.L.R.2d 1358, to the factual circumstances here. That their reliance is
clearly misplaced is demonstrated by an analysis of the six tests of
Biakanja to establish liability in the absence of privity:

1. The extent to which the transaction was intended to affect plaintiff.
Defendant's conduct, including its appraisals, cursory inspections, and
the making of loans, was intended for its own purposes exclusively,
i.e., for the benefit of its shareholders and depositors. No
representations were made to any prospective homeowner and there
was no testimony whatever indicating any actual or prospective
homeowners relied on any representations. There can be no question
that the transaction was intended to affect the lender and the
borrower, and was not for the benefit direct or indirect of plaintiffs.

2. Foreseeability of harm. The issue under this phase of the test is the
foreseeability of harm resulting from the lender's actions as
distinguished from the conduct of the builder. It is scarcely foreseeable
by the lender, as a result of simply providing funds for construction,
that gross structural defects would exist in the homes ultimately
constructed by the builder, particularly in a situation in which
construction was overseen and approved by the governmental


                                   118
agencies of Ventura County, in which experts submitted reports on
construction problems both to the builder and to the county and in
which, contrary to the inferences in the majority opinion, the builder
came highly recommended by another experienced lender. There is a
potential risk of structural defects in any construction, but it is
impossible to find particular foreseeability of construction harm merely
from the act of a financial institution lending money to a builder.

3. The degree of certainty that the plaintiffs suffered injury. We can,
for purposes of this discussion, concede that plaintiffs suffered injury.
The issue is whether liability for that injury is to be imposed on the
nearest solvent bystander or upon the party whose negligent conduct
produced the injury.

4. Closeness of connection between injury suffered and defendant's
conduct. The lender here built no homes, drew no plans, and did not
drive in a single nail. Its function was to finance and not to construct.
The experience of the institutional lender is in lending money, not in
building homes. In short, the two enterprises have no 'closeness of
connection'; they are significantly remote. There is no evidence that
any purchasers knew of the existence of the defendant in its role as
lender of construction funds, much less that they relied upon any
activity of the lender with regard to the development.

5. Moral blame. Blameworthiness implies responsibility. The lender's
only responsibility here was to its shareholders and depositors. If any
moral blame is to be assessed, it must be by them and not by the
plaintiffs.

6. The policy of preventing future harm. Rules of law or conduct
intended to deter or minimize the risk of future harm are imposed only
upon those creating and controlling the risk of harm. The only manner
in which this policy could apply to lenders in the future--and this may
be the ultimate result of the majority opinion--is by compelling lenders
to become joint venturers with entrepreneurs. This, as indicated
heretofore, will result in a substantial alteration in the previously
accepted economic relationship between lenders and entrepreneurial
borrowers.

There appear to be adequate remedies both in law and in equity for
victims of negligent builders. But if home purchasers are not
sufficiently protected today in their available remedies for latent
constructional defects, legislative bodies can take appropriate action to
revamp building codes, give more power to regulatory agencies, make


                                   119
licensing requirements more strict, compel bonding of home builders,
provide for industry-wide insurance. The answer does not lie in a
judicially created cause of action that will compel lending institutions
to assume a supervisory role in home construction. Such a
requirement will raise interest rates and the cost of money and thus
increase the cost of home construction. More significantly, it will place
supervisory responsibility on institutions which are limited by law to
financing operations and therefore ill-equipped with the skilled
scientific, mechanical and engineering personnel necessary to perform
a supervisory function effectively.

For all of the foregoing reasons, I would affirm the judgment.

BURKE, Justice (dissenting).

I dissent. I agree with the Chief Justice that despite the extensive
activities of Great Western here the evidence, viewed most favorably
to plaintiffs, falls short of establishing the existence of a joint venture
between Great Western and Conejo or Goldberg. However, I would
hold a joint venture relationship to be the only basis for imposing
liability upon Great Western. . . .

In each of the cited cases defendant behaved negligently in carrying
out a duty of care Undertaken by defendant toward another. But in the
present case Great Western Undertook no duty toward Conejo,
Goldberg, plaintiffs, or any one else, any violation of which resulted in
plaintiffs' losses. The majority opinion speaks of a negligent failure by
Great Western of 'a duty of care to its shareholders * * * to prevent
the construction of defective homes', and on such asserted failure
appears to predicate the pronouncement of an obligation to protect
plaintiff home buyers from structural defects. Even assuming that
certain officers or employees of Great Western were derelict in their
duties of care toward Great Western and its shareholders, those
officers or employees Are not the corporation; more logically, in such a
context it is the shareholders themselves who might be said to
constitute the corporate entity. In my view negligent performance by
corporate officers or employees of their duty of care toward the
corporation and its shareholders provides no basis for imposing upon
the corporation (and therefore upon its shareholders, who must bear
the loss) a duty toward others (here, plaintiffs). The fallacy of such an
approach is readily perceived by substituting an individual financier for
Great Western. In that situation could it be said that the individual's
failure to exercise prudence and care in protecting Himself gives rise to
a duty of care to others? I think not. Similarly it would appear as


                                    120
sound to rule that an agent's violation of his obligations to his principal
would in and of itself render the principal liable to others injured in the
same transaction, and up to now such has not been the law.
I would affirm the judgment.

McCOBM, J., concurs.

McCOMB, MOSK and BURKE, JJ., dissenting.




                                    121
                  Principal-Agent Issues


                              MEINHARD
                                  v.
                               SALMON
                   249 N.Y. 458, 164 N.E. 545 (1928)

CARDOZO, C. J.

On April 10, 1902, Louisa M. Gerry leased to the defendant Walter J.
Salmon the premises known as the Hotel Bristol at the northwest
corner of Forty-Second street and Fifth avenue in the city of New York.
The lease was for a term of 20 years, commencing May 1, 1902, and
ending April 30, 1922. The lessee undertook to change the hotel
building for use as shops and offices at a cost of $200,000. Alterations
and additions were to be accretions to the land.

Salmon, while in course of treaty with the lessor as to the execution of
the lease, was in course of treaty with Meinhard, the plaintiff, for the
necessary funds. The result was a joint venture with terms embodied
in a writing. Meinhard was to pay to Salmon half of the moneys
requisite to reconstruct, alter, manage, and operate the property.
Salmon was to pay to Meinhard 40 per cent. of the net profits for the
first five years of the lease and 50 per cent. for the years thereafter. If
there were losses, each party was to bear them equally. Salmon,
however, was to have sole power to 'manage, lease, underlet and
operate' the building. There were to be certain pre-emptive rights for
each in the contingency of death.

The were coadventures, subject to fiduciary duties akin to those of
partners. As to this we are all agreed. The heavier weight of duty
rested, however, upon Salmon. He was a coadventurer with Meinhard,
but he was manager as well. During the early years of the enterprise,
the building, reconstructed, was operated at a loss. If the relation had
then ended, Meinhard as well as Salmon would have carried a heavy
burden. Later the profits became large with the result that for each of
the investors there came a rich return. For each the venture had its
phases of fair weather and of foul. The two were in it jointly, for better
or for worse.




                                    122
When the lease was near its end, Elbridge T. Gerry had become the
owner of the reversion. He owned much other property in the
neighborhood, one lot adjoining the Bristol building on Fifth Avenue
and four lots on Forty-Second street. He had a plan to lease the entire
tract for a long term to some one who would destroy the buildings
then existing and put up another in their place. In the latter part of
1921, he submitted such a project to several capitalists and dealers.
He was unable to carry it through with any of them. Then, in January,
1922, with less than four months of the lease to run, he approached
the defendant Salmon. The result was a new lease to the Midpoint
Realty Company, which is owned and controlled by Salmon, a lease
covering the whole tract, and involving a huge outlay. The term is to
be 20 years, but successive covenants for renewal will extend it to a
maximum of 80 years at the will of either party. The existing buildings
may remain unchanged for seven years. They are then to be torn
down, and a new building to cost $3,000,000 is to be placed upon the
site. The rental, which under the Bristol lease was only $55,000, is to
be from $350,000 to $475,000 for the properties so combined. Salmon
personally guaranteed the performance by the lessee of the covenants
of the new lease until such time as the new building had been
completed and fully paid for.

The lease between Gerry and the Midpoint Realty Company was signed
and delivered on January 25, 1922. Salmon had not told Meinhard
anything about it. Whatever his motive may have been, he had kept
the negotiations to himself. Meinhard was not informed even of the
bare existence of a project. The first that he knew of it was in
February, when the lease was an accomplished fact. He then made
demand on the defendants that the lease be held in trust as an asset
of the venture, making offer upon the trial to share the personal
obligations incidental to the guaranty. The demand was followed by
refusal, and later by this suit. A referee gave judgment for the
plaintiff, limiting the plaintiff's interest in the lease, however, to 25 per
cent. The limitation was on the theory that the plaintiff's equity was to
be restricted to one-half of so much of the value of the lease as was
contributed or represented by the occupation of the Bristol site. Upon
cross-appeals to the Appellate Division, the judgment was modified so
as to enlarge the equitable interest to one-half of the whole lease.
With this enlargement of plaintiff's interest, there went, of course, a
corresponding enlargement of his attendant obligations. The case is
now here on an appeal by the defendants.

Joint adventurers, like copartners, owe to one another, while the
enterprise continues, the duty of the finest loyalty. Many forms of


                                     123
conduct permissible in a workaday world for those acting at arm's
length, are forbidden to those bound by fiduciary ties. A trustee is held
to something stricter than the morals of the market place. Not honesty
alone, but the punctilio of an honor the most sensitive, is then the
standard of behavior. As to this there has developed a tradition that is
unbending and inveterate. Uncompromising rigidity has been the
attitude of courts of equity when petitioned to undermine the rule of
undivided loyalty by the 'disintegrating erosion' of particular
exceptions. Only thus has the level of conduct for fiduciaries been kept
at a level higher than that trodden by the crowd. It will not consciously
be lowered by any judgment of this court.

The owner of the reversion, Mr. Gerry, had vainly striven to find a
tenant who would favor his ambitious scheme of demolition and
construction. Beffled in the search, he turned to the defendant Salmon
in possession of the Bristol, the keystone of the project. He figured to
himself beyond a doubt that the man in possession would prove a
likely customer. To the eye of an observer, Salmon held the lease as
owner in his own right, for himself and no one else. In fact he held it
as a fiduciary, for himself and another, sharers in a common venture.
If this fact had been proclaimed, if the lease by its terms had run in
favor of a partnership, Mr. Gerry, we may fairly assume, would have
laid before the partners, and not merely before one of them, his plan
of reconstruction. The pre-emptive privilege, or, better, the pre-
emptive opportunity, that was thus an incident of the enterprise,
Salmon appropriate to himself in secrecy and silence. He might have
warned Meinhard that the plan had been submitted, and that either
would be free to compete for the award. If he had done this, we do not
need to say whether he would have been under a duty, if successful in
the competition, to hold the lease so acquired for the benefit of a
venture than about to end, and thus prolong by indirection its
responsibilities and duties. The trouble about his conduct is that he
excluded his coadventurer from any chance to compete, from any
chance to enjoy the opportunity for benefit that had come to him alone
by virtue of his agency. This chance, if nothing more, he was under a
duty to concede. The price of its denial is an extension of the trust at
the option and for the benefit of the one whom he excluded.

No answer is it to say that the chance would have been of little value
even if seasonably offered. Such a calculus of probabilities is beyond
the science of the chancery. Salmon, the real estate operator, might
have been preferred to Meinhard, the woolen merchant. On the other
hand, Meinhard might have offered better terms, or reinforced his
offer by alliance with the wealth of others. Perhaps he might even


                                   124
have persuaded the lessor to renew the Bristol lease alone, postponing
for a time, in return for higher rentals, the improvement of adjoining
lots. We know that even under the lease as made the time for the
enlargement of the building was delayed for seven years. All these
opportunities were cut away from him through another's intervention.
He knew that Salmon was the manager. As the time drew near for the
expiration of the lease, he would naturally assume from silence, if from
nothing else, that the lessor was willing to extend it for a term of
years, or at least to let it stand as a lease from year to year. Not
impossibly the lessor would have done so, whatever his protestations
of unwillingness, if Salmon had not given assent to a project more
attractive. At all events, notice of termination, even if not necessary,
might seem, not unreasonably, to be something to be looked for, if the
business was over the another tenant was to enter. In the absence of
such notice, the matter of an extension was one that would naturally
be attended to by the manager of the enterprise, and not neglected
altogether. At least, there was nothing in the situation to give warning
to any one that while the lease was still in being, there had come to
the manager an offer of extension which he had locked within his
breast to be utilized by himself alone. The very fact that Salmon was
in control with exclusive powers of direction charged him the more
obviously with the duty of disclosure, since only through disclosure
could opportunity be equalized. If he might cut off renewal by a
purchase for his own benefit when four months were to pass before
the lease would have an end, he might do so with equal right while
there remained as many years. He might steal a march on his
comrade under cover of the darkness, and then hold the captured
ground. Loyalty and comradeship are not so easily abjured. . . .

We have no thought to hold that Salmon was guilty of a conscious
purpose to defraud. Very likely he assumed in all good faith that with
the approaching end of the venture he might ignore his coadventurer
and take the extension for himself. He had given to the enterprise time
and labor as well as money. He had made it a success. Meinhard, who
had given money, but neither time nor labor, had already been richly
paid. There might seem to be something grasping in his insistence
upon more. Such recriminations are not unusual when coadventurers
fall out. They are not without their force if conduct is to be judged by
the common standards of competitors. That is not to say that they
have pertinency here. Salmon had put himself in a position in which
thought of self was to be renounced, however hard the abnegation. He
was much more than a coadventurer. He was a managing
coadventurer. For him and for those like him the rule of undivided
loyalty is relentless and supreme.


                                  125
A different question would be here if there were lacking any nexus of
relation between the business conducted by the manager and the
opportunity brought to him as an incident of management. For this
problem, as for most, there are distinctions of degree. If Salmon had
received from Gerry a proposition to lease a building at a location far
removed, he might have held for himself the privilege thus acquired,
or so we shall assume. Here the subject-matter of the new lease was
an extension and enlargement of the subject-matter of the old one. A
managing coadventurer appropriating the benefit of such a lease
without warning to his partner might fairly expect to be reproached
with conduct that was underhand, or lacking, to say the least, in
reasonable candor, if the partner were to surprise him in the act of
signing the new instrument. Conduct subject to that reproach does not
receive from equity a healing benediction.

A question remains as to the form and extent of the equitable interest
to be allotted to the plaintiff. The trust as declared has been held to
attach to the lease which was in the name of the defendant
corporation. We think it ought to attach at the option of the defendant
Salmon to the shares of stock which were owned by him or were under
his control. The difference may be important if the lessee shall wish to
execute an assignment of the lease, as it ought to be free to do with
the consent of the lessor. On the other hand, an equal division of the
shares might lead to other hardships. It might take away from Salmon
the power of control and management which under the plan of the
joint venture he was to have from first to last. The number of shares
to be allotted to the plaintiff should, therefore, be reduced to such an
extent as may be necessary to preserve to the defendant Salmon the
expected measure of dominion. To that end an extra share should be
added to his half.

Subject to this adjustment, we agree with the Appellate Division that
the plaintiff's equitable interest is to be measured by the value of half
of the entire lease, and not merely by half of some undivided part. A
single building covers the whole area. Physical division is impracticable
along the lines of the Bristol site, the keystone of the whole. Division
of interests and burdens is equally impracticable. Salmon, as tenant
under the new lease, or as guarantor of the performance of the
tenant's obligations, might well protest if Meinhard, Claiming an
equitable interest, had offered to assume a liability not equal to
Salmon's, but only half as great. He might justly insist that the lease
must be accepted by his coadventurer in such form as it had been
given, and not constructively divided into imaginery fragments. What


                                   126
must be yielded to the one may be demanded by the other. The lease
as it has been executed is single and entire. If confusion has resulted
from the union of adjoining parcels, the trustee who consented to the
union must bear the inconvenience. . . .

The judgment should be modified by providing that at the option of the
defendant Salmon there may be substituted for a trust attaching to the
lease a trust attaching to the shares of stock, with the result that one-
half of such shares together with one additional share will in that event
be allotted to the defendant Salmon and the other shares to the
plaintiff, and as so modified the judgment should be affirmed with
costs.

ANDREWS, J. (dissenting).

[omitted].




                                   127
                             KIDD
                              v.
                     THOMAS A. EDISON, Inc.
                      239 F. 405 (S.D.N.Y. 1917)

An agent, authorized to engage singers for recitals in connection with
phonograph records, held to have implied authority to bind his
principal to pay the singer, notwithstanding an undisclosed restriction
to arrange for only such recitals as the dealers would pay for.
This is a motion by the defendant to set aside a verdict for the plaintiff
on exceptions. The action was in contract, and depended upon the
authority of one Fuller to make a contract with the plaintiff, engaging
her without condition to sing for the defendant in a series of 'tone test'
recitals, designed to show the accuracy with which her voice was
reproduced by the defendant's records. The defendant contended that
Fuller's only authority was to engage the plaintiff for such recitals as
he could later persuade dealers in the records to book her for all over
the United States. The dealers, the defendant said, were to agree to
pay her for the recitals, and the defendant would then guarantee her
the dealers' performance. The plaintiff said the contract was an
unconditional engagement for a singing tour, and the jury so found.
The sole exception of consequence was whether there was either any
question of fact involved in Fuller's authority, or a fortiori whether
there was no evidence of any authority. In either event the charge was
erroneous, and the defendant's exception was good.

The pertinent testimony was that of Maxwell, and was as follows: He
intrusted to Fuller particularly the matters connected with the
arranging of these 'tone test' recitals. He told him to learn from the
artists what fees they would expect, and to tell them that the
defendant would pay the railroad fares and expenses. He also told
Fuller to explain to them that the defendant would book them, and act
as booking agent for them, and would see that the money was paid by
the dealers; in fact, the defendant would itself pay it. He told him to
prepare a form of contract suitable for such an arrangement with such
artists as he succeeded in getting to go into it, and that he (Maxwell)
would prepare a form of booking contract with the dealers. He told him
to prepare a written contract with the artists and submit it to him
(Maxwell), which he did. He told him that he was himself to make the
contracts with the artists by which they were to be booked, that he
was not to bring them to him (Maxwell), but that he should learn what




                                   128
fees they would demand, and then confirm the oral agreement by a
letter, which would serve as a contract.
This is all the relevant testimony.

LEARNED HAND, District Judge (after stating the facts as above).

The point involved is the scope of Fuller's 'apparent authority,' as
distinct from the actual authority limited by the instructions which
Maxwell gave him. The phrase 'apparent authority,' though it occurs
repeatedly in the Reports, has been often criticized, and its use is by
no means free from ambiguity. The scope of any authority must, of
course, in the first place, be measured, not alone by the words in
which it is created, but by the whole setting in which those words are
used, including the customary powers of such agents. This is,
however, no more than to regard the whole of the communication
between the principal and agent before assigning its meaning, and
does not differ in method from any other interpretation of verbal acts.
In considering what was Fuller's actual implied authority by custom,
while it is fair to remember that the 'tone test' recitals were new, in
the sense that no one had ever before employed singers for just this
purpose of comparing their voices with their mechanical reproduction,
they were not new merely as musical recitals; for it was, of course, a
common thing to engage singers for such recitals.

When, therefore, an agent is selected, as was Fuller, to engage singers
for musical recitals, the customary implication would seem to have
been that his authority was without limitation of the kind here
imposed, which was unheard of in the circumstances. The mere fact
that the purpose of the recitals was advertisement, instead of entrance
fees, gave no intimation to a singer dealing with him that the
defendant's promise would be conditional upon so unusual a condition
as that actually imposed. Being concerned to sell its records, the
venture might rightly be regarded as undertaken on its own account,
and, like similar enterprises, at its own cost. The natural surmise
would certainly be that such an undertaking was a part of the
advertising expenses of the business, and that therefore Fuller might
engage singers upon similar terms to those upon which singers for
recitals are generally engaged, where the manager expects a profit,
direct or indirect.

Therefore it is enough for the decision to say that the customary
extent of such an authority as was actually conferred comprised such a
contract. If estoppel be, therefore, the basis of all 'apparent authority,'
it existed here. Yet the argument involves a misunderstanding of the


                                    129
true significance of the doctrine, both historically and actually. The
responsibility of a master for his servant's act is not at bottom a
matter of consent to the express act, or of an estoppel to deny that
consent, but it is a survival from ideas of status, and the imputed
responsibility congenial to earlier times, preserved now from motives
of policy. While we have substituted for the archaic status a test based
upon consent, i.e., the general scope of the business, within that
sphere the master is held by principles quite independent of his actual
consent, and indeed in the face of his own instructions. . . . It is only a
fiction to say that the principal is estopped, when he has not
communicated with the third person and thus misled him. There are,
indeed, the cases of customary authority, which perhaps come within
the range of a true estoppel; but in other cases the principal may
properly say that the authority which he delegated must be judged by
his directions, taken together, and that it is unfair to charge him with
misleading the public, because his agent, in executing that authority,
has neither observed, nor communicated, an important part of them.
Certainly it begs the question to assume that the principal has
authorized his agent to communicate a part of his authority and not to
disclose the rest. Hence, even in contract, there are many cases in
which the principle of estoppel is a factitious effort to impose the
rationale of a later time upon archaic ideas, which, it is true, owe their
survival to convenience, but to a very different from the putative
convenience attributed to them.

However it may be of contracts, all color of plausibility falls away in
the case of torts, where indeed the doctrine first arose, and where it
still thrives. It makes no difference that the agent may be disregarding
his principal's directions, secret or otherwise, so long as he continues
in that larger field measured by the general scope of the business
intrusted to his care.

The considerations which have made the rule survive are apparent. If
a man select another to act for him with some discretion, he has by
that fact vouched to some extent for his reliability. While it may not be
fair to impose upon him the results of a total departure from the
general subject of his confidence, the detailed execution of his
mandate stands on a different footing. The very purpose of delegated
authority is to avoid constant recourse by third persons to the
principal, which would be a corollary of denying the agent any latitude
beyond his exact instructions. Once a third person has assured himself
widely of the character of the agent's mandate, the very purpose of
the relation demands the possibility of the principal's being bound



                                    130
through the agent's minor deviations. Thus, as so often happens,
archaic ideas continue to serve good, though novel, purposes.

In the case at bar there was no question of fact for the jury touching
the scope of Fuller's authority. His general business covered the whole
tone test recitals; upon him was charged the duty of doing everything
necessary in the premises, without recourse to Maxwell or any one
else. It would certainly have been quite contrary to the expectations of
the defendant, if any of the prospective performers at the recitals had
insisted upon verifying directly with Maxwell the terms of her contract.
It was precisely to delegate such negotiations to a competent
substitute that they chose Fuller at all.

