Coping With Legal Uncertainty In Business Decisions

In moving towards vague standards where ideals of “fairness” and “good faith” merge with rules of liability, even ethical decisions are not immune to the legal process. There are ways to minimize risk, however.

March 1 1989 by G. Richard Shell


Most business and civic leaders are familiar with the “liability crisis” in the American legal system, but some are discovering a more subtle crisis in the law-that of “legal uncertainty.” As General Motors Chairman Roger B. Smith observes, the increasing vagueness in legal rules affecting business poses one of the most serious threats to “the efficient operation of the American economy.” There is evidence that Smith is correct.

The most notorious recent example of the effect of legal uncertainty on the operation of a business is the Texaco/ Pennzoil case. Pennzoil sued Texaco for interfering with a proposed merger between Pennzoil and Getty Oil. After years of litigation, including a trip into bankruptcy, Texaco is now reemerging as a viable entity, but only after making a precedent-setting settlement payment to Pennzoil of some $3 billion.

The legal posturing between Texaco and Pennzoil was quite complex. But the case essentially boiled down to uncertainty regarding the meaning of the word “contract.” Texaco claimed it was free to make a deal with Getty because Pennzoil and Getty had not yet signed definitive contract documents. There could be no “contract” in a multi-million dollar merger,” argued Texaco, until the parties execute such documents.

Pennzoil countered that its agreement with Getty became legally enforceable at an imprecise point in time when the parties “intended” there to be a contract and that the signing of documents had nothing to do with the issue. Legal uncertainty prevailed. A Texas jury charged with applying New York contract law found that Texaco had violated Pennzoil’s rights by interfering with Pennzoil’s “contract.”

A second example of the trend toward legal uncertainty involves the problem of when public corporations must disclose preliminary merger negotiations in response to inquiries from the press, federal regulators or stock exchanges. In March 1988, the U.S. Supreme Court held that the directors of Basic, Inc., a public company that supplies chemical products to the steel industry, may have violated the federal securities laws by declining to publicly reveal merger negotiations with another company. Basic’s directors argued in favor of a duty of disclosure that would protect the confidentiality of merger talks until after the negotiating parties have reached a firm agreement in principle on the price and structure of their deal. But the Supreme Court adopted a legal standard of “materiality” that requires courts to closely examine all of the facts surrounding merger negotiations and to impose disclosure responsibilities on a case-by-case basis. In effect, the Court said: “You show us your case, and we’ll tell you if you’ve broken the law.”

LEGISLATIVE ENACTMENTS AND LEGAL UNCERTAINTY

The most significant recent developments moving business litigation in the direction of legal uncertainty are federal and state statutes that impose new standards and new remedies in conventional business cases. On the federal level, the most controversial example of such a statute is the Racketeer Influenced and Corrupt Organizations Act (RICO).

Passed in the early 1970s to help curb organized crime, RICO permits private parties, including businesses and consumers, to sue legitimate businesses for misstatements, nondisclosures and other conduct which is common in many business disputes. RICO entitles successful plaintiffs to recover damages equal to three times the plaintiffs’ actual losses and forces the defendant to pay for the plaintiffs’ attorneys’ fees. The statute is also characterized by such a high degree of legal uncertainty that a federal judge recently called it a “sea of confusion.”

Many of the nation’s largest banks, brokerage houses, insurance companies and industrial firms have been named as defendants in RICO cases. Texas Air, the parent company of Eastern Airlines, recently sued its own unions for $1.5 billion under RICO. The business community has mounted an aggressive lobbying campaign to revise the statute. The prospects for reform look good sometime this year. Congress is about to revise RICO so that plaintiffs must show that the defendant was previously convicted of a crime involving the allegations specified in the complaint. This law should sharply limit the use of RICO in conventional business disputes.

However, even if federal RICO is curtailed, business will still be plagued by the statute at the state level. During the last decade more than half the states have enacted versions of RICO, and the number is rising. Many of these state statutes permit private plaintiffs to recover treble damages and attorneys’ fees for frauds committed in business dealings.

