Electronic Casebook – Chapter 1

Transcription

P AYMENT SYSTEMS
E LECTRONIC C ASEBOOK
P ART O NE
© 2008 by Steven L. Harris
All rights reserved.
CHAPTER 1
R IGHTS OF C REDITORS, O WNERS
AND P URCHASERS
As consumers, most of us make payments with some frequency. We pay
for housing, food, transportation, and entertainment. We pay for health
care. We pay taxes. We even pay for casebooks. We use a variety of means
to make our payments—cash, check, credit card, debit card, stored–value
(“prepaid”) card. Some of us arrange for recurring bills to be paid
“automatically” from a checking account or billed “automatically” to a credit
card; others make payments using the internet. Businesses, too, make
payments, frequently by check and credit card. Payments of large amounts
often are made by wire transfer.
We may pay attention to the size of a payment and wonder whether we
can afford to make it. But we rarely, if ever, think about the mechanics of
payment transactions or the likely legal consequences if something were to
go wrong. This book addresses those questions. It examines a number of
payment mechanisms in detail—checks, wire transfers, letters of credit,
credit cards—and gives an overview of still others—debit cards and
automated clearing house entries.
Before we turn to a discussion of the payment transactions themselves,
we examine issues surrounding the transfer (or assignment) of rights in
various kinds of personal property, including a right to be paid.1 Our
discussion begins here for several reasons. First, the most popular payment
system, the checking system, involves the transfer of checks. Examining
transfer-related issues outside the checking context enables us to become
acquainted with the legal regime governing transfer and assignment in a
simpler setting. Second, an examination of the law governing transfer and
assignment affords the opportunity to examine important legal doctrines
that appear elsewhere in commercial law and, more broadly, in the law of
property. It is to these doctrines—security of property and good faith
purchase—that we now turn.
1. “Transfer” and “assignment” are synonyms. The latter is commonly used to refer
to refer to transfers of rights to payment, claims, and liens. The latter commonly is used
to refer to transfers of other interests in property.
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RIGHTS OF CREDITORS, PURCHASERS & OWNERS
S ECTION 1.
T RANSFER OF I NTERESTS IN G OODS
INTRODUCTORY NOTE
In this Chapter we will have occasion to consider the transfer of several
types of personal property, both tangible (e.g., goods) and intangible (e.g.,
a seller’s right to be paid for goods sold). Though our principal concern is
with the transfer of rights to payment, we begin by looking at the rules
applicable to transfers of a type of property that may be more
familiar—goods.
A paradigmatic sequence of events, which can arise in various settings,
is as follows: A is the owner of goods. B acquires the goods under
circumstances that give A the right to recover the goods from B. B,
voluntarily (e.g., by sale or by grant of a security interest) or involuntarily
(e.g., by sheriff’s levy), purports to transfer an interest in the goods to C. A
seeks to recover the goods themselves from C, perhaps by bringing an action
in replevin,1 or to hold C liable for damages in conversion.2
For such cases, the traditional rule is this: B can convey to C, and C can
acquire from B, whatever rights B had in the goods.3 Two different, but
interrelated, ideas are packed into this rule. First, the rule enables B to
dispose of any and all rights that B has. Thus, if B acquires goods free and
clear of all third-party claims, B will be able to convey the goods to C free
and clear. Were the rule otherwise, the value of the goods to B would be
substantially reduced in many cases. When the rule is applied to enable C
to defeat a third party’s claim on the ground that B could have done so, it
sometimes is referred to as a “shelter” or “umbrella” rule.
1. Replevin, like sequestration and claim and delivery, is a judicial remedy to
recover possession of personal property. Replevin statutes are procedural. They do not
create the right to possession but rather aid those who are entitled to possession under
other law.
2. The Restatement (Second) of Torts defines conversion of personal property as
"an intentional exercise of dominion or control over a chattel which so seriously
interferes with the right of another to control it that the actor may justly be required to
pay the other the full value of the chattel." Restatement (Second) of Torts § 222–A(1)
(1965). As with A's replevin suit to recover the cotton, C will be liable to A in conversion
only if A's right to control the cotton is paramount to C's right.
3. The principle that the transferee of property acquires all rights that the
transferor had applies not only to goods (see UCC 2–403(1) (1st sentence)) but also to
rights to payment, whether or not represented by a negotiable instrument (see UCC
9–404(a); UCC 3–203(b)), documents of title (see UCC 7–504(a)), and investment
securities (see UCC 8–302(a)). The conveyancing rules governing rights to payment are
discussed in Section 2, infra; those governing documents of title, in Section 3. Although
this book focuses on personal property, similar principles apply to the transfer of
interests in real property, such as land and buildings.
SECTION 1
PURCHASE OF GOODS
The second idea is that B cannot transfer any greater rights than B has;
that is, B may convey whatever rights B has and no more. This aspect of the
rule, which sometimes is referred to by the Latin phrase nemo dat quod non
habet (one cannot give what one does not have), appears to flow from a
broader principle, sometimes referred to as “security of property.” Security
of property means that a person may not be deprived of property rights
without the person’s consent. It means, for example, that a thief cannot
transfer the real owner’s property interest to a third party. A rule of law
contrary to nemo dat, one that would enable a person to convey rights that
the person did not have, would enable the person to deprive another person
of the other’s rights and would violate the security-of-property principle.
The security-of-property principle is far from ironclad; in fact, the law
often enables a person to convey greater rights to personal property than the
person has. Because those to whom the law affords greater rights than their
transferors had often are good faith purchasers for value, the exceptions to
nemo dat often are termed “good-faith-purchase” rules. As you work through
the following materials, try to articulate the reasons underlying the various
good-faith-purchase rules and to assess the validity of those reasons. You
may also wish to consider whether nemo dat no longer is the baseline rule
but rather has become the exception.
Problem 1.1.1. A’s bales of cotton worth $100,000 were stored in A’s
warehouse. B broke into the warehouse and stole the cotton. B resold the
cotton to C, who paid B $100,000, not suspecting the cotton was stolen. C is
in possession of the cotton. A brings a replevin action to recover the cotton
from C. What result? See UCC 2–403; Note (1) on the Basic Conveyancing
Rules, infra.
Problem 1.1.2. Under the facts of the preceding Problem, assume that
C, before learning of A’s interest, resold the cotton to D.
(a) Does A have a cause of action against C? On what theory?
(b) Does A have any rights against D?
(c) If A recovers from D, does D have a right of recourse against C? See
UCC 2–312.
Problem 1.1.3. B, who only recently entered business and has no credit
history, went to A’s place of business with a forged letter of introduction.
Relying upon the letter, which showed B to be Sterling Worth, a merchant
with well-established credit, A delivered cotton valued at $100,000 to B on
credit. B resold the cotton to C, who paid $100,000 for it and took delivery,
not suspecting the fraud. A sues C to replevy the cotton.
(a) What result? See UCC 2–403; Note (1) on the Basic Conveyancing
Rules, infra. What result if A sues C in conversion?
(b) What result if C is a cotton dealer who never dealt with B previously
and took no measures to check on B’s background. (It is customary for cotton
dealers in the area to purchase only from growers or from other dealers
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whom they know.) See UCC 1–201(b)(20); UCC 2–103(1)(b) [R2–103(1)(j)];
UCC 2–104(1).
(c) What result if C had paid B only $60,000? Cf., e.g., Funding
Consultants, Inc. v. Aetna Casualty and Surety Co., 187 Conn. 637, 447
A.2d 1163 (1982) (trier of fact may reasonably consider whether an
instrument was purchased in good faith if a party pays an amount
considerably less than face value).
(d) What result if C had promised to pay $100,000 but has not yet paid
anything? See UCC 1–204. Under these circumstances, should the law
award the goods to a person who has not paid for them? Does this
transaction pose the same risks to C as does C’s payment of cash to B? Does
this transaction jeopardize A’s interests as much as C’s payment of cash?
(e) What result if C paid B $100,000 but had not yet taken delivery when
A notified C of the fraud? See Note (4) on the Basic Conveyancing Rules,
infra.
NOTES ON THE BASIC CONVEYANCING RULES
(1) Void Title and Voidable Title. The first sentence of UCC 2–403(1),
which embodies the nemo dat principle, takes one only so far. To determine
what the purchaser (C) acquires, one needs to know what rights the
transferor (B) has or has power to convey. What rights does a thief have?
The traditional rule, which still is dominant in Anglo–American law, is that
a thief has “void title,” which is very, very close to having no rights at all 4
The “void title” of a thief is to be distinguished from the “voidable title”
referred to in the second sentence of UCC 2–403(1). The drafters of the UCC
may well have assumed that just as “everyone knows” that the owner of
goods may recover them from a thief, who has “void title,” so “everyone
knows” that a seller who is induced by the buyer’s fraud to enter into a
contract of sale may rescind (avoid) the contract and recover the delivered
goods from the defrauding buyer, who has “voidable title.”
The seminal case in the voidable title area is the English case of Parker
v. Patrick, 101 Eng. Rep. 99 (1793), which was followed in Mowrey v. Walsh,
8 Cow. 238 (N.Y.Sup.Ct.1828). The latter posed the question: “where the
goods are obtained by fraud from the true owner [A], and fairly purchased
of, and the price paid to the fraudulent vendee [B], without notice, by a
stranger [C], which is to sustain the loss, the owner or the stranger?” The
court’s answer: “the innocent purchaser for valuable consideration must be
protected.” The only reason mentioned by the New York court for
distinguishing fraud from theft was the one given by the English court in its
one sentence, per curiam opinion—the existence of a statute as to theft. By
mid-century, however, doctrine had developed to the point that the court
4. In the odd case in which stolen goods are stolen from a thief, the first thief has
the right to recover the goods from the second. See Hall v. Schoenwetter, 239 Conn. 553,
564, 686 A.2d 980, 985 (1996).
SECTION 1
PURCHASE OF GOODS
could write that, where fraud was involved, “the transaction is not
absolutely void, except at the option of the seller; that he may elect to treat
it as a contract, and he must do the contrary before the buyer has acted as
if it were such, and re-sold the goods to a third party.” White v. Garden, 10
C.B. 926, 138 Eng. Rep. 367 (C.P. 1851).
Professor Gilmore’s summary of the historical development deserves an
extended quotation:
The initial common law position was that equities of ownership are to
be protected at all costs: an owner may never be deprived of his property
rights without his consent. That worked well enough against a
background of local distribution where seller and buyer met face to face
and exchanged goods for cash. But as the marketplace became first
regional and then national, a recurrent situation came to be the
misappropriation of goods by a faithless agent in fraud of his principal.
Classical theory required that the principal be protected and that the
risks of agency distribution be cast on the purchaser. The market
demanded otherwise.
The first significant breach in common law property theory was the
protection of purchasers from such commercial agents. The reform was
carried out through so-called Factor’s Acts, which were widely enacted
in the early part of the 19th century. Under these Acts any person who
entrusted goods to a factor—or agent—for sale took the risk of the
factor’s selling them beyond his authority; anyone buying from a factor
in good faith, relying on his possession of the goods, and without notice
of the limitations on his authority, took good title against the true
owner. In time the Acts were expanded to protect people, i.e., banks, who
took goods from a factor as security for loans made to the factor to be
used in operating the factor’s own business. The Factor’s Acts, as much
in derogation of the common law as it is possible for a statute to be, were
restrictively construed and consequently turned out to be considerably
less than the full grant of mercantile liberty which they had first
appeared to be. Other developments in the law gradually took the
pressure off the Factor’s Acts, which came to be confined to the narrow
area of sales through commission merchants, mostly in agricultural
produce markets.
Even while they were cutting the heart out of the Factor’s Acts, the
courts were finding new ways to shift distribution risks. Their happiest
discovery was the concept of “voidable title”—a vague idea, never
defined and perhaps incapable of definition, whose greatest virtue, as a
principle of growth, may well have been its shapeless imprecision of
outline. The polar extremes of theory were these: if B buys goods from
A, he gets A’s title and can transfer it to any subsequent purchaser; if B
steals goods from A, he gets no title and can transfer none to any
subsequent purchaser, no matter how clear the purchaser’s good faith.
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“Voidable title” in B came in as an intermediate term between the two
extremes: if B gets possession of A’s goods by fraud, even though he has
no right to retain them against A, he does have the power to transfer
title to a good faith purchaser.
The ingenious distinction between “no title” in B (therefore true owner
prevails over good faith purchaser) and “voidable title” in B (therefore
true owner loses to good faith purchaser) made it possible to throw the
risk on the true owner in the typical commercial situation while
protecting him in the noncommercial one. Since the law purported to be
a deduction from basic premises, logic prevailed in some details to the
detriment of mercantile need, but on the whole voidable title proved a
useful touchstone.
The contrasting treatment given to sales on credit and sales for cash
shows the inarticulate development of the commercial principle. When
goods are delivered on credit, the seller becomes merely a creditor for
the price: on default he has no right against the goods. But when the
delivery is induced by buyer’s fraud—buyer being unable to pay or
having no intention of paying—the seller, if he acts promptly after
discovering the facts, may replevy from the buyer or reclaim from
buyer’s trustee in bankruptcy. The seller may not, however, move
against purchasers from the buyer, and the term “purchaser” includes
lenders who have made advances on the security of the goods. By his
fraudulent acquisition the buyer has obtained voidable title and
purchasers from him are protected.
Gilmore, The Commercial Doctrine of Good Faith Purchase, 63 Yale L.J.
1057, 1057–60 (1954).
Why do you suppose the UCC neither explains that a thief has void title
nor sets forth a definition of voidable title? Perhaps the drafters thought
that their project—codifying the law of sales—did not require codification
of all the basic common-law rules of personal property conveyancing. Even
if so, it remains puzzling that Article 2 contains some of the “building block”
rules (e.g., the “shelter” principle in the first sentence of UCC 2–403(1)) but
not others. Should Article 2 be revised to set forth basic conveyancing rules?
(2) Conflicting Rules on Good Faith Purchase: Unification.
Consider the observations of the Ontario Law Reform Commission:
It is necessary in every legal system to reconcile the conflict that arises
when a seller purports to transfer title of goods that he does not own, or
that are subject to an undisclosed security interest, to a person who buys
them in good faith and without notice of the defect in title. The
alternative means of resolving this conflict are usually stated in terms
of a policy favouring security of ownership, as opposed to a policy that
favours the safety of commercial transactions. Few, if indeed any, legal
systems have committed themselves fully to the adoption of one or the
SECTION 1
PURCHASE OF GOODS
other solution. Between these extremes there lies a, range of
compromise solutions that depend on the nature of the goods, the
persons involved, and the type of transaction.
2 Ontario Law Reform Commission, Report on Sale of Goods 283 (1979).
As we have seen, the common law begins with the principle that a buyer
acquires no better title to goods than the seller had. To this principle the
common law admits a number of exceptions, the most significant of which
have been the doctrine of voidable title for cases of fraud and, in Great
Britain, the doctrine of “market overt.” The latter doctrine, which was
codified in the (British) Sale of Goods Act § 22(1), would protect a good faith
purchaser of stolen goods who lacks notice of defects in the seller’s title
where the goods “are sold in market overt according to the usage of the
market.”
In recent times, however, a rule designed to promote honesty among
buyers and the integrity of the market came to be seen as providing a
charter for thieves and fences, a perception heightened by the theft of
paintings by Gainsborough and Reynolds from Lincoln’s Inn and their
sale in Bermondsey market. The market overt exception to the nemo dat
rule has now been abolished.
R. Goode, Commercial Law 425 (3d ed. 2004).
The civil law (including the law of France and Germany) begins with a
very different principle under which a good faith purchaser of goods
generally is protected against the original owner, a principle expressed in
the phrase possession vaut titre (possession is the equivalent of title). Civil
law systems therefore have no need for a doctrine of voidable title for cases
of fraud. But many such systems make an exception for cases of theft,
allowing the original owner of stolen goods to reclaim them from a good faith
purchaser within a statutory period. Some of these systems, however,
require the good faith purchaser who has acquired stolen goods at a fair or
a market or from a merchant who deals in similar goods to return the goods
to the original owner only on reimbursement of the purchase price. This rule
has particular significance when the goods have special value to the true
owner or when the purchaser has “snapped up” the goods at a cheap price
but the true owner has difficulty proving that the purchaser did not act in
good faith.
What accounts for the variety of approaches to the universal problem
raised by good faith purchasers of stolen property? One author links the
variety to “the difficulty of discerning the best solution to a hard question.
Societies may share the goal of minimizing the costs associated with the
theft of property but may disagree over the way to achieve this goal.”
Levmore, Variety and Uniformity in the Treatment of the Good–Faith
Purchaser, 16 J. Legal Stud. 43, 45 (1987). In this regard, consider Problem
1.1.1, supra. As between the two innocent parties, A and C, the more
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efficient rule would allocate the loss to the party who could have avoided the
loss at lower cost. Who is that party? Is it less costly for A to protect the
goods from theft (e.g., by hiring more guards or building a stronger fence)
than for C to protect itself from acquiring stolen goods (e.g., by investigating
the circumstances under which B acquired the goods)?
Although the lower-cost loss avoidance analysis projects an aura of
simplicity, its application can be enormously difficult. A complete analysis
would take into account not only the costs of preventing the loss but also a
variety of other costs, including the costs to A (the owner) and C (the good
faith purchaser) of insuring against the loss and the litigation costs
attendant to determining the foregoing costs. And even when efficiency
analysis can be applied with some degree of assurance, other normative
concerns may override it. Judge Posner, for example, assumes that A would
be the lower-cost loss avoider, but he explains that A is the winner under
current law (in the U.S.) because allowing C to win would encourage theft
and “[w]e do not want an efficient market in stolen goods.” R. Posner,
Economic Analysis of Law 91 (5th ed. 1998). See also Weinberg, Sales Law,
Economics, and the Negotiability of Goods, 9 J. Legal Stud. 569, 592 (1980)
(concluding that the “efficiency criterion has proved useful in explaining the
pattern of protection for legally innocent purchasers of goods that exists
under American law,” but recognizing that other issues, such as “costs of a
rule change” and “public and private costs of alternative regimes,” should
be considered before deciding to change the legal rules).
International traffic in ill-gotten goods, like other types of international
trade, seems to be accelerating. More recently, heightened concerns have
been expressed about artwork that may have been looted in Europe
immediately prior to and during World War II and about important cultural
property that has been stolen. The variations in national rules, and the
difficulty of determining which law governs, have led to efforts at
international unification of the law governing the rights of owners of stolen
goods. The most successful of these has been the Convention on Stolen or
Illegally Exported Cultural Objects, promulgated by the International
Institute for the Unification of Private Law (UNIDROIT). Article 2 of the
convention defines “cultural objects” as “those which, on religious or secular
grounds, are of importance for archaeology, prehistory, history, literature,
art or science” and which fall within one of 12 categories, including products
of archaeological excavations, antiquities more than one hundred years old,
property of artistic interest, and rare specimens of fauna, flora, minerals,
and anatomy. As of mid-2008, the convention had entered into force among
29 nations. See http://www.unidroit.org/english/implement/i-95.pdf (visited
July 9, 2008).
(3) Good Faith Purchase and Notice or Knowledge of Conflicting
Claims. To qualify as a “good faith purchaser,” a purchaser must purchase
in “good faith.” The meaning of the term depends on which state’s law
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PURCHASE OF GOODS
applies. Former Article 1 defined “good faith” as “honesty in fact.”
F1–201(19). However, UCC 2–103(1)(b) provides a more demanding
standard in the case of a merchant: “honesty in fact and the observance of
reasonable commercial standards of fair dealing in the trade.” (A similar,
two-pronged test applies to transactions governed by Articles 3, 4, 4A, and
9. UCC 3–103(a)(4); UCC 4–104(c); UCC 4A–105(a)(6); UCC 9–102(a)(43).)
Revised Article 1 adopts the two-pronged test for all UCC transactions other
than letters of credit: “honesty in fact and the observance of reasonable
commercial standards of fair dealing.” UCC 1–201(b)(20). However, of the
19 states that have adopted Revised Article 1 to date, six have retained the
“honesty in fact” definition in Article 1 and the special definition applicable
to merchants in UCC 2-103(1)(b).
Both formulations of “good faith” are silent concerning the effect of C’s
(a putative good faith purchaser from B) knowledge or notice of A’s claim to
the goods (e.g., that B had only voidable title). Despite this silence, no one
would doubt that C would not have acted in good faith if it purchased goods
with actual knowledge of B’s fraud. Aside from the relatively easy case of
actual knowledge, however, there is a wide range of possible application of
the “good faith” requirement, depending on the facts. Of what relevance is
the fact that purchasers under other UCC articles must act not only in good
faith but also without notice of claims in order to benefit from good-faith
purchase rules? See UCC 3–302(a)(2)(ii) and (v); UCC 7–501(a)(5); UCC
8–303(a)(2); UCC 9–403(b)(3). Of what relevance is the pre-UCC law? “Both
case law and commentators agree that subjective knowledge of the original
seller’s claim was not necessary to disqualify a purchaser from the
protection of the voidable-title or estoppel concepts. Reason to know or
circumstances that would put a reasonable man on inquiry were, sufficient.”
McDonnell, The Floating Lienor as Good Faith Purchaser, 50 S.Ca1.L.Rev.
429, 442 (1977).
The Third Circuit applied the UCC 2–103(1)(b) “merchant” standard of
good faith in this context. In Johnson & Johnson Products, Inc. v. Dal
International Trading Co., 798 F.2d 100 (3d Cir.1986), the court “predict[ed]
that the New Jersey Supreme Court would not impose [on a buyer] a duty
to inquire ... into the chain of title of gray market goods.” (Gray market
goods are goods legitimately manufactured and sold abroad under a
trademark and im ported for sale in competition with goods sold by the
American owner of an identical trademark.) The court apparently ignored
the possibility that “reasonable commercial standards of fair dealing in the
trade” may have required an inquiry by the buyer. See UCC 2–103(1)(b).
(4) Delivery and Good Faith Purchase. The role of delivery in good
faith purchase presents an awkward, unsolved problem under Article 2 of
the UCC. In contrast, Articles 3, 7, and 8 face the issue. Articles 3 and 7
confer protection on the “holder” of instruments and documents, which UCC
1–201(b)(21) defines as a person “in possession.” See UCC 3–305 (defenses);
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UCC 3–306 (claims); UCC 7–502. Article 8 makes clear when possession of
a stock certificate or other investment security (by the transferee itself or by
a third party acting on its behalf) is a necessary condition to becoming a
“protected purchaser” and when it is not. See UCC 8–303(a).
In analyzing the solicitude the law should pay to a buyer (C) who pays
before delivery, consider whether it is usual and necessary for a buyer to
pay before receiving the goods. In most cases of payment before delivery, is
it difficult for the buyer (C) to take precautions against misconduct by the
seller (B)? Would it be easier for the original owner (A) to take precautions?
Should it make any difference whether C has a right to possession as
against its seller, B? If C has no right to recover the goods from B, the
malefactor, it would be surprising if C could recover them from A, who also
is a victim of B’s wrongdoing. Article 2 provides pre-delivery possessory
rights to a buyer only under very limited circumstances. See UCC
2–502(1)(b) (reclamation right with respect to consumer goods if at least
part of the price is paid and the seller repudiates or fails to deliver;
reclamation right with respect to all goods “if the seller becomes insolvent
within ten days after receipt of the first installment on their price”); UCC
2–716(1) (authorizing specific performance of the sale contract “where the
goods are unique or in other proper circumstances”); UCC 2–716(3) (right
to replevin of goods identified to the contract in two limited circumstances).
See also R2–716(1) (authorizing specific performance if the parties to a
contract other than a consumer contract have agreed to that remedy). This
approach would answer Problem 1.1.3(e) in favor of A in all but a few cases.
The problem extends beyond “buyers” to a wider category—called
“purchasers”—that, as we shall see, includes those who extend credit on the
security of goods. When (in our model sequence) B gives C a security
interest in goods to secure a loan, B usually needs to keep the goods for B’s
personal or business use. Accordingly, B usually will not deliver the goods
to C. In this setting, the public filing of a “financing statement,” indicating
that C may have a security interest in the goods, is a substitute for
delivery.5 But this public filing has been conceived with concern for the
creditors of B and other “purchasers” from B—not prior owners of the goods.
Should Article 2 be revised to answer clearly the question whether
delivery, or some equivalent, objective step is necessary for protection as a
good-faith purchaser?
Problem 1.1.4. Assume that instead of buying the cotton in Problem
1.1.3, supra, C acquired a judgment against B and caused the sheriff to levy
on the cotton pursuant to a writ of execution. Before the sheriff sells the
5. As we shall see below in Section 2, filing often operates as a substitute for
delivery where the property purchased is an intangible right to payment and thus not
susceptible of delivery.
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PURCHASE OF GOODS
goods, A discovers the fraud.
(a) Who has the better claim to the goods? See UCC 2–403; Oswego
Starch Factory v. Lendrum, infra; UCC 1–201(b)(29), (b)(30); UCC 1–204;
Note(1) on Reliance and Nonreliance Parties, infra.