The exception is without merit; the motion is denied.




                                  131
                       New Castle County.
  In re CAREMARK INTERNATIONAL INC. DERIVATIVE LITIGATION.
                          698 A.2d 959
              Court of Chancery of Delaware (1996)


ALLEN, Chancellor.

Pending is a motion pursuant to Chancery Rule 23.1 to approve as fair
and reasonable a proposed settlement of a consolidated derivative
action on behalf of Caremark International, Inc. (“Caremark”). The suit
involves claims that the members of Caremark's board of directors
(the “Board”) breached their fiduciary duty of care to Caremark in
connection with alleged violations by Caremark employees of federal
and state laws and regulations applicable to health care providers. As
a result of the alleged violations, Caremark was subject to an
extensive four year investigation by the United States Department of
Health and Human Services and the Department of Justice. In 1994
Caremark was charged in an indictment with multiple felonies. It
thereafter entered into a number of agreements with the Department
of Justice and others. Those agreements included a plea agreement in
which Caremark pleaded guilty to a single felony of mail fraud and
agreed to pay civil and criminal fines. Subsequently, Caremark agreed
to make reimbursements to various private and public parties. In all,
the payments that Caremark has been required to make total
approximately $250 million.


This suit was filed in 1994, purporting to seek on behalf of the
company recovery of these losses from the individual defendants who
constitute the board of directors of Caremark. The parties now propose
that it be settled and, after notice to Caremark shareholders, a hearing
on the fairness of the proposal was held on August 16, 1996.




                                  132
A motion of this type requires the court to assess the strengths and
weaknesses of the claims asserted in light of the discovery record and
to evaluate the fairness and adequacy of the consideration offered to
the corporation in exchange for the release of all claims made or
arising from the facts alleged. The ultimate issue then is whether the
proposed settlement appears to be fair to the corporation and its
absent shareholders. In this effort the court does not determine
contested facts, but evaluates the claims and defenses on the
discovery record to achieve a sense of the relative strengths of the
parties' positions. Polk v. Good, Del.Supr., 507 A.2d 531, 536 (1986).
In doing this, in most instances, the court is constrained by the
absence of a truly adversarial process, since inevitably both sides
support the settlement and legally assisted objectors are rare. Thus,
the facts stated hereafter represent the court's effort to understand
the context of the motion from the discovery record, but do not
deserve the respect that judicial findings after trial are customarily
accorded.


Legally, evaluation of the central claim made entails consideration of
the legal standard governing a board of directors' obligation to
supervise or monitor corporate performance. For the reasons set forth
below I conclude, in light of the discovery record, that there is a very
low probability that it would be determined that the directors of
Caremark breached any duty to appropriately monitor and supervise
the enterprise. Indeed the record tends to show an active
consideration by Caremark management and its Board of the
Caremark structures and programs that ultimately led to the
company's indictment and to the large financial losses incurred in the
settlement of those claims. It does not tend to show knowing or
intentional violation of law. Neither the fact that the Board, although
advised by lawyers and accountants, did not accurately predict the
severe consequences to the company that would ultimately follow from
the deployment by the company of the strategies and practices that
ultimately led to this liability, nor the scale of the liability, gives rise to
an inference of breach of any duty imposed by corporation law upon
the directors of Caremark.


I. BACKGROUND

For these purposes I regard the following facts, suggested by the
discovery record, as material. Caremark, a Delaware corporation with
its headquarters in Northbrook, Illinois, was created in November 1992


                                     133
when it was spun-off from Baxter International, Inc. (“Baxter”) and
became a publicly held company listed on the New York Stock
Exchange. The business practices that created the problem pre-dated
the spin-off. During the relevant period Caremark was involved in two
main health care business segments, providing patient care and
managed care services. As part of its patient care business, which
accounted for the majority of Caremark's revenues, Caremark
provided alternative site health care services, including infusion
therapy, growth hormone therapy, HIV/AIDS-related treatments and
hemophilia therapy. Caremark's managed care services included
prescription drug programs and the operation of multi-specialty group
practices.

A. Events Prior to the Government Investigation

A substantial part of the revenues generated by Caremark's businesses
is derived from third party payments, insurers, and Medicare and
Medicaid reimbursement programs. The latter source of payments are
subject to the terms of the Anti-Referral Payments Law (“ARPL”) which
prohibits health care providers from paying any form of remuneration
to induce the referral of Medicare or Medicaid patients. From its
inception, Caremark entered into a variety of agreements with
hospitals, physicians, and health care providers for advice and
services, as well as distribution agreements with drug manufacturers,
as had its predecessor prior to 1992. Specifically, Caremark did have a
practice of entering into contracts for services (e.g., consultation
agreements and research grants) with physicians at least some of
whom prescribed or recommended services or products that Caremark
provided to Medicare recipients and other patients. Such contracts
were not prohibited by the ARPL but they obviously raised a possibility
of unlawful “kickbacks.”


As early as 1989, Caremark's predecessor issued an internal “Guide to
Contractual Relationships” (“Guide”) to govern its employees in
entering into contracts with physicians and hospitals. The Guide
tended to be reviewed annually by lawyers and updated. Each version
of the Guide stated as Caremark's and its predecessor's policy that no
payments would be made in exchange for or to induce patient
referrals. But what one might deem a prohibited quid pro quo was not
always clear. Due to a scarcity of court decisions interpreting the
ARPL, however, Caremark repeatedly publicly stated that there was
uncertainty concerning Caremark's interpretation of the law.



                                  134
To clarify the scope of the ARPL, the United States Department of
Health and Human Services (“HHS”) issued “safe harbor” regulations
in July 1991 stating conditions under which financial relationships
between health care service providers and patient referral sources,
such as physicians, would not violate the ARPL. Caremark contends
that the narrowly drawn regulations gave limited guidance as to the
legality of many of the agreements used by Caremark that did not fall
within the safe-harbor. Caremark's predecessor, however, amended
many of its standard forms of agreement with health care providers
and revised the Guide in an apparent attempt to comply with the new
regulations.

B. Government Investigation and Related Litigation

In August 1991, the HHS Office of the Inspector General (“OIG”)
initiated an investigation of Caremark's predecessor. Caremark's
predecessor was served with a subpoena requiring the production of
documents, including contracts between Caremark's predecessor and
physicians (Quality Service Agreements (“QSAs”)). Under the QSAs,
Caremark's predecessor appears to have paid physicians fees for
monitoring patients under Caremark's predecessor's care, including
Medicare and Medicaid recipients. Sometimes apparently those
monitoring patients were referring physicians, which raised ARPL
concerns.

In March 1992, the Department of Justice (“DOJ”) joined the OIG
investigation and separate investigations were commenced by several
additional federal and state agencies.FN2

C. Caremark's Response to the Investigation

During the relevant period, Caremark had approximately 7,000
employees and ninety branch operations. It had a decentralized
management structure. By May 1991, however, Caremark asserts that
it had begun making attempts to centralize its management structure
in order to increase supervision over its branch operations.

The first action taken by management, as a result of the initiation of
the OIG investigation, was an announcement that as of October 1,
1991, Caremark's predecessor would no longer pay management fees
to physicians for services to Medicare and Medicaid patients. Despite
this decision, Caremark asserts that its management, pursuant to



                                  135
advice, did not believe that such payments were illegal under the
existing laws and regulations.

During this period, Caremark's Board took several additional steps
consistent with an effort to assure compliance with company policies
concerning the ARPL and the contractual forms in the Guide. In April
1992, Caremark published a fourth revised version of its Guide
apparently designed to assure that its agreements either complied
with the ARPL and regulations or excluded Medicare and Medicaid
patients altogether. In addition, in September 1992, Caremark
instituted a policy requiring its regional officers, Zone Presidents, to
approve each contractual relationship entered into by Caremark with a
physician.

Although there is evidence that inside and outside counsel had advised
Caremark's directors that their contracts were in accord with the law,
Caremark recognized that some uncertainty respecting the correct
interpretation of the law existed. In its 1992 annual report, Caremark
disclosed the ongoing government investigations, acknowledged that if
penalties were imposed on the company they could have a material
adverse effect on Caremark's business, and stated that no assurance
could be given that its interpretation of the ARPL would prevail if
challenged.

Throughout the period of the government investigations, Caremark
had an internal audit plan designed to assure compliance with business
and ethics policies. In addition, Caremark employed Price Waterhouse
as its outside auditor. On February 8, 1993, the Ethics Committee of
Caremark's Board received and reviewed an outside auditors report by
Price Waterhouse which concluded that there were no material
weaknesses in Caremark's control structure. Despite the positive
findings of Price Waterhouse, however, on April 20, 1993, the Audit &
Ethics Committee adopted a new internal audit charter requiring a
comprehensive review of compliance policies and the compilation of an
employee ethics handbook concerning such policies.

The Board appears to have been informed about this project and other
efforts to assure compliance with the law. For example, Caremark's
management reported to the Board that Caremark's sales force was
receiving an ongoing education regarding the ARPL and the proper use
of Caremark's form contracts which had been approved by in-house
counsel. On July 27, 1993, the new ethics manual, expressly
prohibiting payments in exchange for referrals and requiring
employees to report all illegal conduct to a toll free confidential ethics


                                   136
hotline, was approved and allegedly disseminated.FN5 The record
suggests that Caremark continued these policies in subsequent years,
causing employees to be given revised versions of the ethics manual
and requiring them to participate in training sessions concerning
compliance with the law.

During 1993, Caremark took several additional steps which appear to
have been aimed at increasing management supervision. These steps
included new policies requiring local branch managers to secure home
office approval for all disbursements under agreements with health
care providers and to certify compliance with the ethics program. In
addition, the chief financial officer was appointed to serve as
Caremark's compliance officer. In 1994, a fifth revised Guide was
published.

D. Federal Indictments Against Caremark and Officers

On August 4, 1994, a federal grand jury in Minnesota issued a 47 page
indictment charging Caremark, two of its officers (not the firm's chief
officer), an individual who had been a sales employee of Genentech,
Inc., and David R. Brown, a physician practicing in Minneapolis, with
violating the ARPL over a lengthy period. According to the indictment,
over $1.1 million had been paid to Brown to induce him to distribute
Protropin, a human growth hormone drug marketed by Caremark. The
substantial payments involved started, according to the allegations of
the indictment, in 1986 and continued through 1993. Some payments
were “in the guise of research grants”, Ind. ¶ 20, and others were
“consulting agreements”, Ind. ¶ 19. The indictment charged, for
example, that Dr. Brown performed virtually none of the consulting
functions described in his 1991 agreement with Caremark, but was
nevertheless neither required to return the money he had received nor
precluded from receiving future funding from Caremark. In addition
the indictment charged that Brown received from Caremark payments
of staff and office expenses, including telephone answering services
and fax rental expenses.

In reaction to the Minnesota Indictment and the subsequent filing of
this and other derivative actions in 1994, the Board met and was
informed by management that the investigation had resulted in an
indictment; Caremark denied any wrongdoing relating to the
indictment and believed that the OIG investigation would have a
favorable outcome. Management reiterated the grounds for its view
that the contracts were in compliance with law.



                                  137
Subsequently, five stockholder derivative actions were filed in this
court and consolidated into this action. The original complaint, dated
August 5, 1994, alleged, in relevant part, that Caremark's directors
breached their duty of care by failing adequately to supervise the
conduct of Caremark employees, or institute corrective measures,
thereby exposing Caremark to fines and liability.

On September 21, 1994, a federal grand jury in Columbus, Ohio
issued another indictment alleging that an Ohio physician had
defrauded the Medicare program by requesting and receiving
$134,600 in exchange for referrals of patients whose medical costs
were in part reimbursed by Medicare in violation of the ARPL. Although
unidentified at that time, Caremark was the health care provider who
allegedly made such payments. The indictment also charged that the
physician, Elliot Neufeld, D.O., was provided with the services of a
registered nurse to work in his office at the expense of the infusion
company, in addition to free office equipment.

An October 28, 1994 amended complaint in this action added
allegations concerning the Ohio indictment as well as new allegations
of over billing and inappropriate referral payments in connection with
an action brought in Atlanta, Booth v. Rankin. Following a newspaper
article report that federal investigators were expanding their inquiry to
look at Caremark's referral practices in Michigan as well as allegations
of fraudulent billing of insurers, a second amended complaint was filed
in this action. The third, and final, amended complaint was filed on
April 11, 1995, adding allegations that the federal indictments had
caused Caremark to incur significant legal fees and forced it to sell its
home infusion business at a loss.

After each complaint was filed, defendants filed a motion to dismiss.
According to defendants, if a settlement had not been reached in this
action, the case would have been dismissed on two grounds. First,
they contend that the complaints fail to allege particularized facts
sufficient to excuse the demand requirement under Delaware Chancery
Court Rule 23.1. Second, defendants assert that plaintiffs had failed to
state a cause of action due to the fact that Caremark's charter
eliminates directors' personal liability for money damages, to the
extent permitted by law.

E. Settlement Negotiations

...



                                   138
Caremark began settlement negotiations with federal and state
government entities in May 1995. In return for a guilty plea to a single
count of mail fraud by the corporation, the payment of a criminal fine,
the payment of substantial civil damages, and cooperation with further
federal investigations on matters relating to the OIG investigation, the
government entities agreed to negotiate a settlement that would
permit Caremark to continue participating in Medicare and Medicaid
programs. On June 15, 1995, the Board approved a settlement
(“Government Settlement Agreement”) with the DOJ, OIG, U.S.
Veterans Administration, U.S. Federal Employee Health Benefits
Program, federal Civilian Health and Medical Program of the Uniformed
Services, and related state agencies in all fifty states and the District
of Columbia.FN10 No senior officers or directors were charged with
wrongdoing in the Government Settlement Agreement or in any of the
prior indictments. In fact, as part of the sentencing in the Ohio action
on June 19, 1995, the United States stipulated that no senior
executive of Caremark participated in, condoned, or was willfully
ignorant of wrongdoing in connection with the home infusion business
practices.

The federal settlement included certain provisions in a “Corporate
Integrity Agreement” designed to enhance future compliance with law.
The parties have not discussed this agreement, except to say that the
negotiated provisions of the settlement of this claim are not redundant
of those in that agreement.

Settlement negotiations between the parties in this action commenced
in May 1995 as well, based upon a letter proposal of the plaintiffs,
dated May 16, 1995.FN12 These negotiations resulted in a
memorandum of understanding (“MOU”), dated June 7, 1995, and the
execution of the Stipulation and Agreement of Compromise and
Settlement on June 28, 1995, which is the subject of this action. The
MOU, approved by the Board on June 15, 1995, required the Board to
adopt several resolutions, discussed below, and to create a new
compliance committee. The Compliance and Ethics Committee has
been reporting to the Board in accord with its newly specified duties.

After negotiating these settlements, Caremark learned in December
1995 that several private insurance company payors (“Private Payors”)
believed that Caremark was liable for damages to them for allegedly
improper business practices related to those at issue in the OIG
investigation. As a result of intensive negotiations with the Private


                                   139
Payors and the Board's extensive consideration of the alternatives for
dealing with such claims, the Board approved a $98.5 million
settlement agreement with the Private Payors on March 18, 1996. In
its public disclosure statement, Caremark asserted that the settlement
did not involve current business practices and contained an express
denial of any wrongdoing by Caremark. After further discovery in this
action, the plaintiffs decided to continue seeking approval of the
proposed settlement agreement.

F. The Proposed Settlement of this Litigation

In relevant part the terms upon which these claims asserted are
proposed to be settled are as follows:

1. That Caremark, undertakes that it and its employees, and agents
not pay any form of compensation to a third party in exchange for the
referral of a patient to a Caremark facility or service or the prescription
of drugs marketed or distributed by Caremark for which
reimbursement may be sought from Medicare, Medicaid, or a similar
state reimbursement program;

2. That Caremark, undertakes for itself and its employees, and agents
not to pay to or split fees with physicians, joint ventures, any business
combination in which Caremark maintains a direct financial interest, or
other health care providers with whom Caremark has a financial
relationship or interest, in exchange for the referral of a patient to a
Caremark facility or service or the prescription of drugs marketed or
distributed by Caremark for which reimbursement may be sought from
Medicare, Medicaid, or a similar state reimbursement program;

3. That the full Board shall discuss all relevant material changes in
government health care regulations and their effect on relationships
with health care providers on a semi-annual basis;

4. That Caremark's officers will remove all personnel from health care
facilities or hospitals who have been placed in such facility for the
purpose of providing remuneration in exchange for a patient referral
for which reimbursement may be sought from Medicare, Medicaid, or a
similar state reimbursement program;

5. That every patient will receive written disclosure of any financial
relationship between Caremark and the health care professional or
provider who made the referral;



                                    140
6. That the Board will establish a Compliance and Ethics Committee of
four directors, two of which will be non-management directors, to
meet at least four times a year to effectuate these policies and monitor
business segment compliance with the ARPL, and to report to the
Board semi-annually concerning compliance by each business
segment; and

7. That corporate officers responsible for business segments shall
serve as compliance officers who must report semi-annually to the
Compliance and Ethics Committee and, with the assistance of outside
counsel, review existing contracts and get advanced approval of any
new contract forms.


II. LEGAL PRINCIPLES

A. Principles Governing Settlements of Derivative Claims

As noted at the outset of this opinion, this Court is now required to
exercise an informed judgment whether the proposed settlement is fair
and reasonable in the light of all relevant factors. Polk v. Good,
Del.Supr., 507 A.2d 531 (1986). On an application of this kind, this
Court attempts to protect the best interests of the corporation and its
absent shareholders all of whom will be barred from future litigation on
these claims if the settlement is approved. The parties proposing the
settlement bear the burden of persuading the court that it is in fact fair
and reasonable. Fins v. Pearlman, Del.Supr., 424 A.2d 305 (1980).

B. Directors' Duties To Monitor Corporate Operations

The complaint charges the director defendants with breach of their
duty of attention or care in connection with the on-going operation of
the corporation's business. The claim is that the directors allowed a
situation to develop and continue which exposed the corporation to
enormous legal liability and that in so doing they violated a duty to be
active monitors of corporate performance. The complaint thus does not
charge either director self-dealing or the more difficult loyalty-type
problems arising from cases of suspect director motivation, such as
entrenchment or sale of control contexts. The theory here advanced is
possibly the most difficult theory in corporation law upon which a
plaintiff might hope to win a judgment. The good policy reasons why it
is so difficult to charge directors with responsibility for corporate losses
for an alleged breach of care, where there is no conflict of interest or


                                    141
no facts suggesting suspect motivation involved, were recently
described in Gagliardi v. TriFoods Int'l, Inc., Del.Ch., 683 A.2d 1049,
1051 (1996) (1996 Del.Ch. LEXIS 87 at p. 20).

1. Potential liability for directoral decisions: Director liability for a
breach of the duty to exercise appropriate attention may, in theory,
arise in two distinct contexts. First, such liability may be said to follow
from a board decision that results in a loss because that decision was
ill advised or “negligent”. Second, liability to the corporation for a loss
may be said to arise from an unconsidered failure of the board to act
in circumstances in which due attention would, arguably, have
prevented the loss. See generally Veasey & Seitz, The Business
Judgment Rule in the Revised Model Act ... 63 Texas L.Rev. 1483
(1985). The first class of cases will typically be subject to review under
the director-protective business judgment rule, assuming the decision
made was the product of a process that was either deliberately
considered in good faith or was otherwise rational. See Aronson v.
Lewis, Del.Supr., 473 A.2d 805 (1984); Gagliardi v. TriFoods Int'l,
Inc., Del.Ch., 683 A.2d 1049 (1996). What should be understood, but
may not widely be understood by courts or commentators who are not
often required to face such questions,FN15 is that compliance with a
director's duty of care can never appropriately be judicially determined
by reference to the content of the board decision that leads to a
corporate loss, apart from consideration of the good faith or rationality
of the process employed. That is, whether a judge or jury considering
the matter after the fact, believes a decision substantively wrong, or
degrees of wrong extending through “stupid” to “egregious” or
“irrational”, provides no ground for director liability, so long as the
court determines that the process employed was either rational or
employed in a good faith effort to advance corporate interests. To
employ a different rule-one that permitted an “objective” evaluation of
the decision-would expose directors to substantive second guessing by
ill-equipped judges or juries, which would, in the long-run, be injurious
to investor interests.FN16 Thus, the business*968 judgment rule is
process oriented and informed by a deep respect for all good faith
board decisions.

FN16. The vocabulary of negligence while often employed, e.g.,
Aronson v. Lewis, Del.Supr., 473 A.2d 805 (1984) is not well-suited to
judicial review of board attentiveness, see, e.g., Joy v. North, 692 F.2d
880, 885-6 (2d Cir.1982), especially if one attempts to look to the
substance of the decision as any evidence of possible “negligence.”
Where review of board functioning is involved, courts leave behind as
a relevant point of reference the decisions of the hypothetical


                                    142
“reasonable person”, who typically supplies the test for negligence
liability. It is doubtful that we want business men and women to be
encouraged to make decisions as hypothetical persons of ordinary
judgment and prudence might. The corporate form gets its utility in
large part from its ability to allow diversified investors to accept
greater investment risk. If those in charge of the corporation are to be
adjudged personally liable for losses on the basis of a substantive
judgment based upon what an persons of ordinary or average
judgment and average risk assessment talent regard as “prudent”
“sensible” or even “rational”, such persons will have a strong incentive
at the margin to authorize less risky investment projects.

Indeed, one wonders on what moral basis might shareholders attack a
good faith business decision of a director as “unreasonable” or
“irrational”. Where a director in fact exercises a good faith effort to be
informed and to exercise appropriate judgment, he or she should be
deemed to satisfy fully the duty of attention. If the shareholders
thought themselves entitled to some other quality of judgment than
such a director produces in the good faith exercise of the powers of
office, then the shareholders should have elected other directors.
Judge Learned Hand made the point rather better than can I. In
speaking of the passive director defendant Mr. Andrews in Barnes v.
Andrews, Judge Hand said:


      True, he was not very suited by experience for the job he
      had undertaken, but I cannot hold him on that account.
      After all it is the same corporation that chose him that now
      seeks to charge him.... Directors are not specialists like
      lawyers or doctors.... They are the general advisors of the
      business and if they faithfully give such ability as they
      have to their charge, it would not be lawful to hold them
      liable. Must a director guarantee that his judgment is
      good? Can a shareholder call him to account for
      deficiencies that their votes assured him did not disqualify
      him for his office? While he may not have been the
      Cromwell for that Civil War, Andrews did not engage to
      play any such role.



