Fresno Lawyer – Randolf Krbechek

Continuing his recent discussion of fault in contract law, Judge Posner explains that,

“The idea of ‘good faith’ is an example.  We generally want people to be honest and aboveboard in their dealings with others.  But there is no general duty of good faith in contract law.  If you offer a low price for some good to its owner, you are not obliged to tell him that you think the good is underpriced – that he does not realize its market value and you do.

“You are not required to be an altruist, to be candid, to be a good guy.  You are permitted to profit from asymmetry of information.  If you could not do that, the incentive to discover information about true values would be blunted.  It is an example of the traditional economic paradox that private vice can be public virtue.”

True, and eloquently stated.  The principle of capitalism is that a person should be able to profit from skill and knowledge.  Continuing his analysis, Judge Posner explains his view the duty of god faith in contract law, stating that,

“There is a legally enforceable contract duty of ‘good faith,’ but it is just a duty to avoid exploiting the temporary monopoly position that a contracting party will sometimes obtain during the course of performance.”

OK.  Good faith in contract law concerns good faith in performance, not to good faith in contract formation (although he recognizes that some standard of decency is necessary to police unreasonably sharp deals).

Thus, “More often than not the parties to a contract do not perform their contractual duties simultaneously, and so one party may unavoidably deliver himself into the power of the other party for a time during the performance of the contract.  [Take this example.]  A may agree to build a swimming pool for B, and B may agree to pay A upon completion.  Suppose that when A has finished, B refuses to pay the agreed-upon price because he knows that A is desperately short of cash and will agree to a reduction in the contract price, having no possible source of cash other than B.  A’s cash shortage, coupled with his having completed performance before B has begun and his having no alternative source of cash, gives B a monopoly position as A’s financier; monopoly is inefficient and so a modification of the contract to lower its price will not be enforced.”

Yes, but, isn’t this conduct bad faith in performance?  If so, should the law award extra-contractual damages for violation?  Judge Posner continues, citing from his opinion in Market Street Associates v. Frey, 941 F.2d 588 (7th Cir. 1991):

“In all these examples the duty of ‘good faith’ arises after the contract has been formed; that is why it is properly called the duty of good faith in performing a contract.  If I may be permitted to quote again from my opinion in the Frey case:

“Before the contract is signed, the parties confront each other with a natural wariness.  Neither expects the other to be particularly forthcoming, and therefore there is no deception when one is not.

“Afterwards the situation is different.  The parties are now in a cooperative relationship the costs of which will be considerably reduced by a measure of trust.  So each lowers his guard a bit, and now silence is more apt to be deceptive . . .

“As performance unfolds, circumstances change, often unforeseeably; die explicit terms of the contract become progressively less apt to the governance of the parties’ relationship; and the role of implied conditions and with it the scope and bite of the good-faith doctrine grows.”

We see the analysis heading toward the territory of the fiduciary, in which neither party may take action to deprive the other of the benefit of the bargain.  The question is, If the action by the contract-breaker is intentional, after the other party has become vulnerable, should the law respond more harshly?  Judge Posner says no – but on a societal level, why should this be the rule?

Richard A. Posner, “Let Us Never Blame a Contract Breaker,” in Michigan Law Review (June 2009), Vol. 107, No. 8, page 1349.

Judge Richard A. Posner of the Seventh Circuit Court of Appeals contributed his thoughts at a symposium on the rationale for liability for breach of contract.  One of his points is a sound analytic distinction between tort liability and contract liability, a concept which is sadly muddled in California cases.

Writes Judge Posner, “Here is a simplified version.  A and B make a written contract.  Later A sues B claiming that during the negotiations B deliberately misrepresented the benefits that A would derive from the contract.  But A does not sue for breach of contract.  He can’t; the parol evidence rule would bar a claim that promises made during the negotiations but not repeated in the contract should be deemed contractually binding.”

That’s clear legal thinking.  There is no claim for breach of contract because the law of evidence excludes evidence of terms that contradict the terms of the contract.

Judge Posner continues.  “So A sues B in tort, charging fraud.  The parol evidence rule is not a rule of tort law.”

