It was a typical Saturday evening in the Bainbridge household. I had made a shrimp pasta for dinner, loosely based on a recipe by the always reliable Giada de Laurentis. To accompany it, I had poured a Veuve Clicquot Brut NV (if it's good enough for Queen Elizabeth II, it's good enough for me). Yum.
Sometime later, Helen and Bella had gone off to bed, while Toby and I curled up at opposite ends of the the living room sofa. Assorted Windham Hills music on the stereo (actually, streaming from iCloud to my TV via Apple TV). I opened a bottle of Dow 20 year old tawny port, lit a Dunhill Peravia, and settled in to read the June 2012 issue of The Green Bag. (Yes, we've kissed and made up from the unpleasantness of a few years ago, which makes me glad because I've always been a huge fan of this self-proclaimed "entertaining journal of law.")
The second article in this issue is entitled "Remarks on Henry Friendly" by Judge Pierre Leval. Only a few paragraphs into it, I was brought up short -- nearly doing a spit take with fairly expensive port, which would have been a tragic waste -- by a paean that transcends mere praise and rises to heights of hagiography:
In every area of the law on which he wrote, during a quarter century on the Second Circuit, his were the seminal and clarifying opinions to which everyone looked as providing and explaining the standards.
I have no quarrel with the proposition that Friendly was a learned jurist whose memory deserves preserving. But I teach two Friendly opinions in Business Associations and while both of them were seminal they were both wrong. Indeed, not just wrong. They were egregiously wrong. Indeed, not just egregiously wrong. They plumb the depths of error.
The first crops up in agency law. As I explain in Agency, Partnerships & LLCs
Perhaps no court has gone further in eviscerating the scope of the employment doctrine than did the Second Circuit (per Judge Friendly) in Ira S. Bushey & Sons, Inc. v. U.S.[1] The Coast Guard ship Tamaroa was being overhauled in a Brooklyn drydock. per the Coast Guard’s contract with the drydock’s owner, the ship’s crew continued to live aboard and therefore were allowed to come and go freely. Late one night Seaman Lane, a member of the crew, returned to the ship in an intoxicated state. As Judge Friendly explained: “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 ... these wheels controlled the water intake valves.” The drydock began to fill with water. The Tamaroa floated free of its supporting blocks and then toppled over against the drydock. Bushey, the corporate owner of the drydock, sued the U.S. government for the resulting damage to its drydock. The trial court ruled that Bushey was entitled to damages in an amount to be determined. The United States appealed, claiming that Lane’s act was outside the scope of his employment.
Obviously, no purpose to serve the master could be found in Lane’s conduct—no matter how hard you look. The trial court nevertheless found for plaintiff Bushey. Under the trial court’s approach, plaintiffs no longer would be required to show that the agent was motivated by a purpose to serve the master. Instead, it would suffice to show that the conduct arose out of and in the course of the employment. The trial court’s analysis amounted to virtually a rule of strict liability for the torts of an employee as long as any connection in time and space could be made between the conduct and the employment.
The trial court’s holding was grounded in economic theory. The court argued that imposing liability on the principal would cause the principal to internalize the negative externalities of its agents conduct. On appeal, however, Judge Friendly rejected this analysis. From a deterrence perspective, as he correctly pointed out, forcing the principal to internalize the costs of particular misconduct by an agent only makes sense if the principal can take steps to prevent future instances of such misconduct. If the principal cannot do so, imposing liability effectively makes the principal an insurer of its agents. On the facts of Bushey, it is far from clear how imposing liability on the government would induce principals to take cost-effective precautions: “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 ship owners is much less likely to lead to accident prevention.”
Despite his rejection of the trial court’s economic analysis, Judge Friendly nevertheless thought the government should be held liable. Instead of economic efficiency, he relied on rather vague fairness concerns; namely, the “deeply rooted sentiment that a business enterprise cannot justly disclaim responsibility for accidents which may fairly be said to be characteristic of its activities.”[2] To implement that sentiment, he adopted a foreseeability standard: (1) If some harm is foreseeable, the principal is liable, regardless of the fact that the particular type of harm was unforeseeable. Why was it foreseeable on these facts that some harm would result? Because the government insisted that the seamen be able to stay on board the boat and be able to go to and fro. (2) Conduct by the servant which does not create risks different from those attendant on the activities of the community in general will not give rise to liability. (3) The conduct must relate to the employment. The notion here seems to be that the existence of the employment relationship causes the employee to encounter unusual circumstances which he or she otherwise would not.
Consider the application of Judge Friendly’s standard to following hypothetical: Mary owns a gas station. She hires Sam to work as a pump attendant. Assume Sam is a servant. Sam smokes cigars. One day Sam is smoking while he fills a patron’s gas tank. An explosion results, injuring the patron. Is the conduct within the scope of the employment? Older cases said smoking was merely a personal convenience and hence outside the scope of the employment. Some modern courts say smoking is necessary to the servant’s comfort while on the job and therefore foreseeable harms are within the scope of the employment.[3] Surely this harm is at least as foreseeable as that involved in Bushey.