In this formulation Learned Hand correctly identifies, in my opinion,
the core element of any corporate law duty of care inquiry: whether
there was good faith effort to be informed and exercise judgment.


                                   143
2. Liability for failure to monitor: The second class of cases in which
director liability for inattention is theoretically possible entail
circumstances in which a loss eventuates not from a decision but, from
unconsidered inaction. Most of the decisions that a corporation, acting
through its human agents, makes are, of course, not the subject of
director attention. Legally, the board itself will be required only to
authorize the most significant corporate acts or transactions: mergers,
changes in capital structure, fundamental changes in business,
appointment and compensation of the CEO, etc. As the facts of this
case graphically demonstrate, ordinary business decisions that are
made by officers and employees deeper in the interior of the
organization can, however, vitally affect the welfare of the corporation
and its ability to achieve its various strategic and financial goals. If this
case did not prove the point itself, recent business history would.
Recall for example the displacement of senior management and much
of the board of Salomon, Inc.; the replacement of senior management
of Kidder, Peabody following the discovery of large trading losses
resulting from phantom trades by a highly compensated trader; or the
extensive financial loss and reputational injury suffered by Prudential
Insurance as a result its junior officers misrepresentations in
connection with the distribution of limited partnership interests.
Financial and organizational disasters such as these raise the question,
what is the board's responsibility with respect to the organization and
monitoring of the enterprise to assure that the corporation functions
within the law to achieve its purposes?

Modernly this question has been given special importance by an
increasing tendency, especially under federal law, to employ the
criminal law to assure corporate compliance with external legal
requirements, including environmental, financial, employee and
product safety as well as assorted other health and safety regulations.
In 1991, pursuant to the Sentencing Reform Act of 1984,FN21 the
United States Sentencing Commission adopted Organizational
Sentencing Guidelines which impact importantly on the prospective
effect these criminal sanctions might have on business corporations.
The Guidelines set forth a uniform sentencing structure for
organizations to be sentenced for violation of federal criminal statutes
and provide for penalties that equal or often massively exceed those
previously imposed on corporations.FN22 The Guidelines offer powerful
incentives for corporations today to have in place compliance
programs to detect violations of law, promptly to report violations to



                                     144
appropriate public officials when discovered, and to take prompt,
voluntary remedial efforts.

In 1963, the Delaware Supreme Court in Graham v. Allis-Chalmers
Mfg. Co., addressed the question of potential liability of board
members for losses experienced by the corporation as a result of the
corporation having violated the anti-trust laws of the United States.
There was no claim in that case that the directors knew about the
behavior of subordinate employees of the corporation that had
resulted in the liability. Rather, as in this case, the claim asserted was
that the directors ought to have known of it and if they had known
they would have been under a duty to bring the corporation into
compliance with the law and thus save the corporation from the loss.
The Delaware Supreme Court concluded that, under the facts as they
appeared, there was no basis to find that the directors had breached a
duty to be informed of the ongoing operations of the firm. In notably
colorful terms, the court stated that “absent cause for suspicion there
is no duty upon the directors to install and operate a corporate system
of espionage to ferret out wrongdoing which they have no reason to
suspect exists.” The Court found that there were no grounds for
suspicion in that case and, thus, concluded that the directors were
blamelessly unaware of the conduct leading to the corporate liability.

How does one generalize this holding today? Can it be said today that,
absent some ground giving rise to suspicion of violation of law, that
corporate directors have no duty to assure that a corporate
information gathering and reporting systems exists which represents a
good faith attempt to provide senior management and the Board with
information respecting material acts, events or conditions within the
corporation, including compliance with applicable statutes and
regulations? I certainly do not believe so. I doubt that such a broad
generalization of the Graham holding would have been accepted by the
Supreme Court in 1963. The case can be more narrowly interpreted as
standing for the proposition that, absent grounds to suspect deception,
neither corporate boards nor senior officers can be charged with
wrongdoing simply for assuming the integrity of employees and the
honesty of their dealings on the company's behalf. See 188 A.2d at
130-31.

A broader interpretation of Graham v. Allis-Chalmers-that it means
that a corporate board has no responsibility to assure that appropriate
information and reporting systems are established by management-
would not, in any event, be accepted by the Delaware Supreme Court
in 1996, in my opinion. In stating the basis for this view, I start with


                                   145
the recognition that in recent years the Delaware Supreme Court has
made it clear-especially in its jurisprudence concerning takeovers,
from Smith v. Van Gorkom through Paramount Communications v.
QVC FN26-the seriousness with which the corporation law views the
role of the corporate board. Secondly, I note the elementary fact that
relevant and timely information is an essential predicate for
satisfaction of the board's supervisory and monitoring role under
Section 141 of the Delaware General Corporation Law. Thirdly, I note
the potential impact of the federal organizational sentencing guidelines
on any business organization. Any rational person attempting in good
faith to meet an organizational governance responsibility would be
bound to take into account this development and the enhanced
penalties and the opportunities for reduced sanctions that it offers.

In light of these developments, it would, in my opinion, be a mistake
to conclude that our Supreme Court's statement in Graham concerning
“espionage” means that corporate boards may satisfy their obligation
to be reasonably informed concerning the corporation, without
assuring themselves that information and reporting systems exist in
the organization that are reasonably designed to provide to senior
management and to the board itself timely, accurate information
sufficient to allow management and the board, each within its scope,
to reach informed judgments concerning both the corporation's
compliance with law and its business performance.

Obviously the level of detail that is appropriate for such an information
system is a question of business judgment. And obviously too, no
rationally designed information and reporting system will remove the
possibility that the corporation will violate laws or regulations, or that
senior officers or directors may nevertheless sometimes be misled or
otherwise fail reasonably to detect acts material to the corporation's
compliance with the law. But it is important that the board exercise a
good faith judgment that the corporation's information and reporting
system is in concept and design adequate to assure the board that
appropriate information will come to its attention in a timely manner
as a matter of ordinary operations, so that it may satisfy its
responsibility.

Thus, I am of the view that a director's obligation includes a duty to
attempt in good faith to assure that a corporate information and
reporting system, which the board concludes is adequate, exists, and
that failure to do so under some circumstances may, in theory at least,
render a director liable for losses caused by non-compliance with
applicable legal standards. I now turn to an analysis of the claims


                                   146
asserted with this concept of the directors’ duty of care, as a duty
satisfied in part by assurance of adequate information flows to the
board, in mind.

III. ANALYSIS OF THIRD AMENDED COMPLAINT AND SETTLEMENT

A. The Claims

On balance, after reviewing an extensive record in this case, including
numerous documents and three depositions, I conclude that this
settlement is fair and reasonable. In light of the fact that the Caremark
Board already has a functioning committee charged with overseeing
corporate compliance, the changes in corporate practice that are
presented as consideration for the settlement do not impress one as
very significant. Nonetheless, that consideration appears fully
adequate to support dismissal of the derivative claims of director fault
asserted, because those claims find no substantial evidentiary support
in the record and quite likely were susceptible to a motion to dismiss in
all events.

In order to show that the Caremark directors breached their duty of
care by failing adequately to control Caremark's employees, plaintiffs
would have to show either (1) that the directors knew or (2) should
have known that violations of law were occurring and, in either event,
(3) that the directors took no steps in a good faith effort to prevent or
remedy that situation, and (4) that such failure proximately resulted in
the losses complained of, although under Cede & Co. v. Technicolor,
Inc., Del.Supr., 636 A.2d 956 (1994) this last element may be thought
to constitute an affirmative defense.

1. Knowing violation for statute: Concerning the possibility that the
Caremark directors knew of violations of law, none of the documents
submitted for review, nor any of the deposition transcripts appear to
provide evidence of it. Certainly the Board understood that the
company had entered into a variety of contracts with physicians,
researchers, and health care providers and it was understood that
some of these contracts were with persons who had prescribed
treatments that Caremark participated in providing. The board was
informed that the company's reimbursement for patient care was
frequently from government funded sources and that such services
were subject to the ARPL. But the Board appears to have been
informed by experts that the company's practices while contestable,
were lawful. There is no evidence that reliance on such reports was not
reasonable. Thus, this case presents no occasion to apply a principle to


                                   147
the effect that knowingly causing the corporation to violate a criminal
statute constitutes a breach of a director's fiduciary duty. See Roth v.
Robertson, N.Y.Sup.Ct., 64 Misc. 343, 118 N.Y.S. 351 (1909); Miller v.
American Tel. & Tel. Co., 507 F.2d 759 (3rd Cir.1974). It is not clear
that the Board knew the detail found, for example, in the indictments
arising from the Company's payments. But, of course, the duty to act
in good faith to be informed cannot be thought to require directors to
possess detailed information about all aspects of the operation of the
enterprise. Such a requirement would simple be inconsistent with the
scale and scope of efficient organization size in this technological age.

2. Failure to monitor: Since it does appears that the Board was to
some extent unaware of the activities that led to liability, I turn to a
consideration of the other potential avenue to director liability that the
pleadings take: director inattention or “negligence”. Generally where a
claim of directorial liability for corporate loss is predicated upon
ignorance of liability creating activities within the corporation, as in
Graham or in this case, in my opinion only a sustained or systematic
failure of the board to exercise oversight-such as an utter failure to
attempt to assure a reasonable information and reporting system
exists-will establish the lack of good faith that is a necessary condition
to liability. Such a test of liability-lack of good faith as evidenced by
sustained or systematic failure of a director to exercise reasonable
oversight-is quite high. But, a demanding test of liability in the
oversight context is probably beneficial to corporate shareholders as a
class, as it is in the board decision context, since it makes board
service by qualified persons more likely, while continuing to act as a
stimulus to good faith performance of duty by such directors.

Here the record supplies essentially no evidence that the director
defendants were guilty of a sustained failure to exercise their oversight
function. To the contrary, insofar as I am able to tell on this record,
the corporation's information systems appear to have represented a
good faith attempt to be informed of relevant facts. If the directors did
not know the specifics of the activities that lead to the indictments,
they cannot be faulted.


The liability that eventuated in this instance was huge. But the fact
that it resulted from a violation of criminal law alone does not create a
breach of fiduciary duty by directors. The record at this stage does not
support the conclusion that the defendants either lacked good faith in
the exercise of their monitoring responsibilities or conscientiously
permitted a known violation of law by the corporation to occur. The


                                   148
claims asserted against them must be viewed at this stage as
extremely weak.

B. The Consideration For Release of Claim

The proposed settlement provides very modest benefits. Under the
settlement agreement, plaintiffs have been given express assurances
that Caremark will have a more centralized, active supervisory system
in the future. Specifically, the settlement mandates duties to be
performed by the newly named Compliance and Ethics Committee on
an ongoing basis and increases the responsibility for monitoring
compliance with the law at the lower levels of management. In
adopting the resolutions required under the settlement, Caremark has
further clarified its policies concerning the prohibition of providing
remuneration for referrals. These appear to be positive consequences
of the settlement of the claims brought by the plaintiffs, even if they
are not highly significant. Nonetheless, given the weakness of the
plaintiffs' claims the proposed settlement appears to be an adequate,
reasonable, and beneficial outcome for all of the parties. Thus, the
proposed settlement will be approved.

IV. ATTORNEYS' FEES

[omitted]




                                  149
                           Securities Law

                       SEC v. Texas Gulf Sulphur Co.
                           401 F.2d 833 (2d Cir. 1968)

WATERMAN, Circuit Judge:

....

THE FACTUAL SETTING

       This action derives from the exploratory activities of TGS begun
in 1957 on the Canadian Shield in eastern Canada. In March of 1959,
aerial geophysical surveys were conducted over more than 15,000
square miles of this area by a group led by defendant Mollision, a
mining engineer and a Vice President of TGS. The group included
defendant Holyk, TGS's chief geologist, defendant Clayton, an
electrical engineer and geophysicist, and defendant Darke, a geologist.
These operations resulted in the detection of numerous anomalies,
i.e., extraordinary variations in the conductivity of rocks, one of which
was on the Kidd 55 segment of land located near Timmins, Ontario.

        On October 29 and 30, 1963, Clayton conducted a ground
geophysical survey on the northeast portion of the Kidd 55 segment
which confirmed the presence of an anomaly and indicated the
necessity of diamond core drilling for further evaluation. Drilling of the
initial hole, K-55-1, at the strongest part of the anomaly was
commenced on November 8 and terminated on November 12 at a
depth of 655 feet. Visual estimates by Holyk of the core of K-55-1
indicated an average copper content of 1.15% And an average zinc
content of 8.64% Over a length of 599 feet. This visual estimate
convinced TGS that it was desirable to acquire the remainder of the
Kidd 55 segment, and in order to facilitate this acquisition TGS
President Stephens instructed the exploration group to keep the
results of K-55-1 confidential and undisclosed even as to other
officers, directors, and employees of TGS. The hole was concealed and
a barren core was intentionally drilled off the anomaly. Meanwhile, the
core of K-55-1 had been shipped to Utah for chemical assay which,
when received in early December, revealed an average mineral
content of 1.18% Copper, 8.26% Zinc, and 3.94% Ounces of silver per
ton over a length of 602 feet. These results were so remarkable that
neither Clayton, an experienced geophysicist, nor four other TGS
expert witnesses, had ever seen or heard of a comparable initial
exploratory drill hole in a base metal deposit. So, the trial court


                                      150
concluded, ‘There is no doubt that the drill core of K-55-1 was
unusually good and that it excited the interest and speculation of those
who knew about it.’ Id. at 282. By March 27, 1964, TGS decided that
the land acquisition program had advanced to such a point that the
company might well resume drilling, and drilling was resumed on
March 31.

       During this period, from November 12, 1963 when K-55-1 was
completed, to March 31, 1964 when drilling was resumed, certain of
the individual defendants listed in fn. 2, supra, and persons listed in
fn. 4, supra, said to have received ‘tips' from them, purchased TGS
stock or calls thereon. Prior to these transactions these persons had
owned 1135 shares of TGS stock and possessed no calls; thereafter
they owned a total of 8235 shares and possessed 12,300 calls.

       On February 20, 1964, also during this period, TGS issued stock
options to 26 of its officers and employees whose salaries exceeded a
specified amount, five of whom were the individual defendants
Stephens, Fogarty, Mollison, Holyk, and Kline. Of these, only Kline was
unaware of the detailed results of K-55-1, but he, too, knew that a
hole containing favorable bodies of copper and zinc ore had been
drilled in Timmins. At this time, neither the TGS Stock Option
Committee nor its Board of Directors had been informed of the results
of K-55-1, presumably because of the pending land acquisition
program which required confidentiality. All of the foregoing defendants
accepted the options granted them.

       When drilling was resumed on March 31, hole K-55-3 was
commenced 510 feet west of K-55-1 and was drilled easterly at a 45
degrees angle so as to cross K-55-1 in a vertical plane. Daily progress
reports of the drilling of this hole K-55-3 and of all subsequently drilled
holes were sent to defendants Stephens and Fogarty (President and
Executive Vice President of TGS) by Holyk and Mollison. Visual
estimates of K-55-3 revealed an average mineral content of 1.12%
Copper and 7.93% Zinc over 641 of the hole's 876-foot length. On
April 7, drilling of a third hole, K-55-4, 200 feet south of and parallel to
K-55-1 and westerly at a 45 degrees angle, was commenced and
mineralization was encountered over 366 of its 579-foot length. Visual
estimates indicated an average content of 1.14% Copper and 8.24%
Zinc. Like K-55-1, both K-55-3 and K-55-4 established substantial
copper mineralization on the eastern edge of the anomaly. On the
basis of these findings relative to the foregoing drilling results, the trial
court concluded that the vertical plane created by the intersection of
K-55-1 and K-55-3, which measured at least 350 feet wide by 500 feet


                                    151
deep extended southward 200 feet to its intersection with K-55-4, and
that ‘There was real evidence that a body of commercially mineable
ore might exist.’ Id. at 281-82.

       On April 8 TGS began with a second drill rig to drill another hole,
K-55-6, 300 feet easterly of K-55-1. This hole was drilled westerly at
an angle of 60 degrees and was intended to explore mineralization
beneath K-55-1. While no visual estimates of its core were
immediately available, it was readily apparent by the evening of April
10 that substantial copper mineralization had been encountered over
the last 127 feet of the hole's 569-foot length. On April 10, a third drill
rig commenced drilling yet another hole, K-55-5, 200 feet north of K-
55-1, parallel to the prior holes, and slanted westerly at a 45 degrees
angle. By the evening of April 10 in this hole, too, substantial copper
mineralization had been encountered over the last 42 feet of its 97-
foot length.

       Meanwhile, rumors that a major ore strike was in the making
had been circulating throughout Canada. On the morning of Saturday,
April 11, Stephens at his home in Greenwich, Conn. read in the New
York Herald Tribune and in the New York Times unauthorized reports
of the TGS drilling which seemed to infer a rich strike from the fact
that the drill cores had been flown to the United States for chemical
assay. Stephens immediately contacted Fogarty at his home in Rye,
N.Y., who in turn telephoned and later that day visited Mollison at
Mollison's home in Greenwich to obtain a current report and evaluation
of the drilling progress.FN7 The following morning, Sunday, Fogarty
again telephoned Mollison, inquiring whether Mollison had any further
information and told him to return to Timmins with Holyk, the TGS
Chief Geologist, as soon as possible ‘to move things along.’ With the
aid of one Carroll, a public relations consultant, Fogarty drafted a
press release designed to quell the rumors, which release, after having
been channeled through Stephens and Huntington, a TGS attorney,
was issued at 3:00 P.M. on Sunday, April 12, and which appeared in
the morning newspapers of general circulation on Monday, April 13. It
read in pertinent part as follows:

      NEW YORK, April 12- The following statement was made
      today by Dr. Charles F. Fogarty, executive vice president
      of Texas Gulf Sulphur Company, in regard to the
      company's drilling operations near Timmins, Ontario,
      Canada. Dr. Fogarty said:




                                    152
     ‘During the past few days, the exploration activities of
     Texas Gulf Sulphur in the area of Timmins, Ontario, have
     been widely reported in the press, coupled with rumors of
     a substantial copper discovery there. These reports
     exaggerate the scale of operations, and mention plans and
     statistics of size and grade of ore that are without factual
     basis and have evidently originated by speculation of
     people not connected with TGS.

     ‘The facts are as follows. TGS has been exploring in the
     Timmins area for six years as part of its overall search in
     Canada and elsewhere for various minerals- lead, copper,
     zinc, etc. During the course of this work, in Timmins as
     well as in Eastern Canada, TGS has conducted exploration
     entirely on its own, without the participation by others.
     Numerous prospects have been investigated by
     geophysical means and a large number of selected ones
     have been core-drilled. These cores are sent to the United
     States for assay and detailed examination as a matter of
     routine and on advice of expert Canadian legal counsel. No
     inferences as to grade can be drawn from this procedure.

     ‘Most of the areas drilled in Eastern Canada have revealed
     either barren pyrite or graphite without value; a few have
     resulted in discoveries of small or marginal sulphide ore
     bodies.

     ‘Recent drilling on one property near Timmins has led to
     preliminary indications that more drilling would be required
     for proper evaluation of this prospect. The drilling done to
     date has not been conclusive, but the statements made by
     many outside quarters are unreliable and include
     information and figures that are not available to TGS.

     ‘The work done to date has not been sufficient to reach
     definite conclusions and any statement as to size and
     grade of ore would be premature and possibly misleading.
     When we have progressed to the point where reasonable
     and logical conclusions can be made, TGS will issue a
     definite statement to its stockholders and to the public in
     order to clarify the Timmins project.’

      The release purported to give the Timmins drilling results as of
the release date, April 12. From Mollison Fogarty had been told of the


                                  153
developments through 7:00 P.M. on April 10, and of the remarkable
discoveries made up to that time, detailed supra, which discoveries,
according to the calculations of the experts who testified for the SEC at
the hearing, demonstrated that TGS had already discovered 6.2 to 8.3
million tons of proven ore having gross assay values from $26 to $29
per ton. TGS experts, on the other hand, denied at the hearing that
proven or probable ore could have been calculated on April 11 or 12
because there was then no assurance of continuity in the mineralized
zone.

       The evidence as to the effect of this release on the investing
public was equivocal and less than abundant. On April 13 the New York
Herald Tribune in an article head-noted ‘Copper Rumor Deflated’
quoted from the TGS release of April 12 and backtracked from its
original April 11 report of a major strike but nevertheless inferred from
the TGS release that ‘recent mineral exploratory activity near Timmins,
Ontario, has provided preliminary favorable results, sufficient at least
to require a step-up in drilling operations.’ Some witnesses who
testified at the hearing stated that they found the release encouraging.
On the other hand, a Canadian mining security specialist, Roche,
stated that ‘earlier in the week (before April 16) we had a Dow Jones
saying that they (TGS) didn't have anything basically’ and a TGS stock
specialist for the Midwest Stock Exchange became concerned about his
long position in the stock after reading the release. The trial court
stated only that ‘While, in retrospect, the press release may appear
gloomy or incomplete, this does not make it misleading or deceptive
on the basis of the facts then known.’ Id. at 296.

       Meanwhile, drilling operations continued. By morning of April 13,
in K-55-5, the fifth drill hole, substantial copper mineralization had
been encountered to the 580 foot mark, and the hole was
subsequently drilled to a length of 757 feet without further results.
Visual estimates revealed an average content of 0.82% Copper and
4.2% Zinc over a 525-foot section. Also by 7:00 A.M. on April 13, K-
55-6 had found mineralization to the 946-foot mark. On April 12 a
fourth drill rig began to drill K-55-7, which was drilled westerly at a 45
degrees angle, at the eastern edge of the anomaly. The next morning
the 137 foot mark had been reached, fifty feet of which showed
mineralization. By 7:00 P.M. on April 15, the hole had been completed
to a length of 707 feet but had only encountered additional
mineralization during a 26-foot length between the 425 and 451-foot
marks. A mill test hole, K-55-8, had been drilled and was complete by
the evening of April 13 but its mineralization had not been reported
upon prior to April 16. K-55-10 was drilled westerly at a 45 degrees


                                   154
angle commencing April 14 and had encountered mineralization over
231 of its 249-foot length by the evening of April 15. It, too, was
drilled at the anomaly's eastern edge.