Right again.  Parol evidence knocks out the contract claim, but not the tort claim.

“B has a defense [to the fraud claim]: the written contract had included a clause stating that neither party was relying on any representations not embodied in the written contract.”

According to Judge Posner, “The ‘no reliance’ clause scotches A’s fraud suit because you cannot obtain damages for fraud unless you relied on the fraudulent representations, and A has disclaimed such reliance.  So although B is assumed to have acted wrongfully, A has no remedy either in contract or in tort.”

Well, maybe not so fast.  Isn’t the whole point of the fraud claim that the wrongdoer deceived the victim?  Conceptually, I don’t see how the bad guy gets to hide behind his contract, when the injured part was induced, by false promises, to enter into the contract.  The false promises should negate the terms of the contract, at least insofar as such terms act to exculpate the bad guy.

Now, here’s an even deeper way to look at the issue, which takes us into philosophical terms.  Judge Posner posits that, “There is, however, a limited duty of good faith at the contract-formation stage as well.”

Now we’re getting to the point.  Are we focusing on a wrong arising out of the contract, or a wrong that preceded the contract?

“It is one thing to say that you can exploit your superior knowledge of the market for if you cannot, you will not be able to recoup the investment you made in obtaining that knowledge or that you are not required to spend money bailing out a contract partner who has gotten into trouble.  It is another thing to say that you can take deliberate advantage of an oversight by your contract partner concerning his rights under the contract.”

This runs straight to a utilitarian moral theory, which is not easy to square with cold-blooded contract analysis.  Yet Judge Posner continues on.  “Such taking advantage is not the exploitation of superior knowledge or the avoidance of unbargained-for expense . . . Like theft, it has no social product, and also like theft it induces costly defensive expenditures, in the form of overelaborate disclaimers or investigations into the trustworthiness of a prospective contract partner, just as the prospect of theft induces expenditures on locks.”

Richard A. Posner, “Let Us Never Blame a Contract Breaker,” in Michigan Law Review, Vol. 107, No. 8, page 1349

Prof. Deborah A. DeMott from Duke University School of Law has written a thoughtful article in which she differentiates among the fiduciary duties owed by agents.  Prof. Demott begins as follows:

“Legal theorists differ on how best to characterize fiduciary duty; to some, it’s best understood as a consequence of contract – as a set of default terms to which parties would agree, had they the benefit of unlimited resources.”

[On this topic, see my prior article regarding Le vs. Pham, in which I posit that the court got it wrong by creating additional duties where the contract already established the relationship between the parties.]

Prof. DeMott continues.  “It’s conventional to distinguish among an agent’s duties.  Restatement (Third) of Agency uses the terminology of duties of performance and duties of loyalty.

Hooray – someone who breaks down the different duties owed by a fiduciary.  As to agents, she says it’s a duty of loyalty and a duty of performance.

The duty of performance is seemingly self-evident.  “An agent’s duties of performance include the duty:

• To act only as authorized by the principal;
• To fulfill any obligations to the principal defined by contract;
• To act with the competence, care, and diligence normally exercised by agents in similar circumstances; and
• To use reasonable effort to provide the principal with facts material to the agent’s duties to the principal.

“An agent’s duties of performance are often defined by agreement between principal and agent.”

The obligations arising the duty of loyalty are more subtle.  “An agent’s duties of loyalty stem from the agent’s basic obligation to act loyally for the principal’s benefit in matters connected with the agency relationship.  An agent’s more specific duties of loyalty include:

• A duty not to acquire a material benefit from a third party in connection with transactions or other actions taken on behalf of the principal or otherwise through the agent’s use of position;
• A duty not to deal with the principal as or on behalf of an adverse party;
• A duty not to compete with the principal or assist the principal’s competitors during the duration of the agency relationship; and
• A duty not to use property of the principal, and not to use or communicate confidential information of the principal, for the agent’s own purposes or those of a third party.”

The author then tracks the effects of the legal analysis to the remedies available to the principal.  Explains Prof. DeMott, “The remedies available to a principal do not map neatly onto the contours of either contract law or tort law principles and remedies.