The Federal Trade Commission (FTC) Act has introduced high degrees of uncertainty into business litigation. Although the FTC Act has been around since the beginning of this century, the FTC finds new ways of interpreting its mandate under the statute.

Section 5 of the FTC Act declares that “unfair methods of competition and unfair or deceptive acts or practices” are illegal. The ambiguity of the words “unfair” and “deceptive” makes decision-making regarding product advertising and marketing difficult. For example, in April 1988, a U.S. court approved an FTC order disciplining the Orkin company for “unfairly” breaching contracts with consumers-even though the FTC admitted there was no misrepresentation or deception in the company’s conduct. This case marks the first time that simple breaches of contract have been the subject of FTC regulation under the “unfairness” language of section 5.

So-called “baby FTC Acts” are less known, but equally important, sources of legal uncertainty. All fifty states have adopted some variant of section 5 of the FTC Act. State versions of section 5 differ sharply from the federal statute because they permit private legal actions by consumers and businesses against business defendants. In addition, many baby FTC Acts permit plaintiffs to recover statutory penalties, multiple or punitive damages, and attorneys’ fees. The wholesale replacement of state common law rules of contract and tort with vague standards such as “unfair” and “deceptive” in business cases contributes greatly to America’s uncertain legal environment.

THE COMMON LAW AND LEGAL UNCERTAINTY

In the U.S., most legal rules are enacted through the legislature or by administrative agencies. But there are still many “common law” rules dealing with such subjects as contracts, torts, and property that are developed and changed solely by judges. The Texaco/Pennzoil dispute regarding the definition of a “contract” was an example of such common law rules in action. The courts are adding to legal uncertainty by reforming common law standards governing breach of contract and business torts.

 FIDUCIARY DUTIES

The label “fiduciary” has traditionally been reserved for specialized types of relationships characterized by a high degree of dependence and trust, such as the relationships between partners in a partnership or trustees and beneficiaries. But in recent years, references to the fiduciary’s duty of candid disclosure have begun to appear more frequently in cases involving conventional business dealings. For example, courts have held that parties negotiating a sale of a business must be completely candid in disclosing past profits or losses and the prospects for future earning because of the “superior knowledge” of the seller on such matters. Similarly, courts have rescinded real estate deals when the seller failed to disclose defects with the property.

Some courts have imposed an explicit fiduciary duty on large business suppliers to act for the benefit of smaller contracting partners, such as dealers and distributors. In one such case, the court held that a supplier was under a duty during negotiations to disclose all pending and prior litigation by dealers against the supplier. Moreover, manufacturers may be required to show “just cause” for terminating a dealership. And banks have found that the courts are willing to hear claims of breach of fiduciary duty brought by disappointed customers over loan practices.

 UNCONSCIONABILITY

Unconscionability is the legal rubric under which courts may refuse to enforce “oppressive” contracts. Unconscionability most often applies to relieve low-income consumers from onerous contracts or payment terms imposed by a more powerful party. Recently, unconscionability has become an alternative to the “fiduciary duty” doctrine in negotiation and termination cases between dealers and manufacturers and franchisees and franchisors. The basic notion is that a more powerful economic party may not treat a less powerful party unfairly. The lack of definition of what is unconscionable, however, leaves most business decision-makers guessing at the boundaries of the law.

GOOD FAITH AND FAIR DEALING

The Uniform Commercial Code-the basic legal framework for business dealings in all fifty states-speaks of “good faith” between business parties. Until recently, this duty was honored more as a moral principle than as a legal doctrine. Today, however, the “duty of good faith and fair dealing” is enjoying rapid legal development in commercial disputes. Courts have begun to recognize breach of the “covenant of good faith and fair dealing” as a “tort for commercial breach of contract that gives an aggrieved party the right to punitive damages. For example, a jury returned a $59.4 million judgement against Texas Commerce Bank for “willfully” violating contract terms in a loan agreement with a commercial customer. The case was settled on appeal for an undisclosed amount.

Courts have also used the doctrine to limit employer’s rights to terminate employees “at will.”