(b) What result if the sheriff sells the cotton to D before A discovers the
fraud? See Mazer v. Williams Bros., 461 Pa. 587, 337 A.2d 559 (1975) (buyer
at sheriff’s sale not “bona fide purchaser” under F1–201(32), (33), F8–302).
Problem 1.1.5. What result in Problem 1.1.3 if, instead of buying the
cotton, C took it as security for a loan that C had extended to B six months
earlier? See UCC 1–201(b)(29), (b)(30); UCC 1–204; Note (2) on Reliance and
Nonreliance Parties, infra.
Oswego Starch Factory v. Lendrum
Supreme Court of Iowa 1881.
57 Iowa 573, 10 N.W. 900.
Action of replevin by Oswego Starch against sheriff Lendrum. Plaintiff’s
petition alleged that plaintiff had sold and shipped goods to Thompson &
Reeves, and that this firm prior to the purchase was knowingly insolvent
and intended to defraud plaintiff of the purchase price. Defendant Lendrum
levied on the goods for creditors of Thompson & Reeves and thereafter
plaintiff elected to rescind the sale because of fraud.
Lendrum demurred on the ground, inter alia, that he and the attaching
creditors had no knowledge of the alleged fraud and that therefore the
contract could not be rescinded after the levy. From a decision for Lendrum,
plaintiff appealed.
O B ECK, J. ... [T]he point of contest involves the rights of an attaching
creditor without notice.
The title of the property was not divested by the attachment, but
remained in the vendees. The seizure conferred upon the creditors no right
to the property as against plaintiff other or different from those held by the
vendee. The sole effect of the seizure was to place the property in the
custody of the law, to be held until the creditors’ execution. They parted
with no consideration in making the attachment, and their condition as to
their claims were in no respect changed. Their acts were induced by no
representation or procurement originating with plaintiff which would in law
or equity give them rights to the property as against plaintiff. Plaintiff’s
right to rescind the sale inhered in the contract and attached to the
property. It could not be defeated except by a purchaser for value without
notice of the fraud....
Our position is simply this, that as an attaching creditor parts with no
consideration, and does not change his position as to his claim, to his
prejudice, he stands in the shoes of the vendee. . . . The innocent purchaser
11
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CHAPTER 1
for value occupies a different position, and his rights are, therefore,
different. [Reversed.]
NOTES ON RELIANCE AND NONRELIANCE PARTIES
(1) The Position of a Creditor Who Levies. Oswego Starch concerns
an attempt by creditors of Thompson & Reeves to use the judicial process to
collect a debt owed to them by the firm. Courses on Creditors’ Rights provide
a detailed examination of the legal process for collection of debts. For our
purposes, the following, highly simplified overview should suffice. Collecting
a debt through the judicial process typically involves three steps. The first
is to obtain a judgment against the debtor. The second is to acquire a lien
on particular property of the judgment debtor. The third is to turn the lien
into cash.
A lien is a property interest of a particular kind. The holder of the lien
(the lienor) may use the property subject to the lien for only one purpose,
to apply toward satisfaction of the debt it secures. A lien that arises through
the judicial process is called a judicial lien. It must be distinguished from
a lien that arises by agreement of the parties, known as a consensual lien
or security interest. Although state laws and procedures governing
postjudgment liens vary, generally speaking a judgment creditor acquires
a judicial lien on personal property, such as goods and rights to payment, in
one of two ways.6 The creditor may obtain from the clerk of the court a writ
of execution, instructing the sheriff to levy upon or attach (seize) goods or
other personal property of the judgment debtor located within the sheriff’s
bailiwick (usually a county). In the majority of states, the creditor acquires
an execution lien (which is a species of judicial lien) on whatever property
the sheriff levies upon before the writ expires.7
While levy is a suitable means for acquiring a lien upon tangible
personal property, a different method is necessary when the creditor seeks
6. In most states, a judgment creditor may obtain a judicial lien on a debtor's real
property by recording a memorandum or abstract of the judgment in the real estate
records or (depending on local law) having the court clerk enter the judgment in the
docket book. Upon the recordation or docketing, a judgment lien (which is a species of
judicial lien) arises on all of the debtor's interests in real property in the county. In only
a few states does a judgment lien extend to personal property. See, e.g., Cal. Code Civ.
Proc. § 697.530 (judgment lien arises on most nonexempt personal property upon filing
a notice with the Secretary of State). Because this book is concerned exclusively with
personal property, we shall have no more to say about judgment liens.
7. In a minority of states, an inchoate execution lien arises on all property of the
judgment debtor that is located and that can be found within the bailiwick when the writ
is delivered to the sheriff; however, the inchoate lien cannot be enforced against specific
property until the sheriff levies upon the property and the lien becomes consummate.
If the sheriff fails to levy before the writ expires, the inchoate lien is discharged.
SECTION 1
PURCHASE OF GOODS
to acquire a lien on a debtor’s intangible personal property, which, by its
very nature, cannot be seized. A common example of intangible property is
a right to payment from a third party. Suppose, for example, that Creditor
has reason to know that Dana, its judgment debtor, has a $100 claim
against Kerry. Creditor could cause the clerk of the court to issue a writ of
garnishment instructing Kerry (the garnishee) to inform the court whether
Kerry is indebted to Dana and, if so, for how much. In most jurisdictions, a
garnishment lien (which is another species of judicial lien) on Dana’s right
to payment from Kerry arises when the writ is served upon Kerry.
Garnishments often are used to reach bank accounts. This is because a bank
account is actually a debt owed by the bank to its depositor.
Oswego Starch concerns yet another species of judicial lien—an
attachment lien. Before they obtained judgment against Thompson &
Reeves, certain creditors obtained a writ of attachment, which instructed
the sheriff, Lendrum, to levy upon (i.e., seize) property belonging to
Thompson & Reeves.8 After the sheriff’s levy, the plaintiff, Oswego Starch,
sought to replevy the goods from Lendrum on the ground that Thompson &
Reeves had obtained them from Oswego Starch by fraud.
The Oswego Starch decision represents the preponderant view of the
pre-UCC case law. See 3 Williston, Sales § 620 (1948). Is it persuasive?
What is the basis of the distinction the court draws between a judicial lien
creditor, against whom the right to rescind may be exercised, and a
“purchaser for value,” who would defeat this right? Is the court correct that
“an attaching creditor parts with no consideration”? If so, then how could
the creditors in Oswego Starch have obtained judgment against Thompson
& Reeves, the debtor?
Does UCC 2–403(1) change the pre-UCC result? B’s rights to the goods
are subject to A’s right to rescind the transaction and recover the goods. See
Problem 1.1.3, supra. But does B have power to convey greater rights? Even
if B has “voidable title” (see Note (1) on the Basic Conveyancing Rules,
supra), the answer is “no,” unless the lien creditor is a “good faith purchaser
for value.”
8. Most states make some provision for attachment, and other prejudgment, liens
under limited circumstances, e.g., upon a showing that the defendant is about to abscond
from the jurisdiction or hide property otherwise available to creditors. Prejudgment liens
are similar in many ways to postjudgment liens. The principal difference is that the
creditor ordinarily cannot cause the former to be turned into cash until judgment is
entered against the defendant-debtor. Many of the restrictions on the availability of
prejudgment remedies, including those affording the debtor notice of the exercise of the
remedy and an opportunity to be heard, reflect cases decided under the Due Process
Clause of the Fourteenth Amendment. See, e.g., North Georgia Finishing, Inc. v.
Di–Chem, Inc., 419 U.S. 601, 95 S.Ct. 719, 42 L.Ed.2d 751 (1975) (discussing
constitutional requirements surrounding prejudgment garnishment of corporate debtor's
bank account).
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CHAPTER 1
A lien creditor is likely to meet the good faith and value requirements.
See UCC 1–201(b)(20); UCC 1–204. Is the lien creditor a “purchaser”? The
UCC defines “purchase” (UCC 1–201(b)(29)) to include “taking by sale,
discount, negotiation, mortgage, pledge, lien, security interest, issue or
re-issue, gift or any other voluntary transaction creating an interest in
property.” One will note that the list of transactions includes “taking by . . .
lien,” and a judgment creditor who levies execution on property often is
called a “lien creditor.” See UCC 9–102(a)(52). But the word “lien” is a
chameleon; prior to the UCC voluntary transactions creating mortgages and
similar security interests were often said to create a “lien.” In the setting of
the types of transactions listed in the definition of “purchase” and the
concluding characterization that the list applies to “any other voluntary
transaction,” it seems fairly clear that the drafters did not mean to say that
the seizure of a debtor’s property by a sheriff acting for a creditor makes the
creditor a “purchaser.” This conclusion becomes inescapable in the light of
UCC sections that distinguish between, on the one hand, lien creditors and,
on the other, transferees or purchasers. See, e.g., UCC 9–317(a), (b).
Does any policy justify distinguishing between a judicial lien creditor
and a buyer? Consider some of the ways in which the two are different.
Unlike a buyer, who contracts to purchase all of the rights to the goods, a
lien creditor acquires only a limited interest in (i.e., a lien on) the goods.
And unlike a buyer, whose rights arise by virtue of its contract, a judicial
lien creditor acquires its rights through the judicial process. Finally,
whereas a buyer typically acquires its rights in exchange for new
consideration (current payment or a promise to pay), a lien creditor’s
extension of credit is divorced from the property on which it subsequently
obtains a lien. Is any of these distinctions relevant?
(2) The Position of an Article 9 Secured Party. All things being
equal, a creditor would be in a better position if it could acquire a lien
without first having to obtain a judgment and invoke the power of the
sheriff. At the time a creditor extends credit, or at any time thereafter, the
creditor and debtor may agree that the creditor would have a limited
interest in particular property. The nature of this interest is such that if the
debtor fails to pay, the creditor may cause the property to be sold and apply
the proceeds to the satisfaction of its claim without the need to incur the
costs and delay attendant to obtaining a judgment and collecting it through
the judicial process. When the property concerned is personal property, this
kind of consensual lien, which arises by the agreement of the parties, is
called a security interest. (A consensual security interest must be
distinguished from a judicial lien, which arises through the exercise of
judicial process, and a statutory lien, which arises by operation of law in
favor of certain suppliers of goods and services.) A security interest affords
yet another benefit to the holder that a judicial lien does not. Whereas the
law governing judicial liens differs from state to state, the law governing
SECTION 1
PURCHASE OF GOODS
security interests, including the rights and duties of the immediate parties
(debtor and creditor) and the rights of third parties, is found largely in UCC
Article 9.
Like a judicial lien creditor, an Article 9 secured party can be expected
ordinarily to meet the good faith and value requirements.9 But unlike a
judicial lien creditor, a secured party is a “purchaser” as defined in UCC
1–201. This means that an Article 9 secured party, like a buyer, may cut off
A’s right to rescind a transaction and recover goods, whereas a judicial lien
creditor cannot. Can one justify this distinction?
One can draw several comparisons with buyers and judicial lien
creditors. An Article 9 secured party is like a buyer, in that its rights in the
goods (a security interest, defined in UCC 1–201(b)(35)) arise by contract.
See UCC 9–109(a)(1). It is like a judicial lien creditor in that it acquires only
a limited interest in the goods. This limited interest entitles the secured
party, upon its debtor’s (B’s) default, to repossess the goods, sell them, and
apply the proceeds to its claim against the debtor.
Sometimes, an Article 9 secured party takes a security interest in
specific goods owned by the debtor at the time the loan is made or acquired
by the debtor in conjunction with the extension of credit. In this respect a
secured party is like a buyer, exchanging new consideration for an interest
in goods. Other times, as in Problem 1.1.5, supra, an Article 9 secured party
takes a security interest to secure an antecedent debt, i.e., a debt owed
before the security interest is taken. This secured party seems to be
analogous to a judicial lien creditor—it has extended credit on an unsecured
basis, and its acquisition of rights in particular property is not a quid pro
quo for the loan (although it may have taken the security interest in
exchange for its forbearance in exercising its remedies).
(3) The Role of Reliance in Resolving Competing Claims. Personal
property law often distinguishes among third-party claimants on the basis
of whether they gave value in reliance upon the transferor’s (in our case,
B’s) apparent ownership of particular property. This distinction is reflected
in Oswego Starch, supra, as well as in Mowrey v. Walsh, 8 Cow. 238, 245
(N.Y.Sup.Ct.1828) (“The judgment creditor had not advanced money upon
these goods, and his loss placed him in no worse situation than he was in
before the fraud.”).
What is the appropriate role for reliance to play in resolving competing
claims to goods? Consider the following:
(i) Is a third party’s reliance on its transferor’s apparent ownership
of goods at all relevant to whether that party’s claim to goods should
prevail?
9. The most serious challenge to a secured party's good faith is likely to arise from
its knowledge or notice of competing claims. See Note (3) on the Basic Conveyancing
Rules, supra.
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(ii) If reliance is relevant, should the strength of a person’s claim to
goods turn on whether the person actually relied, or should it turn on (i)
whether the person belongs to a class that generally relies and on (ii)
whether, had the person investigated, it would have uncovered facts
that would have formed the basis for reasonable reliance upon the
debtor’s ownership (e.g., the goods in question were located in the
debtor’s warehouse in boxes addressed to the debtor)?
(iii) As an empirical matter, do buyers generally give value in
reliance upon their seller’s apparent ownership of particular property?
Do judicial lien creditors? Do Article 9 secured parties?
Problem 1.1.6. A owned cotton worth $100,000. A placed it in storage
with B, who not only stores cotton but also regularly buys and sells it. B
wrongfully sold and delivered the cotton to C, who did not suspect B’s
wrongdoing, for $100,000. A sues C to replevy the cotton.
(a) What result? See UCC 2–403; UCC 1–201(b)(9); Notes on
Entrustment, infra.
(b) What result in part (a) if C had promised to pay $100,000 but has not
yet paid it when A claims the cotton?
(c) What result in part (a) if C, instead of buying the cotton from B, had
taken it as security for a loan that C had extended to B six months earlier.
Compare Problem 1.1.5, supra.
(d) What result if B had wrongfully delivered the cotton to C who is in
the cotton business, as security for a loan that C had extended to B six
months earlier, and C had sold the cotton to D, who suspected nothing, for
$100,000? Cf. Canterra Petroleum, Inc. v. Western Drilling & Mining
Supply, 418 N.W.2d 267 (N.D.1987) (buyer in ordinary course of business
can cut off rights of true owner who entrusts goods to merchant-dealer when
employees of merchant-dealer transfer goods to “dummy corporation,” which
then sells to the buyer). See also PEB Article 2 Report 130 (“[I]t should be
made clear that if the goods are entrusted to Merchant #1, who sells to
non-BIOCB [non-buyer in ordinary course of business] Merchant #2, who
sells to BIOCB, the BIOCB takes ‘all rights’ or takes ‘free’ of a security
interest.”). Would the result be different if B had wrongfully delivered the
cotton to C for temporary storage purposes and not as security?
NOTES ON ENTRUSTMENT
(1) The Historical Development of the Law of “Entrusting.” UCC
2–403(2) represents a sharp break with the traditional law of good faith
purchase. Under facts similar to those in Problem 1.1.6, the common law
usually favored the original owner. Merely entrusting possession to a dealer
was not sufficient to clothe the dealer with the authority to sell. “If it were
otherwise people would not be secure in sending their watches or articles of
SECTION 1
PURCHASE OF GOODS
jewelry to a jeweller’s [sic] establishment to be repaired, or cloth to a
clothing establishment to be made into garments.” Levi v. Booth, 58 Md. 305
(1882).
During the nineteenth century, however, many states enacted “Factor’s
Acts” under which an owner of goods who entrusted them to an agent (or
“factor”) for sale took the risk that the agent might sell them beyond the
agent’s authority. A good faith purchaser from the agent, relying on the
agent’s possession of the goods and having no notice that the agent’s sale
was unauthorized, took good title against the original owner. (See the
discussion by Professor Gilmore in Note (1) on the Basic Conveyancing
Principles, supra.) But the Factor’s Acts did not protect the good faith
purchaser where, as in Problem 1.1.6, the owner entrusted the goods to
another for some purpose other than that of sale. A mere bailee could not
pass good title, even to a good faith purchaser for value.
In this regard UCC 2–403(2) goes well beyond the Factor’s Acts, since
it applies to “[a]ny entrusting,” i.e., “any delivery” under UCC 2–403(3),
regardless of the purpose. The section gives protection, however, only to a
“buyer,” not to all those who give value and take in good faith from the
person to whom the goods are entrusted. Contrast the narrow scope of
“buyer in ordinary course” under UCC 1–201(b)(9) with the definitions of
“purchase” and “purchaser” in UCC 1–201(b)(29) and UCC 1–201(b)(30). See
Comment 3 to UCC 2–403. 10
(2) Testing the Limits of UCC 2–403(2): Porter v. Wertz. Despite its
apparent simplicity, UCC 2–403(2) contains a number of wrinkles, several
of which came to light in Porter v. Wertz, 68 A.D.2d 141, 416 N.Y.S.2d 254
(1979), affirmed mem., 53 N.Y.2d 696, 439 N.Y.S.2d 105, 421 N.E.2d 500
(1981), a case with particularly interesting facts:
Samuel Porter, an art collector, owned Utrillo’s painting “Chateau de
Lion-sur-Mer,” but lost the painting through the machinations of one Harold
10. According to Professor Gilmore: “For some reason, the security transferees who
were protected in the voidable title subsection by the use of the term ‘purchaser’ do not
qualify for protection under the entrusting section. I have no idea why the draftsmen
chose thus to narrow the protected class.” Gilmore, The Good Faith Purchase Idea and
the Uniform Commercial Code: Confessions of a Repentant Draftsman, 15 Ga. L. Rev.
605, 618 (1981). The Ontario Law Reform Commission was “attracted to the distinction”:
The supporting theory is, presumably, grounded on either of the following premises:
namely, that commerce will not be impeded if lenders are required to assume the
risk of a merchant-borrower exceeding his actual authority; or, that lenders are in
as good a position as are entrusters, or perhaps even better, to protect themselves
against a dishonest merchant.
2 Ontario Law Reform Commission, Report on Sale of Goods 314–15 (1979).
It also has been suggested that transfers for security are transfers “in which the
price or consideration received for the goods . . . is likely to be considerably less than the
amount normally received in a sale of the same goods in other transactions.” Leary &
Sperling, The Outer Limits of Entrusting, 35 Ark.L.Rev. 50, 65 (1981).
17
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CHAPTER 1
“Von” Maker—sometimes operating under the name of Peter Wertz, a junior
collaborator over whom, the trial judge observed, Von M aker “cast his
hypnotic spell . . . and usurped his name, his signature and his sacred
honor.”
Von Maker had engaged in several transactions as an art dealer. (Other
activities had led to arrests for possession of obscene literature and theft of
checks, and to conviction for transmitting a forged cable in connection with
a scheme to defraud the Chase Manhattan Bank.) Von Maker (alias
“Wertz”), in his capacity as art dealer, approached Porter and expressed an
interest in the Utrillo. Porter, unaware of Von Maker’s illegal activities,
permitted Von Maker to hang the Utrillo temporarily in Von Maker’s home
pending a decision as to purchase.
Without Porter’s knowledge, Von Maker’s junior collaborator, the true
Peter Wertz, sold the Utrillo to an art dealer, Feigen Galleries. Feigen sold
the painting to Brenner, who resold it to a third party, who took the
painting to South America.
Porter brought actions for conversion against Wertz and Von Maker and
also against the purchasers, Feigen and Brenner. Defendant Feigen argued
that Porter “entrusted” the painting to Von Maker and as a consequence: (1)
Feigen was protected under UCC 2–403(2) as a “buyer in ordinary course of
business,” and (2) Porter’s claim as owner was barred by equitable estoppel.
The trial court rejected Feigen’s defense based on UCC 2–403(2) but
concluded that Porter was barred by equitable estoppel and dismissed his
action. The Appellate Division reversed the trial court and held that neither
statutory estoppel (UCC 2–403(2)) nor equitable estoppel barred recovery.
It found that Feigen was not a buyer in ordinary course because Wertz, from
whom Feigen bought the Utrillo, was not an art dealer (“[i]f anything, he
was a delicatessen employee”) and because Feigen did not act in good faith
(good faith, as defined in UCC 2–103(1)(b) “should not—and cannot—be
interpreted to permit, countenance, or condone commercial standards of
sharp trade practice or indifference as to the ‘provenance’, i.e., history of
ownership or the right to possess or sell an object d’art, such as is present
in the case before us.”).
Feigen appealed to the Court of Appeals, which affirmed the Appellate
Division. The court wrote (421 N.E.2d at 501):
Because Peter Wertz was not an art dealer and the Appellate
Division has found that Feigen was not duped by Von M aker into
believing that Peter Wertz was such a dealer, subdivision (2) of section
2–403 of the Uniform Commercial Code is inapplicable for three distinct
reasons: (1) even if Peter Wertz were an art merchant rather than a
delicatessen employee, he is not the same merchant to whom Porter
entrusted the Utrillo painting; (2) Wertz was not an art merchant; and
(3) the sale was not in the ordinary course of Wertz’ business because he
SECTION 2
ASSIGNMENT OF INTERESTS IN RIGHTS TO PAYMENT
did not deal in goods of that kind [F 1–201(9)]. 11
Would it have made any difference if Feigen had bought the Utrillo from
Von Maker rather than from Wertz? Why?
What is the relevance, if any, of the knowledge of either the entruster or
the buyer? Does it make a difference under UCC 2–403(2) if the original
owner of the goods does not know that the person to whom the owner
entrusts them is a merchant who deals in goods of that kind? See Atlas Auto
Rental Corp. v. Weisberg, 54 Misc.2d 168, 281 N.Y.S.2d 400 (Civ.Ct.1967)
(knowledge of dealer-merchant status is necessary element of entrusting).
Accord, Leary & Sperling, The Outer Limits of Entrusting, 35 Ark. L. Rev.
50, 83–85 (1981) (relying on Atlas Auto). But cf. Antigo Co-op. Credit Union
v. Miller, 86 Wis.2d 90, 271 N.W.2d 642 (1978) (knowledge by secured party
that debtor was a dealer-merchant not necessary for applicability of
analogous provision in F9–307(1)).
Suppose Feigen had been duped by Von M aker into believing that Wertz
was an art dealer. Suppose that Feigen had been duped by Wertz, who held
himself out as an art dealer. Compare UCC 2–104(1) with UCC 2–403(2). In
Sea Harvest, Inc. v. Rig & Crane Equipment Corp., 181 N.J.Super. 41, 436
A.2d 553 (1981), the court said: “A buyer’s misunderstanding that the seller
was in the business of selling does not improve the former’s position.” Do
you agree with this reading of the UCC?
S ECTION 2.
P AYMENT
A SSIGNMENT OF I NTERESTS IN R IGHTS TO
We turn now from transfers of goods to assignments of rights to payment
(or, as they often are called, receivables). 1 One can earn a right to payment
in a wide variety of settings. Lenders of money and sellers of goods, services,
and real property come readily to mind. But persons who are entitled to a
tax refund or who win the Powerball jackpot likewise enjoy a right to
payment, as do tort victims and ex-spouses in whose favor a judge has
entered a support order.
Like an interest in goods, an interest in a right to be paid is property.
Just as the owner of goods can sell them or use them to secure a loan, a
person who has a right to be paid at a future time can assign that right in
order to obtain funds now. The rules governing transfers of interests in
11. Although it received amicus briefs on the “good faith” question from both the
New York State Attorney General (arguing that good faith among art merchants requires
inquiry as to ownership) and the Art Dealers Association of America, Inc. (arguing that
a duty of inquiry would cripple the art business), the court found no need to reach the
question.
1. The term “assignment” commonly refers to voluntary transfers of rights to
payment, claims, and security interests and other liens.
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CHAPTER 1
goods take account of the fact that goods are tangible. See, e.g., UCC
2–403(2) (“entrustment” rule). Rights to payment are intangible; you can’t
see them; you can’t touch them. The legal rules governing the purchase of
rights to payment often reflect this practical difference.
Many rights to payment are evidenced by a writing; others are evidenced
by an electronic record. These written and electronic records may have legal
significance for purposes of the Statute of Frauds or under the rules of
evidence; however, as we shall see, most have no legal significance insofar
as assignment of the right to payment is concerned. Rights to payment that
are embodied in a negotiable instrument (as defined in UCC 3–104(a)) are
an exception to this general rule. Negotiable instruments constitute a type
of property in which an intangible right takes on some of the attributes of
the tangible piece of paper that evidences the right. As such they fall into
an intermediate category between tangible and intangible property.
(A) C OMPETING C LAIMS TO N EGOTIABLE N OTES
Problem 1.2.1. A sold and delivered goods to Q, who promised to pay
$5,000 for them 30 days after delivery. Q’s obligation to pay was evidenced
by a purchase order. (An example of a purchase order form appears on page
22, infra.) B stole the purchase order from A and delivered it, together with
B’s signed assignment of the right to payment, to C, who paid B $4,200 and
took possession of the assignment without suspecting B’s wrongdoing. Who
owns the right to be paid by Q? Does UCC Article 2 apply? See UCC
2–105(1) [R2–103(1)(k)].
