Fresno Lawyer – Randolf Krbechek

Strange how an idea that was once old can become new again.  Roscoe Pound, Dean of the Harvard Law School, was a prolific legal writer in the 1920s and 1930s.  From my perspective, his best work concerned the development of the American legal system from 1850 through 1900, as America reached the end of its Western expansion.

Writing in 1938, Dean Pound discussed why legislation was not effective to address rapidly-changing areas of the law.  Here is Dean Pound’s analysis:

“It would seem that while legislation has proved an effective agency of ridding the law of particular institutions and precepts which have come down from the past and have not been adapted or were not adaptable to the needs of the time, it has not been able, in our legal system, except in rare instances, to do much of the constructive work of change in eras of growth.  So far as everyday relations and conflicts of interests are concerned, it has not been able to anticipate new demands nor to move fast enough when they made themselves felt through litigation.”  Roscoe Pound, The Formative Era of American Law (Little, Brown and Company 1938), pp. 44-45.

At the same time, I was reading a new law review article by Professor Mark Burge, discussing the future of the law of payment systems.  Once upon a time, the law of payment systems dealt principally with bank drafts, checks, and bills of exchange.  These days, the law of payment systems also encompasses credit cards, debit cards, ETF’s, Apple Pay, and Bitcoin.

As is apparent, payment systems is a rapidly developing area of the law.  In his article, Prof. Burge discusses why efforts at codification via the Uniform Commercial Code have failed, in large part because opponents of consumer protection provisions have “spiked the cannon” (my words, not his).  Note Professor Burge’s analysis of legislative action in this area:

“Public law should presumptively not be the governing device for payments, although the presumption is a rebuttable one … Experience provides three interrelated reasons to err on the side of private governance.

“First, private law is more capable of adapting to technological change in a meaningful timeframe … Public legislative or regulatory process is not nimble enough to keep up with the times. That fact is not a design flaw in deliberative democracy; it is an intentional feature where the intention dates at least as far back as the United States Constitution …

“Second, after bright-line public law protections of system users are in place, the remaining incentives will be for system operators to conduct themselves in a manner that produces the most social benefit.

“Finally, the parties operating a payment system are in the best position to determine allocation of risks unaccounted for by limited public law, and also to handle a limited collection of risks that public law should impose.”

Although separated by 80 years, Prof. Burge’s analysis is not far off the mark from Dean Pound.  Reminding us that everything old is new again.

Mark Edwin Burge, Apple Pay, Bitcoin, and Consumers: the ABCs of Future Public Payments Law, forthcoming in 67 Hastings L.J. (2016)

The Uniform Commercial Code covers a wide scope of commercial transactions, from the sale of goods to warehouse receipts to secured transactions.  Article 3 deals with promissory notes, sometimes referred to as negotiable instruments.

In his 2012 book,  The End of Negotiable Instruments, James Steven Rogers argued that most of the law contained in Article 3 of the Uniform Commercial Code lost real-world relevance long ago.

Rogers echoed Grant Gilmore, who famously described Article 3 as “museum of antiquities – a treasure house crammed full of ancient artifacts whose use and function have long since been forgotten.”  Grant Gilmore, Formalism and the Law of Negotiable Instruments, 13 Creighton L. Rev. 441, 461 (1979).

Gilmore had a brilliant mind, and glib turn of phrase.  His quote is often-repeated:  “Codification … preserve[d] the past like a fly in amber.”

Not so fast.  Article 3 continues to provide useful guidance, right through the mortgage crisis.  One of the pre-eminent scholars of commercial law is Alvin C. Harrell, a Professor of Law at Oklahoma City University School of Law.  Prof. Harrell is the Executive Director of the Conference on Consumer Finance Law; a member of the American Law Institute (ALI); and a member of the American College of Commercial Finance Lawyers.

Heed carefully Prof. Harrell’s following comments on the Uniform Commercial Code.

“These cases reinforce the observation that the UCC is the most carefully-drafted statute in history.  It can be noted that UCC Articles 3 and 4 are written in relatively clear and simple terms and yet answer most of the legal questions that arise within their scope.  It is rare for a modern statute to do this, but the UCC does so on a regular, even continual basis.