LEGAL UNCERTAINTY: HOW TO COPE

Business leaders can cope with the uncertain legal environment and even buck the trend by taking the following four steps:

Understand the Problem. Legal uncertainty is inherent in any system of law that uses language to convey its commands. It is nearly impossible to find or create a legal rule that eliminates all uncertainty and assures accurate prediction of the outcome of all potential cases. So, business must be conducted in an uncertain legal environment even when legal rules are “clear.”

Moreover, the roots of the legal attitude favoring uncertainty go deep. One of the common law traditions America inherited from England was a system of “equity” jurisprudence that ran parallel to the judicial system based on “law.” Equity courts were free to make exceptions to the rules of “law” and were charged with seeing that “justice” was done rather than with consistently enforcing the rules. In addition, American law schools teach that commercial law should promote justice and fairness, as well as efficiency. Uncertain legal standards give judges the flexibility to serve such goals.

Target areas for legislative reform. This is one way of coping with legal uncertainty, taking an active role in opposing the current trend toward legal ambiguity. Efforts to reform current law should be carefully considered, however, because legally vague standards sometimes benefit business defendants, depending on the situation.

The current products liability crisis, for instance, stems in part from a shift toward legal certainty. The vague legal doctrine of negligence, which requires a plaintiff to prove that the defendant did not exercise reasonable care in the design or manufacture of a product, has been superceded by a “rule” regime of strict liability which virtually guarantees recovery by the plaintiff so long as the plaintiffs injury was caused by the product.

An example of legal evolution from fixed rule to general standard that benefits business is the Supreme Court’s decision to apply a vague “rule of reason” legal analysis (as opposed to a clear per se rule) in federal antitrust cases. The rule of reason approach has recently been adopted in cases dealing with terminations by manufacturers of dealers and distributors who sell the manufacturer’s products at discount prices. The “rule of reason” test permits business practices so long as their economic effects are not anti-competitive. The per se rule simply bans business practices, such as price-fixing, based on a judicially perceived threat to competition. The more uncertain standard gives suppliers and manufacturers greater flexibility in marketing decisions than they’d have under the per se rule.

Some legal developments, however, seem to be bad for all business interests and warrant reform efforts. No one in Con, gress ever intended RICO to apply to conventional business disputes, and its application in such cases causes confusion and escalates conflict. Statutes like RICO impose net costs on all business transactions by needlessly increasing the legal risk factor in decision-making. Once Congress finishes reforming RICO, business leaders seeking more legal certainty should see that similar reforms are enacted in states that have RICO statutes.

Watch Out For the Lawyers. In seeking reform, you should know who you are up against. Many economic interest groups benefit in various ways from different legal schemes based on uncertain legal standards. There is only one group, however, that benefits from all such schemes: The legal profession. Lawyers have a controlling grip on both the drafting of laws and the rendering of judicial opinions. Legal uncertainty increases business for lawyers at every level of legal practice. Corporate lawyers must be consulted more frequently when a general legal standard is unclear. Trial lawyers must try more cases and take more appeals to test and clarify vague laws. Even judges play a more important role in a system based on vague standards than one based on rules. A judge is going to be more engaged in his work when called upon to render judgments on what is “fair” than when asked to enforce a legal formula that dictates a result.

Be aware of the fact that lawyers, as a group, have great interest in resisting reform toward more certain legal rules.

Bring More Ethical Norms Into Your Decision Process. Even the most vigorous reform effort will leave business facing a substantial number of uncertain legal rules. Business leaders should give more thought to ethics in their decision-making process.

The law is moving toward the use of vague standards that merge ethical ideals such as “good faith,” “fairness,” and “honesty” with rules of legal liability. The people whose judgment is to be questioned by the law-business executives-should therefore use ethics explicitly in business decisions. An ethical response to a business situation cannot guarantee freedom from liability in an era of high legal uncertainty, but it will reduce exposure to legal risk by providing a coherent, principled basis on which to defend business decisions.


G. Richard Shell is the Pfizer, Inc. Term Assistant Professor of Legal Studies at the Wharton School of the University of Pennsylvania. The research underlying this article was supported by the Reginald H. Jones Center for Management Policy, Strategy and Organization.