Problem 1.2.2. A owned $1,000 in $100 Federal Reserve Notes. B stole
the $1,000 and gave it to C, who did not suspect the theft, in payment for
cotton. A sues C to replevy the money. What result? Does Article 2 or 3 of
the UCC apply? See UCC 2–105(1) [R2–103(1)(k)]; UCC 1–201(b)(24); UCC
3–102(a); UCC 3–104(a), (e); Miller v. Race, infra. See also In re Koreag,
Controle et Revision S.A., 961 F.2d 341 (2d Cir.1992) (in currency exchange
contract “money is not the medium of exchange, but rather the object of
exchange” and “currency thus constitutes ‘goods’” under Article 2); City of
Portland v. Berry, 86 Or. App. 376, 739 P.2d 1041 (1987) (“money rule”
applied to $500 and $1,000 bills though Treasury has not printed them since
1945 and “has been systematically taking them out of circulation and
destroying them since 1969”).
Problem 1.2.3. A was the owner of a negotiable promissory note, made
by M, who promised “to pay on demand to bearer $1,000.” B stole the note
from A and gave it to C, who did not suspect the theft, in return for $950. A
sues C to replevy the note.
(a) What result? See UCC 3–306; UCC 3–302; UCC 1–201(b)(21); UCC
3–201; UCC 3–109; UCC 3–303; Miller v. Race, infra; Note (3) on N egotiable
Instruments and Negotiation, infra.
SECTION 2
(b) Would it make a difference if the note were dated May 15, 2003, and
C purchased it on February 18, 2008? See UCC 3–304(a).
by M, who promised “to pay on demand to the order of A $1,000.” B stole it
from A and for $950 sold it to C, who did not suspect the theft. A sues C to
replevy the note.
(a) What result? See UCC 3–306; UCC 3–302; UCC 1–201(b)(21); UCC
3–201; UCC 3–205; UCC 3–403; UCC 1–201(b)(41). (As to B’s liability to C,
see UCC 3–416(a)(2).)
(b) What result if, before selling the note to C, B had indorsed the note
on the back by forging A’s signature?
(c) What result if, before the theft, A had indorsed the note on the back
by signing “A”?
(d) What result if, before the theft, A had indorsed the note on the back
by writing “Pay to the order of P, (signed) A”?
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CHAPTER 1
PURCHASE ORDER FORM
SECTION 2
Miller v. Race
Court of King’s Bench 1758.
1 Burr. 452, 97 Eng. Rep. 398.
It was an action of trover against the defendant, upon a bank note, [*] for
the payment of twenty-one pounds ten shillings to one William Finney or
bearer, on demand.
The cause came on to be tried before Lord M ansfield at the sittings in
Trinity term last at Guildhall, London: and upon the trial it appeared that
William Finney, being possessed of this bank note on the 11th of December
1756, sent it by the general post, under cover, directed to one Bernard
Odenharty, at Chipping Norton in Oxfordshire; that on the same night the
mail was robbed, and the bank note in question (amongst other notes) taken
and carried away by the robber; that this bank note, on the 12th of the same
December, came into the hands and possession of the plaintiff, for a full and
valuable consideration, and in the usual course and way of his business, and
without any notice or knowledge of this bank note being taken out of the
mail.
It was admitted and agreed, that, in the common and known course of
trade, bank notes are paid by and received of the holder or possessor of
them, as cash; and that in the usual way of negotiating bank notes, they
pass from one person to another as cash, by delivery only and without any
further inquiry or evidence of title, than what arises from the possession. It
appeared that Mr. Finney, having notice of this robbery, on the 13th
December, applied to the Bank of England, “to stop the payment of this
note:” which was ordered accordingly, upon M r. Finney’s entering into
proper security “to indemnify the bank.”
Some little time after this, the plaintiff applied to the bank for the
payment of this note; and for that purpose delivered the note to the
defendant, who is a clerk in the bank: but the defendant refused either to
pay the note, or to re-deliver it to the plaintiff. Upon which this action was
brought against the defendant.
The jury found a verdict for the plaintiff, and the sum of 21l. 10s.
damages, subject nevertheless to the opinion of this Court upon this
question—“Whether under the circumstances of this case, the plaintiff had
a sufficient property in this bank note, to entitle him to recover in the
present action?” . . .
L ORD M ANSFIELD now delivered the resolution of the Court.
After stating the case at large, he declared that at the trial, he had no
sort of doubt, but this action was well brought, and would lie against the
*. [Bank of England notes did not become legal tender until 1833. 3 & 4 Wm. IV,
c. 98, § 6. Until 1931 the holder of a bank note had a right to payment of the note in
gold.]
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defendant in the present case; upon the general course of business, and from
the consequences to trade and commerce: which would be much incommoded
by a contrary determination.
It has been very ingeniously argued by Sir Richard Lloyd for the
defendant. But the whole fallacy of the argument turns upon comparing
bank notes to what they do not resemble, and what they ought not to be
compared to, viz. to goods, or to securities, or documents for debts.
Now they are not goods, not securities, nor documents for debts, nor are
so esteemed: but are treated as money, as cash, in the ordinary course and
transaction of business, by the general consent of mankind; which gives
them the credit and currency of money, to all intents and purposes. They are
as much money, as guineas themselves are; or any other current coin, that
is used in common payments, as money or cash.
They pass by a will, which bequeaths all the testator’s money or cash;
and are never considered as securities for money, but as money itself. Upon
Ld. Ailesbury’s will, 900l. in bank-notes was considered as cash. On
payment of them, whenever a receipt is required, the receipts are always
given as for money; not as for securities or notes.
So on bankruptcies, they cannot be followed as identical and
distinguishable from money: but are always considered as money or cash.
It is a pity that reporters sometimes catch at quaint expressions that
may happen to be dropped at the Bar or Bench; and mistake their meaning.
It has been quaintly said, “that the reason why money can not be followed
is, because it has no ear-mark:” but this is not true. The true reason is, upon
account of the currency of it: it can not be recovered after it has passed in
currency. So, in case of money stolen, the true owner can not recover it, after
it has been paid away fairly and honestly upon a valuable and bona fide
consideration: but before money has passed in currency, an action may be
brought for the money itself. There was a case in 1 G. 1, at the sittings,
Thomas v. Whip, before Ld. Macclesfield: which was an action upon
assumpsit, by an administrator against the defendant, for money had and
received to his use. The defendant was nurse to the intestate during his
sickness; and, being alone, conveyed away the money. And Ld. Macclesfield
held that the action lay. Now this must be esteemed a finding at least.
Apply this to the case of a bank-note. An action may lie against the
finder, it is true; (and it is not at all denied:) but not after it has been paid
away in currency. And this point has been determined, even in the infancy
of bank-notes; for 1 Salk. 126, M. 10 W. 3, at Nisi Prius, is in point. And Ld.
Ch. J. Holt there says that it is “by reason of the course of trade; which
creates a property in the assignee or bearer.” (And “the bearer” is a more
proper expression than assignee.)
Here, an inn-keeper took it, bona fide, in his business from a person who
made an appearance of a gentleman. Here is no pretence or suspicion of
SECTION 2
collusion with the robber: for this matter was strictly inquired and
examined into at the trial; and is so stated in the case, “that he took it for
a full and valuable consideration, in the usual course of business.” Indeed
if there had been any collusion, or any circumstances of unfair dealing, the
case had been much otherwise. If it had been a note for 1000l. it might have
been suspicious: but this was a small note for 21l. 10s. only: and money
given in exchange for it.
Another case cited was a loose note in 1 Ld.Raym. 738, ruled by Ld. Ch.
J. Holt at Guildhall, in 1698; which proves nothing for the defendant’s side
of the question: but it is exactly agreeable to what is laid down by my Ld.
Ch. J. Holt, in the case I have just mentioned. The action did not lie against
the assignee of the bank-bill; because he had it for valuable consideration.
In that case, he had it from the person who found it: but the action did
not lie against him, because he took it in the course of currency; and
therefore it could not be followed in his hands. It never shall be followed into
the hands of a person who bona fide took it in the course of currency, and in
the way of his business.
The case of Ford v. Hopkins, was also cited: which was in Hil. 12 W. 3,
coram Holt Ch. J. at Nisi Prius, at Guildhall; and was an action of trover for
million-lottery tickets. But this must be a very incorrect report of that case:
it is impossible that it can be a true representation of what Ld. Ch. J. Holt
said. It represents him as speaking of bank-notes, Exchequer-notes, and
million lottery tickets, as like to each other. Now no two things can be more
unlike to each other than a lottery-ticket, and a bank-note. Lottery tickets
are identical and specific: specific actions lie for them. They may prove
extremely unequal in value: one may be a prize; another, a blank. Land is
not more specific than lottery-tickets are. It is there said, “that the delivery
of the plaintiff’s tickets to the defendant, as that case was, was no change
of property.” And most clearly it was no change of the property; so far, the
case is right. But it is here urged as a proof “that the true owner may follow
a stolen bank-note, into what hands soever it shall come.”
Now the whole of that case turns upon the throwing in banknotes, as
being like to lottery-tickets.
But Ld. Ch. J. Holt could never say “that an action would lie against the
person who, for a valuable consideration, had received a bank note which
had been stolen or lost, and bona fide paid to him:” even though the action
was brought by the true owner: because he had determined otherwise, but
two years before; and because banknotes are not like lottery-tickets, but
money.
The person who took down this case, certainly misunderstood Lord Ch.
J. Holt, or mistook his reasons. For this reasoning would prove, (if it was
true, as the reporter represents it,) that if a man paid to a goldsmith 500l.
in bank-notes, the goldsmith could never pay them away.
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A bank-note is constantly and universally, both at home and abroad,
treated as money, as cash; and paid and received, as cash; and it is
necessary, for the purposes of commerce, that their currency should be
established and secured.
Lord Mansfield declared that the Court were all of the same opinion, for
the plaintiff; and that Mr. Just. Wilmot concurred.
Rule—That the postea be delivered to the plaintiff.
BANK OF ENGLAND NOTE 2
FEDERAL RESERVE NOTE
Open your wallet and take a look.
2.
This is not the very note that was the subject of Miller v. Race.
SECTION 2
FORM OF COMMERCIAL PROMISSORY NOTE
[Front]
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SECTION 2
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FORM OF COMMERCIAL PROMISSORY NOTE
[Back]
SECTION 2
NOTES ON NEGOTIABLE INSTRUMENTS AND NEGOTIATION
(1) Negotiable Instruments and Negotiability. UCC Article 3
applies to “negotiable instruments.” UCC 3–104(a), which defines the term,
preserves the tradition that, in negotiable instruments law, form triumphs
over substance. The term includes only a “promise” (defined in UCC
3–103(a)(9)) or an “order” (defined in UCC 3–103(a)(6)) to pay a fixed
amount of “money” (defined in UCC 1–201(b)(24)). An instrument is a “note”
if it is a promise to pay and a “draft” if it is an order to pay. UCC 3–104(e).
The most common form of draft is a “check.” As used in Article 3, “check”
includes an order to a bank that is payable on demand. UCC 3–104(f).
Other sections in Part 1 of Article 3 explain the requirements that the
promise or order be “unconditional” (UCC 3–106); that it be for a fixed
amount of money, with or without “interest” (UCC 3–112(b)); that it be
“payable to bearer or to order” (UCC 3–109); and that it be “payable on
demand” or “at a definite time” (UCC 3–108). Still other sections in Part 1
are devoted to other aspects of the form of negotiable instruments.
We consider UCC 3–104 and the “formal requisites” of negotiability in
greater detail below. See Problem 1.2.11 and the related materials. For now
it suffices to observe that these formal requirements were based initially on
commercial practice and case law. They were embodied in the pre–1990
version of UCC Article 3 and its predecessors, the Negotiable Instruments
Law of 1896 (which was adopted in each of the United States) and the
(British) Bills of Exchange Act of 1882. The continued emphasis on form
may seem an anachronism, but perhaps it serves a purpose. Rights to
payment that are embodied in negotiable instruments constitute a different
kind of property from rights to payment that are not so embodied. One who
owns, or becomes a party to, a negotiable instrument assumes special risks.
The formal requisites, like the fence and warnings around high voltage
equipment, arguably confine and identify the danger areas. Of course, the
formalities afford no warning to one who is unfamiliar with this specialized
branch of the law.
(2) Uses of the Negotiable Note. Lord Mansfield’s opinion in Miller
v. Race rests on what he perceives to be the commercial utility of enabling
those who are paid in bank notes, like those who are paid in cash, not to
worry about where the paper has been: “[T]rade and commerce . . . would be
much incommoded by a contrary determination.” Nor need a person who
takes payment in bank notes be concerned about the transaction giving rise
to the note. As Lord Mansfield stated in a later opinion, “The law is settled,
that a holder, coming fairly by a bill or note, has nothing to do with the
transaction between the original parties . . . .” Peacock v. Rhodes, 2 Doug.
636, 99 Eng. Rep. 403 (K.B. 1781).
Today, of course, people do not use promissory notes—even notes made
by banks—like cash. Would trade and commerce suffer if takers of stolen
promissory notes ran the risk that the notes were stolen? If the rationale of
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Miller v. Race does not explain the result in Problem 1.2.3, then what does?
In the commercial setting, negotiable notes rarely are used to evidence
an obligation to pay for goods sold on credit.3 When a negotiable note is
used, it typically is in connection with a loan of money. Nevertheless, in
either case, the payee (i.e., the person to whom the note is payable) may sell
the note or use it to secure a loan. Like Article 2, Article 3 contains both
security-of-property and good-faith-purchase rules governing the extent to
which a purchaser (buyer or secured party) takes a negotiable instrument
free from competing claims. Unless a person has the rights of a holder in
due course (“HDC”), the person takes the instrument subject to any existing
claim of a property or possessory right in the instrument or its proceeds.
UCC 3–306. A person having the rights of a holder in due course takes free
of the claim to the instrument. Id. The freedom from “claims” is analogous
to the protection from ownership interests that Article 2 affords to a good
faith purchaser of goods. See UCC 2–403 and Section 1, supra.
(3) Holder in Due Course. “Holder in due course” is the name given
to certain good faith purchasers for value of negotiable instruments under
Article 3. UCC 3–302(a) defines the term. Observe that not every person
who takes an instrument in good faith and for value qualifies as an HDC.
One also must be without notice of any of a variety of claims, defenses, and
irregularities. (You may recall that notice of competing claims may be
relevant to a putative good faith purchaser’s “good faith” under Article 2.)
Two other requirements for becoming a holder in due course are less
obvious. First, one must be the holder of an “instrument,” which UCC
3–104(b) defines as a “negotiable instrument.” Second, the person must be
a “holder.” When the instrument is payable to an identified person and the
identified person is in possession of the instrument, the person is the holder.
Alternatively, when the instrument is payable to bearer, the person in
possession is the holder. See UCC 1–201(b)(21).
M’s note in Problem 1.2.4, like the overwhelming majority of negotiable
promissory notes, is payable to the order of an identified person (A) and not
payable to bearer. To become a holder, C not only must take possession but
also must obtain the indorsement (signature) of A, the payee. Custom
3. This has been true for quite some time. Writing more than sixty years ago, Karl
Llewellyn observed:
I shall not undertake to explain how or why the commercial system of a century ago
lost the use of notes to evidence the credit-price of freshly delivered goods. It is
enough here that the practice went into decline, and that between merchants goods
are now delivered typically on purely “open” credit (resulting in a “book account,”
and “account receivable”), often with the buyer, if he is financially strong, paying
within ten days against a large “cash discount.” The giving of a commercial note
between dealers has come to be the gesture with which a stale account, long overdue,
is promised really to be met next time. Such a note smells.
Llewellyn, Meet Negotiable Instruments, 44 Colum.L.Rev. 299, 321–22 (1944).
SECTION 2
dictates that A will indorse the note on the back. A’s indorsement may
identify C as the person to whom the instrum ent is payable (e.g., A’s
signature may be accompanied by the words “Pay to C”), or it may identify
no such person (e.g., it may consist only of A’s signature) and thereby make
the note payable to bearer. See UCC 3–205(a), (b). In either case, C will
become a holder upon taking possession of the note. If C also meets the
other requirements of UCC 3–302(a), then C will become a holder in due
course and take free of all claims, including A’s ownership claim.
by M, who promised “to pay on demand to bearer $5,000.” B stole the note
from A and gave it to C, who did not suspect the theft, in return for $2,500.
A sues C to replevy the note.
(a) What result? See UCC 3–103(a)(4); UCC 3–303; Note on Value, infra.
Compare Problem 1.1.3(c), supra, page 3.
(b) What result if C had promised to pay B $5,000 but has not yet paid
it? Compare Problem 1.1.3(d), supra. Would you advise C to pay B now, after
learning of the theft?
(c) What result if B gave the note to C in exchange for C’s promise to
deliver specially manufactured goods?
(d) What result if B gave the note to C in exchange for a $5,000 check
that is still in B’s hands? See UCC 3–303, Comment 5.
(e) What result if C took the note as security for a $2,500 loan that C had
extended to B six months earlier? See UCC 3–302(e). Compare Problem
1.1.5, supra.
NOTE ON VALUE
Good-faith-purchase rules are designed to protect purchasers for value.
See, e.g., UCC 2–403(1), (2); UCC 3–302(a)(2). The general definition of
“value” makes it clear that one gives “value” if one gives “any consideration
sufficient to support a simple contract.” UCC 1–204(4). But as defined in
Article 1, “value” is a broader concept than “consideration”; one can give
value by giving something that one already was obligated to give and that,
because of the pre-existing duty rule, would not qualify as consideration. See
UCC 1–204(2).
In Swift v. Tyson, Mr. Justice Story justified this result in connection
with the good faith purchase of negotiable instruments. Taking as given
that the holder of a negotiable instrument acquires good-faith-purchase
rights only where the holder receives the instrument for a valuable
consideration, the court asked:
. . . And why upon principle should not a pre-existing debt be deemed
such a valuable consideration? It is for the benefit and convenience of
the commercial world to give as wide an extent as practicable to the
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credit and circulation of negotiable paper, that it may pass not only as
security for new purchases and advances, made upon the transfer
thereof, but also in payment of and as security for pre-existing debts.
The creditor is thereby enabled to realize or to secure his debt, and thus
may safely give a prolonged credit or forbear from taking any legal steps
to enforce his rights. The debtor also has the advantage of making his
negotiable securities of equivalent value to cash. But establish the
opposite conclusion, that negotiable paper cannot be applied in payment
of or as security for pre-existing debts, without letting in all the equities
between the original and antecedent parties, and the value and
circulation of such securities must be essentially diminished, and the
debtor driven to the embarrassment of making a sale thereof, often at
a ruinous discount to some third person, and then by circuity to apply
the proceeds to the payment of his debts. . . . The doctrine would strike
a fatal blow at all discounts of negotiable securities for pre-existing
debts.
Swift v. Tyson, 41 U.S. (16 Pet.) 1, 20, 10 L.Ed. 865 (1842).4 Could the same
argument be made with equal force with respect to goods?
For the purposes of Articles 3 and 4, the general definition of “value” in
UCC 1–204 is subject to the modifications imposed by UCC 3–303, UCC
4–210, and UCC 4–211. UCC 3–303(a)(3) preserves the departure from the
pre-existing debt rule justified by Mr. Justice Story. Indeed, UCC 3–303(b)
goes on to say that, for purposes of Articles 3 and 4, an instrument issued
for value is supported by consideration even if this would not be so under
contract law, as in the case of a note issued for an antecedent debt. See UCC
3–303, Comment 1, Case # 1.
Although UCC 3–303(a)(3) broadens the definition of “value,” subsection
(a)(1) narrows it substantially. It provides that a purchaser who gives a
promise takes an instrument for value only “to the extent that the promise
has been performed.” As Comment 2 explains, “The policy basis for
subsection (a)(1) is that the holder who gives an executory promise of
performance will not suffer an out-of-pocket loss to the extent the executory
promise is unperformed at the time the holder learns of dishonor of the
instrum ent.” In terms familiar to the law of contracts, the expectation to
which an executory promise gives rise is not enough; there must be actual
4. Ironically, Swift v. Tyson is better known today for the choice-of-law rule that
was given its quietus in Erie Railroad Co. v. Tompkins, 304 U.S. 64, 58 S.Ct. 817, 82
L.Ed. 1188 (1938), than for the rule of negotiable instruments that survived. Devotees
of the “federal common law” will recall Clearfield Trust Co. v. United States, 318 U.S.
363, 63 S.Ct. 573, 87 L.Ed. 838 (1943), in which it was concluded that “the rights and
duties of the United States on commercial paper which it issues are governed by federal
rather than local law.” For later applications of the Clearfield doctrine, see Note, 66 Iowa
L.Rev. 391 (1981). That the UCC is a source of federal common law, see United States
v. Conrad Pub. Co., 589 F.2d 949, 953 (8th Cir.1978); Note, 20 B.C.L.Rev. 680, 680–81
(1979).
SECTION 2
reliance in the form of performance of that promise. Subsections (a)(4) and
(5) provide limited exceptions to this principle, notably in the case where the
executory promise is embodied in a negotiable instrument.5
How persuasive do you find this explanation? Did the holder in part (e)
of Problem 1.2.5, who took the note to secure an antecedent debt, suffer an
out-of-pocket loss in reliance on the negotiation of the note? Did the holder
in part (c), who took the note in exchange for a promise to deliver specially
manufactured goods?
by M, who promised “to pay on demand to bearer $1,000.” B stole it from A
and gave it to C, who did not suspect the theft, in return for $1,000. (These
are the facts of Problem 1.2.3, supra, page 20) C gave the note to his
daughter, D, as a gift for her twenty-first birthday. A sues D to replevy the
note. What result? See UCC 3–306; UCC 3–203. Would your answer change
if D had stolen the note from her father, C? See UCC 1–201(b)(15).
by M, who promised “to pay $5,000 to the order of A on June 30, 2008.” A
sold the note to B, who paid $4,200 for it. A agreed to retain possession of
the note and collect it for B when it came due. Thereafter, in violation of the
agreement, A sold and delivered the note to C without an indorsement. B
learns about the purported sale to C and demands that C “give me back my
note immediately.”
(a) What result? See UCC 3–306; UCC 3–102(b); UCC 9–109(a)(3); UCC
9–102(a)(65); UCC 9–102(a)(47); UCC 9–330(d); UCC 1–201(b)(35) (2d
sentence); Note on Multiple Assignments of Rights to Payment, infra.
(b) Recall Problem 1.1.6, supra, page 16. How does the rule in UCC
9–330(d) compare with the rule in UCC 2–403(2)?
NOTE ON MULTIPLE ASSIGNMENTS OF RIGHTS TO PAYMENT
The typical commercial note is payable to the order of an identified
person (the payee). Although a note may be transferred or negotiated many
times, most negotiable notes are transferred or negotiated once (if at all),
from the payee to a purchaser. The risk that the transferor acquired the
note through theft or fraud and that the true owner will claim it from the
purchaser, as in Problem 1.2.3 on page 20, supra, is negligible. A greater
risk, but one that is still rather small, is that the transferor previously sold
the note or used it to secure a loan or other obligation.
We have seen that a holder in due course takes free of ownership claims
to the instrument. See UCC 3–306; Problems 1.2.3 and 1.2.4, supra.
5.
The exception in UCC 4–210(a)(2) will be considered later in the course.
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Inasmuch as a security interest is a property claim, a person having the
rights of a holder in due course also takes free of security interests that
secure an obligation. See UCC 3–306; UCC 9–331(a). But, as explained
below, even if the purchaser of a note is not a holder in due course, the
purchaser is likely to prevail over competing secured parties if it takes
possession of the note. See UCC 9–330(d).
To see why the law protects most purchasers of negotiable instruments
who take possession, it will be useful first to understand how the law deals
with multiple assignments of rights to payment that are not embodied in a
negotiable instrument. Consider these facts. An equipment dealer (Dealer)
is having difficulty selling its wares. Dealer finally succeeds in selling a
machine to Buyer, who agrees to pay $100,000 for it in 30 days. Dealer
assigns the right to payment (“account”) to Finance Company, which pays
Dealer $100,000 less a discount. But Dealer is in desperate financial straits.
The following day, Dealer assigns the same right to payment to Bank, which
also pays Dealer $100,000 less a discount. Who has the better claim to the
right to payment, Finance Company or Bank?
We have seen this problem before, with respect to goods. A person who
contracts to buy goods that the seller does not own normally acquires no
rights in the goods. See UCC 2–403(1) (first sentence). Nemo dat quod non
habet. We also have seen circumstances where an owner who parts with
possession of goods risks losing its ownership interest. See UCC 2–403(1)
(2d sentence) (owner who delivers goods to a fraud empowers the fraud to
divest the owner of its ownership rights); UCC 2–403(2) (buyer in ordinary
course of business from a merchant who deals in goods of the kind and to
whom the goods have been entrusted acquires all rights of the entruster).
A buyer can protect itself to a considerable degree by demanding to see the
goods before contracting to buy them and then taking immediate possession
of the goods it bought.