“The result is exceptional legal clarity as to important yet routine transactions.  Those of us who conduct these transactions should not fail to appreciate the benefits of this legal environment.  It is surely a key factor in the continuing prosperity that we often take for granted.

“Obviously, and as noted by others, it is easier to disrupt such a structure than to create or preserve it.  The UCC was one of the great achievements of the Twentieth Century.  Keeping it may be one of the great challenges of the Twenty-first.”

Alvin C. Harrell, “2014 UCC Articles 3 and 4 Update,” in Consumer Finance Law Quarterly, Vol. 68, No. 3 (2014)

In a law review article published 50 years ago, Cambridge law professor L.S. Sealy reviewed two centuries of English case law on fiduciary relationships.  He concluded, correctly, that different relationships give rise to different duties.

As a starting point, “Fletcher Moulton L.J. once warned against what he called ‘the danger of trusting to verbal formulae’ in this way. After illustrating a number of fiduciary situations and describing the ways in which the courts had interfered to grant relief in these cases, he said:

“Thereupon in some minds there arises the idea that if there is any fiduciary relation whatever any of these types of interference is warranted by it.  They conclude that every kind of fiduciary relation justifies every kind of interference.  Of course that is absurd.

“The nature of fiduciary relation must be such that it justifies the interference.  It is obvious that we cannot proceed any further in our search for a general definition of fiduciary relationships. We must define them class by class, and find out the rule or rules which govern each class.”

Such statement is too often ignored by lawyers and judges alike.  Consider this further analysis:

“Fry J.’s definition emphasises the essential quality of all fiduciary relationships: every remedy which can be sought against a fiduciary is one which might be sought against a trustee on the same grounds.  But it is really not a definition at all: although it describes a common feature, it does not teach us to recognise a fiduciary relationship when we meet one.

“Still less does it assist us when we are faced with a particular relationship and asked the practical question: does a certain principle of the law of trust and trustee apply?  John is my agent and is therefore, on good authority, in a fiduciary position towards me.  Does this mean that he must not mix with his own money the sums which he holds on my account?  Is there a presumption of undue influence if I make him a gift?  Is he disqualified from becoming the lessee of land formerly held by me, after I have failed to secure a renewal of the lease for myself?  Do all the trust principles apply to this fiduciary situation?

“When we examine the authorities, we learn – perhaps with some surprise – that this is not so. The word ‘fiduciary,’ we find, is not definitive of a single class of relationships to which a fixed set of rules and principles apply.  Each equitable remedy is available only in a limited number of fiduciary situations; and the mere statement that John is in a fiduciary relationship towards me means no more than that in some respects his position is trustee-like; it does not warrant the inference that any particular fiduciary principle or remedy can be applied.”

And he elegantly explains why banks do not owe fiduciary duties to their borrowers: “No trust can, of course, exist where there is a debtor-creditor relationship: In equity, restitution stopped where repayment began.”

L. S. Sealy, Fiduciary Relationships, 1962 Cambridge L.J. 69 (1962)

Prof. Larry E. Ribstein from the University of Illinois School of Law, a leading scholar on business entities, has given considerable thought to the concept of fiduciary duties.  When this author thinks of fiduciary duties, he thinks of three broad obligations – care, confidentiality, and impartiality.

Prof. Ribstein, in a recent article, seeks a unified fiduciary standard centered in the entrustment of property by one person to another.  More precisely, Prof. Ribstein’s “definition [of a fiduciary relationship] focuses on the particular type of entrustment that arises from a property owner’s delegation to a manager of open-ended management power over property without corresponding economic rights.”

In this way, “a fiduciary relationship differs from the broader category of agency relationships.”  Prof. Ribstein finds the existence of a fiduciary relationship when “the resulting separation of ownership and control means the agent might manage the property so as to realize benefits without incurring the full costs of her conduct.”