       While drilling activity ensued to completion, TGC officials were
taking steps toward ultimate disclosure of the discovery. On April 13, a
previously-invited reporter for The Northern Miner, a Canadian mining
industry journal, visited the drillsite, interviewed Mollison, Holyk and
Darke, and prepared an article which confirmed a 10 million ton ore
strike. This report, after having been submitted to Mollison and
returned to the reporter unamended on April 15, was published in the
April 16 issue. A statement relative to the extent of the discovery, in
substantial part drafted by Mollison, was given to the Ontario Minister
of Mines for release to the Canadian media. Mollison and Holyk
expected it to be released over the airways at 11 P.M. on April 15th,
but, for undisclosed reasons, it was not released until 9:40 A.M. on the
16th. An official detailed statement, announcing a strike of at least 25
million tons of ore, based on the drilling data set forth above, was read
to representatives of American financial media from 10:00 A.M. to
10:10 or 10:15 A.M. on April 16, and appeared over Merrill Lynch's
private wire at 10:29 A.M. and, somewhat later than expected, over
the Dow Jones ticker tape at 10:54 A.M.

      Between the time the first press release was issued on April 12
and the dissemination of the TGS official announcement on the
morning of April 16, the only defendants before us on appeal who
engaged in market activity were Clayton and Crawford and TGS
director Coates. Clayton ordered 200 shares of TGS stock through his
Canadian broker on April 15 and the order was executed that day over
the Midwest Stock Exchange. Crawford ordered 300 shares at midnight
on the 15th and another 300 shares at 8:30 A.M. the next day, and
these orders were executed over the Midwest Exchange in Chicago at
its opening on April 16. Coates left the TGS press conference and
called his broker son-in-law Haemisegger shortly before 10:20 A.M. on
the 16th and ordered 2,000 shares of TGS for family trust accounts of
which Coates was a trustee but not a beneficiary; Haemisegger
executed this order over the New York and Midwest Exchanges, and he
and his customers purchased 1500 additional shares.

       During the period of drilling in Timmins, the market price of TGS
stock fluctuated but steadily gained overall. On Friday, November 8,
when the drilling began, the stock closed at 17 3/8; on Friday,
November 15, after K-55-1 had been completed, it closed at 18. After
a slight decline to 16 3/8 by Friday, November 22, the price rose to 20


                                   155
7/8 by December 13, when the chemical assay results of K-55-1 were
received, and closed at a high of 24 1/8 on February 21, the day after
the stock options had been issued. It had reached a price of 26 by
March 31, after the land acquisition program had been completed and
drilling had been resumed, and continued to ascend to 30 1/8 by the
close of trading on April 10, at which time the drilling progress up to
then was evaluated for the April 12th press release. On April 13, the
day on which the April 12 release was disseminated, TGS opened at 30
1/8, rose immediately to a high of 32 and gradually tapered off to
close at 30 7/8. It closed at 30 1/4 the next day, and at 29 3/8 on
April 15. On April 16, the day of the official announcement of the
Timmins discovery, the price climbed to a high of 37 and closed at 36
3/8. By May 15, TGS stock was selling at 58 1/4.

I. THE INDIVIDUAL DEFENDANTS

      Rule 10b-5, 17 CFR 240.10b-5, on which this action is
predicated, provides:

It shall be unlawful for any person, directly or indirectly, by the use of
any means or instrumentality of interstate commerce, or of the mails,
or of any facility of any national securities exchange,

(1) to employ any device, scheme, or artifice to defraud,

(2) to make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statements made, in
the light of the circumstances under which they were made, not
misleading, or

(3) to engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person, in
connection with the purchase or sale of any security.

      Rule 10b-5 was promulgated pursuant to the grant of authority
given the SEC by Congress in Section 10(b) of the Securities Exchange
Act of 1934 (15 U.S.C. § 78j(b). . . . The essence of the Rule is that
anyone who, trading for his own account in the securities of a
corporation has ‘access, directly or indirectly, to information intended
to be available only for a corporate purpose and not for the personal
benefit of anyone’ may not take ‘advantage of such information
knowing it is unavailable to those with whom he is dealing,’ i.e., the
investing public. Matter of Cady, Roberts & Co., 40 SEC 907, 912
(1961). Insiders, as directors or management officers are, of course,


                                    156
by this Rule, precluded from so unfairly dealing, but the Rule is also
applicable to one possessing the information who may not be strictly
termed an ‘insider’ within the meaning of Sec. 16(b) of the Act. Cady,
Roberts, supra. Thus, anyone in possession of material inside
information must either disclose it to the investing public, or, if he is
disabled from disclosing it in order to protect a corporate confidence,
or he chooses not to do so, must abstain from trading in or
recommending the securities concerned while such inside information
remains undisclosed. So, it is here no justification for insider activity
that disclosure was forbidden by the legitimate corporate objective of
acquiring options to purchase the land surrounding the exploration
site; if the information was, as the SEC contends, material,FN9 its
possessors should have kept out of the market until disclosure was
accomplished. Cady, Roberts, supra at 911.

        FN8. 15 U.S.C. § 78j reads in pertinent part as follows:§ 78j.
Manipulative and deceptive devices. It shall be unlawful for any
person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce or of the mails, or of any
facility of any national securities exchange-(b) To use or employ, in
connection with the purchase or sale of any security registered on a
national securities exchange or any security not so registered, any
manipulative or deceptive device or contrivance in contravention of
such rules and regulations as the Commission may prescribe as
necessary or appropriate in the public interest or for the protection of
investors.

      An insider is not, of course, always foreclosed from investing in
his own company merely because he may be more familiar with
company operations than are outside investors. An insider's duty to
disclose information or his duty to abstain from dealing in his
company's securities arises only in ‘those situations which are
essentially extraordinary in nature and which are reasonably certain to
have a substantial effect on the market price of the security if (the
extraordinary situation is) disclosed.’ Fleischer, Securities Trading and
Corporate Information Practices: The Implications of the Texas Gulf
Sulphur Proceeding, 51 Va.L.Rev. 1271, 1289.

      Nor is an insider obligated to confer upon outside investors the
benefit of his superior financial or other expert analysis by disclosing
his educated guesses or predictions. 3 Loss, op. cit. supra at 1463.
The only regulatory objective is that access to material information be
enjoyed equally, but this objective requires nothing more than the
disclosure of basic facts so that outsiders may draw upon their own


                                   157
evaluative expertise in reaching their own investment decisions with
knowledge equal to that of the insiders.

       This is not to suggest, however, as did the trial court, the ‘the
test of materiality must necessarily be a conservative one, particularly
since many actions under Section 10(b) are brought on the basis of
hindsight,' 258 F.Supp. 262 at 280, in the sense that the materiality of
facts is to be assessed solely by measuring the effect the knowledge of
the facts would have upon prudent or conservative investors. As we
stated in List v. Fashion Park, Inc., 340 F.2d 457, 462, ‘The basic test
of materiality * * * is whether a reasonable man would attach
importance * * * in determining his choice of action in the transaction
in question. Restatement, Torts § 538(2)(a); accord Prosser, Torts
554-55; I Harper & James, Torts 565-66.’ This, of course,
encompasses any fact ‘* * * which in reasonable and objective
contemplation might affect the value of the corporation's stock or
securities * * *.’ List v. Fashion Park, Inc., supra at 462, quoting from
Kohler v. Kohler Co., 319 F.2d 634, 642, 7 A.L.R.3d 486 (7 Cir. 1963).
Such a fact is a material fact and must be effectively disclosed to the
investing public prior to the commencement of insider trading in the
corporation's securities. The speculators and chartists of Wall and Bay
Streets are also ‘reasonable’ investors entitled to the same legal
protection afforded conservative traders. Thus, material facts include
not only information disclosing the earnings and distributions of a
company but also those facts which affect the probable future of the
company and those which may affect the desire of investors to buy,
sell, or hold the company's securities.

       In each case, then, whether facts are material within Rule 10b-5
when the facts relate to a particular event and are undisclosed by
those persons who are knowledgeable thereof will depend at any given
time upon a balancing of both the indicated probability that the event
will occur and the anticipated magnitude of the event in light of the
totality of the company activity. Here, notwithstanding the trial court's
conclusion that the results of the first drill core, K-55-1, were ‘too
‘remote’ * * * to have had any significant impact on the market, i.e.,
to be deemed material,' 258 F.Supp. at 283, knowledge of the
possibility, which surely was more than marginal, of the existence of a
mine of the vast magnitude indicated by the remarkably rich drill core
located rather close to the surface (suggesting mineability by the less
expensive openpit method) within the confines of a large anomaly
(suggesting an extensive region of mineralization) might well have
affected the price of TGS stock and would certainly have been an
important fact to a reasonable, if speculative, investor in deciding


                                   158
whether he should buy, sell, or hold. After all, this first drill core was
‘unusually good and * * * excited the interest and speculation of those
who knew about it.’ 258 F.Supp. at 282.

       Our disagreement with the district judge on the issue does not,
then, go to his findings of basic fact, as to which the ‘clearly
erroneous' rule would apply, but to his understanding of the legal
standard applicable to them. See Baranow v. Gibralter Factors Corp.,
366 F.2d 584, 587-589 (2 Cir. 1966), and cases cited in footnote 11
supra. Our survey of the facts found below conclusively establishes
that knowledge of the results of the discovery hole, K-55-1, would
have been important to a reasonable investor and might have affected
the price of the stock.FN12 On April 16, The Northern Miner, a trade
publication in wide circulation among mining stock specialists, called
K-55-1, the discovery hole, ‘one of the most impressive drill holes
completed in modern times. Roche, a Canadian broker whose firm
specialized in mining securities, characterized the importance to
investors of the results of K-55-1. He stated that the completion of
‘the first drill hole’ with ‘a 600 foot drill core is very very significant * *
* anything over 200 feet is considered very significant and 600 feet is
just beyond your wildest imagination.’ He added, however, that it ‘is a
natural thing to buy more stock once they give you the first drill hole.’
Additional testimony revealed that the prices of stocks of other
companies, albeit less diversified, smaller firms, had increased
substantially solely on the basis of the discovery of good anomalies or
even because of the proximity of their lands to the situs of a
potentially major strike.

      FN12. We do not suggest that material facts must be disclosed
immediately; the timing of disclosure is a matter for the business
judgment of the corporate officers entrusted with the management of
the corporation within the affirmative disclosure requirements
promulgated by the exchanges and by the SEC. Here, a valuable
corporate purpose was served by delaying the publication of the K-55-
1 discovery. We do intend to convey, however, that where a corporate
purpose is thus served by withholding the news of a material fact,
those persons who are thus quite properly true to their corporate trust
must not during the period of non-disclosure deal personally in the
corporation's securities or give to outsiders confidential information not
generally available to all the corporations' stockholders and to the
public at large.

      Finally, a major factor in determining whether the K-55-1
discovery was a material fact is the importance attached to the drilling


                                      159
results by those who knew about it. In view of other unrelated recent
developments favorably affecting TGS, participation by an informed
person in a regular stock-purchase program, or even sporadic trading
by an informed person, might lend only nominal support to the
inference of the materiality of the K-55-1 discovery; nevertheless, the
timing by those who knew of it of their stock purchases and their
purchases of short-term calls- purchases in some cases by individuals
who had never before purchased calls or even TGS stock- virtually
compels the inference that the insiders were influenced by the drilling
results. This insider trading activity, which surely constitutes highly
pertinent evidence and the only truly objective evidence of the
materiality of the K-55-1 discovery, was apparently disregarded by the
court below in favor of the testimony of defendants' expert witnesses,
all of whom ‘agreed that one drill core does not establish an ore body,
much less a mine,’ 258 F.Supp. at 282-283. Significantly, however,
the court below, while relying upon what these defense experts said
the defendant insiders ought to have thought about the worth to TGS
of the K-55-1 discovery, and finding that from November 12, 1963 to
April 6, 1964 Fogarty, Murray, Holyk and Darke spent more than
$100,000 in purchasing TGS stock and calls on that stock, made no
finding that the insiders were motivated by any factor other than the
extraordinary K-55-1 discovery when they bought their stock and their
calls. No reason appears why outside investors, perhaps better
acquainted with speculative modes of investment and with, in many
cases, perhaps more capital at their disposal for intelligent speculation,
would have been less influenced, and would not have been similarly
motivated to invest if they had known what the insider investors knew
about the K-55-1 discovery.

       Our decision to expand the limited protection afforded outside
investors by the trial court's narrow definition of materiality is not at
all shaken by fears that the elimination of insider trading benefits will
deplete the ranks of capable corporate managers by taking away an
incentive to accept such employment. Such benefits, in essence, are
forms of secret corporate compensation, see Cary, Corporate
Standards and Legal Rules, 50 Calif.L.Rev. 408, 409-10 (1962),
derived at the expense of the uninformed investing public and not at
the expense of the corporation which receives the sole benefit from
insider incentives. Moreover, adequate incentives for corporate officers
may be provided by properly administered stock options and employee
purchase plans of which there are many in existence. In any event, the
normal motivation induced by stock ownership, i.e., the identification
of an individual with corporate progress, is ill-promoted by condoning
the sort of speculative insider activity which occurred here; for


                                   160
example, some of the corporation's stock was sold at market in order
to purchase short-term calls upon that stock, calls which would never
be exercised to increase a stockholder equity in TGS unless the market
price of that stock rose sharply.

       The core of Rule 10b-5 is the implementation of the
Congressional purpose that all investors should have equal access to
the rewards of participation in securities transactions. It was the intent
of Congress that all members of the investing public should be subject
to identical market risks,- which market risks include, of course the
risk that one's evaluative capacity or one's capital available to put at
risk may exceed another's capacity or capital. The insiders here were
not trading on an equal footing with the outside investors. They alone
were in a position to evaluate the probability and magnitude of what
seemed from the outset to be a major ore strike; they alone could
invest safely, secure in the expectation that the price of TGS stock
would rise substantially in the event such a major strike should
materialize, but would decline little, if at all, in the event of failure, for
the public, ignorant at the outset of the favorable probabilities would
likewise be unaware of the unproductive exploration, and the
additional exploration costs would not significantly affect TGS market
prices. Such inequities based upon unequal access to knowledge
should not be shrugged off as inevitable in our way of life, or, in view
of the congressional concern in the area, remain uncorrected.

       We hold, therefore, that all transactions in TGS stock or calls by
individuals apprised of the drilling resultsFN14 of K-55-1 were made in
violation of Rule 10b-5. Inasmuch as the visual evaluation of that drill
core (a generally reliable estimate though less accurate than a
chemical assay) constituted material information, those advised of the
results of the visual evaluation as well as those informed of the
chemical assay traded in violation of law. The geologist Darke
possessed undisclosed material information and traded in TGS
securities. Therefore we reverse the dismissal of the action as to him
and his personal transactions. The trial court also found, 258 F.Supp.
at 284, that Darke, after the drilling of K-55-1 had been completed
and with detailed knowledge of the results thereof, told certain outside
individuals that TGS ‘was a good buy.’ These individuals thereafter
acquired TGS stock and calls. The trial court also found that later, as of
March 30, 1964, Darke not only used his material knowledge for his
own purchases but that the substantial amounts of TGS stock and calls
purchased by these outside individuals on that day, see footnote 4,
supra, was ‘strong circumstantial evidence that Darke must have
passed the word to one or more of his ‘tippees' that drilling on the


                                     161
Kidd 55 segment was about to be resumed.’ 258 F.Supp. at 284.
Obviously if such a resumption were to have any meaning to such
‘tippees,’ they must have previously been told of K-55-1.

       Unfortunately, however, there was no definitive resolution below
of Darke's liability in these premises for the trial court held as to him,
as it held as to all the other individual defendants, that this
‘undisclosed information’ never became material until April 9. As it is
our holding that the information acquired after the drilling of K-55-1
was material, we, on the basis of the findings of direct and
circumstantial evidence on the issue that the trial court has already
expressed, hold that Darke violated Rule 10b-5(3) and Section 10(b)
by ‘tipping’ and we remand, pursuant to the agreement of the parties,
for a determination of the appropriate remedy. As Darke's ‘tippees' are
not defendants in this action, we need not decide whether, if they
acted with actual or constructive knowledge that the material
information was undisclosed, their conduct is as equally violative of the
Rule as the conduct of their insider source, though we note that it
certainly could be equally reprehensible.

       With reference to Huntington, the trial court found that he ‘had
no detailed knowledge as to the work’ on the Kidd-55 segment, 258
F.Supp. 281. Nevertheless, the evidence shows that he knew about
and participated in TGS's land acquisition program which followed the
receipt of the K-55-1 drilling results, and that on February 26, 1964 he
purchased 50 shares of TGS stock. Later, on March 16, he helped
prepare a letter for Dr. Holyk's signature in which TGS made a
substantial offer for lands near K-55-1, and on the same day he, who
had never before purchased calls on any stock, purchased a call on
100 shares of TGS stock. We are satisfied that these purchases in
February and March, coupled with his readily inferable and probably
reliable, understanding of the highly favorable nature of preliminary
operations on the Kidd segment, demonstrate that Huntington
possessed material inside information such as to make his purchase
violative of the Rule and the Act.

C. When May Insiders Act?

      Appellant Crawford, who orderedFN17 the purchase of TGS stock
shortly before the TGS April 16 official announcement, and defendant
Coates, who placed orders with and communicated the news to his
broker immediately after the official announcement was read at the
TGS-called press conference, concede that they were in possession of
material information. They contend, however, that their purchases


                                   162
were not proscribed purchases for the news had already been
effectively disclosed. We disagree.

      FN17. The effective protection of the public from insider
exploitation of advance notice of material information requires that the
time that an insider places an order, rather than the time of its
ultimate execution, be determinative for Rule 10b-5 purposes.
Otherwise, insiders would be able to ‘beat the news,’ cf. Fleischer,
supra, 51 Va.L.Rev. at 1291, by requesting in advance that their
orders be executed immediately after the dissemination of a major
news release but before outsiders could act on the release. Thus it is
immaterial whether Crawford's orders were executed before or after
the announcement was made in Canada (9:40 A.M., April 16) or in the
United States (10:00 A.M.) or whether Coates's order was executed
before or after the news appeared over the Merrill Lynch (10:29 A.M.)
or Dow Jones (10:54 A.M.) wires.

       Crawford telephoned his orders to his Chicago broker about
midnight on April 15 and again at 8:30 in the morning of the 16th,
with instructions to buy at the opening of the Midwest Stock Exchange
that morning. The trial court's finding that ‘he sought to, and did, ‘beat
the news,“ 258 F.Supp. at 287, is well documented by the record. The
rumors of a major ore strike which had been circulated in Canada and,
to a lesser extent, in New York, had been disclaimed by the TGS press
release of April 12, which significantly promised the public an official
detailed announcement when possibilities had ripened into actualities.
The abbreviated announcement to the Canadian press at 9:40 A.M. on
the 16th by the Ontario Minister of Mines and the report carried by The
Northern Miner, parts of which had sporadically reached New York on
the morning of the 16th through reports from Canadian affiliates to a
few New York investment firms, are assuredly not the equivalent of
the official 10-15 minute announcement which was not released to the
American financial press until after 10:00 A.M. Crawford's orders had
been placed before that. Before insiders may act upon material
information, such information must have been effectively disclosed in a
manner sufficient to insure its availibility to the investing public.
Particularly here, where a formal announcement to the entire financial
news media had been promised in a prior official release known to the
media, all insider activity must await dissemination of the promised
official announcement.

       Coates was absolved by the court below because his telephone
order was placed shortly before 10:20 A.M. on April 16, which was
after the announcement had been made even though the news could


                                   163
not be considered already a matter of public information. 258 F.Supp.
at 288. This result seems to have been predicated upon a
misinterpretation of dicta in Cady, Roberts, where the SEC instructed
insiders to ‘keep out of the market until the established procedures for
public release of the information are carried out instead of hastening
to execute transactions in advance of, and in frustration of, the
objectives of the release,’ 40 SEC at 915. The reading of a news
release, which prompted Coates into action, is merely the first step in
the process of dissemination required for compliance with the
regulatory objective of providing all investors with an equal
opportunity to make informed investment judgments. Assuming that
the contents of the official release could instantaneously be acted
upon,FN18 at the minimum Coates should have waited until the news
could reasonably have been expected to appear over the media of
widest circulation, the Dow Jones broad tape, rather than hastening to
insure an advantage to himself and his broker son-in-law.FN19

       FN18. Although the only insider who acted after the news
appeared over the Dow Jones broad tape is not an appellant and
therefore we need not discuss the necessity of considering the
advisability of a ‘reasonable waiting period’ during which outsiders
may absorb and evaluate disclosures, we note in passing that, where
the news is of a sort which is not readily translatable into investment
action, insiders may not take advantage of their advance opportunity
to evaluate the information by acting immediately upon dissemination.
In any event, the permissible timing of insider transactions after
disclosures of various sorts is one of the many areas of expertise for
appropriate exercise of the SEC's rule-making power, which we hope
will be utilized in the future to provide some predictability of certainty
for the business community.

       FN19. The record reveals that news usually appears on the Dow
Jones broad tape 2-3 minutes after the reporter completes dictation.
Here, assuming that the Dow Jones reporter left the press conference
as early as possible, 10:10 A.M., the 10-15 minute release (which took
at least that long to dictate) could not have appeared on the wire
before 10:22, and for other reasons unknown to us did not appear
until 10:54. Indeed, even the abbreviated version of the release
reported by Merrill Lynch over its private wire did not appear until
10:29. Coates, however, placed his call no later than 10:20.

D. Is An Insider's Good Faith A Defense Under 10b-5?




                                   164
      Coates, Crawford and Clayton, who ordered purchases before
the news could be deemed disclosed, claim, nevertheless, that they
were justified in doing so because they honestly believed that the
news of the strike had become public at the time they placed their
orders. However, whether the case before us is treated solely as an
SEC enforcement proceeding or as a private action, FN20 proof of a
specific intent to defraud is unnecessary. In an enforcement
proceeding for equitable or prophylactic relief, the common law
standard of deceptive conduct has been modified in the interests of
broader protection for the investing public so that negligent insider
conduct has become unlawful.

      Absent any clear indication of a legislative intention to require a
showing of specific fraudulent intent, see Note, 63 Mich.L.Rev. 1070,
1075, 1076 n. 29 (1965), the securities laws should be interpreted as
an expansion of the common lawFN21 both to effectuate the broad
remedial design of Congress. Moreover, a review of other sections of
the Act from which Rule 10b-5 seems to have been drawn suggests
that the implementation of a standard of conduct that encompasses
negligence as well as active fraud comports with the administrative
and the legislative purposes underlying the Rule. Finally, we note that
this position is not, as asserted by defendants, irreconcilable with
previous language in this circuit because ‘some form of the traditional
scienter requirement,’ is preserved. This requirement, whether it be
termed lack of diligence, constructive fraud, or unreasonable or
negligent conduct, remains implicit in this standard, a standard that
promotes the deterrence objective of the Rule.