A purchaser of Dealer’s right to payment from Buyer cannot do the
same. Though the sale of a $100,000 item of equipment might be evidenced
by a formal written agreement, goods frequently are bought and sold on the
basis of a purchase order and a confirmation (remember the “Battle of the
Forms”?). 6 These writings may provide helpful, if not essential, evidence
that the obligation was incurred. Even so, possession of these writings
typically affords no right to collect from Buyer. (This situation is to be
contrasted with a right to payment evidenced by a negotiable instrument.
As we shall see, the right to enforce a negotiable instrument typically
depends on possession of the instrument.)
In the absence of a negotiable instrument, who enjoys the superior right
to collect the amount owing from Buyer? (This right to payment is called an
“account.” See UCC 9–102(a)(2).) “To the delight of contracts teachers, the
6.
A form of purchase order appears on page 22, supra.
SECTION 2
courts fashioned no fewer than three colorfully captioned rules to resolve
this issue. There was a ‘New York’ rule, an ‘English’ rule, and a
‘Massachusetts’ or ‘four horsemen’ rule.” E. Farnsworth, Contracts 714 (4th
ed. 2004). Fortunately, these multiple rules have all but fallen into
desuetude. The Restatement (Second) of Contracts adopts the
Massachusetts rule, which is most protective of good faith purchasers.7
In most transactions, however, UCC Article 9 (and not the common law)
resolves the competing claims of multiple assignees. The applicable Article
9 rules are somewhat complicated. To simplify, Article 9 provides:
a system by which a secured creditor can perfect a security interest in
most kinds of personal property by filing in a government office a
financing statement briefly describing that interest. [A form financing
statement appears in UCC 9–521(a).] Because Article 9 is not limited to
assignments of accounts for security, its rules on filing extend to
outright sales of accounts as well. Under the Code, in a contest between
two assignees that have given value, the assignee that first files a
financing statement covering its assignment prevails. Thus the second
assignee might achieve priority over the first assignee by filing first.
E. Farnsworth, Contracts 719 (4th ed. 2004).
Just as a buyer of goods can rely on the seller’s possession, an assignee
of accounts can rely on the filing system to reduce the risk that it is
purchasing property to which someone else has a claim. If an assignee
“checks the files before it takes an assignment and finds no other financing
statement, it can, by filing immediately itself, get priority over any other
assignee, even if the other assignee’s assignment was prior in time.” Id.
Unlike accounts, negotiable instruments can be the subject of
possession. Accordingly, Article 9 provides that a purchaser of an
instrument loses priority to a subsequent purchaser if the latter “gives value
and takes possession of the instrument in good faith and without knowledge
that the purchase violates the rights” of the earlier purchaser. UCC
9–330(d). A subsequent purchaser who takes possession may prevail even
7. Except as otherwise provided by statute, the right of an assignee is superior to
that of a subsequent assignee of the same right from the same assignor, unless
(a) the first assignment is ineffective or revocable or is voidable by the assignor or
by the subsequent assignee; or
(b) the subsequent assignee in good faith and without knowledge or reason to know
of the prior assignment gives value and obtains
(i) payment or satisfaction of the obligation,
(ii) judgment against the obligor,
(iii) a new contract with the obligor by novation, or
(iv) possession of a writing of a type customarily accepted as a symbol or as
evidence of the right assigned.
Restatement (Second) Contracts § 342.
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if the initial purchaser had filed a financing statement and even if the
subsequent purchaser checked the public record and saw the financing
statement. Of course, if the subsequent purchaser is a holder in due course,
then the purchaser will take free of all claims to the instrument. See UCC
9–331(a); UCC 3–306.
(B) D EFENSES TO R IGHTS TO P AYMENT
A purchaser who takes an assignment of a right to payment of some
kind (e.g., the assignor’s right to payment for goods sold or the payee’s right
to payment of a negotiable instrument) is concerned not only with taking the
property free from the claims of third parties but also, and usually more so,
with acquiring the ability to enforce the obligation free of the obligor’s
defenses.
Problem 1.2.8. A manufactures and sells auto parts on credit to
wholesale dealers. One customer, O, contracted to pay $60,000 for a
shipment of goods. When the time for payment came, O paid only $20,000
because the goods were seriously defective.
(a) A brings suit against O for the $40,000 balance. What result? See
UCC 2–709; UCC 2–714; UCC 2–717.
(b) What result in part (a) if O refused to pay the balance because A had
failed to repay a $40,000 loan from O? Does UCC 2–717 apply? See UCC
2–717, Comment 1; Note (6) on Defenses to Payment Obligations, infra. If
not, what law does apply? See UCC 1–103(b).
Problem 1.2.9. Suppose that, under the facts of the Problem 1.2.8(a),
A assigned to B, a finance company, “all A’s existing and after-acquired
rights to payment for goods sold (‘accounts’) and all notes and other
instruments representing such rights to payment.” B properly demanded
payment from each of A’s customers, including O, who paid only $20,000
because the goods were seriously defective. B brings suit against O for the
$40,000 balance.
(a) What result? See UCC 9–404(a); Note (1) on Defenses to Payment
Obligations, infra. Cf. Restatement (Second) of Contracts § 336(1).8
8. Restatement (Second) of Contracts § 336(1) provides as follows:
By an assignment the assignee acquires a right against the obligor only to the
extent that the obligor is under a duty to the assignor; and if the right of the
assignor would be voidable against the obligor or unenforceable against him if
no assignment had been made, the right of the assignee is subject to the
infirmity.
As to A’s liability to B, Restatement (Second) of Contracts § 333(1) provides:
Unless a contrary intention is manifested, one who assigns . . . a right by
assignment . . . for value warrants to the assignee . . . that the right, as
assigned, actually exists and is subject to no limitations or defenses good
against the assignor other than those stated or apparent at the time of the
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(b) What result if O paid only $20,000 because A had failed to repay a
$40,000 loan from O? Does it matter when A’s default occurred? See UCC
9–404(a). Cf. Restatement (Second) of Contracts § 336(2).9
(c) Assume the contract of sale contained the following provision: “Buyer
[O] understands and acknowledges that Seller [A] may assign Seller’s rights
under this Agreement for collateral purposes or otherwise. Buyer agrees
that, in the event of any such assignment, Buyer will not assert against any
assignee any claims or defenses that Buyer may have against Seller arising
under this Agreement or otherwise.” What result in parts (a) and (b)? See
UCC 9–403(a)–(c); UCC 3–305.
(d) Why would anyone sign a contract that contains the provision set
forth in part (c)? Consider the options that would be available to O if it
refused to agree to A’s terms and see Note (2) on Defenses to Payment
Obligations, infra.
Problem 1.2.10. A manufactures and sells auto parts on credit to
wholesale dealers. To obtain funds immediately, A assigned to B, a finance
company, “all A’s existing and after-acquired rights to payment for goods
sold (‘accounts’) and all notes and other instruments representing such
rights to payment.” A promptly delivered each assigned instrument to B.
One customer, M, signed a promissory note, in which M agreed to pay
$60,000 on a specified date “to the order of A” for a shipment of goods. B
properly demanded payment from each of A’s customers, including M, who
paid only $20,000 because the goods were seriously defective. B brings suit
against M for the $40,000 balance.
(a) What result if A had indorsed the note, “pay to B, [signed] A” before
delivering it? See UCC 3–412; UCC 3–104; UCC 3–301; UCC 3–305(a), (b);
UCC 3–302; UCC 1–201(20); UCC 3–205; UCC 3–303; UCC 3–103(a)(4);
UCC 1–201(25); Note (4) on Defenses to Payment Obligations, infra.
(b) What result if A delivered the note to B without having indorsed it?
Can B even bring suit against M? See UCC 3–412; UCC 3–301; UCC 3–203;
UCC 3–305. Would B improve its position by obtaining A’s indorsement
before bringing suit? See UCC 3–203(c).
(c) Assume that A delivered the note without having indorsed it. What
result if M refused to pay for the goods because A had failed to repay a loan
from M? Does it matter when A’s default occurred? See UCC 3–203(c); UCC
3–305(a) and Comment 3 (last paragraph).
(d) To what extent do your answers to this Problem differ from your
assignment . . . .
9. Restatement (Second) of Contracts § 336(2) provides: “The right of an assignee
is subject to any defense or claim of the obligor which accrues before the obligor receives
notification of the assignment but not to defenses or claims which accrue thereafter
except as stated in this Section or as provided by statute.”
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answers to Problem 1.2.9? Are the differences justified?
Kaw Valley State Bank & Trust Co. v. Riddle
Supreme Court of Kansas, 1976.
219 Kan. 550, 549 P.2d 927.
O F ROMME, J USTICE.
This action was brought by The Kaw Valley State Bank and Trust
Company (hereinafter referred to as Kaw Valley) to recover judgment
against John H. Riddle d/b/a Riddle Contracting Company (hereafter
referred to as Riddle) on two notes . . . . The two notes were covered by
separate security agreements and were given to purchase construction
equipment. . . . Kaw Valley had acquired the two notes and the security
agreements by assignment from Co-Mac, Inc. (hereafter referred to as
Co-Mac), a dealer, from whom Riddle purchased the construction
equipment.
In a trial to the court Kaw Valley was found not to be a holder in due
course of one of the notes. Its claim on said note, totaling $21,904.64, was
successfully defended on the grounds of failure of consideration. It was
stipulated at the trial that none of the construction equipment for which the
note was given had ever been delivered by Co-Mac. Kaw Valley has
appealed.
...
Prior to the transactions in question Riddle had purchased construction
equipment and machinery from the dealer, Co-Mac. A number of these
purchases had been on credit and discounted to Kaw Valley by Co-Mac.
Including the Riddle transactions, Kaw Valley had purchased over 250
notes and security agreements from Co-Mac during the prior ten year
period. All were guaranteed by Co-Mac and by its president personally.
In May, 1971, Riddle negotiated for the purchase of a model 6-c
Caterpillar tractor, a dozer and a used 944 Caterpillar wheel tractor with
a two yard bucket. Riddle was advised that this machinery could be
delivered but it would first be necessary for Co-Mac to have a signed note
and security agreement to complete the transaction. An installment note,
security agreement and acceptance of delivery of the machinery was mailed
to Riddle. These were signed and returned to Co-Mac. Ten days later, the
machinery not having been delivered, Riddle called Co-Mac and inquired
about purchasing a D-8 Caterpillar and a #80 Caterpillar scraper in place
of the first machinery ordered. Co-Mac agreed to destroy the May 11, 1971
papers and sell this larger machinery to Riddle in place of that previously
ordered.
The sale of this substitute machinery was completed and the machinery
was delivered after the execution of an additional note and security
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agreement. However, the May 11, 1971 papers were not destroyed. The note
had been discounted and assigned to Kaw Valley prior to the sale of the
substitute machinery. Thereafter Co-Mac, who was in financial trouble,
made regular payments on the first note to Kaw Valley. The note was thus
kept current by Co-Mac and Riddle had no knowledge of the continued
existence of that note. The 6-c Caterpillar tractor, dozer and the used 944
Caterpillar wheel tractor were never delivered to Riddle. Riddle received no
consideration for the May 11, 1971 note . . . .
On February 24, 1972, representatives of Riddle, Co-Mac and Kaw
Valley met for the purpose of consolidating the indebtedness of Riddle on
machinery notes held by Kaw Valley and guaranteed by Co-Mac. . . .
Thereupon a renewal note and security agreement for $44,557.70 dated
February 24, 1972, was drawn consolidating and renewing the seven
remaining notes. Riddle then asked Kaw Valley if this was all that it owed
the bank and he was assured that it was. The renewal note was then
executed by Riddle.
It was not until March 12, 1972, that Riddle was advised by Kaw Valley
that it held the note and security agreement dated May 11, 1971, which
Riddle believed had been destroyed by Co-Mac. This was within a week after
a receiver had been appointed to take over Co-Mac’s business affairs. Riddle
explained the machinery had never been delivered and Co-Mac promised to
destroy the papers. No demand for payment of the May 11, 1971 note was
made on Riddle until this action was filed.
...
The primary point on appeal questions the holding of the trial court that
Kaw Valley was not a holder in due course of the note and security
agreement dated May 11, 1971.
[F3–305] provides that unless a holder of an instrument is a holder in
due course he takes the instrument subject to the defenses of want or failure
of consideration, nonperformance of any condition precedent, nondelivery
or delivery for a special purpose. [Cf. UCC 3–305(a).] It was undisputed in
this case that Riddle received no consideration after executing the note. The
machinery was never delivered and he was assured by Co-Mac that the
papers would be destroyed. The parties so stipulated. If Kaw Valley was not
a holder in due course the proven defense was a bar to recovery by Kaw
Valley.
[F3–302] states a holder in due course is a holder who takes the
instrument (1) for value, (2) in good faith and (3) without notice of any
defense against it. [Cf. UCC 3–302(a).] It was not disputed and the court
found that Kaw Valley took the note for value so the first requirement was
satisfied. The other requirements were subject to dispute. The trial court
concluded:
“Kaw Valley State Bank and Trust Company is not a holder in due
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course of the note and security agreement, dated May 11, 1971 for the
reason that it did not establish in all respects that it took said
instruments in good faith and without notice of any defense against or
claimed to it on the part of John H. Riddle, and Kaw Valley State Bank
and Trust Company therefor took said instruments subject to the
defense of failure of consideration. (Citations omitted.)”
So we are confronted with the question of what is required for a holder
to take an instrument “in good faith” and “without notice of defense”. We
will consider the two parts of the question in the order mentioned.
“Good faith” is defined in [F1–201(19)] as “honesty in fact in the conduct
or transaction concerned.” The first draft of the Uniform Commercial Code
(U.C.C.) as proposed required not only that the actions of a holder be honest
in fact but in addition it required the actions to conform to reasonable
commercial standards. This would have permitted the courts to inquire as
to whether a particular commercial standard was in fact reasonable. (See
Uniform Commercial Code, Proposed Final Draft [1950], § 1-201, 18, p. 30.)
However, when the final draft was approved the test of reasonable
commercial standards was excised thus indicating that a more rigid
standard must be applied for determining “good faith”.
From the history of the Uniform Commercial Code it would appear that
“good faith” requires no actual knowledge of or participation in any material
infirmity in the original transaction.
The second part of our question concerns the requirement of the U.C.C.
that a holder in due course take the instrument without notice of any
defense to the instrument. [F1–201(25)] provides:
“A person has ‘notice’ of a fact when
“(a) he has actual knowledge of it; or
“(b) he has received a notice or notification of it; or
“(c) from all the facts and circumstances known to him at the time
in question he has reason to know that it exists. A person ‘know[s]’ or
has ‘knowledge’ of a fact when he has actual knowledge of it. ‘Discover’
or ‘learn’ or a word or phrase of similar import refers to knowledge
rather than to reason to know. The time and circumstances under which
a notice or notification may cease to be effective are not determined by
this act.” [Cf. UCC 1–202.]
As is apparent from reading the above statute the standard enunciated
is not limited to the rigid standard of actual knowledge of the defense.
Reason to know appears to be premised on the use of reasonable commercial
practices. Since “good faith” and “no notice of defense” are both required of
a holder to claim the status of a holder in due course it would appear that
the two standards are not in conflict even though the standards of conduct
may be different.
There is little or no evidence in the present case to indicate that Kaw
SECTION 2
Valley acted dishonestly or “not in good faith” when it purchased the note
of May 11, 1971. However, as to “notice of defense” the court found from all
the facts and circumstances known to Kaw Valley at the time in question it
had reason to know a defense existed. The court found:
“During the period 1960 to May, 1971, plaintiff purchased from
Co-Mac over 250 notes and secured transactions and held at any given
time between $100,000.00 and $250,000.00 of such obligations. All of
which were guaranteed by Co-Mac and personally guaranteed by D. J.
Wickern, its president. Conant Wait personally handled most if not all
of such transactions for plaintiff. Mr. Wait was aware that Co-Mac was
making warranties and representation as to fitness to some purchasers
of new and used equipment. Mr. Wait further knew that some
transactions were in fact not as they would appear to be in that the
money from Kaw Valley would be used by Co-Mac to buy the equipment
that was the subject matter of the sale. Further, that delivery to the
customer of said purchased equipment was sometimes delayed 60 to 90
days for repairing and/or overhauling of same. The plaintiff obviously on
many transactions was relying on Co-Mac to insure payment of the
obligations and contacted Co-Mac to collect delinquent payments. Some
transactions involved delivery of coupon books to Co-Mac rather than
the debtor so Co-Mac could bill service and parts charges along with the
secured debt. Co-Mac collected payments directly from debtors in
various transactions and paid plaintiff. Plaintiff did not concern itself
with known irregularities in the transactions as it clearly was relying
on Co-Mac;
“The coupon book on the May 11, 1971 transaction was not sent to
defendant Riddle; no payments on same were made by defendant Riddle;
the payments were made by Co-Mac until January 25, 1972; prior to
early March, 1972, defendant Riddle did not know plaintiff had the May
11, 1971 secured transaction; knowledge of said transaction came to
defendant Riddle on March 12, 1972 when Mr. Wait contacted defendant
Riddle’s manager; that Co-Mac had shortly before been placed in
receivership; that no demand for any payment on said transaction was
made by plaintiff to defendant Riddle until September 1972.”
To further support its holding that Kaw Valley had reason to know that
the defense existed the court found that when Kaw Valley, Co-Mac and
Riddle met on February 24, 1972, to consolidate all of Riddle’s past due
notes Kaw Valley recognized Co-Mac’s authority to act for it. Co-Mac and
accepted return of the machinery on one of the eight transactions and Kaw
Valley recognized its authority as their agent to do so and cancelled the
$5,000.00 balance remaining due on the note held by the bank.
The cases dealing with the question of “reason to know a defense exists”
seem to fall into four categories.
The first includes those cases where it is established the holder had
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information from the transferor or the obligor which disclosed the existence
of a defense. In those cases it is clear if the holder takes an instrument
having received prior or contemporaneous notice of a defense he is not a
holder in due course. Our present case does not fall in that category for
there is no evidence that Co-Mac or Riddle informed Kaw Valley that the
machinery had not been delivered when the note was negotiated.
The second group of cases are those in which the defense appears in an
accompanying document delivered to the holder with the note. For example,
when a security agreement is executed concurrently with a note evidencing
an indebtedness incurred for machinery to be delivered in the future. In
such case the instrument may under certain circumstances disclose a
defense to the note, such as nondelivery of the machinery purchased. Our
present case does not fall in this category because Riddle had signed a
written delivery acceptance which was handed to Kaw Valley along with the
note and security agreement.
A third group of cases are those in which information appears in the
written instrument indicating the existence of a defense, such as when the
note on its face shows that the due date has passed or the note bears visible
evidence of alteration and forgery or the note is clearly incomplete. In our
present case the instrument assigned bore nothing unusual on its face and
appeared complete and proper in all respects.
In the fourth category of cases it has been held that the holder of a
negotiable instrument may be prevented from assuming holder in due
course status because of knowledge of the business practices of his
transferor or when he is so closely aligned with the transferor that
transferor may be considered an agent of the holder and the transferee is
charged with the actions and knowledge of the transferor.
Under our former negotiable instruments law containing provisions
similar to the U.C.C. this court refused to accord holder in due course status
to a machinery company receiving notes from one of its dealers because of
its knowledge of the business practices of the dealer and the company’s
participation and alignment with the dealer who transferred the note.
In Unico v. Owen, 50 N.J. 101, 232 A.2d 405, the New Jersey court
refused to accord holder in due course status to a financing partnership
which was closely connected with the transferor and had been organized to
finance the commercial paper obtained by the transferor and others. The
financing partnership had a voice in setting the policies and standards to be
followed by the transferor. Under such circumstances the court found that
the holder must be considered a participant in the transaction and subject
to defenses available against the payee-transferor. In United States Finance
Company v. Jones, 285 Ala. 105, 229 So.2d 495, it was held that a finance
company purchasing a note from a payee for fifty percent of its face value
did not establish holder in due course status and must be held subject to
defenses inherent in the original transaction. Other jurisdictions have
SECTION 2
followed the rationale of Unico. See American Plan Corp. v. Woods, 16 Ohio
App.2d 1, 240 N.E.2d 886, where the holder supplied forms to the payee,
established financing charges and investigated the credit of the maker of the
note; Calvert Credit Corporation v. Williams, 244 A.2d 494 (D.C.App.1968),
where the holder exerted total control over payee’s financial affairs; and
Jones v. Approved Bancredit Corp., 256 A.2d 739 (Del.1969), where
ownership and management of the holder and payee were connected.
In the present case Kaw Valley had worked closely with Co-Mac in over
250 financing transactions over a period of ten years. It knew that some of
these transactions were not for valuable consideration at the time the paper
was delivered since the bank’s money was to be used in purchasing the
machinery or equipment represented in the instruments as already in
possession of the maker of the note. Kaw Valley had been advised that
delivery to Co-Mac’s customers was sometimes times delayed from 60 to 90
days. Kaw Valley continued to rely on Co-Mac to assure payment of the
obligations and contacted it to collect delinquent payments. Some of these
transactions, including the one in question, involved the use of coupon books
to be used by the debtor in making payment on the notes. In the present
case Kaw Valley did not notify Riddle that it was the holder of the note. It
delivered Riddle’s coupon book to Co-Mac as if it were the obligor or was
authorized as its collection agent for this transaction. Throughout the period
from May 11, 1971, to February 25, 1972, Kaw Valley received and credited
the monthly payments knowing that payments were being made by Co-Mac
and not by Riddle. Then when Riddle’s loans were consolidated, the May 11,
1971 transaction was not included by Kaw Valley, either by oversight or by
intention, as an obligation of Riddle. Co-Mac occupied a close relationship
with Kaw Valley and with its knowledge and consent acted as its agent in
collecting payments on notes held by Kaw Valley. The working relationship
existing between Kaw Valley and Co-Mac was further demonstrated on
February 24, 1972, when the $5,000.00 balance due on one of Riddle’s notes
was cancelled when it was shown that the machinery for which the note was
given had previously been returned to Co-Mac with the understanding that
no further payments were due.
[F3–307(3)] provides:
“After it is shown that a defense exists a person claiming the rights
of a holder in due course has the burden of establishing that he or some
person under whom he claims is in all respects a holder in due course.”
[Cf. UCC 3–308(b).]
In the present case the court found that the appellant, Kaw Valley, had
not sustained its burden of proving that it was a holder in due course. Under
the evidence in this case the holder failed to advise the maker of the note of
its acquisition of the note and security agreement. It placed the payment
coupon book in the hands of Co-Mac and received all monthly payments
from them. A close working relationship existed between the two companies
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and Co-Mac was clothed with authority to collect and forward all payments
due on the transaction. Agency and authority was further shown to exist by
authorizing return of machinery to Co-Mac and terminating balances due
on purchase money paper. We cannot say under the facts and circumstances
known and participated in by Kaw Valley in this transaction it did not at
the time in question have reason to know that the defense existed. This was
a question of fact to be determined by the trier of fact which if supported by
substantial competent evidence must stand.
...
The judgment is affirmed.
NOTES ON DEFENSES TO PAYMENT OBLIGATIONS
(1) Defenses to a Contractual Obligation. Problem 1.2.9 represents
a typical commercial transaction. Seller (A) sells goods to Buyer (O) on open
account, i.e., Buyer’s unsecured obligation is represented by a purchase
order or other record that, perhaps taken together with other records,
creates a contract. Finance Company (B) finances Seller’s rights to payment
(accounts) by advancing funds against the accounts as they arise. In this
way, Seller obtains cash immediately, without having to wait for the credit
period to expire. Depending on how the transaction is structured, the funds
advanced by Finance Company may represent a loan to Seller, secured by
the accounts, or the purchase price for an outright sale of the accounts.
(Accounts receivable financing is quite complicated; further details are best
left to later in the course.)
Upon Seller’s default on its obligation to Finance Company, and even
before if Seller agrees, Finance Company may collect from Buyer on Buyer’s
obligation. See UCC 9–607(a)(1) (in Article 9 terminology, Finance Company
is the “secured party” and Buyer is an “account debtor”). Whether Finance
Company will succeed in collecting from Buyer depends in large part on
whether Buyer is able to pay and whether it is legally obligated to do so.
Before it advances funds to Seller, Finance Company may take steps to
reduce credit risk, i.e., the risk that, when the obligation is enforced, Buyer
will be unable or unwilling to pay. Finance Company normally will
investigate the creditworthiness of Buyer. It may insist that one or more
other persons guarantee the payment of Buyer’s obligations, as was the case
in Kaw Valley. If Finance Company is receiving an assignment of a large
number of receivables, then it may elect to investigate the creditworthiness
of Seller’s customers generally before it agrees to take the assignment. In
addition, Finance Company can take steps to minimize the risk that Buyer
can assert valid defenses to its obligation. These steps may include
determining Seller’s reputation for performing its contracts before Finance
Company advances funds.