As a corollary, Prof. Ribstein adds that his “view of the fiduciary relationship is necessarily contractual in the sense that one becomes a fiduciary only by contract, including by contracting for a relationship in which the law says fiduciary duties arise.”

This interpretation makes a great deal of sense, because it focuses on the situations in which a fiduciary relationship may be said to arise.  We look a transfer of control or management to a third party, in which the third-party is not subject to contractual restraints on misconduct.  In this way, the law of fiduciary duties seeks to restrain misconduct by managers who otherwise may not be held accountable.

While I applaud Prof. Ribstein’s coherent frame to determine when fiduciary relationships may be said to exist (more on this below), this author does not fully endorse his definition of fiduciary duties as consisting solely of “the strict fiduciary duty of selflessness.”  Prof. Ribstein adds that,

• “Fiduciaries commonly have a duty of care. However, this is not a fiduciary duty, which as described above is a duty of unselfishness.”
• “The duty not to misappropriate information, business opportunities or other property is not a fiduciary duty. It simply reflects the limits on business owners’ and agents’ rights to property owned by the firm.”

Yet this author disagrees with the conclusion that, “The fiduciary duty of unselfishness should be distinguished from duties that can exist outside the fiduciary setting, including the duties of care, good faith and fair dealing, and to refrain from misappropriation.”  The fact that these duties can be said to overlap with other obligations at law does not mean that we should exclude them from the list of duties found applicable once a fiduciary relationship is established.

Returning to issues of management and control, Prof. Ribstein argues that, “Although partners, majority shareholders and creditors may control the firms in which they invest, this control is not necessarily open-ended enough to warrant fiduciary treatment. The control exercised by ownership factions often is carefully negotiated and limited to the power to approve major transactions and, in corporations, to elect directors …

“It follows from this analysis that partners do not have fiduciary duties merely as such …Even a partner who contributed most of the funding may be outvoted by two service-only partners under the one-partner-one-vote partnership default rule.”

This is a well-reasoned point, and explains why fiduciary obligations are (or should be) imposed only in limited situations: “Managers’ and directors’ wide discretion to control this residual justifies their strong fiduciary duty of unselfishness to shareholders.”

Continuing this theme, Prof. Ribstein articulately argues that a person who provides advice, but who does not hold management powers, should not be bound by fiduciary standard.  “One who is only an advisor or professional sells advice, not management … The client purchases the advice… Applying fiduciary duties to all advisors and professionals therefore would be unrealistic and would dilute the concept of fiduciary duties.”

“Contrast this situation with the fiduciary context. One who decides not only to obtain advice from an expert but to entrust her property to the expert’s management ceases to make her own decisions concerning whether and how much to rely on each of the fiduciary’s judgments. This open-ended delegation of control to the fiduciary calls for more than just disclosure of material facts.”

This is a thoughtful piece, with its sage recommendation that “The usefulness of the fiduciary duty depends on its being kept in a corral rather than set loose to roam broadly among commercial relationships where it does not belong.”

Prof. Larry E. Ribstein, Fencing Fiduciary Duties (Illinois Public Law and Legal Theory Research Paper No. 10-20)

The law of eviction, or unlawful detainer, has roots that extend back hundreds of years.  Here in California, where everyone has the opportunity to make a fresh start, we sometimes forget the past and how it affects our laws.

Yet in eviction, which is properly referred to as “unlawful detainer,” the historical underpinnings are quite plain.  Unlawful detainer is concerned with the possession of real property and is described as a “summary remedy.”  In contrast, an action to determine title to real estate is known as a “quiet title” proceeding, and involves the full trial process.

This distinction between an action for possession and an action for title existed in feudal England.  Legal historian R.C. Van Caenegem, in a series of lectures compiled in The Birth of the English Common Law (Cambridge Univ. Press 1973), explained how these two legal actions were established under King Henry II (1133–89), who reigned from 1154.

It is astonishing to note how closely the forms of action that existed almost 900 years ago parallel those that we use today in California.  Prof. Van Caenegem begins by noting that, “The assize and the action based on it offered protection of tenure, i.e. the peaceful possession and exploitation of free land, at a time when land was the essential form of wealth, the basis of almost everyone’s livelihood and the great source of power and prestige.”