       Thus, the beliefs of Coates, Crawford and Clayton that the news
of the ore strike was sufficiently public at the time of their purchase
orders are to no avail if those beliefs were not reasonable under the
circumstances. Crawford points to the scattered rumors of the
discovery which had been circulating for some time before April 15, to
the release of the information to The Northern Miner on April 15 to be
published by it on the 16th, to the arrangement made by TGS with the
Ontario Minister of Mines for the release of an abbreviated report on
the evening of the 15th (which did not eventuate until 9:40 A.M., April
16), and to the corporation's official announcement at 10:00 A.M. on
the 16th, all of which transpired prior to an anticipated execution of his
purchase orders that had been placed by him after trading had closed
on the Midwest Exchange on April 15. However, the rumors and casual
disclosure through Canadian media, especially in view of the April 12
‘gloomy’ or incomplete release denying the rumors and promising
official confirmation, hardly sufficed to inform traders on American


                                   165
exchanges affected by Crawford's purchases. Moreover, the formal
announcement could not reasonably have been expected to be
disseminated by the time of the opening of the exchanges on the
morning of April 16, when Crawford must have expected his orders
would be executed.

       Clayton, who was unaware of the April 16 disclosure
announcement TGS was to make can, in support of his claim that the
favorable news was public, rely only on the rumors and on the phone
calls received by TGS prior to the placing of his order from those who
seemed to have heard some version or rumors of the news. His
awareness of the contents of the April 12 release renders
unreasonable any claim that he believed the news was truly public.

       Finally, Coates, as we have already indicated in fn. 19, supra,
could not reasonably have expected the official release to have been
disseminated when he placed his order before 10:20 for immediate
execution nor were the Canadian disclosures relied on by Crawford
sufficient to render the conduct of Coates permissible under the
circumstances.

       On February 20, 1964, defendants Stephens, Fogarty, Mollison,
Holyk and Kline accepted stock options issued to them and a number
of other top officers of TGS, although not one of them had informed
the Stock Option Committee of the Board of Directors or the Board of
the results of K-55-1, which information we have held was then
material. The SEC sought rescission of these options. The trial court, in
addition to finding the knowledge of the results of the K-55 discovery
to be immaterial, held that Kline had no detailed knowledge of the
drilling progress and that Holyk and Mollison could reasonably assume
that their superiors, Stephens and Fogarty, who were directors of the
corporation, would report the results if that was advisable; indeed all
employees had been instructed not to divulge this information pending
completion of the land acquisition program, 258 F.Supp. at 291.
Therefore, the court below concluded that only directors Stephens and
Fogarty, of the top management, would have violated the Rule by
accepting stock options without disclosure, but it also found that they
had not acted improperly as the information in their possession was
not material. 258 F.Supp. at 292. In view of our conclusion as to
materiality we hold that Stephens and Fogarty violated the Rule by
accepting them. However, as they have surrendered the options and
the corporation has canceled them, supra at 292, n. 17, we find it
unnecessary to order that the injunctions prayed for be actually
issued. We point out, nevertheless, that the surrender of these options


                                   166
after the SEC commenced the case is not a satisfaction of the SEC
claim, and a determination as to whether the issuance of injunctions
against Stephens and Fogarty is advisable in order to prevent or deter
future violations of regulatory provisions is remanded for the exercise
of discretion by the trial court.

       Contrary to the belief of the trial court that Kline had no duty to
disclose his knowledge of the Kidd project before accepting the stock
option offered him, we believe that he, a vice president, who had
become the general counsel of TGS in January 1964, but who had
been secretary of the corporation since January 1961, and was present
in that capacity when the options were granted, and who was in
charge of the mechanics of issuance and acceptance of the options,
was a member of top management and under a duty before accepting
his option to disclose any material information he may have
possessed, and, as he did not disclose such information to the Option
Committee we direct rescission of the option he received.FN24 As to
Holyk and Mollison, the SEC has not appealed the holding below that
they, not being then members of top management (although Mollison
was a vice president) had no duty to disclose their knowledge of the
drilling before accepting their options. Therefore, the issue of whether,
by accepting, they violated the Act, is not before us, and the holding
below is undisturbed.

II. THE CORPORATE DEFENDANT

       At 3:00 P.M. on April 12, 1964, evidently believing it desirable to
comment upon the rumors concerning the Timmins project, TGS
issued the press release quoted in pertinent part in the text at page
845, supra. The SEC argued below and maintains on this appeal that
this release painted a misleading and deceptive picture of the drilling
progress at the time of its issuance, and hence violated Rule 10b-
5(2).FN25 TGS relies on the holding of the court below that ‘the
issuance of the release produced no unusual market action’ and ‘in the
absence of a showing that the purpose of the April 12 press release
was to affect the market price of TGS stock to the advantage of TGS or
its insiders, the issuance of the press release did not constitute a
violation of Section 10(b) or Rule 10b-5 since it was not issued ‘in
connection with the purchase or sale of any security“ and,
alternatively, ‘even if it had been established that the April 12 release
was issued in connection with the purchase or sale of any security, the
Commission has failed to demonstrate that it was false, misleading or
deceptive.’ 258 F.Supp. at 294.



                                   167
      FN25. Rule 10b-5(2) provides in pertinent part: It shall be
unlawful for any person, directly or indirectly, by the use of any means
or instrumentality of interstate commerce, * * * (2) to make any
untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, * * * in
connection with the purchase or sale of any security.

      Before further discussing this matter it seems desirable to state
exactly what the SEC claimed in its complaint and what it seeks. The
specific SEC allegation in its complaint is that this April 12 press
release ‘* * * was materially false and misleading and was known by
certain of defendant Texas Gulf’s officers and employees, including
defendants Fogarty, Mollison, Holyk, Darke and Clayton, to be
materially false and misleading.’

      The specific relief the SEC seeks is, pursuant to Section 21(e) of
Securities Exchange Act of 1934, 15 U.S.C. § 78u(e), a permanent
injunction restraining the issuance of any further materially false and
misleading publicly distributed informative items.FN26

       . . . . Congress intended to protect the investing public in
connection with their purchases or sales on Exchanges from being
misled by misleading statements promulgated for or on behalf of
corporations irrespective of whether the insiders contemporaneously
trade in the securities of that corporation and irrespective of whether
the corporation or its management have an ulterior purpose or
purposes in making an official public release. Indeed, the Commission
has been charged by Congress with the responsibility of policing all
misleading corporate statements from those contained in an initial
prospectus to those contained in a notice to stockholders relative to
the need or desirability of terminating the existence of a corporation or
of merging it with another. To render the Congressional purpose
ineffective by inserting into the statutory words the need of proving,
not only that the public may have been misled by the release, but also
that those responsible were actuated by a wrongful purpose when they
issued the release, is to handicap unreasonably the Commission in its
work. We should have in mind the wise words of Judge Learned Hand
in Cawley v. United States, 272 F.2d 443, 445 (2 Cir. 1959), relative
to an interpretation of the words contained within a congressional
statute, that ‘* * * unless they explicitly forbid it, the purpose of a
statutory provision is the best test of the meaning of the words
chosen. We are to put ourselves so far as we can in the position of the
legislature that uttered them, and decide whether or not it would


                                   168
declare that the situation that has arisen is within what it wishes to
cover. Indeed, at times the purpose may be so manifest as to override
even the explicit words used. Markham v. Cabell,326 U.S. 404, 66
S.Ct. 193, 90 L.Ed. 165.’

       Turning first to the question of whether the release was
misleading, i.e., whether it conveyed to the public a false impression
of the drilling situation at the time of its issuance, we note initially that
the trial court did not actually decide this question. Its conclusion that
‘the Commission has failed to demonstrate that it was false,
misleading or deceptive,’ 258 F.Supp. at 294, seems to have derived
from its views that ‘The defendants are to be judged on the facts
known to them when the April 12 release was issued,’ 258 F.Supp. at
295, (emphasis supplied), that the draftsmen ‘exercised reasonable
business judgment under the circumstances,’ 258 F.Supp. at 296, and
that the release was not ‘misleading or deceptive on the basis of the
facts then known,’ 258 F.Supp. at 296 (emphasis supplied) rather than
from an appropriate primary inquiry into the meaning of the statement
to the reasonable investor and its relationship to truth. While we
certainly agree with the trial court that ‘in retrospect, the press release
may appear gloomy or incomplete,’ FN28 *863 258 F.Supp. at 296, we
cannot, from the present record, by applying the standard Congress
intended, definitively conclude that it was deceptive or misleading to
the reasonable investor, or that he would have been misled by it.
Certain newspaper accounts of the release viewed the release as
confirming the existence of preliminary favorable developments, and
this optimistic view was held by some brokers, so it could be that the
reasonable investor would have read between the lines of what
appears to us to be an inconclusive and negative statement and would
have envisioned the actual situation at the Kidd segment on April 12.
On the other hand, in view of the decline of the market price of TGS
stock from a high of 32 on the morning of April 13 when the release
was disseminated to 29 3/8 by the close of trading on April 15, and
the reaction to the release by other brokers, it is far from certain that
the release was generally interpreted as a highly encouraging report or
even encouraging at all. Accordingly, we remand this issue to the
district court that took testimony and heard and saw the witnesses for
a determination of the character of the release in the light of the facts
existing at the time of the release, by applying the standard of
whether the reasonable investor, in the exercise of due care, would
have been misled by it.

      In the event that it is found that the statement was misleading
to the reasonable investor it will then become necessary to determine


                                    169
whether its issuance resulted from a lack of due diligence. The only
remedy the Commission seeks against the corporation is an injunction,
see footnote 26, supra, and therefore we do not find it necessary to
decide whether just a lack of due diligence on the part of TGS, absent
a showing of bad faith, would subject the Corporation to any liability
for damages. We have recently stated in a case involving a private suit
under Rule 10b-5 in which damages and an injunction were sought, “It
is not necessary in a suit for equitable or prophylactic relief to
establish all the elements required in a suit for monetary damages.”

       We hold only that, in an action for injunctive relief, the district
court has the discretionary power under Rule 10b-5 and Section 10(b)
to issue an injunction, if the misleading statement resulted from a lack
of due diligence on the part of TGS. The trial court did not find it
necessary to decide whether TGS exercised such diligence and has not
yet attempted to resolve this issue. While the trial court concluded that
TGS had exercised ‘reasonable business judgment under the
circumstances,’ 258 F.Supp. at 296 (emphasis supplied) it applied an
incorrect legal standard in appraising whether TGS should have issued
its April 12 release on the basis of the facts known to its draftsmen at
the time of its preparation, 258 F.Supp. at 295, and in assuming that
disclosure of the full underlying facts of the Timmins situation was not
a viable alternative to the vague generalities which were asserted. 258
F.Supp. at 296.

      It is not altogether certain from the present record that the
draftsmen could, as the SEC suggests, have readily obtained current
reports of the drilling progress over the weekend of April 10-12, but
they certainly should have obtained them if at all possible for them to
do so. However, even if it were not possible to evaluate and transmit
current data in time to prepare the release on April 12, it would seem
that TGS could have delayed the preparation a bit until an accurate
report of a rapidly changing situation was possible. See 258 F.Supp. at
296. At the very least, if TGS felt compelled to respond to the
spreading rumors of a spectacular discovery, it would have been more
accurate to have stated that the situation was in flux and that the
release was prepared as of April 10 information rather than purporting
to report the progress ‘to date.’ Moreover, it would have obviously
been better to have specifically described the known drilling progress
as of April 10 by stating the basic facts. Such an explicit disclosure
would have permitted the investing public to evaluate the ‘prospect’ of
a mine at Timmins without having to read between the lines to
understand that preliminary indications were favorable- in itself an
understatement.


                                   170
       The choice of an ambiguous general statement rather than a
summary of the specific facts cannot reasonably be justified by any
claimed urgency. The avoidance of liability for misrepresentation in the
event that the Timmins project failed, a highly unlikely event as of
April 12 or April 13, did not forbid the accurate and truthful divulgence
of detailed results which need not, of course, have been accompanied
by conclusory assertions of success. Nor is it any justification that such
an explicit disclosure of the truth might have ‘encouraged the rumor
mill which they were seeking to allay.’ 258 F.Supp. at 296.

       We conclude, then, that, having established that the release was
issued in a manner reasonably calculated to affect the market price of
TGS stock and to influence the investing public, we must remand to
the district court to decide whether the release was misleading to the
reasonable investor and if found to be misleading, whether the court in
its discretion should issue the injunction the SEC seeks.




                                   171
                  BASIC, INC. V. LEVINSON
                          485 U.S. 224 (1978)



Justice BLACKMUN delivered the opinion of the Court.

      This case requires us to apply the materiality requirement of §
10(b) of the Securities Exchange Act of 1934, (1934 Act), 48 Stat.
881, as amended, 15 U.S.C. § 78a et seq. and the Securities and
Exchange Commission's Rule 10b-5, 17 CFR § 240.10b-5 (1987),
promulgated thereunder, in the context of preliminary corporate
merger discussions. We must also determine whether a person who
traded a corporation's shares on a securities exchange after the
issuance of a materially misleading statement by the corporation may
invoke a rebuttable presumption that, in trading, he relied on the
integrity of the price set by the market.

I

      Prior to December 20, 1978, Basic Incorporated was a publicly
traded company primarily engaged in the business of manufacturing
chemical refractories for the steel industry. As early as 1965 or 1966,
Combustion Engineering, Inc., a company producing mostly alumina-
based refractories, expressed some interest in acquiring Basic, but was
deterred from pursuing this inclination seriously because of antitrust
concerns it then entertained. See App. 81-83. In 1976, however,
regulatory action opened the way to a renewal of Combustion's
interest.FN1 The “Strategic Plan,” dated October 25, 1976, for
Combustion's Industrial Products Group included the objective:
“Acquire Basic Inc. $30 million.” App. 337.

      Beginning in September 1976, Combustion representatives had
meetings and telephone conversations with Basic officers and
directors, including petitioners here,FN2 concerning the possibility of a
merger.FN3 During 1977 and 1978, Basic made three public
statements denying that it was engaged in merger negotiations.FN4
On December 18, 1978, Basic asked the New York Stock Exchange to
suspend trading in its shares and issued a release stating that it had
been “approached” by another company concerning a merger. Id., at
413. On December 19, Basic's board endorsed Combustion's offer of
$46 per share for its common stock, id., at 335, 414-416, and on the



                                   172
following day publicly announced its approval of Combustion's tender
offer for all outstanding shares.

      FN4. On October 21, 1977, after heavy trading and a new high in
Basic stock, the following news item appeared in the Cleveland Plain
Dealer:“[Basic] President Max Muller said the company knew no
reason for the stock's activity and that no negotiations were under way
with any company for a merger. He said Flintkote recently denied Wall
Street rumors that it would make a tender offer of $25 a share for
control of the Cleveland-based maker of refractories for the steel
industry.” App. 363.On September 25, 1978, in reply to an inquiry
from the New York Stock Exchange, Basic issued a release concerning
increased activity in its stock and stated that“management is unaware
of any present or pending company development that would result in
the abnormally heavy trading activity and price fluctuation in company
shares that have been experienced in the past few days.” Id., at
401.On November 6, 1978, Basic issued to its shareholders a “Nine
Months Report 1978.” This Report stated:“With regard to the stock
market activity in the Company's shares we remain unaware of any
present or pending developments which would account for the high
volume of trading and price fluctuations in recent months.” Id., at 403.

       Respondents are former Basic shareholders who sold their stock
after Basic's first public statement of October 21, 1977, and before the
suspension of trading in December 1978. Respondents brought a class
action against Basic and its directors, asserting that the defendants
issued three false or misleading public statements and thereby were in
violation of § 10(b) of the 1934 Act and of Rule 10b-5. Respondents
alleged that they were injured by selling Basic shares at artificially
depressed prices in a market affected by petitioners' misleading
statements and in reliance thereon.

       The District Court adopted a presumption of reliance by
members of the plaintiff class upon petitioners' public statements that
enabled the court to conclude that common questions of fact or law
predominated over particular questions pertaining to individual
plaintiffs. See Fed.Rule Civ.Proc. 23(b)(3). The District Court therefore
certified respondents' class. FN5 On the merits, however, the District
Court granted summary judgment for the defendants. It held that, as
a matter of law, any misstatements were immaterial: there were no
negotiations ongoing at the time of the first statement, and although
negotiations were taking place when the second and third statements
were issued, those negotiations were not “destined, with reasonable



                                   173
certainty, to become a merger agreement in principle.” App. to Pet. for
Cert. 103a.

       The United States Court of Appeals for the Sixth Circuit affirmed
the class certification, but reversed the District Court's summary
judgment, and remanded the case. 786 F.2d 741 (1986). The court
reasoned that while petitioners were under no general duty to disclose
their discussions with Combustion, any statement the company
voluntarily released could not be “ ‘so incomplete as to mislead.’ ” Id.,
at 746, quoting SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 862
(CA2 1968) (en banc), cert. denied, sub nom. Coates v. SEC, 394 U.S.
976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969). In the Court of Appeals'
view, Basic's statements that no negotiations where taking place, and
that it knew of no corporate developments to account for the heavy
trading activity, were misleading. With respect to materiality, the court
rejected the argument that preliminary merger discussions are
immaterial as a matter of law, and held that “once a statement is
made denying the existence of any discussions, even discussions that
might not have been material in absence of the denial are material
because they make the statement made untrue.” 786 F.2d, at 749.

     The Court of Appeals joined a number of other Circuits in
accepting the “fraud-on-the-market theory” to create a rebuttable
presumption that respondents relied on petitioners' material
misrepresentations, noting that without the presumption it would be
impractical to certify a class under Federal Rule of Civil Procedure
23(b)(3). See 786 F.2d, at 750-751.

II

       The 1934 Act was designed to protect investors against
manipulation of stock prices. See S.Rep. No. 792, 73d Cong., 2d Sess.,
1-5 (1934). Underlying the adoption of extensive disclosure
requirements was a legislative philosophy: “There cannot be honest
markets without honest publicity. Manipulation and dishonest practices
of the market place thrive upon mystery and secrecy.” H.R.Rep. No.
1383, 73d Cong., 2d Sess., 11 (1934). This Court “repeatedly has
described the ‘fundamental purpose’ of the Act as implementing a
‘philosophy of full disclosure.’ ”

      Pursuant to its authority under § 10(b) of the 1934 Act, 15
U.S.C. § 78j, the Securities and Exchange Commission promulgated
Rule 10b-5.FN6 Judicial interpretation and application, legislative
acquiescence, and the passage of time have removed any doubt that a


                                   174
private cause of action exists for a violation of § 10(b) and Rule 10b-5,
and constitutes an essential tool for enforcement of the 1934 Act's
requirements. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185,
196, 96 S.Ct. 1375, 1382, 47 L.Ed.2d 668 (1976); Blue Chip Stamps
v. Manor Drug Stores, 421 U.S. 723, 730, 95 S.Ct. 1917, 1923, 44
L.Ed.2d 539 (1975).

        FN6. In relevant part, Rule 10b-5 provides:“It shall be unlawful
for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any
facility of any national securities exchange,

      ***

      “(b) To make any untrue statement of a material fact or to omit
to state a material fact necessary in order to make the statements
made, in the light of the circumstances under which they were made,
not misleading....,“in connection with the purchase or sale of any
security.”

      ...


III

       The application of [the] materiality standard to preliminary
merger discussions is not self-evident. Where the impact of the
corporate development on the target's fortune is certain and clear, the
TSC Industries materiality definition admits straightforward
application. Where, on the other hand, the event is contingent or
speculative in nature, it is difficult to ascertain whether the
“reasonable investor” would have considered the omitted information
significant at the time. Merger negotiations, because of the ever-
present possibility that the contemplated transaction will not be
effectuated, fall into the latter category.

A

       Petitioners urge upon us a Third Circuit test for resolving this
difficulty.FN10 See Brief for Petitioners 20-22. Under this approach,
preliminary merger discussions do not become material until
“agreement-in-principle” as to the price and structure of the
transaction has been reached between the would-be merger partners.
By definition, then, information concerning any negotiations not yet at


                                   175
the agreement-in-principle stage could be withheld or even
misrepresented without a violation of Rule 10b-5.

      Three rationales have been offered in support of the
“agreement-in-principle” test. The first derives from the concern
expressed in TSC Industries that an investor not be overwhelmed by
excessively detailed and trivial information, and focuses on the
substantial risk that preliminary merger discussions may collapse:
because such discussions are inherently tentative, disclosure of their
existence itself could mislead investors and foster false optimism. The
other two justifications for the agreement-in-principle standard are
based on management concerns: because the requirement of
“agreement-in-principle” limits the scope of disclosure obligations, it
helps preserve the confidentiality of merger discussions where earlier
disclosure might prejudice the negotiations; and the test also provides
a usable, bright-line rule for determining when disclosure must be
made.

        None of these policy-based rationales, however, purports to
explain why drawing the line at agreement-in-principle reflects the
significance of the information upon the investor's decision. The first
rationale, and the only one connected to the concerns expressed in
TSC Industries, stands soundly rejected, even by a Court of Appeals
that otherwise has accepted the wisdom of the agreement-in-principle
test. “It assumes that investors are nitwits, unable to appreciate-even
when told-that mergers are risky propositions up until the closing.”
Disclosure, and not paternalistic withholding of accurate information, is
the policy chosen and expressed by Congress. We have recognized
time and again, a “fundamental purpose” of the various Securities
Acts, “was to substitute a philosophy of full disclosure for the
philosophy of caveat emptor and thus to achieve a high standard of
business ethics in the securities industry.” The role of the materiality
requirement is not to “attribute to investors a child-like simplicity, an
inability to grasp the probabilistic significance of negotiations,” but to
filter out essentially useless information that a reasonable investor
would not consider significant, even as part of a larger “mix” of factors
to consider in making his investment decision.

      The second rationale, the importance of secrecy during the early
stages of merger discussions, also seems irrelevant to an assessment
whether their existence is significant to the trading decision of a
reasonable investor. To avoid a “bidding war” over its target, an
acquiring firm often will insist that negotiations remain confidential,
and at least one Court of Appeals has stated that “silence pending


                                   176
settlement of the price and structure of a deal is beneficial to most
investors, most of the time.”

       We need not ascertain, however, whether secrecy necessarily
maximizes shareholder wealth-although we note that the proposition is
at least disputed as a matter of theory and empirical research FN12-
for this case does not concern the timing of a disclosure; it concerns
only its accuracy and completeness. We face here the narrow question
whether information concerning the existence and status of
preliminary merger discussions is significant to the reasonable
investor's trading decision. Arguments based on the premise that
some disclosure would be “premature” in a sense are more properly
considered under the rubric of an issuer's duty to disclose. The
“secrecy” rationale is simply inapposite to the definition of materiality.