“For example, remedies that have the consequence of stripping profit or benefit from the agent do not necessarily approximate the amount of harm that a principal either has suffered or would be able to prove or the benefit that the principal expected to realize through the transaction conducted by the agent.”

From “DISLOYAL AGENTS” by Deborah A. DeMott, Professor of Law, Duke University School of Law.  Prof. Demott served as the Reporter for the Restatement (Third) of Agency.

Alabama Law Review (2007) Vol. 58:5:1049

Legal scholar John Langbein addresses a question that has been on my mind – When did trust agreements evolve from classic fiduciary relationships into will substitutes?

The answer is – a long time ago.  Explains Prof. Langbein, “Trust law is an ancient field.  The enforcement of trusts in the English court of Chancery can be traced back to the late fourteenth century, and there is some indication that the courts of the English church may have been enforcing trusts even earlier.”

Trusts have long been used to circumvent probate administration.  Thus, “The trust originated as a device for transferring real property[.]  Trust conveyancing allowed an owner to escape the medieval rule, which lasted into the seventeenth century, that freehold land was not devisable.”

Stop right there.  Land in the feudal English system could not be conveyed by will, which restriction lasted into the 1600s.  Instead, “land that was transferred on death had to descend by intestacy rather than pass by will.”

Such transfers were subject to many restrictions.  “A widow was restricted to the one-third life estate called dower; primogeniture awarded the entire remaining estate to the eldest male heir if any; transfer taxes known as feudal incidents were exacted when an heir succeeded to an ancestor’s estate; and minors and unmarried females suffered further disadvantages in heirship.”

For this reason, attorneys several hundred years ago employed a trust to evade the limitations established by law.  Prof. Langbein notes that, “Trust conveyancing deftly evaded this medieval law of succession.  The owner of land, the person whom we now call the settlor, would transfer the land to a trustee or trustees, who were commonly relatives or gentlemen friends, subject to trust terms that functioned like a will.”

Of course, the trust only works if some court will enforce it after the settlor’s death, which was the early purview of the ecclesiastical courts.   “There is nothing novel [ ] about our modern understanding that a trust can function as a will substitute.  What is new is that the characteristic trust asset has ceased to be ancestral land and has become instead a portfolio of marketable securities.  Long into the nineteenth century, the trust was still primarily a branch of the law of conveyancing, that is, the law of real property . . . The modern trust, by contrast, is primarily a management device for assembling and administering a portfolio of financial assets . . . as the predominant form of personal wealth.”

“Why Did Trust Law Become Statute Law in the United States?” by  Prof. John H. Langbein (Yale University) Ala. Law Rev. Vol. 58:5, page 1069 (2007)

I have been approached by numerous potential clients asking if I can help with the restructuring of their mortgages.  The short answer is that I can provide no assurance regarding a refinancing.  The rules are murky, and the literature indicates that lenders are not providing meaningful reductions.

A recent article by Prof. Brent White from the University of Arizona law school has provoked heartburn in the lending community.  Prof. White argues that that many borrowers would be better off if they simply walked away from their underwater loans and rented a house.  He cites statistics showing that 71% of mortgages in the Fresno area are underwater as of 2009.  It’s even worse in Bakersfield, where 79% of mortgages are underwater.

Prof. White argues that strong societal and emotional ties keep borrowers from walking away, even if walking away would save them $100,000, $200,000, or even more over the course of the loan.  Lenders know that most persons will do almost anything to avoid a foreclosure.  Here’s his all-too-true explanation of how the refinancing process works in the real world:

“A seriously underwater homeowner with good credit and solid mortgage payment history who calls his lender to work out a loan modification is likely to be told by his leader that it will not discuss a loan modification until the homeowner is 30 days or more delinquent on his mortgage payment.  The lender is making a bet (and a good one) that the homeowner values his credit score too much to miss a payment and will just give up the idea of a loan modification.

“However, if the homeowner does what the lender suggests –  misses a payment and calls back to discuss a loan modification in 30 days –  the homeowner is likely to be told to call back when he is 90 days delinquent.