Let’s pause.  It was important for the King to maintain peace in his kingdom.  Acts of self-help to regain possession of real property were likely to lead to violent responses.  The use of the courts, and a ban on self-help, helped preserve peace.  We continue to follow this rule to this day.

Prof. Van Caenegem continues.  “The classic action of novel disseisin, a fruit of Henry II’s reign, was the culmination of a very long royal preoccupation with seisin, witnessed by numerous orders to restore possession, with or without certain forms of judicial enquiry.”

“It was not the preoccupation with seisin that was new, but its systematic judicial form in the hands of the royal justices and the fact that it was now at the disposal of all free men.  Seisin and the protection of seisin – as opposed to right and the lawsuits connected with it – were very old notions, with roots in Germanic gewere, feudal vestitura and ecclesiastical ideas . . . of the early Middle Ages.”

Listen carefully to the following words, for they remain valid today.  “People had known for centuries that seisin and right – possessio and proprietas being the corresponding Roman notions – were two different things and that measures concerning seisin could be followed by litigation on right, but could just as well be taken for their own sake and without further litigation.  So it had been in the past and so it remained after novel disseisin had taken shape.”

Here he is explaining that distinct legal procedures existed for actions based on possession, as opposed to actions based on title, during the time of Henry II.  Were we to meet a lawyer from that time, we would speak the same language when it came to a lawsuit for eviction, in which the sole legal issue is the right to possession of the property.  That is a remarkable notion.

Prof. Van Caenegem continues. “Of course, people who lost their case on seisin could try an action on right, but this was an exceedingly rare phenomenon and the reason is not far to seek.  Seisin was not merely a question of material but of lawful detention: ‘seisin must include some modicum of right, and it is hardly possible to say where seisin ends and right begins.’”

“The question put to the jury was not only whether A had been disseised without judgment, but whether he had been disseised unjustly and without judgment: the jury had to go into the legal situation and if a jury of twelve lawful freemen had found that a man had not been disseised unjustly the chances that a subsequent jury of twelve knights in a process on right would find that he had, after all, the greater right were very small.  It is not because a negative judgment on seisin leaves the loser the theoretical liberty to start a plea on right that his real chances are good.”

So remains the law today.  Which is remarkable to this author; an everyday lawsuit in California is the same lawsuit that would have been filed in feudal England in 1150.

R.C. Van Caenegem, The Birth of the English Common Law (Cambridge Univ. Press 1973)

A recent article by attorney Thomas M. Madden compares the fiduciary obligations applicable to limited liability companies under the laws of five different states – Delaware, Massachusetts, New York, California, and Illinois.

Mr. Madden concludes that, “A look at the five major states’ codes will quickly dispel any presumption that all states treat limited liability companies alike.  Each state has a distinct approach to fiduciary duties – ignoring them entirely, recognizing them in some fashion, setting them out extensively in black letter, or some variation on the foregoing.”

The author provides further analysis.  “While the express, statutory duties of members and managers of limited liability companies range from the practically nonexistent in Delaware to the substantial and detailed in Illinois, well established statutory and common law duties between majority stockholders of close corporations and minority holders exist in the five major states.”

Of course, the question is, To what extent will a court draw from a different body of law?  The author finds strong links.  “The range, or continuum, from the lacking to the pronounced, holds consistently in both corporate and limited liability company law from least strict in establishing and enforcing fiduciary duties in Delaware to most strict in Illinois . . .

“This body of statutory and common law on fiduciary duties tied to limited liability companies, though not as developed into enduring doctrines as with the corporate common law, is growing, and indicates a strong link to the predecessor parallel law on close corporations.”

The author does not hesitate in his analysis.  “While we can draw the obvious and tiresome conclusion that fiduciary duties in corporations – specifically close corporations – are more pronounced and more enforceable in the five major states generally than fiduciary duties in limited liability companies, I believe the cited case law, if not the statutory law of the five major states as well, supports a real connection between the treatment of fiduciary duties associated with close corporations and the treatment of fiduciary duties associated with limited liability companies – a connection that is increasing with the age and growth of the body of law on LLCs.”