       The final justification offered in support of the agreement-in-
principle test seems to be directed solely at the comfort of corporate
managers. A bright-line rule indeed is easier to follow than a standard
that requires the exercise of judgment in the light of all the
circumstances. But ease of application alone is not an excuse for
ignoring the purposes of the Securities Acts and Congress' policy
decisions. Any approach that designates a single fact or occurrence as
always determinative of an inherently fact-specific finding such as
materiality, must necessarily be overinclusive or underinclusive. In
TSC Industries this Court explained: “The determination [of
materiality] requires delicate assessments of the inferences a
‘reasonable shareholder’ would draw from a given set of facts and the
significance of those inferences to him....” 426 U.S., at 450, 96 S.Ct.,
at 2133. After much study, the Advisory Committee on Corporate
Disclosure cautioned the SEC against administratively confining
materiality to a rigid formula. Courts also would do well to heed this
advice.

       We therefore find no valid justification for artificially excluding
from the definition of materiality information concerning merger
discussions, which would otherwise be considered significant to the
trading decision of a reasonable investor, merely because agreement-
in-principle as to price and structure has not yet been reached by the
parties or their representatives.

B

       The Sixth Circuit explicitly rejected the agreement-in-principle
test, as we do today, but in its place adopted a rule that, if taken


                                    177
literally, would be equally insensitive, in our view, to the distinction
between materiality and the other elements of an action under Rule
10b-5:

       “... In analyzing whether information regarding merger
discussions is material such that it must be affirmatively disclosed to
avoid a violation of Rule 10b-5, the discussions and their progress are
the primary considerations. However, once a statement is made
denying the existence of any discussions, even discussions that might
not have been material in absence of the denial are material because
they make the statement made untrue.” 786 F.2d, at 748-749
(emphasis in original).

      This approach, however, fails to recognize that, in order to
prevail on a Rule 10b-5 claim, a plaintiff must show that the
statements were misleading as to a material fact. It is not enough that
a statement is false or incomplete, if the misrepresented fact is
otherwise insignificant.

C

       Even before this Court's decision in TSC Industries, the Second
Circuit had explained the role of the materiality requirement of Rule
10b-5, with respect to contingent or speculative information or events,
in a manner that gave that term meaning that is independent of the
other provisions of the Rule. Under such circumstances, materiality
“will depend at any given time upon a balancing of both the indicated
probability that the event will occur and the anticipated magnitude of
the event in light of the totality of the company activity.” SEC v. Texas
Gulf Sulphur Co., 401 F.2d, at 849. Interestingly, neither the Third
Circuit decision adopting the agreement-in-principle test nor
petitioners here take issue with this general standard. Rather, they
suggest that with respect to preliminary merger discussions, there are
good reasons to draw a line at agreement on price and structure.

      In a subsequent decision, the late Judge Friendly, writing for a
Second Circuit panel, applied the Texas Gulf Sulphur
probability/magnitude approach in the specific context of preliminary
merger negotiations. After acknowledging that materiality is something
to be determined on the basis of the particular facts of each case, he
stated:

      “Since a merger in which it is bought out is the most important
event that can occur in a small corporation's life, to wit, its death, we


                                    178
think that inside information, as regards a merger of this sort, can
become material at an earlier stage than would be the case as regards
lesser transactions-and this even though the mortality rate of mergers
in such formative stages is doubtless high.”

      We agree with that analysis.

       Whether merger discussions in any particular case are material
therefore depends on the facts. Generally, in order to assess the
probability that the event will occur, a factfinder will need to look to
indicia of interest in the transaction at the highest corporate levels.
Without attempting to catalog all such possible factors, we note by
way of example that board resolutions, instructions to investment
bankers, and actual negotiations between principals or their
intermediaries may serve as indicia of interest. To assess the
magnitude of the transaction to the issuer of the securities allegedly
manipulated, a factfinder will need to consider such facts as the size of
the two corporate entities and of the potential premiums over market
value. No particular event or factor short of closing the transaction
need be either necessary or sufficient by itself to render merger
discussions material.

      As we clarify today, materiality depends on the significance the
reasonable investor would place on the withheld or misrepresented
information. The fact-specific inquiry we endorse here is consistent
with the approach a number of courts have taken in assessing the
materiality of merger negotiations.FN19 Because the standard of
materiality we have adopted differs from that used by both courts
below, we remand the case for reconsideration of the question
whether a grant of summary judgment is appropriate on this record.

IV

A

      We turn to the question of reliance and the fraud-on-the-market
theory. Succinctly put:

      “The fraud on the market theory is based on the hypothesis that,
in an open and developed securities market, the price of a company's
stock is determined by the available material information regarding the
company and its business.... Misleading statements will therefore
defraud purchasers of stock even if the purchasers do not directly rely
on the misstatements.... The causal connection between the


                                   179
defendants' fraud and the plaintiffs' purchase of stock in such a case is
no less significant than in a case of direct reliance on
misrepresentations.”

      Our task, of course, is not to assess the general validity of the
theory, but to consider whether it was proper for the courts below to
apply a rebuttable presumption of reliance, supported in part by the
fraud-on-the-market theory. Cf. the comments of the dissent, post, at
994-995.

       This case required resolution of several common questions of law
and fact concerning the falsity or misleading nature of the three public
statements made by Basic, the presence or absence of scienter, and
the materiality of the misrepresentations, if any. In their amended
complaint, the named plaintiffs alleged that in reliance on Basic's
statements they sold their shares of Basic stock in the depressed
market created by petitioners. See Amended Complaint in No. C79-
1220 (ND Ohio), ¶¶ 27, 29, 35, 40; see also id., ¶ 33 (alleging effect
on market price of Basic's statements). Requiring proof of
individualized reliance from each member of the proposed plaintiff
class effectively would have prevented respondents from proceeding
with a class action, since individual issues then would have
overwhelmed the common ones. The District Court found that the
presumption of reliance created by the fraud-on-the-market theory
provided “a practical resolution to the problem of balancing the
substantive requirement of proof of reliance in securities cases against
the procedural requisites of [Federal Rule of Civil Procedure] 23.” The
District Court thus concluded that with reference to each public
statement and its impact upon the open market for Basic shares,
common questions predominated over individual questions, as
required by Federal Rules of Civil Procedure 23(a)(2) and (b)(3).

      Petitioners and their amici complain that the fraud-on-the-
market theory effectively eliminates the requirement that a plaintiff
asserting a claim under Rule 10b-5 prove reliance. They note that
reliance is and long has been an element of common-law fraud, and
argue that because the analogous express right of action includes a
reliance requirement, see, e.g., § 18(a) of the 1934 Act, as amended,
15 U.S.C. § 78r(a), so too must an action implied under § 10(b).

      We agree that reliance is an element of a Rule 10b-5 cause of
action. SReliance provides the requisite causal connection between a
defendant's misrepresentation and a plaintiff's injury. There is,
however, more than one way to demonstrate the causal connection.


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Indeed, we previously have dispensed with a requirement of positive
proof of reliance, where a duty to disclose material information had
been breached, concluding that the necessary nexus between the
plaintiffs' injury and the defendant's wrongful conduct had been
established. Similarly, we did not require proof that material omissions
or misstatements in a proxy statement decisively affected voting,
because the proxy solicitation itself, rather than the defect in the
solicitation materials, served as an essential link in the transaction.

     The modern securities markets, literally involving millions of
shares changing hands daily, differ from the face-to-face transactions
contemplated by early fraud cases,FN21 and our understanding of Rule
10b-5's reliance requirement must encompass these differences.FN22

B

       Presumptions typically serve to assist courts in managing
circumstances in which direct proof, for one reason or another, is
rendered difficult. The courts below accepted a presumption, created
by the fraud-on-the-market theory and subject to rebuttal by
petitioners, that persons who had traded Basic shares had done so in
reliance on the integrity of the price set by the market, but because of
petitioners' material misrepresentations that price had been
fraudulently depressed. Requiring a plaintiff to show a speculative
state of facts, i.e., how he would have acted if omitted material
information had been disclosed, would place an unnecessarily
unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has
traded on an impersonal market.

       Arising out of considerations of fairness, public policy, and
probability, as well as judicial economy, presumptions are also useful
devices for allocating the burdens of proof between parties. The
presumption of reliance employed in this case is consistent with, and,
by facilitating Rule 10b-5 litigation, supports, the congressional policy
embodied in the 1934 Act. In drafting that Act, Congress expressly
relied on the premise that securities markets are affected by
information, and enacted legislation to facilitate an investor's reliance
on the integrity of those markets:

      “No investor, no speculator, can safely buy and sell securities
upon the exchanges without having an intelligent basis for forming his
judgment as to the value of the securities he buys or sells. The idea of
a free and open public market is built upon the theory that competing
judgments of buyers and sellers as to the fair price of a security brings


                                   181
[sic] about a situation where the market price reflects as nearly as
possible a just price. Just as artificial manipulation tends to upset the
true function of an open market, so the hiding and secreting of
important information obstructs the operation of the markets as
indices of real value.” H.R.Rep. No. 1383, at 11.

      The presumption is also supported by common sense and
probability. Recent empirical studies have tended to confirm Congress'
premise that the market price of shares traded on well-developed
markets reflects all publicly available information, and, hence, any
material misrepresentations. It has been noted that “it is hard to
imagine that there ever is a buyer or seller who does not rely on
market integrity. Who would knowingly roll the dice in a crooked crap
game?” Indeed, nearly every court that has considered the proposition
has concluded that where materially misleading statements have been
disseminated into an impersonal, well-developed market for securities,
the reliance of individual plaintiffs on the integrity of the market price
may be presumed. Commentators generally have applauded the
adoption of one variation or another of the fraud-on-the-market
theory. An investor who buys or sells stock at the price set by the
market does so in reliance on the integrity of that price. Because most
publicly available information is reflected in market price, an investor's
reliance on any public material misrepresentations, therefore, may be
presumed for purposes of a Rule 10b-5 action.

C

       The Court of Appeals found that petitioners “made public,
material misrepresentations and [respondents] sold Basic stock in an
impersonal, efficient market. Thus the class, as defined by the district
court, has established the threshold facts for proving their loss.” 786
F.2d, at 751. The court acknowledged that petitioners may rebut proof
of the elements giving rise to the presumption, or show that the
misrepresentation in fact did not lead to a distortion of price or that an
individual plaintiff traded or would have traded despite his knowing the
statement was false. Id., at 750, n. 6.

      FN27. The Court of Appeals held that in order to invoke the
presumption, a plaintiff must allege and prove: (1) that the defendant
made public misrepresentations; (2) that the misrepresentations were
material; (3) that the shares were traded on an efficient market; (4)
that the misrepresentations would induce a reasonable, relying
investor to misjudge the value of the shares; and (5) that the plaintiff
traded the shares between the time the misrepresentations were made


                                   182
and the time the truth was revealed. See 786 F.2d, at 750.Given
today's decision regarding the definition of materiality as to
preliminary merger discussions, elements (2) and (4) may collapse
into one.

       Any showing that severs the link between the alleged
misrepresentation and either the price received (or paid) by the
plaintiff, or his decision to trade at a fair market price, will be sufficient
to rebut the presumption of reliance. For example, if petitioners could
show that the “market makers” were privy to the truth about the
merger discussions here with Combustion, and thus that the market
price would not have been affected by their misrepresentations, the
causal connection could be broken: the basis for finding that the fraud
had been transmitted through market price would be gone. FN28

Similarly, if, despite petitioners' allegedly fraudulent attempt to
manipulate market price, news of the merger discussions credibly
entered the market and dissipated the effects of the misstatements,
those who traded Basic shares after the corrective statements would
have no direct or indirect connection with the fraud.FN29 Petitioners
also could rebut the presumption of reliance as to plaintiffs who would
have divested themselves of their Basic shares without relying on the
integrity of the market. For example, a plaintiff who believed that
Basic's statements were false and that Basic was indeed engaged in
merger discussions, and who consequently believed that Basic stock
was artificially underpriced, but sold his shares nevertheless because
of other unrelated concerns, e.g., potential antitrust problems, or
political pressures to divest from shares of certain businesses, could
not be said to have relied on the integrity of a price he knew had been
manipulated.

      FN28. By accepting this rebuttable presumption, we do not
intend conclusively to adopt any particular theory of how quickly and
completely publicly available information is reflected in market price.
Furthermore, our decision today is not to be interpreted as addressing
the proper measure of damages in litigation of this kind.

      FN29. We note there may be a certain incongruity between the
assumption that Basic shares are traded on a well-developed, efficient,
and information-hungry market, and the allegation that such a market
could remain misinformed, and its valuation of Basic shares depressed,
for 14 months, on the basis of the three public statements. Proof of
that sort is a matter for trial, throughout which the District Court
retains the authority to amend the certification order as may be


                                     183
appropriate. Thus, we see no need to engage in the kind of factual
analysis the dissent suggests that manifests the “oddities” of applying
a rebuttable presumption of reliance in this case. See post, at 998-
999.

V

      In summary:

      1. We specifically adopt, for the § 10(b) and Rule 10b-5 context,
the standard of materiality set forth in TSC Industries, Inc. v.
Northway, Inc., 426 U.S., at 449, 96 S.Ct., at 2132.

      2. We reject “agreement-in-principle as to price and structure”
as the bright-line rule for materiality.

     3. We also reject the proposition that “information becomes
material by virtue of a public statement denying it.”

      4. Materiality in the merger context depends on the probability
that the transaction will be consummated, and its significance to the
issuer of the securities. Materiality depends on the facts and thus is to
be determined on a case-by-case basis.

     5. It is not inappropriate to apply a presumption of reliance
supported by the fraud-on-the-market theory.

      6. That presumption, however, is rebuttable.

       7. The District Court's certification of the class here was
appropriate when made but is subject on remand to such adjustment,
if any, as developing circumstances demand.

      The judgment of the Court of Appeals is vacated, and the case is
remanded to that court for further proceedings consistent with this
opinion.

      It is so ordered.




                                   184
FOR EDUCATIONAL USE ONLY


 THE MECHANISMS OF MARKET EFFICIENCY TWENTY YEARS LATER:
                   THE HINDSIGHT BIAS

                   Ronald J. Gilson and Reinier Kraakman

                  28 Journal of Corporation Law 715 (2003)

I. Introduction

This is a propitious time to revisit The Mechanisms of Market Efficiency
("MOME"). We began that project some twenty years ago, as newly
minted corporate law academics trying to understand what to make of
a large empirical literature proclaiming the efficiency of the U.S. stock
market. In an observation then offered as a simple description of the
state of play, Michael Jensen announced that "there is no other
proposition in economics which has more solid empirical evidence
supporting it than the Efficient Market Hypothesis" ("EMH"). But if this
were so, it seemed to us that it could not be because market efficiency
was a physical property of the universe arising, like gravity, in the
milliseconds following the big bang. Rather, the prompt reflection of
publicly available information in a security's price had to be the
outcome of institutional and market interactions whose proper
functioning necessarily depended on the character of those
institutions. Thus, MOME represented the efforts of two young scholars
to understand the institutional underpinnings of the empirical
phenomenon called market efficiency.

We concluded that the level of market efficiency with respect to a
particular fact is dependent on which of a number of mechanisms--
universally informed trading, professionally-informed trading,
derivatively informed trading, and uninformed trading--operated to
cause that fact to be reflected in market price. Which mechanism was
operative, in turn, depended on the breadth of the fact's distribution,
which in turn depended on the cost structure of the market for
information. The lower the cost of information, the wider its
distribution, the more effective the operative efficiency mechanism
and, finally, the more efficient the market.




                                    185
Revisiting this framework is particularly appropriate because we are
now experiencing the early stages of a quite different framework for
evaluating the efficiency of the stock market, also supported by a
growing number of empirical studies and also accompanied by an
expansive description of the literature's reach by another respected
Harvard economist. The new framework is styled "behavioral finance"
and its ascent and market efficiency's descent is recounted by Andrei
Shleifer: "Whatever the reason why it took so long in practice, the
cumulative impact of both [behavioral finance] theory and the
evidence has been to undermine the hegemony of the EMH . . . ."
Michael Jensen's 1978 statement of the empirical support for market
efficiency is now proffered with a tone somewhere between irony and
condescension.

The movement from Jensen's to Shleifer's formulation over twenty
years surely merits a reconsideration of the substance and implications
of market efficiency for legal and public policy, a task that the
interesting papers in this symposium pursue with vigor. Although no
longer new to the academy, in the end we remain convinced that how
quickly and accurately the stock market reflects information in the
price of a security is a function of the performance of institutions. In
what follows we offer a brief, appropriately tentative assessment of the
fit of behavioral finance with the framework developed twenty years
ago in MOME, and an even briefer and more tentative evaluation of the
policy implications arising from the behavioral finance framework.

In Part I, we put market efficiency in an intellectual context--as part of
the shift of finance from description to applied microeconomics that
also included the development of the Capital Asset Pricing Model and
the Miller-Modigliani Irrelevancy Propositions, and ultimately gave rise
to the award of three Nobel Prizes. Part II briefly recounts the MOME
thesis, and Part III describes the challenge of behavioral finance. In
Part IV, we offer our assessment of the central principles that drive
behavioral finance and in Part V evaluate how the MOME thesis stands
up to the challenge. In Part VI we stick our necks out a little, offering
some MOME based predictions about where it is likely that behavioral
finance will and will not have significant policy implications. Part VII
concludes.



II. Putting MOME in an Intellectual Context: The Rise of Modern
Finance



                                   186
MOME was written in response to the first spillover of finance into
another discipline. Thus, to place MOME in its proper context we first
need a snippet of intellectual history--a capsule account of the
development of modern finance. The nature of that development set
the stage for MOME and, we will argue, for the important recent work
in behavioral finance.

A fair place to begin is 1960. The Journal of Finance was then only
eight years old and, according to a popular historian of modern
finance's early years, to that date had published no "more than five
articles that could be classified as theoretical rather than descriptive."
Thus, it was hardly surprising that a generation of younger
economists, intent on transforming finance into a mathematically
rigorous branch of microeconomics, was focusing on developing
theories that might explain description. Science involves empirically
testing hypotheses, but formulating hypotheses requires an animating
theory.

For present purposes, we will focus on three bodies of theory that
arose in the period from the late 1950s to the early 1970s. These
sought to state rigorously how capital assets are priced, whether a
corporation's choice of which capital assets to issue affects the
corporation's value, and whether the market price of capital assets
reflects all available information concerning their value. These three
familiar theories--the Capital Asset Pricing Model, the Miller-Modigliani
Irrelevance Propositions, and the Efficient Capital Market Hypothesis --
shared a critical common methodology. The theories' rigor is achieved
through an extensive set of perfect markets assumptions--in essence,
rational investors, perfect information, and no transaction costs.

Start with the Capital Asset Pricing Model (CAPM). If one assumes that
all unsystematic risk can be diversified away, what else but systematic
risk could affect the price of capital assets? If investors need not bear
unsystematic risk, then investors who do not bear it will require the
lowest return (pay the highest price) for a capital asset, thereby
setting the asset's price. CAPM simply takes the next step of
identifying the systematic risk that matters to investors with the
covariance of an asset's returns with those of the market-- i.e., beta.
Given these assumptions, CAPM is, in short, a tautology.

The Miller-Modigliani Irrelevance Propositions share the same
conceptual structure. That the choice of a debt-equity ratio does not
affect firm value is, in Miller's words thirty years later, "an implication
of equilibrium in perfect capital markets." Like CAPM, the perfect


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capital market assumptions result in the Irrelevance Propositions
appearing tautological. Think of a simple T diagram, with assets on
one side and ownership interests-- debt and equity--on the other. The
balance sheet balances because of another tautology: the total value
of the assets corresponds to the total ownership-- debt and equity--
interests. Why then should the divisions on the right side of the
balance sheet--the manner in which ownership interests are divided--
affect the left side of the balance sheet--that is, the value of the
assets? If for some reason debt or equity was mispriced, arbitrage
would restore the proper relation, so that increasing the amount of
lower cost debt would result in an offsetting increase in the cost of
equity and vice versa.

The Efficient Capital Market Hypothesis ("ECMH") also builds on perfect
market assumptions. Commenting on Fama's 1970 seminal review
article, William Sharpe stated: "Simply put, the thesis is this: in a well-
functioning market, the prices . . . [of securities] will reflect predictions
based on all relevant and available information. This seems almost
trivially self-evident to most professional economists--so much so, that
testing seems rather silly." William Beaver made much the same point
ten years later: "Why would one ever expect prices not to 'fully reflect'
publicly available information? Won't market efficiency hold trivially?"

In addition to its prediction of the information content of stock prices,
the ECMH also played a critical integrative role, providing the
necessary link between asset pricing and capital structure choice
through the medium of market prices. Both CAPM and the Modigliani-
Miller propositions depend on an arbitrage mechanism for their proof:
mispricing will be traded away. But for arbitrage to be triggered by
mispricing, market prices must be reasonably informative. Thus, along
this important dimension, the positive power of the three theories rise
and fall together.

Despite their tautological character, all three theories generated a
groundswell of angry response because, if one imagined that their
predictions survived the release of their perfect market assumptions,
each theory attacked the value of important participants in the capital
market. CAPM called into question the value of highly paid portfolio
managers--simply assessing the volatility of an asset relative to that of
the market might not command the same rewards as firm specific
assessments of risk and reward. The Irrelevancy Propositions were
even more offensive. Getting a corporation's debt-equity ratio right
was a central function of chief financial officers (and their highly
compensated investment banker consultants); why pay people large


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amounts to engage in an activity that does not increase the value of
the firm? The ECMH took the attack one step further, calling into
question not only the value of chartists (marginalized by weak form
efficiency), but fundamental analysis as well (marginalized by semi-
strong form efficiency).

While it is tempting to dismiss the reaction of capital market
professionals as simply turf protection, that would miss the deeply felt
belief that all three theories' perfect market elegance did not reflect
the world in which the professionals worked. What happens when the
theories confronted the real world where information was costly and
asymmetrically distributed, at least some investors were plainly
irrational, and transactions costs were pervasive?

Thus, the transformation of finance into financial economics gave rise
to a set of theorems that explained the operation of asset pricing and
capital structure in perfect capital markets and evoked a predictable
reaction from those whose function the theorems called into question.
The next step, clear in hindsight but perhaps more murky at the time,
was to find out the extent to which the real world capital market
worked the way the financial economics predicted. This conflict--
between the elegant world of perfect capital markets and the messy
real world--defined the problem we addressed in MOME. We said that
"[w]hat makes the ECMH non-trivial, of course, is its prediction that,
even though information is not immediately and costlessly available to
all participants, the market will act as if it were." Thus, in MOME, we
proposed "a general explanation for the elements that lead to--and
limit--market efficiency."