Seller’s failure to perform its obligations under the contract with Buyer
SECTION 2
may give Buyer a legal justification for not paying the price of the goods. For
example, if, as in Kaw Valley, the goods never were delivered, Buyer would
have a defense of failure of consideration. If the goods were delivered and
accepted but were nonconforming, as in Problem 1.2.8(a), Buyer would have
the right to deduct from its obligation for the price (UCC 2–709) its damages
for breach of warranty (UCC 2–714). See UCC 2–717. The right to deduct
sometimes is called a claim in recoupment. See Note (6), infra. Under
some circumstances, Buyer may be able to revoke its acceptance of the
goods. See UCC 2–608. The question for us now is: Are Buyer’s defenses and
claims in recoupment available to defeat Finance Company?
UCC 9–404(a) contains a provision that protects parties to contracts,
like Buyer, from unexpected inroads on their contractual relationships.
Under this provision, the assignee of a right to payment, like the purchaser
of goods, ordinarily acquires no better rights than the assignor had.10 Thus,
the assignment of Seller’s right to payment does not ipso facto deprive
Buyer of its right to defend against the claim.11 UCC 9–404(a) is another
example of the “security of property” (nemo dat) principle discussed in
Section 1, supra. On the other han d, UCC 9–403(b) contains a
good-faith-purchase rule: A waiver-of-defense clause, whereby Buyer
agrees not to assert against an assignee any claim or defense that Buyer
may have against Seller, is enforceable by an assignee who takes the
assignment for value, in good faith, and without notice of any claim or
defense.12
The implications of the preceding sentence may not be readily apparent.
Buyer buys goods on credit from Seller pursuant to an agreement containing
a waiver-of-defense clause. Seller borrows from Finance Company and uses
Buyer’s obligation (and the obligations of Seller’s other customers) to secure
the loan. The goods prove to be defective. If Seller were to demand payment
from Buyer, Buyer would have a defense—either by rejecting the goods if
they have not already been accepted (UCC 2–601), or, if they have been
accepted, by revoking acceptance (UCC 2–608) or recouping damages for
breach of warranty against the buyer’s obligation for the price (UCC 2–714,
10. With respect to transactions not covered by Article 9, see Restatement (Second)
of Contracts §§ 336(1), (2), which contain rules that are similar to UCC 9–404(a) and are
set forth in notes 7 and 8, supra.
11. UCC 9–404(a) subjects the assignee to a buyer’s claims as well as its defenses.
A buyer who pays the contract price for defective goods has a claim against the seller for
damages. See UCC 2–714. A buyer may assert this claim against the seller’s assignee
(here, Finance Company) only to reduce the amount the buyer owes; the buyer may not
recover from Finance Company any payments already made. UCC 9–404(b).
12. An assignee that is protected by UCC 9-403(b) essentially receives the same
protection as does an HDC of a negotiable instrument. See 9-403(c). UCC 9-403(b) is a
safe harbor. If other law so provides, an agreement to waive defenses may be enforceable
also by assignees who do not qualify as good faith purchasers and may enable assignees
to take free of defenses that cannot be asserted against an HDC. See UCC 9–403(f).
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2–717). But Finance Company may enforce the agreement and take free of
that defense if it acquired its security interest for value, in good faith, and
without notice of any claims or defenses. In short, Buyer is legally obligated
to pay Finance Company for the defective goods.
Of course, even if Buyer must pay the price to Finance Company, Buyer
still has a claim against Seller. The following considerations, which are
particularly striking in consumer transactions (discussed below in Note (7)),
suggest that Buyer is in a stronger position if it can assert a defense against
Finance Company:
(1) The inertia of litigation. Setting up a defense is easier than starting
an action, even though the “burden of proof” with regard to Seller’s
breach may fall on Buyer in either case. In practice, this consideration
has its greatest impact on the settlement value of Buyer’s claim, since
a reduction in price is much easier to negotiate than a cash refund. (As
we shall see, imposing the “burden of bringing litigation” on the other
party is an objective shared by contracting parties in a variety of
settings.)
(2) The strain of current cash outlay. Buyer may not have the resources
to pay the full amount for defective goods and wait (perhaps for years)
until a legal action against Seller can reach trial and finally be
converted into a judgment.
(3) The risk of Seller’s insolvency. Seller may be insolvent or judgment
proof. Seller may have been a fly-by-night operator, or driven into
sharp practice by financial pressure, or forced to the wall by keen
competition, poor management, or a business recession.
Conversely, these advantages to Buyer in preserving defenses against
an action for the price suggest the importance to Finance Company of
freeing itself from these defenses. Finance Company’s interest is magnified
to the extent that buyers interpose spurious defenses in an attempt to scale
down or avoid their obligation to pay for what they buy.
(2) Who Benefits from a Waiver of Defenses? In considering who
benefits from a buyer’s or other account debtor’s waiver of its defenses, it is
best to concentrate on the normal case, in which the buyer asserts no
defense to its obligation, rather than the abnormal case (popular with
editors of casebooks), in which the buyer does assert a defense. Obviously
the financing agency benefits by being freed from most defenses in the
abnormal case. But in the normal case, the seller and the buyer benefit as
well because of the resulting expansion of the “market” for rights to
payment. The seller, as the payee who dealt with the buyer, would not have
been protected if the seller had retained the right to payment. However, the
seller benefits indirectly from the protection that the waiver of defenses
affords the financing agency to which the seller assigns the account, because
financing agencies, freed from most of the buyer’s defenses, are more willing
SECTION 2
to finance transactions and to do so on more favorable terms, e.g., by
lowering the discount and advancing a larger amount against the account.
This, in turn, enables the seller to sell to more buyers on credit and to offer
them more favorable terms. And this may make credit available to the buyer
when it otherwise would be denied or make credit available to the buyer at
more favorable terms than otherwise would pertain. On this reasoning, a
buyer’s ability to waive most defenses as against a financing agency may
benefit all three parties—buyer, seller, and financier.
Waivers of defenses in the consumer setting have been particularly
controversial and have been addressed at both the Federal and State level.
See Note (7), infra.
(3) Liability “on the Instrument”; Person Entitled to Enforce the
Instrum ent. Signing a negotiable instrument is a significant act: A person
who signs a negotiable instrument becomes obligated to pay it. The precise
terms and conditions of the obligation to pay the instrument are set forth in
UCC 3–412 through 3–415 and depend on the capacity in which the person
signs. For example, the obligation of the maker of a note under UCC 3–412
differs from the obligation of the drawer of a check under UCC 3–414 and
the obligation of an indorser under UCC 3-415. The obligation on the
instrument is separate from, but related to, the obligation for which the
instrument is given (e.g., the obligation to pay for goods). The relationship
between these two obligations is discussed in Note (8), infra.
Generally speaking, an obligation on an instrument is owed to a “person
entitled to enforce the instrument” (“PETETI”). This term is defined in UCC
3–301. Except in the rare cases in which an instrument is lost, destroyed,
stolen, or paid by mistake, the person entitled to enforce the instrument
must be in possession of the instrument, specifically, it must be “the holder
of the instrument” or “a nonholder in possession of the instrument who has
the rights of a holder.”
How does a nonholder acquire the rights of a holder? By “transfer” of the
instrument. “Transfer of an instrument . . . vests in the transferee any right
of the transferor to enforce the instrument . . . .” UCC 3–203(b). This rule
reflects the principle of nemo dat quod non habet discussed in Section 1,
supra. As we saw with respect to goods, nemo dat means that a transferor
with good title can transfer good title even to a person who does not qualify
as a good faith purchaser for value. Likewise, a person having the rights of
a holder in due course can transfer those rights, even to a person that does
not itself qualify as an HDC (e.g., because it is not a holder or did not take
the instrument for value). UCC 3–203(b). Under those circumstances, the
transferee acquires whatever enforcement rights the HDC enjoyed. Nemo
dat also means that a transferor with limited rights can transfer only those
limited rights. The transferee may acquire greater rights than the
transferor, however, if the transferee takes the instrument for value and
otherwise qualifies as a holder in due course.
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How is an instrument transferred? “An instrument is transferred when
it is delivered by a person other than its issuer for the purpose of giving to
the person receiving delivery the right to enforce the instrument.” UCC
3–203(a). How does a “transfer” differ from a “negotiation”? Compare UCC
3–203(a) with UCC 3–201(a).
(4) Defenses to Obligations on Negotiable Instruments; Holders
in Due Course. UCC 3–412 imposes on the issuer (maker) of a negotiable
note an unconditional obligation to pay. However, the right to enforce the
obligation of a party to an instrument ordinarily is subject to the claims and
defenses set forth in UCC 3–305(a). These include “a defense of the obligor
that would be available if the person entitled to enforce the instrument were
enforcing a right to payment under a simple contract,” UCC 3–305(a)(2), as
well as certain “claim[s] in recoupment.” UCC 3–305(a)(3).
As is the case with claims, Article 3 contains not only a security-ofproperty rule but a good-faith-purchase rule with respect to defenses. The
preceding Note discusses the security-of-property rule found in UCC
3–203(b): Transfer of an instrument vests in the transferee any right of the
transferor to enforce the instrument. UCC 3–305(b) contains the good-faithpurchase rule: A holder in due course takes free of most defenses and claims
in recoupment.
In effect, the act of signing a negotiable instrument constitutes the
signer’s agreement to waive its defenses and claims in recoupment in favor
of a holder in due course. Who benefits from negotiable instruments having
this quality? Who suffers? Do the benefits justify the costs?
We saw in Note (3) on Negotiable Instruments and Negotiation, supra,
that only a holder qualifies as a holder in due course. To qualify as an HDC,
the holder must take the instrument in value, in good faith, and without
notice of any of a variety of claims, defenses, and irregularities. We
considered the value requirement above. See Note on Value, supra. We now
consider the good-faith and notice requirements.
Good Faith. The standard of good faith applicable to negotiable
instruments—and particularly the relationship of negligence to good
faith—has had a checkered career both in Great Britain and here in the
United States. Indeed, the applicable definition in the UCC itself has
changed over time. The drafters of Article 3 originally laid down a standard
of good faith that was not unlike the merchant’s standard of good faith in
Article 2. In the 1952 edition of the UCC, UCC 3–302(1)(b) read: “(b) in good
faith including observance of the reasonable commercial standards of any
business in which the holder may be engaged . . . .”
The comment to this section explained:
The “reasonable commercial standards” language added here and in
comparable provisions elsewhere in the Act, e.g., Section 2–103, merely
makes explicit what has long been implicit in case-law handling of the
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“good faith” concept. A business man engaging in a commercial
transaction is not entitled to claim the peculiar advantages which the
law accords to the good faith purchaser—called in this context holder in
due course—on a bare showing of “honesty in fact” when his actions fail
to meet the generally accepted standards current in his business, trade
or profession. The cases so hold; this section so declares the law.
The 1957 edition applied the “honesty in fact” test of F1–201(19) to
Article 3. The reason given for the change was: “. . . to make clear that the
doctrine of an objective standard of good faith, exemplified by the case of
Gill v. Cubitt, 3 B. & C. 446 (1824) [good faith requires “a proper and
reasonable degree of caution necessary to preserve the interest of trade”],
is not intended to be incorporated. . . .” Am. Law Inst. & Nat’l Conf. of
Comm’rs on Unif. State Laws, 1956 Recommendations of the Editorial
Board for the Uniform Commercial Code 103 (1957).
The 1990 revisions of Articles 3 and 4 returned to a definition of good
faith that is similar to the definition applicable to merchants in Article 2:
“honesty in fact and the observance of reasonable commercial standards of
fair dealing.” UCC 3–103(a)(4). Comment 4 cautions the careless reader,
who might misconstrue the provision as reestablishing the negligence
standard of good faith:
Although fair dealing is a broad term that must be defined in context,
it is clear that it is concerned with the fairness of conduct rather than
the care with which an act is performed. Failure to exercise ordinary
care in conducting a transaction is an entirely different concept than
failure to deal fairly in conducting the transaction. Both fair dealing and
ordinary care, which is defined in Section 3–103(a)(7), are to be judged
in the light of reasonable commercial standards, but those standards in
each case are directed to different aspects of commercial conduct.
What exactly does it mean for a purchaser to be honest but unfair?
Section 205 of the Restatement (Second) of Contracts provides that every
contract imposes upon each party a duty of good faith and fair dealing in its
performance and its enforcement. Comment b explains that, in the context
of good faith purchase, “‘good faith’ focuses on the honesty of the purchaser,
as distinguished from his care or negligence. . . . This focus on honesty is
appropriate to cases of good faith purchase; it is less so in cases of good faith
performance.” On the other hand, in speaking of good faith performance,
Comment d explains that “fair dealing may require more than honesty.”
Notice. UCC 3–302(a)(2) conditions HDC status on a purchaser’s taking
the negotiable instrument not only “in good faith” but also “without notice”
that it is overdue or has been dishonored or of any defense or claim.
(Compare the voidable-title rule of UCC 2-403(1), which does not contain a
separate notice requirement. See Note (3) on the Basic Conveyancing Rules,
supra, pp. 8–9.)
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The definition of “notice” in UCC 1–202 includes not only a subjective
standard but also objective ones. Nevertheless, the concept in the UCC is
not nearly as broad as it is in certain other areas of the law. For example,
in other contexts, a person has “constructive notice” of facts appearing in
documents recorded in the public record, even if the person did not see the
document and is ignorant of the facts. Likewise, in other contexts, a person
may have “inquiry notice” of facts that a reasonably prudent person would
have discovered through an inquiry, even if the person does not conduct an
inquiry and is ignorant of the facts. Neither “constructive notice” nor
“inquiry notice” constitutes “notice” under UCC 1–202. Be sure you read the
definition to see why.
Often the same facts may be used both to show lack of good faith and to
show notice, but, as the Kaw Valley case indicates, good faith and notice
need not always overlap in this way.
(5) “Real” and “Personal” Defenses. The defenses specified in UCC
3–305(a)(1), which may be asserted even against a holder in due course,
traditionally are called “real defenses.” With the exception of the maker’s
discharge in bankruptcy, they arise only rarely.
The defenses in specified in UCC 3–305(a)(2), which are not available
against a holder in due course, arise more often. Although they are just as
genuine as the “real” defenses, the defenses that an HDC cuts off are called
“personal” defenses. They include defenses that would be available on a
simple contract, such as fraud in the inducement, misrepresentation, and
mistake in the issuance of the instrument. They also include defenses stated
elsewhere in Article 3. For a list, see UCC 3–305, Comment 2.
The fraud described in subsection (a)(1), which is a real defense, is
referred to as “fraud in the factum.” The maker of a note asserted this
defense under the Negotiable Instruments Law in First National Bank of
Odessa v. Fazzari, 10 N.Y.2d 394, 223 N.Y.S.2d 483, 179 N.E.2d 493 (1961).
Fazzari, who was unable to read or write English, was induced to sign a
note upon the payee’s misrepresentation that it was a statement of wages
the payee had earned and was necessary for income-tax purposes. The note
was negotiated to a bank, which brought an action against Fazzari.
Although Fazzari was induced to sign something entirely different from
what he thought he was signing, he failed to establish a defense of fraud in
the factum. At the time he signed the note, his wife was in an adjoining
room. She was able to read English, but Fazzari did not ask her to read the
note before he signed it. Would the result change under the UCC? See UCC
3–305(a)(1)(iii) (defense of “fraud that induced the obligor to sign the
instrument with neither knowledge nor reasonable opportunity to learn of
its character or its essential terms”).
Fraud in the factum, which may be asserted even against a holder in
due course, should be distinguished from the more common “fraud in the
inducement,” which an HDC cuts off. Fraud in the inducement arises when
SECTION 2
a person is damaged by justifiably relying on a false representation of a
material fact, if the representation is made with intent to deceive, with
knowledge of its falsity, or with reckless disregard as to whether it is true
or false. Even though fraud in the inducement makes a contract voidable at
the instance of the defrauded party, it does not affect the rights of an HDC
to enforce the defrauded party’s obligation on a negotiable instrument.
(6) Recoupm ent and Setoff. An HDC also takes free of certain claims
in recoupment. UCC 3–305(a)(3). The UCC does not define “recoupment.”
Generally speaking, it means the right of a defendant to reduce its liability
for damages by deducting damages caused by the plaintiff’s failure to
comply with its obligations in the same transaction. Consider the facts of
Problems 1.2.8(a), 1.2.9(a), and 1.2.10. By accepting nonconforming goods,
Buyer becomes liable for their price under UCC 2–709; however, the
nonconformity gives rise to a claim for damages against Seller (A) under
UCC 2–714. UCC 2–717 affords Buyer a right of recoupment: “The buyer on
notifying the seller of his intention to do so may deduct all or any part of the
damages resulting from any breach of the contract from any part of the price
still due under the contract.” Ordinarily, Finance Company (B) will take
subject to this right of recoupment, regardless of whether Buyer’s obligation
to pay is embodied in a negotiable instrument. See UCC 9–404(a)(1); UCC
3–305(a)(3). 13
Not uncommonly, as in Problems 1.2.8(b), 1.2.9(b), and 1.2.10(c), Buyers
seek to set off against their obligation to pay for goods, a claim against the
Seller arising from an unrelated transaction.14 In some jurisdictions, Buyer’s
right to set off would be a good defense against Seller’s action for the price.
Regardless of whether Buyer enjoys setoff rights against Seller, the drafters
of Article 3 apparently intended that Buyer not be permitted to set off
against Seller’s transferees, such as Finance Company. They accomplished
this result through the negative implicit in UCC 3–305(a)(3): The right to
enforce is subject to “a claim in recoupment . . . if the claim arose from the
transaction that gave rise to the instrument.” The right to enforce is not
subject to claims in recoupment (i.e., setoff rights) that arise from other
13. The statement in the text assumes that, where Buyer’s obligation is an
account, Buyer did not agree to waive defenses and that, where Buyer’s obligation is
embodied in a negotiable instrument, Finance Company is not an HDC. In the former
case, Buyer may use its claim for breach of warranty “only to reduce the amount the
account debtor owes.” UCC 9–404(b). Buyer may not use this claim to recover from
Finance Company amounts previously paid. Article 3 takes the same approach to rights
to payment that have been embodied in a negotiable instrument. See UCC 3–305(a)(3).
14. Setoff is not restricted to merchants and other commercial parties. Suppose
Jack and Jill go out to dinner and a movie. Jack pays $12 for Jill’s dinner and Jill pays
$8 for Jack’s movie ticket. Rather than give Jack $12 for dinner and then collect $8 from
Jack for the movie, Jill will set off her $8 claim against her $12 obligation and pay Jack
the difference, $4.
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transactions. See UCC 3–305, Comment 3 (last paragraph).15
Enabling the transferee of a note to take free of the maker’s rights of
setoff may result in the anomaly that a transferee who gives no value for the
note (e.g., Buyer’s donee) acquires better rights than a person who gives
value for an assignment of an obligation that is not represented by a note
(e.g., B in Problem 1.2.9(b)), supra. See UCC 9–404(a). Can this anomaly be
justified, especially given that UCC 9–403 analogizes good-faith purchasers
of rights to payment with holders in due course of negotiable instruments?
(7) Good Faith Purchase in Consum er Transactions. Permitting
buyers to waive their right to assert defenses against third parties, whether
by a waiver-of-defense clause or a negotiable note, has been controversial.
In the teeth of statutory language designed to protect freedom of contract
and the negotiability of notes, a substantial number of courts found legal
grounds to place the burden of adjustment for sellers’ defaults upon secured
parties.
Judicial Intervention. By the early 1950’s courts began to hold that, for
one reason or another, a financing agency that was closely connected with
a retailer could not be an HDC and was not protected by a waiver-of-defense
clause. These courts twisted traditional notions of good faith and notice to
reach what they regarded as a just result. According to the Supreme Court
of Arkansas, in an early seminal case, the finance company “was so closely
connected . . . with the deal that it can not be heard to say that it, in good
faith, was an innocent purchaser” of a note given by a buyer for a car.
Commercial Credit Co. v. Childs, 199 Ark. 1073, 1077, 137 S.W.2d 260, 262
(1940). According to the Supreme Court of Florida, where a finance company
had been involved in the transaction it “had such notice of . . . infirmity” in
a note given by a grocer for a freezer. The court also stated the policy behind
such decisions. “We believe the finance company is better able to bear the
risk of the dealer’s insolvency than the buyer and in a far better position to
protect his interests against unscrupulous and insolvent dealers.” Mutual
Finance Co. v. Martin, 63 So.2d 649, 653 (Fla.1953). Other courts followed
suit. See the discussion in Kaw Valley, supra.
The nature of the transaction made it difficult for the financing agency
to divorce itself from the seller sufficiently to avoid being characterized as
“closely connected.” Since the relationship ordinarily is a continuing one,
typically there is a master agreement and some arrangement for a fund to
be retained by the financing agency to secure its right of recourse against
the seller. In addition, the financing agency will insist that the standard
forms for contracts with buyers as well as for assignments be its own.
15. In many jurisdictions, setoff differs from recoupment: the former relates to
claims unrelated to the contract upon which the defendant is being sued, whereas the
latter relates to claims based upon the same contract. Often, however, the term setoff is
used to encompass both concepts. In contemplating “recoupment” claims that arise from
unrelated transactions, Article 3 is rather idiosyncratic.
SECTION 2
Courts were particularly solicitous of consumer buyers, and Article 9
deferred to their concerns. See F9–206(1) (validating waiver-of-defense
clauses “[s]ubject to any statute or decision which establishes a different
rule for buyers or lessees of consumer goods.”); accord, R9–403(f). But
inasmuch as buyers had to show a sufficiently close connection between the
seller and the financing agency in each case, judicial decisions fell short of
protecting buyers in all cases.
Legislative Intervention. By the early 1970’s, most state legislatures had
enacted statutes applicable to consumer transactions prohibiting negotiable
instruments and waiver-of-defense clauses, limiting their effectiveness, or
depriving them of effect altogether. Under these statutes, some of which
derive from 1974 version of the Uniform Consumer Credit Code (“U3C”)
3.307, 3.404, it is no longer necessary to show that the financing agency and
the seller were closely connected.16
The 1974 U3C also dealt with a developing practice, known as “dragging
the body,” whereby a seller refers the buyer to a financing agency that
makes a direct loan to the buyer. The loan is secured by an interest in the
goods purchased by the buyer, and the financing agency makes sure that the
loan proceeds are applied to purchase the goods by making its check payable
jointly to the buyer and the seller. Should the buyer refuse payment of the
loan on the ground of a defense against the seller, the financing agency
responds that its contract with the buyer is entirely separate from the
seller’s contract with the buyer and was fully performed when it gave the
buyer (borrower) the money. Statutes protecting consumers in the case of
direct loans include a requirement that there be a sufficient connection
between the seller and the lender; for this reason they tend to be complex.
The FTC Initiative. In 1976, Federal Trade Commission Rule 433 took
effect. Its stated purpose is to deny protection to financing agencies in
transactions involving consumer goods and services.17 But because the FTC
has no jurisdiction over banks and it was thought undesirable to regulate
some financing agencies but not others, the rule was not made applicable to
financing agencies. Instead the rule makes it an “unfair and deceptive trade
practice” for a seller to fail to incorporate in a contract of sale to a consumer
16. These statutes contain varying definitions of “consumer,” but U3C 1.301 is
typical. Its definition of “consumer credit sale” requires: that the buyer be a person other
than an organization; that the credit be granted pursuant to a seller credit card or by a
seller who regularly engages in credit transactions of the same kind; that the goods,
services, or interest in land sold be purchased primarily for a personal, family, household
or agricultural purpose; that the debt be payable in installments or a finance charge is
made; and that, with respect to a sale of goods or services, the amount financed not
exceed $25,000. Furthermore, the sections quoted here do not apply to transactions
primarily for an agricultural purpose.
17. The rule defines a consumer as: “A natural person who seeks or acquires goods
or services for personal, family, or household use.”
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a legend that will preserve the buyer’s defenses against the financing
agency.
If the transaction is one in which the seller assigns the contract with the
buyer to a financing agency, the contract must include the following legend
in at least ten-point, bold type:
NOTICE
ANY HOLDER OF THIS CONSUMER CREDIT CONTRAC T IS
SUBJECT T O ALL CLAIMS AND DEFENSES WHICH THE
DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS
OR SERVICES OBTAINED PURSUANT HERETO OR WITH THE
PROCEEDS HEREOF. RECOVERY H ER EUNDER BY THE
DEBT O R SHALL NOT EXCEED AMOUNTS PAID BY THE
DEBTOR HEREUNDER.
If a seller receives the proceeds from a direct loan made to the buyer by a
financing agency to which the seller “refers consumers” or with whom the
seller “is affiliated . . . by common control, contract, or business
arrangement,” the loan contract must include a similar legend. 16 C.F.R.
433.1(d); 433.2. In both cases the legend must state also that the buyer’s
recovery against an assignee with respect to claims and defenses against the
seller may not exceed amounts paid by the buyer under the contract. See 16
C.F.R. 433.2. Placing the required legend on a note does not of itself destroy
the note’s negotiability; however, there cannot be an HDC of the note, even
if the note otherwise is negotiable. UCC 3–106(d).
Staggering numbers of sellers and lenders, large and small, fall within
the terms of the FTC Regulation. Suppose that sellers and lenders are not
inclined to obey the Regulation and fail to use the prescribed provision. How
effective are the FTC’s tools to compel compliance? The FTC is authorized
to bring civil actions against persons who violate FTC cease and desist
orders and (more importantly) against persons who violate FTC rules
respecting “unfair or deceptive acts or practices.” See 15 U.S.C. § 57b.