“The real question, then, is the normative one: should duties like those owed by majority shareholders of close corporations to minority shareholders exist regarding limited liability company members and managers, strengthened by statute and/or enforced at common law, and be treated increasingly similarly?”

“Our look at the five major states gives us no consensus answer to the normative question.  On the treatment of duties in limited liability companies becoming increasingly similar to those in close corporations, there is a clear consensus from the five major states as a group that this is occurring (whether or not it ought} – albeit in a manner and to a degree inconsistent among those five major states.”

There are substantial differences between the various states, “from the Delaware pro-contractarian model to which Massachusetts statutory law, if not common law, seems to be following (each allowing the near elimination of all fiduciary duties in the name of freedom of contract particularly applied to operating agreements) to the Illinois codified duties of loyalty and due care.”

Here then is the question: “Should the [expansive] sort of duty enforced in Van Gorkom apply to members and managers of private limited liability companies?  Rather, should those duties be stripped to the near bare version of UCC-like good faith and fair dealing in contract?  The best solution is probably something in between.

According to Mr. Madden, “Putting aside the economic based arguments of the contractarians, it would seem that [ ] a majority with no duties to a minority would wield power so great as to enable the facile pursuit of pure self-interest over the interest of the entity and/or its minority owners.”

I fully endorse this position.  The notion that the parties, at the inception, could agree to bargain away remedies for wrongs as yet uncommitted seems a folly.  Even more, “it is simply hard to believe that any parties with some equality of bargaining power would rationally contract away some fiduciary duty of the majority to the minority and the entity itself.  This would be tantamount to investment without recourse.  Doesn’t any investor – public or private – have some bottom line expectation of fair treatment?  Shouldn’t the law recognize and enforce that expectation?”

“Would it not make more sense to keep in place some level of fiduciary duty beyond the basic UCC contractual obligation of good faith and fair dealing while making goals and rights explicit in operating agreements?  For instance, provide a call right upon certain major decision triggers where a minority member’s interests might diverge from the majority.  Adept drafting of an operating agreement at the formation of the venture would go a long way toward preventing situations where minority members were likely to assert different interests from the majority, while allowing the existence of fiduciary obligations of the majority to the entity and to the minority to maintain the adequate protection of them from the pure self-interest of those in control.”

Agreed.  The needs to help limit unbridled self-interest.  From my view, the duties established in the corporate model are much to be commended, and should generally be made part of an operating agreement for a limited liability company.

Thomas M. Madden, Do Fiduciary Duties of Managers and Members of Limited Liability Companies Exist as with Majority Shareholders of Closely Held Corporations?, in 12 Dusquesne Bus. Law Rev. 211 (Summer 2010)

Wading hip deep into the debate over the standard of conduct applicable to investment advisors, author Kristina A. Fausti brings helpful insight in A Fiduciary Duty for All?

Ms. Fausti is the Director of Legal and Regulatory Affairs for Fiduciary360, and is knowledgeable about the investment world.

What she demonstrates is that the investment world is not equally knowledgeable about fiduciary standards, even at the highest levels of the Securities and Exchange Commission, which shows bone-headed ignorance regarding fiduciary obligations.

Ms. Fausti shows her expertise when she notes that “Broker-dealers [ ] often have competing interests with their customers that they neither must avoid nor disclose in most cases.  For example, as Professor Mercer Bullard noted, an investment adviser would be required under the fiduciary standard to disclose any differential compensation it receives as the result of recommending different products to its client because of the conflict of interest such differential compensation creates.  Broker-dealers, however, generally have no such obligation to disclose differential compensation to their clients.”

Now that is what the fiduciary standard really means – full, complete, and candid disclosure.  And that scares the heck out of Wall Street.