“In the meantime, the lender will send the borrower a series of strongly-worded notices reminding him of his moral obligation to pay and threatening legal action, including foreclosure and a deficiency judgment if the homeowner does not bring his mortgage payments current.

“The lender is again making a bet (and again a good one) that the homeowner will be shamed or frightened into paying their mortgage.  If the homeowner calls the lender’s bluff and calls back when he is 90 days delinquent, there is a good possibility that he will be told that his credit score is now so low that he does not qualify for a loan modification.

“The homeowner must then decide whether to bring the loan current or face foreclosure.  If the homeowner somehow makes clear to the lender that he has chosen foreclosure, the lender may finally be willing to negotiate a loan modification, a short-sale or a deed-in-lieu of foreclosure – all of which still leave the homeowner’s credit in tatters (at least temporary).

“Most lenders will in other words, take full advantage of the asymmetry of norms between lender and homeowner and will use the threat of damaging the borrower’s credit score to bring the homeowner into compliance.  Additionally, many lenders will only bargain when the threat of damaging the homeowner’s credit has lost its force and it becomes clear to the lender that foreclosure is imminent absent some accommodation.”

That’s a fair reflection of the process, as potential clients have explained it to me.  Lenders have not established clear procedures for refinancing.  Lenders do not want to write down the value of their loans.  Lenders know that there is a strong negative societal cost to the borrower from a foreclosure.  Lenders have made the refinancing process difficult, if not impossible, for most persons.

This is a difficult argument, as it mixes morals and finances.  Like many persons, I think that we have a moral obligation to pay our debts.  Further, there is no legal obligation for the lender to change the terms of the loan.  On the other hand, the way some of these loans are written, the borrowers will end up up paying hundreds of thousands of dollars that could be avoided if they executed a “strategic foreclosure.”  Paying all this extra money might be construed as “waste” in economic terms.

Also, Prof. White points out that the underwater homes are disrupting the labor markets, in that individuals are reluctant to move because they do not wish to take a loss on their home.  When homeowners are unwilling to move because their house is underwater, labor mobility is seriously hindered by the housing crisis.

Cite to:
Brent T. White, University of Arizona – James E. Rogers College of Law

Arizona Legal Studies Discussion Paper No 09-35

Some commentators view fiduciary duties through a contractual framework.  Judge Frank Easterbrook and Professor Fischel state, “The fiduciary principle is fundamentally a standard term in the contract.  Fiduciary duties are not special duties; they have no moral footing; they are the same sort of obligations, derived and enforced in the same way, as other contractual undertakings.”

In their view fiduciary law parallels contract law, because the objective is to “promote the parties’ own perception of their joint welfare.”

Profession Scott Fitzgibbon, in his article, “Fiduciary Relationships Are Not Contracts,” 82 Marq. Law Rev. 2 (Winter 1999), criticizes this analysis.  The law of fiduciary duties is all about “gap filling,” meaning that courts are setting forth the terms that were not expressly defined by the parties.  Professor Fitzgibbon then cites from a decision written by Judge Posner as follows:

“The common law imposes a fiduciary duty when the disparity between the parties relevant to the performance of an undertaking is so vast that it is a reasonable inference is that had the parties in advance negotiated expressly over the issue they would have agreed that the agent owed the principal the high duty that we have described, because otherwise the principal would be placing himself at the agent’s mercy.”  Burdett v. Miller, 957 F.2d 1375, 1381 (7th Cir. 1992).

Yet, the traditional contractual analysis does not explain how courts assess fiduciary obligations.  Professor Fitzgibbon explains that, in a contractual gap-filling situation, “Courts usually fill gaps by looking hard at the facts of the transaction before them rather than proceeding ‘generically.’”

Thus, when confronted with missing terms in a contractual setting, the court proceeds narrowly, based on the precise facts of the case.  Yet fiduciary duties are applied using a broad brush, which reflects a critical difference between a contractual approach and the fiduciary law approach when it comes to gap filling – “Fiduciary law usually takes a generic approach insisting that all trustees are subject to a standard panoply of duties.”