Now suppose Shirley works as a cashier in the gas station. After years of inhaling Sam’s smoke, she comes down with lung cancer. If she sues Mary, is Sam’s conduct within the scope of the employment? Arguably it is foreseeable, as we are routinely told that passive inhalation of smoke may cause cancer. On the other hand, Judge Friendly did say that conduct by the servant which does not create risks different from those attendant on the activities of the community in general will not give rise to liability. But then again, the harm did occur within the physical boundaries of the enterprise, which does tend to distinguish it from the examples he cites. It would be foolhardy to pretend to know how this last case would come out. One can say this much, however: Judge Friendly was absolutely right when he said “the rule we lay down lacks sharp contours.”
Not exactly the sort of opinion that can be praised for "providing and explaining the standards." Instead, the sort that should be condemned for mucking up the standards. The scope of the employment doctrine was a mess before Friendly took it on in Bushey. Afterwards, however, there was nothing left to do but blow the whole thing up and start over.
My second sample of Friendly's handwork comes up when we reach insider trading. In SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969), Friendly established the so-called disclose or abstain rule. He did so by holding that when an insider has material nonpublic information the insider must either disclose such information before trading or abstain from trading until the information has been disclosed.
Of course, that's not really an option that's available in the real world. presumably phrased the rule in terms of disclosure because this was an omissions case under Rule 10b-5. Recall that in such cases the defendant must owe a duty of disclosure to some investor in order for liability to be imposed. As a practical matter, however, disclosure will rarely be an option. Given that the corporation typically will have no duty to disclose, the insiders’ fiduciary duties to the corporation would preclude them disclosing it for personal gain. Put bluntly, Friendly's suggestion that disclosure could ever be an option was a bogus fig leaf to cover what amounted to a blanket prohibition on insider trading unsupported by either the statute or the legislative history (a point I make at some length in The Law and Economics of Insider Trading: A Comprehensive Primer).
The policy foundation on which Friendly erected the disclose or abstain rule was equality of access to information. He contended that the federal insider trading prohibition was intended to assure that “all investors trading on impersonal exchanges have relatively equal access to material information.” Put another way, he thought Congress intended “that all members of the investing public should be subject to identical market risks.” Again, the legislative history analyzed in my Primer shows just how egregiously this missstates the scant legislative history.
The real world implications of the equal access principle become troubling when we start dealing with attenuated circumstances, moreover, especially with respect to market information. Suppose a representative of TGS had approached a landowner in the Timmons area to negotiate purchasing the mineral rights to the land. TGS’s agent does not disclose the ore strike, but the landowner turns out to be pretty smart. She knows TGS has been drilling in the area and has heard rumors that it has been buying up a lot of mineral rights. She puts two and two together, reaches the obvious conclusion, and buys some TGS stock. Under a literal reading of Texas Gulf Sulphur, has our landowner committed illegal insider trading?
The surprising answer is “probably.” The Texas Gulf Sulphur court stated that the insider trading prohibition applies to “anyone in possession of material inside information,” because § 10(b) was intended to assure that “all investors trading on impersonal exchanges have relatively equal access to material information.” The court further stated that the prohibition applies to anyone who has “access, directly or indirectly” to confidential information (here is the sticking point) if he or she knows that the information is unavailable to the investing public.
In Chiarella v. US, 445 U.S. 222 (1980), the Supreme Court squarely rejected Friendly's approach. Indeed, the SCOTUS tore Friendly's approach out of the law books root and branch. In doing so, the SCOTUS made clear that the disclose or abstain rule was inconsistent with the basic function and purpose of the securities laws, holding that there can be no fraud absent a duty to speak, and no such duty arises from the mere possession of nonpublic information.
Once again, we thus confront an an important Friendly opinion that no one any longer looks to as "providing and explaining the standards." To the contrary, we still teach it mainly to act as a foil by which to show why an overly expansive insider trading ban is a bad idea.
Again, my point is not that Friendly was a bad judge. And I admit that I've offered up just two anecdotes (while falling back on the aphorism that lawyers believe the plural of anecdote is data). My point is just that, like all of us, Friendly's record needs balanced assessment, not mere hagiography.
[1] 398 F.2d 167 (2d Cir. 1968).
[2] Query how the negligence of a drunken seaman “may fairly be said to be characteristic of [the Coast Guard’s] activities.” Indeed, most instances of employee negligence are hardly “characteristic” of the employer's activity in any meaningful sense of the word. See Gary T. Schwartz, The Hidden and Fundamental Issue of Vicarious Liability, 69 S. Cal. L. Rev. 1739, 1749-50 (1996).
[3] See, e.g., Iandiorio v. Kriss & Senko Enterprises, Inc., 517 A.2d 530 (Pa. 1986), in which the dissent cited Restatement (Second) § 229 for the proposition that “personal acts of employees may be within the scope of employment when they are part of the work, but not when they are for ‘personal convenience of the employees and are merely permitted by the master in order to make the employment more desirable....’ Smoking is an activity which is in no way related to the work of remodeling a service station, and is permitted solely for the personal convenience of the employees to make their work more desirable. The conclusion is inescapable, therefore, that smoking is not within the scope of employment applying Section 229 and that the employer, therefore, is not vicariously liable for the injuries ....” Id. at 536 (emphasis removed). In contrast, the majority held that an employer could be held liable it “not only knew that its employees smoked at work, but, in fact, dictated where employees should take breaks and smoke.” Id. at 534.