Ms. Fausti notes that “the Obama Administration’s plan called for legislators and regulators to ‘harmonize’ the investment adviser and broker-dealer regulatory regimes.”  The investment community has thrived in the confusion of a post Glass-Steagall era. “The Administration’s recommendations were based on the widespread recognition that retail investors are often confused about the differences between investment advisers and broker-dealers.”

That statement is as right as rain.  “The RAND Report issued by the SEC in January 2008 [ ] concluded that investors did not understand key distinctions between investment advisers and broker-dealers, including their duties, the titles they use, and the services they offer.  Also contributing to investor confusion is the ambiguity and inconsistency in titles used across the financial services industry.”

What, then, is the delay in establishing such harmony?  The desire of the financial services industry to maintain confusion.  “In practice many financial professionals use varying titles to describe themselves including: financial advisor, financial consultant, advisor, financial planner, and stockbroker.”

Author Fausti sees the ball clearly.  “In its most basic form, to act as a ‘fiduciary’ is to serve under an already defined standard based on a relationship of trust that carries with it duties of loyalty, due care, and utmost good faith.”

Yes, but don’t forget that those are aspects of the fiduciary obligation, in other words, the duties and consequences that flow from a finding that the parties occupy a fiduciary relationship.

Sadly, SEC Commissioner Luis A. Aguilar lacks similar clarity of thought, having “passionately emphasized” that “there is only one fiduciary standard and it means that a fiduciary has an affirmative obligation to put a client’s interests above his or her own.”

Wrong, wrong, wrong.  That is simply sloppy thinking.  By an SEC Commissioner.

In contrast, these guys get it right.  Says the author, “A group of advisory and investor advocates, dubbed the Committee for the Fiduciary Standard, recently articulated a set of five core fiduciary principles: (1) put client’s interest first, (2) act with prudence, (3) do not mislead clients, (4) avoid conflicts of interest, and (5) fully disclose and fairly manage unavoidable conflicts.”

OK, now we are back on track.  “What these principles illustrate is a basic relationship based on trust that demands that loyalty and due care always remain at the foundation of the fiduciary standard.”

SEC Commissioner Elisse B. Walter “has noted that what is required under the fiduciary duty depends on the scope of the engagement as well as the sophistication of the investor.”

Wrong again.  If someone is in a fiduciary relationship, then the expertise or knowledge of the beneficiary matters not one whit.  The beneficiary gets to put complete trust in his or her fiduciary, and never has to defend his own interests because he is a “big boy” (the so-called “big boy” defense).

It’s simply gobbly-gook for the investment community to claim differing duties “where a financial professional is a ‘dual hatter,’ [which] is meant to refer to a professional who is registered both as a broker-dealer and an investment adviser representative and who, therefore, switches professional hats for different services and products.”

According to Wall Street, “the professional would be a fiduciary and subject to Adviser Act and the fiduciary duty when providing investment advice, but subject to Exchange Act and FINRA rules when executing recommended transactions; thus, switching back and forth between acting as a fiduciary.”

That is just impossible.  A mainstay of the fiduciary standard is the duty of care.  The fiduciary looks out for his or her beneficiary, not the other way around.  Wall Street’s proposal (which proposal is not backed by Ms. Fausti, may I add) is voodoo.

One standard for all financial advisers.  One set of obligations, anchored in duties of care and disclosure.  That’s not so hard.  But it scares the hell out of Wall Street.

Kristina A. Fausti, A Fiduciary Duty for All?, in 12 Duquesne Bus. Law Rev. 183 (Summer 2010)

Prof. Seana Shiffrin of UCLA Law School tackles the issue of “contract law’s strong traditional bar on punitive damages for intentional, gratuitous breach of contract.”

She jumps right into the fray:  “Morality, I claimed, correctly regards some breaches of promise as morally wrong and as warranting not only compensation but the administration of morality’s punitive remedies, including blame, criticism, recrimination, and avoidance.”

That is a valid point.  There are times when morality must be part of contract law.  States Prof. Shiffrin, “The contract law invokes promise as the fundamental component of a contract but, puzzlingly, does not subject gratuitous breaches of contract (and hence breaches of promise) to the distinctive punitive measures endorsed and administered by law, save when those breaches are also torts.”