III. The MOME Thesis

Beginning in the 1980s, a growing empirical literature challenged the
predictions of the 1960s perfect market theorems, and in turn gave
rise to a reassessment of the underlying theory. The Mechanisms of
Market Efficiency was one such effort at explanation and
reassessment. The principal focus of the MOME thesis was a concept
that we termed "relative efficiency." By this we meant that particular
information might be reflected in real--as opposed to ideal--market
prices more or less rapidly (or, in our terminology, with more or less
relative efficiency). The more quickly that prices reequilibrated to
reflect new information, the more closely they behave "as if" they were
set by the theorist's ideal of a market populated exclusively by fully-
informed traders. Thus market efficiency, as we saw it, concerned how
rapidly prices responded to information, rather than whether they


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responded "correctly" according to the predictions of a particular asset
pricing model such as CAPM. By the early 1980s, a large body of
empirical work demonstrated that price responded extremely rapidly to
most public and even "semi-public" information--too rapidly to permit
arbitrage profits on most of this information. By and large, then, the
public equities market appeared to be semi-strong form efficient,
meaning that relative efficiency was high for public information. But
how was this possible, given that most traders were likely to be
uninformed about the content of much of this information?

We addressed this question on two levels. On the level of the capital
markets, MOME proposed that four mechanisms work to incorporate
information in market prices with progressively decreasing relative
efficiency. First, market prices immediately reflect information that all
traders know, simply because this information necessarily informs all
trades, just as perfect markets theorists assumed ("universally-
informed trading"). Second, information that is less widely known but
nonetheless public, is incorporated into share prices almost as rapidly
as information known to everyone through the trading of savvy
professionals ("professionally-informed trading"). Third, inside
information known to only a very few traders would find its way into
prices more slowly, as uninformed traders learned about its content by
observing tell-tale shifts in the activity of presumptively informed
traders or unusual price and volume movements ("derivatively-
informed trading"). Finally, information known to no one might be
reflected, albeit slowly and imperfectly, in share prices that aggregated
the forecasts of numerous market participants with heterogeneous
information ("uninformed trading").

In retrospect, the four market mechanisms that we introduced to
sketch the institutional reality behind the rapid incorporation of public
and semi-public information into share price seem stylized themselves.
Subsequent research into the structure of trading markets reveals yet
another level of micro-trading mechanisms at play in the channeling of
information in prices, including the critical role played by market
makers.

Our concern, however, was not with the microstructure that underlies
the mechanisms of market efficiency, but rather with the larger
institutional framework of the market that regulated the distribution of
information among traders, and hence determines which market
mechanism incorporates information into price. Simply put, MOME's
second claim was that cost determines the distribution of information
in the market, and that this cost of information, in turn, depends on


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the market institutions that produce, verify, and analyze information--
ranging from the Wall Street Journal to the exhaustive research of the
best professional investors. While every step in the institutional
pathways that channel information into price bears on the relative
efficiency of market price, none are as important as the institutions
that determine the transaction costs of acquiring and verifying
information in the first instance.

IV. The Challenge of Behavioral Finance

In finance itself, the empirical literature challenging the perfect market
theorems soon gave rise to a reassessment of the underlying theory.
With respect to the Irrelevance Propositions, a focus on the
imperfections in the market for information stimulated a series of
explanations of how capital structure could matter if information was
costly and asymmetrically distributed. If corporate managers had
private information concerning the corporation's future prospects, and
if bankruptcy is costly to managers, then exposing the corporation to a
greater risk of bankruptcy either by paying dividends or maintaining a
higher debt to equity ratio could credibly signal that information to the
market and thereby influence the price of the corporation's securities.
Correspondingly, capital structure could also function as an incentive:
an increased risk of bankruptcy resulting from a more leveraged
capital structure provides an incentive for managers, for whom
bankruptcy would be costly, to work even harder.

The Capital Asset Pricing Model always had problems when attention
shifted from theory to empirical testing. First, it was not clear that
CAPM could be tested at all. CAPM predicts a linear relationship
between a stock's systematic risk and returns on the market portfolio.
While the market portfolio is operationally defined as a securities index
like the S&P 500, the market portfolio theoretically consists of all
investment assets, including non- tradable assets such as human
capital. If the investigator cannot specify how the proxy for the market
portfolio differs from the real but unobservable market portfolio, it is
difficult to evaluate empirical results concerning how accurately CAPM
predicts stock prices. Either a good prediction or a bad prediction may
be the result of using an incomplete proxy for the market portfolio. A
second problem arises out of the integrative role played by the ECMH.
CAPM predicts how prices should be set. If observed prices are
different from predicted prices, it could mean that CAPM is wrong, but
it could also mean that the ECMH is wrong.




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Conceptual problems aside, the empirical results were not kind to
CAPM. In the end, a security's beta does not predict its return very
well. Two categories of evidence are especially relevant here. First,
studies show that asset pricing models with multiple factors in addition
to systematic risk do a better job of predicting prices. Fama and
French, for example, find that they can better predict market prices
with a three-factor pricing model that includes company size and book-
to-market ratio in addition to systematic risk. More generally, the
Arbitrage Pricing Model abandons the effort to determine
nondiversifiable risk factors on the basis of a priori economic
reasoning. Instead, the APM specifies that prices are a linear function
of factors derived from the data itself, which may include what appear
to be measures of, perhaps, liquidity or inflation.

Second, the CAPM's empirical failures appear to exhibit certain
empirical regularities. The literature identifies a number of what are
styled "anomalies," that is, persistent evidence of higher than
predicted returns based on publicly available information. Consistent
with the joint test problem, these results seem to be inconsistent both
with CAPM and with the ECMH. Such anomalies include the tendency of
small companies to earn higher than predicted returns; the seeming
existence of a "January effect," in which much of the abnormal returns
to smaller firms occurs during the first half of January; the "weekend
effect," in which stock returns are predictably negative over weekends;
and the "value effect," in which firms with high earnings-to-price
ratios, high dividend yields, or high book-to-market ratios earn higher
than predicted returns.

A variety of explanations have been offered for the empirical
discrepancies. Some explain the data as the result of incorrect asset
pricing models. Others note that the studies revealing the anomalies
are sensitive to the particular empirical techniques used, or
demonstrate that at least some of the anomalies disappear or are
dramatically reduced in size following their announcement in the
literature, thus suggesting that markets learn, although not
necessarily quickly.

These more particularized problems with the link between perfect
capital market theories and empirical reality have had their most
significant impact, however, with respect to the ECMH. Here, in a
movement called behavioral finance, an alliance of cognitive
psychologists and financial economists have taken direct issue with the
perfect market foundations of modern finance in general and the ECMH
in particular. As discussed above, the core theories of modern finance


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assume that investors are fully rational (or that the market acts as if
they are), and that markets are efficient and transactions costs small
so that professionally-informed traders quickly notice and take
advantage of mispricing, thereby driving prices back to their proper
level. Behavioral finance takes issue with both these premises, arguing
that many investors are not rational in their financial decision-making,
that there are observable directional biases resulting from departures
from rational decision-making, and that significant barriers prevent
professional traders from fully correcting the mistakes made by less
than rational investors.

The criticism of the rationality premise builds on an important
literature growing out of work by cognitive psychologists Daniel
Kahneman and Amos Tversky, which uses decision-making
experiments to show how individuals' cognitive biases can lead them
to systematically misassess an asset's value. The list of biases has
grown impressively with time, and includes overconfidence, the
tendency of individuals to overestimate their skills; the endowment
effect, the tendency of individuals to insist on a higher price to sell
something they already own than to buy the same item if they do not
already own it; loss aversion, the tendency for people to be risk averse
for profit opportunities, but willing to gamble to avoid a loss;
anchoring, the tendency for people to make decisions based on an
initial estimate that is later adjusted, but not sufficiently to eliminate
the influence of the initial estimate; framing, the tendency of people to
make different choices based on how the decision is framed such as
whether it is framed in terms of the likelihood of a good outcome or in
terms of the reciprocal likelihood of a bad outcome; and hindsight, the
tendency of people to read the present into assessments of the past.

Individuals whose decisions are subject to one or more of these
biases, referred to in the literature as "noise traders," will then make
investment decisions that deviate from those that theory would predict
of rational investors. Lee, Shliefer, and Thaler's clever effort to explain
the discount often associated with closed-end mutual funds, one of the
long-standing phenomena that conflicts with the ECMH, aptly
illustrates the potential for such misguided investors to influence price
efficiency. When an investor sells shares in a closed-end mutual fund,
she receives whatever a buyer is willing to pay, rather than a
proportionate share of the fund's net asset value, as she would if she
redeemed her interest in an open-end mutual fund. Because the net
assets of a closed-end fund are observable, the ECMH predicts that the
stock price of a closed-end fund should reflect its net asset value. In
fact, closed-end funds systematically (but not uniformly) trade at a


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discount from their underlying asset value, a serious problem for the
claim that stock prices generally are the best estimate of a security's
value. In the one case where we can actually observe underlying asset
value, stock price diverges from it.

Lee, Shleifer, and Thaler blame this phenomenon on noise traders,
whose views about value, perhaps because of some combination of the
litany of cognitive biases, plainly ignore the value in their primary
market of the securities held by the closed-end fund. Using individual,
non-professional investors as a proxy for noise traders--should we all
take this personally?--the authors note that institutions hold only a
very small percentage of closed-end mutual fund shares, leaving
individual investors as the central clientele for this type of investment.

Importantly, however, the presence of noise traders alone is
insufficient to result in inefficient market prices. Two other elements
are necessary. First, the biases held by the noise traders must be
more or less consistent; otherwise, at least some of the biases will, in
effect, regress out. Second, arbitrageurs must be unwilling to police
the resulting price inaccuracies. Under perfect capital market
assumptions, fully informed traders with unlimited access to capital
immediately pounce on mispriced securities. If arbitrageurs were
available to trade against the noise traders, then their action would
suffice to return prices to their efficient level. In the case of closed-end
mutual funds, however, the absence of institutional investors in this
niche limits the extent of corrective arbitrage, and prices retain an
irrationality component.

This limited arbitrage condition is critical to the behavioral finance
perspective, and the problem is more general than the simple case of
closed-end mutual funds. Limits on arbitrage fall into four general
categories: fundamental risk; noise trader risk; institutional limits,
both regulatory and incentive; and the potential that even professional
traders may be subject to cognitive biases.

The problem of fundamental risk simply reflects the fact that, unless
hedged, the arbitrageur has a position in the stock of a particular
company that is exposed to loss from a change in that company's
fortunes. This can be avoided by holding an offsetting position in a
substitute security. However, substitutes may not be available and in
all events will be imperfect. Barberis and Thaler offer the illustration of
an arbitrageur who believes that Ford is underpriced. To hedge the risk
associated with purchasing Ford, the arbitrageur simultaneously shorts
GM. But this strategy only provides a hedge against bad news in the


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automobile industry generally; it does not hedge against firm-specific
bad news about Ford (and to the extent that bad news for Ford is good
news for GM, it may actually increase firm-specific risk). The
arbitrageur must therefore expect a higher return to offset her basis
risk, which in turn reduces arbitrage activity and lowers market
efficiency. The result is much like Grossman and Stiglitz's now familiar
point that informationally efficient markets are impossible because full
efficiency eliminates the returns to the very activity that makes the
market efficient, with the result of an "equilibrium degree of
disequilibrium."

The impact of noise trader risk on arbitrage effectiveness reflects the
same mechanism as operative with respect to fundamental risk but
differs in the mechanism's trigger. With respect to fundamental risk,
the arbitrageur must be compensated for the risk that she will have
accurately estimated the probability distribution concerning future
economic performance, but that the ultimate realization turns out
unfavorable to her position. With respect to noise trader risk, the
uncertainty concerns neither the accuracy of the arbitrageur's analysis,
nor even the realization. In addition to this fundamental risk, the
arbitrageur also bears the risk that noise traders will continue to be
irrational, therefore maintaining, or even increasing, the mispricing.
Since the arbitrageur will also have to be compensated for the risk that
noise traders continued confusion will adversely affect the value of
their rational bets, the required return goes up and level of activity
goes down, resulting in a cost driven level of market inefficiency.

Institutional limits on arbitrage reflect barriers to arbitrageurs trading
away information inefficiencies that result not from market risk, but
from the structure of the institutions through which the arbitrageurs
act. For our purposes, these limits fall into two categories: regulatory
and market constraints on the mechanisms of arbitrage, and the
structure of arbitrageurs' incentives. Each category operates to restrict
the extent to which arbitrage can correct mispricing.

Regulatory restrictions on arbitrage are directed at short-sales,
undertaken by an arbitrageur when she believes the market price of a
security is higher than its efficient price. In a short sale, the
arbitrageur sells a security she does not own. To accomplish this, she
must first find an existing owner of the overpriced security who is
willing to lend the security to the arbitrageur. The borrowed stock is
then sold, the arbitrageur betting that the price of the security will fall
before the security must be purchased to repay the loan.



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Securities Exchange Act Rules 10a-1 and 10a-2 provide the basic
regulatory framework. Rule 10a-1, the "uptick test," generally
prohibits a short sale at a price below the security's last reported price,
and Rule 10a-2 restricts activities by broker-dealers that could
facilitate a violation of the uptick rule. The idea behind the
prohibitions, dating to aftermath of the stock market crash of 1929, is
to prevent "speculators" from driving down the price of a stock by
continuing to sell stock below the market price. The difficulty with the
rule is simply the obverse of its asserted benefit. Short-selling,
through its information revealing properties, pushes stock prices to a
lower, more efficient level; to the extent that the uptick rule actually
succeeds in restricting arbitrage, the level of market efficiency suffers.

Market restrictions on short-selling involve both limits on the demand
side-- the parties who can engage in short selling--and on the supply
side--the costs and availability of shares to borrow to affect a short
sale. While the Securities Exchange Act 316(c) restricts short-selling
by officers, directors, and large shareholders of publicly traded
companies, the more serious demand constraint is voluntary; a recent
SEC study reports that only some 43% of mutual funds were
authorized by their charters to sell short. During the six-month period
ending April 30, 2003, only approximately 2.5% of registered
investment companies (236 out of some 9000) actually engaged in
short-selling. Because 79% of mutual funds report that they do not
use derivatives, it is unlikely that the charter restrictions are being
avoided through the use of synthetic securities.

Market restrictions on the supply side relate to the lending market for
the securities that must be borrowed for a short sale to be made.
Preparation for a short sale begins with a request that the
arbitrageur's broker find a lender for the shares that are to be sold.
The universe for potential lenders include the broker itself if it has an
inventory of the desired stock, or institutional investors, including
pension funds, insurance companies, and index funds, all of whom
have long-term strategies that are unlikely to be negatively affected
by liquidity constraints resulting from securities lending. The
arbitrageur transfers collateral to the lender in the amount of 102% of
the value of the borrowed securities, typically in cash. The lender then
pays interest to the arbitrageur on the cash collateral, termed the
rebate rate, and has the right to call the loan at any time. If the loan is
called at a time when the shares have risen in value, the arbitrageur
will be forced to close her position at a loss unless another lender is
found. Additionally, SEC Regulation T requires that the arbitrageur



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post a margin of 50% of the borrowed securities' value in additional
collateral.

In general, the lending market available to short sellers for large issuer
securities is broad and deep. Large cap stocks are generally easy and
cheap to borrow, with the great majority requiring loan fees of less
than 1% per year. In contrast, borrowing smaller cap stocks with little
institutional ownership may be difficult and expensive. As many as
16% of the stocks in the Center for Research in Security Prices file
may be impossible to borrow. These companies are quite small, in
total accounting for less than 1% of the market by value, with most
being in the bottom decile by size and typically trading at under $5.00.

Recent theoretical and empirical work suggests that it is more costly to
borrow a stock the greater the divergence of opinion in the security's
value. The logic reflects the fact that those who do not lend the
security forego the price they would have received for its loan. Thus,
those holding a stock must value it more highly than those who lend it
by an amount in excess of the loan fee. The greater the divergence of
opinion concerning the stock's value, the higher the loan fees, yielding
the perverse result that the transaction costs of arbitrage increase in
precisely the circumstance when the activity is most important.

Consistent with significant market limits on arbitrage, short interest in
securities is generally quite small. A recent study reports that over the
period 1976 through 1993, more than 80% of listed firms had short
interests of less than 0.5% of outstanding shares, and more than 98%
had short interests of less than 5%, a level consistent in magnitude
with earlier assessments. And consistent with a significant impact on
market efficiency from limited arbitrage, the empirical evidence "is
broadly consistent with the idea that short-sales constraints matter for
equilibrium stock prices and expected returns." The problem, however,
is with the magnitude of the costs. If the stock of all but small, non-
institutional stock is readily available for borrowing, the regulatory and
market imposed transaction costs of short-selling seem too small to
account for the limited amount of short-selling we observe and for its
impact on pricing. A recent study of the impact of short-selling
constraints concluded that

An interesting question that our work raises, but does not answer, is
this: why do short-sale constraints seem to be so strongly binding? Or
said slightly differently: why, in spite of the high apparent risk-
adjusted returns to strategies involving shorting, is there so little
aggregate short interest in virtually all stocks? . . . [W]e are skeptical


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that all, or even most of the answer has to do with . . . specific
transaction costs.

The structure of arbitrageurs' incentives may provide the identity of
the dark matter of the short sale universe--the source of constraints
that the transaction costs of short selling do not explain. Recent work
highlights a number of incentive problems, including a more realistic
account of arbitrageurs' goals and the agency costs of arbitrage.

The first problem is that we have, to this point, operated on a quite
naïve framing of the goal of arbitrageurs. In effect, we have treated
arbitrageurs as a kind of market-maker whose role is to police the
efficiency of prices and whose efforts will be compromised to the
extent that regulatory and transaction costs make short-selling costly.
In fact, however, arbitrageurs have a quite different goal: to make
money. This, in turn, suggests that arbitrageurs act not only on a
difference between a stock's market price and its fundamental value,
but also on a difference between a stock's current market price and its
future market price, regardless of the relation between its future
market price and its fundamental value. Here the idea is simply that if
overly optimistic noise traders are in the market, shorting the stock is
not the only way to make money. Instead, one can profit by
anticipating the direction of the noise traders' valuation error, and
taking advantage of that error through long, not short, positions with
the goal of selling the shares to noise traders at a higher future price.
The result may be to drive up the price of already overvalued stocks,
and to prolong the length and increase the extent of bubbles.

The second problem is the agency costs of arbitrage, arising from, as
Andrei Shleifer has nicely put it, the fact that "brains and resources are
separated by an agency relationship." To see this, keep in mind that
arbitrage positions are made based on ex ante expectations, but the
gain realized depends on ex post outcomes. The two may differ
because of either the arbitrageur's skill in identifying mispricing or
because of fundamental or noise trader risk; that is, an investment
may fail either because of bad judgment or because of bad luck.

For an arbitrageur trading for her own account, we can presume the
explanation for a failed investment is observable. But now assume that
the arbitrageur is instead an investment professional whose capital is
raised from institutional investors and who receives a portion of the
profits--the arbitrageur runs a hedge fund. Because the initial ex ante
assessment of the portfolio investment is not observable to the fund
investor, the investor then may use the investment's ex post outcome


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as a proxy of the arbitrageur's skill, with the effect of exposing the
arbitrageur's human capital to both fundamental and noise trader risk
because the fund investor may mistakenly treat a loss that really
results from bad luck as evidence of bad judgment. Arbitrageurs
thought to have "bad judgment" will have difficulty raising new funds.
This potential, in turn, will cause the arbitrageur to reduce her risk by
taking more conservative positions. Importantly, the personal risk to
the arbitrageur increases as the importance of arbitrage as a means to
correct market price increases. The greater the disagreement about a
stock's price, the greater the bad luck risk that the arbitrage position
turns out badly and, hence, the greater risk to the arbitrageur's human
capital.

This interaction between noise trader risk and the agency costs of
arbitrage can plausibly lead to bubble-like conditions. Once noise
traders enter the market in large numbers, the risk to arbitrage
increases, which in turn results in an independent reduction in the
level of arbitrage. This reduction, one might imagine, is more or less
linear. More important, the presence of a market driven by noise
traders has the potential to create a kink in the arbitrage supply curve,
when the potential profits from momentum trading exceeds the
potential profit from short-selling. From this perspective and
extrapolating from Lee, Shleifer, and Charles' treatment of closed end
mutual funds, one might consider a sharp increase in the number of
individual investors in the market as a pre-bust signal of a bubble. This
assessment turns on its head the familiar anecdotal observation that
when individuals get into the market the professionals get out: when
individuals enter the market in large numbers, professionals find
something to sell them.

A final potential limit on arbitrage looks back to the psychological
biases that may underlie the noise trader phenomenon. To this point,
we have treated arbitrageurs as if they still met the perfect rationality
assumption of traditional theory--even if they are responding to the
presence of noise traders or frictions in the incentive structure they
face, they do so rationally. In the end, however, even professional
traders are people. Maybe they are subject to cognitive biases as well;
that is, the existence of irrational professional traders may be a limit
to arbitrage.

The issue whether some or all of the cognitive biases are hard wired or
can be diminished by education or experience is a contested subject
whose review is far beyond our ambition here. For present purposes,
we note only that when the studies place individuals in a position


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where the goal is to make money, the cognitive biases seem to
disappear quickly. And because the organization has the capacity to
shape the traders' incentives so that the goal is clear, the potential for
learning to occur and be reinforced is significant. Thus, for our
purposes, we will treat professional traders as rational actors in
responding to the incentives that they face.

V. A Tentative Assessment of the Behavioral Finance Principles

Assessing the contribution of behavioral finance to the market
efficiency debate even on the tentative basis we have in mind here, as
well as avoiding some of the shrillness that has been associated with
the debate, requires that we be quite clear both about the aspect of
market efficiency we have in mind, and which of the two behavioral
finance principles--investor irrationality and limits on arbitrage--is
doing the heavy lifting. From our perspective, evidence that some
investors sometimes systematically deviate from rational decision-
making is not a revelation. Roughly coincident with the publication of
MOME, one of us published a text on the Law and Finance of Corporate
Acquisitions that contained a lengthy excerpt from a survey article by
Amos Tversky and Daniel Kahneman, to our knowledge the first time
their work appeared in corporate law teaching materials. What makes
the market efficiency claim non-trivial is that prices are said to be
efficient despite the fact that perfect market assumptions do not hold.
Investor irrationality on the part of some investors, like information
costs and transaction costs, affects relative efficiency. Irrationality
takes on special meaning only if its impact on the incorporation of
information into price differs from that of other market imperfections.
Otherwise, limits on arbitrage should command the most attention
(including, of course, those limits that are linked to investor
irrationality).