This is a major distinction – contracts are interpreted narrowly, fiduciary obligations are applied broadly.  They can’t come from the same root stock, and certainly are not treated the same by courts.

This is the third part of a review of Mary Szto’s article, “Limited Liability Company Morality: Fiduciary Duties in Historical Context,” 23 Quinnipiac Law Review 61 (2004-2005).  This week we get to the heart of the matter – the case law summary.

The author starts by explaining that, “In the Anglo-American tradition, principals of a firm are fiduciaries expected to lay aside self-interests.  A fiduciary’s duties, include a duty of care and a duty of loyalty owed to the firm, other principals, and/or other members of the firm.”

As the author surveys the case law involving fiduciary duties in a limited liability company context, she posits that courts “demonstrate a preference for corporate duty of care and a partnership duty of loyalty.”

Building on her history lessons she states that, “Canonists may never have imagined that the corporate form would become the chief engine for business growth today.  Nevertheless, in the 1800’s, business corporations came into prominence.  Agency, partnership, and trust duties chiefly influenced them, and still do today . . . English and American commentators readily applied agency, trust and partnership law to corporate fiduciary law.  Duties of care and loyalty were also addressed.”

Says Ms. Szto, “The duty of care cases focus on statutory or contractual corporate standards.  Duty of loyalty cases show a slight preference for partnership standards.  Also, enforcing contractual provisions, the courts still find equitable duties.  Even when LLC members ‘opt out’ of loyalty duties, courts find equitable duties that cannot be eviscerated.  This is in agreement with equity.  Many courts, notably Delaware’s and Ohio’s recognize a transcendent selfless standard for LLC fiduciaries.”

As Ms. Szto reviews the case law, she concludes, “In duty of loyalty cases, courts enforce contractual waivers and standards for fiduciary duties.  However, where there was self-serving behavior, they also found equitable duty breaches.  This was the case even when LLC operating agreements modified or limited fiduciary duties.  Of note is approach of Delaware, Ohio, New York, and Indiana.  Duty of loyalty cases may concern usurpation of firm opportunities, the duty to disclose information, conflicts of interests, and the duty not to compete with the firm.”

Ms. Szto states, “Also, when a statutory duty existed, corporate standards were applied using the best interests of the LLC as a main factor.  For example, a Maryland case found that all decisions by the LLC’s board were protected from second guessing by the business rule, which insulated the board from claims unless it ‘acted in bad fath.’  Another Maryland case noted that a majority interest holder owes a fiduciary duty to the LLC’s minority interests holder, which standard is similar to that of closely-held corporations.

The author states, “In sum recent LLC cases illustrate that in duty of care cases, corporate standards prevail.  ‘Best interests of the LLC’ are a primary focus.  In duty of loyalty cases, agency and partnership standards are favored.  Also, courts (Delaware’s chief among them), recognized equitable duties that are transcendent.  Ohio’s court stated that LLC members owe each other the ‘up most trust and loyalty.’”

The author concludes that, “Fiduciary duties are ingrained in Anglo-American jurisprudence in the business association.  They reach back to the biblical tradition, Roman, and ecclesiastical law.  They develop with fidei commissa, utilitas ecclesiae, the use, trusts, and agents.  They constitute partnerships, limited partnerships, and corporations.”

“To the extent that LLC fiduciary duties are true to their equitable roots, the LLC will take its place among enduring business entities and are constituted by a transcendent business morality.  There is promise of this in legislation that affirms equitable standards and in case law that promotes a corporate duty of care and partnership duty of loyalty that is selfless.  This is the rich legacy of fiduciary duties.”

I give this article six stars out of ten.  I would have appreciated more focus on the theories of LLCs and how these theories tie in to the particular fiduciary duties assigned by the courts, and less on the Anglo-Saxon religious roots.  In the end, the title has more sizzle than the article.

This is part two of a discussion of an intriguing law review article on fiduciary duties as applied in the context of limited liability companies.  The prior blog considered the theological roots cited by Ms. Szto.  This part examines other roots for fiduciary duties.

Ms. Szto starts again with a religious analysis.  Says she, “Canon lawyers provided the link between Roman legal devices and biblical views of property.  For several centuries, the study of Roman law found a home within the church.  Augustine taught that property must have a spiritual use.”