The argument continues.  “If the law’s rationale for the bar on punitive damages is that the prospect of punitive damages might discourage efficient breach of contract – I label this the efficient-breach rationale – then the divergence between morality’s response to breach and the law’s response to breach is problematic in ways that morally decent citizens cannot accept.”

“The efficient-breach rationale forwards a justification for a legal doctrine that consists in the claim that barring punitive damages would encourage and facilitate certain breaching behavior.”

“But this behavior is condemned by morality.  To the extent the law adopts and embodies this rationale, it thereby embraces and tries to encourage and facilitate immoral behavior.  Although the law need not enforce morality as such, it is problematic when the law, either directly, or by way of the justifications underlying the law, embraces and encourages immoral action.”

Amen.  It’s about time someone steps up like this.  The law of contracts should not turn a blind eye to contract that is immoral.

Prof Shiffrin concludes that “Citizens, who in a democratic polity must be thought of as partial authors of the law, cannot, in all consistency, accept such laws and their justifications while simultaneously acting and reasoning as moral agents.  The law ought not to be structured or justified in ways that place citizens in such an untenable position: it must accommodate the needs of moral agency even if it need not or should not enforce morality directly.”

(Seana Shiffrin, Could Breach of Contract Be Immoral?, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1551.)

Prof. Stefan Grundmann argues that strict liability is essential to contract law because it enforces an important societal norm – freedom of choice.

According to Prof. Grundmann, “The majority of civil law scholars endorse the idea that the fault principle is ethically well-founded, and some scholars clearly see it as ethically superior to strict liability.  The core argument is the following: A system that grounds damages in fault gives the breaching party more freedom, since he does not have to answer for developments that he could not control.”

The professor bends the opposing argument.  The application of fault to contract law rests on the premise that the society should condemn some acts, to a greater extent than merely enforcing the financial obligations that are established by private contract.

Prof. Grundmann continues.  “In a Kantian tradition, it is seen as an act of freedom to choose between breach or conformity with a contract.  Others, however, argue that a regime of strict liability may also foster some level of freedom by furthering the principle of pacta sunt servanda, that agreements must be kept – a principle of equal importance with freedom of will.  Therefore, balancing of both principles seems necessary.”

Here the professor seeks to balance two moral standards.  He asserts that “freedom and pacta sunt servanda are not of equal importance, at least not in the context discussed here.  There is actually a clear hierarchy between them, and pacta sunt servanda is clearly more important because of the following reason.”

“Those who advocate the ethical superiority of the fault principle because it gives the breaching party the freedom to answer only for those acts and events for which he is responsible forget one rather simple fact: there is an earlier type of freedom that allows each party to decide what offers he makes and to which standards he wants to bind himself, i.e., the freedom of contract.”

Here we get to the heart of the argument – that protection of individual rights is more important than protection of societal norms.  States Prof. Grundmann, “The most vital tenet of freedom in modern times [ ] is the right of each person to decide, to the greatest extent possible, which obligations to assume.  This freedom – which comes first – is disregarded if the question of whether fault or strict liability should govern is decided, not on the basis of the parties’ expressed or implicit intentions, but rather on the basis of an ‘ethical credo’ about the superiority of fault or of strict liability.”

Again, the focus on individual rights ignores the question of whether fault – not as an excuse for breach of contract, but as justification for additional remedies – advances important societal values.

Concludes the author, “strict liability better fosters freedom of contract.”  Thus, “If the freedom of the parties is taken seriously, the question is how to interpret their intentions, not to impose on them a regime judged by scholars, legislatures, or any other third party to foster their freedom and therefore be ethically superior.  Replacing the choice made by the parties – even if justified as fostering freedom – is paternalistic.”

(Stefan Grundmann, The Fault Principle as the Chameleon of Contract Law: A Market Function Approach, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1583.)

Prof. Roy Kreitner of Tel Aviv University shows great insight into the dichotomy between tort and contract law.  He first discusses how tort law shifted toward a fault-based system during the nineteenth century.