Suppose a seller or lender nevertheless fails to include the prescribed
formula in a contract and that, under state law, negotiable notes and
waiver-of-defense clauses are effective to bar buyers from asserting defenses
against transferees. Will the FTC Regulation override state law and allow
the buyer to assert a defense or claim a refund? A substantial body of case
law holds that FTC regulations do not ipso facto modify private rights or
confer private rights of action. Under this view, when a contract or note fails
to include the required notice, the consumer buyer would be unable to assert
defenses against an assignee if other law, such as the UCC, so provides.
Other courts have disagreed. For example, one court held that “it would
turn the law on its head” to allow a financier to avoid the consequences of
the notice by its own illegal failure to include the notice in the transaction
documents. Gonzalez v. Old Kent Mortgage Co., 2000 WL 1469313 (E.D. Pa.
SECTION 2
2000). Should this result obtain also where the assignor prepares the
transaction documents and the assignee has difficulty ascertaining whether
the transaction is covered by the FTC rule?
Revised Article 9 answers in the affirmative. Under UCC 9–403(d) an
assignee of a consumer contract takes subject to the consumer account
debtor’s claims and defenses to the same extent as it would have if the
writing had contained the required notice. The 2002 amendment to UCC
3–305, which adds subsection (e), would extend this rule to negotiable
instruments.
(8) The Relationship Between the Obligation on the Instrument
and the Obligation for Which the Instrument Is Given. Consider the
case in which Buyer’s obligation to pay for several deliveries of goods from
Seller is long overdue. To induce Seller to continue making deliveries, Buyer
agrees to repay the past due balance, with interest, under specified terms
that are incorporated into a negotiable promissory note payable to Seller.18
When the agreed time to pay arrives and Buyer defaults (again!), can Seller
recover from Buyer twice—once under UCC 2–709 for the price of the goods
and once “on the instrument” under UCC 3–412? Of course not. When a
person takes a negotiable note for an obligation, such as an obligation to pay
for delivered goods, the obligation is suspended until the note is dishonored
or paid. Payment of the note discharges Buyer’s obligation not only on the
note (UCC 3–412) but also on the contract for the sale of the goods (UCC
2–709). If the note is dishonored and Seller remains the person entitled to
enforce the instrument, then Seller may enforce either the note or Buyer’s
obligation to pay the price of the goods. See UCC 3–310(b)(2), (3). Rules of
pleading and practice may permit Seller to bring both causes of action in a
single complaint; however, Seller will be limited to one recovery.
Suppose that Seller has negotiated the note to Bank. UCC 3–310,
Comment 3, explains:
If the right to enforce the instrument is held by somebody other than the
seller, the seller can’t enforce the right to payment of the price under the
sales contract because that right is represented by the instrument which
is enforceable by somebody else. Thus, if the seller sold the note . . . to
a holder and has not reacquired it after dishonor, the only right that
survives is the right to enforce the instrument.
A person who brings an action on the instrument may take advantage
of special rules of pleading and proof. For example, every negotiable
instrument is presum ed to have been issued for consideration, so that even
when the instrument remains in the hands of the original payee, the burden
is shifted to the person obligated on the instrument to show that there was
no consideration. See UCC 3–308(b); UCC 3–303(b).
18.
As to the aromatic nature of this note, see note 3, supra, page 18.
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Problem 1.2.11. Would the answer to Problem 1.2.10(a) be different if
the body of the promissory note read as follows:
For value received, I promise to pay to the order of A, $100,000, payable
$50,000 in six months after date and $50,000 in twelve months after date,
with interest payable monthly at three per cent over Chase Bank Prime to
be adjusted monthly, with the privilege of discharging this note by payment
of principal less a discount of five per cent within thirty days from the date
hereof. The entire principal of this note shall become due and payable on
demand should the holder at any time deem itself insecure. This note is
secured by a security agreement of the same date to which reference is made
as to rights in collateral. See UCC 3–104; UCC 3–106; UCC 3–108; UCC
3–109; UCC 3–112.
Taylor v. Roeder
Supreme Court of Virginia 1987.
234 Va. 99, 360 S.E.2d 191.
O R USSELL, J USTICE.
[Olde Towne borrowed $18,000 from VMC, evidenced by a 60-day note
secured by a deed of trust on land in Fairfax County. The note provided for
interest at “[t]hree percent (3.00%) over Chase Manhattan Prime to be
adjusted monthly.” The note provided for renewal “at the same rate of
interest at the option of the makers up to a maximum of six (6) months in
sixty (60) day increments with the payment of an additional fee of [t]wo (2)
points.”]
The dispositive question in this case is whether a note providing for a
variable rate of interest, not ascertainable from the face of the note, is a
negotiable instrument. We conclude that it is not.
...
[F3–104(1)] provides, in pertinent part:
Any writing to be a negotiable instrument within this title must
...
(b) contain an unconditional promise or order to pay a sum certain in
money. . . .
[Cf. UCC 3–104(a) (“promise or order to pay a fixed amount of money”)]
The meaning of “sum certain” is clarified by Code [F3–106(1)]:
(1) The sum payable is a sum certain even though it is to be paid
(a) with stated interest or by stated installments; or
(b) with stated different rates of interest before and after default or a
specified date; or
(c) with a stated discount or addition if paid before or after the date fixed
for payment; or
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(d) with exchange or less exchange, whether at a fixed rate or at the
current rate; or
(e) with costs of collection or an attorney's fee or both upon default.
(2) Nothing in this section shall validate any term which is otherwise
illegal.
Official Comment 1, which follows, states in part:
It is sufficient [to establish negotiability] that at any time of payment
the holder is able to determine the amount then payable from the
instrument itself with any necessary computation. . . . The computation
must be one which can be made from the instrument itself without
reference to any outside source, and this section does not make
negotiable a note payable with interest “at the current rate.”
(Emphasis added.) [F3–107] provides an explicit exception to the “four
corners” rule laid down above by providing for the negotiability of
instruments payable in foreign currency.
We conclude that the drafters of the Uniform Commercial Code adopted
criteria of negotiability intended to exclude an instrument which requires
reference to any source outside the instrument itself in order to ascertain
the amount due, subject only to the exceptions specifically provided for by
the U.C.C.
The appellee points to the Official Comment to [F3–104]. Comment 1
states that by providing criteria for negotiability “within this Article,” . . .
[F3–104(1)] “leaves open the possibility that some writings may be made
negotiable by other statutes or by judicial decision.” The Comment
continues: “The same is true as to any new type of paper which commercial
practice may develop in the future.” The appellee urges us to create, by
judicial decision, just such an exception in favor of variable-interest notes.
Appellants concede that variable-interest loans have become a familiar
device in the mortgage lending industry. Their popularity arose when
lending institutions, committed to long-term loans at fixed rates of interest
to their borrowers, were in turn required to borrow short-term funds at high
rates during periods of rapid inflation. Variable rates protected lenders
when rates rose and benefitted borrowers when rates declined. They suffer,
however, from the disadvantage that the amount required to satisfy the debt
cannot be ascertained without reference to an extrinsic source—in this case
the varying prime rate charged by the Chase Manhattan Bank. Although
that rate may readily be ascertained from published sources, it cannot be
found within the “four corners” of the note.
Other courts confronted with similar questions have reached differing
results.
The U.C.C. introduced a degree of clarity into the law of commercial
transactions which permits it to be applied by laymen daily to countless
transactions without resort to judicial interpretation. The relative
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predictability of results made possible by that clarity constitutes the
overriding benefit arising from its adoption. In our view, that factor makes
it imperative that when change is thought desirable, the change should be
made by statutory amendment, not through litigation and judicial
interpretation. Accordingly, we decline the appellee's invitation to create an
exception, by judicial interpretation, in favor of instruments providing for
a variable rate of interest not ascertainable from the instrument itself.
In an alternative argument, the appellee contends that even if the notes
are not negotiable, they are nevertheless “symbolic instruments” which
ought to be paid according to their express terms. Those terms include the
maker's promises to pay “to VMC Mortgage Company or order,” and in the
event of default, to make accelerated payment “at the option of the holder.”
The emphasized language, appellee contends, makes clear that the makers
undertook an obligation to pay any party who held the notes as a result of
a transfer from VMC. Assuming the abstract correctness of that argument,
it does not follow that the makers undertook the further obligation of
making a monthly canvass of all inhabitants of the earth in order to
ascertain who the holder might be. In the absence of notice to the makers
that their debt had been assigned, they were entitled to the protection of the
rule in Evans v. Joyner in making good-faith payment to the original payee
of these non-negotiable notes.
Accordingly, we will reverse the decree and remand the cause to the trial
court for entry of a permanent injunction against foreclosure.
Reversed and remanded.
O C OMPTON , J USTICE, DISSENTING.
The majority views the Uniform Commercial Code as inflexible,
requiring legislative action to adapt to changing commercial practices. This
overlooks a basic purpose of the Code, flexibility and adaptability of
construction to meet developing commercial usage.
According to Code [F1–102(1)], the UCC “shall be liberally construed
and applied to promote its underlying purposes and policies.” One of such
underlying purposes and policies is “to permit the continued expansion of
commercial practices through custom, usage and agreement of the parties.”
[F1–102(2)(b).] Comment 1 to this section sets out clearly the intention of
the drafters:
“This Act is drawn to provide flexibility so that, since it is intended to be
a semipermanent piece of legislation, it will provide its own machinery
for expansion of commercial practices. It is intended to make it possible
for the law embodied in this Act to be developed by the courts in light of
unforeseen and new circumstances and practices. However, the proper
construction of the Act requires that its interpretation and application
be limited to its reason.” (Emphasis added).
The majority's rigid interpretation defeats the purpose of the Code.
SECTION 2
Nowhere in the UCC is “sum certain” defined. This absence must be
interpreted in light of the expectation that commercial law continue to
evolve. The [F3–106] exceptions could not have been intended as the
exclusive list of “safe harbors,” as the drafters anticipated “unforeseen”
changes in commercial practices. Instead, those exceptions represented, at
the time of drafting, recognized conditions of paym ent which did not impair
negotiability in the judgment of businessmen. To limit exceptions to those
existing at that time would frustrate the “continued expansion of
commercial practices” by freezing the Code in time and requiring additional
legislation whenever “unforeseen and new circumstances and practices”
evolve, regardless of “custom, usage, and agreement of the parties.”
“The rule requiring certainty in commercial paper was a rule of
commerce before it was a rule of law. It requires commercial, not
mathematical, certainty. An uncertainty which does not impair the
function of negotiable instruments in the judgment of business men
ought not to be regarded by the courts.... The whole question is, do [the
provisions] render the instruments so uncertain as to destroy their
fitness to pass current in the business world?” Cudahy Packing Co. v.
State National Bank of St. Louis, 134 F. 538, 542, 545 (8th Cir.1904).
Instruments providing that loan interest may be adjusted over the life
of the loan routinely pass with increasing frequency in this state and many
others as negotiable instruments. This Court should recognize this custom
and usage, as the commercial market has, and hold these instruments to be
negotiable.
The majority focuses on the requirement found in Comment 1 to
[F3–106] that a negotiable instrument be self-contained, understood without
reference to an outside source. Our cases have interpreted this to mean that
reference to terms in another agreement which materially affect the
instrument renders it nonnegotiable.
The commercial market requires a self-contained instrument for
negotiability so that a stranger to the original transaction will be fully
apprised of its terms and will not be disadvantaged by terms not
ascertainable from the instrument itself. For example, interest payable at
the “current rate” leaves a holder subject to claims that the current rate was
established by one bank rather than another and would disadvantage a
stranger to the original transaction.
The rate which is stated in the notes in this case, however, does not
similarly disadvantage a stranger to the original agreement. Anyone coming
into possession could immediately ascertain the terms of the notes; interest
payable at three percent above the prime rate established by the Chase
Manhattan Bank of New York City. This is a third-party objective standard
which is recognized as such by the commercial market. The rate can be
determined by a telephone call to the bank or from published lists obtained
on request.
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Accordingly, I believe these notes are negotiable under the Code and I
would affirm the decision below.
NOTES ON THE FORMAL REQUISITES OF NEGOTIABILITY
(1) The Importance of Form. Promissory notes, which are often
relatively elaborate and may contain hand-tailored provisions to suit the
particular transaction, are more likely to run afoul of the requisites of
negotiability than are checks and other drafts, which usually are relatively
simple in form. The creditor who is the payee of a note will want to bind the
debtor with numerous obligations in addition to the clean-cut promise to pay
money. The creditor wants to be able to declare the entire debt due if the
debtor defaults on any obligation or if the debtor’s financial position
becomes shaky. The creditor who takes a security interest in personal
property wants to bind the debtor not to make off with the collateral and
also to keep it insured, undamaged, and free from liens.
This need to obtain a wide assortment of promises from the debtor came
into collision with the traditional rules on the proper scope of
negotiability—a tradition epitomized by Chief Justice Gibson’s famous
dictum that a negotiable instrument must be “a courier without luggage.”
Overton v. Tyler, 3 Pa. 346, 45 Am. Dec. 645 (1846). The fences that were
erected to confine the doctrine of negotiability took the form of the “formal
requisites” for negotiable instruments set forth in painful detail in the
Negotiable Instruments Law and carried forward, with significant
relaxations, in Article 3 of the UCC. See UCC 3–104 through 3–113.
Why have such complex “formal requisites”? Why not permit the parties
to a contract to make it a negotiable instrument simply by so stating in the
contract itself? Professor Chafee advanced the following explanation:
Although the law usually cares little about the form of a contract and
looks to the actual understanding of the parties who made it, the form
of a negotiable instrument is essential for the security of mercantile
transactions. The courts ought to enforce these requisites of commercial
paper at the risk of hardship in particular cases. A businessman must
be able to tell at a glance whether he is taking commercial paper or not.
There must be no twilight zone between negotiable instruments and
simple contracts. If doubtful instruments are sometimes held to be
negotiable, prospective purchasers of queer paper will be encouraged to
take a chance with the hope that an indulgent judge will call it
negotiable. On the same principle, if trains habitually left late, more
people would miss trains than under a system of rigid punctuality.
Chafee, Acceleration Provisions in Time Paper, 32 Harv.L.Rev. 747, 750
(1919). Is this the only reason for confining the attributes of negotiability to
a limited class of paper? If the “security of mercantile transactions” is the
only object, why have such complex requisites?
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Contrast with Chafee’s remarks the following comment by Professor
Gilmore:
Few generalizations have been more fully repeated, or by
generations of lawyers more devoutly believed, than this: negotiability
is a matter rather of form than substance. It is bred in the bone of every
lawyer that an instrument to be negotiable must be “a courier without
luggage.” It must conform to a set of admirably abstract specifications
which, for our generation, have been codified in Section 1 of the
Negotiable Instruments Law and spelled out in the nine following
sections. These rules are fixed, external and immutable. No other
branch of law is so clear, so logical, so inherently satisfying as the law
of formal requisites of negotiability. To determine the negotiability of
any instrument, all that need be done is to lay it against the yardstick
of NIL sections 1–10: if it is an exact fit it is negotiable; a hair’s breadth
over or under and it is not.
Few generalizations, legal or otherwise, have been less true; the
truth is, in this as in every other field of commercial law, substance has
always prevailed over form. “The law” has always been in a constant
state of flux as it struggles to adjust itself to changing methods of
business practice; what purport to be formal rules of abstract logic are
merely ad hoc responses to particular situations.
Nevertheless, the cherished belief in the sacrosanct nature of formal
requisites serves, as do most legal principles, a useful function. The
problem is what types of paper shall be declared negotiable so that
purchasers may put on the nearly invincible armor of the holder in due
course. The policy in favor of protecting the good faith purchaser does
not run beyond the frontiers of commercial usage. Beyond those confines
every reason of policy dictates the opposite approach. The formal
requisites are the professional rules with which professionals are or
ought to be familiar. As to instruments which are amateur productions
outside any concept of the ordinary course of business, or new types
which are just coming into professional use, it is wiser to err by being
unduly restrictive than by being over liberal. The formal requisites serve
as a useful exclusionary device and as a brake on a too rapid acceptance
of emerging trends.
...
. . . As long as the law distinguishes between commercial and
non-commercial property on the basis of form, there will have to be
borderline or fringe litigation. On the whole a continuing trickle of such
litigation is not obnoxious; it produces a clearer state of the law than
does the law of sales where the doctrines say one thing and mean
another, a situation not productive of certainty and predictability.
Gilmore, The Commercial Doctrine of Good Faith Purchase, 63 Yale L.J.
1057, 1068–69, 1072 (1954).
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According to Soia Mentschikoff, the Associate Chief Reporter for the
UCC, “the classification of these pieces of paper [bills of exchange, notes,
checks] as negotiable instruments should be dependent on commercial use
and the nature of the current markets to be protected.” Mentschikoff,
Highlights of the Uniform Commercial Code, 27 Mod.L.Rev. 167, 176 (1964).
Do the UCC provisions seem to take “commercial usage” and current
markets into account?
(2) Variable Interest Rates. Professor Mentschikoff’s suggestion that
negotiability “should be dependent on commercial use and the nature of
current markets to be protected” was severely tested when, after the
enactment of former Article 3, variable rate notes came into widespread use
during the double-digit inflation of the 1970s. Under F3–104, the sum
payable was a sum certain even though payable “with stated interest,” but
there was no provision for a variable rate of interest.
Most courts that considered the issue reached the same conclusion as
did Taylor v. Roeder, supra, although there were occasional contrary
decisions upholding the negotiability of variable rate notes. Many states
enacted statutes allowing variable rate notes to be negotiable. These
statutes are replaced by UCC 3–112(b), which provides that a variable rate
of interest does not impair negotiability and adds that the rate “may require
reference to information not contained in the instrum ent.”
The United Nations Convention on International Bills of Exchange and
International Promissory Notes contains a comparable provision.19 Under
article 8(6), any rate referred to “must be published or otherwise available
to the public and not be subject, directly or indirectly, to unilateral
determination by a person who is named in the instrument at the time the
bill is drawn or the note is made, unless the person is named only in the
reference rate provisions.” Does the absence of such language in UCC
3–112(b) suggest a different rule?
(3) Acceleration Clauses. Under UCC 3–108(b), negotiability is not
impaired by the fact that the instrument is subject to rights of acceleration.
It may seem surprising that such a provision was thought to be necessary
inasmuch as a note payable at a definite time but subject to acceleration is
no less certain as to time of payment than a note payable on demand.
Nevertheless, under the Negotiable Instruments Law courts generally held
that at least some types of acceleration clauses impaired negotiability.
Typical of the clauses condemned by this argument were those giving the
holder the power to accelerate “at will” or “when he deems himself insecure.”
The comments to an early draft of Article 3 of the UCC gave the
following explanation for this line of decisions:
It seems evident that the courts which give uncertainty of time of
19. This Convention, promulgated by the United Nations Commission on
International Trade Law (“UNCITRAL”) in 1988, has yet to enter into force.
SECTION 2
payment as a reason for denying negotiability are in reality objecting to
the acceleration clause itself. This objection may be founded on abuses
of the clause. The signer of an acceleration note, unlike the signer of a
demand note, does not expect to be called upon to pay before the
ultimate date. Normally he understands the acceleration clause to be for
the protection of the holder against his own insolvency or similar
contingencies, and he expects that the note will not be accelerated
without good reason. An unscrupulous creditor can accelerate it without
reason, and a note prematurely called may ruin the debtor . . . . Inquiry
among banks has led to the conclusion that the privilege of acceleration
at the option of the holder has real advantage to the creditor, who
frequently must act on the basis of confidential information or evidence
as to the condition of the debtor which does not amount to definite proof.
The effect of denying negotiability to acceleration paper is not to remedy
any abuses arising in connection with the acceleration clause, which
remains in effect even if the instrument be treated as a simple contract.
It is merely to open the paper to defenses which have nothing to do with
acceleration.
Commercial Code, Comments and Notes to Article III 43–44 (Tent. Draft
No. 1, 1946).
The UCC, therefore, makes the power to accelerate irrelevant to the
issue of negotiability. But UCC 1–309 limits the holder’s power to accelerate
“at will” or “when he deems himself insecure” by requiring “good faith.”
What does “good faith” mean in this sense? See UCC 1–201(b)(20). How easy
would it be for the maker to prove lack of good faith? Does UCC 1–309 limit
the power of the holder of a note payable on demand to demand payment?
Why? See UCC 1–309, Comment 1. Does it limit the power of the holder of
a note that permits acceleration at the holder’s option on the maker’s
default? See, e.g., Greenberg v. Service Business Forms Industries, 882 F.2d
1538 (10th Cir.1989) (refusing to apply the good faith requirement of
F1–208 to a note that permits the holder to accelerate upon the maker’s
default).
One reason for including a clause permitting acceleration “should the
holder of this note deem itself insecure” is suggested by State National Bank
of Decatur v. Towns, 36 Ala. App. 677, 62 So. 2d 606 (1952). In that case the
bank that held such a note as payee was served, before the maturity date of
the note, with a writ of garnishment by which a judgment creditor of the
maker sought satisfaction from the maker’s bank account. However the
bank was held to be entitled to accelerate the maturity date under the
clause and set off its debt ahead of the judgment creditor. “By the
garnishment the judgment plaintiff acquired only the rights to the judgment
defendant. As to the judgment defendant the bank, as a result of the
acceleration clause in the note, had a right of set off against any claim of the
judgment defendant in a suit against it.” The note held by the bank also
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contained a clause purporting to give the bank a “lien” on the maker’s
account, but the court did not rely on this, pointing out that a bank has a
right to set off a general deposit against a debt of the depositor if the debt
is matured.
(4) Nonnegotiable Instruments and Magic Words. Under the
Negotiable Instruments Law, unless the instrument complied with the
requisites of negotiability, none of the statutory provisions was applicable.
In many instances the rules were the same for instruments that were not
negotiable, but this was not because the statute controlled but because the
statute was, in part, a codification of common law rules, some of which
applied to nonnegotiable instruments as well. In addition, in a few
instances, courts applied the statutory provisions to nonnegotiable
instruments by analogy. Former Article 3 departed from the approach of the
Negotiable Instruments Law in two significant respects. First, while NIL 1
provided that an instrument had to comply with the stated requisites “to be
negotiable,” F3–104 said only that it must comply “to be a negotiable
instrument within this Article.” According to Comment 1 to that section,
this language left “open the possibility that some writings may be made
negotiable by other statutes or by judicial decision.” Second, F3–805, which
had no counterpart in the Negotiable Instruments Law, created a special
class of nonnegotiable instrument to which all of former Article 3 applied
with the very important exception that “there can be no holder in due course
of such an instrument.” Because it covered nonnegotiable as well as
negotiable instrum ents, former Article 3 was styled “Commercial Paper.”
Current Article 3, like the Negotiable Instruments Law, “applies to
negotiable instruments” (UCC 3–102(a)) and is styled “Negotiable
Instruments” to reflect its more limited scope (UCC 3–101). Its provisions
might, of course, be applied by analogy to what would have been
nonnegotiable instruments under former Article 3, but such instruments
seem rarely to produce litigation.
To come under Article 3 today, an instrument must be payable to “order”
or “bearer.” See UCC 3–104(a)(1); UCC 3–109. (Of course, the inclusion of
one of these “magic words” does not of itself confer negotiability on an
instrum ent.) UCC 3–104(c) makes a significant exception in this respect for
checks, as to which magic words are not necessary for negotiability. As
Comment 2 to UCC 3–104 explains, the absence of such words on a check
“can easily be overlooked and should not affect the rights of holders who
may pay money or give credit for a check without being aware that it is not
in conventional form.”
(5) Negotiability Revisited. A quarter of a century after expressing
the thoughts in Note (1), supra, Professor Gilmore had these harsh words
for former Article 3:
As a general rule, anything—including negotiability—which was good
SECTION 2
enough for Lord Mansfield was good enough for Llewellyn.[20] That
attitude, unfortunately, carried through to the drafting of Article 3 of
the Code, which can be described as the N.I.L. doubled in spades or
negotiability in excelsis. Article 3 gravely takes up each of the pressure
points which developed in the N.I.L. case law and resolves the issue in
favor of negotiability. [In a footnote Gilmore gives examples including
the provisions of F3–109 on acceleration clauses, discussed in Note (3),
supra, and of F3–105 on notes with security agreements.] . . . What
Article 3 really is [is] a museum of antiquities—a treasure house
crammed full of ancient artifacts whose use and function have long since
been forgotten. Another function of codification, we may note, is to
preserve the past, like a fly in amber.
Gilmore, Formalism and the Law of Negotiable Instruments, 13 Creighton
L. Rev. 441, 460-61 (1979).
(6) “Transferable Records.” To qualify as a negotiable instrument
under UCC Article 3, a note must be written. See UCC 3–104(a); UCC
3–103(a)(9). In the 1990’s business transactions increasingly became
evidenced by electronic rather than paper records. We have seen that one
of the major benefits of negotiability—the ability to acquire a right to
payment free of the claims and defenses of the person obligated to pay—can
be acquired by obtaining the obligated person’s agreement to that effect. See
UCC 9–403(b). Other benefits, including the ability to acquire the right to
payment free of third-party claims, cannot be achieved readily (if at all) by
contract. To enable businesses to acquire the benefits of negotiability in an
electronic environment, in 1999 NCCUSL promulgated section 16 of the
Uniform Electronic Transactions Act (“UETA”). UETA has since been
enacted in nearly every state.