A. The Investor Irrationality Principle

Despite the body of experimental evidence supporting persistent
decision-making biases in some portion of the population, we are
skeptical that this phenomenon will be found, generally, to play a
significant role in setting aggregate price levels. Start with the familiar
complaint that the sheer number of biases that have been identified,
together with the absence of precision about which bias, or
combination of biases, are operative in particular circumstances,
leaves too many degrees of freedom in assigning causation. For
example, the psychology literature has been proffered to support
giving a target board of directors more discretion to undertake


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defensive action-- cognitive biases may cause the shareholders to
make the wrong decision. But what bias can be predicted to operate in
this setting? If one imagines the endowment effect is at work on target
shareholders, then they may require too high a price for their stock,
and mistakenly let a good offer pass. Alternatively, if one imagines
that the shareholders are loss averse, and if they anchor the measure
of their loss by the premium offered, they may fear the risk of losing
the existing premium more than they value the chance of a still higher
offer. One cannot help but be reminded of Karl Llewellyn's famous
demonstration that for every canon of statutory interpretation there is
an equal and opposite canon, leaving one in search of a meta principle
that dictates when one or the other applies.

Indeed, this indeterminacy concerning the incidence and interaction of
the variety of cognitive biases raises the possibility that biases could
not be shown to influence aggregate price levels even if they did. Here
the concern echoes that raised by Richard Roll with respect to testing
CAPM--if one cannot observe the market portfolio, one cannot assess
the extent to which one's proxy differs from it. If one cannot observe
which biases are operative and their interaction, one may not be able
to assess whether a market price reflects any bias at all.

To be sure, the indeterminacy criticism is overstated in the sense that
it applies the ambitions of economics to cognitive psychology. It is
unlikely that this body of work will lead to models like arbitrage
pricing, which would aspire to estimate what biases apply in particular
circumstances and their coefficient--the weight each bias has in the
ultimate decision. As Mark Kelman stated recently:

[T]he fact that one recognizes the existence of hindsight bias may
make it somewhat more plausible that decision makers are not
perfectly rational in general or, a touch more narrowly, in assessing
the probability of events. However, its existence does not make it any
more likely that they are subject to any of the other particular
infirmities of reasoning . . . that behavioral researchers have
identified. But the fact that a vice does not quite close does not mean
it is without value in addressing more general, as opposed to more
precise, problems.

For the purpose of evaluating the role of irrationality in setting prices,
however, this criticism is important. It means that the simple presence
of cognitive biases has no necessary implications for prices at all.
Indeed, we cannot dismiss the possibility that the price effects of
offsetting biases, on a single individual or across individuals, regress


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out in significant respect and thereby reduce the pressure on
arbitrage, that is, on the mechanisms of market efficiency.

The same analysis also suggests circumstances where investor
irrationality should be a matter of real concern. When a single bias
extends across most noise traders, the price effect will not regress out,
leaving a much heavier burden on arbitrage. And the problem will
increase more than monotonically as the number of infected noise
traders increases. As the volume of irrational trades increases, a point
is reached where the arbitrageur's most profitable strategy shifts from
betting against the noise traders to buying in front of them, with the
goal of exploiting the noise traders mistake by selling them overvalued
stock. In other words, increasing numbers of similarly mistaken noise
traders serves to turbo-charge the price impact of their mistake. A
sharp increase in the participation of individual investors is a powerful
indication that they share a common bias--the likelihood that a
coincidence of different biases all lead to increasing participation at the
same time seems small. Thus, a spike in individual trading, Lee,
Shleifer, and Thaler's proxy for noise trading, may serve as a limited
predictor of price bubbles.

Where do we come out, then? Very tentatively, we suggest that noise
trading-- or investor irrationality--is likely to matter to price
episodically. Under conditions of "normal trading," the arbitrage
mechanism will suffice to cabin the eddies of bias in noise trading, and
the extent to which irrationality influences price will be set by other
constraints on arbitrage including transaction costs and the costs of
information. However, circumstances of abnormal trading--when a
spike in the number of individual investors suggests that noise traders
will share a common mistaken belief--will give rise to a shift in
arbitrageur strategy that drives prices further from efficiency. On
these occasions, arbitrage constraints on price are relaxed, and the
effects of cognitive biases on prices are likely to be of significantly
greater magnitude than cost-based deviations from perfect market
conditions.

Thus, our attention will focus on arbitrage limits in assessing the
impact of behavioral finance on the market efficiency debate.
However, this emphasis does not mean that the bias literature does
not usefully speak to matters of financial market concern. Rather, we
expect that it will have its greatest impact on circumstances when the
concern is not with aggregate price effects, but with the behavior of
individual investors. As we will discuss in more detail in Part VI, we
may care a great deal if individuals systematically make poor


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investment decisions with respect to their retirement savings,
especially with the growing shift from defined benefit to defined
contribution pension plans, even if their mistakes do not affect price
levels at all. Put differently, we may care what happens to the people
whose mistakes are regressed out.

B. Limits on Arbitrage

In contrast to our skepticism that cognitive biases will have a
significant influence on relative market efficiency other than
episodically (when the number of individual investors spikes and their
biases therefore likely coincide), we are quite sympathetic to concerns
that agency and incentive problems constrain the professionally-
informed trading mechanism continuously, even in times of normal
trading. MOME's relative efficiency concept, following Grossman &
Stiglitz, builds on the idea that the cost of information limits the
effectiveness of professionally-informed trading--it has to pay to be
informed. Agency and incentive problems between, for example,
hedge funds and their investors and between hedge funds and their
portfolio managers, pose the same kind of tradeoff--it has to pay to
reduce these costs.

That said, the recent literature identifying the limits on arbitrage closes
a fascinating circle of intellectual history. As we described in Part I, the
late 1950s and early 1960s gave rise to a wave of models that
described the workings of segments of the capital market under
perfect market conditions: asset prices were a function only of
systematic risk; capital structure did not affect firm value; and
informationally efficient markets policed these relationships through
arbitrage. Almost from the beginning, the Irrelevancy Propositions
were attacked for the extent to which their assumptions differed from
the observed world, and for the fact that observed capital structures
displayed regularities. The parallel rise of agency and information
economics then provided a conceptual structure to order how
deviations from perfect market assumptions rippled through corporate
finance. The limits on arbitrage literature extends this project to the
joined-at-the-hip subjects of asset pricing and market efficiency. The
circle closes.

But why all the fanfare? Precisely because it does not depend on the
presence of cognitive biases, the limits on arbitrage literature seems to
be very useful, but entirely straightforward steps in the project of
moving from a perfect market extreme null hypothesis to the messy
world where transaction costs are positive, agents are disloyal, and


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information is costly and unevenly distributed. We thought we had
signed on to this project twenty years ago although, as we confess in
the next Part, we were painfully naïve about the level of frictions
affecting the professionally-informed trading mechanism. But if this is
behavioral finance, then it began with Grossman and Stiglitz. The
fanfare seems to us a little late.


VI. How Well Does MOME Stand Up To Behavioral Finance? Good News
and Bad

If, as we claim, MOME is a precursor of some aspects of modern
behavioral finance, it is only fair to ask how well MOME's focus on the
distribution and cost of information stands up to behavioral finance
today. The answer, we believe, is mixed. The good news is that the
central categories of MOME, including the market mechanisms and the
concept of relative efficiency, are consistent not only with the
established empirical findings of behavioral finance but with some of
its more promising models as well. The bad news is that back in the
early 1980s, we greatly underestimated the institutional obstacles to
the production and rapid reflection of information in share prices.

A. The Good News

The good news about MOME extends to both fact and theory. On the
empirical side, proponents of both rational markets and behavioral
finance agree that many of the long-term pricing anomalies that cut
against the efficiency of market prices largely disappear when analysts
control for company size. These disappearing anomalies include, for
example, the underpricing of IPOs and seasoned equity offerings. The
size-related character of these anomalies is good news because it is
precisely what MOME would predict on the assumption that the size of
the float is a critical determinant of the amount and quality of
information about issuers, and the relative efficiency with which this
information is reflected in market prices. The reasoning is simple.
Small issuers have a limited following among analysts and other
professional investors, in part because there is little profit to be made
by researching issuers whose size restricts the potential gains. As a
result, less information is produced, verification of information is more
costly, and net returns available to investors and securities traders are
lower as a result.

Size, analyst coverage, and the attendant availability can account for
pricing anomalies of other sorts as well. On the theory side, an


                                   204
important model developed by Hong and Stein explains momentum
trading and skewness in stock prices on the basis of the slow diffusion
of private information through the economy. Traders without access to
private information rationally treat price movements as a proxy for the
injection of new information, which explains momentum trading as
well as sudden reversals in price, when traders discover they have
already overshot share value. In support of this model, Hong, Lim, and
Stein present evidence that momentum trading in shares is particularly
strong among small firms and firms that attract little interest among
analysts.


B. The Bad News

If recent models of the production and diffusion of information confirm
the continuing relevance of MOME's analysis, our original account of
market mechanisms and the institutional production of information
suffered from what might be termed "naiveté bias." We implicitly
underestimated the institutional complexities that attend the
production, processing, and verification of market information, as well
as its reflection in share prices. Some aspects of our naiveté were
discussed earlier in this essay: in particular, the legal and institutional
limitations on arbitrage, including the agency problems that afflict
institutional investors--such as the role of incentive structures in
encouraging herding behavior by fund managers at the expense of
fund investors.


But even more important than underestimating the limits on the
arbitrage mechanism, we failed to appreciate the magnitude of the
incentive problems in the core market institutions that produce, verify,
and process information about corporate issuers. As the Enron cohort
of financial scandals demonstrated, lucrative equity compensation has
had the side effect of creating powerful incentives for managers to
increase share prices. Usually, we suppose, managers respond by
creating additional value for shareholders. But sometimes they
respond by feeding distorted information to the market--or even by
lying outright, as in recent cases such as WorldCom and HealthSouth
Corporation. Similarly, recent scandals demonstrate that we also were
too sanguine about the role of the institutions that we termed
"reputational intermediaries"--the established investment banks,
commercial banks, accounting firms, and law firms that use their
reputations to vouch for the representations of unknown issuers, and
so reduce the information costs of investors. As the example of Arthur


                                    205
Andersen's relationship to Enron demonstrated all too clearly,
misaligned incentives and intra-organizational agency problems limit
the ability of even the largest reputational intermediaries to police the
accuracy of their clients' representations. Finally, we were naïve about
the role of security analysts, and particularly those employed by the
investment banks on the sell-side of the market. These analysts, it
appears, often acted as selling agents for the client-issuers of the
institutions that employ them. Or, put differently, an investment
bank's reputation among issuers is likely to matter more to it than its
reputation among the lay investors who rely on its analysts' reports.

In sum, on every dimension of information costs--the costs of
producing, verifying, and processing valuation data--we confess error
by implication, not about the roles of the institutions that supply
information to the market, but about how well they perform their
roles. The point is perhaps too obvious today to merit elaboration, but
the market cannot be more efficient than the institutions that fix
quality and cost of valuation information permit. That, after all, was
MOME's principal point.


VII. The Future of Behavioral Finance: Research and Policy
Implications

We have argued that the binding constraints on market efficiency
arise, either from institutional limitations or the interaction of the
arbitrage mechanism with cognitive biases--not from the widespread
existence of cognitive biases alone. There are implications of this view
for future research as well as the formulation of regulatory policy.

A. Future Research

We will not fully understand the import of psychological distortions on
the functioning of the capital market until we first understand the
institutional limitations on the production and distribution of valuation
information. The well-documented list of cognitive biases that
motivates much of behavioral finance allows so many degrees of
freedom that the framing of testable predictions about real world
financial markets is difficult. Fruitful hypotheses will require not only
an understanding of cognitive biases but, even more importantly, an
understanding of the market processes that screen, channel, dampen,
or amplify the biases of traders to produce observed market behavior.




                                   206
In pursuing this research agenda, the most fruitful topics of
investigation are likely to be market frenzies and crashes, such as the
1987 market crash and the recent internet bubble, rather than well-
documented pricing anomalies such as the closed-end fund discount or
the underpricing of IPOs. The evidence suggests that the traditional
anomalies--the usual suspects--can be comfortably explained within
the MOME framework as a function of institutional limitations on the
operation of the mechanisms of market efficiency in the course of
"normal trading," including limitations on the ability of informed
traders to engage in arbitrage. We know much less about the
institutional and psychological underpinnings of bubbles and crashes.
On one hand, the attractions of psychological hypotheses are greatest
for explaining such unusual or violent market behavior. As we
suggested in Part IV, above, the price effects of cognitive pathologies
are likely to be episodic: associated with bias, surges of individual
trading, and extraordinary breakdowns in the arbitrage mechanism.
This scenario fits nicely with the periodic appearance and demise of
market bubbles. On the other hand, there is a competing body of
literature pointing to institutional pathologies that can generate
seemingly irrational market disturbances even without the help of
noise traders. If the study of market institutions teaches anything, it is
that not every instance of collective irrationality is necessarily rooted
in individual irrationality.


B. Policy Implications

Given the limits of our knowledge at the moment, it is useful to ask
about the policy implications that follow from the progress that
behavior finance has made or is likely to make in the foreseeable
future. These implications, it seems to us, fall into two categories:
those in which behavioral finance holds promise for guiding regulatory
policy and those in which it does not.

1. Where Behavioral Finance Can Guide Reform

We see two principal areas where behavioral finance is likely to have
policy implications in the near term. One lies on the institutional side.
Given the importance of limitations on the arbitrage mechanism that
we have emphasized thus far, regulators should clearly seek to reduce
legal and institutional barriers to arbitrage. Thus, the SEC should
consider removing the uptick rule and margin requirements that
burden short-selling, as well as campaigning against the lingering taint
that makes institutional investors such as mutual funds reluctant to


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pursue short-selling strategies. Far from being suspect, short-selling
actually confers a positive externality on the entire market by speeding
the reflection of unfavorable information in share prices. In addition,
behavioral finance may support temporary interventions in the market,
such as trading halts, when market behavior suggests a surge of
biased trading that threatens to destabilize arbitrage. We hesitate to
make this prediction too forcefully, however, as there is still much
work to be done in parsing out the psychological and institutional roots
of market frenzies.

We are far more confident about a second area in which behavioral
finance might eventually inform regulatory policy: the protection of
individual investors. The possible consequences for policy involve
paternalistic responses to cognitive bias. As we argued above, three
conditions must be met for psychological distortions to affect share
prices: (1) cognitive biases must be pervasive (as most commentators
believe they are); (2) they must be correlated (because otherwise they
are offsetting); and finally, (3) the arbitrage mechanism must fail with
respect to their effects. Notice, however, that cognitive bias can injure
investors even if it has no effect whatsoever on share prices, i.e.,
conditions (2) and (3) are not met. Perhaps the best example is the
employee who, as a result of limited knowledge or cognitive bias,
misallocates investment in a 401k plan by failing to diversify her
investments, or assumes a level of risk inappropriate to her age and
retirement aspirations. As Howell Jackson's paper in this symposium
points out, the rise of defined contribution and voluntary investment
plans has shifted discretion over retirement savings from professional
traders to individual "lay" investors, who are often noise traders as
well. It might well be, then, that we would be wise to limit the
investment discretion of these employee-investors, precisely in order
to prevent them from harming themselves. Such limitations might be
mandatory for government-sponsored or tax-favored retirement plans:
for example, an inflexible diversification requirement. Alternatively,
these limitations might take the form of what one group of authors has
termed "asymmetric paternalism," i.e., default rules that sophisticated
investors can avoid but that are binding on unsophisticated investors
who are more likely to make costly errors as a result of cognitive bias
or bounded rationality.

2. The Limits of Behavioral Finance as a Policy Tool

Once we leave the easy cases of short-selling restrictions, obvious
market frenzies, and undiversified retirement savings, the legal
implications of behavioral finance for corporate and securities law


                                  208
become much murkier for the simple reason that we know little about
both the extent and nature of cognitive bias among traders or the
interaction of cognitive bias with the institutions that generate
information and the mechanisms that reflect it in price (including,
above all, the arbitrage activity of sophisticated investors). We
therefore find ourselves largely in agreement with Donald Langevoort's
assessment of the implications of behavioral finance for securities
regulation, which, no doubt over-simplifying, we would summarize as,
"not much so far, although lawmakers should stay tuned to current
research and keep an open mind." Indeed, we would go one step
further, to caution against the use of behavioral finance to advance
policy agendas that it cannot possibly support. We close this essay
with the cautionary example of a policy debate in which behavioral
finance is sometimes said to have important implications when in fact
it does not.

3. The Takeover Debate and the Limits of Behavioral Finance

The example we have in mind is the claim that is sometimes made in
debates over takeovers that investor irrationality demonstrates the
wisdom of vesting discretion over the decision to defend against
hostile takeovers in the hands of managers rather than shareholders.
We find this claim unpersuasive for several reasons that nicely
illustrate the limits of cognitive psychology in setting basic corporate
policy. In the first place, market efficiency has a limited role in the
takeover debate. The primary policy tradeoff is between the absence
of strong form efficiency--the possibility that managers have
information about the corporation's value the market lacks, which is
the reason for giving management discretion to defend--and the
possibility of managerial agency cost, the reason for giving the
decision to shareholders. This one comes out in favor of shareholder
decision-making because target management can always ameliorate
the failure of strong form efficiency by disclosing its information if
takeover decision making is allocated to shareholders, while allocating
authority to management does nothing to ameliorate the agency cost
problem.

It is at this point that the cognitive bias component of behavioral
finance comes into play: the balance may shift if, despite disclosure,
shareholders will predictably reject target managers' advice because of
one or another cognitive bias. Of course, given the range of cognitive
biases one cannot entirely reject this possibility. As we suggested
above, some biases predict that shareholders will tender too readily
while others predict an unwarranted reluctance to tender. In the


                                   209
context of the allocation of takeover decision-making between
managers and shareholders, however, the critical point is that
cognitive bias analysis be applied on a bilateral or comparative basis.

This concern grows out of the fact that the experimental literature is
largely unilateral in its focus. The experiments are concerned only with
whether a particular decision-maker is subject to a cognitive bias, not
whether one competing decision-maker is more impaired than another.
But when cognitive bias is invoked to allocate authority among
competing decision-makers, the analysis must be bilateral; the
potential biases of the decision-makers must be compared. In our
context, the question is: whether managers' or shareholders' decisions
are likely to be more distorted?

The comparison seems to us to favor allocating decision-making
authority to shareholders. First, it is simply unclear which, if any,
biases are likely to apply to individual shareholders when they must
choose whether to accept a hostile offer. Moreover, the outcome of the
takeover is likely to be determined by the decisions of institutional
investors, who are less likely to be subject to cognitive biases (but
may be subject to institutional influences). The shareholders critical to
the outcome of a hostile takeover look little like the noise trader
clientele of closed-end mutual funds. Finally, the market for corporate
control operates, to an extent, as a backstop in case cognitive biases
nonetheless cause target shareholders to tender into too low an offer.
The ubiquity of competing bidders emerging in response to an
underpriced offer can save the shareholders from their biases.

On the other side, one can imagine a range of biases that may
influence target managers to resist a hostile takeover even when the
transaction is in the shareholders' best interests. A reaction to
cognitive dissonance may cause managers to respond to an offer that
calls into question their performance and competence by deriding the
bidder's motives and promising a brighter future if only the
shareholders have patience. Managers may genuinely believe their
claims, but behavioral finance suggests that their assessment may be
driven by a cognitive bias. This effort at dissonance reduction may, in
turn, be exacerbated by the overconfidence bias--managers' vigorous
defense may be encouraged by a biased assessment of their own
skills. Other examples are possible, but the point by now should be
clear: when cognitive bias analysis is invoked to illuminate the choice
between two decision makers, its application must be bilateral.




                                   210
In all events, we conclude that the cognitive bias element of
behavioral finance is unlikely to change the trade off between agency
costs and strong form market inefficiency that we believe supports
allocating the choice whether a hostile takeover goes forward to
shareholders. To be sure, by highlighting the possibility of good faith
but systematically misguided defensive action, the cognitive bias
analysis does serve to give richness to the explanation for target
managers' behavior that agency theory's simple self-interest paradigm
lacks. But this useful insight reinforces, rather than undercuts, an
allocation of decision-making authority to shareholders.



VIII. Conclusion
So where does our retrospective leave us? Twenty years further, we
think, along the road leading from elegant models of the workings of
the capital market in a frictionless world, to an understanding of how
the market operates in a world where information is costly and
unevenly distributed, agents are self-interested, transactions costs are
pervasive, and noise traders are common. The nature of this more
realistic understanding is beginning to take shape, and it can be
described in a single word: messy. There are a lot more moving parts
with, as a result, a much larger number of interactions to understand.
Models will be necessarily partial, illuminating particular interactions
but far short, and without the ambition, of a unified field theory. That
said, we come away with some confidence in a number of themes,
some that were explicit in MOME, some that we missed, and others
that reflect an assessment of the likely contribution of cognitive
psychology to our understanding of how the capital market functions.

First, as was explicit in MOME, we believe that understanding the
structure of institutions is central to understanding the operation of the
capital market. MOME's shortcoming was the failure to drill deeply
enough into the incentive and agency structure of important market
institutions like those through which arbitrage is carried out. To the
large extent that behavioral finance is composed of applying agency
information and incentive analysis to capital market institutions, it
promises to deepen our understanding of how the capital market
operates in the real world.

Second, we are skeptical that the new focus on cognitive biases in the
end will explain very much about price formation, except in
circumstances in which the biases of investor biases both coincide and
give rise to increased participation. Thus, we expect that this


                                   211
component of behavioral finance will have a limited role in the market
efficiency debate. In contrast, this literature can be quite important in
circumstances where we care about the consequences of biased
decision-making on the decision-makers themselves, independent of
whether aggregate price levels are affected. Reform efforts directed at
individuals' decisions with respect to pension investments, as with
401K, provide a good example.

Our final theme is one of balance. When cognitive psychology is used
to analyze issues relating to the allocation of decision-making between
competing parties, the application must be bilateral and comparative.
Demonstrating one party's cognative bias merely begins the analysis;
to complete the analysis this bias must be compared to those of
alternative decision-makers. As we suggested in our analysis of the
application of cognitive bias analysis to tender offers, the fact that
shareholders may have a bias in deciding whether to tender does not
demonstrate that managers should have the power to block an offer.
Rather, the shareholders' bias must be compared with those biases
that affect management.

Twenty years after publication, we remain comfortable with the
analytic framework that animates MOME. We should have been more
skeptical of market institutions then, but skepticism grows with age.




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REFERENCE MANUAL ON MULTIPLE REGRESSION

               Daniel Rubinfeld


In Federal Judicial Center, Reference Manual on
           Scientific Evidence (2000)




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