Now we are introduced to the connection between fiduciary obligations and the church – Ecclesiastical courts handled probate matters.

Says the author, “The Middle Ages saw the development of the use, the forbear of trust and agency law (agency and trust law being the forbears of partnership and corporate law).  This came about mainly through ecclesiastical courts.  It was accomplished through continued clerical adaptation of fidei commissa . . . and the ecclesiastical court’s jurisdiction over probate law.  Eventually, the Courts of Chancery enforced uses.  All these lay the groundwork for high business fiduciary duties, many centuries later.”

In this way, fiduciary relationships evolved from rules limiting inheritances in real property.  Ms.  Szto explains that, “Uses of personalty were enforced in the 1100’s by English common law courts.  However, the Franciscans are credited for the first wide-scale employment.  St. Francis of Assisi founded the Franciscan Order in 1209.  According to Maitland, although the Franciscans had taken vows of property, they employed the ‘ad opus’ to receive the benefits of property ownership, which was akin to the Roman ‘usus.’”

Which is to say, the clergy helped drive the “use,” in which beneficial possession was separated from actual legal title.  Even more, conveyance of fee ownership by will was limited, at least in England.  “Because the common law prohibited the devise of freehold land, the feoffment to uses were popular during the rein of Edward III (1327-1377).  Feoffors would convey land to feoffees, who then conveyed land to third persons – cestui que uses – named in the feoffors’ wills.  The terms use, confidence, and trust were used simultaneously.”

Still, a right without a remedy has little value.  The court must step in when misconduct occurs.   “There is evidence that ecclesiastical courts enforced uses before the Courts of Chancery did.  This is because ecclesiastical courts had jurisdiction over probate matters. . . . Interestingly, records of ecclesiastical enforcement of uses disappear in the last part of the 1400’s, apparently because of the jurisdiction of the Courts of Chancery over uses at that time.”

More next week on the limited liability companies.

Mary Szto, “Limited Liability Company Morality: Fiduciary Duties in Historical Context,” 23 Quinnipiac Law Review 61 (2004-2005).

Legal commentators have differing opinions regarding the origin and background of fiduciary duties.  A recent article by Mary Szto would seem to focus on the business side of things, as her article is entitled “Limited Liability Company Morality: Fiduciary Duties in Historical Context,” 23 Quinnipiac Law Review 61 (2004-2005).

However, the author strikes a deep religious tone to fiduciary relationships.  Says Ms. Szto, “Fiduciary duties are the offspring of ecclesiastical property views and Roman legal forms.  They would then mature into agency and trust law; partnership and corporate law would later wed them to the business association.  They are Christological in origin.  Fiduciary duties acknowledge that property ownership, including the business enterprise, requires stewardship.”

In analyzing the history of fiduciary duties, she argues that, “The origin of fiduciary duties has religious and secular roots.  These roots were wed by canon lawyers in the medieval era . . . Fiduciary duties in the biblical tradition begin in the Genesis creation account.  The human mission on earth is being a fiduciary, being a steward of God’s and other’s property.  Israel is a fiduciary.  So is Jesus Christ.”

Continuing in this vein, she explains that,  “In the biblical account, after creating the world, God appoints man and woman as agents.  They steward the world, exercise dominion, and are fruitful.   God is the world’s eternal owner, and his agents are stewards.  Fiduciary duties thus bond God, his creation, and his creatures.  Adam and Eve failed in the enterprise, however, and the rest of biblical history is the story of redemption.  It is a search for the faithful fiduciary and a permanent inheritance.  God redeems Israel from Egypt and gives Canaan to her as an inheritance.

“Within this creative-redemptive-consumptive framework, business people in the Bible have fiduciary duties to God and others . . . In Christian theology, Christ is the perfect fiduciary.  He is the selfless steward who lays down his life for others.  By dying and rising, he enables those who accept him to have an eternal inheritance.  Christ is the bridge between death and life, time and eternity, temporal and permanent property.”

Next week we’ll continue an analysis of this article.