UETA 16(a) provides for the creation of a “transferable record”—an
electronic record that would be a note under UCC Article 3 if it were in
writing.21 An electronic record can qualify as a transferable record only if the
issuer agrees that it is a transferable record. UETA 16(a)(2). A person can
become the holder of a transferable record and acquire the same rights as
a holder of a negotiable note under Article 3 by having “control” of the
electronic record. UETA 16(d). As Comment 3 to UETA 16 explains, “Under
Section 16 acquisition of ‘control’ over an electronic record serves as a
substitute for ‘possession’ in the paper analog. More precisely, ‘control’
under Section 16 serves as the substitute for delivery, indorsement and
possession of a negotiable promissory note.” A person who has control and
also satisfies the requirements of UCC 3–302(a) acquires the rights of a
20. [Professor Karl N. Llewellyn (1893-1962) was the Chief Reporter for the UCC
as well as the Reporter for Article 2.]
21. The term “transferable record” also encompasses an electronic record that
would be a document under UCC Article 7 if it were in writing. See Section 3, infra.
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holder in due course. UETA 16(d).
UETA 16 establishes a general standard for control: “A person has
control of a transferable record if a system employed for evidencing the
transfer of interests in the transferable record reliably establishes that
person as the person to which the transferable record was issued or
transferred.” UETA 16(b). It also provides, in UETA 16(c), “a safe harbor list
of very strict requirements for such a system.” UETA 16, Comment 3. To
qualify for the safe harbor, a transferable record must be “created, stored,
and assigned in such a manner that . . . a single authoritative copy of the
transferable record exists which is unique, identifiable, and [with certain
exceptions] unalterable.” UETA 16(c)(1). Neither the general standard nor
the safe harbor mandates the use of particular technology; rather, any
system that accomplishes the purpose of “control”—to reliably establish the
identity of the person entitled to payment—is sufficient.
Federal law also contemplates the creation of negotiable, “transferable
records.” See Electronic Signatures in Global and National Commerce Act
(“E–SIGN”), Pub. L. No. 106–229, § 201, 114 Stat. 464 (2000) (codified at 15
U.S.C. § 7021). Section 201 of E–SIGN generally tracks UETA 16, but the
federal rule applies only to an electronic record that “relates to a loan
secured by real property.” Id. § 201(a)(1)(C).
Although systems for control of electronic notes are still being developed
and refined, one system that is up and running describes its services as
follows:
The eOriginal eCore Business Suite . . . fully complies with E-Sign,
UETA, and UCC Revised Article 9 legislation requirements for the
creation and management of electronic negotiable instrum ents (e.g.,
bills of lading, promissory notes, chattel paper, etc.). It . . . provides the
means for establishing ownership and control of Electronic Original
documents, allowing for the transfer of ownership of those documents
within a secure and trusted environment, among multiple parties
instantaneously.
http://www.eoriginal.com/products/product_overview.html (visited Apr. 4,
2005).
Problem 1.2.12. In exchange for an anticipated delivery of goods, M
makes a negotiable note payable “to A or order” in the amount of $60,000.
A acquired the goods from the manufacturer, who at A’s instruction “drop
shipped” them directly to M. After accepting the goods, M discovered that
they are seriously nonconforming and refused to pay more than $20,000. A
brings suit against M. What result? Is A a holder in due course? If so, do A’s
rights include the right to enforce M’s obligation free of M’s claim in
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recoupm ent? See UCC 3–305 & Comment 3. Is it in fact “obvious that
holder-in-due-course doctrine cannot be used to allow Seller to cut off a
warranty claim that Buyer has against Seller”?
NOTE ON PAYEE AS HOLDER IN DUE COURSE
We already have seen two ways in which a party to a transaction is
better off by becoming the payee of a negotiable instrument than the obligee
on a simple contract. Unlike an obligee on a contract, a holder of (or other
person entitled to enforce) a negotiable instrument, including a payee of the
instrument, does not take subject to the obligor’s setoff rights. See UCC
3–305(a); Note (6) on Defenses to Payment Obligations, supra. In addition,
a holder or other person entitled to enforce enjoys the benefits of the rules
of pleading and proof in UCC 3–308.
Of course, a holder in due course receives greater protection than a mere
holder. The HDC doctrine rests upon the idea that third-party purchasers
should be able to acquire negotiable instruments without having to concern
themselves with the transaction giving rise to the instrument. One would
assume, therefore, that the special protection afforded to holders in due
course ordinarily would not be available to a party to the very transaction
giving rise to the instrument. UCC 3–302, Comment 4, observes that “in a
small percentage of cases it is appropriate to allow the payee of an
instrument to assert rights as a holder in due course.” Those cases are ones
“in which conduct of some third party is the basis of the defense of the issuer
of the instrument.” Does Problem 1.2.12 present such a case? If so, what, if
anything, prevents A from acquiring the rights of an HDC and cutting off
M’s claim for breach of warranty?
(C) D ISCHARGE (T HE “M ERGER” D OCTRINE)
To what extent, in performing an obligation, must the obligor pay
attention to the whereabouts of the writing that evidences it? An obligor on
an ordinary contract right can safely deal with the original obligee in
discharging the obligation, even if the right is evidenced by a writing, unless
the obligor has received notification of an assignment. The Restatement
(Second) of Contracts so provides in § 338(1). 22 UCC 9–406(a) puts the
general rule as follows:
22.
Restatement (Second) of Contracts § 338(1) provides as follows:
[N]otwithstanding an assignment, the assignor retains his power to discharge
or modify the duty of the obligor to the extent that the obligor performs or
otherwise gives value until but not after the obligor receives notification that
the right has been assigned and that performance is to be rendered to the
assignee.
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[A]n account debtor . . . may discharge its obligation by paying the
assignor until, but not after, the account debtor receives a notification,
authenticated by the assignor or the assignee, that the amount due or
to become due has been assigned and that payment is to be made to the
assignee. After receipt of the notification, the account debtor may
discharge its obligation by paying the assignee and may not discharge
the obligation by paying the assignor.
In contrast, the obligor on a negotiable instrument cannot safely deal with
the original obligee without paying attention to the writing that embodies
the obligation.
Problem 1.2.13. A sold O a machine for O’s factory for $100,000,
payable in 30 days. A assigned the right to payment to the B finance
company, which paid A $100,000 less a discount. At the end of the 30 days,
O, who did not know of the assignment, paid A $100,000. B sues A for
$100,000.
(a) Must O pay again? What could the losing party have done to prevent
the loss? What should the losing party do now? See UCC 9–406(a);
Restatement (Second) of Contracts § 338(1), supra; Note (1) on the Merger
Doctrine, infra.
(b) Suppose that, shortly after the sale of the machine, O received a
letter from B stating,“Pleased be advised that all amounts owing from
yourself to A have been sold to the undersigned. Kindly remit your payment
to the undersigned at the address above.” O is reluctant to pay B; O doesn’t
believe A has stooped so low as to “hock its receivables.” What should O do?
See UCC 9–406(a), (c).
Problem 1.2.14. A sold M a machine for M’s factory for $100,000,
payable in 30 days. In connection with the sale, M executed a negotiable
promissory note, promising to “pay $100,000 to the order of A” in 30 days.
A assigned the right to payment and delivered the note to the B finance
company, which paid A $100,000 less a discount. At the end of the 30 days,
M, who did not know of the assignment, paid A $100,000. B sues A for
$100,000.
(a) Must M pay again if the 1990 (unamended) UCC 3–602 is in effect? 23
See UCC 3–301; UCC 1–201(b)(21); UCC 3–203(a), (b). What could the
losing party have done to protect itself? What should the losing party do
now? See UCC 3–601; 1990 UCC 3–602; UCC 3–412.
(b) Must M pay again if R3–602(b) is in effect? What could the losing
party have done to protect itself? What should the losing party do now?
NOTES ON THE “MERGER” DOCTRINE AND PAYMENT BY MISTAKE
23. If your statute book does not contain the unamended version of UCC 3–602,
consult the Revised version but ignore subsections (b), (d), and (f).
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(1) Whom Must an Obligor Pay? Knowing the proper party to pay is
(or should be) a major concern for a person who owes a debt. If an obligor
pays the wrong party, the obligor does not discharge its obligation and will
have to pay again—this time to the proper party. Of course, the mistaken
obligor will be entitled to recover a payment from a party who is not entitled
to receive it. See Restatement (Third) of Restitution and Unjust Enrichment
§ 6 (Tent. Draft No. 2) (2002). This restitutionary remedy may provide little
comfort to an obligor who must litigate against a person who wrongfully
kept funds to which it was not entitled.
Like Restatement (Second) of Contracts § 338(1), supra, UCC 9–406(a)
contains what sometimes is referred to as the “notification” rule: Even if a
right to payment has been assigned, the obligor (whom Article 9 refers to as
an “account debtor”) may discharge its obligation by paying the assignor
until, but not after, the account debtor receives a notification “that the
amount due or to become due has been assigned and that payment is to be
made to the assignee.” UCC 9–406(a). Subsections (b) and (c) of UCC 9–406
help protect the account debtor from having to pay twice.
(2) The “Merger” Doctrine and its Decline. UCC 9–406(a) applies
only to an “account debtor”; it does not apply to persons obligated on a
promissory note or other instrument. See 9–102(a)(3) (“account debtor” does
not include persons obligated to pay a negotiable instrument). What law
does apply? If the promissory note is negotiable, then UCC Article 3
determines whom the maker (or other person obligated on the instrument)
must pay to discharge its obligation. One traditional characteristic of
negotiable instruments is that the instrument is treated as if it actually
were the right to payment that it evidences. Alternatively stated, under
traditional negotiable instruments law, the right to payment “merges” into
the writing that evidences the right. Accordingly, when a person takes a
negotiable instrument for an obligation, payment of the instrument
discharges the obligation. See UCC 3–310(b).
The pre-1990 version of Article 3 reflects traditional merger doctrine.
The holder (who, by definition, had possession) of a negotiable note was
entitled to enforce it, see F3–301, and the liability of the maker was
discharged “to the extent of his payment or satisfaction to the holder.”
F3–603(1). The 1990 revision of Article 3 made a significant inroad in the
doctrine by creating the concept of a “person entitled to enforce the
instrum ent.” The maker’s obligation to pay a note “is owed to a person
entitled to enforce the instrument.” UCC 3–412. And, under UCC 3–602(a),
“an instrument is paid to the extent payment is made . . . to a person
entitled to enforce the instrument. To the extent of the payment, the
obligation of the party obligated to pay is discharged . . . .” We saw in Note
(3) on Defenses to Payment Obligations, supra, that “person entitled to
enforce” an instrument includes not only a holder but also “a nonholder in
possession of the instrument who has the rights of a holder,” UCC 3–301,
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and that “transfer” of the instrument, which requires delivery, vests in the
transferee any right of the holder to enforce the instrument. See UCC
3–203. Thus, a transferee of an instrument from a holder would acquire the
holder’s right to enforce the instrument and become a person entitled to
enforce.
As it plays out under Article 3 (1990), the merger concept—in which the
right to paym ent travels with the paper evidencing it—makes commercial
sense only if (i) makers understand that they cannot discharge their
obligation unless they pay a person in possession of the note, (ii) makers are
in a position to demand that the note be exhibited before making a payment,
and (iii) those in possession of a negotiable instrument reliably have
obtained it by transfer, i.e., by a voluntary delivery for the purpose of giving
the person receiving delivery the right to enforce the instrument. How often
do you think these conditions are met?
Of course, stating the rule may be easier than paying the person entitled
to enforce. Consider, for example, a note that requires payment in monthly
installments. Is it reasonable to expect the maker to demand that the note
be exhibited before each installment is paid?24 Even if so, does the fact that
a person is in possession of the note necessarily mean that the person is
entitled to enforce it? See Problem 1.2.4(a), supra, page 21. Can those who
sign notes reasonably be expected to know the special discharge rules for
negotiable instruments? Can they reasonably be expected to be able to
determine whether any given note is negotiable?
As a practical matter, makers often pay whoever demands payment.
Rarely, however, has a maker been required to pay twice. In many, if not
most, cases, payments have been made to the person entitled to enforce. In
other cases, courts have used a variety of legal doctrines to protect the
maker. As the Restatement (Third) of Property explains with respect to
mortgage notes:
[T]he U.C.C.’s requirement that payment be made to the person in
possession of the instrument is only rarely a problem for payors who pay
the original mortgagee. One reason is that many notes secured by real
estate mortgages are not negotiable in form because their promise to pay
is conditional, because they are not payable to “bearer” or “order,” or
because they contain additional undertakings beyond the payment of
money. See U.C.C. § 3–104 (1995). The U.C.C. does not govern discharge
of nonnegotiable obligations.
Another reason is that very frequently when a mortgage loan is sold
on the secondary mortgage market, the original mortgagee is formally
24. Note, in this regard, that the 1990 version of Article 3 deleted the requirement
of presentment (i.e., demand for payment) as a condition of dishonor for time notes. See
UCC 3–502(a)(3). A person to whom presentment is made may demand that the person
making presentment exhibit the instrument. UCC 3–501(b)(2). Does a person who
becomes obligated to pay without presentment enjoy the same right?
SECTION 2
designated as “servicer” of the mortgage loan by the holder, with full
authority to receive payments on behalf of the holder. Hence such
payments count as if they had been made to the holder directly.
Moreover, if the servicing duties are later shifted to a different entity,
federal law requires that notification of the change be given to the
mortgagor if the mortgage is “federally related”; see 12 U.S.C.A. § 2605.
Some state statutes impose similar duties.
Even when there is no specific grant of collection authority to the
original mortgagee by the holder, courts often find implied authority
from the prior course of dealing between the holder and the mortgagee
. . . . If there is no such course of dealing, the holder’s conduct may estop
it from denying the mortgagee’s authority . . . . Finally, the holder’s
conduct after the mortgagee has received payment may constitute a
ratification of that payment, thus compelling the holder to give credit for
it. . . .
Restatement (3d) of Property (Mortgages) § 5.5, Comment b (1999).
Notwithstanding that traditional merger doctrine “only rarely”
presented a problem, the real-estate bar’s strenuous objections to the
doctrine led to the 2002 amendments to 3–602. These go a long way towards
abandoning the merger doctrine in favor of the “notification” rule. See
R3–602(b), (d). As of October 2007, five states had enacted these
amendments: Arkansas, Kentucky, Minnesota, Nevada, and Texas.
(3) Discharge of Nonnegotiable Instruments. If a promissory note
is not negotiable, then law other than the UCC determines whom a person
obligated on the instrument must pay to discharge its obligation. Certain
types of writings are treated in the ordinary course of business as symbols
of contractual rights and in ordinary course of business are transferred by
delivery with any necessary indorsement or assignment. According to the
Restatement (Second) of Contracts, an obligor on such a symbolic writing
who pays without requiring production of the writing takes the risk that the
person receiving payment does not have possession of the writing because
the person has assigned it. Restatement (2d) of Contracts § 338(4),
Comment g. In other words, “Non-production has the same effect as receipt
of notification of assignment . . . .” Id.
(4) Recovery of Payments Made by Mistake. Although Article 9
specifies the person whom an account debtor must pay to discharge its
obligation, it does not address the rights of the parties with respect to a
payment that is made to the “wrong” person. Rather, it leaves this issue to
non-UCC law. See UCC 1–103(b). An obligor who pays the wrong person
ordinarily may recover the amount of the mistaken payment from the
recipient under the law of restitution. See Restatement (Third) of
Restitution and Unjust Enrichment § 6 (Tent. Draft No. 1) (2001). Indeed,
as Comment a observes, “[m]istaken payment of money not due presents one
of the core cases of restitution, whether liability is explained by reference to
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the transferee’s unjustified enrichment or to the transferor’s unintended
dispossession.”
The UCC expressly addresses recovery of a mistaken payment on a
negotiable instrument. The general rule appears in UCC 3–418(b): A person
who pays an instrument by mistake may recover the payment from the
person to whom it was made, “to the extent permitted by the law governing
mistake and restitution.” But UCC 3–418(c) provides that, notwithstanding
UCC 3–418(b), the right to recover a mistaken payment may not be asserted
against (i) a person who took the instrument in good faith and for value or
(ii) a person who in good faith changed position in reliance on the payment.
Consider Problem 1.2.14(a), in which M paid A even though B was the
PETETI. Would M have a right to recover the payment from A under UCC
3–418(b), which incorporates the law of mistake and restitution? If so, does
UCC 3–418(c) immunize A, as “a person who took the instrument in good
faith and for value”? There seems to be no reason why A’s having taken the
instrument in good faith should entitle A to keep a payment that A knew it
was not entitled to receive. Can you think of a way to interpret UCC
3–418(c) so as to preserve M’s right to recover from A?
(D) “S PENT” I NSTRUMENTS
To what extent, after making a payment, does the obligor run a risk by
leaving outstanding (without cancellation or some appropriate notation of
performance) the writing that evidences the obligation to pay? In other
words, to what extent can the good faith purchaser of a right to payment
safely rely on the writing as an indication that the obligation has not
already been discharged? The answer may depend on whether the right to
payment is embodied in a negotiable instrument.
Problem 1.2.15. A sold O a machine for O’s factory for $100,000,
payable in 30 days. Before the 30 days were up, O paid A $100,000, but left
the written contract of sale in A’s hands without any notation on it. A then
assigned the right to payment and delivered the written contract to the B
finance company, which paid A $100,000 less a discount without knowing
of O’s payment to A. At the end of the 30 days, O refused to pay B. B sues A
for $100,000. Must O pay again? What could the losing party have done to
protect itself? What should the losing party do now? See UCC 9–404(a);
Restatement (Second) of Contracts § 336(1), supra note 7; Restatement
(Second) of Contracts § 333(1), supra note 7.
Problem 1.2.16. A sold M a machine for M’s factory for $100,000,
payable in 30 days. In connection with the sale, M executed a negotiable
promissory note, promising “to pay to the order of A $100,000” in 30 days.
Before the 30 days were up, M paid A $100,000 but left the written contract
of sale and the promissory note in A’s hands without any notation on them.
A then assigned the right to payment, indorsed the note, and delivered both
SECTION 2
the written contract and the note to the B finance company, which paid A
$100,000 less a discount without knowing of M’s payment to A. At the end
of the 30 days, M refused to pay B. B sues M for $100,000.
(a) What is the effect, if any, of M’s payment to A under the 1990
(unamended) UCC 3–602? Is M obligated to pay B? See UCC 3–601(b). What
could the losing party have done to protect itself? What should the losing
party do now? See UCC 3–601; UCC 3–602;
(b) What is the effect, if any, of M’s payment to A under R3–602(b)? Is
M obligated to pay B?
(c) Return to the facts of Problem 1.2.14(b), where M paid A $100,000
after the note was delivered to B. Did M discharge its obligation under
R3–602(b)? Even if so, must M pay B? See UCC 3–601(b); R3–602(d) &
Comment 4.
NOTE ON “SPENT” INSTRUMENTS
Although waiver-of-defense clauses and negotiable notes may
accomplish the same primary objective—to insulate third parties from the
obligor’s defenses—the negotiable note can have legal consequences that
reach beyond a contractual “cut-off” clause. For example, an obligor on an
ordinary right to payment, such as an account, runs no risk by leaving the
writing that evidences the account outstanding. To put it differently, a good
faith purchaser who takes such a right by assignment cannot safely rely on
the writing as an indication that the obligation has not already been
discharged. See UCC 9–404(a); Restatement (Second) of Contracts § 336(1).
In contrast, a person who has executed a negotiable note cannot safely make
payment without obtaining the instrument and seeing that the payment is
noted on it. The reason is that the instrument might be negotiated
thereafter to a holder in due course, who, under the basic rules of UCC
3–305, takes free of the maker’s defenses, including payment. See also UCC
3–601(b) (discharge is not effective against a person acquiring rights of an
HDC without notice of the discharge). Do you think most makers of
negotiable notes are aware of this risk? If so, do you think they take steps
to prevent it from arising? (A railroad or warehouse that has issued a
negotiable document of title—bill of lading or warehouse receipt—runs a
similar risk if it delivers the goods without surrender of, or notation on, the
document. See Problem 1.3.6, infra.)
NEGOTIABILITY—WHO NEEDS IT?
Professor Albert Rosenthal raised quite a stir when he published an
article on negotiable instruments with a provocative title: “Negotiability—
Who Needs It?,” 71 Colum.L.Rev. 375 (1971). In assessing whether the
negotiability of notes serves a useful purpose, it is important to distinguish
between (i) the aspects of negotiability that relate to the mechanics of
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transfer, such as the merger doctrine, and (ii) the aspects of negotiability
that afford special protection to holders in due course. With respect to the
latter, one might consider whether allowing good faith purchasers of rights
to payment to take free of claims and defenses is commercially useful. Even
if good-faith-purchase protection is desirable, to what extent should the
protection depend on the use of a negotiable instrument? Would it be
practical for commercial parties who seek the good-faith-purchase benefits
of negotiability to provide for them by contract?
S ECTION 3.
P URCHASE OF D OCUMENTS OF T ITLE
INTRODUCTORY NOTE
Another type of personal property that may serve as collateral for a
secured loan is a “document of title.” As the definition of the term suggests
(UCC 1–201(b)(16)), documents of title purport to cover goods in the
possession of a bailee. The two major types of documents of title are the
“bill of lading” (UCC 1–201(b)(6)), as to which the bailee is in the business
of transporting or forwarding goods (e.g., a railroad), and the “warehouse
receipt” (UCC 1–201(b)(42)), as to which the bailee is engaged in the
business of storing goods for hire (e.g., a warehouse).
A description of the common uses for the bill of lading and the
warehouse receipt will aid in understanding the rights of secured parties
whose collateral consists of documents of title and the rights of transferees
of documents generally.
Bills of Lading. A bill of lading (originally, “bill of loading”) is a
document of title that a railroad or other carrier issues when goods are
delivered to it for shipment. See UCC 1–201(b)(6), (16). The UCC’s rules
governing bills of lading are collected in Article 7.1 However, bills of lading
in interstate shipments and exports are governed by the federal law, 49
U.S.C. §§ 80101–16, and not by the UCC. For present purposes, however,
the differences are not crucial.
The bill of lading, in part, embodies a contract between the carrier and
the shipper (often termed the “consignor,” see UCC 7–102(a)(4)). This
contract sets forth, inter alia, the consignor’s obligations to pay freight and
other charges and the carrier’s obligations with respect to the transportation
and delivery of the goods. It also addresses the carrier’s liability in the event
of casualty to the goods or failure to deliver.
1. Not all of Article 7 applies to bills of lading; Part 2 contains special provisions
applicable only to warehouse receipts. Article 7 was revised in 2003, primarily in order
to accommodate electronic documents of title and to modernize the article to take account
of federal and international developments. Revised Article 7, Prefatory Note. Citations
in these materials to pre-revision Article 7 are to F7–xxx.
SECTION 3
PURCHASE OF DOCUMENTS OF TITLE
Control of the bill of lading can be used to control delivery of the goods.
In this regard, one must distinguish between the nonnegotiable (or
straight) bill of lading and the negotiable one. As is true with instruments,
see supra Section 2, the form of the paper is determinative. See UCC 7–104.
Under the nonnegotiable bill of lading, the carrier undertakes to deliver the
goods to a stated person (the “consignee”). See UCC 7–102(a)(3); UCC
7–104(b). For example, if the bill of lading runs “to Buyer & Co.,” then the
carrier discharges its delivery obligation by delivering the goods to Buyer
& Co. Because the carrier can perform its contract by delivering to the
named person (Buyer & Co.), Buyer need not present the bill of lading or
even have taken possession of it. See UCC 7–403; UCC 7–102(a)(9); UCC
7–404.
Buyer may have bought the goods for resale (to, say, C). If C contracts
to buy the goods before Buyer takes delivery, Buyer will give written
instructions to the carrier to deliver the goods to C, thereby entitling C to
enforce the carrier’s delivery obligation. See UCC 7–403; UCC 7–102(a)(9).
In this way, Buyer can transfer control over the goods without taking
possession of them. Note, however, that although notification of the carrier
entitles C to obtain delivery, the carrier nevertheless may honor Seller’s
instruction to stop delivery if it wishes to do so. See UCC 7–403(a)(4); UCC
2–705.
Under the negotiable bill of lading, the carrier agrees to deliver the
goods to the order of a stated person, e.g., “to the order of Seller & Co.,” or
occasionally to “bearer.” The carrier’s delivery obligation runs to the holder
of the document. See UCC 7–403; UCC 7–102(a)(9); UCC 1–201(b)(21). If the
document runs to the order of Seller but the person to receive the goods is
someone other than Seller (say, Buyer or C), then Seller must indorse and
deliver the bill of lading to that person so that the person becomes a holder.