States Prof Kreitner, “the early [tort] law asked simply, ‘Did the defendant do the physical act which damaged the plaintiff?’  T[ort] law of today, except in certain cases based upon public policy, asks the further question, ‘Was the act blameworthy?’”

Thus, “the ethical standard of reasonable conduct has replaced the unmoral standard of acting at one’s peril.  It is most likely that theories of strict liability were dominant during the formative years of the common law.  But during the nineteenth century . . . there was a decided and express shift towards the theories of negligence.”

Prof Kreitner continues.  “The accounts of such a shift are persuasive, but only when one acknowledges that the shift took place over the course of decades (rather than, say, through one key judgment of an individual court) and that it solidified quite late in the nineteenth century.”

Further, the shift in tort liability occurred among societal changes.  “The importance of the shift in background assumptions about liability could hardly have been imagined early in the nineteenth century, when the number of serious injuries from industrial activity was minuscule in comparison to what would emerge in the last third of the century.”

“By the last two decades of the nineteenth century, the question of the extent to which injuries from industrial accidents could go uncompensated had become a major economic battleground in ways that would have been difficult to appreciate early in the century.”

Prof Kreitner then turns to contract liability.  As he states, “Everyone is familiar with the idea that contract rests on a species of strict liability, namely the claim that in general “duties imposed by contract are absolute . . . It remains an ingrained aspect of mainstream understandings of contract.”

He explains that, “What generally escapes appreciation is that the understanding of contract as a strict liability regime is anything but an age-old phenomenon.  In fact, such a regime emerged in the United States only at about the same time as the solidification of the no-liability-without-fault regime in tort, during the final decades of the nineteenth century.”

“During the first half of the nineteenth century, although receding slowly in the decades following, contract was understood as a fault-based regime.”  The professor explains that fault was interposed because contracts arose out of relationships.  Contract law “was understood in direct reference to the typical contractual relationships that constituted it.  This world of contract was inhabited by people in relational pairs: bailor and bailee, principal and agent, master and servant, principal and factor, landlord and tenant, vendor and purchaser, husband and wife.”

Given these relationships, “actors had standardized duties, whose contours were shaped by the relation itself.  Individual agreement tailored these duties only on the margins.  And while some of the relations included duties we could characterize as absolute, it was far more typical for duties to be framed in terms of reasonable skill, reasonable diligence, or reasonable care.”

Accordingly, early contract liability was premised on fault.  “It was a failure to meet the standard of care, often phrased directly in terms of negligence, that triggered contractual liability.  Thus, the basic standard of liability was one of fault, even if fault of an objective variety.”

Societally-imposed standards were gradually removed from contract law.  “In order to exclude the state, the theory of contract had to place the parties in full control of the relationship.  Once that was accomplished, the road was open for the parties’ self-imposed obligation to be construed as absolute.”

The shift was societal standards (i.e., liability based on fault) to absolute liability has been complete in contract law for a century.  “Contract was thus established as the very center of the private realm, in part by purging its fault-based standards.  Indeed, it is the image of strict liability that heightens the sense of party control and autonomy, since it is always assumed that the parties could, if they wished, contract for any other standard of liability within their contract.”

Yet, norms of conduct remain part of contract law, which is why concepts of fault have not been eradicated from contract theory.  “Part of what parties to a contract are involved in is the generation of a public good [. ]  This idea should not sound farfetched.  It is intuitive that contracting parties generate a public good in the shape of trust in the market, or the idea of safe contracting.”

“Consider, for example, the difference between analyses of nondisclosure and misrepresentation: when dealing with silence regarding features of the transaction . . . The analysis of misrepresentation is fundamentally different, quintessentially fault based, and obviously reliant on sources outside the parties’ own agreement – and yet, no less contractual for that.  Nondisclosure can theoretically be overcome simply by asking the right question.  Misrepresentation, however, threatens to unravel the basic background trust without which market transactions would be far more difficult.”

(Roy Kreitner, Fault at the Contract-Tort Interface, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1533.)