One of the important practical consequences of shipping under a
negotiable bill of lading is that the carrier will deliver the goods only to one
who surrenders the bill of lading. See UCC 7–403(c)(1). If Seller wants to be
sure of being paid before Buyer gets the goods, Seller may use a negotiable
bill of lading, consign the shipment to the order of Seller, and thereby
maintain control over the goods until Buyer pays. When Seller (or, more
often, its local agent) receives payment, the agent will deliver the indorsed
bill of lading to Buyer. At that point Buyer can take the bill of lading to the
carrier and receive the goods.
Warehouse Receipts. Warehouse receipts (receipts issued by a person in
the business of storing goods for hire, see UCC 1–201(b)(42), function much
like bills of lading: They serve as a receipt for goods delivered to a bailee, set
forth the terms of the contract between the bailor and bailee (warehouse),
and enable parties to transfer control over goods without the need to take
possession of them. Like bills of lading, warehouse receipts may be
negotiable or nonnegotiable, depending upon their form. See UCC 7–104.
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Nature delivers great crops at annual harvests, while consumption is
gradual throughout the year. Consequently, commodities of enormous value
must be kept in storage pending processing, distribution, and use. Other
commodities—like fuel oil—are stored in large quantities because their use
is seasonal. In other instances, storage is a significant part of preparation
for use. Seasoning for years in charred oak barrels is of the essence in
making good whiskey. Warehouse receipts may be employed as a means for
traders to deal in these goods without the inconvenience of physical
delivery. A slightly different use arises when a concern, such as a brewer or
a mill, needs to hold commodities that tie up more capital than it can spare.
Using warehouse receipts as collateral may facilitate a low-interest loan
that otherwise would not be available.
A negotiable warehouse receipt and a nonnegotiable warehouse receipt
are reproduced below on pages 80 through 83.
Purchasers of Documents of Title. A person who buys a warehouse
receipt or bill of lading, or a creditor who takes such a document of title to
secure a loan, wishes to be sure that it takes both the document and the
goods free from the claims of third parties, including secured parties. The
first three Problems below address some of the risks that a purchaser runs
in this regard. A purchaser also wishes to take free of any defenses the
issuer (warehouse or carrier) may raise to its delivery obligation. Problem
1.3.4 and the Notes following address three of these potential defenses as
they apply to warehouse receipts: nonreceipt (the warehouse never received
the goods); misdescription (the goods actually received were not as described
in the receipt); and disappearance (the goods disappeared).
Electronic Documents of Title. Although UCC Article 7 originally
contemplated only written documents of title, the storage and
transportation industries have begun to use electronic documents. The first
statutory basis for electronic documents appeared in the United States
Warehouse Act, which authorizes the use of electronic warehouse receipts
covering cotton and contains provisions specifically addressing security
interests in cotton covered by an electronic receipt. See 7 U.S.C. § 259(c)
(repealed 2000). In 2000 the Act was amended to authorize the use of
electronic documents covering other agricultural products as well. See 7
U.S.C. § 241 et seq.
We saw in Section 2, supra, that the Uniform Electronic Transactions
Act provides a statutory framework for the transfer of an electronic record
that would be a note under UCC Article 3 if it were in writing. The same
framework applies to an electronic record that would be a document under
Article 7 if it were in writing. As with electronic notes, an electronic
document (warehouse receipt or bill of lading) is a “transferable record”
under UETA only if the issuer of the electronic record expressly agrees that
the record is to be considered a “transferable record.” See UETA 16(a). A
person can become the holder of a transferable record and acquire the same
SECTION 3
rights as a holder of an equivalent document under Article 7 by having
“control” of the electronic record. Id. A person who has control and also
satisfies the requirements of UCC 7–501 acquires the rights of a holder to
whom a negotiable document of title has been duly negotiated
(“HTWANDOTHBDN”). UETA 16(d).
Revised Article 7 borrowed from the UETA structure and concepts. It
explicitly contemplates the use of electronic documents of title as well as
tangible documents of title. See Revised Article 7, Prefatory Note; UCC
1–201(b)(16) (defining “document of title” and explaining the meaning of
“electronic document of title” and “tangible document of title”). It provides
explicitly that due negotiation of an electronic document of title can be
effected through the voluntary transfer of “control.” See UCC 1–201(b)(15)
(defining “delivery); UCC 7–501(b) (due negotiation of electronic document
of title); UCC 7–106 (control of electronic document of title).
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NEGOTIABLE WAREHOUSE RECEIPT
[Front—Printed on Green Paper—Reduced in Size]
SECTION 3
NONNEGOTIABLE WAREHOUSE RECEIPT
[Front—Printed on White Paper—Reduced in Size]
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NEGOTIABLE OR NONNEGOTIABLE WAREHOUSE RECEIPT
[Back— Printed on Same Color Paper as Front]
SECTION 3
NEGOTIABLE OR NONNEGOTIABLE WAREHOUSE RECEIPT
[Back— Printed on Same Color Paper as Front]
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A warehouse receipt embodying the obligation of the bailee to deliver
goods has some similarity to a promissory note embodying the obligation of
the maker to pay money. After you have worked through the following three
Problems, consider the following: To what extent are the rules applicable to
the transfer of warehouse receipts similar to those applicable to the transfer
of negotiable instruments calling for the payment of money? To what extent
are they similar to those applicable to the transfer of the goods themselves?
To what extent must a person acquire the status of HTWANDOTHBDN in
order to take free of claims to the goods and defenses of the warehouse? To
what extent does such a holder enjoy the same freedom from claims and
defenses as a holder in due course?
Problem 1.3.1. A warehouse receipt covering 600 barrels of whiskey
was issued to “Old Soak Beverage Company or order.” In preparation for a
proposed sale of the whiskey to another company, the president of Old Soak
(A) indorsed the Company’s name on the receipt. That night, Sal Sly (B), an
ambitious bookkeeper, arranged to work late and took the receipt from the
vault. Sly delivered the receipt to a friend in the liquor business (C), who
sold and delivered the receipt to DT Beverage Company (D) for $120,000
cash (the fair market value). Both Sly and the friend disappeared.
(a) Who has the better claim to the whiskey? See UCC 7–104; UCC
7–502; UCC 7–501(a).
(b) Suppose D is Downtown Bank, which took the receipt to secure a new
$25,000 loan. Is A’s claim of ownership of the whiskey superior to D’s
security interest in it? Would the answer change if D took the warehouse
receipt to secure a preexisting, unsecured loan?
(c) What result if B, rather than C, sold and delivered the warehouse
receipt to DT Beverage Company? See UCC 7–501(a)(5) and Comment 1;
UCC 7–504(a). Does the statutory text adequately support the Comment?
(d) Suppose that A’s president had not endorsed the document, but that
B supplied a clever imitation of the president’s signature. Is A or D entitled
to the whiskey? See UCC 7–502(a); UCC 7–501(a)(5) (“negotiated”) (“the
named person’s indorsement”); UCC 7–504(a).
(e) Suppose that the warehouse receipt ran “for the account of Old Soak
Beverage Company.” Is A or D entitled to the whiskey? See UCC 7–104;
UCC 7–504.
Problem 1.3.2. Old Soak Beverage Company (A) instructed Dale Driver
(B), one of its truck drivers, to haul 100 barrels of whiskey from Old Soak’s
warehouse to the bottling works. Instead, Driver hauled the whiskey to
Waiting Warehouse Company, stored the whiskey, and took a warehouse
receipt deliverable to “Dale Driver or order.” Driver then indorsed and
delivered the warehouse receipt to Creative Finance Company (C) to secure
a previously unsecured note. Driver is unable to pay the note, and both
Creative Finance and Old Soak claim the whiskey.
SECTION 3
(a) Who prevails? See UCC 7–502; UCC 7–503; UCC 7–504; Note on
Authority and Power of Disposition, infra.
(b) What result if Driver had negotiated the receipt to a friend in the
liquor business, who had negotiated it to Creative Finance?
Problem 1.3.3. While its own warehouse was being refurbished, Old
Soak Beverage Company (A) temporarily stored several hundred barrels of
whiskey with B, a competitor. Without Old Soak’s consent, B delivered the
goods to Waiting Warehouse Company, which issued a negotiable
warehouse receipt to “B or order.”
(a) B indorsed and delivered the receipt to DT Beverage Company (C),
which promised to pay fair value for the whiskey in 30 days and did not
suspect B’s wrongdoing. Who has the better claim to the whiskey, A or C?
Would the answer change if the warehouse receipt were nonnegotiable?
(b) What result if B indorsed and delivered the negotiable warehouse
receipt to Downtown Bank, which took the receipt to secure a new loan and
did not suspect B’s wrongdoing? Would the answer change if the warehouse
receipt were nonnegotiable?
(c) Compare your answers to this Problem with your answers to Problem
1.1.6 on page 16, supra. Can you account for the differences in result?
NOTE ON AUTHORITY AND POWER OF DISPOSITION
Problem 1.3.2 invites you to consider, inter alia, whether Driver had
“actual or apparent authority to ship, store, or sell” the whiskey. UCC
7–503(a)(1)(A). Section 2.02(1) of the Restatement (2006) explains that an
agent has actual authority to take action designated or implied in the
principal's manifestations to the agent. An agent also has actual authority
to take acts necessary or incidental to achieving the principal's objectives.
In determining whether action was designated or implied in the principal’s
manifestations and whether acts are necessary or incidental to achieving
the principal's objectives, one is to look to how the agent reasonably
understands the manifestations and objectives when the agent determines
how to act.
What is the least actual authority that would empower Driver to pass
good title under U CC 7–502 and 7–503? Consider: (i) actual authority to
transport the whiskey to Old Soak’s warehouse; (ii) actual authority to
transport the whiskey to Waiting Warehouse; (iii) actual authority to deliver
the whiskey to a named purchaser; (iv) actual authority to complete a sale
to a named purchaser at a named price.
The near demise of law school courses in Agency makes it desirable to
underline the limited applicability of the term “apparent authority” in UCC
7–503(a)(1). Section 2.03 of the Restatement (Third) of Agency (2006)
provides that:
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Apparent authority is the power held by an agent or other actor to affect
a principal's legal relations with third parties when a third party
reasonably believes the actor has authority to act on behalf of the
principal and that belief is traceable to the principal's manifestations.
Note that, unlike actual authority, which depends upon the agent’s
reasonably understanding of the principal’s manifestations, apparent
authority focuses on a third party’s reasonable belief that one person is
authorized to act on behalf of the principal. The third party’s belief must be
traceable to the principal. As comm ent c to section 2.03 explains, “An agent’s
success in misleading the third party as to the existence of actual authority
does not in itself make the principal accountable.”
Does the notion of “apparent authority” extend to the situations covered
by the “entrusting” provision of UCC 2–403(2), discussed in Section 1,
supra? Even if it does not, “power of disposition” under UCC 2–403 affords
an alternative ground for depriving a person of its ownership interest or
security interest in the goods when that interest comes in conflict with a
claim of a HTWANDOTHBDN. UCC 2–403(2) affords a merchant to whom
goods have been entrusted and who deals in goods of that kind the “power
to transfer all rights of the entruster to a buyer in ordinary course of
business.” As the Notes on Entrustment, supra, pages 16 ff., suggest, the
merchant does not enjoy the power to transfer the entruster’s rights to other
(non-buyer) purchasers. Does UCC 7–503(a)(1) expand this “power of
disposition”? Should it?
Note that even if B (in Problems 1.3.2 and 1.3.3) has “actual or apparent
authority” or “power of disposition,” Old Soak is not necessarily out of luck.
See the last clause of UCC 7–501(a)(5).
(B) D EFENSES
Problem 1.3.4. A fraudulently induced the W warehouse to issue a
negotiable warehouse receipt for $100,000 worth of cotton that was not
delivered to it. A duly negotiated the receipt to B, who did not suspect the
fraud and paid A $100,000.
(a) What are B’s rights against W? See UCC 7–203. See Note (1) on the
Scope of the Warehouse’s Responsibility, infra. (As to B’s recourse against
A, see UCC 7–507.) Would it make a difference if the warehouse receipt had
not been indorsed? If it had not been negotiable?
(b) What result if the receipt had covered barrels of whiskey instead of
bales of cotton and the barrels had contained water? (Is the answer affected
by any of the language of the form warehouse receipts?)
(c) What result if W had received the cotton from A but had lost it in
some way? See UCC 7–204; Note (2) on the Scope of the Warehouse’s
Responsibility, infra. (Is the answer affected by any of the language of the
form warehouse receipts?)
SECTION 3
NOTES ON THE SCOPE OF THE WAREHOUSE’S RESPONSIBILITY
(1) Non–Receipt and Misdescription of Goods. What risks does a
secured party take when its collateral consists of goods covered by a
document of title? The problems in this section address the risk of
competing claims to documents of title and priority conflicts. But there are
other risks. For example, what if the warehouse never received the goods
that the document purports to cover (called “nonreceipt”)? What if the goods
are not as described in the warehouse receipt (called “misdescription”)?
Under UCC 7–203, a warehouse is liable in damages to a party to a
warehouse receipt or to a good faith purchaser for value of the warehouse
receipt in the case nonreceipt or misdescription. Note that UCC 7–203
works in favor of all good faith purchasers for value, whether or not the
purchaser takes by due negotiation and even if the warehouse receipt is
nonnegotiable.
What UCC 7–203 gives may easily be taken away. UCC 7–203(1)
provides that the warehouse is not liable to the extent that the warehouse
receipt “conspicuously indicates that the issuer does not know whether all
or part of the goods in fact were received or conform to the description,” but
only if “the indication is true.” The section also provides examples of such
conspicuous indications, including “‘contents, condition, and quality
unknown’.” These disclaimers are standard. For example, examine again the
front pages of the warehouse receipts on pages 80 and 81 and note the
exculpatory language. Damages also will not be available if the party or
purchaser “otherwise has notice” of the nonreceipt or misdescription. UCC
7–203(2).
To the extent a warehouse makes a conspicuous disclaimer on the
warehouse’s receipt that is effective under UCC 7–203, and the disclaimer
is true, a party or purchaser cannot recover from the warehouse. As an
alternative to seeking recovery from the warehouse, a purchaser can seek
damages from its transferor for breach of warranty under UCC 7–507. Of
course, if the transferor is insolvent or judgment-proof, that claim may have
little value.
In many situations, the liability of a warehouse may be much less of an
issue than the effectiveness of a limitation in the warehouse receipt on the
amount for which A may be liable. See, e.g., Section 11(C) of the form of
warehouse receipt (p. 82). Typically, damages are limited to amounts that
are nominal in comparison with the value of stored goods. However, such
limitations are “not effective with respect to the warehouse’s liability for
conversion to its own use.” UCC 7–204(b) (2d sentence).
(2) Liability When Goods “Disappear”: I.C.C. Metals v. Municipal
Warehouse. Under UCC 7–204(a), a warehouse is liable for loss of (or
injury to) the goods caused by its failure to exercise reasonable care but is
not liable for damages that could not have been avoided by the exercise of
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such care. Observe that this section does not limit the universe of potential
plaintiffs to holders to whom negotiable warehouse receipts have been duly
negotiated or even to holders of negotiable warehouse receipts. Note as well
that the standard of care imposed by UCC 7–204(a) cannot be disclaimed.
UCC 1–302.
Although the burden of going forward with evidence normally rests on
the plaintiff (here, the bailor), a number of cases applying former 7–204
have imposed this burden on the defendant warehouse.2 Of particular
interest is I.C.C. Metals, Inc. v. Municipal Warehouse Co., 50 N.Y.2d 657,
431 N.Y.S.2d 372, 409 N.E.2d 849 (1980), in which a commercial warehouse
informed the bailor, an international metals trader, that it was unable to
locate three lots (845 pounds) of an industrial metal called indium that it
had taken for storage. The bailor commenced an action in conversion,
seeking to recover the value of the indium, $100,000. The warehouse
contended that the metal had been stolen through no fault of its own and
that, in any event, the terms of the warehouse receipt limited the bailor’s
potential recovery to a maximum of $50 per lot, or $150. (The limitation
complied with F7–204(2).)
The trial court granted summary judgment for the bailor for the full
value of the metal. It found that the bailor had made out a prima facie case
of conversion by proffering undisputed proof that the indium had been
delivered to the warehouse and that the warehouse had failed to return it
upon a proper demand. The court concluded that the warehouse’s contention
that the metal had been stolen was completely speculative and that the
warehouse had failed to raise any question of fact sufficient to warrant a
trial on the issue. Finally, the trial court held that the contractual limitation
upon liability was inapplicable to a conversion action. The Appellate
Division affirmed, as did the Court of Appeals.
The Court of Appeals observed that F7–204 contemplated that “a
warehouse which fails to redeliver goods to the person entitled to their
return upon a proper demand, may be liable for either negligence or
conversion, depending upon the circumstances.” Moreover, “although the
merely careless bailee remains a bailee and is entitled to whatever
limitations of liability the bailor has agreed to, the converter forsakes his
status as bailee completely and accordingly forfeits the protections of such
limitations.” See F7–204(2).
In negligence cases, the established rule in New York is that once the
plaintiff proffers proof of delivery to the defendant warehouse, of a proper
demand for its return, and of the warehouse’s failure to honor the demand,
then “the warehouse must come forward and explain the circumstances of
the loss of or damage to the bailed goods upon pain of being held liable for
2. The substance of the provisions of F7–204 discussed in the text are the same as
those of UCC 7–204.
SECTION 3
negligence.” For the first time, the court unambiguously applied the same
burden-shifting rule to conversion cases. Thus, unless the warehouse comes
forward with “an explanation supported by evidentiary proof in admissible
form,” the plaintiff will not be required to prove that the warehouse
converted the goods.
Applying this rule to the explanation presented by the warehouse, the
court stated the following in a footnote:
Viewed most favorably to defendant, this evidence would indicate at
most that theft by a third party was one possible explanation for the
defendant’s failure to redeliver the indium to plaintiff. This is simply
insufficient, since the warehouse is required to show not merely what
might conceivably have happened to the goods, but rather what actually
happened to the goods. Defendant proved only that theft was possible,
and presented no proof of an actual theft. Hence, the proffered
explanation was inadequate as a matter of law.
409 N.E.2d at 853 n.3. The bailor having made a prima facie case of
conversion and the warehouse having failed to present an adequate
explanation, the bailor was entitled to summary judgment. Inasmuch as
judgment was entered for conversion, rather than for negligence, the
contractual limitation of damages became ineffective, see F7–204(2) (2d
sentence), and the bailor became entitled to recover the actual value of the
missing indium.
A dissenting opinion accused the majority of “eras[ing] the critical
distinction between negligence and conversion” and “doing violence to the
law, without rhyme or reason.” What policy considerations support imposing
on the warehouse the burden of going forward with an explanation of what
happened to the goods when negligence is alleged? Do these considerations
support the two principal rulings in I.C.C. Metals : (i) permitting a plaintiff
to sustain a conversion action without proving any intentional wrongdoing
by the defendant and (ii) rendering ineffective a contractual limitation on
liability entered into between two commercial parties? In practical effect,
how far removed is the approach in I.C.C. Metals from the imposition of
absolute liability on the warehouse? Is the result consistent with the
standard of “care” in UCC 7–204(a)? Judicial response to I.C.C. Metals has
been mixed, and Comment 4 to UCC 7–204 expressly disapproves the
holding in the case.
(3) The Great “Salad Oil Swindle.” Questions of warehouse
responsibility in excelsis arose in connection with the 1963 disappearance
from field warehouse tanks in Bayonne, New Jersey, of over a billion
pounds of vegetable oils—one of the great commercial frauds of modern
times. Leading banks in the United States and Britain had made loans
totaling $150 million “secured” by warehouse receipts for oil for which the
bailee was unable to account. See Procter & Gamble Distrib. Co. v.
Lawrence American Field Warehousing Corp., 16 N.Y.2d 344, 266 N.Y.S.2d
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785, 213 N.E.2d 873 (1965); N. Miller, The Great Salad Oil Swindle (1965);
Brooks, Annals of Finance: Making the Customer Whole, The New Yorker,
Nov. 14, 1964, at 160.
(4) Warehouses, Carriers, and Statutory Interpretation. An
interesting (and puzzling) contrast is presented by the UCC’s language on
the responsibility of warehouses (UCC 7–204) and the provision on the
responsibility of carriers (UCC 7–309). Subsection d of UCC 7–204 states,
“This section does not modify or repeal . . .” and invites each state’s
legislature to insert a reference to any statutes that may impose a higher
responsibility on the warehouse or invalidate a contractual limitation on
liability. On the other hand, UCC 7–309(a) on the responsibility of carriers,
after articulating the “reasonably careful person” test, adds: “This
subsection does not affect any statute, regulation, or rule of law that imposes
liability upon a common carrier for damages not caused by its negligence”
(emphasis added). The phrase “rule of law” (as contrasted with the reference
to specific statutes in UCC 7–204) provides access to (and possibly
development of) the broad common-law liability of carriers as insurers of
goods.3 Note, however, that UCC 7–309(b) affords carriers the opportunity
to limit damages. Do the reasons that led to the absolute liability of carriers
apply to warehouses? Does the difference between the approaches of these
two sections of the UCC bar the extension by analogy of absolute liability to
warehouses? Would the failure of a warehouse to carry insurance protecting
both itself and the owner constitute a default in the “reasonable care”
standard? If so, should the net result be simplified by a change in the
language of the UCC?
In the drafting of statutory provisions like those of Article 7, who are
likely to be more vocal—warehouses or those who may store goods with
warehouses? In construing statutes that are reasonably susceptible to two
interpretations, should courts give voice to those who are less vocal during
the legislative process? Cf. Restatement (Second) of Contracts § 206 (1981)
(“In choosing among the reasonable meanings of a promise or agreement or
a term thereof, that meaning is generally preferred which operates against
the party who supplies the words or from whom a writing otherwise
proceeds.”). Or should courts assume that the squeaky wheel got the grease
and construe the statute to favor the “prevailing” interests?
(C) D ISCHARGE
Problem 1.3.5. A, a dealer in cotton, deposited $100,000 worth of cotton
3. Federal law codifies the common-law liability of certain carriers for loss or
injury to goods in interstate shipments, imports, and exports. See 49 U.S.C. §§ 11706,
14706 (imposing liability for “actual loss or injury to the property caused by” certain
carriers). For certain carriers, the remedies provided “are in addition to remedies
existing under another law or common law.” 49 U.S.C. § 13103.
with the W warehouse, which issued a nonnegotiable warehouse receipt to
A. A transferred the receipt to B, who paid B $100,000. Later, on demand by
A, W redelivered the cotton to A.
(a) Is W liable to B? See UCC 7–403; UCC 7–102(a)(9); UCC 7–404.
Would it make a difference if B had notified W of the transfer before W’s
redelivery to A? See UCC 7–504.
(b) What result if the warehouse receipt had been a negotiable one,
which was issued to A’s order and negotiated to B? See UCC 7–502.
(c) What is the relationship, if any, between the results of the preceding
parts and the results of Problems 1.2.13(a) and 1.2.14(a), supra, page 70?
(D) “S PENT” D OCUMENTS
Problem 1.3.6. A, a dealer in cotton, deposited $100,000 worth of cotton
with the W warehouse, which issued a nonnegotiable warehouse receipt to
A. On demand by A, W redelivered the cotton to A but left the “spent”
warehouse receipt in A’s hands. A transferred the receipt to B, who paid A
$100,000 without knowing that W previously had redelivered the cotton to
A.
(a) Is W liable to B? See UCC 7–403; R7–102(a)(9); UCC 7–504.
(b) What result if the receipt had been a negotiable one, which was
issued to A’s order? Assume that after redelivering the cotton to A, W left
the “spent” warehouse receipt in A’s hands without any notation on it. (See
the notations on the form on page 80.) See UCC 7–502.
(c) What is the relationship, if any, between the results of the preceding
parts and the results of Problems 1.2.15 and 1.2.16(a), supra, page 74?
NOTE ON “SPENT” BILLS OF LADING
A railroad delivered goods without requiring surrender of the negotiable
bill of lading. Months later the holder of the bill of lading changed the dates
to reflect a current transaction and negotiated it to a bank as security for a
loan. The bank was denied recovery against the railroad on the ground that,
in view of the intervening “forgery,” the railroad’s default was not the
“proximate cause” of the bank’s loss. Saugerties Bank v. Delaware &
Hudson Co., 236 N.Y. 425, 141 N.E. 904 (1923) (4–3 decision). The result has
been sharply criticized. See Fulda, Surrender of Documents of Title on
Delivery of the Property, 25 Cornell L.Q. 203 (1940). The UCC seems not to
have dealt with this problem. See UCC 7–306; UCC 7–403(c); UCC
7–501(a)(5); UCC 7–502(1)(d) and Comment 3. Could a warehouse make an
equally strong argument for freedom of liability on a “spent” warehouse
receipt? Cf. American Cotton Cooperative Association v. Union Compress &
Warehouse Co., 193 M iss. 43, 7 So.2d 537, 139 A.L.R. 1483 (1942).
91

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